Item 1. Business......................................................... 3 Item 2.
ITEM 2. PROPERTIES
Our principal corporate offices are located in Los Angeles, California where we lease approximately 64,000 square feet under a lease that expires in 2010. In addition, we currently lease approximately 1,400 square feet for our New York sales office under a lease that expires in November 2002 and lease approximately 3,500 square feet for our San Francisco office under a lease that expires in May 2002. We expect that our current space will accommodate our needs for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may be involved in litigation relating to claims arising out of our ordinary course of business. We are not presently involved in any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
ARTISTDIRECT's common stock is listed for quotation on the Nasdaq National Market under the symbol "ARTD." The following table sets forth, for the periods indicated, the high and low closing sale prices for our common stock as reported by Nasdaq since our initial public offering which was completed in March 2000:
On March 15, 2001, the closing sale price for our common stock as reported by Nasdaq was $0.7812.
HOLDERS
As of March 15, 2001, there were 130 holders of record of our common stock.
DIVIDENDS
We have never paid any cash dividends on our common stock and we have no current plans to do so.
SALES OF UNREGISTERED SECURITIES
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data with respect to ARTISTDIRECT's consolidated statements of operations for the years ended and consolidated balance sheets as of December 31, 2000, 1999, 1998, 1997 and 1996 are derived from the audited Consolidated Financial Statements of the company. The following information should be read in conjunction with the Consolidated Financial Statements of the company and the related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K.
(1) The loss from continuing operations per common share is for the period from October 1, 1999 through December 31, 1999. The Company was merged into a C corporation on October 6, 1999. Consequently, there is no loss per share before that date as the Company was an LLC.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The following discussion should be read in conjunction with our consolidated financial statements and the notes to those financial statements included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties. The statements are based on current expectations and actual results could differ materially from those discussed herein. Factors that could cause or contribute to the differences are discussed in "Risk Factors" and elsewhere in this Annual Report on Form 10-K.
OVERVIEW
We are an online music company that connects artists directly with their fans worldwide. We provide music entertainment through our ARTISTdirect Network, an integrated network of Web sites offering multi-media content, music news and information, community around shared music interests, and music-related commerce. As of December 31, 2000, ARTISTdirect featured 125 unique, artist-owned ARTISTchannels, and had signed agreements to launch channels with an additional 11 artists. The ARTISTdirect Network also features the UBL, a music search engine on the Web, iMusic, a popular online community where fans exchange music interests and commentary and Digital Music, a feature that allows users to download music, both free and paid, stream promotional tracks and listen to Internet radio stations on the ARTISTdirect Network. We also operate a music talent agency, the ARTISTdirect Agency. Prior to June 30, 2000, we also managed a traditional record label, Kneeling Elephant Records, which we no longer operate.
ARTISTdirect was organized as a California limited liability company in August 1996 and conducts operations through a group of affiliated limited liability companies. From inception through December 1996, our primary activities consisted of developing our business model, recruiting and training employees and developing our infrastructure. During 1997, our operations consisted primarily of the ARTISTdirect Agency and the Kneeling Elephant Records label. In July 1997, we formed a joint venture to own a controlling interest in UBL, LLC.
In September 1997, we launched our first ARTISTchannel. In June 1998, we expanded content offerings on the UBL and added an online retail store now known as the ARTISTdirect Superstore. Also in June 1998, we launched our second ARTISTchannel and, by the end of 1998, we had nine ARTISTchannels in operation.
In February 1999, ARTISTdirect acquired all of the outstanding capital stock of iMusic, Inc. The purchase consideration for iMusic was approximately $2.5 million, including $110,000 in cash, a redeemable put option valued at approximately $2.2 million and the assumption of approximately $180,000 in liabilities. The acquisition was accounted for as a purchase. The purchase price has been largely allocated to goodwill, which is being amortized over five years.
In May 1999, we engaged in an exchange transaction in which all membership interests in UBL, LLC that we did not own were exchanged for membership interests in ARTISTdirect, LLC. The value of the consideration given was approximately $13.9 million and the transaction was accounted for as a purchase. The purchase price has been largely allocated to goodwill, which is being amortized over five years.
In July 1999, we officially launched the ARTISTdirect Network, integrating the UBL and iMusic Web sites with our ARTISTchannels. Since 1997, our revenue mix has shifted from primarily agency commissions and record label revenue to electronic commerce revenue and online advertising; however, given the recent industry-wide decrease in amounts spent on online advertising, we do not know if this trend will continue.
In August 2000, ARTISTdirect acquired all of the outstanding capital stock of Mjuice.com, Inc. The total purchase consideration for Mjuice.com was approximately $5.1 million. The acquisition was accounted for as a purchase. The purchase price has been largely allocated to goodwill, which is being amortized over five years.
ARTISTdirect has incurred cumulative net losses of $123.9 million from inception to December 31, 2000 of which approximately $48.5 million represented stock-based compensation expense. While we expect our net losses to decrease in the future, we do not expect to become profitable in the near future, and cannot assure you that we will ever achieve profitability. We have a limited operating history on which to base an evaluation of our business and prospects. Our prospects must be considered in light of the risks, expenses, and difficulties encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets, such as electronic commerce. See "Risk Factors" beginning on page 14 for a more complete description of the many risks we face. Our business is evolving rapidly, and therefore we believe that period-to-period comparisons of our operating results are not meaningful and should not be relied upon as an indication of future performance.
On October 6, 1999, ARTISTdirect, LLC merged into ARTISTdirect, Inc. Before that time, we operated as a group of limited liability companies and did not incur federal and state income taxes, other than iMusic, which is a Washington corporation that we acquired in February 1999. Federal and state income taxes attributable to income during such periods were incurred and paid directly by the members. Accordingly, no discussion of income taxes is included in "Results of Operations" beginning on page 29. Any tax benefit attributable to losses generated before our conversion will not be available to us. As a Delaware corporation, we are fully subject to federal and state income taxation.
REVENUE
We generate revenue from the ARTISTdirect Network, the ARTISTdirect Agency, and, prior to June 30, 2000, also generated revenue from Kneeling Elephant Records. Substantially all of our revenue is generated in cash. Trade and barter revenue represented approximately 1% of our revenue for the year ended December 31, 2000 and less than 1% for the year ended December 31, 1999.
Revenue from the ARTISTdirect Network consists primarily of online product sales and advertising revenue as described below:
- Revenue from online product sales includes the sale of music and related merchandise, such as apparel, collectibles and accessories, through our ARTISTchannels and the ARTISTdirect Superstore. We recognize the gross amount of product sales and shipping revenue upon shipment of the item and record appropriate reserves for product returns. We have experienced seasonality with respect to our online product sales. In particular, our online product sales in December have, on average, been higher than in other months. We believe that this trend may continue for the foreseeable future. For the years ended December 31, 2000 and 1999, online product sales revenue constituted approximately 56% and 51%, respectively, of our total net revenue for those periods.
- Advertising revenue consists primarily of sales of banner advertisements and sponsorships. In sales of banner advertisements, we principally earn revenue based on the number of impressions or times an advertisement appears on pages viewed within our Web sites. Our banner advertising commitments generally range from one to three months. Banner advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of ARTISTdirect remain and collection of the resulting receivable is probable. We typically guarantee a minimum number of impressions to the advertiser. To the extent that minimum guaranteed page deliveries are not met, we defer recognition of the corresponding revenue until the guaranteed impressions are delivered. We also sell to advertisers sponsorships of a Web page or event for a specified period of time. We recognize sponsorship revenue over the period in which the sponsored page or event is displayed. To the extent that committed obligations under sponsorship agreements are not met, revenue recognition is deferred until the obligations are met. For the years ended December 31, 2000 and 1999, advertising revenue constituted approximately 29% and 28%, respectively, of our total net revenue for those periods.
Revenue from the ARTISTdirect Agency consists primarily of commissions generated on tour and event bookings of artists represented by the agency. Agency commission revenue is recognized at the time the artist gets paid. Agency commission revenue fluctuates depending on touring schedules of major artists represented by the agency. Touring schedules are subject to
seasonality, with summer typically being a more active period. For the years ended December 31, 2000 and 1999, commission revenue constituted approximately 14% and 13%, respectively, of our total net revenue for those periods.
Prior to June 30, 2000, revenue from Kneeling Elephant Records was generated from overhead advances and from royalties earned on albums sold by artists signed to the label. We recognized royalties at the time the releases were shipped to the retailer. Reserves were established for possible returns.
During the year ended December 31, 2000, Pringles, a division of Procter & Gamble, accounted for 11% and Universal Music Group accounted for 16% of the Company's advertising revenue.
During the fourth quarter of 2000 and the first quarter of 2001, we laid off 105 employees. We expect this to help us decrease our net loss and conserve our cash resources given prevailing market conditions.
We have received notice from Nasdaq that our shares of common stock will be delisted from the NASDAQ National Market and have received a hearing date of April 12, 2001 with Nasdaq regarding its decision to delist our shares. While we believe our common stock will continue to be listed on the NASDAQ National Market during the pendency of such hearing process, we cannot assure you that our shares will not be delisted after the conclusion of the hearing process. Such delisting or a prolonged decline in the price of our stock may reduce the liquidity of our stock and adversely impact our ability to execute our business plan.
COST OF REVENUE
Cost of revenue consists primarily of amounts payable to artists, which includes the cost of merchandise sold and share of net proceeds, online transaction costs, including credit card fees, fulfillment charges and shipping costs, Web site hosting and maintenance costs, online content and programming costs, online advertising serving costs, record royalties payable to artists, payroll and related expenses for staff involved in Web site maintenance, content programming and the ARTISTdirect Agency, and amortization of non-cash compensation expense related to vendor warrants and ARTISTchannel stock options granted to artists and their advisors in connection with opening their ARTISTchannels. Artist royalties are based on electronic commerce and advertising revenue generated from their ARTISTchannels. Web site maintenance costs include personnel-related costs, software consulting costs, Internet hosting charges, and networking costs.
In connection with the amortization of vendor warrants and ARTISTchannel stock options granted through December 31, 2000, we recorded non-cash compensation expense of approximately $7.5 million for the year ended December 31, 2000 and approximately $1.8 million for the year ended December 31, 1999. We may grant additional equity instruments in the future related to ARTISTchannels. Due to these equity grants, we expect to record substantial non-cash compensation expense into the foreseeable future.
OPERATING EXPENSE
Web Site Development. Web site development expense consists primarily of expenses required to design and develop our Web sites and underlying technology infrastructure. These expenses primarily include payments to third-party service vendors and personnel costs.
Sales and Marketing. Sales and marketing expense consists primarily of advertising, marketing and promotion expenses incurred to promote our Web sites and our brands, plus payroll and related expenses for personnel engaged in advertising sales, business development, marketing and customer service activities.
General and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel, professional services expenses, facilities expenses, travel and other general corporate expenses.
Amortization of Stock-based Compensation. We recorded a total of $39.2 million of stock-based compensation expense for the period from inception through December 31, 2000 in connection with equity granted to employees, directors, professional firms, artists and advisors during this period. We recorded amortization of stock-based compensation expense of $5.1 million and $30.3 million during the years ended December 31, 2000 and 1999. We anticipate granting additional equity securities in the future to employees, directors and artists.
The Company is currently anticipating initiating a rescission offer during the second quarter of 2001 with respect to options and shares of its common stock issued prior to its initial public offering. To the extent that employees holding options, subject to the rescission offer, accept the offer, the Company will record compensation expense for such payments, which could be significant. The amount of expense recorded for the repurchase of unexercised stock options from employees shall be the sum of the intrinsic value at the original measurement date (less any expense related to the intrinsic value recorded up to the acceptance of the rescission offer) and the amount of cash paid to the holder that exceeds the lesser of the intrinsic value at the original measurement date or immediately prior to settlement. The amount of expense that shall be recorded for the repurchase of unexercised non-employee options shall be the difference between the amount paid for each option and the fair value of the options on the date the repurchase offer is accepted. The fair value of the options shall be determined using the Black-Scholes option pricing model over the remaining expected life of the options. Any unamortized expense at the time of repurchase related to the initial grant of the options to the non-employees shall continue to be amortized over the remaining service period related to the original option grants. The Company shall also record as expense for the repurchase of shares issued pursuant to the exercise of options the difference between the cash paid for the repurchase of the shares and the fair value of the shares on the date the repurchase is accepted. The amount of expense will vary depending on the number of individuals that accept the rescission offer and the Company's stock price on the date any rescission is consummated.
Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of fixed assets and the amortization of acquired intangible assets. The acquisitions of iMusic, Mjuice and the minority interest of the UBL were accounted for using the purchase method of accounting and, accordingly, the purchase prices have been allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their fair value on the acquisition dates. Substantially all of the purchase price of these transactions is attributable to the acquired intangible assets. As a result, the aggregate excess purchase price over the net tangible assets to date has been estimated to be $20.6 million and is being amortized over five years, the expected estimated useful life of these assets. These non-cash charges will significantly affect our reported operating results over the next several years.
INTEREST INCOME AND EXPENSE
Interest income consists of earnings on our cash and cash equivalents and short-term investments, and interest expense consists of interest associated with short-term borrowings.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2000 AND 1999
NET REVENUE
Net revenue for the year ended December 31, 2000 increased to $21.7 million from $10.3 million for the year ended December 31, 1999, which represented an increase of 111%. The increase was due to increases in online product sales revenues, advertising revenue and agency commission revenue.
Online product sales revenue for the year ended December 31, 2000, increased 130% to $12.2 million from $5.3 million for the year ended December 31, 1999, primarily as a result of an increase in the number of ARTISTchannels that were operated.
Advertising and other revenue increased $3.4 million, or 117%, to $6.3 million for the year ended December 31, 2000, from $2.9 million for the year ended December 31, 1999, primarily as a result of an increase in the number of advertisers, increased page views generated by our Web sites plus a significant increase in the number of advertisers, primarily in sales of non-impression based sponsorships.
Commission revenue from the ARTISTdirect Agency increased from $1.3 million for the year ended December 31, 1999 to $2.9 million for the year ended December 31, 2000, which represented an increase of 126%, due primarily to increased touring activity of the agency's artists.
COST OF REVENUE
Direct cost of product revenue. Direct cost of product revenue increased to $10.4 million for the year ended December 31, 2000 from $5.1 for the year ended December 31, 1999, which represented an increase of 104%. This $5.3 million increase
corresponded with the increase in online product sales revenue and was primarily attributable to a $3.7 million increase in product and royalty costs payable to our vendors and artists and a $1.6 million increase in transaction costs.
Other cost of revenue. Other cost of revenue increased to $8.6 million for the year ended December 31, 2000, from $3.4 million for the year ended December 31, 1999, which represented an increase of 155%. This $5.2 million increase was primarily due to increases in Web site hosting and maintenance costs.
Stock-based compensation. For the year ended December 31, 2000, we recorded non-cash stock-based compensation charges of $7.5 million compared to $1.8 million for the year ended December 31, 1999. The stock-based compensation expense relates primarily to the amortization of the estimated value of the options, using the Black-Scholes method, given to artists in connection with the operation of their stores and is amortized over the life of the associated contract periods. As of December 31, 2000, $11.1 million of unearned compensation remains to be amortized. Of this amount, $6.2 million will be recorded as stock-based compensation expense in 2001, $4.8 million in 2002 and $196,000 in 2003.
OPERATING EXPENSE
Web Site Development. Web site development expense increased to $5.4 million for the year ended December 31, 2000, from $1.8 million for the year ended December 31, 1999, which represented an increase of 196%. This increase was primarily attributable to increased fees paid to third party service vendors relating to the continued development of our Web site, as well as an increase in the development costs of programming.
Sales and Marketing. Sales and marketing expense increased to $25.6 million for the year ended December 31, 2000 from $13.2 million for the year ended December 31, 1999, which represented an increase of 94%. The increase was primarily attributable to a significant increase in our online advertising expenditures, as well as increased offline advertising. We expect the growth rate of sales and marketing expenses to decrease in future periods.
General and Administrative. General and administrative expense increased to $17.9 million for the year ended December 31, 2000 from $10.3 million for the year ended December 31, 1999, which represented an increase of 73%. This increase was primarily attributable to increases in personnel and related expenses, facilities and outside professional services expenses. We expect the growth rate of general and administrative expense to decrease as we seek to operate more efficiently.
Amortization of Stock-based Compensation. We recorded stock-based compensation expense of $5.1 million for the year ended December 31, 2000 in connection with stock issuances to employees, directors, professional firms, artists and advisors for promotional services, which represented a decrease of 83% for the comparable period in 1999. Stock-based compensation for the comparable period in 1999 was $30.3 million, primarily in connection with stock issuances to employees, directors and professional firms. The expense during the year ended December 31, 2000 reflected a credit to stock-based compensation of $6.6 million related to stock appreciation rights granted to certain executives of the Company as a result of a reduction in the valuation of the Company's underlying common stock as compared with December 31, 1999. This credit was offset by $11.7 million of amortization of stock-based compensation expense related to options granted to employees, professional firms, artists and advisors.
Depreciation and Amortization. Depreciation and amortization expense increased to $6.2 million for the year ended December 31, 2000 from approximately $2.5 million for the year ended December 31, 1999, which represented an increase of 149%. This increase was primarily attributable to the amortization of the goodwill associated with the acquisition of iMusic, Mjuice and the minority interest in the UBL, as well as an increase in depreciation of fixed assets and amortization of leasehold improvements.
INTEREST INCOME AND EXPENSE
Interest income increased to $6.0 million for the year ended December 31, 2000 from $281,000 for the year ended December 31, 1999, which represented an increase of 2,024%. The increase is due to interest earned on higher cash balances resulting from the proceeds we received from our initial public offering in March 2000 and the Series C redeemable preferred shares issued in December 1999 and January 2000.
NET LOSS
Net loss increased to $59.3 million for the year ended December 31, 2000, compared to $57.8 million for the year ended December 31, 1999, which represented an increase of 3%. The increase in the net loss is primarily attributable to a $4.9 million
decrease in gross profit due to stock-based compensation related to artist store agreements, a $12.4 million increase in sales and marketing expense, a $7.6 million increase in general and administrative expense and a $3.7 million increase in depreciation and amortization expense, partially offset by a $25.2 million decrease in the amortization of stock-based compensation and a $5.7 million increase in interest income.
FISCAL YEARS ENDED DECEMBER 31, 1999 AND 1998
NET REVENUE
Net revenue increased to $10.3 million in the year ended December 31, 1999 from $4.6 million in the same period of 1998, which represented an increase of approximately 124%. The increase was primarily due to an increase in online product sales revenue to $5.3 million from $1.5 million, reflecting additional ARTISTchannels plus contributions from the ARTISTdirect Superstore. Advertising and other revenue also increased to $2.9 million from $552,000, which represented an increase of approximately 425%, reflecting an increase in the page views generated by our Web sites plus a significant increase in sales of sponsorships. Commission revenue from the ARTISTdirect Agency decreased from $1.9 million to $1.3 million, which represented a decrease of approximately 32%, due primarily to a decrease in the touring activity of the agency's artists.
COST OF REVENUE
Direct cost of product revenue increased to $5.1 million in the year ended December 31, 1999 from $1.5 million for the same period of 1998, which represented an increase of 240%. This $3.6 million increase corresponded with the increase in online product sales revenue and was primarily attributable to a related $2.4 million increase in royalties payable to artists and $1.1 million increase in transaction costs. Other cost of revenue increased to $5.1 million in 1999 from $1.0 million in 1998, which represented an increase of 410%. This $4.1 million increase was primarily due to a $2.0 million increase in Web site hosting and maintenance costs and $1.8 million of non-cash expense for the amortization of warrants issued to vendors and options issued to artists and their advisors related to our rights to operate ARTISTchannels. In total, in 1999 we recorded non-cash compensation charges of $15.5 million and such amount will be amortized to cost of revenue over the life of the contract periods associated with the warrants and options. Our overall gross profit margin decreased to 0.3% of net revenue for the year ended December 31, 1999 from 45% of net revenue for the year ended December 31, 1998, due to a higher proportion of online product sales revenue, which has lower gross margin than our other sources of revenue, and the increased costs detailed above.
OPERATING EXPENSE
Web Site Development. Web site development expense increased to $1.8 million for the year ended December 31, 1999 from $589,000 for the same period in 1998, which represented an increase of approximately 208%. This increase was primarily attributable to fees paid to third party service vendors relating to the development of the new ARTISTdirect Network Web site, which launched in July 1999.
Sales and Marketing. Sales and marketing expense increased to $13.2 million for the year ended December 31, 1999 from $1.4 million for the same period in 1998, which represented an increase of approximately 846%. The increase was primarily attributable to a significant increase in online and offline advertising, promotion and sponsorship. In addition, personnel and related expenses increased as we added to our advertising sales and marketing staffs.
General and Administrative. General and administrative expense increased to $10.3 million for the year ended December 31, 1999 from $2.5 million for the year ended December 31, 1998, which represented an increase of 305%. This increase was primarily attributable to a $3.0 million increase in personnel and related expenses and a $2.0 million increase in outside professional services expenses.
Amortization of Stock-based Compensation. We recorded a total of $30.3 million of stock-based compensation expense for the year ended December 31, 1999 in connection with stock issuances to employees, directors, professional firms and artists and advisors for promotional services which were being treated as variable stock compensation, which represented an increase of approximately 692% for the comparable period in 1998. Stock-based compensation for the comparable period in 1998 was $3.8 million, primarily in connection with stock issuances to employees, directors and professional firms.
Depreciation and Amortization. Depreciation and amortization expense increased to $2.5 million for the year ended December 31, 1999 from approximately $59,000 in the same period of 1998, which represented an increase of approximately
4,153%. This increase was primarily attributable to the amortization of the goodwill associated with the acquisition of iMusic and the minority interest in the UBL.
NET LOSS
Net loss increased to $57.8 million in the year ended December 31, 1999 compared to $6.3 million in the year ended December 31, 1998, which represented an increase of approximately 817%. The increase in the net loss can be primarily attributed to a $26.5 million increase in the amortization of stock-based compensation, $11.8 million increase in sales and marketing expense, $7.8 million increase in general and administrative expense, $2.5 million increase in depreciation and amortization expense and $2.0 million decrease in gross profit due to increased expenditures for Web site hosting, maintenance and content compared with the prior year.
LIQUIDITY AND CAPITAL RESOURCES
On March 31, 2000, we completed our IPO and raised net proceeds of approximately $52.4 million through the sale of 5,000,000 common shares. In addition, we raised an aggregate of $97.5 million of gross proceeds through the sale of 7,000,291 shares of Series C preferred stock in December 1999 and January 2000. In May 1999, we issued 3,750,0000 shares of Series B preferred securities in exchange for an aggregate purchase price of $15.0 million. Between July 1998 and December 1998, we issued 3,207,815 shares of Series A preferred securities in exchange for an aggregate purchase price of $4.9 million. Prior to July 1998, we financed our operations and growth entirely from internally generated cash flow and capital contributions from founders. As of December 31, 2000, we had $51.4 million of cash and cash equivalents, excluding cash held for clients, and held $36.4 million in short-term investments. In February 2001, we commenced a partial self-tender offer for up to 2,000,000 of our outstanding shares at a price per share not less than $1.25 and not greater than $1.50. Assuming that we purchase all 2,000,000 shares at the maximum purchase price of $1.50, we expect our out-of-pocket costs, including expenses associated with the tender offer, to be approximately $3.2 million, which we expect to fund from our existing cash and cash equivalents. We currently expect the tender offer to be consummated in the second quarter of 2001.
Net cash used in operating activities was $35.1 million for the year ended December 31, 2000, and $26.0 million and $2.3 million for the years ended December 31, 1999 and 1998, respectively. Net cash used in operating activities for each of these periods primarily consisted of net losses partially offset by non-cash items such as stock-based compensation and depreciation and amortization.
Net cash used in investing activities was $46.3 million for the year ended December 31, 2000, which consisted of purchases of fixed assets of $7.5 million, primarily computer equipment to support the ARTISTdirect Network, leasehold improvements to our corporate offices, the purchase of short-term investments of $36.4 million, and $2.0 million relating to the purchase of Mjuice.com, Inc. Net cash used was $4.4 million and $514,000 for the years ended December 31, 1999 and 1998, respectively, and consisted primarily of fixed asset purchases.
Net cash provided by financing activities was $63.7 million for the year ended December 31, 2000 which was principally attributable to the proceeds of our initial public offering in March 2000 in which we raised approximately $52.4 million, net of underwriters' discounts and offering costs, and $10.4 million raised from the sale of Series C preferred stock in January 2000, net of offering costs.
Net cash provided by financing activities was $97.6 million for the year ended December 31, 1999, and $4.6 million for the fiscal year ended December 31, 1998. Net cash provided by financing activities during each of these periods primarily consisted of cash proceeds from the following issuances of preferred securities:
- Between July 1998 and December 1998, we issued 3,207,815 shares of Series A preferred securities in exchange for an aggregate purchase price of $4.9 million.
- In May 1999, we issued 3,750,000 shares of Series B preferred securities in exchange for an aggregate purchase price of $15.0 million.
- In December 1999, we issued an aggregate of 5,905,374 shares of Series C preferred shares for a total purchase price of approximately $82.3 million.
As of December 31, 2000 our principal commitments consisted of obligations outstanding under operating leases and employment contracts.
We currently anticipate that our available cash resources will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. There can be no assurance, however, that the underlying assumed levels of revenues and expenses will prove to be accurate. Although we do not currently have any specific material capital commitments beyond such 12-month period, if we are unsuccessful in generating sufficient cash flow from operations, we may need to raise additional funds in future periods through public or private financings, or other arrangements to fund our operations and potential acquisitions. If any additional financing is needed, we might not be able to raise capital on reasonable terms or at all. Failure to raise capital when needed could seriously harm our business and operating results. If additional funds were raised through the issuance of equity securities, the percentage of ownership of our stockholders would be reduced. Furthermore, these equity securities might have rights, preferences or privileges senior to our common stock. We currently do not have any plans for future equity offerings.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board recently issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective date of FASB Statement No. 133" and SFAS 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities." These pronouncements become effective January 1, 2001 and establish accounting and reporting standards for derivative instruments and hedging activities by requiring that all derivative instruments be reported as assets or liabilities and measured at their fair values. Under SFAS 133, changes in the fair values of derivative instruments are recognized immediately in earnings unless those instruments qualify as hedges of the (1) fair values of existing assets, liabilities, or firm commitments, (2) variability of cash flows of forecasted transactions, or (3) foreign currency exposures on net investments in foreign operations. We are required to adopt SFAS No. 133 for the year ended December 31, 2000. The adoption of these pronouncements will not have an impact on our consolidated financial statements.
In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") 101, Revenue Recognition in Financial Statements. SAB 101 provides guidance on the recognition, presentation, and disclosure of revenue in financial statements of all public registrants. Any change in the Company's revenue recognition policy resulting from the implementation of SAB 101 would be reported as a change in accounting principle. In June 2000, the SEC issued SAB 101B which delayed the implementation date of SAB 101 until the fourth fiscal quarter of fiscal years beginning after December 15, 1999. The adoption of SAB 101 did not have an impact on our consolidated financial statements.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market rate risk for changes in interest rates is related primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. Our short term investments are comprised of U.S. government obligations and public corporate debt securities. Interest rate fluctuations impact the carrying value of the portfolio. We do not believe that the future market risks related to the above securities will have material adverse impact on our financial position, results of operations or liquidity.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and schedule, as listed under Item 14, appear in a separate section of this Annual Report on Form 10-K beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The sections titled "Executive Officers of the Company," "Directors and Nominees" and "Compliance with Section 16(a) of the Exchange Act" appearing in the Company's Proxy Statement for the 2001 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The section titled "Executive Compensation and Related Information" appearing in the Company's Proxy Statement for the 2001 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The section titled "Principal Stockholders" appearing in the Company's Proxy Statement for the 2001 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The section titled "Certain Transactions" appearing in the Company's Proxy Statement for the 2001 Annual Meeting of Stockholders is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1). FINANCIAL STATEMENTS
ARTISTDIRECT's financial statements appear in a separate section of this Annual Report on Form 10-K beginning on the pages referenced below:
(2) FINANCIAL STATEMENT SCHEDULE
ARTISTDIRECT's financial statement schedule appears in a separate section of this Annual Report on Form 10-K on the pages referenced below. All other schedules have been omitted as they are not applicable, not required or the information is included in the consolidated financial statements or the notes thereto.
(3) EXHIBITS
- -------------------------
* Incorporated by reference to the same exhibit in the Registrant's Registration Statement on Form S-1 (Registration Number 333-87547) initially filed on September 22, 1999, as amended by Amendment No.'s 1-7 thereto.
** Incorporated by reference to the same exhibit in the Registrant's Registration Statement on Form S-1 (Registration Number 333-41630) initially filed on July 18, 2000.
+ Confidential treatment has been requested for certain confidential portions of this exhibit pursuant to Rule 406 under the Securities Act. In accordance with Rule 406, these confidential portions have been omitted from this exhibit and filed separately with the Commission.
(b) EXHIBITS ON FORM 8-K
No Current Reports on Form 8-K were filed during the quarter ended December 31, 2000.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
ARTISTDIRECT, INC.
Date: April 2, 2001 By: /s/ MARC P. GEIGER --------------------------------- Marc P. Geiger Chief Executive Officer and Chairman of the Board
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.
ARTISTDIRECT, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Board of Directors ARTISTdirect, Inc.
We have audited the accompanying consolidated balance sheets of ARTISTdirect, Inc. (and its predecessor company ARTISTdirect, LLC) and subsidiaries (the Company) as of December 31, 1999 and 2000 and the related consolidated statements of operations, changes in members' and stockholders' equity (deficit) and cash flows for each of the years in the three year period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ARTISTdirect, Inc. and subsidiaries as of December 31, 1999 and 2000 and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Los Angeles, CA February 19, 2001
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT FOR SHARE DATA)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS' AND STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
ORGANIZATION
ARTISTdirect, Inc. (the "Company") was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC (the "Capital Reorganization"). The Capital Reorganization was only a change in the form of ownership of the Company. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. ARTISTdirect, LLC had a 99% ownership interest in ARTISTdirect Agency LLC, Kneeling Elephant Records, LLC and ARTISTdirect NewMedia, LLC ("Affiliated Companies") and has consolidated their results since inception. In February 1999, Ultimate Band List, LLC ("UBL") acquired the remaining 80% of iMusic, Inc., a Washington corporation, that it did not already own. On May 18, 1999, ARTISTdirect, LLC entered into an agreement with UBL and the Affiliated Companies whereby units in ARTISTdirect, LLC were exchanged for the membership interests of UBL and the Affiliated Companies (Exchange Transaction). The acquisition of the minority interest in UBL was accounted for under purchase accounting.
PRINCIPLES OF CONSOLIDATION
The accompanying financial statements include the consolidated accounts of the Company and its subsidiaries in which it has controlling interests in the form of voting and operating control. All significant intercompany accounts and transactions have been eliminated for all periods presented. UBL generated losses on its operations for all periods prior to the Company's purchase of the minority interest in UBL. Due to the full funding of those losses by the Company and its members, none of the losses generated by UBL during the periods presented have been allocated to the minority holders.
2. CAPITAL REORGANIZATION AND REVERSE STOCK SPLIT
The common units and redeemable preferred units outstanding immediately prior to the Capital Reorganization were converted into common stock and redeemable preferred stock of the C corporation. Each common and preferred unit converted into one share of common and preferred stock, respectively.
On March 21, 2000, the Company effected a 1 for 4 reverse stock split (the "Reverse Stock Split"). The outstanding common securities, redeemable securities, options and warrants have been retroactively adjusted to reflect the Reverse Stock Split. All discussion of equity amounts in the following footnotes reflect the effect of the Capital Reorganization and Reverse Stock Split.
3. SIGNIFICANT ACCOUNTING POLICIES
CASH EQUIVALENTS
Cash equivalents consist of investments, which are readily convertible into cash and have maturities of three months or less at the time of purchase.
CASH HELD FOR CLIENTS
Cash held for clients consists of funds held on behalf of the Company's clients for musical performances. The cash is restricted for payment to the clients, and there is a corresponding amount due to clients.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SHORT TERM INVESTMENTS
The Company's investments are classified as held-to-maturity as the Company has the intent and ability to hold the securities to maturity. The securities are stated at amortized cost, adjusted for amortization of premiums and accretion discounts to maturity. The Company invests exclusively in fixed income securities with maturities of one year or less at the time of purchase.
DEPRECIATION
Depreciation is provided using the straight-line method over the following estimated useful lives:
REVENUE RECOGNITION
Online product sales, which consist primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, include shipping fees and are recognized when the products are shipped. The Company obtains merchandise from merchandisers and manufacturers, music from a third party distributor, contracts for warehousing and fulfillment, processes customer orders and provides customer service. The Company takes title to all products sold and bears the risk of loss for collections and non-delivery subject to any recourse against the shipper. Online product sales are subject to amounts due to the respective artists based on their contracts, and such expense is recorded as part of direct cost of product sales.
The Company generates revenue from the sale of advertisements and sponsorships, both online and offline, under short-term contracts. To date, the duration of the Company's advertising and sponsorship commitments has generally averaged from one to three months. The Company's online obligations typically include the guarantee of a minimum number of "impressions" or times that an advertisement appears in pages viewed by the users of the Company's online properties. Online advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of the Company remain and collection of the resulting receivable is probable. The Company records a reserve for contracts in which the guarantee of a minimum number of impressions are not expected to be met. There were no such instances as of December 31, 1998, 1999 and 2000. Revenue generated from offline advertising and sponsorships is recognized ratably over the terms of the sponsorship agreements.
The Company entered into several contracts with advertisers whereby the parties exchanged online and offline advertising. This revenue was recognized as trade and barter. Trade and barter is valued based upon similar cash transactions, which have been entered into within six months prior to the respective trade and barter agreement. Trade and barter revenue was $0, $98,000 and $309,000 for years ended December 31, 1998, 1999 and 2000, respectively.
Agency commission revenue is recognized in accordance with the terms of the representation agreements between the Company and its clients. Revenue is generally recorded upon payment for the performance of services or delivery of materials created by the artists represented.
Overhead advances on the record label are recognized as revenue evenly over the period covered by the advances. Royalties earned on albums sold by artists signed to the record label are recognized
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
as revenue at the time the releases are shipped to the retailer. Reserves are established for possible returns.
COST OF REVENUE
Direct cost of product sales consists of amounts payable to artists, which includes the cost of merchandise sold and a share of net proceeds, and online commerce transaction costs, including credit card fees, fulfillment charges and shipping costs. Other cost of revenue consists primarily of Web site hosting and maintenance costs, online content programming costs, online advertising serving costs, record royalties payable to artists and payroll and related expenses for staff involved in Web site maintenance, content programming and the agency. Stock-based compensation expense relates to non-cash charges in connection with warrants issued to vendors and options issued to artists and their advisors for the right to operate their stores. Amounts payable to artists and transaction costs are recognized upon shipment. Web site-related costs are recognized immediately when incurred. Payroll and related expenses are recognized in the period incurred. Non-cash stock-based compensation charges are recognized over the period of the related agreements.
INVENTORIES
Inventories, included in prepaid expenses and other current assets, consist of music-related merchandise and amounts advanced for inventory on behalf of artists and are stated at net realizable value. Cost is determined using the first-in, first-out method.
INCOME TAXES
Prior to the Capital Reorganization, the Company was treated as a limited liability company for federal and state income tax reporting purposes whereby income (or losses) of the Company was reported in the individual income tax returns of the Company's members. After the Capital Reorganization, the Company began accounting for income taxes under Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
WEBSITE DEVELOPMENT COSTS
Website development costs consist primarily of third-party development costs and payroll and related expenses for in-house Web site development costs incurred in the start-up and production of the Company's content and services. These costs are expensed as incurred. The implementation of Emerging Issues Task Force No. 00-02 "Accounting for Website Development Costs," effective July 1, 2000, has not had a material impact on the consolidated financial statements.
ADVERTISING COSTS
Advertising costs are expensed as incurred and totaled $461,000, $7.7 million and $14.7 million during the years ended December 31, 1998, 1999 and 2000, respectively.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
INTANGIBLE ASSETS
Intangible assets consist almost entirely of goodwill resulting from the excess of the purchase price over the net assets acquired from the acquisition of a minority interest in the UBL, and the acquisitions of iMusic, Inc. and Mjuice.com, Inc. Intangible assets are amortized on a straight-line basis over five years, the estimated period of benefit.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company periodically reviews the carrying amounts of long-lived assets to determine whether current events or circumstances warrant adjustments to such carrying amounts. An impairment adjustment is necessary in the event the net book value of such long-lived assets exceeds the future undiscounted cash flows attributable to such assets. In such an event, the loss is measured by the amount that the carrying value of such assets exceeds their fair value. Considerable management judgment is necessary to estimate the fair value of assets; accordingly, actual results could vary significantly from such estimates.
CONCENTRATION OF CREDIT RISK AND SUPPLIER RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, short term investments and trade accounts receivable. The Company places its cash and short term investments in high credit quality instruments. Cash balances at certain financial institutions may exceed the FDIC insurance limits. The Company performs ongoing credit evaluations of its customers but does not require collateral. Exposure to losses on receivables is principally dependent on each customer's financial condition. The Company monitors its exposure to credit losses and maintains allowances for anticipated losses.
The Company purchases a large percentage of its music-related merchandise inventory from five suppliers. The Company is subject to risk in the event that any of the suppliers is unable to fulfill customer orders.
FAIR VALUES OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, which include cash, cash held for clients, short term investments, accounts receivable, accounts payable and accrued expenses and amounts due to employees, approximate fair value because of the short maturity of these instruments.
INVESTMENTS IN AFFILIATED COMPANIES
Investments in affiliated companies in which the Company's voting interest is 20% to 50%, or in which the Company is able to exert significant influence in instances where the voting interest is less than 20%, are accounted for under the equity method of accounting. Under this method, the investment, originally recorded at cost, is adjusted to recognize the Company's share of the net earnings or losses of the affiliates as they occur rather than as dividends or other distributions received. The Company's share of losses is generally limited to the extent of the Company's investment in, advances to and commitments for the investee.
LOSS PER COMMON SHARE
The Company computes net loss per share in accordance with SFAS No. 128, "Earnings per Share" and Securities and Exchange Commission Staff Accounting Bulletin No. 98 (SAB 98).
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SFAS No. 128 requires companies with complex capital structures to present basic and diluted EPS. Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g. convertible securities, options, etc.) as if they had been converted at the beginning of the periods presented. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from diluted EPS. Dividends to preferred shareholders and interest on the rescission offer balance are added to the net loss in determining the net loss attributable to common shareholders. Prior to the Capital Reorganization on October 6, 1999 (see Note 2), the Company was organized as a limited liability company and had not issued common stock. Accordingly, no historical loss per share information is included in the attached financial statements for periods prior to October 6, 1999.
Included in net loss attributable to common shareholders for the year ended December 31, 2000 is the effect of the beneficial conversion feature of the Series C redeemable preferred stock which converted into common shares as of March 31, 2000 in connection with the initial public offering. The value of the beneficial conversion feature was calculated based on the $2.40 per share difference between the initial public offering price of $12.00 and the effective conversion price of $9.60 multiplied by the 10,156,252 shares of common stock issued to the Series C shareholders.
The diluted loss per share excludes 7.6 million and 9.8 million securities (after giving effect to the Reverse Stock Split) as of December 31, 1999 and 2000, respectively, since the impact would be anti-dilutive.
STOCK-BASED COMPENSATION
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25 and FASB Interpretation No. 44 (FIN 44), "Accounting for Certain Transactions Involving Stock Compensation," and complies with the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation." Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company's stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, "Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services", which addresses the measurement date and recognition approach for such transactions.
The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service.
Stock-based compensation is comprised of sales and marketing expense of $0, $8,551 and $2,209 for the years ended December 31, 1998, 1999 and 2000, respectively, and general and administrative expense of $3,828, $21,753 and $2,858 for the years ended December 31, 1998, 1999 and 2000, respectively.
COMPREHENSIVE LOSS
The Company has no significant components of other comprehensive income, and accordingly, the comprehensive loss is the same as net loss for all periods.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board recently issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective date of FASB Statement No. 133") and SFAS 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," which becomes effective January 1, 2001. These pronouncements establish accounting and reporting standards for derivative instruments and hedging activities by requiring that all derivative instruments be reported as assets or liabilities and measured at their fair values. Under SFAS 133, changes in the fair values of derivative instruments are recognized immediately in earnings unless those instruments qualify as hedges of the (1) fair values of existing assets, liabilities, or firm commitments, (2) variability of cash flows of forecasted transactions, or (3) foreign currency exposures on net investments in foreign operations. The adoption of these pronouncements will not have an impact on the consolidated financial statements of the Company.
In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") 101, Revenue Recognition in Financial Statements. SAB 101 provides guidance on the recognition, presentation, and disclosure of revenue in financial statements of all public registrants. Any change in the Company's revenue recognition policy resulting from the implementation of SAB 101 would be reported as a change in accounting principle. In June 2000, the SEC issued SAB 101B which delayed the implementation date of SAB 101 until the fourth fiscal quarter of fiscal years beginning after December 15, 1999. The adoption of SAB 101 did not have an impact on the Company's consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS
Significant non-cash investing and financing activities are reflected in the following table:
5. SHORT TERM INVESTMENTS
The Company's short-term investments consist of the following held-to-maturity securities:
DECEMBER 31, 2000 -------------------- FAIR MARKET AMORTIZED VALUE COST ------- --------- (IN THOUSANDS) U.S. corporate and bank debt............. $30,361 $30,362 U.S. government and agencies............. 4,001 4,002 International corporate and bank debt.... 2,003 2,004 ------- ------- Total investments................. $36,365 $36,368 ======= =======
All held-to-maturity securities mature within one year.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and consist of the following:
7. ALLOWANCE FOR DOUBTFUL ACCOUNTS AND SALES RETURN RESERVE
A summary of the activity of the allowance for doubtful accounts for the periods indicated is reflected in the following table:
A summary of the activity of the reserve for sales returns for the periods indicated is reflected in the following table:
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
9. INVESTMENTS IN AFFILIATED COMPANIES
As of December 31, 1999 and 2000, the Company had a 45% ownership in SnoCore, LLC, and accounts for the investment under the equity method. The Company recorded income of $50,000 and $15,000 for this investment for the years ended December 31, 1999 and 2000, respectively. The Company received a $33,000 distribution of income from the investee during the year ended December 31, 1999.
During the year ended December 31, 2000, the Company entered into a joint venture, ARTISTdirect Latin America, LLC in which the Company holds a 50% ownership interest. The Company accounts for the investment under the equity method. The Company made an initial investment of $250,000 during the year ended December 31, 2000. The Company recorded its share of losses of $250,000 for this investment for the year ended December 31, 2000.
In 1998 the Company acquired a 1.7% ownership in American Digital Networks ("ADN") and accounted for this investment under the cost method. During 1999, the Company fully reserved its investment in ADN to reflect its estimated net realizable value.
As of December 31, 1998, the Company had an approximate 20% ownership in iMusic, Inc. The majority owner in iMusic, Inc. had a 76% voting interest. As the Company was not able to exert significant influence in the management of iMusic, Inc., the investment was accounted for under the cost method. In February 1999, the Company acquired all of the outstanding capital stock of iMusic, Inc. that it did not already own.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. LINE OF CREDIT
In 1997, the Company obtained a $250,000 line of credit with a financial institution. The line was increased to $500,000 during 1998, to $2.0 million in February 1999 and to $5.0 million in November 1999. The line of credit is guaranteed by certain officers and stockholders of the Company and bears interest, which is payable monthly, at a base rate as defined in the lending agreement plus 1%. No balance outstanding on the line of credit as of December 31, 1998 and the line of credit was terminated at the Company's option in September 1999 and reinstated in October 1999. As of December 31, 1999, there was no balance outstanding on the line of credit. In March 2000, the line of credit expired.
11. ACQUISITIONS
In February 1999, the Company acquired the remaining 80% of iMusic, Inc. that it did not own. The consideration paid for the acquisition included $110,000 in cash, redeemable common units of UBL equal to 2% of its membership interests and the assumption of approximately $180,000 of liabilities. The value of the redeemable common units given was approximately $2.2 million. The acquisition has been accounted for as a purchase and the operations of iMusic, Inc. have been included from the date of acquisition. The Company recorded goodwill of approximately $2.4 million as a result of this acquisition, which is being amortized over a five year period.
In May 1999 the Company acquired the 40.29% minority interest in the UBL in exchange for common interests in ARTISTdirect, LLC. The value of the consideration given was approximately $13.9 million, which was based on the value of the equity given, using the pricing of third party equity contributed at or around the time of the purchase transaction; the transaction has been accounted for as a purchase. Due to the full funding of the losses of UBL by the Company and its members prior to the purchase of the minority interest, none of the losses generated by UBL during the periods presented have been allocated to the minority holders. The Company recorded goodwill of approximately $13.1 million as a result of this acquisition, which is being amortized over a five year period.
In August 2000, ARTISTdirect acquired all of the outstanding capital stock of Mjuice.com, Inc., a company involved in the development and distribution of the secure digital distribution of MP3-formatted music. The Company issued 900,000 of its common shares and common share equivalents in exchange for all the outstanding equity of Mjuice.com, Inc. The total purchase consideration for Mjuice.com was approximately $5.1 million, which includes cash paid of approximately $2.0 million. The acquisition was accounted for as a purchase, with $5.0 million being recorded as goodwill, which is being amortized over a period of five years.
The pro forma results of operations assuming the above transactions had occurred at the beginning of the following periods are as follows:
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The accumulated amortization related to the above intangible assets was $2.1 million and $5.7 million as of December 31, 1999 and 2000, respectively.
12. INCOME TAXES
Income taxes for the period from October 6, 1999 (the date of conversion to a C corporation) to December 31, 1999 and for the year ended December 31, 2000 differs from the amount computed using the Federal income tax rate of 35% as a result of the following (amounts in thousands):
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and (liabilities) at December 31, 1999 and 2000 are presented below:
At December 31, 2000, the Company had net operating loss carryforwards totaling approximately $52.8 million for Federal income tax purposes expiring beginning in 2019 and California state net operating loss carryforwards of $52.8 million expiring beginning in 2007. Due to the uncertainty surrounding the realization of the benefits of its tax attributes, including net operating loss carryforwards in future tax returns, the Company has recorded a valuation allowance against its deferred tax assets as of December 31, 1999 and 2000 of $18.2 million and $41.2 million, respectively.
In assessing the potential realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the Company attaining future taxable income during the periods in which those temporary differences become deductible. In addition, Internal Revenue Code Section 382 substantially restricts the ability of a Corporation to utilize existing net operating losses in the event of an "ownership change." Therefore, the Company's net operating losses for Federal income tax purposes may be limited due to changes in ownership.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. SIGNIFICANT CONTRACTS
The Company entered into a settlement agreement with an employee in connection with the termination of his employment in October 1997. Pursuant to this agreement, the employee received a severance payment of $175,000, to be paid out in eight quarterly installments. The amount due under this severance arrangement was $88,000 as of December 31, 1998. The amount was paid in full in 1999. As part of the settlement agreement, the individual received an option to purchase the lesser of 100,000 securities or 2.5% of the shares offered to the public upon an initial public offering at an exercise price that will be set at the completion of the initial public offering pursuant to the provision defined in the settlement agreement. The employee exercised the purchase option of 100,000 shares. The Company recorded compensation expense of $1,025,000 for the year ended December 31, 2000, which represented the difference between the fair value of the common stock and the amount paid.
In 1998 the Company entered into an employment agreement with an officer of the Company under which deferred compensation of up to $200,000 was granted. The value of the deferred compensation was determined based on the value of the Company as of the payment date. The Company has accrued $200,000 in deferred compensation.
For the years ended December 31, 1998, 1999 and 2000, the Company incurred legal expenses of approximately $450,000, $1,101,000 and $464,000, respectively, for legal services provided by Lenard & Gonzalez LLP. Allen Lenard, one of the Company's directors, is Managing Partner of Lenard & Gonzalez LLP.
Kneeling Elephant Records, LLC, a subsidiary of the Company, entered into an agreement with RCA in January 1997. Kneeling Elephant was a record label managed by the Company. Under the agreement, RCA provided all funding to the Company for the label and owns the rights to all sound recordings made under artist agreements during the initial three year term of the agreement. RCA had an option to terminate its agreement with Kneeling Elephant after three years, at which point, the assets and properties of Kneeling Elephant would be divided based on the terms of the agreement. Under the agreement, RCA provided funding of $300,000 in January 1997, which was recognized ratably over the minimum three year operating term. Additionally, RCA has provided annual funding of $450,000, paid on a quarterly basis, to the Company for the operation of Kneeling Elephant under the terms of the agreement. The original agreement with RCA was extended through June 30, 2000, at which point it was terminated.
In April 1999, the Company entered into an agreement with a merchandiser for a term of four years. In exchange for merchandise fulfillment services, the Company granted the merchandiser warrants to purchase 131,250 shares of common stock (after giving effect to the Reverse Stock Split) upon the signing of the agreement. Additional warrants to purchase common stock may be earned by the merchandiser based on the achievement of certain sales levels, none of which have been reached to date.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In June 1999, the Company entered into an agreement with a merchandiser for a three-year term. In exchange for merchandise fulfillment services over the term of the agreement, the Company paid a deposit of $1.0 million which is being amortized over the term of the agreement, and granted the merchandiser warrants to purchase 228,426 shares of common stock (after giving effect to the Reverse Stock Split) upon the signing of the agreement. Additional warrants to purchase common stock may be earned by the merchandiser based on the achievement of certain sales levels, none of which have been reached to date. In January 2001, the merchandiser filed for bankruptcy protection under Chapter 11.
In November 1999, the Company entered into a three year programming license agreement with CHUMcity International. The Company is amortizing the license cost over the contractual license period.
In December 1999, the Company entered into an eighteen month marketing agreement with ABC News Internet Ventures. The agreement provides for the exchange and distribution of content by both parties. As the values of the content and services being provided by both parties is not readily determinable, the content and services provided and received by the Company are being recorded at their cost basis to the Company, which is zero.
In connection with the issuance of Series C Preferred shares, the Company entered into strategic relationships with four record labels. Under the terms of these agreements, the Company has the right to purchase certain content related to each of the respective companies' artists on terms generally made available to other online music companies. The cost associated with the acquisition of such content will be expensed as it is acquired and broadcast online.
In December 1999, the Company entered into an advertising and promotion agreement with Yahoo! pursuant to which the Company purchases media placement on Yahoo! in return for certain promotional considerations. The Company is recording the expense related to the amounts paid to Yahoo! for advertising and promotion services over the term of the agreement as services or promotions are received. On November 7, 2000, the Company amended this agreement such that it has been terminated as of December 31, 2000. Yahoo! will deliver certain additional page views containing the Company's banners on various Yahoo! properties through June 30, 2001. Under the amendment, the Company has no additional payment obligations to Yahoo!. In connection with the original agreement, the Company issued Yahoo! warrants to purchase 339,254 shares of common stock (after giving effect to the Reverse Stock Split). The exercise price for 169,627 of the warrants is $13.93, and the exercise price for the remaining warrants is $12.00. The expense related to the warrants is being amortized through June 30, 2001 (see discussion of fair value under "Warrants" in note 15).
The Company entered into an agreement with a landlord for office space for a term of ten years. In connection with the agreement, the Company issued warrants to purchase 62,500 shares of common stock at $13.93 per share. The expense related to the warrants is being amortized over the term of the agreement.
14. REDEEMABLE SECURITIES
From July through December 1998, the Company issued redeemable preferred units for proceeds of $4.9 million. These preferred units were converted into 12.8 million Series A ARTISTdirect, LLC redeemable preferred securities pursuant to the Exchange Transaction, and were converted into 3,207,815 shares of Series A Redeemable Preferred Stock (Series A Preferred) pursuant to the Capital Reorganization and Reverse Stock Split. The Series A Preferred shares carried a 10%
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cumulative annual dividend. The liquidation preference and redemption value of the Series A Preferred shares was approximately $5.0 million as of December 31, 1999. The Series A Preferred shares and accrued dividend were converted to common shares upon the closing of the initial public offering.
On February 17, 1999, the Company issued 170,443 redeemable common shares (Redeemable Stock) (after giving effect to the Reverse Stock Split) for the purchase of the remaining 80% of iMusic, Inc. The holder of the Redeemable Stock had the right to redeem the Redeemable Stock upon the earlier of an initial public offering or February 17, 2002 at a redemption value of $2.8 million. The holder chose not to redeem the shares. The accreted value of $2.4 million was included in redeemable common securities in the balance sheet as of December 31, 1999 and was converted to common shares upon the completion of the initial public offering in March 2000.
On May 18, 1999, the Company issued 3,750,000 Series B redeemable preferred shares (Series B Preferred) (after giving effect to the Reverse Stock Split) for proceeds of $15 million. The Series B Preferred shares had the same redemption terms as the Series A Preferred shares, and had an original conversion price of $4.00 per share. The Series B Preferred shares had liquidation preference over all other classes of shares. The liquidation preference and redemption value of the Series B Preferred shares was $15.4 million as of December 31, 1999. The Series B Preferred shares and accrued dividends were converted to common shares upon the closing of the initial public offering in March 2000.
In December 1999, the Company issued 5,905,374 Series C redeemable preferred shares (Series C Preferred) (after giving effect to the Reverse Stock Split) for proceeds of $82.2 million and in January 2000, the Company issued an additional 1,094,917 Series C Preferred shares for proceeds of $15.2 million. The total sum of $97.5 million was raised through the sale of shares to six music and media companies which included Universal Music Group, BMG Entertainment, Sony Music Entertainment, Time Warner Inc., an affiliate of Cisneros Television Group and Yahoo! The Series C Preferred shares had the same redemption terms as the Series A and Series B Preferred shares and had an initial conversion price of $13.928 per share. The liquidation preference and redemption value as of December 31, 1999 was $82.3 million. The Series C Preferred shares were converted to 10,156,252 common shares upon the closing of the initial public offering. The conversion rate was 1.45 common shares for each Series C Preferred share based on the offering price and pursuant to the Series C shareholder agreement.
Included in redeemable common securities are amounts related to options and securities subject to a potential rescission offer. The Company issued shares or options to purchase shares to employees, artists and advisors. The issuance of these shares or options did not fully comply with certain requirements under the Securities Act, or available exemptions there under, and as a result the Company intends to make a rescission offer to all these persons pursuant to a registration statement to be filed under the Securities Act and pursuant to California securities law.
In the rescission offer, the Company will offer to repurchase from these persons all shares issued directly to these persons or pursuant to option exercises by these persons before the expiration of the rescission offer for an amount equal to the purchase or exercise price paid for the shares, plus interest at the rate of 7% from the date of issuance until the rescission offer expires. The rescission offer will expire approximately 30 days after the effectiveness of the rescission offer registration statement. Based upon the number of options exercised through December 31, 2000, the out-of-pocket cost to the Company would be approximately $2.2 million, plus interest.
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In addition, the Company will also offer to repurchase all unexercised options to these persons at 20% of the option exercise price times the number of option shares, plus interest at the rate of 7% from the date the options were granted. Based on the number of options outstanding as of December 31, 2000, and assuming that none of these options are exercised prior to the end of the rescission offer, the out-of-pocket cost to the Company in repurchasing such options would be approximately $7.8 million, plus interest.
The Company has accrued $114,000, $6.7 million and $3.9 million related to the rescission offer for the years ended December 31, 1998, 1999 and 2000. Of the $10.8 million accrued as of December 31, 2000, $7.8 million represents the accrual for options issued during the period that are subject to the rescission offer, $2.2 million represents amounts due as a result of the exercise of options and $769,000 represents accrued interest.
15. MEMBERS' EQUITY
MEMBER DISTRIBUTIONS
The Company made distributions to members of $249,000 and $741,000 in 1998 and 1999, respectively.
VARIABLE EQUITY INTERESTS
During 1998, the Company issued common units, which were converted to common shares upon the conversion of the Company to a C Corporation in October 1999, to certain executive employees and its outside legal counsel in connection with services rendered and to be rendered. In January 1998, Keith Yokomoto and L&G Associates One, an affiliate of Lenard and Gonzalez LLP, one of the Company's outside legal counsel, received interests of 10.1% and 3.03% respectively. In June 1998, Steve Rennie and Robert Morse received interests of 4.04% and 1.01% respectively. The units provided for the holder to share in the capital of the Company to the extent of increases in the fair value of the Company subsequent to the issuance of the units (Appreciation Rights). The Appreciation Rights issued to employees have been accounted for as stock appreciation rights. The Appreciation Rights issued to the outside legal counsel were valued at the estimated fair value as determined by the Company and expensed immediately as they related to past services. Accordingly, the value of the Appreciation Rights has been adjusted based on changes in the fair value of the Company. The Company has estimated the fair value based on third party equity transactions and ultimately on the trading price of the Company's common shares upon the completion of the initial public offering. The Appreciation Rights were settled upon the closing of the initial public offering on March 31, 2000. The Company has recognized as stock based compensation expense $3.8 million and $16.3 million for the years ended December 31, 1998 and 1999, respectively. The Company recorded a credit to stock based compensation in the amount of $6.6 million for the year ended December 31, 2000 as a result of the decline in the value of the Company's common shares from December 31, 1999 to March 31, 2000, the date on which the Appreciation Rights were settled.
WARRANTS
In May and June 1999, the Company issued warrants to purchase 359,676 shares of common stock (after giving effect to the Reverse Stock Split) at $4.00 per share to two vendors from whom it purchases merchandise ("merchandisers"). The value of the warrants was $864,000, of which $168,000 and $262,000 has been recognized as expense for the years ended December 31, 1999 and 2000, respectively. The value of the warrants is being amortized as cost of revenues over the term of
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the related merchandising agreements. All of the warrants are exercisable as of December 31, 2000 and none have been exercised. Additionally, the merchandisers may earn up to 545,464 of additional warrants based on certain performance levels as specified in the merchandising agreements, none of which have been reached as of December 31, 2000.
In December 1999, the Company issued warrants to purchase 339,254 shares of common stock in connection with an advertising and promotion agreement. The warrants vest in December 2001. The value of the warrants upon issuance was $2.0 million, of which $19,000 was recorded as expense for the year ended December 31, 1999. These warrants are being accounted for as variable instruments under EITF 96-18. Due to the decrease in fair value of the Company's common stock, the value of the warrants was reduced to $92,000 as of December 31, 2000. The related expense for the year ended December 31, 2000 was $28,000. The value of the warrants is being amortized through June 30, 2001.
In January 2000, the Company issued warrants to purchase 62,500 shares of common stock in connection with an office lease. The warrants were exerciseable upon grant, and none have been exercised as of December 31, 2000. The warrants were valued at $568,000, of which $47,000 has been recorded as expense for the year ended December 31, 2000. The value of the warrants is being amortized over the term of the related lease.
In August 2000, the Company issued warrants to purchase 13,059 shares of common stock to various consultants in connection with the acquisition of Mjuice.com, Inc. These warrants were valued at $34,000 and were accounted for as part of the purchase price. The warrants have exercise prices ranging from $0.19 to $6.35 per share, and all of the warrants were exerciseable as of December 31, 2000.
PREFERRED DIVIDENDS
On May 18, 1999, the Company paid to the Series A redeemable preferred securities holders the accrued dividends to that date of $355,000 in the form of 88,632 common shares (after giving effect to the Reverse Stock Split), as well as a cash payment of $85,000.
On October 6, 1999, the Company paid to the Series A and B redeemable preferred stockholders the accrued dividends to that date of $767,000 in the form of 213,002 shares of common stock (after giving effect to the Reverse Stock Split), as well as a cash payment of $191,000.
Upon the conversion of the Series A, B and C Preferred shares to common shares, accrued dividends of $963,000 were converted into 80,216 common shares.
PURCHASE OF SHARES BY OFFICER
In September 1999, the Company's Chief Financial Officer purchased 111,111 shares of common securities from certain officer stockholders at a purchase price of $3.60 per share. The difference between the purchase price and the fair value of the securities as of the date of the transaction has been reflected as stock-based compensation. The amount of stock-based compensation aggregated $875,000 for the year ended December 31, 1999. The Company determined the fair value of the securities based on the continued growth of the Company's operations and recent equity transactions with third parties.
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EQUITY TRANSFER
In March 2000, the founders of the Company entered into a series of transactions whereby two employees and an outside legal counsel would receive the appreciation on the Company's common stock above $13.93 per share through the third day of trading after the initial public offering. Additionally, the two employees and outside legal counsel received stock options on the third day of trading after the initial public offering with an exercise price of $13.93. There was no expense charge for the appreciation rights and stock options granted to the two employees, as the stock price was below $13.93 per share on the third day of trading and the exercise price on the stock options was greater than the fair value of the Company's common stock on the date of grant. The fair value of the appreciation rights and stock options granted to the outside legal counsel was $2,029,000 and was recorded as expense for the year ended December 31, 2000, as the grants related to past services.
16. OPTIONS
In July 1998, the Company implemented the 1998 Unit Option Plan (which was subsequently amended and replaced by the 1999 Employee Stock Option Plan), which has reserved 6,500,000 shares (after giving effect to the Reverse Stock Split) of the Company's common stock for issuance to employees, non-employee members of the board of directors and consultants. This share reserve will automatically increase on the first trading day in January each calendar year, beginning 2001, by an amount equal to two percent (2%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 875,000 shares. No option may have a term in excess of 10 years. The options issued during 1998, 1999 and 2000 vest within three years. As of December 31, 2000, 746,401 shares remained available for future option grant.
The Company accounts for its employee stock option plan in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," Interpretation No. 44, and other related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
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Summary stock option activity for 1999 Employee Stock Option Plan during the years ended December 31, 1998, 1999 and 2000 is as follows (after giving effect to the Reverse Stock Split):
During the year ended December 31, 1999 the Company issued 7,500 options to consultants, resulting in a weighted average fair value per option of $10.21, and a total value of $77,000. The Company recorded this amount as stock based compensation for the year ended December 31, 1999.
In February 2000, the Company accelerated the vesting of 114,796 stock options granted to an executive of the Company. The resulting compensation expense of $964,000, which represented the difference between the fair value of the Company's common stock on the date of modification and the exercise price, was recorded during the year ended December 31, 2000.
If the Company had elected to recognize compensation cost based on the fair value at the date of grant, consistent with the method as prescribed by SFAS No. 123, net loss for the years ended December 31, 1998, 1999 and 2000 would have changed to the pro forma amounts indicated below:
The fair value of options granted during 1998 and 1999 was determined using a minimum value pricing model with the following assumptions: risk-free interest rate of 6.0% and an expected life of five years. The fair value of options granted during the year ended December 31, 2000 was determined using a Black-Scholes model with the following assumptions: risk free rate of 6.38%, a volatility factor of 100%, no expected dividends and an expected life of five years. The weighted
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average fair values of the options on the date of grant were $.32 per share, $5.56 per share and $5.83 for the options granted in 1998, 1999 and 2000, respectively.
The following table summarizes information regarding options outstanding and options exerciseable at December 31, 2000 (after giving effect to the Reverse Stock Split):
In June 1999 and as amended in October 1999 and March 2000 the Company adopted the 1999 Artist and Artist Advisor Stock Option Plan (the Advisor Plan). The Advisor Plan has reserved 1,850,000 shares (after giving effect to the Reverse Stock Split) of common stock for issuance to artists for whom the Company maintains ARTISTchannels and their agents, business managers, attorneys and other advisors. This share reserve will automatically increase on the first trading day in January each calendar year, beginning 2001, by an amount equal to one percent (1%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 375,000 shares. As of December 31, 2000, 521,170 shares remained available for future option grants. The options expire seven years from the date of grant. Vesting generally varies between one to three years, as specifically stated in each advisor's option agreement. In January 2000, the vesting of certain options was accelerated such that these options grants vested immediately.
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Summary stock option activity for the Advisor Plan options during the years ended December 31, 1999 and 2000 is as follows (after giving effect to the Reverse Stock Split):
The weighted average fair value of options granted under the Advisor Plan was $9.34 and $6.65 per option, resulting in a total value for options granted of $9.7 million and $2.1 million for the years ended December 31, 1999 and 2000, respectively. Of the $2.1 million in option fair value in 2000, $1.8 million was expensed immediately, as it related to past services. Consequently, $9.7 million and $300,000 for 1999 and 2000, respectively, of total value for options granted has been recorded as unearned compensation in the statement of changes in members' and stockholders' equity (deficit) and is being amortized over the term of the artists' and advisors' option agreement.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2000 (after giving effect to the Reverse Stock Split):
In June 1999 and as amended in October 1999, the Company adopted the 1999 Artist Stock Plan (the Artist Option Plan), which has reserved 4,000,000 shares (after giving effect to the Reverse Stock Split) of common stock for issuance to artists for whom the Company maintains ARTISTchannels. This share reserve will automatically increase on the first trading day in January each calendar year, beginning 2001, by an amount equal to two percent (2%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar
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year, but in no event will this annual increase exceed 875,000 shares. As of December 31, 2000, 1,416,564 shares remained available for future option grants. The options expire seven years from the date of grant. Vesting generally varies between one to three years, as specifically stated in each artist's option agreement. In January 2000, the vesting of certain options was accelerated such that these options vested immediately.
Summary stock option activity for the Artist Option Plan during the years ended December 31, 1999 and 2000 is as follows (after giving effect to the Reverse Stock Split):
The weighted average fair value of the options granted under the Artist Option Plan was $8.33 and $9.97 per option, resulting in a total value for options granted of $20.6 million and $4.7 million for the years ended December 31, 1999 and 2000, respectively, which has been recorded as unearned compensation in the statement of changes in members' and stockholders' equity, and is being amortized over the service period of the related artist agreements.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2000 (after giving effect to the Reverse Stock Split):
Total compensation expense related to the Advisor Plan and the Artist Option Plan was $12.4 million and $10.2 million for the years ended December 31, 1999 and 2000 respectively, of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
which $1.6 million and $7.3 million, respectively, was included in cost of revenue, and $10.8 million and $2.9 million, respectively, was included in operating expenses.
The estimated fair values of the options granted under the Advisor Plan and the Artist Option Plan was determined using the Black-Scholes model. The key assumptions used in the model for the purpose of the calculation were: a risk free rate of 6.0%, a volatility factor of 80%, no expected dividends and an expected life of seven years for options granted in 1999; and a risk free rate of 6.4%, a volatility factor ranging from 80% to 150%, no expected dividends and an expected life of seven years for options granted in 2000.
For the year ended December 31, 1999, the addition to unearned compensation of $67.7 million was comprised of the issuance of options under the Artist Option Plan and Advisor Plan with a fair value of $30.3 million; the issuance of compensatory options granted under the 1999 Employee Stock Option Plan with a fair value of $17.9 million; options granted to non-employees under the 1999 Employee Stock Option Plan with a fair value of $77,000; warrants granted to suppliers with a fair value of $864,000; warrants granted for advertising services with a fair value of $2.0 million; and an increase in the value of the variable equity interests of $16.5 million.
For the year ended December 31, 2000, the decrease to unearned compensation of $1.4 million was comprised of additions of $5.7 million, which were offset by reductions of $7.1 million. The additions were a result of the grant of options under the Artist Option Plan and Advisor Plan with a fair value of $4.9 million; warrants granted to the landlord with a fair value of $568,000; and the issuance of compensatory options under the 1999 Employee Stock Option Plan with a fair value of $210,000. The reductions were a result of the cancellation of options under the Artist Option Plan and Advisor Plan with an unamortized balance of $1.3 million on the cancellation date; a decrease in the value of the unamortized portion of the variable equity interest of $600,000; a decrease in the value of warrants accounted for as variable instruments of $1.9 million; and the cancellation of unvested compensatory employee options with a remaining unamortized value of $3.3 million as a result of terminations in 2000.
In October 1999, the Company adopted the 1999 Employee Stock Purchase Plan, which initially reserved 500,000 shares of common stock for issuance under this plan. This share reserve automatically increases on the first trading day in January each calendar year, beginning 2001, by an amount equal to one percent (1%) of the total number of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 250,000 shares. Terms of the plan permit eligible employees to purchase common stock through payroll deduction of up to 15% of each employee's compensation. The accumulated deductions will be applied to the purchase on shares on each semi-annual purchase date at a purchase price per share equal to 85% of the fair market value per share on the participant's entry date into the offering period or the semi-annual purchase date, whichever is lower. Pursuant to the provisions of APB No. 25, shares issued to employees under this plan are considered noncompensatory. As of December 31, 2000, 67,578 shares were issued under this plan for total proceeds of $40,000.
In connection with the acquisition of Mjuice.com, Inc. in August 2000, the Company assumed the Audio Explosion, Inc. 1998 Stock Option Plan and the Mjuice.com, Inc. 1999 Stock Option Plan. Options granted to employees, consultants and directors under these plans were converted into options to purchase shares of the Company's common stock. Options currently outstanding vest over periods of up to 48 months from their grant date. Each option shall terminate 10 years after the date of grant. The value of the options issued by the Company was included as part of the purchase price.
Summary stock option activity for the Audio Explosion and Mjuice.com Stock Option Plans during the year ended December 31, 2000 is as follows:
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The following table summarizes information regarding options outstanding and options exercisable at December 31, 2000:
17. 401(K) PLAN
In February 1999 and as amended in January 2000, the Company adopted the Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the 401(k) Plan, participating employees may defer a percentage (not to exceed 15%) of their eligible pretax earnings up to the Internal Revenue Service's annual contribution limit. All employees of the Company age 21 years or older who complete three months of service are eligible to participate in the 401(k) Plan. The Company does not match participants' contributions to the 401(k) Plan. Accordingly, there is no expense for the years ended December 31, 1999 and 2000.
18. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
Future minimum lease payments under operating leases for facilities and certain equipment, including leases entered into subsequent to December 31, 2000, are as follows as of the years ended December 31:
Rent expense under operating leases for the years ended December 31, 1998, 1999 and 2000 for the Company was $109,000, $341,000 and $1,735,000, respectively.
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EMPLOYMENT CONTRACTS
Future payments under employment contracts are as follows for the years ended December 31:
LITIGATION
The Company is subject to various pending and threatened legal actions, which arise in the normal course of business. The Company's management believes that the impact of such litigation will not have a material adverse impact on its financial position or results of operations.
19. REPORTABLE SEGMENTS
The Company provides integrated music entertainment products and services through three reportable segments. The three reportable segments are music-related Web site operations ("ARTISTdirect Network"), musical artist booking operations ("Talent Agency") and record label operations ("Record Label"). ARTISTdirect Network generates revenue primarily from the sale of recorded music and music-related merchandise and from the sale of advertising on our Web sites. The Talent Agency generates revenue from commissions based on the income received by agency clients for live performances. The Record Label generated revenue from advances under an agreement with RCA, which was terminated in June 2000, and from royalties on sales of recorded music. The factors for determining reportable segments were based on service and products. Each segment is responsible for executing a unique marketing and business strategy. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes. The following table summarizes the revenue, operating income and depreciation and amortization by segment for the years ended December 31, 1998, 1999 and 2000.
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The following tables summarize the capital expenditures for the years ended December 31, 1998, 1999 and 2000 and assets as of December 31, 1998, 1999 and 2000.
Assets by segment are those assets used in the Company operations in each segment. Corporate assets are principally made up of cash and cash equivalents, short term investments, prepaid expenses, computer equipment, leasehold improvements and other assets.
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20. QUARTERLY RESULTS OF OPERATIONS
The following table sets forth unaudited quarterly results of operations for the eight most recent quarters ended December 31, 2000. This unaudited quarterly information has been derived from the Company's unaudited financial statements and, in the Company's opinion, includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the periods covered. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
21. SUBSEQUENT EVENTS
In February 2001, the Company authorized the repurchase of up to 2.0 million shares of the Company's outstanding shares of common stock. The repurchase will be made through a "Dutch Auction" style self-tender offer, at an expected offering range of between $1.25 and $1.50 per share, subject to market conditions prior to commencement of the tender offer. If the number of shares tendered is greater than the number sought, the Company will select the tendered price within the range that allows the Company to repurchase the entire 2.0 million shares at the lowest aggregate price, with purchases to be made on a pro-rata basis for stockholders tendering at or below the purchase price.
EXHIBIT INDEX
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* Incorporated by reference to the same exhibit in the Registrant's Registration Statement on Form S-1 (Registration Number 333-87547) initially filed on September 22, 1999, as amended by Amendment No.'s 1-7 thereto.
** Incorporated by reference to the same exhibit in the Registrant's Registration Statement on Form S-1 (Registration Number 333-41630) initially filed on July 18, 2000.
+ Confidential treatment has been requested for certain confidential portions of this exhibit pursuant to Rule 406 under the Securities Act. In accordance with Rule 406, these confidential portions have been omitted from this exhibit and filed separately with the Commission.