Item 1.
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Legal Proceedings
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On September 6, 2007, we filed a lawsuit seeking a declaratory relief judgment against
Universal Music Group, Inc. and related entities (UMG) in the United States District Court for the Southern District of California. In the lawsuit we allege that UMG has asserted claims of copyright infringement against us arising from
the operation of Stage6, our online video community service. We further allege that UMG claimed that the Digital Millennium Copyright Act, including without limitation its notice-and-takedown procedures, was inapplicable to the activities of Stage6.
We ask that the court declare that we are not liable to UMG for copyright infringement based upon the operation of Stage6 or in the alternative that any potential liability is barred by provisions of the Digital Millennium Copyright Act. UMG has
responded by filing a lawsuit against us in the Central District of California on October 22, 2007, and has announced it will seek to dismiss or transfer the lawsuit that we initially filed in the United States District Court for the Southern
District of California. Litigation is inherently uncertain and an unfavorable resolution of this proceeding could materially affect our future operating results or financial conditions in particular periods.
We are also involved in various legal proceedings from time to time arising from the normal course of business activities, including commercial, employment and other
matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could
materially affect our future operating results or financial condition in a particular period.
Before you decide to invest or maintain an interest in our common stock, you should consider
carefully the risks described below, together with the other information contained in this Quarterly Report on Form 10-Q. We believe the risks described below are the risks that are material to us as of the date of this Quarterly Report on Form
10-Q. If any of the following risks comes to fruition, our business, financial condition, results of operations and future growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common
stock could decline, and you may lose all or part of your investment.
The risk factors set forth below with an asterisk (*) next to the title
are new risk factors or risk factors containing changes, including any material changes, from the risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2006, as filed with the Securities and
Exchange Commission.
Risks related to our business
* Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, we may be unable to maintain or expand our business.
Maintaining and strengthening the DivX brand is critical to maintaining and expanding our business, as well as to our ability to enter into
new markets for our technologies and products. If we fail to promote and maintain the DivX brand successfully, our ability to sustain and expand our business and enter into new markets will suffer. Maintaining and strengthening our brand will depend
heavily on our ability to continue to develop and provide innovative and high-quality technologies and products for consumers, content owners, consumer hardware device manufacturers and software vendors as well as to appropriately manage our
relationship with Stage6.com during its planned sale or transition to a private company. Moreover, because we engage in relatively little direct brand advertising, the promotion of our brand depends, among other things, upon hardware device
manufacturing partners displaying our trademarks on their products. If these partners choose for any reason not to display our trademarks on their products, or if our partners use our trademarks incorrectly or in an unauthorized manner, the strength
of our brand may be diluted or our ability to maintain or increase our brand awareness may be harmed. In addition, if we fail to maintain high-quality standards for products that incorporate our technologies through the quality-control certification
process that we require of our licensees, or if we take other steps to commercialize our products and services that our customers or potential customers reject, the strength of our brand could be adversely affected. Further, unauthorized third
parties may use our brand in ways that may dilute or undermine its strength.
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* If we are unable to penetrate existing markets or adapt or develop technologies and products for new markets, our
business prospects could be limited.
We expect that our future success will depend, in part, upon our ability to successfully
penetrate existing markets for digital media technologies, including:
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network connected DVD players;
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high definition DVD players;
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portable media players;
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digital media software applications;
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To date, we
have penetrated only some of these markets, including the markets for DVD players, network connected DVD players, portable media players, digital still cameras, smart TVs and mobile handsets. Our success depends upon our ability to further penetrate
these markets, some of which we have only penetrated to a limited extent, and to successfully penetrate those markets in which we currently have no presence. Demand for our technologies in any of these developing markets may not grow or develop, and
a sufficiently broad base of consumers and professionals may not adopt or continue to use our technologies. In addition, our ability to generate revenue from these markets may be limited to the extent that service providers in these markets choose
to provide competitive technologies and entertainment at little or no cost. Because of our limited experience in certain of these markets, we may not be able to adequately adapt our business and our technologies to the needs of consumers and
licensees in these markets.
* We face significant competition in various markets, and if we are unable to compete successfully, our ability to
generate revenues from our business will suffer.
We face significant competition in the digital media markets in which we operate.
We believe that our most significant competitive threat comes from companies that have the collective financial, technical and other resources to develop the technologies, services, products and partnerships necessary to create a digital media
ecosystem that can compete with the DivX ecosystem. Those potential competitors currently include Adobe Systems, Apple Computer, Google, Microsoft, News Corporation, Sony and Yahoo!.
We also compete with companies that offer products or services that compete with specific aspects of our digital media ecosystem. For example, our
digital rights management technology competes with technologies from companies such as Apple Computer, ContentGuard, Intertrust Technologies, Microsoft, Nagra Audio, NDS Group and 4C Entity, as well as the internal development efforts of certain of
our licensees. Similarly, content distribution providers, such as Amazon.com, Apple Computer, CinemaNow, Google, Joost, MovieLink, Netflix and subscription entertainment services and cable and satellite providers compete against our content
distribution services. In addition, Google, Microsoft, Yahoo!, MySpace.com, a subsidiary of News Corporation, and YouTube, a subsidiary of Google, offer online communities that compete with Stage6.com.
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Our proprietary technologies also compete with other video compression technologies, including other
implementations of MPEG-4 or implementations of H.264/AVC. A number of companies such as Google, Microsoft, On2 Technologies and RealNetworks offer other competing video formats.
We also face competition from subscription entertainment services, cable and satellite providers, DVDs and other emerging technologies and products
related to content distribution. Stage6.com faces significant competition from services, such as peer-to-peer and content aggregator services that allow consumers to directly access an expansive array of content without securing licenses from
content providers.
Some of our current or future competitors may have significantly greater financial, technical, marketing and other
resources than we do, may enjoy greater name recognition than we do, or may have more experience or advantages than we have in the markets in which they compete. For example, companies such as Apple Computer, Amazon.com, Google, Microsoft, Sony and
Yahoo! may have competitive advantages over us because of their greater size and resources and the strength of their respective brand names. In addition, some of our current or potential competitors, such as Apple Computer, Dolby Laboratories,
Microsoft and Sony, may be able to offer integrated system solutions in certain markets for entertainment technologies, including audio, video and rights management technologies related to personal computers or the Internet, which could make
competing products and technologies that we develop unnecessary. By offering an integrated system solution, these potential competitors also may be able to offer competing products and technologies at lower prices than our products and technologies.
Further, many of the consumer hardware and software products that include our technologies also include technologies developed by our competitors. As a result, we must continue to invest significant resources in product development in order to
enhance our technologies and our existing products and introduce new high-quality technologies and products to meet the wide variety of such competitive pressures. Our ability to generate revenues from our business will suffer if we fail to do so
successfully.
* We are dependent on the sale by our licensees of consumer hardware and software products that incorporate our technologies. Our top
10 licensees by revenue accounted for approximately 50% of our total net revenues during the nine months ended September 30, 2007, and a reduction in revenues from those licensees or a loss of one or more of our key licensees would adversely
affect our licensing revenue.
We derive most of our revenue from the licensing of our technologies to consumer hardware device
manufacturers, software vendors and consumers. We derived 79%, 80% and 82% of our total net revenues from licensing our technology in the nine months ended September 30, 2007 and in the full years 2006 and 2005, respectively. One or a small
number of our licensees generally represents a significant percentage of our technology licensing revenues. For example, in the nine months ended September 30, 2007, LG accounted for approximately 11% of our total net revenues, and our top 10
licensees by revenue accounted for approximately 50% of our total net revenues. Our technology licensing revenues are particularly dependent upon our relationships with consumer hardware device manufacturers such as LG and Sony. We cannot control
consumer hardware device manufacturers and software developers product development or commercialization efforts or predict their success. Our license agreements typically require manufacturers of consumer hardware devices and software
vendors to pay us a specified royalty for every shipped consumer hardware or software product that incorporates our technologies, but many of these agreements do not require these manufacturers to guarantee us a minimum royalty in any given period.
Accordingly, if our licensees sell fewer products incorporating our technologies, or otherwise face significant economic difficulties, our licensing revenues will be adversely affected. Our license agreements are generally for two years or less in
duration, and a significant number of these agreements expire in any given quarter. Upon expiration of their license agreements, manufacturers and software developers may not renew their agreements or may elect not to enter into new agreements with
us on terms as favorable as our current agreements.
* Our software distribution and promotion agreement with Google, which represented approximately
20% of our total net revenues in the nine months ended September 30, 2007, is scheduled to expire on November 30, 2007, and if we do not effectively transition our software distribution and promotion relationship from Google to Yahoo! our
revenues may significantly decrease.
In the past we have relied on a software distribution and promotion agreement with Google for
a significant portion of our revenue. Pursuant to our agreement with Google we include and distribute the Mozilla Firefox Browser and Certain related Google software products with our software products. Revenues under our agreement with Google
represented approximately 20% of our total revenues in the nine months ended September 30, 2007. Our agreement with Google is scheduled to expire on November 30,
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2007. In September 2007, we entered into a software distribution and promotion agreement with Yahoo! which is expected to replace our existing agreement with
Google. Although we commenced distribution pursuant to the Yahoo! agreement in early November 2007, if we fail to effectively transition our software distribution and promotion business from Google to Yahoo!, our revenues would significantly
decrease.
* Our September 2007 software distribution and promotion agreement with Yahoo! is our first distribution agreement with Yahoo!, and if
products from Yahoo! are not as popular as Google products, or if they are more difficult to install or distribute than Google products, or if products from Yahoo! have greater market saturation than Google products, then our revenues may
significantly decrease.
Pursuant to our September 2007 agreement with Yahoo!, we agreed to distribute a version of Internet
Explorer browser optimized for Yahoo! and a co-branded version of the Yahoo! Toolbar with our software products and Yahoo! will pay us fees based on the number of certain distributions or installations of the Yahoo! software. Our agreement with
Yahoo! also affects our ability to offer our software products with third party web browsers, toolbars and search services other than those provided by Yahoo!. As a result, if the Yahoo! products we plan to distribute are not as popular as, or if
they have greater market saturation than, the Google products we have distributed in the past, or if they are more difficult to install or distribute, our revenues may significantly decrease. Any decline in the popularity of our products or
Yahoo!s products among consumers or market saturation of those products could result in a decrease in revenue under our agreement with Yahoo!. In addition, if we fail to achieve certain minimum distribution volumes or certain minimum
installations of the Yahoo! software for specific periods described in the agreement, Yahoo! may elect to terminate the agreement.
* The success of
our business depends on the interoperability of our technologies with consumer hardware devices.
To be successful we must design
our digital media platform to interoperate effectively with a variety of consumer hardware devices, including personal computers, DVD players, DVD recorders, digital cameras, portable media players, smart TVs and mobile handsets. We depend on
significant cooperation with manufacturers of these devices and the components integrated into these devices, as well as software providers that create the operating systems for such devices, to incorporate our technologies into their product
offerings and ensure consistent playback of DivX-encoded files. Currently, a limited number of devices are designed to support our technologies. If we are unsuccessful in causing component manufacturers, device manufacturers and software providers
to integrate our technologies into their product offerings, our technologies may become less accessible to consumers, which would adversely affect our revenue potential.
If we fail to develop and deliver innovative technologies and products in response to changes in our industry, including changes in consumer tastes or trends, our revenues could decline.
The markets for our technologies and products are characterized by rapid change and technological evolution. We will need to expend considerable resources
on product development in the future to continue to design and deliver enduring and innovative technologies and products. For example, significant portions of Stage6.com remain under development and we are continuing to upgrade the technologies we
license for use in consumer hardware and software products. Despite our efforts, we may not be able to develop and effectively market new technologies and products that adequately or competitively address the needs of the changing marketplace. In
addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic. Our future success depends to a great extent on our ability to develop and
deliver innovative technologies that are widely adopted in response to changes in our industry and that are compatible with the technologies or products introduced by other participants in our industry. If we fail to deliver innovative technologies,
we may be unable to meet changes in consumer tastes or trends, which could decrease our revenues.
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Our licensing revenue depends in large part upon integrated circuit manufacturers incorporating our technologies
into their products for sale to our consumer hardware device manufacturer licensees and if our technologies are not incorporated in these integrated circuits or fewer integrated circuits are sold that incorporate our technologies, our revenues will
be adversely affected.
Our licensing revenue from consumer hardware device manufacturers depends in large part upon the
availability of integrated circuits that incorporate our technologies. Integrated circuit manufacturers incorporate our technologies into their products, which are then incorporated into consumer hardware devices. We do not manufacture integrated
circuits, but rather depend on integrated circuit manufacturers to develop, produce and sell these products to licensed consumer hardware device manufacturers. We do not control the integrated circuit manufacturers decision whether or not to
incorporate our technologies into their products, and we do not control their product development or commercialization efforts. If we fail to develop new technologies that adequately or competitively address the needs of the changing marketplace,
integrated circuit manufacturers may not be willing to implement our technologies into their products. The process utilized by integrated circuit manufacturers to design, develop, produce and sell their products is generally 12 to 18 months in
duration. As a result, if an integrated circuit manufacturer is unwilling or unable to implement our technologies into an integrated circuit that it is producing, we may experience significant delays in generating revenue while we wait for that
manufacturer to begin development of a new integrated circuit that may incorporate our technologies. In addition, while the design cycles utilized by integrated circuit manufacturers are typically long, the life cycles of our technologies tend to be
short as a result of the rapidly changing technology environment in which we operate. If integrated circuit manufacturers are unable or unwilling to implement technologies we develop into their products, or if they sell fewer products incorporating
our technologies, our revenues will be adversely affected.
Our business is dependent in part on technologies we license from third parties, and
these license rights may be inadequate for our business.
Certain of our technologies and products are dependent in part on the
licensing and incorporation of technologies from third parties. For example, we have entered into a license agreement with MPEG LA pursuant to which we have acquired rights to use in our technologies and products certain MPEG-4 intellectual property
licensed to MPEG LA. Our licensing agreement with MPEG LA grants us a sublicense only to the rights in MPEG-4 intellectual property licensed to MPEG LA. There are other parties who have competing rights to MPEG-4 intellectual property, and to the
extent that the rights of such other parties conflict with or are superior to the rights licensed to MPEG LA, our rights to utilize MPEG-4 technology in our technologies and products could be challenged. If the technology we license fails to perform
as expected, if key licensors do not continue to support their technology or intellectual property because the licensor has gone out of business or otherwise or if it is determined that any of our licensors are not entitled to license to us any of
the technologies or intellectual property that are subject to our current license agreements, then we may incur substantial costs in replacing the licensed technologies or intellectual property or fall behind in our development schedule while we
search for a replacement. In addition, replacement technology may not be available for license on commercially reasonable terms, or at all.
In addition, our agreements with licensors generally require us to give them the right to audit our calculations of royalties payable to them. If a licensor challenges the basis of our calculations, the amount of royalties we have to pay
them could increase. Any royalties paid as a result of a successful challenge would increase our expenses and could impair our ability to continue to use and re-license technologies or intellectual property from that licensor.
We rely on our licensees to accurately prepare royalty reports for our determination of licensing revenues, and if these reports are inaccurate, our revenues may
be under- or over-stated and our forecasts and budgets may be incorrect.
Our licensing revenues are generated primarily from
consumer hardware device manufacturers and software vendors who license our technologies and incorporate them into their products. Under these arrangements, these licensees typically pay us a specified royalty for every consumer hardware or software
product they ship that incorporates our technologies. We rely on our licensees to accurately report the number of units shipped. We calculate our license fees, prepare our financial reports, projections and budgets, and direct our sales and
technology development efforts based in part on these reports. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately. This is especially true with respect to software
incorporating our technologies because software can be copied relatively easily and we often do not have ways to readily determine how many copies have been made. Licensees in specific countries, including China, have a history of underreporting or
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failing to report shipments of their products that incorporate our technologies. Most of our license agreements permit us to audit our licensees
records, but audits are generally expensive and time consuming. We have initiated, and intend to initiate, audits with certain of our licensees to determine whether their shipment reports for past periods were accurate. Such audits could harm our
relationships with our licensees or may result in the cancellation or termination of our agreements with such licensees. In addition, the license agreements that we have entered into with most of our licensees impose restrictions on our audit
rights, such as limitations on the number of audits we may conduct. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to
which we are entitled. Alternatively, we have experienced limited instances in which a customer has notified us that it previously reported and paid royalties on units in excess of what the customer actually shipped. In such cases, the customer
requested, and we granted, a credit for the excess royalties paid. If a similar event occurs in the future, we may be required to record the credit as a reduction in revenue in the period in which it is granted, and such a reduction could be
material.
Any development delays or cost overruns may affect our ability to respond to technological changes, competitive developments or customer
requirements and expose us to other adverse consequences.
We have experienced development delays and cost overruns in our
development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, competitive developments or customer requirements. Also, our technologies and
products may contain undetected errors that could cause increased development costs, loss of revenue, adverse publicity, reduced market acceptance of our technologies and products or lawsuits by participants in the consumer hardware or software
industries or consumers.
* We conduct a substantial portion of our business outside North America and, as a result, we face diverse risks related to
engaging in international business.
We have offices in five foreign countries as well as sales staff in six other foreign
countries, and we are dedicating a significant portion of our sales efforts in countries outside North America. We are dependent on international sales for a substantial amount of our total revenues. For the nine months ended September 30, 2007
and for the full years 2006 and 2005, our sales outside North America comprised 73%, 76% and 78%, respectively, of our total revenues. We expect that international sales will continue to represent a substantial portion of our revenues for the
foreseeable future. These future international revenues will depend to a large extent on the continued use and expansion of our technologies in entertainment industries worldwide. Increased worldwide use of our technologies is also an important
factor in our future growth.
We are subject to the risks of conducting business internationally, including:
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our ability to enforce our contractual and intellectual property rights, especially in those foreign countries that do not respect and protect intellectual property
rights to the same extent that the United States does, which increases the risk of unauthorized and uncompensated use of our technology;
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United States and foreign government trade restrictions, including those that may impose restrictions on importation of programming, technology or components to or
from the United States;
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foreign government taxes, regulations and permit requirements, including foreign taxes that we may not be able to offset against taxes imposed upon us in the United
States, and foreign tax and other laws limiting our ability to repatriate funds to the United States;
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foreign labor laws, regulations and restrictions;
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changes in diplomatic and trade relationships;
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difficulty in staffing and managing foreign operations;
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fluctuations in foreign currency exchange rates and interest rates, including risks related to any interest rate swap or other hedging activities we undertake;
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political instability, natural disasters, war and/or events of terrorism; and
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the strength of international economies.
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We face risks with respect to conducting business in China due to Chinas historically limited recognition and
enforcement of intellectual property and contractual rights.
We currently have direct license relationships with over 50 consumer
hardware device manufacturers located in China. In addition, a number of the OEMs that license our technologies utilize captive or third-party manufacturing facilities located in China. We expect this to continue in the future as consumer hardware
device manufacturing in China continues to increase due to its lower manufacturing cost structure as compared to other industrialized countries. As a result, we face many risks in China, in large part due to Chinas historically limited
recognition and enforcement of contractual and intellectual property rights. In particular, we have experienced, and expect to continue to experience, problems with China-based consumer hardware device manufacturers underreporting or failing to
report shipments of their products that incorporate our technologies, or incorporating our technologies or trademarks into their products without our authorization or without paying us licensing fees. We may also experience difficulty enforcing our
intellectual property rights in China, where intellectual property rights are not as respected as they are in the United States, Japan and Europe. Unauthorized use of our technologies and intellectual property rights may dilute or undermine the
strength of our brand. Further, if we are not able to adequately monitor the use of our technologies by China-based consumer hardware device manufacturers, or enforce our intellectual property rights in China, our revenue potential could be
adversely affected.
Pricing pressures on the consumer hardware device manufacturers and software vendors who incorporate our technologies into their
products could limit the licensing fees we charge for our technologies and adversely affect our revenues.
The markets for the
consumer hardware and software products in which our technologies are incorporated are intensely competitive and price sensitive. For example, retail prices for consumer hardware devices that include our digital media platform, such as DVD players,
have decreased significantly in recent years, and we expect prices to continue to decrease for the foreseeable future. In response, consumer hardware device manufacturers and software vendors have sought to reduce their product costs, which can
result in downward pressure on the licensing fees we charge our licensees who incorporate our technologies into the consumer hardware and software products that they sell. In addition, we have experienced erosion in the average royalty we can charge
for specific versions of our technologies to our OEM partners since the release of these technologies. To maintain higher overall per unit royalties, we must continue to introduce new, more highly functional versions of our products for which we can
charge a higher royalty. Any inability to introduce such products in the future or other declines in the royalties we charge would adversely affect our revenues.
* We do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players level off or decline, or alternative technologies in which we do not participate replace DVDs as
a dominant medium for consumer video entertainment, our licensing revenue will be adversely affected.
Growth in our revenue over
the past several years has been the result, in large part, of the rapid growth in sales of DVD players incorporating our technologies. For the nine months ended September 30, 2007, and in the full years 2006 and 2005, we derived approximately
70%, 72% and 71%, respectively, of our total revenues from technology licensing to consumer hardware device manufacturers, a majority of which are derived from sales of DVD players incorporating our technologies. However, as the markets for DVD
players mature, we do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players level off or decline, our licensing revenue will be adversely affected. In addition, if new
technologies are developed for use with DVDs or new technologies are developed that substantially compete with or replace DVDs as a dominant medium for consumer video entertainment such as high definition DVD or Blu-ray Disc, and if we are unable to
develop and successfully market technologies that are incorporated into or compatible with such new technologies, our ability to generate revenues will be adversely affected.
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Digital video technologies could be treated as a commodity in the future, which could expose us to significant
pricing pressure.
We believe that the success we have had licensing our digital video technologies to consumer hardware device
manufacturers and software vendors is due, in part, to the strength of our brand and the perception that our technologies provide a high-quality video solution. However, as applications that incorporate digital video technologies become increasingly
prevalent, we expect more competitors to enter this field with other solutions. Furthermore, to the extent that competitors solutions are perceived, accurately or not, to provide the same or greater advantages as our technologies, at a lower
or comparable price, there is a risk that video encoding and decoding technologies such as ours will be treated as commodities, exposing us to significant pricing pressure.
Current and future government standards or standards-setting organizations may limit our business opportunities.
Various national governments have adopted or are in the process of adopting standards for digital television broadcasts, including cable and satellite broadcasts. In the event national governments adopt similar
standards for video codecs used in consumer hardware devices, software products or Internet applications, our technology may be excluded from such standards. We have not made any efforts to have our technologies adopted as standards by any national
governments, nor do we currently expect that our technologies will be adopted as standards by any national government in the future. If national governments adopt standards that exclude our technologies, we will be required to redesign our
technologies to comply with such government standards to allow our products to be utilized in those countries. Costs or potential delays in the development of our technologies and products to comply with such government standards could significantly
increase our expenses. In addition, standards-setting organizations are adopting or establishing formal technology standards for use in a wide range of consumer hardware devices, software products and Internet applications. We currently do not
participate in standards-setting organizations, nor do we seek or expect to have our technologies adopted as industry standards. As such, participants in the consumer hardware or software industries or consumers may elect not to purchase our
technologies because they have not been adopted by standards-setting organizations or if a competing technology is adopted as an industry standard.
Our business may depend in part upon our ability to provide effective digital rights management technology.
Our
business may depend in part upon our ability to provide effective digital rights management technology that controls access to digital content that addresses, among other things, content providers concerns over piracy. We cannot be certain
that we can continue to develop, license or acquire such technology, or that content licensors, consumer hardware device manufacturers or consumers will accept such technology. In addition, consumers may be unwilling to accept the use of digital
rights management technology that limits their use of content, especially with large amounts of free content readily available. We may need to license digital rights management technology from third parties to support our technologies and products.
Such technology may not be available to us on reasonable terms, or at all. If digital rights management technology is not effective, is perceived as not effective or is compromised by third parties, or if laws are enacted that require digital rights
management technology to allow consumers to convert content stored in a protected format into an unprotected format, content providers may not be willing to encode their content using our products and consumer hardware device manufacturers may not
be willing to include our technologies in their products.
We have offered and we expect to continue to offer some of our products and technologies
for reduced prices or free of charge, and we may not realize the benefits of this marketing strategy.
We have offered and expect to
continue to offer some of our products and technologies to consumers for reduced prices or free of charge as part of our overall strategy of developing a digital media ecosystem and promoting additional penetration of our products and technologies
into the markets in which we compete. If we offer such products and technologies at reduced prices or free of charge, we will forego all or a portion of the revenue from licensing these products, and we may not realize the intended benefits of this
marketing strategy.
* Stage6.com, our online video community service, is rapidly evolving and may not prove to be a viable business model.
Online video distribution is a relatively new business model for delivering digital media over the Internet and we have only recently
launched our efforts to develop a business centered around online content delivery. We must continue to scale our online video community service, Stage6.com, to accommodate its rapid growth in users. If we fail to effectively scale Stage6.com, user
experience may suffer, which may in turn adversely impact user growth, our brand in general and our ability to monetize the service. We may also fail to develop a viable business model that properly monetizes our online video community.
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In addition, distributing video to users of Stage6.com involves substantial cost, including bandwidth
costs, and currently all of the content on Stage6.com is available for free. We expect that the costs of Stage6.com will continue to increase significantly before any meaningful revenue is generated by the service. If we are unable to successfully
monetize the use of Stage6.com, either through advertising or fees for use, our operating results will continue to be adversely affected.
The
success of Stage6.com will depend on our ability to license compelling content on commercially reasonable terms or enter into successful partnering relationships with content providers.
The success of Stage6.com will depend on our obtaining compelling digital media content to attract users. In some cases, we expect to pay substantial fees
to obtain premium content even though we have limited experience determining what video content will be successful with consumers. Alternatively, we may be unable to obtain premium content on commercially reasonable terms, or at all.
* We may be unable to attract advertisers to Stage6.com.
We expect that advertising revenue will comprise a significant portion of the revenue to be generated by Stage6.com. Most large advertisers have fixed advertising budgets, only a small portion of which is allocated to
Internet advertising. We expect that advertisers will continue to focus most of their efforts on traditional media or may decrease their advertising spending. If we fail to convince advertisers to spend a portion of their advertising budgets with
us, we will be unable to generate revenues from advertising.
Also, even if we initially attract advertisers to Stage6.com, they may decide
not to advertise to our community if their investment does not generate sales leads, and ultimately customers, or if we do not deliver their advertisements in an appropriate and effective manner. If we are unable to provide value to our advertisers,
advertisers may not place ads with us.
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Whether or not the proposed sale or separation of Stage6.com is completed, we will incur substantial
costs.
The proposed sale or separation of Stage6.com into a private company will be complex, time consuming and expensive, and may
disrupt our business and result in the loss of key personnel. The diversion of managements attention and any delays or difficulties encountered in connection with the transaction also could have an adverse effect on our business and results of
operations. We will incur substantial costs related to the proposed sale or separation of Stage6.com, including fees for financial advisors, attorneys and accountants, whether or not the transaction is completed. In addition, we expect to continue
to incur significant expenses related to the operation of Stage6.com prior to the proposed sale or separation.
* We will need to increase the size
of our organization, and we may experience difficulties in managing growth.
As of September 30, 2007 we had 300 full-time
employees, including full-time equivalents. We will need to continue to expand our managerial, operational, financial and other resources to manage our business, including our relationships with key customers and licensees. Our current facilities
and systems will not be adequate to support this future growth. We will require additional office space to accommodate our growth. Additional office space may not be available on commercially reasonable terms and may result in a disruption of our
corporate culture. Our need to effectively manage our operations, growth and various projects requires that we continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain
sufficient numbers of talented employees. We may be unable to successfully implement these tasks on a larger scale, which could prevent us from executing our business strategy.
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* We have experienced recent changes in our senior management, which may disrupt our operations.
We have recently experienced several changes in our senior management, including the departure of our former Chief Financial Officer, the
appointment of Kevin Hell as our Chief Executive Officer and the addition of Dan L. Halvorson as our Executive Vice President and Chief Financial Officer. In addition, we recently announced that R. Jordan Greenhall, our former Chief Executive
Officer, has resigned as an employee of DivX, Inc. We may experience disruptions in our operations as a result of these changes and as the new members of our management team become acclimated to their roles and to our company in general. If we
experience any of these disruptions or a loss of management attention to our core business, our operating results could be adversely affected.
* Our
business, in particular Stage6.com and our content distribution offerings, will suffer if our systems or networks fail, become unavailable or perform poorly so that current or potential users do not have adequate access to our online products and
websites.
Our ability to provide our online offerings will depend on the continued operation of our information systems and
networks. As our user traffic increases and our products become more complex, we will need more computing power. We expect to spend substantial amounts to purchase or lease data centers and equipment and to upgrade our technology and network
infrastructure to handle increased traffic on our website and to introduce new technologies and products. This expansion will be expensive and complex and could result in inefficiencies or operational failures. If we do not implement this expansion
successfully, or if we experience inefficiencies and operational failures during the implementation, the quality of our technologies and products and our users experience could decline. This could damage our reputation and lead us to lose
current and potential users, advertisers and content providers.
In addition, significant or repeated reductions in the performance,
reliability or availability of our information systems and network infrastructure could harm our ability to provide Stage6.com, content distribution offerings and advertising. We could experience failures in our systems and networks from our failure
to adequately maintain and enhance these systems and networks, natural disasters and similar events, power failures, intentional actions to disrupt our systems and networks and many other causes. The vulnerability of our computer and communications
infrastructure is increased because it is located at facilities in San Diego, California, an area that is at heightened risk of earthquake, wildfires and flood. We are vulnerable to terrorist attacks, fires, power loss, telecommunications failures,
computer viruses, computer denial of service attacks or other attempts to harm our systems. Moreover, our facilities are located near the landing path of a military base and are subject to risks related to falling debris and aircraft crashes. We do
not currently have fully redundant systems or a formal disaster recovery plan, and we may not have adequate business interruption insurance to compensate us for losses that may occur from a system outage.
Any failure or interruption of the services provided by bandwidth providers, data centers or other key third parties could subject our business to disruption and
additional costs and damage our reputation.
We rely on third-party vendors, including data center and bandwidth providers for
network access or co-location services that are essential to our business. Any interruption in these services, including any failure to handle current or higher volumes of use, could subject our business to disruption and additional costs and
significantly harm our reputation. Our systems are also heavily reliant on the availability of electricity, which also comes from third-party providers. The cost of electricity has risen in recent years with the rising costs of fuel. If the cost of
electricity continues to increase, such increased costs could significantly increase our expenses. In addition, if we were to experience a major power outage, it could result in a significant disruption of our business.
Our network is subject to security risks that could harm our reputation and expose us to litigation or liability.
Online commerce and communications depend on the ability to transmit confidential or proprietary information securely over private and public networks.
Any compromise of our ability to transmit and store such information and data securely, and any costs associated with preventing or eliminating such problems, could impair our ability to distribute technologies and products or collect revenue,
threaten the proprietary or confidential nature of our technology, harm our reputation and expose us to litigation or liability. We also may be required to expend significant capital or other resources to protect against the threat of security
breaches or hacker attacks or to alleviate problems caused by such breaches or attacks. Any successful attack or breach of our security could hurt consumer demand for our technologies and products and expose us to consumer class action lawsuits and
other liabilities. In addition, our vulnerability to security risks may affect our ability to maintain effective internal controls over financial reporting as contemplated by Section 404 of the Sarbanes-Oxley Act of 2002.
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It is not yet clear how laws designed to protect children that use the Internet may be interpreted and enforced,
and whether new similar laws will be enacted in the future which may apply to our business in ways that may subject us to potential liability.
The Child Online Protection Act and the Childrens Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet
to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors, direct our websites, including Stage6.com, to children under the age of 13, or collect
personal information from children under the age of 13. However, we are not able to control the ways in which consumers use our technology, and our technology may be used for purposes that violate these laws. The manner in which these Acts may be
interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations.
* We may be subject to market risk and legal liability in connection with the data collection capabilities of Stage6.com.
Many components of Stage6.com are interactive Internet services that by their very nature require communication between a client and server to operate. To
provide better consumer experiences and to operate effectively, we collect certain information from users. Our collection and use of such information may be subject to United States state and federal privacy and data collection laws and regulations,
as well as foreign laws such as the EU Data Protection Directive. We post an extensive privacy policy concerning the collection, use and disclosure of user data, including that involved in interactions between our client and server products. Because
of the evolving nature of our business and applicable law, our privacy policy may now or in the future fail to comply with applicable law. Any failure by us to comply with our posted privacy policy, any failure by us to conform our privacy policy to
changing aspects of our business or applicable law, or any existing or new legislation regarding privacy issues could impact the market for our online video community service, technologies and products and subject us to fines, litigation or other
liability.
Improper conduct by users of our websites could subject us to claims and compliance costs.
The terms of use of our websites prohibit a broad range of unlawful or undesirable conduct. However, we are unable to block access in all instances to
users who are determined to gain access to our websites for improper motives. Claims may be threatened or brought against us using various legal theories based on the nature and content of information that may be posted online or generated by our
users or the use of our technology to copy or distribute third-party content. Investigating and defending any of these types of claims could be expensive, even if the claims do not ultimately result in liability. In addition, we may incur
substantial costs to enforce our terms of use and to exclude certain users of our websites who violate such terms of use or who otherwise engage in unlawful or undesirable conduct.
* We may be subject to legal liability for the provision of third-party products, services, content or advertising.
We have entered into, and expect to continue to enter into, arrangements for third-party products, services, content or advertising to be offered in connection with Stage6.com and our content distribution offerings.
Certain of these arrangements involve enabling the distribution of digital content owned by third parties, which may subject us to third party claims related to such products, services, content or advertising, including defamation, violation of
privacy laws, misappropriation of publicity rights, violation of United States federal CAN-SPAM legislation, and infringement of intellectual property rights. We require users of Stage6.com to agree to terms of use that prohibit, among other things,
the posting of content that violates third party intellectual property rights, or that is obscene, hateful or defamatory. We have implemented procedures to enforce such terms of use, including taking down content that violates our terms of use that
we have received notification of, or that we are aware of, and/or blocking access by, or terminating the accounts of, users determined to be repeat violators of our terms of use. Despite these measures, we cannot guarantee that such unauthorized
content will not exist on our service, that these procedures will reduce our liability with respect to such unauthorized third party conduct or content, or that we will be able to resolve any disputes that may arise with content providers or users
regarding such conduct or content, Our agreements with these parties may not adequately protect us from these potential liabilities. Investigating and defending any of these types of claims is expensive, even if the claims do not result in
liability. If any of these claims results in liability, we could be required to pay damages or other penalties.
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We may be subject to assessment of sales taxes and other taxes for our licensing of technology or sale of products.
We do not currently directly collect sales taxes or other taxes on the licensing of our technology, the sale of our products over
the Internet, or our distribution of content. Although we have evaluated the tax requirements of certain major tax jurisdictions with respect to the licensing of our technology or the sale of our products over the Internet, in the past we have
licensed or sold, and in the future we may license or sell, our technologies or products to consumers located in jurisdictions where we have not evaluated the tax consequences of such license or sale. We would incur substantial costs if one or more
taxing jurisdictions required us to collect sales or other taxes from past licenses of technology or sales or distributions of our products or content over the Internet, particularly because we would be unable to go back to customers to collect
sales, value added or other taxes for past licenses, sales or distributions and would likely have to pay such taxes out of our own funds. Certain of our licensing agreements require our partners to pay taxes to applicable taxing jurisdictions as a
result of the sale of products that incorporate our technologies. If our licensees fail to pay such taxes, we may become liable for the payment of such taxes.
We also intend to sell content over the Internet to consumers throughout the world in conjunction with Stage6.com. We intend to comply with applicable tax requirements of certain major tax jurisdictions with respect
to such sales. However, we may sell content to consumers located in jurisdictions where we have not evaluated the tax consequences of such sale. If we fail to comply with tax requirements of tax jurisdictions in which we sell content online, we may
become liable for substantial costs or penalties.
Inflation and other unfavorable economic conditions may adversely affect our revenues, margins and
profitability.
Our consumer software products, as well as the consumer hardware device and software products that contain our
technologies, are discretionary purchases for consumers. Consumers are generally more willing to make discretionary purchases during favorable economic conditions. As a result of inflation or other unfavorable economic conditions, including higher
interest rates, increased taxation, higher consumer debt levels and lower availability of consumer credit, consumers purchases of discretionary items may decline, which could adversely affect our revenues. In addition, while inflation
historically has not had a material effect on our operating results, we may experience inflationary conditions in our cost base due to changes in foreign currency exchange rates that reduce the purchasing power of the United States dollar, increases
in selling, general and administrative expenses and other factors. These inflationary conditions may harm our margins and profitability if we are unable to increase our license, advertising and content distribution fees or reduce our costs
sufficiently to offset the effects of inflation in our cost base. Our attempts to offset the effects of inflation and cost increases through controlling our expenses, passing cost increases on to our licensees, advertisers and partners or any other
method may not succeed.
Failure to comply with applicable current and future government regulations could limit our ability to license our
technologies, sell our products or distribute content, and expose us to additional costs and liabilities.
Our operations and
business practices are subject to federal, state and local government laws and regulations, as well as international laws and regulations, including those relating to import or export of technology and software, distribution or censorship of
content, use of encryption or other digital rights management software and consumer and other safety-related compliance for electronic equipment. Any failure by us to comply with the laws and regulations applicable to us or our technologies,
products or our distribution of content could result in our inability to license those technologies, sell those products, or distribute content, additional costs to redesign technologies, products or our methods for distribution of content to meet
such laws and regulations, fines or other administrative, civil or criminal liability or actions by the agencies charged with enforcing compliance and, possibly, damages awarded to persons claiming injury as the result of our non-compliance. Changes
in or enactment of new statutes, rules or regulations applicable to us could have a material adverse effect on our business.
* If we lose the
services of key members of our senior management team, we may not be able to execute our business strategy.
Our future success
depends in large part upon the continued services of key members of our senior management team. All of our executive officers and key employees are at will employees, and we do not maintain any key person life insurance policies. The loss of our
management or key personnel could seriously harm our ability to execute our business strategy. We also may have to incur significant costs in identifying, hiring, training and retaining replacements for key employees.
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We rely on highly skilled personnel, and if we are unable to retain or motivate key personnel or hire qualified
personnel, we may not be able to maintain our operations or grow effectively.
Our performance is largely dependent on the talents
and efforts of highly skilled individuals. These individuals have acquired specialized knowledge and skills with respect to us and our operations. Our employment relationship with each of these individuals is on an at will basis and can be
terminated at any time. If any of these individuals or a group of individuals were to terminate their employment unexpectedly, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any
such successor obtains the necessary training and experience.
Our future success depends on our continuing ability to identify, hire,
develop, motivate and retain highly skilled personnel for all areas of our organization. In this regard, if we are unable to hire and train a sufficient number of qualified employees for any reason, we may not be able to implement our current
initiatives or grow effectively. We have in the past maintained a rigorous, highly selective and time-consuming hiring process. We believe that our approach to hiring has significantly contributed to our success to date. However, our highly
selective hiring process has made it more difficult for us to hire a sufficient number of qualified employees, and, as we grow, our hiring process may prevent us from hiring the personnel we need in a timely manner. Moreover, the cost of living in
the San Diego area, where our corporate headquarters are located, has been an impediment to attracting new employees in the past, and we expect that this will continue to impair our ability to attract and retain employees in the future. If we do not
succeed in attracting qualified personnel and retaining and motivating existing personnel, our ability to execute our business strategy may suffer.
* Our recent acquisitions, as well as any companies or technologies we may acquire in the future, could prove difficult to integrate and may result in unexpected costs and disruptions to our business.
We recently acquired all of the outstanding shares of MainConcept AG, a leading provider of audio and video codecs and software development kits to the
broadcast, film and consumer markets. Earlier this year we acquired all of the assets of a limited liability corporation engaged in developing real-time digital video processing technology for the purposes of producing enhanced video search and
discovery services. We expect to continue to evaluate possible additional acquisitions of technologies and businesses on an ongoing basis. Our recent acquisitions, as well as acquisitions in which we may engage in the future, entail numerous
operational and financial risks including certain of the following risks:
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exposure to unknown liabilities;
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disruption of our business and diversion of our managements time and attention to developing acquired products or technologies;
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incurrence of substantial debt or dilutive issuances of securities to pay for acquisitions;
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higher than expected acquisition and integration costs;
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increased amortization expenses;
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difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel;
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impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and
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inability to retain key employees of any acquired businesses.
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We have limited experience in identifying new acquisition targets, successfully completing acquisitions and integrating any acquired products, businesses or technologies into our current infrastructure. Moreover, in
the future we may devote resources to potential acquisitions that are never completed or that fail to realize any of their anticipated benefits.
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* We may not realize the benefits we expect from the acquisition of MainConcept.
The integration of MainConcepts technology may be time consuming and expensive, and may disrupt our business. We will need to overcome significant
challenges to realize any benefits or synergies from this transaction. These challenges include the timely, efficient and successful execution of a number of post-transaction integration activities, including:
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integrating MainConcepts technology;
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entering markets in which we have limited or no prior experience;
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successfully completing the development of MainConcepts technologies;
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developing commercial products based on those technologies;
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retaining and assimilating the key personnel of MainConcept;
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attracting additional customers for products based on MainConcepts technologies;
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implementing and maintaining uniform standards, controls, processes, procedures, policies, accounting systems and information systems; and
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managing expenses of any undisclosed or potential legal liability of MainConcept.
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In particular, we may encounter difficulties successfully integrating our operations, technologies, services and personnel with those of MainConcept, and
our financial and management resources may be diverted from our existing operations. For example, following our acquisition of MainConcept we will have additional offices in Germany, Russia and Japan. Maintaining offices in multiple countries could
create a strain on our ability to effectively manage our operations and personnel. In addition, the process of integrating operations and technology could cause an interruption of, or loss of momentum in, the activities of one or more of our
businesses and the loss of key personnel. The delays or difficulties encountered in connection with the integration of MainConcepts technologies could have an adverse effect on our business, results of operations or financial condition. We may
not succeed in addressing these risks or any other problems encountered in connection with this transaction. Our inability to successfully integrate the technology and personnel of MainConcept, or any significant delay in achieving integration,
including regulatory approval delays, could have a material adverse effect on us and, as a result, on the market price of our common stock.
Our
corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity and teamwork fostered by our culture.
We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and teamwork. As our
organization grows and we are required to implement more complex organizational management structures, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future
success.
Risks related to our finances
* Our
quarterly operating results and stock price may fluctuate significantly.
We expect our operating results to be subject to quarterly
fluctuations. The revenues we generate and our operating results and the market price of our common stock will be affected by numerous factors, including:
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demand for our technologies and products;
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costs related to the continued operation of Stage6.com;
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introduction, enhancement and market acceptance of technologies and products by us and our competitors;
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price reductions by us or our competitors or changes in how technologies and products are priced;
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the mix of technologies and products offered by us and our competitors;
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the mix of distribution channels through which our technologies and products are licensed and sold;
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our ability to successfully generate revenues from advertising and content distribution;
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the mix of international and United States revenues attributable to our technologies and products;
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costs of intellectual property protection and any litigation;
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timing of payments received by us pursuant to our licensing agreements;
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our ability to hire and retain qualified personnel; and
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growth in the use of the Internet.
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As a result of the variances in quarterly volumes reported by our consumer hardware device manufacturing customers, we expect our revenues to be subject to seasonality, with our second quarter revenues expected to be lower than the revenues
we derive in our other quarters. In addition, a substantial majority of our quarterly revenues are based on actual shipment of products incorporating our technologies in that quarter, and not on contractually agreed upon minimum revenue commitments.
Because the shipping of products by our consumer hardware and independent software vendor partners are outside our control and difficult to predict, our ability to accurately forecast quarterly revenue is substantially limited. Quarterly
fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication
of our future performance.
* We have a history of net losses and only recently achieved profitability on a quarterly basis, and we may not be able
to sustain our profitability.
We incurred net losses from our inception through June 30, 2005. We may not generate sufficient
revenue to be profitable on a quarterly or annual basis in the future. In addition, we devote significant resources to developing and enhancing our technology and to selling, marketing and obtaining content for our technologies and products. We
expect our operating expenses to increase, as we, among other things:
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develop and grow Stage6.com;
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expand our domestic and international sales and marketing activities;
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increase our product development efforts to advance our existing technologies and products and develop new technologies and products;
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hire additional personnel;
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upgrade our operational and financial systems, procedures and controls and plan for compliance with Section 404 of the Sarbanes-Oxley Act; and
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continue to assume the responsibilities of being a public company.
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In addition, starting January 1, 2006, we adopted SFAS No. 123(R),
Share-Based Payment
, which required that we record stock-based compensation charges in connection with our equity compensation for
employees. As a result, we expect to record significant additional expenses in future periods and we will need to generate significant revenue to be profitable in the future.
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We may require additional capital, and raising additional funds by issuing securities, debt financing or through
strategic alliances or licensing arrangements may cause dilution to existing stockholders, restrict our operations or require us to relinquish proprietary rights.
We may raise additional funds through public or private equity offerings, debt financings, strategic alliances or licensing arrangements. To the extent that we raise additional capital by issuing equity securities,
our existing stockholders ownership will be diluted. Any debt financing we enter into may involve covenants that restrict our operations. These restrictive covenants may include limitations on additional borrowing, specific restrictions on the
use of our assets as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, if we raise additional funds through strategic alliances or licensing arrangements, it may be necessary to
relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.
Risks related to our intellectual property
* We are, and may in the future be, subject to intellectual property rights claims, which
are costly to defend, could require us to pay damages and could limit our ability to use certain technologies or content in the future.
Companies in the technology and entertainment industries own large numbers of patents, copyrights, trademarks and trade secrets and they frequently commence litigation based on allegations of infringement or other violations of intellectual
property rights, including those relating to digital media standards such as MPEG-4, H.264, MP3 and AAC or relating to video or music content. We have faced such claims in the past, we currently face such claims, and we expect to face similar claims
in the future. For instance, we have been contacted by third parties regarding the licensing of certain patents characterized by such parties as being essential to the MPEG-4 visual standard. In this regard, AT&T has offered to license us
certain patents it claims are essential to MPEG-4 and our products, and we are evaluating these claims. We have also been contacted by LG Electronics regarding a license to certain patents that LG Electronics owns and claims are related to the
MPEG-4 visual standard. LG Electronics is one of our most significant customers in consumer hardware technology licensing and any dispute with LG over intellectual property rights could materially and adversely affect this important commercial
relationship. In the event we determine that we need to obtain a license from AT&T or any other third party, we cannot guarantee that we would be able to obtain such license on commercially reasonable terms, if at all. We may be required to
develop non-infringing alternative technologies, which could be very time consuming and expensive, and there is no guarantee that we would be successful in developing such technologies. We have also been asked by content owners to stop the display
or hosting of copyrighted materials on our websites, including notices provided to us pursuant to the Digital Millennium Copyright Act. For instance, several major motion picture studios, record labels, television networks, and trade associations
such as the Recording Industry Association of America and the Motion Picture Association of America have asked us to remove content posted by users of our website which it claims infringe its rights in such content. Among those labels who have asked
us to remove content is Universal Music Group, Inc. (UMG), who also asserted claims of copyright infringement against us arising from the operation of Stage6, our online video community service. As a result, on September 6, 2007, we
filed a lawsuit against UMG seeking a declaratory relief judgment against UMG, and UMG has filed a countersuit against us. Moreover, content providers may claim that we are contributorily or vicariously liable for third parties use of our
technology or Stage6.com to infringe the content providers copyrights. Users of our services, including Stage6.com, are subject to terms of use that prohibit the posting of content that violates third party intellectual property rights. We
have and will promptly respond to legitimate takedown notices or complaints, including but not limited to those submitted pursuant to the Digital Millennium Copyright Act, notifying us that we are providing unauthorized access to copyrighted content
by removing such content and/or any links to such content from our websites. Nevertheless, we cannot guarantee that our prompt removal of content, including removal pursuant to the provisions of the Digital Millennium Copyright Act, will prevent
disputes with content providers, that infringing content will not exist on our services, or that we will be able to resolve any disputes that may arise with content providers or users regarding such infringing content. Any intellectual property
claims, with or without merit, could be time-consuming, expensive to litigate or settle and could divert management resources and attention. An adverse determination could require that we pay damages, block access to certain content, or stop using
technologies found to be in violation of a third partys rights, and could prevent us from offering our technologies, products or certain content to others. To avoid these restrictions, we may be required to seek a license for the technology or
content from additional third parties. Such licenses may not be available on reasonable terms, could require us to pay significant royalties and may significantly increase our cost of revenues. The technologies or content also may not be available
for license to us at all. As a result, we may be required to develop alternative non-infringing technologies, or license alternative content, which could require significant effort and expense. If we cannot license or develop technologies or content
for any infringing aspects of our business, we may be forced to limit our technology or content offerings and may be unable to compete effectively with entities that offer such technology or content. In addition, from time to time we engage in
disputes regarding the licensing of our intellectual property rights, including matters related to our royalty rates and other terms of our licensing arrangements. These types
39
of disputes can be asserted by our licensees or prospective licensees or by other third parties as part of negotiations with us or in private actions seeking
monetary damages or injunctive relief. Any disputes with our licensees or potential licensees or other third parties could harm our reputation and expose us to additional costs and other liabilities.
* We may be unable to adequately protect the proprietary rights in our technologies and products.
We have only two issued patents in the United States and no issued patents elsewhere, and we generally do not rely upon patents to protect our proprietary
rights. In addition, our ability to obtain patent protection for our technologies and products will be limited as a result of the incorporation of aspects of MPEG-4 and MP3 technologies into our technologies and products. We license such
technologies from third party licensors and do not own any patents relating to such technologies. As a result, we do not have the right to defend perceived infringements of patents relating to such technologies. Moreover, the licensors from which we
have acquired the right to incorporate MPEG-4 and MP3 technologies into our products are not the exclusive owners of the patents relating to such technologies. As a result, our licensors must coordinate enforcement efforts with the owners of such
patents to protect or defend against infringements of patents relating to such technology, which can be expensive, time consuming and difficult. Any significant impairment of the intellectual property rights relating to the MPEG-4 or MP3
technologies we license for use in our technologies and products could reduce the value of such technologies, which could impair our ability to compete.
Our ability to compete partly depends on the superiority, uniqueness and value of our technologies, including both internally developed technology and technology licensed from third parties. To protect our proprietary
rights, we rely on a combination of trademark, patent, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. Despite our efforts to protect our intellectual property,
any of the following occurrences may reduce the value of our intellectual property:
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our applications for trademarks or patents may not be granted and, if granted, may be challenged or invalidated;
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issued patents, copyrights and trademarks may not provide us with any competitive advantages;
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our efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology or dilution of our trademarks;
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our efforts may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those that we develop;
or
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another party may obtain a blocking patent that would force us to either obtain a license or design around the patent to continue to offer the contested feature or
service in our technologies.
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Legislation may be passed that would require companies to share information about their
digital rights management technology to permit interoperability with other systems. If this legislation is enacted, we may be required to reveal our proprietary digital rights management code to competitors. Furthermore, if content must be formatted
such that it can be played on a media player other than a DivX Certified player, then the demand for DivX Certified players could decrease.
We may
be forced to litigate to defend our intellectual property rights or to defend against claims by third parties against us relating to intellectual property rights.
Disputes regarding the ownership of technologies and rights associated with digital media technologies and online businesses are common and likely to arise in the future. We may be forced to litigate to enforce or
defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of other parties proprietary rights. Any such litigation could be very costly and could distract our management from focusing on
operating our business.
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Our ability to maintain and enforce our trademark rights has a large impact on our ability to prevent third party
infringement of our brand and technologies.
We generally rely on enforcing our trademark rights to prevent unauthorized use of our
brand and technologies. Our ability to prevent unauthorized uses of our brand and technologies would be negatively impacted if our trademark registrations were overturned in the jurisdictions where we do business. Our brand and logo are widely used
by consumers and entities, both licensed and unlicensed, in association with digital video compression technology, and if we are not vigilant in preventing unauthorized or improper use of our trademarks, then our trademarks could become generic and
we would lose our ability to assert such trademarks against others. We also have trademark applications pending in a number of jurisdictions that may not ultimately be granted, or if granted, may be challenged or invalidated, in which case we would
be unable to prevent unauthorized use of our brand and logo in such jurisdiction. We have not filed trademark registrations in all jurisdictions where our brand and logo are used.
Some software we provide may be subject to open source licenses, which may restrict how we use or distribute our software or require that we release the source code of certain products subject to
those licenses.
Some of the products we support and some of our proprietary technologies incorporate open source software such as
open source MP3 codecs that may be subject to the Lesser Gnu Public License or other open source licenses. The Lesser Gnu Public License and other open source licenses typically require that source code subject to the license be released or made
available to the public. Such open source licenses typically mandate that software developed based on source code that is subject to the open source license, or combined in specific ways with such open source software, become subject to the open
source license. We take steps to ensure that proprietary software we do not wish to disclose is not combined with, or does not incorporate, open source software in ways that would require such proprietary software to be subject to an open source
license. However, few courts have interpreted the Lesser Gnu Public License or other open source licenses, and the manner in which these licenses may be interpreted and enforced is therefore subject to some uncertainty. In addition, we rely on
multiple software programmers to design our proprietary products and technologies. Although we take steps to ensure that our programmers do not include open source software in products and technologies we intend to keep proprietary, we do not
exercise complete control over the development efforts of our programmers and we cannot be certain that our programmers have not incorporated open source software into products and technologies we intend to keep proprietary. In the event that
portions of our proprietary technology are determined to be subject to an open source license, or are intentionally released under an open source license, we could be required to publicly release the relevant portions of our source code, which could
reduce or eliminate our ability to commercialize our products and technologies.
Risks related to the securities markets and investment in our common
stock
* The market price of our common stock may decline as a result of the proposed sale of Stage6.com or separation of Stage6.com into a
private company.
The market price of our common stock may decline as a result of our proposed separation of Stage6.com for a number
of reasons, including:
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uncertainty surrounding the proposed transaction;
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the costs related to the continued operation of Stage6.com and the related impact to our results of operations;
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the failure to complete the proposed separation in a timely manner, or at all;
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the level and value of any ongoing ownership interest in Stage6.com that we might retain after the proposed separation; or
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the failure of the proposed separation to achieve its expected benefits as rapidly or to the extent anticipated by financial or industry analysts.
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Market volatility may affect our stock price and the value of your investment.
The market price for our common stock has been and is likely to continue to be volatile, in part because our shares have only recently been traded
publicly. In addition, the market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including:
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announcements of new products, services or technologies, commercial relationships or other events by us or our competitors;
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regulatory developments in the United States and foreign countries;
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fluctuations in stock market prices and trading volumes of similar companies;
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variations in our quarterly operating results;
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changes in securities analysts estimates of our financial performance;
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changes in accounting principles;
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sales of large blocks of our common stock, including sales by our executive officers, directors and significant stockholders;
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additions or departures of key personnel; and
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discussion of us or our stock price by the financial press and in online investor communities.
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* Shares of our common stock are relatively illiquid.
As of October 31, 2007, we had 34,446,973 shares of common stock outstanding, excluding 157,887 shares subject to repurchase. As a result of our relatively small public float, our common stock may be less liquid than the stock of
companies with broader public ownership. Among other things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our shares than would be the case if our public float were larger.
Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more
difficult and may prevent attempts by our stockholders to replace or remove our current management.
Provisions in our certificate
of incorporation and bylaws may delay or prevent an acquisition of us or a change in our management. These provisions include a classified board of directors, a prohibition on actions by written consent of our stockholders and the ability of our
board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which limits the ability
of stockholders owning in excess of 15% of our outstanding voting stock to merge or combine with us. Although we believe these provisions collectively provide for an opportunity to obtain higher bids by requiring potential acquirors to negotiate
with our board of directors, they would apply even if an offer were considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by
making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.
We do not intend to pay dividends on our common stock.
We have never declared or paid any cash dividend on our
capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.
We will incur
increased costs as a result of changes in laws and regulations relating to corporate governance matters.
Changes in the laws and
regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act and rules adopted by the SEC and by The Nasdaq Stock Market, will result in increased costs to us as we continue to evaluate the implications of these
laws and respond to their requirements. The impact of these laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We
are presently evaluating and monitoring developments with respect to these laws and regulations and cannot predict or estimate the amount or timing of additional costs we may incur to respond to their requirements.
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If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements
could be impaired, which could adversely affect our ability to operate our business and our stock price.
Ensuring that we have
adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are in
the process of documenting, reviewing and, where appropriate, improving our internal controls and procedures in preparation for compliance with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the
effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. Both we and our independent auditors will be testing our internal controls in connection with the Section 404
requirements and could, as part of that documentation and testing, identify material weaknesses, significant deficiencies or other areas for further attention or improvement. Our networks are vulnerable to security risks and hacker attacks, which
may affect our ability to maintain effective internal controls as contemplated by Section 404. Implementing any appropriate changes to our internal controls may require specific compliance training for our directors, officers and employees,
entail substantial costs to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that
adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, disclosure regarding our internal controls
or investors perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may adversely affect our stock price.
* If our executive officers, directors and their affiliates choose to act together, they may be able to control our operations and act in a manner that advances their best interests and not necessarily those of
other stockholders.
Our executive officers, directors and their affiliates beneficially own approximately 27.6% of our common stock
as of October 31, 2007. As a result, these stockholders, acting together, are able to effectively control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business
combination transactions. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders, and they may act in a manner that advances their best interests and not necessarily those of
other stockholders.
* Future sales of our common stock may cause our stock price to decline.
As of October 31, 2007, there were 34,446,973 shares of our common stock outstanding. Excluding 157,887 shares subject to repurchase,
substantially all of these shares became eligible for sale in the public market upon expiration of lock-up agreements on March 20, 2007, although as of October 31, 2007, 10,287,411 of these shares were held by directors, executive officers
and other affiliates and will be subject to volume limitations under Rule 144. In addition, as of October 31, 2007 we had outstanding warrants to purchase up to 77,407 shares of common stock that, if exercised, will result in these
additional shares becoming available for sale. A large portion of these shares and warrants are held by a small number of persons and investment funds. Sales by these stockholders or warrantholders of a substantial number of shares could
significantly reduce the market price of our common stock. Moreover, the holders of 9,912,726 shares of common stock at October 31, 2007 have rights, subject to some conditions, to require us to file registration statements covering the shares
they currently hold or to include these shares in registration statements that we may file for ourselves or other stockholders.
As of
October 31, 2007, an aggregate of approximately 5,724,187 shares of our common stock were reserved for future issuance under our 2000 Stock Option Plan, or 2000 Plan, our 2006 Equity Incentive Plan, or 2006 Plan, and our 2006 Employee
Stock Purchase Plan, or 2006 Purchase Plan, and the share reserve under our 2006 Plan and our 2006 Purchase Plan are subject to automatic annual increases in accordance with the terms of the plans. These shares can be freely sold in the public
market upon issuance. If a large number of these shares are sold in the public market, the sales could reduce the trading price of our common stock and impede our ability to raise future capital.
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