10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) {X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly period ended June 30, 2001 ------------- OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 1-14007 ------- SONIC FOUNDRY, INC. ------------------- (Exact name of registrant as specified in its charter) MARYLAND 39-1783372 ------------------------------- ---------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1617 Sherman Avenue, Madison, WI 53704 -------------------------------------- (Address of principal executive offices) (608)256-3133 ------------- (Registrant's telephone number including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days Yes X No _____. ----- State the number of shares outstanding of each of the issuer's common equity as of the last practicable date: Outstanding Class August 13, 2001 ----- --------------- Common Stock, $0.01 par value 22,292,082 SONIC FOUNDRY, INC. QUARTERLY REPORT ON FORM 10-Q QUARTER ENDED JUNE 30, 2001 TABLE OF CONTENTS

PAGE NO. -------- PART I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Consolidated Balance Sheets - June 30, 2001 (Unaudited) and September 30, 2000............................................................... 3 Consolidated Statements of Operations (Unaudited) - Nine months ended June 30, 2001 and 2000 and the Three months ended June 30, 2001 and 2000................................................. 5 Consolidated Statements of Cash Flows (Unaudited) - Nine months ended June 30, 2001 and 2000............................................ 6 Notes to Consolidated Financial Statements (Unaudited)................................ 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................. 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................................................... 17 PART II OTHER INFORMATION Item 1. Legal Proceedings..................................................................... 18 Item 4. Submission of Matters to a Vote of Security Holders................................... 18 Item 6. Exhibits and Reports on Form 8-K...................................................... 19

2 Sonic Foundry, Inc. Consolidated Balance Sheets (in thousands except for share data)

June 30, September 30, 2001 2000 ---------------------------------- (Unaudited) Assets Current Assets: Cash and cash equivalents $ 9,608 $ 21,948 Accounts receivable, net of allowances of $2,122 and $1,209 at June 30, 2001 and September 30, 2000 5,082 9,075 Accounts receivable, other 57 355 Revenues in excess of billings for software license fees - 105 Inventories 984 1,906 Prepaid expenses and other current assets 763 1,591 Prepaid advertising 1,000 1,000 --------------------------------- Total current assets 17,494 35,980 Property and equipment: Land - 95 Buildings and improvements 2,382 3,186 Equipment 15,672 15,370 Furniture and fixtures 545 504 Assets held for sale 77 - --------------------------------- Total property and equipment 18,676 19,155 Less accumulated depreciation 4,795 3,071 --------------------------------- Net property and equipment 13,881 16,084 Other assets: Goodwill and other intangibles, net 51,302 73,632 Capitalized software development costs, net 150 518 Long-term investment 514 514 Other assets 40 97 --------------------------------- Total other assets 52,006 74,761 --------------------------------- Total assets $ 83,381 $ 126,825 =================================

See accompanying notes. 3 Sonic Foundry, Inc. Consolidated Balance Sheets (in thousands except for share data)

June 30, September 30, Liabilities and stockholders' equity 2001 2000 -------------------------------------- Current liabilities: Accounts payable $ 1,879 $ 5,231 Accrued liabilities 2,159 2,819 Accrued restructuring charges 341 - Current portion of long-term debt 4,042 4,300 Current portion of capital lease obligations 1,329 1,477 Other current liabilities 76 - -------------------------------------- Total current liabilities 9,826 13,827 Long-term obligations, net of current portion 258 923 Capital lease obligations, net of current portion 805 1,703 Other liabilities 29 6 Stockholders' equity: Preferred stock, $.01 par value, authorized 5,000,000 - - shares, none issued and outstanding 5% preferred stock, Series B, voting, cumulative, convertible, $.01 par value (liquidation preference at par), authorized 10,000,000 shares, none issued and outstanding - - Common stock, $.01 par value, authorized 100,000,000 shares; 22,304,126 and 21,904,574 shares issued and 22,276,376 and 21,876,824 outstanding at June 30, 2001 223 219 and September 30, 2000 Common stock to be issued 5,579 5,579 Additional paid-in capital 147,740 148,290 Accumulated deficit (80,874) (42,388) Receivable for common stock issued (26) (72) Cumulative foreign currency translations/adjustments (29) 137 Unearned compensation - (1,249) Treasury stock, at cost, 27,750 shares (150) (150) -------------------------------------- Total stockholders' equity 72,463 110,366 -------------------------------------- Total liabilities and stockholders' equity $ 83,381 $ 126,825 ======================================

See accompanying notes. 4 Sonic Foundry, Inc. Statements of Operations (Unaudited) (in thousands except for per share data)

Three Months Ended Nine Months Ended June 30, June 30, 2001 2000 2001 2000 -------------------------------------------------------------------- Revenue: Software license fees $ 4,161 $ 5,115 $ 12,683 $ 15,800 Media services 2,933 1,627 8,193 2,030 -------------------------------------------------------------------- Total revenue 7,094 6,742 20,876 17,830 Cost of revenue: Cost of software license fees 1,171 1,220 4,365 3,424 Cost of media services 1,793 1,773 6,083 2,247 -------------------------------------------------------------------- Total cost of revenue 2,964 2,993 10,448 5,671 -------------------------------------------------------------------- Gross margin 4,130 3,749 10,428 12,159 Operating expenses: Selling and marketing expenses 1,973 5,711 10,140 13,778 General and administrative expenses 2,231 3,864 7,922 7,039 Product development expenses 1,685 2,238 6,312 4,950 Amortization of goodwill and other intangibles 6,726 6,793 20,753 6,793 Restructuring expenses - - 3,782 -------------------------------------------------------------------- Total operating expenses 12,615 18,606 48,909 32,560 -------------------------------------------------------------------- Loss from operations (8,485) (14,857) (38,481) (20,401) Other income (expense): Interest expense (141) (45) (513) (270) Interest and other income 90 593 508 1,688 -------------------------------------------------------------------- Total other income (51) 548 (5) 1,418 -------------------------------------------------------------------- Net loss before taxes (8,536) (14,309) (38,486) (18,983) Income tax benefit - 8 - 8 -------------------------------------------------------------------- Net loss $ (8,536) $ (14,301) $ (38,486) $ (18,975) ==================================================================== Loss per common share - Basic $ (.39) $ (.66) $ (1.75) $ (1.10) ==================================================================== Diluted $ (.39) $ (.66) $ (1.75) $ (1.10) ====================================================================

See accompanying notes. 5 Sonic Foundry, Inc. Consolidated Statements of Cash Flows (In thousands) (Unaudited)

Nine months ended June 30, 2001 2000 ------------------------------- Operating activities Net loss $ (38,486) $ (18,975) Adjustments to reconcile net loss to net cash used in operating activities: Amortization of goodwill and other intangibles 20,753 6,793 Depreciation and amortization of property and equipment 2,566 1,528 Amortization of capitalized software development 368 442 Non-cash charge for common stock warrants and options 550 343 Amortization of debt discount and debt issuance costs - 163 Amortization of unearned compensation - 50 (Gain)/Loss on disposal of assets and investments 1,557 (650) Income tax benefit - (8) Changes in operating assets and liabilities: Accounts receivable and revenues in excess of billings 4,396 (3,893) Inventories 922 (921) Prepaid expenses and other assets 750 (462) Accounts payable and accrued liabilities (2,870) 1,029 ------------------------------- Total adjustments 28,992 4,414 ------------------------------- Net cash used in operating activities (9,494) (14,561) Investing activities Acquisition, net of cash acquired (679) (4,042) Purchases of property and equipment (1,955) (4,927) Proceeds on sales of property and equipment 1,213 1,000 ------------------------------- Net cash used in investing activities (1,421) (7,969) Financing activities Proceeds from sale of common stock, net of issuance costs 300 53,381 Borrowings on line of credit, net 595 - Proceeds from debt 436 - Payments on long-term debt and capital leases (2,887) (212) ------------------------------- Net cash (used in)/provided by financing activities (1,556) 53,169 ------------------------------- Effect of exchange rate changes on cash 131 - ------------------------------- Net increase/(decrease) in cash (12,340) 30,639 Cash and cash equivalents at beginning of period 21,948 5,889 ------------------------------- Cash and cash equivalents at end of period $ 9,608 $ 36,528 ===============================

See accompanying notes. 6 Supplemental cash flow information: Interest paid $ 258 $ 76 Noncash transactions - Capital lease acquisitions 86 1,365 Issuance of stock in exchange for future advertising - 2,500 Issuance of stock for acquisition of Jedor - 300 Issuance of stock and stock options for acquisition of STV - 72,480 Stock to be issued for acquisition of International Image - 6,900 Cash to be paid for acquisition of International Image at close - 8,000 Reclassification of goodwill to fixed assets upon final appraisal of International Image 1,281 - Reduction of goodwill upon settlement of notes due certain International Image shareholders 200 - Cancellation of unvested stock options classified as unearned compensation upon acquisition of STV 1,249 - Issuance of warrants for consulting services 19 696 Conversion of subordinated debt and associated debt issuance costs and accrued interest into common stock - 2,890 See accompanying notes. 7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. Basis of Presentation and Significant Accounting Policies Interim Financial Data The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with the Company's annual report filed on Form 10-K for the fiscal year ended September 30, 2000. In the opinion of management, all adjustments (consisting only of adjustments of a normal and recurring nature) considered necessary for a fair presentation of the results of operations have been included. Operating results for the periods presented are not necessarily indicative of the results that might be expected for the year ended September 30, 2001. Inventories Inventory consists of the following (in thousands): June 30, September 30, 2001 2000 ------------------------------- Raw materials and supplies $ 434 $1,121 Work-in-process 304 213 Finished goods 246 572 ------------------------------- $ 984 $1,906 =============================== Net Loss Per Share The following table sets forth the computation of basic and diluted loss per share:

Three Months Nine Months Ended June 30, Ended June 30, 2001 2000 2001 2000 ------------------------------------------------- Denominator Denominator for basic and diluted loss per share - weighted average common shares 22,127,533 21,557,209 21,999,981 17,312,753 ================================================ Securities that could potentially dilute basic earnings per share in the future that are not included in the computation of diluted loss per share as their impact is antidilutive (treasury stock method) Options and warrants 787,108 605,517 904,621 2,838,885 Common stock to be issued 485,100 600,000 485,100 600,000

8 Accounting Pronouncements In May 2000, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-14, "Accounting for Certain Sales Incentives." EITF No. 00-14 requires cash rebates to be classified as a reduction of revenue rather than a marketing expense. Historically, the Company has recognized revenue for products with cash rebates on a gross basis at the time of the sale, and cash rebates expected to be claimed were charged to marketing expense. Adoption of EITF No. 00-14 affects the presentation of rebates in the statement of operations, but does not affect the loss from operations reported. EITF No. 00-14 is required to be adopted beginning July 1, 2001, however, the Company has elected to make it effective October 1, 2000. Prior periods presented for comparative purposes have been reclassified to comply with the new presentation requirements. For the quarter ended June 30, 2001 and 2000, rebates were $331,000 and $132,000 respectively. In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, "Business Combinations," and No. 142 "Goodwill and Other Intangible Assets," effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2003. If adopted for fiscal 2002 the nonamortization provisions of the Statement would result in a decrease in net loss of $26,904,000 ($1.21 per share) per year. The Company will perform the first required impairment tests of goodwill and indefinite lived intangible assets as of October 1, 2002 and has not yet determined what the effect of these tests will be on earnings and financial position of the Company. 2. Restructuring Charge As a result of rapidly changing market conditions, in December 2000 the Board of Directors authorized management to make a 40% workforce reduction in order to improve cash flow. The restructuring charges were determined based on plans submitted by the Company's management and approved by the Board of Directors using information available at the time. As a result of this reduction, the Company recorded restructuring charges of $3,782,000 during the first quarter of fiscal 2001 and recorded a restructuring accrual of $2,557,000. The accrual was reduced by $2,070,000 in the second quarter of fiscal 2001 and $146,000 in the third quarter. No additional restructuring charges were recorded in the second and third quarters, however, the Company continues to evaluate whether any further charges are necessary. 3. Subsequent Events In early January 2001, a $4 million note was due the former shareholders of International Image. We withheld paying the note pending the resolution of certain disputed representations made during the acquisition. In January 2001 the noteholders initiated litigation against us in Toronto for payment of the note and in March, 2001 we initiated a counter action for damages incurred. In April 2001, we paid the minority shareholders $500,000 in full settlement of $700,000 of the note plus accrued interest originally owed. Litigation with the majority shareholders is still pending. 9 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the consolidated financial position and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this form 10-Q and the Company's annual report filed on form 10-K for the fiscal year ended September 30, 2000. In addition to historical information, this discussion contains forward-looking statements such as statements of the Company's expectations, plans, objectives and beliefs. These statements use such words as "may," "will," "expect," "anticipate," "believe," "plan," and other similar terminology. Actual results could differ materially due to changes in the market acceptance of our products, market introduction or product development delays, our ability to effectively integrate acquired businesses, global and local business conditions, legislation and governmental regulations, competition, our ability to effectively maintain and update our product portfolio, shifts in technology, political or economic instability in local markets, and currency and exchange rate fluctuations. Overview In accordance with FAS 131 disclosure on segment reporting, the SEC's guidance has been to present financial information in a format that is used by the Company's management to make decisions. The Company is a digital media solutions provider with two primary revenue centers: a software product division, with a full suite of software products utilized by both producers and consumers of digital media; and a media services division, which provides broadcast conversion, tape duplication, audio and video encoding, video-on- demand production work and consulting services. We analyze these two revenue centers, along with their respective production costs, independently from each other. However, because the majority of our operating expenses support both revenue centers, we analyze all items below gross margin on a combined basis. Results of Operations The following chart has been presented to add clarification only and should be read in conjunction with the consolidated financial statements.

Three Months Ended June 30, Nine Months Ended June 30, 2001 2000 2001 2000 ------------------------------------------------------------------------ Software license fees $4,161 100% $5,115 100% $12,683 100% $15,800 100% Cost of software license fees 1,171 28 1,220 24 4,365 34 3,424 22 ------------------------------------------------------------------------ Gross margin-software license fees $2,990 72% $3,895 76% $ 8,318 66% $12,376 78% ======================================================================== Media services $2,933 100% $1,627 100% $ 8,193 100% $ 2,030 100% Cost of media services 1,793 61 1,773 109 6,083 74 2,247 111 ------------------------------------------------------------------------ Gross margin-media services $1,140 39% $ (146) (9)% $ 2,110 26% $ (217) (11)% ========================================================================

10 Total Net Revenue Total net revenues increased 5% to $7,094 for the three months ended June 30, 2001 from $6,742 in the comparable period of 2000. Total net revenues increased 17% to $20,876 for the nine months ended June 30, 2001 from $17,830 in the comparable period of 2000. The overall net increase in revenue for both periods is due to our acquired service businesses. We began consolidated reporting with STV Communications, Inc. ("STV") in April 2000 and with International Image ("II") in June 2000. The revenue from our traditional software business declined for both periods, primarily because of a decline in revenues from our OEM partners and reduced sales in the retail channel. Net revenues from international customers accounted for 27% and 15% of total net revenues for the nine months ended June 30, 2001 and 2000, respectively. The significant increase is primarily due to the acquisition of International Image, which has an office located in Toronto that services primarily Canadian clients. For detailed information on revenue recognition principles, see Note 1 to the audited financial statements in the annual report filed as part of Form 10-K for the fiscal year ended September 30, 2000. Revenue from Software License Fees Revenues from software license fees consist of fees charged for the licensing of Windows based software products that are built on the principle of "Create" (the ACID(TM) family), "Edit" (Sound Forge(R), Sound Forge Studio XP, Vegas(R) Audio, Vegas(R) Video, VideoFactory(TM)) and "Deliver" (Siren(TM) Jukebox and Stream Anywhere). These software products are marketed to all levels of both consumers and producers of digital media. We reach both our domestic and international markets through traditional retail distribution channels, our direct sales effort and OEM partnerships. Three months ended June 30, 2001 ("Q3-2001") compared to the three months ended June 30, 2000 ("Q3-2000") and the nine months ended June 30, 2001 ("YTD-2001") compared to the nine months ended June 30, 2000 ("YTD-2000") Net revenues from software license fees decreased $954 from Q3-2000 to Q3-2001 and decreased $3,117 from YTD-2000 to YTD-2001. Both the quarterly and the year-to-date decline resulted from the following items: . Revenue from our retail channel declined $1,082 from Q3-2000 to Q3-2001 and $2,319 from YTD-2000 to YTD-2001. The overall weakening in the retail market primarily impacted sales of Siren, which declined 90% from Q3-2000 to Q3-2001. Our decision to adopt EITF 00-14 prior to effectiveness of the pronouncement also impacted retail 11 revenues this quarter. EITF 00-14 relates to rebates and other sales incentives and requires that they be accounted for as a reduction of revenues rather than as a marketing expense. Q3-2001 rebates were $331 compared to $132 in Q3-2000. . Revenue generated from OEM partners declined $1,187 from Q3-2000 to Q3-2001 and $3,627 from YTD-2000 to YTD-2001. This is due primarily to a recent trend towards OEM's bundling much larger volumes of a scaled-down version of our product with their hardware or software in exchange for mass marketing opportunities intended to drive upgrade revenues through our direct sales channel. In addition, Q3-2000 OEM revenue of $1,431 included a one-time licensing transaction with Pinnacle Systems, Inc., custom software development revenues from the recently completed Screenblast project for Sony Pictures and revenues from Hewlett Packard Company under a contract that expired September 2000. OEM revenues were $244 in the current quarter. . Revenues from our direct channel increased $1,315 from Q3-2000 to Q3-2001 and $2,829 from YTD-2000 to YTD-2001. The launch of ACID Pro 3.0, continuing demand for Sound Forge 5.0 and a number of email-based promotional offers targeted at several thousand potential buyers was the primary reason for the growth. Direct revenues were 53% of software license fees in Q3-2001. Costs of Software License Fees Costs of software license fees include product material costs, contracted and internal assembly labor, freight, royalties on third party technology or intellectual content, and amortization of previously capitalized product development and localization costs. Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 Cost of software license fees decreased to $1,171 in Q3-2001, the lowest since Q2-2000, and improved slightly from $1,220 in Q3-2000. However, it increased as a percentage of net software revenues both in Q3-2001 and YTD-2001. Both the Q3-2001 and YTD-2001 increase are due primarily to a significant decline in high-margin OEM revenues, an increase in royalties paid for third party technology such as MP3 compression, an increase in amortization of capitalized localization costs and write-offs of slow moving inventory. These gross margin reductions have been partially offset by the growing number of downloadable products being sold from our website. Revenue from Media Services In October 1999, we announced the formation of our Media Services division by offering audio and video encoding services from our Madison location. In April 2000, we added additional encoding capabilities, hosting, streaming, syndication and a California presence with the acquisition of STV. In June 2000 the acquisition of II became effective, which added tape duplication, video-on- demand production and broadcast conversion services to our media services division. Since the beginning of fiscal 2001, we have sold, terminated or reduced our 12 emphasis on efforts such as syndication, content hosting, webcasting and dot.com encoding in order to concentrate on higher gross margin business; primarily video and video-on-demand production and our Enterprise Content Management initiative. Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 Net revenues from media services increased $1,306 from Q3-2000 to Q3-2001, and increased $6,163 from YTD-2000 to YTD-2001. Both the quarterly and the year-to- date increases are due to the acquisition of II, which became effective on June 1, 2000. Growth in revenues over Q1 and Q2 of the current year reflects strong seasonal demand from our TV industry customers for our traditional videotape conversion services. This seasonal demand typically declines in the fourth quarter. Costs of Media Services Costs of media services include compensation and benefits for direct labor, depreciation on production equipment, and other general expenses associated with production personnel. Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 Costs of media services increased $20 from Q3-2000 to Q3-2001, and $3,836 from YTD-2000 to YTD-2001. Both the quarterly and the year-to-date increase in dollars resulted from the acquisition of STV and II. As a percentage of media services revenue, overall service margins improved to 39% for Q2-2001 and 26% for YTD-2001. These improvements were led by higher margin video-tape services gained with the acquisition of II, the elimination of a permanent production workforce for encoding services in Q1-2001 and a reduction in depreciation expense in Q3-2001 from underutilized production assets that we intend to place for sale. 13 Operating Expenses The following chart is provided to add clarification by presenting items as a percentage of total revenues. This should be read in conjunction with the unaudited consolidated financial statements presented in this filing.

Three Months Ended Nine Months Ended June 30, June 30, 2001 2000 2001 2000 ----------------------------------------------------------- Total revenue 100 % 100 % 100 % 100 % Total cost of revenue 42 44 50 32 --------------------------------------------------------- Gross margin 58 56 50 68 Operating expenses: Selling and marketing expenses 28 85 49 77 General and administrative expenses 31 57 38 39 Product development expenses 24 33 30 28 Amortization of goodwill and other intangibles 95 101 99 38 Restructuring expenses - - 18 - --------------------------------------------------------- Total operating expenses 178 276 234 182 --------------------------------------------------------- Loss from operations (120) % (220) % (184) % (114) % =========================================================

Selling and Marketing Expenses Selling and marketing expenses include wages and commissions for sales, marketing and technical support personnel, our direct mail catalog, co-operative advertising with our software distributors, print advertising and various promotional expenses for both our products and services. Timing of these costs may vary greatly depending on introduction of new products and services or entrance into new markets. Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 Selling and marketing expenses decreased by $3,738 from Q3-2000 to Q3-2001, and decreased by $3,638 from YTD-2000 to YTD-2001. This decrease can be attributed to the following items; 1) significant staff reductions in the sales and marketing department in December, 2000; 2) a greater percentage of revenues coming from the media services division, which requires less expensive, more targeted forms of marketing; which coincides with 3) a lesser focus on more costly brand marketing such as tradeshows and media advertising. We will continue to focus on our direct mail effort and co-operative advertising with our retailers and distributors to drive software sales, as well as more targeted forms of marketing to reach our media services clients. 14 General and Administrative Expenses ("G&A Expenses") G&A expenses consist primarily of personnel and related costs associated with the facilities, finance, executive, legal, and information technology departments, as well as other expenses not fully allocated to functional areas. Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 G&A expenses decreased by $1,633 from Q3-2000 to Q3-2001, but increased by $883 from YTD-2000 to YTD-2001. Higher G&A expenses in Q3-2000 up through Q1-2001 are primarily attributable to newly acquired companies and the integration of multiple locations. The restructuring that occurred at the end of Q1-2001 reduced G&A expenses by eliminating duplicative positions and consolidating facilities. Product Development Expenses Product development expenses include salaries and wages of the software research and development staff and an allocation of benefits, facility and administrative expenses, net of product development expenses capitalized pursuant to SFAS No. 86, "Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed." Q3-2001 compared to Q3-2000 and YTD-2001 compared to YTD-2000 Product development expenses decreased by $553 from Q3-2000 to Q3-2001, but increased by $1,362 from YTD-2000 to YTD-2001. As a percentage of total revenues, product development expenses decreased to 24% for Q3-2001 compared to 33% in Q3-2000, however the YTD percentage increased slightly from 28% for YTD- 2000 to 30% for YTD-2001. The YTD increase is primarily due to product development expenses incurred in Q1-2001, which were 43% of total revenues. The decrease from 43% in Q1-2001 to approximately 25% for the past two quarters, is due to the company-wide restructuring that occurred at the end of Q1-2001. As part of the restructuring, we eliminated low volume, niche products such as CD Architect and Soft Encode as well as the engineering staff positions required to maintain these products. In accordance with SFAS Number 86, the Company capitalizes the cost of development of software products that have reached technological feasibility. No development costs for our core product line were capitalized during the current period. Going forward, we believe software development costs qualifying for capitalization will be less significant, and, as such, we expect that we will expense most or all research and development costs as incurred. Restructuring Charges As outlined in footnote 2 to the unaudited consolidated financial statements included in this report, a restructuring charge of $3,782 was incurred in Q1- 2001 consistent with management's plan to reduce costs in response to weak market conditions. This restructuring charge primarily consisted of: 1) an accrual for 60 days of severance and benefits for domestic employees terminated on December 20, 2000; 2) severance and other expenses associated with closing our 15 office in the Netherlands; 3) an asset impairment charge related to the sale, disposal or write-down of PCs, office equipment and other assets no longer required; 4) operating and lease termination costs related to the consolidation of facilities; and 5) miscellaneous charges such as forfeited tradeshow deposits. We have not yet completed the disposal of underutilized assets, however, at the beginning of Q3-2001 we discontinued depreciation of additional assets no longer used in operations. The Company continues to evaluate whether any further charges are necessary. Amortization of Goodwill and Other Purchase Intangibles The amortization of goodwill and other purchase intangibles consists of expense associated with the purchases of STV and II. STV's total purchased intangibles consist of assembled workforce of $1 million, which was fully amortized at the end of Q2-2001 and goodwill of $70 million, which is being amortized over a three year period. II's total purchased intangibles consist of assembled workforce of $2.2 million, which is being amortized over a five year period and goodwill of $12.9 million, which is being amortized over a three to seven year period. In the quarter ended December 31, 2000 we received a final appraisal of II's fixed assets and, as a result, reclassified $1.2 million of the purchase price from goodwill to fixed assets. In April 2001, we paid $500 in full settlement of a $700 note due the minority shareholders of II, which resulted in a reduction of II's goodwill. Liquidity and Capital Resources Cash used in operating activities amounted to $9,493 for YTD-2001 and $14,561 for YTD-2000. Decreased use of operating cash of $5,068 from 2000 to 2001 consisted primarily of operating cost reductions identified in the Q1-2001 restructuring. On a quarterly basis, $105 cash was provided by operations in Q3-2001 compared to cash used in operations of $7,751 in Q1-2001 and $1,847 in Q2-2001. Contributing to the improvement in Q3-2001 were the following items; 1) Loss from operations before amortization of goodwill and restructuring charges continues to improve in the current fiscal year from $8,965 in Q1-2001 to $1,759 in Q3-2001, 2) Improved collections driven by increased credit card sales in our direct channel, and 3) Reduced inventory balances due to increases in the electronic delivery of our software products. Cash used in investing activities was $1,421 for YTD-2001 and $7,969 for YTD-2000. Investing uses in the current year related to $679 of legal, accounting, and other professional fees accrued in the prior year for the II acquisition and $1,955 for fixed asset purchases relating to our media services effort and leasehold improvements. Partially offsetting these uses were proceeds of $1,213 for sales of property and equipment no longer fully utilized. In YTD-2000, fixed asset purchases of $4,927 - primarily for the media services effort-were partially offset by the December 1999 sale of real estate no longer needed in the Company's operations. In YTD-2001, $1,556 was used in financing activities, with $2,887 used for payments on debt and capital leases. The majority of the increase in debt and lease payments relates to lease financing for Media Services equipment obtained in the STV transaction. Cash provided by 16 financing activities includes $300 received from the sale of common stock and a $595 draw on our line of credit in Toronto. In November and December of 2000, we reduced headcount across all departments, eliminated certain sales and marketing programs and discontinued non-core media services efforts such as syndication, streaming and webcasting. These cuts were not anticipated to and have not appeared to impact future revenue generation or the quality of products and services we provide. Although these efforts have allowed us to generate positive cash flow from operations in this quarter, there can be no assurance we will maintain positive cash flow in the future due to sales mix, market conditions and other factors. In order to finance growth, maintain operations and pursue additional technologies, we may pursue cash in the equity market with key strategic partners or private investors. We are also reviewing other financing activities such as debt and subleasing arrangements and the sale of underutilized assets. There can be no assurance that we will obtain additional debt or equity on satisfactory terms. In early January 2001, a $4 million note was due the former shareholders of International Image. We withheld paying the note pending the resolution of certain disputed representations made during the acquisition. In January 2001 the noteholders initiated litigation against us in Toronto for payment of the note and in March, 2001 we initiated a counter action for damages incurred. In April 2001, we paid the minority shareholders $500 in full settlement of $700 of the note plus accrued interest originally owed. Litigation with the majority shareholders is still pending. It is too early in the litigation to assess the ultimate outcome or liability. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Because our cash equivalents consist of overnight investments in money market funds, we will not experience decreases in principal value associated with a decline in interest rates. Although we license our software to customers overseas in U.S. dollars, we have exposure to foreign currency fluctuations associated with liabilities, bank accounts and other assets maintained by our offices in Canada. We currently do not hedge our exposure to foreign currency fluctuations, which have historically been immaterial. 17 PART II OTHER INFORMATION Item 1. LEGAL PROCEEDINGS Reference is made to the discussion of the case entitled 1456096 Ontario Limited, et. al. v. Sonic Foundry (Nova Scotia) Inc., et. al. in Item I of Part II in our 10-Q for the quarter ended March 31, 2001. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders was held on May 24, 2001. A quorum consisting of approximately 85% of the Company's common stock issued and outstanding was represented either in person or by proxy. At the meeting the following proposals were approved by the stockholders: 1. To re-elect Frederick H. Kopko, Jr. as a Class two Director for a term of five years. Rimas Buinevicius, Monty Schmidt, Curtis Palmer, Arnold Pollard and David Kleinman continued as directors following the meeting. 2. To ratify the appointment of Ernst & Young LLP as independent auditors of Sonic Foundry for the year ending September 30, 2001.

For Against Abstain/Withheld --- ------- ---------------- Proposal #1 18,673,318 - 144,835 Proposal #2 18,702,811 82,940 32,402

18 Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (see exhibit list) (b) Reports on Form 8-K - None ITEM 6(a) NUMBER DESCRIPTION ------ ------------------------------------------------------------------- 3.1 Amended and Restated Articles of Incorporation of the Registrant, filed as Exhibit No. 3.1 to the registration statement on amendment No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the "Registration Statement"), and hereby incorporated by reference. 3.2 Amended and Restated By-Laws of the Registrant, filed as Exhibit No. 3.2 to the Registration Statement, and hereby incorporated by reference. 10.1 Registrant's 1995 Stock Option Plan, as amended, filed as Exhibit No. 4.1 to the Registration Statement on Form S-8 on September 8, 2000, and hereby incorporated by reference. 10.2 Registrant's Non-Employee Directors' Stock Option Plan, filed as Exhibit No. 10.2 to the Registration Statement, and hereby incorporated by reference. 10.3 Commercial Lease between Registrant and The Williamson Center, LLC regarding 740 and 744 Williamson Street, Madison, Wisconsin dated January 20, 1998, filed as Exhibit No. 10.3 to the Registration Statement, and hereby incorporated by reference. 10.4 Employment Agreement between Registrant and Rimas Buinevicius dated as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and hereby incorporated by reference. 10.5 Employment Agreement between Registrant and Monty R. Schmidt dated as of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and hereby incorporated by reference. 10.6 Employment Agreement between Registrant and Curtis J. Palmer dated as of January 1, 2001, filed as Exhibit 10.6 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and hereby incorporated by reference. 10.7 Digital Audio System License Agreement between Registrant and Dolby Laboratories Licensing Corporation dated July 28, 1997, filed as Exhibit No. 10.7 to the Registration Statement, and hereby incorporated by reference. 19 10.8 Digital Audio System License Agreement between Registrant and Dolby Laboratories Licensing Corporation dated July 28, 1997, filed as Exhibit No. 10.8 to the Registration Statement, and hereby incorporated by reference. 10.12 Software License Agreement, effective as of September 29, 1998, between Registrant and Hewlett-Packard Company - CONFIDENTIAL MATERIAL FILED SEPARATELY, and hereby incorporated by reference. 10.14 Business Note Agreement, dated March 3, 1999 between Registrant and Associated Bank South Central, filed as Exhibit No. 10.15 to the Quarterly Report on form 10-QSB for the period ended March 31, 1999, and hereby incorporated by reference. 10.15 Convertible Debenture Purchase Agreement dated September 13, 1999 between Purchasers and the Registrant filed as Exhibit No. 10.17 to the Current Report on form 8-K filed on September 24, 1999, and hereby incorporated by reference. 10.16 Commercial Lease between Registrant and Tenney Place Development, LLC regarding 1617 Sherman Ave., Madison, Wisconsin dated October 1, 1999, filed as Exhibit No. 10.18 to the Annual Report on form 10-K for the period ended September 30, 1999, and hereby incorporated by reference. 10.17 Registrant's 1999 Non-Qualified Stock Option Plan, filed on Form S-8 on September 8, 2000, and hereby incorporated by reference. 10.18 Commercial Lease between Registrant and Hargol Management Limited regarding 23 Prince Andrew Place, Don Mills, Ontario, Canada dated January 15, 1990, filed as Exhibit No. 10.20 to the Amended Annual Report on Form 10-K/A for the year ended September 30, 2000, and hereby incorporated by reference. 10.19 Commercial Lease between Registrant and the Richlar Partnership regarding 1703 Stewart St., Santa Monica, CA, dated August 10, 1995, filed as Exhibit No. 10.21 to the Amended Annual Report on Form 10- K/A for the year ended September 30, 2000, and hereby incorporated by reference. 10.20 Commercial Lease between Registrant and Thomas Seaman regarding 12233 Olympic Blvd., Santa Monica, CA, dated January 23, 2000 filed as Exhibit No. 10.22 to the Amended Annual Report on Form 10-K/A for the year ended September 30, 2000, and hereby incorporated by reference. 10.21 Agreement and Plan of Merger, dated as of March 15, 2000, by and among the Registrant, New Sonic, Inc., and STV Communications, Inc., filed as Exhibit 2.1 to a Current Report on Form 8-K dated April 18, 2000 and hereby incorporated by reference. 20 10.22 Stock Purchase Agreement, dated January 18, 2000, by and among the Registrant, Jedor, Inc., and certain principals of Jedor, Inc., filed as Exhibit 2.2 to the registration statement filed on Form S-3 on May 12, 2000 and hereby incorporated by reference. 10.23 Share Purchase Agreement dated as of June 1, 2000, by and among the Registrant, Sonic Foundry (Nova Scotia) Inc., Charles Ferkranus, Michael Ferkranus, 1096159 Ontario Limited, 1402083 Ontario Limited, Dan McLellan, Curtis Staples, Bank of Montreal Capital Corp., Roynat Inc. and DGC Entertainment Ventures Corp., filed as Exhibit 2 to the Current Report filed on Form 8-K on September 12, 2000, and hereby incorporated by reference. 10.24 Stock Restriction and Registration Agreement, dated as of March 15, 2000, among the Company, Jan Brzeski, Jeffrey Gerst, David Fife, and Fife Capital, L.L.C., filed as Exhibit 4.2 to the Registration Statement filed on Form S-3 on May 12, 2000, and hereby incorporated by reference. 10.25 Voting and Option Agreement, dated March 15, 2000, among the Company, certain of its stockholders, and Jan Brzeski, David Fife, Jeffrey Gerst, and Fife Waterfield, filed as Exhibit 4.3 to the Registration Statement filed on Form S-3 on May 12, 2000, and hereby incorporated by reference. 10.26 Subscription Agreement dated February 8, 2000 between Subscribers and the Company, filed as Exhibit 10.19 of a Current Report on Form 8-K dated February 14, 2000, and hereby incorporated by reference. 10.27 Registration Rights Agreement, dated February 8, 2000, by and among the Company and certain investors, filed as Exhibit 4.5 to the Registration Statement filed on Form S-3 on May 12, 2000, and hereby incorporated by reference. 10.28 Registration Rights Agreement, dated March 31, 2000, among the Company and Sony Pictures Entertainment Inc., filed as Exhibit 4.6 to the Registration Statement filed on Form S-3 on May 12, 2000, and hereby incorporated by reference. 10.29 Share Exchange Agreement, dated August 24, 2000 among the Registrant, Sonic Foundry (Nova Scotia), Inc., Charles Ferkranus, Michael Ferkranus, 1096159 Ontario Limited, and 10402083 Ontario Limited, filed as Exhibit 4.2 to the Registration Statement filed on Form S-3 on November 7, 2000, and hereby incorporated by reference. 10.30 Buyer Non-Voting Exchangeable Share Option Agreement, dated August 24, 2000, among the Registrant, Dan McLellan, Curtis Staples, and Sonic Foundry (Nova Scotia), Inc., filed as Exhibit 4.3 to the Registration Statement filed on Form S-3 on November 7, 2000, and hereby incorporated by reference. 21 10.31 Support Agreement, dated August 24, 2000, between the Company and Sonic Foundry (Nova Scotia), Inc. filed as Exhibit 4.4 to the Registration Statement filed on Form S-3 on November 7, 2000 and hereby incorporated by reference. 22 SIGNATURES Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Sonic Foundry, Inc. ------------------- (Registrant) August 9, 2001 By: /s/ Rimas P. Buinevicius ------------------------ Rimas P. Buinevicius Chairman and Chief Executive Officer August 9, 2001 By: /s/ Kenneth A. Minor -------------------- Kenneth A. Minor Chief Financial Officer and Secretary 23