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, 2002 ------------- 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 Aug 12, 2002 ----- ------------ Common Stock, $0.01 par value 27,691,426 SONIC FOUNDRY, INC. QUARTERLY REPORT ON FORM 10-Q QUARTER ENDED JUNE 30, 2002 TABLE OF CONTENTS

PAGE NO. -------- PART I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Consolidated Balance Sheets - June 30, 2002 (Unaudited) and September 30, 2001 .............................................. 3 Consolidated Statements of Operations (Unaudited) - Three months ended June 30, 2002 and 2001, and the nine months ended June 30, 2002 and 2001 ................................. 5 Consolidated Statements of Cash Flows (Unaudited) - Nine months ended June 30, 2002 and 2001. ........................... 6 Notes to Consolidated Financial Statements (Unaudited) ................ 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................. 16 Item 3. Quantitative and Qualitative Disclosures About Market Risk ................................................... 27 PART II OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds ............................. 29 Item 6. Exhibits and Reports on Form 8-K ...................................... 29

2 Sonic Foundry, Inc. Consolidated Balance Sheets (in 000's except for share data)

June 30, September 30, 2002 2001 --------------------------------- Assets (Unaudited) Current assets: Cash and cash equivalents $ 6,314 $ 7,809 Restricted cash 1,000 - Accounts receivable, net of allowances of $745 and $1,075 4,581 4,065 Accounts receivable, other 124 26 Inventories 403 1,118 Prepaid expenses and other current assets 779 1,085 -------------------------------- Total current assets 13,201 14,103 Property and equipment: Buildings and improvements 2,434 2,409 Equipment 13,511 13,823 Furniture and fixtures 571 542 Assets held for sale - 40 -------------------------------- Total property and equipment 16,516 16,814 Less accumulated depreciation 7,127 5,010 -------------------------------- Net property and equipment 9,389 11,804 Other assets: Goodwill and other intangibles, net 8,222 44,732 Capitalized software development costs and purchased technology, net 1,433 73 Long-term investment - 514 Debt issue costs, net 717 - Other assets 30 457 -------------------------------- Total other assets 10,402 45,776 -------------------------------- Total assets $ 32,992 $ 71,683 ================================

See accompanying notes. 3 Sonic Foundry, Inc. Consolidated Balance Sheets (in 000's except for share data)

June 30, September 30, 2002 2001 ------------------------------ Liabilities and stockholders' equity (Unaudited) Current liabilities: Accounts payable $ 2,046 $ 2,316 Unearned revenue 64 83 Accrued liabilities 1,606 1,719 Accrued restructuring charges 45 345 Current portion of long-term debt 3,116 4,003 Convertible debt, net of discount 2,763 - Current portion of capital lease obligations 922 1,216 ------------------------------ Total current liabilities 10,562 9,682 Long-term obligations, net of current portion 294 217 Capital lease obligations, net of current portion 76 525 Other liabilities 165 28 Stockholders' equity Preferred stock, $.01 par value, authorized 5,000,000 shares, none issue 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; 27,215,251 and 22,345,503 shares issued and 27,187,501 and 22,317,753 outstanding at June 30, 2002 and September 30, 2001 272 223 Common stock to be issued 660 5,375 Additional paid-in capital 166,247 148,188 Accumulated deficit (145,013) (92,248) Receivable for common stock issued (26) (34) Cumulative foreign currency translations/adjustments (29) 7 Unearned compensation (66) (130) Treasury stock, at cost, 27,750 shares (150) (150) ------------------------------ Total stockholders' equity 21,895 61,231 ------------------------------ Total liabilities and stockholders' equity $ 32,992 $ 71,683 ==============================

See accompanying notes. 4 Sonic Foundry, Inc Statements of Operations (Unaudited)

Three months ended Nine months ended (in 000's except for per share data) June 30, June 30, -------------------------------------------------------------- 2002 2001 2002 2001 -------------------------------------------------------------- Revenue: Software $ 4,660 $ 4,161 $ 12,364 $ 12,683 Services 2,574 2,933 7,358 8,193 -------------------------------------------------------------- Total revenue 7,234 7,094 19,722 20,876 Cost of revenue: Cost of software 733 1,171 2,702 4,365 Cost of services 1,802 1,793 5,376 6,083 -------------------------------------------------------------- Total cost of revenues 2,535 2,964 8,078 10,448 -------------------------------------------------------------- Gross profit 4,699 4,130 11,644 10,428 Operating expenses: Selling and marketing expenses 2,061 1,973 6,385 10,140 General and administrative expenses 1,586 2,231 4,827 7,922 Product development expenses 1,755 1,685 5,418 6,312 Amortization of goodwill and other intangibles - 6,726 - 20,753 Restructuring charges - - - 3,782 -------------------------------------------------------------- Total operating expenses 5,402 12,615 16,630 48,909 -------------------------------------------------------------- Loss from operations (703) (8,485) (4,986) (38,481) Other income (expense): Interest expense (207) (141) (396) (513) Non-cash interest expense (1,299) - (2,157) - Interest and other (87) 90 (286) 508 -------------------------------------------------------------- Total other income (expense) (1,593) (51) (2,839) (5) -------------------------------------------------------------- Loss before income taxes and cumulative effect of change in accounting principle (2,296) (8,536) (7,825) (38,486) Income taxes (208) - (208) - -------------------------------------------------------------- Loss before cumulative effect of change in accounting principle Cumulative effect of change in accounting (2,504) (8,536) (8,033) (38,486) principle - - (44,732) - -------------------------------------------------------------- Net loss $ (2,504) $ (8,536) $ (52,765) (38,486) ============================================================== Loss per common share: Loss before cumulative effect of change in $ accounting principle (.09) $ (0.39) $ (.30) $ (1.75) Cumulative effect of change in accounting principle - - (1.69) - -------------------------------------------------------------- Net loss per common share - basic and diluted $ (.09) $ (0.39) $ (1.99) $ (1.75) ==============================================================

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

Nine months ended June 30, (in 000's) 2002 2001 ---------------------------------- Operating activities Net loss $ (52,765) $ (38,486) Adjustments to reconcile net loss to net cash used in operating activities: Cumulative effect of change in accounting principle 44,732 - Amortization of goodwill, other intangibles, purchased technology and capitalized software development costs 305 21,121 Depreciation and amortization of property and equipment 2,533 2,566 Amortization of debt discount and debt issue costs 2,157 - Noncash charge for common stock warrants and options 168 550 Loss on sale of assets 227 1,557 Write-off of long-term investment 514 0 Gain on settlement of debt (238) 0 Changes in operating assets and liabilities: Accounts receivable (606) 4,396 Inventories 715 922 Prepaid expenses and other assets 222 750 Accounts payable and accrued liabilities (3,359) (2,870) ---------------------------------- Total adjustments 47,370 28,992 ---------------------------------- Net cash used in operating activities (5,395) (9,494) Investing activities Acquisition, net of cash acquired (579) (679) Purchases of property and equipment (450) (1,955) Sales of property and equipment 4 1,213 ---------------------------------- Net cash used in investing activities (1025) (1,421) Financing activities Proceeds from sale of common stock 260 300 Proceeds from debt, net of commissions and issue costs 6,758 436 Borrowings on line of credit, net - 595 Payments on long-term debt and capital leases (1,097) (2,887) Cash placed in escrow (1,000) - ---------------------------------- Net cash provided by (used in) financing activities 4,921 (1,556) Effect of exchange rate changes on cash 4 131 ---------------------------------- Net increase (decrease) in cash (1,495) (12,340) Cash and cash equivalents at beginning of period 7,809 21,948 ---------------------------------- Cash and cash equivalents at end of period $ 6,314 $ 9,608 ==================================

6 Sonic Foundry, Inc. Consolidated Statements of Cash Flows (continued) (Unaudited) Supplemental cash flow information: Interest paid $ 277 $ 258 Non-cash transactions - Capital lease acquisitions 17 86 Issuance of options for deferred compensation plan 104 - Issuance of warrants for consulting services 49 19 Conversion of exchangeable stock into common stock 5,375 - Common stock and stock options issued for MediaSite 5,016 - Common stock issued for Digital Savant 541 - Common stock issued for liabilities assumed in MediaSite transaction 125 - Common stock to be issued for debt settlement 660 Reclassification of goodwill to fixed assets upon final appraisal of International Image - 1,281 Cancellation of unvested stock options classified as unearned compensation upon acquisition of STV - 1,249 7 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 ("GAAP") 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, 2001. 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 nine-month period ended June 30, 2002 are not necessarily indicative of the results that might be expected for the year ended September 30, 2002. Revenue Recognition Revenues from software license fees consist of fees charged for the licensing of Windows-based software products. We recognize software product revenue upon delivery, net of estimated returns, provided that collection is determined to be probable and no significant obligations remain. Software product revenue from certain distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection if given, and rebates at the time the related revenue is recorded or promotion is offered. The estimates for returns are adjusted periodically based upon historical rates of returns, estimated inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. Delivery occurs through the following methods: . Direct Distribution: Direct revenues are recognized upon delivery to the end-user either via shipment of a boxed product from the Company's fulfillment contractor or electronic download. No returns are accepted. . Retail Distribution: Retail revenues are recognized upon delivery to a third-party distributor, net of allowances for estimated returns, rebates and price protection. . OEM and System Integrators: OEM and System Integrator revenues are generated through partnerships with hardware and software vendors who license the right to bundle one of the Company's products with the partner's products. Typically, this type of revenue is recognized as the partner sells through to the end-user. 8 . Consulting: Consulting revenues include fees recorded pursuant to long-term contracts, using the percentage of completion method of accounting, when significant customization or modification of a product is required. . Consignment: Consignment revenues are recognized when a third-party reseller delivers the boxed product to their customer. All desktop software products sold include free installation support and professional software products sold include 60 days of free telephone support. Costs associated with free support are accrued at the date of sale because the free support is not significant. Customers that require additional post-contract customer support ("PCS") are charged a separate fee either through a telephone charge or annual subscription charge. Revenue and associated costs for PCS are recognized as the services are performed or on a straight-line basis over the contractual period. Revenues from services are typically recognized when persuasive evidence of a contract exists, the service has been completed and no significant obligations of the Company remain, the fee is fixed and determinable and collection of the resulting receivable is deemed probable. The Company records revenue on a percentage of completion method, generally by using the number of tapes completed as a percentage of total tapes included in the contract, when performing services of a duration of 30 days or more and all criteria for recognition of service revenue are met other than completion. We perform ongoing credit evaluations of our customers' financial condition and generally do not require collateral. We maintain allowances for potential credit losses and such losses have been within our expectations. Inventories Inventory consists of the following (in thousands):

June 30, September, 30 2002 2001 --------------------------------------- Raw materials and supplies $ 241 $ 390 Work-in-process 26 112 Finished goods 136 616 --------------------------------------- $ 403 $ 1,118 =======================================

9 Net Loss Per Share The following table sets forth the computation of basic and diluted loss per share:

Three months ended Nine months ended June 30, June 30, 2002 2001 2002 2001 ------------------------------------------------------------ Denominator Denominator for basic and diluted loss per share - weighted average common shares 27,122,342 22,127,533 26,517,529 21,999,981 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 anti-dilutive: Options, warrants and exchangeable shares 1,660,420 1,272,208 2,253,555 1,389,721 Convertible subordinated debt 2,908,162 - 1,523,323 -

Accounting Pronouncements In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. FAS 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. The Company adopted FAS 144 as of October 1, 2001. The adoption of the Statement had no significant impact on the Company's financial position and results of operations. Effective October 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill is no longer amortized but reviewed for impairment annually, or more frequently if certain indicators arise. The Company was required to complete the initial step of a transitional impairment test within six months of adoption of SFAS No. 142. During the first quarter of 2002, the Company retained an outside valuation firm to assist in the completion of the transitional impairment test. It was determined that the remaining goodwill of the services reporting unit associated with the acquisitions of STV Communications, Inc. and International Image Services, Inc. was entirely impaired, which resulted in a $44,732,000 charge reflected as a cumulative effect of change in accounting principle. See Note 5 for additional details. Subsequent impairment charges for MediaSite or other acquisitions, if any, will be reflected as an operating expense in the income statement. Had the Company been accounting for its goodwill under SFAS No. 142 for all periods presented, the Company's net income and earnings per share would have been as follows: 10

(in thousands, except per share data) Nine months ended June 30, 2002 2001 --------------------------------------- Reported net loss $ (52,765) $ (38,486) Add back cumulative effect of change in accounting principle 44,732 - Add back goodwill amortization - 20,753 -------------------------------------- Adjusted net loss $ (8,033) $ (17,733) ====================================== Basic and diluted - net loss per share Reported net loss per share $ (1.99) $ (1.75) Cumulative effect of change in accounting Principle 1.69 - Goodwill amortization - .94 -------------------------------------- Adjusted net loss per share $ (.30) $ (.81) ======================================

2. Restructuring Charge As a result of rapidly changing market conditions, in December 2000 the Company's Board of Directors authorized management to make a 40% workforce reduction affecting all divisions of the Company in order to reduce future cash expenditures. The restructuring charges were determined based upon plans submitted by the Company's management and approved by the Board of Directors using information available at the time. As a result of the workforce reduction, the Company exited four leased facilities and disposed of fixed assets (mainly computer equipment and trade show assets) that were no longer necessary for future operations. Future lease obligations of facilities exited were accrued net of estimated sub-lease income to be generated through the lease term. Computer equipment and trade show assets no longer necessary for operations were written down from a carrying amount of $3.1 million to their anticipated net realizable value. As a result of the workforce reductions, termination of leases and disposal of fixed assets, the Company recorded restructuring charges of $3,782,000 during the first quarter of fiscal 2001. In the fourth quarter of fiscal 2001, the Company refined the net realizable value of equipment no longer necessary in operations that was identified in the December 2000 restructuring plan, which resulted in an additional charge of $1,191,000. The remaining balance will continue to decrease as lease obligations are paid and sublease income is received.

(in thousands) Severance and Lease Fixed asset Related Charges Terminations Disposals Other Total --------------- ------------ --------- ----- ----- Charge in December 2000 $ 1,470 $ 1,555 $ 594 $ 163 $ 3,782 Charge in September 2001 - - 1,191 - 1,191 ----------------------------------------------------------------- Total charges 1,470 1,555 1,785 163 4,973 Adjustments to December 2000 charge - (503) 503 - - Amount paid in fiscal 2001, net (1,470) (707) - (2) (2,179) Non-cash charges - - (2,288) (161) (2,449) ----------------------------------------------------------------- Accrued liabilities at September 30, 2001 - 345 - - 345 Adjustments to December 2000 Charge (121) 121

11 Amount paid in fiscal 2002, net (179) - - (179) Non-cash charges (121) - (121) -------------------------------------------------------------------------- $ - $ 45 $ - $ - $ 45 -------------------------------------------------------------------------- 3. Contingencies In early January 2001, the Company withheld payment on a $4 million note due to the former shareholders of International Image pending the resolution of certain disputed representations made during the acquisition. In January 2001 certain of the note holders initiated litigation against the Company in Toronto for payment of the note and in March 2001 the Company initiated a counter action for damages incurred. In April 2001, the Company paid certain shareholders $500,000 in full settlement of $700,000 of the note plus accrued interest originally owed. Litigation with the remaining shareholders continued. In October 2001, pursuant to an agreement with the plaintiffs, the Company deposited $1,000,000 with the Ontario Superior Court of Justice to be held in trust until settlement of the suit. The transaction was recorded as restricted cash. In June 2002, the Company settled $2.8 million of the remaining $3.3 million note balance plus accrued interest for $1.9 million and 500,000 shares of common stock valued at $660,000. The difference between the principal and accrued interest balance and the settlement cost was recorded as a gain, net of certain legal costs. The payment and issuance of shares did not occur until early July 2002. A remaining amount of $330,000 to one former shareholder is still in litigation. We have filed the necessary documentation with the Ontario Superior Court of Justice for the return of a portion of the $1,000,000 held in escrow. 4. Acquisitions On October 15, 2001, the Company completed the asset purchase of MediaSite, Inc., which provided automated rich media publishing, management and access solutions. Under terms of the purchase agreement, a wholly-owned subsidiary of the Company purchased the majority of the assets of MediaSite and assumed certain of its liabilities in exchange for 3,880,000 shares of the Company's common stock and 300,000 warrants valued at $1.20 per share. Also as part of the purchase, the Company capitalized $490,000 in closing costs, $3,101,000 in assumed liabilities and a $365,000 advance that was issued to MediaSite in September 2001. Approximately $9,100,000 of intangible assets resulted from the purchase. The Company obtained an independent appraisal, which resulted in an allocation of $120,000 to the Carnegie Mellon University license agreement, $130,000 to the MediaSite trade name and $1,400,000 to acquired technology. All three were determined to have useful lives of 5 years and will be amortized to cost of goods sold. The remaining balance of $7,450,000 was assigned to goodwill 12 and, in accordance with SFAS No. 142, will not be amortized, but will be reviewed annually for impairment. On February 12, 2002 the Company's services division purchased all the intellectual property rights to Media Taxi (TM) from Los Angeles based Digital Savant, Inc. in exchange for $100,000 and 221,000 shares of the Company's common stock. Media Taxi is a widely deployed browser-based media asset management system focused on streamlining the management and distribution of marketing and publicity materials for the entertainment industry. A large portion of the acquisition price, $430,000, was assigned to goodwill and, in accordance with SFAS No. 142, will not be amortized, but will be reviewed annually for impairment. The remaining $240,000 was assigned to purchased technology and will be amortized to cost of services over two years. 5. Goodwill and Other Intangible Assets - Adoption of Statement No. 142 In July 2001, the FASB issued SFAS No. 142 Goodwill and Other Intangible Assets, which established financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, Intangible Assets. The Company early adopted SFAS No. 142 on October 1, 2001, the beginning of its fiscal year. SFAS No. 142 requires that goodwill and intangible assets that have indefinite useful lives not be amortized but, instead, tested at least annually for impairment. Accordingly, the Company reclassified the net book value of assembled workforce to goodwill and ceased amortization of all goodwill, on October 1, 2001. Intangible assets that have finite useful lives, primarily developed technology and know-how, continue to be amortized over their useful lives. The standard also requires that goodwill be tested for impairment annually. In the year of adoption, the standard required a transitional goodwill impairment evaluation, which was a two-step process. The first step was a screen for whether there was an indication that goodwill was impaired as of October 1, 2001. At this time, the Company had two reporting units - software and services. The entire goodwill balance, which had resulted from the 2000 acquisitions of STV Communications and International Image, related to the services unit. To determine if the goodwill was impaired, the company retained an independent appraisal firm to perform a valuation of the services unit using the criteria prescribed under FAS 142. As of December 2001, the appraisers completed this first step, which indicated that goodwill recorded during the 2000 acquisitions mentioned above was impaired as of October 1, 2001. For the second step, the Company used the services of the same independent appraisal firm to compare the implied fair value of the affected reporting unit's goodwill to its carrying value in order to measure the amount of impairment. The fair value of goodwill was determined by allocating the reporting unit's fair value to all of its assets and liabilities in a manner similar to a purchase price allocation in accordance with SFAS No. 141 Business Combinations. As of December 2001, the appraisers concluded that goodwill was 100% impaired. Therefore, the Company recorded an impairment loss of $44.7 million as a cumulative effect of a change in accounting principle in its statement of operations. The circumstances leading to the goodwill impairment related to: 1) the decreased demand for digital services such as encoding (especially from dot coms); 2) significant reductions of STV's 13 workforce; 3) the company's decreased market capitalization; and 4) a history of cash flow and operating losses for the services unit. These negative trends provided evidence that initial growth expectations of STV and International Image did not materialize. The fair value used to determine the impairment was based on a combination of discounted cash flow valuation techniques, market transactions and the prices of publicly traded comparable companies. 6. Convertible Subordinated Debt In January and February 2002, the Company completed a $7,125,000 offering of convertible subordinated debt with several investors. The promissory notes ("Notes") bear interest at 10% per annum and begin requiring the Company to repay principal (if not converted) in monthly installments commencing on August 1, 2002. The aggregate amount of such monthly installments for all the Notes is $330,000 with a final installment in the aggregate amount of $1,181,000 due on the maturity date of February 1, 2004. In July of 2002, the Company initiated discussions with a majority of the debt holders for the right to make principal and interest payments in the form of stock. The proposed agreement would allow the Company, at our discretion, to issue shares at an 8% discount to the average closing price for the previous month. The Notes may be converted into shares of our common stock, in whole or in part, at any time. The conversion price is $2.45 per share, subject to potential anti-dilution adjustments. The Investors also received 1,163,000 warrants to purchase shares of common stock at an exercise price of $2.94. The Notes include a covenant requiring the Company to have $3 million of available cash at the end of each quarter. The Company also paid $502,000 in commissions and issued 154,000 warrants to purchase common stock at an exercise price of $2.94. The commissions and value of the warrants are classified as debt issuance costs in the accompanying balance sheet. Warrants granted to the Investors and the placement agents expire in February 2006. The value allocated to the warrants issued was measured at the date of grant because the number of shares was fixed and determinable. The value was determined based upon a Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 3%, dividend yield of 0%, expected common stock market price volatility factor of 1.5 and the expected life of the warrants. The valuation of the investor warrants reduced the carrying value of the debt by $2.8 million and was recorded as a debt discount. The debt discount recorded for the warrant valuation caused a beneficial embedded conversion feature valued at $3.5 million and was recorded as an additional debt discount. The debt discount is being amortized using an effective interest method over the two-year term of the debt. The unamortized balance of the debt discount at June 30, 2002, was $4,362. The debt 14 issuance costs are being amortized using the straight-line method over the two-year term of the debt. 15 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, 2001. 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 leading provider of professional rich media solutions with three primary revenue centers: Desktop Software develops sophisticated software tools used by professionals and hobbyists for the creation, editing and publishing of digital audio and video. We currently focus our software efforts on the Sound Forge(R), ACID(TM), and Vegas(R) Video platforms. Systems Software (formerly MediaSite) develops automated rich-media applications and scalable solutions that allow media owners - including entertainment companies, educational institutions, corporations and government organizations - to deploy, manage, index and distribute video content on IP-based networks. Services supplies media digitization, management and delivery solutions for various industries, particularly the entertainment sector. These services consist of conversion, reformatting and encoding of television, film and other video content for multiple delivery platforms. These three revenue centers, along with their respective production costs, are analyzed independently from each other. However, because the majority of operating expenses support all revenue centers, all items below gross margin are analyzed on a combined basis. Critical Accounting Policies 16 We have identified the following as critical accounting policies to our company and have discussed the development, selection of estimates and the disclosure regarding them with the audit committee of the board of directors: . Revenue recognition, sales returns, allowance for doubtful accounts and other credits; . Impairment of investments and . Impairment of long-lived assets. Revenue Recognition, Sales Returns, Price Protection and Rebates We recognize revenue for licensing of software products upon shipment, net of estimated returns, provided that collection is determined to be probable and no significant obligations remain. Product revenue from distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection when given, and rebates at the time the related revenue is recorded or promotion is offered. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. While management believes it can make reliable estimates for these matters, nevertheless unsold products in these distribution channels are exposed to rapid changes in consumer preferences or technological obsolescence due to new operating environments, product updates or competing products. Significant judgments and estimates must be made and used in connection with establishing reserves for sales returns, price protection and rebates in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. During fiscal 2001, returns from software products sold to consumer retail distributors were higher than historical rates incurred in fiscal 2000 and 1999. In response to economic factors affecting the consumer retail market, we began recording revenues to consumer retail distributors on a consignment basis in September 2001. Please refer to Note 1 of our Notes to Consolidated Financial Statements for further information on our revenue recognition policies. The preparation of our consolidated financial statements also requires us to make estimates regarding the collectability of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Impairment of Investments We periodically evaluate whether any estimated decline in the fair value of our long-term investment is other-than-temporary. Significant judgments and estimates must be made to assess the fair value of 17 our investment and determine whether an other-than-temporary decline in fair value of our investment has occurred. This evaluation consists of a review of qualitative and quantitative factors, review of publicly available information regarding the investee and discussions with investee management. Since our investment is in a private company with no quoted market price, we also consider the implied value from any recent rounds of financing completed. Based upon an evaluation of the facts and circumstances during the quarter ended June 30, 2002, we determined that our investment had a significant decline in fair value and that we are unlikely to recover most, if any, of our investment. Accordingly, we wrote off the entire $514,000 balance. Impairment of long-lived assets We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following: . poor economic performance relative to historical or projected future operating results; . significant negative industry, economic or company specific trends; . changes in the manner of our use of the assets or the plans for our business; and . loss of key personnel If we determine that the fair value of a reporting unit is less than its carrying value including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would then measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference. The Company evaluates all of its long-lived assets, including intangible assets other than goodwill, for impairment in accordance with the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 requires that long-lived assets and intangible assets other than goodwill be evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. Should events indicate that any of the Company's assets are impaired; the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired asset and recorded in earnings during the period of such impairment. We Disclose Pro Forma and EBITDA Financial Information We release quarterly unaudited financial statements prepared in accordance with GAAP. We also disclose and discuss certain pro forma and EBITDA financial information in the related earnings release and investor conference call. Our pro forma financial information does not include 18 amortization of purchased technology, restructuring charges, amortization of goodwill or other purchased intangibles, non-cash interest expense, or cumulative effect of changes in accounting principle. EBITDA excludes other income (expense), depreciation, amortization and income taxes. We believe the disclosure of the pro forma and EBITDA financial information provides investors with additional benchmarks to evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases and compare that GAAP financial information with the pro forma and EBITDA financial results disclosed in our quarterly earnings releases and investor calls, as well as in some of our reports. The following table shows the Company's pro forma and EBITDA results reconciled to the GAAP Consolidated Statements of Operations. Sonic Foundry, Inc Pro Forma Analysis

(In 000's, except per share data) Three months ended Nine months ended June 30, June 30, 2002 2001 2002 2001 ---------------------------------------------------- $ (2,504) $ (8,536) $(52,765) $ (38,486) Net loss Non-cash interest expense 1,299 - 2,157 - Amortization of purchased technology 112 - 232 - Amortization of goodwill and other intangibles - 6,726 - 20,753 Restructuring charges - - - 3,782 Cumulative effect of changes in accounting principle - - 44,732 - ---------------------------------------------------- Pro forma net loss (1,093) (1,810) (5,644) (13,951) ---------------------------------------------------- Depreciation and amortization 824 1,014 2,606 2,934 Interest expense 207 141 396 513 Taxes and Other 295 (90) 494 (509) ---------------------------------------------------- EBITDA $ 233 $ (745) $ (2,148) $ (11,013) ==================================================== Pro forma net loss per common share - basic and diluted $ (.04) $ (0.08) $ (.21) $ (.63) ====================================================

Results of Operations The following chart has been presented to add clarification and should be read in conjunction with the consolidated financial statements. 19

Three months ended June 30, Nine months ended June 30, 2002 2001 2002 2001 ------------------------------------------------------------------------------- Desktop software license fees $ 4,485 100% $ 4,161 100% $ 11,646 100% $ 12,683 100% Cost of desktop software license fees 639 14 1,171 28 2,449 21 4,365 34 ----------------------------------------------------------------------------- Gross margin-desktop software license fees $ 3,846 86% $ 2,990 72% $ 9,197 79% $ 8,318 66% Systems software license fees $ 175 100% - - $ 718 100% - - Cost of systems software license fees 94 54 - - 253 35 - - ----------------------------------------------------------------------------- Gross margin- systems software license fees $ 81 46% - - $ 465 65% - - Services $ 2,574 100% $ 2,933 100% $ 7,358 100% $ 8,193 100% Cost of services 1,802 70 1,793 61 5,376 73 6,083 74 ----------------------------------------------------------------------------- Gross margin-services $ 772 30% $ 1,140 39% $ 1,982 27% $ 2,110 26%

Revenue from Software License Fees Software License Fees in the Statement of Operations include both desktop and systems software. Revenues from desktop software license fees consist of fees charged for the licensing of Windows based software products. The Company's primary focus is on the platforms of ACID(R), Sound Forge(R) and Vegas(R) Video. These software products are marketed to 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. Q3-2002 compared to Q3-2001 and YTD-2002 (nine months) compared to YTD-2001 (nine months) Net revenues from desktop software license fees increased $324 or 8% from Q3-2001 to Q3-2002 and decreased $1,037 or 9% from YTD-2001 to YTD-2002. The net changes resulted from the following items: . $850 of the quarter-to-quarter increase resulted from sales of Sound Forge. Version 6 of Sound Forge was released in May 2002 and generated over $1.8 million in Q3-2002. Version 5 of Sound Forge was released in Q2-2001 with sales of nearly $2 million. An 8% decline in Sound Forge sales from YTD-2001 to YTD-2002 can be attributed to more significant feature enhancements in version 5. . ACID and ACID Loop sales declined $1.3 million from Q3-2001 to Q3-2002. Sales of ACID 3.0 tapered off with the anticipation of the August 2002 release of Version 4.0. In Q3-2001, the release of version 3.0 of Acid generated nearly $1.9 million. We anticipate that version 4.0 will have similar impact on Q4-2002 results. 20 . The growth of Vegas Video has somewhat offset the quarter and YTD declines mentioned above. Vegas Video sales of $442 for the quarter and $1.6 million YTD are significant increases over the 2001 totals of $122 and $189. A new version of Vegas Video is due out in early 2003. . An additional contributor to the quarter-to-quarter increase was an OEM bundling arrangement with Sony. This arrangement netted $400 in Q3-2002. This arrangement is not expected to net significant additional revenues in future periods. Gross Margin from Software License Fees Costs of software includes both desktop and systems software. Included in costs of desktop software license fees are product material costs, assembly labor, freight, royalties on third party technology or intellectual content, and amortization of previously capitalized product development and localization costs. Despite the YTD decline in software revenues, 2002 software gross margin dollars have increased over both Q3-2001 and YTD-2001 amounts. The much-improved margins on a percentage basis can be attributed to: . A reduction in material costs associated with an increase in the number of electronic downloads (in Q3-2002, half of the Sound Forge sales were delivered in this manner). . Reduced obsolescence and scrap due to lower inventory levels . A shift toward higher priced professional products from lower (less than 50%) margin consumer software products. We anticipate that software margins will continue to exceed 80% in the foreseeable future. Revenue from Systems Software Revenue from our Systems software division, established upon the acquisition of MediaSite, consist of fees charged for the licensing of software products and custom software development. The primary focus is on the platforms of MediaSite Publisher(TM) and MediaSite Live(TM). These software products are marketed to government agencies, educational institutions, and corporations who need to deploy, manage, index and distribute video content on IP-based networks. We reach both our domestic and international markets through reseller networks, a direct sales effort and Integrator partnerships. System software revenues in Q3-2002 amounted to $175; the YTD total is $718. The revenues can be segmented as follows: . MediaSite Publisher sales were $88 for the quarter and $368 for YTD. Over half of the YTD Publisher revenues represent what we believe to be the first stage of a relationship with a unit of the Federal Government, from which we expect to generate additional license and support revenues in the future. . MediaSite Live, which was completed in mid-June 2002, experienced sales of $50 in Q3-2002. . Custom development for a Federal agency accounted for $37 of revenue in Q3-2002 and $252 of revenue YTD. This contract was completed in May-2002. Total Federal government system software revenue totaled $108 in Q3-2002 and $538 YTD. 21 Gross Margin from Systems Software The significant components of cost of systems include: . A 5% royalty on sales of MediaSite Publisher's technology. . Cost of hardware that is bundled with MediaSite Live. Live sales should typically result in gross margins of approximately 60%. . Amortization of MediaSite acquisition amounts assigned to purchased technology and other identified intangibles. We will be amortizing approximately $100 per quarter over the next 5 years for the identified intangibles of the MediaSite purchase. Based on recent projections we anticipate that, especially in the near term, Live units may become a much more significant portion of system sales. Revenue from Services Revenue from services includes tape duplication for broadcast distribution, broadcast standard conversions, audio and video encoding, as well as fees for consulting and development services. Revenue from services declined $359 or 14%, from Q3-2001 to Q3 2002. A decline in advertising income of entertainment companies led to decreased demand (over $700) for our traditional duplication and conversion services. This decline was partially offset by growth in our digital restoration and High Definition services ($340) and revenues from consulting and the MediaTaxi technology, acquired from Digital Savant in February 2002, (over $60) during Q3-2002. Revenue from services declined $835, or 11%, from YTD-2001 to YTD-2002. Reasons for the change mirror those in the quarter discussion above. Traditional services declined approximately $1.2 million while Digital Restoration and High Definition services rose by $600. A decrease in encoding revenues of $375 also contributed to the overall decline. Gross Margin from Services Costs of services include compensation, benefits and other expenses associated with production personnel, videotape costs, depreciation on production equipment and an allocation for general and administrative expenses such as facility costs. These costs have become relatively stable and fixed in dollars since Q3-2001 and we anticipate no major increases in the near future. Future fluctuations in gross margin will result primarily from changes in revenue because: 1) these costs should remain relatively fixed going forward; and 2) newer offerings, such as MediaTaxi and MediaDub, are lower cost procedures dependent on software code rather than headcount. Gross Margin from services declined from 39% to 30% from Q3-2001 to Q3-2002. The decline relates to the revenue decreases discussed above and demonstrates the fixed nature of our cost of services. Q3-2002 included $30 of amortization of MediaTaxi technology acquired in February. Gross margin from services improved from 26% to 27% from YTD-2001 to YTD-2002. Revenues from services declined $835, while cost of services declined $707. The decline in cost 22 of services is related to the Company's restructuring that occurred in Q1-2001, which included the elimination of duplicate positions, operational and process improvements, a switch to a temporary labor force for encoding services and a reduction in depreciation expenses from the write-off and disposal of underutilized assets no longer needed for the service business. Operating Expenses The following chart is provided to add clarification by presenting items as a percentage of total revenues. For comparison purposes, amortization of goodwill has been excluded from the 2001 results due to the adoption of SFAS No. 142. Please see Note 1 of the financial statements for further details. 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, 2002 2001 2002 2001 --------------------------------------------------------------- Total revenues 100% 100% 100% 100% Cost of revenues 35 42 41 50 --------------------------------------------------------------- Gross margin 65 58 59 50 Operating expenses Selling and marketing expenses 29 28 32 49 General and administrative expenses 22 31 24 38 Product development expenses 24 24 27 30 Restructuring charges - - - 18 --------------------------------------------------------------- Total operating expenses 75 83 83 135 --------------------------------------------------------------- Loss from operations (10)% (25)% (24)% (85)% ===============================================================

Selling and Marketing Expenses Selling and marketing expenses include: wages and commissions for sales, marketing, business development and technical support personnel; our direct mail catalog; and co-operative advertising with our software distributors, print advertising and various promotional expenses for our products, services and systems. Timing of these costs may vary greatly depending on introduction of new offerings and entrance into new markets. Q3-2002 compared to Q3-2001 and YTD-2002 compared to YTD-2001 Selling and marketing expenses as a percentage of revenues and in gross dollars remained relatively flat for the quarter period and decreased significantly for the YTD period. A slight $87 or 4% increase from Q3-2001 to Q3-2002 is attributable to a decline in catalog and advertising spending being more than offset by increases in strategy and systems sales and marketing. Expenditures for the direct catalog campaign decreased $225 from quarter-to-quarter. Over the past year we have built a larger database of names and no longer have to rent expensive lists for our catalog campaigns. Also, much of the direct advertising has switched to 23 email. Coop and other advertising declined $300 from quarter-to-quarter. Much of the past expenses related to our lower end consumer products which demanded heavier in store promotions. As sales have shifted, so have the marketing efforts. The above items were offset by increases in the new systems software and business development divisions. The addition of these divisions has added nearly 20 people. Total expenditures - primarily salaries, travel and public relations - amounted to over $700 in the current quarter. The YTD decline of $3,755 or 37% in selling and marketing directly resulted from our December 2000 restructuring. The key actions were: 1) reduction in retail advertising ($2.2 million of the change); 2) significant staff reductions in marketing and customer service (over $1 million of the change); and 3) decline in tradeshows, outsourced customer service, and catalog expenses (over $500 of the change). Other reductions such as travel have been offset by the growth in systems sales and marketing efforts. We anticipate that the continued promotion of our new systems offerings and the Q4-2002 release of Acid 4.0 will lead to increases in selling and marketing expenses for the remaining fiscal year. We expect the Q4-2002 level to be near the Q1-2002 total of $2.4 million. General and Administrative Expenses General and administrative ("G&A") expenses consist of personnel and related costs associated with the facilities, finance, legal, human resource and information technology departments, as well as other expenses not fully allocated to functional areas. Q3-2002 compared to Q3-2001 and YTD-2002 compared to YTD-2001 G&A expenses declined by $645 or 29%, from Q3-2001 to Q3-2002. The decline is primarily the result of: 1) a $220 reduction in bad debt expense which reflects 2001 write-offs related to audio encoding services to dot coms; 2) $125 of the change related to salary waiver program for executives that began in December 2001 (under the terms of the salary waiver program, certain executives waived salary in exchange for stock options); and 3) headcount reductions in G&A and growth in other cost centers have led to a larger proportion of facilities (rent, telephone, equipment depreciation) being allocated to cost of services, sales and product development. The addition of MediaSite's Pittsburgh facility, which primarily houses sales and marketing and product development staff, had minimal impact on G&A expenses. The YTD reduction of $3,095 or 39% is due to the elimination of non-recurring, integration related expenses and elements of the Q1-2001 restructuring plan which included the removal of duplicate personnel functions and the consolidation of facilities. In addition, bad debt expense decreased by $632 for the nine-month periods. For the remainder of fiscal 2002 and into fiscal 2003, we anticipate G&A expenses will remain constant. We feel we have adequate resources and infrastructure to support future growth. Product Development Expenses 24 Product development expenses include salaries and wages of the software research and development staff and an allocation of benefits, facility and administrative expenses. Fluctuations in product development expenses correlate directly to changes in headcount. Q3-2002 compared to Q3-2001 and YTD-2002 (nine months) compared to YTD-2001 (nine months) Product development expenses increased $70 or 4% from Q3-2001 to Q3-2002. Head count increased slightly as the addition of the MediaSite staff slightly exceeded other attrition. Product development costs declined $894 or 14% from YTD-2001 to YTD-2002. The decrease resulted from the company-wide restructuring that occurred at the end of Q1-2001. Headcount at the beginning of that quarter was just over 100. As part of the restructuring, we eliminated low volume, niche products such as CD Architect(TM) and Soft Encode as well as the engineering 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 and then amortizes that cost over the anticipated life of the product. No development costs for our core product line were capitalized during fiscal 2001 or the first three quarters of 2002. Amortization of capitalized software development was $55 in Q1-2002 and relates to Viscosity(TM), which was a result of the Jedor acquisition in February 2000. Viscosity was fully amortized in January 2002. Going forward we anticipate spending for research and development to remain relatively stable and we do not anticipate that any fiscal 2002 software development efforts will qualify for capitalization under SFAS Number 86. 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, the restructuring charge primarily consisted of: 1) an accrual for 60 days of severance and benefits for domestic employees terminated on December 20, 2000 as well as severance and other expenses associated with closing our office in the Netherlands; 2) an asset impairment charge related to the sale, disposal or write-down of PCs, office equipment and other assets no longer required; 3) operating and lease termination costs related to the consolidation of facilities; and 4) miscellaneous charges such as forfeited tradeshow deposits. As of June 30, 2002, $45 remained in the restructuring accrual. Certain equipment disposals resulted in larger write-offs than were originally accrued. As a result of the under accrual, the restructuring accrual will be $0 by the end of fiscal 2002. In fiscal 2003, we may incur approximately $100 of rent expense that was not accounted for under the original accrual. Such expense would be accounted for in G&A. Other Income (Expense) 25 The increase in interest expense was due to the subordinated debt issuance in February 2002. (see note 6 to the consolidated financial statements). In addition, other expense included a $219 loss on asset disposals during Q2-2002. In Q3-2002 we recorded a $514 loss on the write-off of long-term investment, and a $238 gain on the settlement of debt (see footnote 3). The amortization of the debt discount and debt issuance costs will approximate $1.5 million per quarter through the remainder of fiscal 2002. If some of the debt were converted, the unamortized debt issuance and discount amounts would be reclassified to equity. Cumulative Effect of Changes in Accounting Principle Effective October 2001, the Company adopted Financial Accounting Standards Board ("SFAS") No. 142, "Goodwill and Other Intangible Assets." Under the new rules, the Company ceased the amortization of goodwill associated with the services reporting unit, which included the acquisitions of STV Communications and International Image. Implementation of the new rules also requires an assessment of the carrying value of goodwill using a number of criteria, including the value of the overall enterprise as of October 1, 2001. The Company retained an independent appraisal firm to assist in the assessment, which resulted in a $44,732 write off of the entire remaining value of goodwill associated with the services reporting unit. Future impairment charges, if any, associated with MediaSite or other acquisitions will be reflected as an operating expense in the statement of operations. Liquidity and Capital Resources Cash used in operating activities was $5,395 YTD-2002 compared to $9,494 in YTD-2001. The decrease of $4,099 consisted primarily of operating cost reductions identified in the Q1-2001 restructuring. The primary reason for the change was the net change in loss from operations before amortization of goodwill and restructuring charges, which improved from $13,946 in YTD-2001 to $4,986 in YTD-2002. This improvement was offset by payments of liabilities assumed in the MediaSite acquisition ($2.8 million). Approximately $600 of the assumed liabilities remain as of June 30, 2002. Cash used in investing activities was $1,025 in YTD-2002 compared to $1,421 in YTD-2001. A $1.5 million decline in the purchase of equipment partially offset by cash from sale of a building in YTD-2001 led to the difference between the two periods. The reductions in purchases relate to our previous build up of certain services business lines such as encoding and webcasting. The Investing activities in the current year also included legal, professional and other closing costs associated with the MediaSite acquisition while the prior year included certain payments related to the International Image acquisition. No significant investing activity is expected for the remainder of 2002. Cash provided by financing activities was $4,921 in YTD-2002 compared to cash used of $1,556 in YTD-2001. The primary change was due to additional subordinated debt, which resulted in $6,592 of net proceeds. In October 2001, we deposited $1,000 with the Ontario Superior Court of Justice to be held in trust until settlement of a lawsuit with the former shareholders of International Image. This $1,000 has been recorded as restricted cash. Payments on other debt 26 and capital leases decreased $1,790 due to the early 2001 sale of a building, and corresponding mortgage retirement. Recent Developments Impacting Liquidity In June 2002, the Company settled $2.8 million of the remaining $3.3 million note balance plus accrued interest due the former owners of International Image for $1.9 million and 500,000 shares of common stock valued at $660,000. The difference between the principal and accrued interest balance and the settlement cost was recorded as a gain, net of certain legal costs. The payment and issuance of shares did not occur until early July 2002. In May 2002 and August 2002 we made the quarterly interest payment of $175 on the subordinated debt. Payments are due quarterly over the next two years. Monthly principal payments of approximately $330 begin in August 2002. In July of 2002, the Company initiated discussions with a majority of the debt holders for the right to make principal and interest payments in the form of stock. The proposed agreement would allow the Company, at our discretion, to issue shares in lieu of cash at an 8% discount to the average closing price for the previous month. The nine-month period included cash expenditures for non-recurring items such as MediaSite acquisition costs, large settlement payments on the delinquent accounts payable assumed from MediaSite and cash placed in escrow. With the expected agreement to pay a portion of the principal payments with stock, we believe we have access to sufficient resources and operating flexibility to fund operations and subordinated debt payments for at least the next twelve months. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Derivative Financial Instruments The Company is not party to any derivative financial instruments or other financial instruments for which the fair value disclosure would be required under SFAS No. 107, Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. The Company's cash equivalents consist of overnight investments in money market funds that are carried at fair value. Accordingly, we believe that the market risk of such investments is minimal. Interest Rate Risk The Company's cash equivalents are subject to interest rate fluctuations, however, we believe this risk is immaterial due to the short-term nature of these investments. Foreign Currency Exchange Rate Risk 27 All international sales of our software products are denominated in US dollars. However, the majority of transactions for our services division in Toronto are denominated in Canadian dollars. Although these transactions are not generally subject to significant foreign exchange rate gains and losses, they are translated into US dollars as part of our consolidated financial statements and therefore fluctuations in the exchange rate will affect our consolidated financial statements. The Canadian dollar has been stable relative to the US dollar and we have not engaged in any foreign currency hedging activities. 28 PART II OTHER INFORMATION Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (a) None (b) None (c) None 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 2.1 Amendment No. 1 to the Purchase Agreement dated February 11, 2002 by and between Sonic Foundry, Inc. and Omicron Partners, L.P, filed as exhibit 2.1 to the registration statement on Form S-3 filed on April 29, 2002, and hereby incorporated by reference. 2.2 Note - Exhibit A to Amendment No. 1 to the Purchase Agreement, filed as exhibit 2.2 to the registration statement on Form S-3 filed on April 29, 2002, and hereby incorporated by reference. 2.3 Warrant - Exhibit B to Amendment No. 1 to the Purchase Agreement, filed as exhibit 2.3 to the registration statement on Form S-3 filed on April 29, 2002, and hereby incorporated by reference. 2.4 Registration Rights Agreement - Exhibit C to Amendment No. 1 to the Purchase Agreement, filed as exhibit 2.4 to the registration statement on Form S-3 filed on April 29, 2002, and hereby incorporated by reference. 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 29 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 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. 10.4 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. 10.5 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. 10.6 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. 10.7 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. 10.9 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. 10.10 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. 10.11 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 30 reference. 10.12 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. 10.13 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. 10.14 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. 10.15 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. 10.16 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. 10.17 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. 10.18 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. 10.19 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. 31 10.20 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. 10.21 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. 10.22 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. 10.23 Commercial Lease between Ewart Associates, L.P. and Sonic Foundry Systems Group, Inc. (now known as Sonic Foundry Media Systems, Inc.), regarding 925 Liberty Avenue, Pittsburgh, PA 15222, dated November 30, 2001, filed as Exhibit No. 10.23 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference. 10.24 Commercial Lease between Stonewood East and Sonic Foundry Media Systems, Inc. regarding 12300 Perry Highway, Wexford, PA, dated January 13, 2002 filed as Exhibit No. 10.24 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference. 10.25 Asset Purchase Agreement and Plan of Asset Transfer and Reorganization dated September 6, 2001 by and among Sonic Foundry, Inc., Sonic Foundry Systems Group, Inc. (formerly known as MediaSite Acquisition, Inc.), and MediaSite, Inc., filed as Exhibit No. 2.1 to the Current Report on Form 8-K dated October 30, 2001, and hereby incorporated by reference. 10.26 Asset Purchase Agreement dated February 6, 2002 by and among Sonic Foundry Media Services, Inc. and Digital Savant, Inc, filed as Exhibit No. 10.26 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference. 10.27 Registrant's 2001 Deferred Compensation Plan, filed as Exhibit 4.4 to Form S-8 on November 21, 2001 and hereby incorporated by reference. 10.28 Stock Restriction and Registration Agreement between Sonic Foundry, Inc., Zero Stage Capital VI Limited Partnership, Saturn Capital, Inc. and Saturn Partners Limited Partnership dated October 15, 2001 filed as Exhibit 4.4 to Form S-3 filed on December 21, 2001, and hereby incorporated by reference. 10.29 Registrant's Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to Form S-8 on December 21, 2001, and hereby incorporated by reference. 32 10.30 Software License and Marketing Agreement effective as of March 25, 2002 between Registrant and Broderbund Properties LLC filed on filed as Exhibit No. 99.2 to the Registration Statement on Form S-3 filed on August 13, 2002 and hereby incorporated by reference. 10.31 Amended and Restated License Agreement effective October 15, 2001 between Carnegie Mellon University and MediaSite, Inc. filed as Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference 33 SIGNATURES This Report on Form 10-Q fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)) and information contained in this Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the registrant. 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 14, 2002 By: /s/ Rimas P. Buinevicius ------------------------ Rimas P. Buinevicius Chairman and Chief Executive Officer August 14, 2002 By: /s/ Kenneth A. Minor -------------------- Kenneth A. Minor Chief Financial Officer and Secretary