10-Q 1 p16661_10q.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______. Commission file number 0-21336 THE 3DO COMPANY (Exact name of registrant as specified in its charter) DELAWARE 94-3177293 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 CARDINAL WAY REDWOOD CITY, CALIFORNIA 94063 (Address of principal executive offices, including zip code) (650) 385-3000 (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 [ ] As of January 31, 2003, the number of outstanding shares of the registrants' common stock was 8,383,496. THE 3DO COMPANY FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 2002 INDEX

2 Part I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements THE 3DO COMPANY CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)

The accompanyingnotes are part of the consolidated financial statements. 3 THE 3DO COMPANY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited)

The accompanying notes are an integral part of the consolidated financial statements. 4 THE 3DO COMPANY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)

The accompanying notes are an integral part of the consolidated financial statements. 5 THE 3DO COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE 1 - GENERAL In April 1993, The 3DO Company was incorporated as a Delaware holding company. The accompanying consolidated financial statements include the accounts of The 3DO Company and its wholly owned subsidiaries, 3DO Europe, Ltd. and Studio 3DO K.K. (the "Company"). The Company develops and publishes branded interactive entertainment software for multiple platforms. These financial statements have been prepared on a basis which assumes that the Company will continue as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company recorded a net loss attributable to common stockholders of $50.5 million on revenues of $53.7 million for fiscal year 2002 and also sustained significant losses for the fiscal year ended 2001. At December 31, 2002, the Company had an accumulated deficit of $262.0 million. These circumstances raise substantial doubt about the Company's ability to continue as a going concern. The Company's continued existence is dependent on its ability to obtain adequate funding and eventually establish profitable operations though increasing revenues and controlling costs. The Company began this process during the third quarter of fiscal 2002 by implementing a restructuring program to align its cost structure with its projected revenues and to reduce future operating expenses. In October and December 2002, the Company raised $6.2 million through entering into a short term debt financing with the Company's CEO and Chairman, William M. Hawkins III. In January 2003, the Company increased the borrowing from Mr. Hawkins from $6.2 million to $12.0 million. Also in January 2003, the Company raised an additional $0.7 million through the sale of common stock and warrants to purchase common stock. The Company will need to obtain additional financing in addition to the equity already raised through the sale of common stock and short term debt financing. The Company believes that additional financing is needed to provide the Company with sufficient working capital to execute its plans for the year ending March 31, 2003. Additional financing, whether through public or private equity or debt financing, collaborative or other arrangements with corporate sources or stockholders or other sources to fund operations, may not be available, or if available, may be on terms unacceptable to the Company. The Company's plans could be affected by unanticipated decreases in revenues or other events and in any case, future liquidity will be dependent upon its ability to raise additional funding. The Company may be forced to sell assets, refinance existing indebtedness, further reduce its business and operations, or combine with another company. There remains substantial doubt about the Company's ability to continue as going concern. However, the accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. NOTE 2 - CAPITALIZATION OF SOFTWARE DEVELOPMENT COSTS The Company has capitalized internal and external software development costs in accordance with Statement of Financial Accounting Standard No. 86 "Accounting for the Costs of Computer Software to be Sold, Licensed, or Otherwise Marketed"("SFAS No. 86"). Costs capitalized for internally developed software include salary and overhead associated with development. Capitalized external developed software costs primarily include costs for contract developers and product localization costs. Capitalization of internal software development costs begins upon establishment of technological feasibility and ceases when the product is available for general release to customers. Technological feasibility is established by the completion of a detailed program design, or in its absence, a working model of the product. Prior to fiscal 2001, the establishment of technological feasibility for internal development projects substantially coincided with the general release of the products and the Company had not capitalized any software development costs on internal development projects, as the eligible costs were determined to be insignificant. From fiscal 2001 forward, the Company incurred significant costs subsequent to the establishment of technological feasibility due to the development of a second wave of games for the next generation of platforms. For these games, the code was essentially retained intact and revisions were made primarily to the artwork and storyline. Accordingly, the Company considered the games to have achieved technological feasibility as the engines had been ready for marketplace introduction and as such constitutes a working model of the products. External development costs are capitalized upon technological feasibility being established or if the development costs have an alternative future use. The criteria for establishing technological feasibility for external development projects is consistent with that used for internal development projects noted above. In some overseas territories, where localization was required, this localization was 6 historically performed by external developers who were directly contracted by the Company's distributors. Where this occurred, the Company shipped a product master to the distributor and the Company's agreements with these distributors specified that the distributor was responsible for all localization costs and no product return rights were granted to the distributors. In this case, the Company capitalized no costs in relation to localization as these costs were not borne by the Company or re-billed to the Company. Localization typically consists of taking an established product, retaining the same game engine, which the Company considers to be a working model and translating the product into a local language. This localization is typically performed by external developers contracted by and reporting to the Company. Technological feasibility of the localized products is established by existing products when the game engine is already available for general release within the USA, and consequently the Company capitalizes these localization costs to the point that the product is localized sufficiently to be available for general release in the relevant overseas territory. During each of the three-month periods ended December 31, 2001 and 2002, the Company capitalized less than $0.1 million of external development costs related to localization. The table below sets forth capitalized internal, external and localization software development costs for the three and nine months ended December 31, 2001 and 2002:

Amortization of capitalized software costs is recognized on a straight-line basis over the estimated economic lives of the related products or the amount computed using the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues for that product, whichever is greater, and is included in cost of revenues. During the three months ended December 31, 2001 and 2002, the Company amortized approximately $4.5 million and $0.1 million of capitalized software development costs, respectively. During the nine months ended December 31, 2001 and 2002, the Company amortized approximately $6.0 million and $2.2 million of capitalized software development costs, respectively. Details of the projects cancelled as a result of restructuring can be found in Note 8 of these financial statements. At each balance sheet date, the Company assesses the recoverability of its unamortized capitalized software costs by determining whether the amortization of the asset balance over its remaining life can be recovered through future operating cash flows. The amount of write-down, if any, is recognized to the extent that the carrying value exceeds the projected net realizable value, as specified in SFAS No. 86. In addition, when it is no longer probable that computer software being developed will be placed in service, any capitalized costs will be written off. During the three months ended December 31, 2001 and 2002, the Company recorded a loss due to write-down of capitalized software development costs of $3.3 million and $0.1 million, respectively. During the nine months ended December 31, 2001 and 2002, the Company recorded a loss due to write-off of capitalized software development costs of $3.3 million and $4.4 million, respectively. 7 NOTE 3 - ACCRUED EXPENSES Accrued expenses consist of the following (unaudited): March 31, December 31, 2002 2002 -------- ------- Accrued compensation.............................. $ 2,727 $ 2,199 Accrued restructuring charge...................... 7,102 300 Accrued inventory................................. 1,770 156 Other............................................. 4,740 1,769 -------- ------- Total accrued expenses............................ $ 16,339 $ 4,424 ======== ======= NOTE 4 - SHORT-TERM DEBT In April 2000, the Company entered into a revolving line of credit with a bank. The credit facility allowed the Company to borrow the lesser of $30.0 million, or 85% of qualified accounts receivables, with an interest rate at the bank's prime rate plus 0.25% to 1.25% per annum, depending on the Company's tangible net worth. On April 5, 2002, the credit facility agreement expired and was not renewed. On June 27, 2002, the Company entered into a Loan and Security Agreement (the "Loan Agreement") with a financial institution. Under the Loan Agreement, eligible receivable monies collected were paid into an account of the financial institution. On December 5, 2002, the Company notified the financial institution that it was terminating the Loan Agreement. On October 1, 2002, the Company entered into a transaction where the Company borrowed $3.0 million from the Company's CEO, William M. Hawkins, III. The bridge note bears interest at a rate of 9.5% per year and is payable quarterly. The Company granted Mr. Hawkins a security interest in all of the Company's property and assets as security for its obligations under the bridge note. On December 27, 2002, the Company entered into a Note and Warrant Purchase Agreement with Mr. Hawkins, whereby he agreed to lend the Company up to $8.0 million through June 30, 2003. The outstanding note balance bears interest at a rate of 9.5% per year and is payable quarterly. Notes issued under the Note and Warrant Purchase Agreement are collateralized by all of the the Company's property and assets and are payable upon five days notice by Mr. Hawkins or upon an event of default. An event of default includes, but is not limited to, a failure to pay interest or principal due under the notes, or upon bankruptcy or insolvency proceedings. Pursuant to the Note and Warrant Purchase Agreement, the Company amended and restated the October 1, 2002 bridge note with Mr. Hawkins to be included as part of the Note and Warrant Purchase Agreement. Additionally, during December 2002, the Company issued two additional notes under the Note and Warrant Purchase Agreement with an aggregate principal amount of $3.2 million. At December 31, 2002, the total indebtedness to Mr. Hawkins under the notes was $6.2 million. In connection with this transaction, the Company granted Mr. Hawkins certain registration rights on all issued and issuable shares of common stock held by him. Additionally, the Company issued to Mr. Hawkins a warrant to purchase 2,000,000 shares of common stock with an exercise price of $2.52 per share. The Company estimated the fair value of the warrants to be approximately $2.2 million using the Black-Scholes valuation model and the following assumptions: dividend yield of 0%, volatility of 78.9%, risk free interest rate of 2.49%, and a term of 4 years. As the notes issued under the Note and Warrant Purchase Agreement are payable upon five days notice by Mr. Hawkins, the value of the warrants were expensed immediately to interest during the quarter ended December 31, 2002. Pursuant to the Note and Warrant Purchase Agreement, if the Company completes an equity or debt financing prior to March 31, 2003, the Company has the option to convert up to $3.0 million of principal and accrued interest due to Mr. Hawkins into securities issued under the future contemplated equity or debt financing. During January 2003, the Company borrowed the remaining $1.8 million available under the Note and Warrant Purchase Agreement from Mr. Hawkins. 8 NOTE 5 - REDEEMABLE CONVERTIBLE PREFERRED STOCK On December 10, 2001, the Company issued a total of 15,820 shares of redeemable convertible Series A Preferred Stock ("Preferred Stock") for an aggregate purchase price of $15.8 million. Associated with the issuance of the Preferred Stock, the Company issued immediately exercisable warrants to acquire common stock. The $15.0 million in net proceeds were allocated to the Preferred Stock and the warrants resulting in $12.2 million and $2.8 million assigned to Preferred Stock and warrants, respectively. Voting Holders of Preferred Stock do not have voting rights, except as required by law, including but not limited to the Delaware General Corporation Law. Conversion Initially, each share of Preferred Stock has a stated value of $1,000 and was convertible into common stock at an initial conversion price of $22.16 per share, which was 120% of the weighted average price of the Company's common stock during the 10 trading days preceding the initial issuance date. During the period starting February 15, 2002, and ending on June 14, 2002 ("Alternative Conversion Period"), the Preferred Stock was convertible at 90% of the weighted average price of the Company's common stock during the 20 trading days preceding conversion. On June 15, 2002, the conversion price was fixed at $6.220848, which was 120% of the weighted average price of the common stock during the 20 trading days immediately prior to the adjustment date. This fixed conversion price is subject to adjustment in the event the Company issues common shares (or instruments that may become common shares) at a price per share that is less than the fixed conversion price. The fixed conversion price may also be adjusted in the event of a sale of the Company and certain other specified changes in ownership. Due to the issuance of a warrant to purchase common stock on December 27, 2002 at a price below the fixed conversion price, the fixed conversion price was reduced to $5.4829983. The fixed conversion price was subsequently reduced to $5.2943362 in conjunction with a January 2003 equity financing. In connection with the issuance of the Preferred Stock, the Company calculated a beneficial conversion feature and recorded the associated charge over the beneficial conversion period ended on June 15, 2002. That charge, in the amount of approximately $2.5 million, was based on the difference between the most favorable conversion price and the market price of the Company's common stock on the date the Preferred Stock was issued. As a result of the adjustment of the preferred stock fixed conversion price in connection with the December 27, 2002 financing and warrant issuance, an additional beneficial conversion feature charge was calculated and expensed during the quarter ended December 31, 2002. That charge, in the amount of approximately $9.7 million, was based on the difference between the fair market value of the common stock conversion price at the inception of the December 10, 2001 Preferred Stock financing and the new fixed conversion price on December 27, 2002 and was limited to the total proceeds allocated to the Preferred Stock at the time of the Preferred Stock financing. As of December 31, 2002, 4,952 shares of Preferred Stock had been converted into 944,454 shares of common stock. The Company recorded accretion of the Preferred Stock discount during the three and nine months ended December 31, 2002, of $0.2 million and $2.7 million, respectively. Additionally, the Company recorded dividends for the three and nine months ended December 31, 2002, of $0.1 million and $0.4 million, respectively. Liquidation In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company, the holders of the Preferred Stock shall be entitled to receive cash from the liquidation of assets before any amount is paid to the holders of the common stock of the Company. The liquidation amount due per Preferred Stock share is equal to the conversion amount. If the liquidation funds are insufficient to pay the full amount due to the holders of Preferred Stock, then each holder of Preferred Stock, shall receive an allocated percentage of the liquidation funds based on the number of shares held by the holder of Preferred Stock. Redemption At the option of the holders of Preferred Stock, shares are convertible at any time and become mandatorily redeemable at $1,000 per share stated value plus any unpaid accrued dividends on December 10, 2004. Redemption may be in cash or common stock, at the Company's option, subject to certain limitations. The Preferred Stock is redeemable at the option of the holder upon the 9 occurrence of a `triggering event' which includes breaches of agreements, delisting from the Nasdaq National Market and other similar events. The redemption price in such case is the greater of (i) 125% of the stated value plus accrued but unpaid dividends and (ii) the product of (x) the number of shares of common stock into which the shares of Preferred Stock are convertible into multiplied by (y) the volume weighted average price of our common stock on the trading day immediately preceding the triggering event. Upon a change of control and certain other changes in ownership, each holder of Preferred Stock has an option to require the Company to redeem all or a portion of such holder's shares at a price equal to the greater of (i) 110% of the stated value plus accrued but unpaid dividends and (ii) the product of (x) the number of shares of common stock which would otherwise be issuable upon conversion of the shares at the time the holder delivers a notice of redemption to the Company and (y) the average daily volume weighted average price of the Company's common stock on the trading day immediately preceding such change of control. In addition, the Company may redeem the Preferred Stock on the first and second anniversaries of their issuance at 110% and 105% of the stated value plus accrued but unpaid dividends, respectively, if certain conditions are met. Dividends Holders of the Preferred Stock are entitled to a cumulative 5% per annum dividend, payable quarterly in cash or common stock, at the Company's option, subject to certain limitations. On April 1, 2002, July 1, 2002 and October 1, 2002, the Company issued dividends of 37,105, 30,009 and 89,260 shares of common stock to Preferred Stockholders. For the three and nine months ended December 31, 2002, the Company recorded dividends payable to holders of Preferred Stock of $0.1 million and $0.4 million, respectively. Warrants for common stock The Preferred Stock investors received immediately exercisable warrants to purchase 256,949 shares of the Company's common stock at an exercise price of $22.16 per share. The warrants have a three year term. The exercise price of the warrants is subject to adjustment in the event the Company issues common shares (or instruments that may become common shares) at a price per share that is less than the initial exercise price. In conjunction with the issuance of common stock warrants on December 27, 2002, the warrant exercise price was reduced to $17.1002616. As of December 31, 2002, none of these warrants have been exercised. In conjunction with the January 2003 financing, the warrant exercise price was subsequently reduced to $16.46961268. The Company also issued immediately exercisable warrants to acquire 38,355 shares of its common stock at an exercise price of $19.84 per share to an investment banking firm in partial payment of the placement fee for the Preferred Stock. The warrant has a five year term and the Company recorded the warrant as a reduction of the proceeds received from the sale of the Preferred Stock. The exercise price and number of warrants to purchase common stock is subject to adjustment in the event the Company issues common shares (or instruments that may become common shares) at a price per share that is less than the initial exercise price. In conjunction with the issuance of common stock warrants on December 27, 2002, the warrant exercise price was reduced to $18.350093 and the number of warrants was adjusted to 44,500. As of December 31, 2002, none of these warrants have been exercised. In conjunction with the January 2003 financing, the warrant exercise price was subsequently reduced to $17.507549 and increased the number of warrants to 46,202. As the conversion ratio of Preferred Stock, described above, did not include a specified lower floor during the Alternative Conversion Period, the Company has followed the provisions of EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and recorded the warrants issued with the common stock financing on October 9, 2001, and the warrants issued with the Preferred Stock financing on December 10, 2001, as liabilities. The reclassification was performed during fiscal 2002 and the warrants were marked to market at June 14, 2002. The effect of the mark to market on the three months ended December 31, 2001, was to increase other income by $0.6 million. The effect of the mark to market on the nine months ended December 31, 2002, was to increase other income by $0.8 million. Due to the expiration of the Alternative Conversion Period on June 15, 2002, the Company was able to determine that sufficient common shares were authorized and available for all outstanding warrants, and as such was able to reclassify the warrants from a liability to equity. 10 NOTE 6 - COMMON STOCK On August 22, 2002, the Company effected a one-for-eight reverse stock split of outstanding common shares. All common stock prices and amounts in the accompanying financial statements have been retroactively adjusted to reflect the reverse stock split. The reverse stock split did not affect the number of shares of outstanding Preferred Stock.. On October 9, 2001, the Company sold 591,626 shares of common stock at $16.48 per share. As part of the transaction, the Company issued warrants to purchase 177,488 shares of its common stock, which were fully exercisable, with an exercise price of $18.16 per share. The Company's Chief Executive Officer and Chairman of the Board, William M. (Trip) Hawkins III, purchased 491,626 of these shares and was issued warrants to purchase 147,488 shares of its common stock on terms equivalent with third party purchasers. As of December 31, 2002, none of these warrants have been exercised. The Company has never declared or paid any dividends on its common stock. The Company currently expects to retain future earnings, if any, for use in the operation and expansion of its business and does not anticipate paying any cash dividends on common stock in the foreseeable future. The Company's common stock trades on the Nasdaq National Market, which specifies certain requirements for the continued listing of common stock. One of these requirements is that the minimum closing bid price per share not fall below $1.00 for an extended period of time. On March 22, 2002, the Nasdaq Staff notified the Company that the bid price of its common stock had closed at less than $1.00 per share over the previous 30 consecutive trading days, and as a result, the Company did not comply with Marketplace Rule 4450(a)(5). Therefore, in accordance with the Marketplace Rule 4450(e)(2), the Company was provided 90 calendar days, or until June 20, 2002, to regain compliance with the Rule. On June 21, 2002, Nasdaq notified the Company that it had not regained compliance with Marketplace Rule 4450(e)(2) and as a result the Company's securities would be delisted from The Nasdaq National Market upon the opening of business on July 1, 2002. The Company requested and was granted a hearing on August 8, 2002, regarding the Nasdaq staff's determination. The Company presented its plan of action, which included the one-for-eight reverse stock split, to maintain compliance with the Nasdaq National Market continued listing standards. On September 9, 2002, the Company was notified that the Nasdaq Panel determined to continue the listing of the Company's stock on the Nasdaq National Market and the hearing file was closed. Option Exchange Program On October 23, 2002, the Company filed a tender offer statement on Schedule TO related to an offer by the Company to employees to exchange certain qualifying options. The offer allowed option holders the ability to cancel outstanding options to purchase up to an aggregate of approximately 2,480,000 shares of the Company's common stock in exchange for a promise to grant new options on a 1 to 1 basis no earlier than 6 months and 1 day from the offer's final acceptance date. The offer was applicable to holders of options with exercise prices greater than or equal to $5.76 per share that were outstanding under the Company's 1993 Incentive Stock Plan. Additionally, option holders are required to cancel all options that were received in the prior 6 months to be eligible to participate in the exchange offer. Option holders were allowed to accept the offer of exchange up until November 21, 2002. As of that date, options to purchase 2,383,426 shares of common stock were exchanged and are eligible for future grants. Future grants are expected to have an exercise price equal to the common stock price on the date of the grant. NOTE 7 - REVENUE RECOGNITION The Company recognizes revenue in accordance with Statement of Position 97-2 "Software Revenue Recognition". Revenue from the sale of software titles published and distributed by the Company is recognized at the time of receipt of the Company's goods by their customers based on the agreed upon shipping terms. The Company permits its customers to exchange software titles published and distributed by the Company, within certain specified periods, and provides price protection on certain unsold merchandise. Software publishing revenue is reflected net of allowances for returns, price protection and discounts. Software licensing revenue is recognized upon persuasive evidence of an arrangement, 3DO's fulfillment of its obligations (e.g., delivery of the product golden master) under any such licensing agreement, and determination that collection of a fixed or determinable license fee is considered reasonably assured. Per-copy royalties on sales that exceed the minimum guarantee are recognized upon being reported to the Company. The Company establishes allowances for expected product returns based on historical trends, in accordance with Statement of Financial Accounting Standards No. 48, " Revenue Recognition When Right of Return Exists". In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. SAB 101 provides guidance on applying generally accepted accounting principles to revenue recognition issues in financial statements. In October 2000, the SEC Staff released a frequently asked questions document to provide additional guidance on implementing SAB 101. The Company adopted SAB 101 and changed its revenue recognition policy, accordingly, effective April 1, 2000, based on guidance provided therein to recognize revenue based on agreed upon shipping terms. Prior to the 11 Company's adoption of Staff Accounting Bulletin No. 101 on April 1, 2000, revenue from the sales of software titles published and distributed by the Company was recognized at the time of shipment. The effect of SAB 101 was to include in both the fourth quarter of fiscal 2000 and the first quarter of fiscal 2001, revenue of $3.1 million and cost of goods sold of $1.1 million. The net effect of $2.0 million was recorded as a cumulative effect of accounting change during the first quarter of fiscal 2001. NOTE 8 - RESTRUCTURING CHARGES During fiscal year 2001, the Company recorded $1.2 million in restructuring charges. These charges included a reduction in force of 69 employees of $0.3 million, and realized and anticipated costs of $1.0 million for a vacated portion of our headquarters. As of March 31, 2001, the Company had accrued $0.8 million for anticipated costs associated with finding a sub-lessee. An additional restructuring charge of $1.0 million relating to a revision of the estimated time that it will take to find a suitable sub-lessee for the vacated office space from nine months to twelve months was recorded during the first quarter of fiscal 2002. During the third quarter of fiscal 2002, the Company implemented a restructuring program to align its organization's cost structure with its projected sales resulting from the current unfavorable economic conditions and to reduce future operating expenses. Under the restructuring program, the Company reduced its worldwide workforce by 160 employees for $0.5 million, wrote-off leasehold improvements related to vacant facitilated of $2.8 million, wrote-off capitalized development costs due to project cancellations of $3.3 million and provided for additional anticipated costs associated with finding a sub-lessee for $7.4 million. On May 14, 2002, the Company amended the lease on its headquarters facility. The amendment substantially changed the terms of the original lease agreement, which now expires in April 2006. Under the terms of the amendment, the Company has significantly reduced the monthly cash payments, the term of the lease and the amount of square footage leased. Under the terms of the original agreement dated June 12, 1999, the Company was required to maintain restricted cash of $5.2 million and a deposit with the leassor of $0.4 million. The amendment granted authorization to use the restricted cash and deposit as follows: $3.8 million will be used for fiscal 2003 rent and operating expenses, $0.7 million for fiscal 2004 rent and operating expenses, and $1.1 million for termination fees. As a result of the lease renegotiation, the Company's straight line rent accrual of $1.5 million was no longer required, and as such, the Company reversed the accrual against general and administrative expense as the accrual was not set-up as part of the restructuring charges. Additionally, the Company reversed the restructuring accrual related to lease cost of $4.7 million on its headquarters in Redwood City, California. The following table sets forth the restructuring costs:

NOTE 9 - NET LOSS PER SHARE Basic earnings per share is computed using the weighted-average number of shares of common stock outstanding. Diluted earnings per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, common equivalent shares from options and warrants to purchase common stock using the treasury stock method. On August 22, 2002, the Company effectuated a one-for-eight reverse stock split of issued and outstanding common shares. All per share amounts have been retroactively adjusted to reflect the reverse stock split. 12 The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the periods presented (in thousands, except per share amounts):

Options to purchase 2,855,464 and 267,020 shares of common stock were excluded from the Company's dilutive net loss per share calculations for the three months ended December 31, 2001 and 2002, respectively, because their effect was anti-dilutive. These anti-dilutive shares had weighted-average exercise prices of $30.79 and $17.64 for the three months ended December 31, 2001 and 2002, respectively. Warrants to purchase 688,463 and 2,694,607 shares of common stock were excluded from the Company's dilutive net loss per share calculations for the three and nine months ended December 31, 2001 and 2002, respectively, because their effect was anti-dilutive. These anti-dilutive shares had weighted-average exercise prices of $33.59 and $10.09 for the three and nine months ended December 31, 2001 and 2002, respectively. Preferred stock convertible into 715,953 and 1,986,472 shares of common stock were excluded from the Company's dilutive net loss per share calculations for the three and nine months ended December 31, 2001 and 2002, respectively, because their effect was anti-dilutive. These anti-dilutive shares had conversion price of $22.16 and $5.48299872 for the three and nine months ended December 31, 2001 and 2002, respectively. NOTE 10 - COMPREHENSIVE INCOME The Company's total comprehensive loss were as follows:

13 NOTE 11 - Recent Accounting Pronouncements In April 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 145 ("SFAS No. 145"), "Rescission of FASB Statements Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". SFAS No. 145 eliminates the requirement that gains and losses from the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. SFAS No. 145 was adopted by the Company in the three months ended June 30, 2002, and resulted in a reclassification of the fiscal 2001 loss on the early extinguishment of debt from an extraordinary item to a non-operating item. In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 ("SFAS No. 146"), "Accounting for Exit or Disposal Activities." SFAS No. 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under Emerging Issues Task Force ("EITF") No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The scope of SFAS No. 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS No.146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. The Company will adopt SFAS No.146 during the fourth quarter ending March 31, 2003. The provisions of EITF No. 94-3 shall continue to apply for an exit activity initiated under an exit plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS No. 146. The effect on adoption of SFAS No. 146 will change on a prospective basis the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred. In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN No. 45 requires that a liability be recorded in the guarantor's balance sheet upon issuance of a guarantee or indemnification. In addition, FIN No. 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity's product warranty liabilities. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN No. 45 during the period ended December 31, 2002, did not have a material effect on these quarterly financial statements, however, management is continuing to evaluate the impact on future financial statements. In December 2002, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 148 ("SFAS No. 148"), "Accounting for Stock-Based Compensation, Transition and Disclosure." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The Company believes that the adoption of this standard will increase the amount of disclosures in the financial statements. NOTE 12 - GEOGRAPHIC, SEGMENT AND SIGNIFICANT CUSTOMER INFORMATION The Company operates in a single operating segment, interactive entertainment software products. The disaggregated financial information on a product basis reviewed by the Company's Chief Executive Officer is as follows (in thousands):

14 For the three months ended December 31, 2001, the Company's top three customers accounted for 33%, 14% and 12% of revenues. For the three months ended December 31, 2002, the Company's top customer accounted for 44% of revenue. For the nine months ended December 31, 2001, the Company's top three customers accounted for 14%, 12% and 10% of revenues. For the nine months ended December 31, 2002, the Company's top two customers accounted for 14% and 11% of revenues. Sales to the Company's largest five customers accounted for approximately 68% and 47% of our software publishing revenues in the three and nine month periods ended December 31, 2001, respectively. Sales to the Company's largest five customers accounted for approximately 64% and 44% of our software publishing revenues in the three and nine month periods ended December 31, 2002, respectively. The Company's video game and computer software products are now sold in international markets both principally through licensees, primarily in the United Kingdom and other European countries, and to a lesser extent, in Asia and Latin America. The Company's international publishing sales were approximately $2.5 million and $0.5 million, or 27% and 12% of total revenues for the three months ended December 31, 2001 and 2002, respectively. The Company's international publishing sales were approximately $9.8 million and $3.2 million, or 25% and 16% of total revenues for the nine months ended December 31, 2001 and 2002, respectively. NOTE 13 - SUBSEQUENT EVENTS On January 16, 17 and 21, 2003, the Company sold an aggregate of 423,528 shares of common stock at $1.70 per share for gross proceeds of approximately $720,000. As part of the transaction, the Company issued warrants to purchase 105,880 shares of common stock. The warrants have an exercise price of $2.525 per share and are exercisable for four years, but may not be exercised for a period of 180 days after the issue date. The Company also paid approximately $43,200 and issued warrants to purchase 28,797 shares of common stock as consideration of the services of an investment bank in connection with the transaction. On January 30, 2003, the Company borrowed an additional $4.0 million from the Company's CEO, William M. Hawkins, III. The note bears interest at a rate equal to the amount of interest payable by Mr. Hawkins to his bank or, if Mr. Hawkins does not owe any obligations to his bank, the note bears interest at 9.5%. The note is payable upon 5 days written notice by Mr. Hawkins or immediately if there is an event of default. An event of default includes, but is not limited to, failure to pay interest or principal on the note, or upon bankruptcy or insolvency proceedings. Interest is payable when interest is payable by Mr. Hawkins to his bank, or quarterly if no obligations are outstanding to his bank. All of the Company's property and assets are collateral under the note. 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Form 10-Q contains forward-looking statements that involve risks and uncertainties. We use words such as "anticipates," "believes," "plans," "expects," "future," "intends," "may," "will," "should," "estimates," "predicts," "potential," "continue" and similar expressions to identify such forward-looking statements. These forward-looking statements include, but are not limited to, statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations". Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance, achievements and prospects to be materially different from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among others, those identified under "Risk Factors" and elsewhere in this Form 10-Q. These forward-looking statements apply only as of the date of this Form 10-Q. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this Form 10-Q might not occur. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described above and elsewhere in this Form 10-Q and readers are cautioned not to place undue reliance on these forward looking statements, which reflect management's analysis only as of the date hereof. Such forward-looking statements include statements as to, among others: o our ability to extend our brands across multiple genres and platforms; o the timing of the introduction of some new products; o our expectations regarding the number of new product releases for fiscal 2003; o our expectations regarding the timing of the introduction of new platforms; o our expectation that the introduction of new platforms will accelerate the video game cycle; o our expectations regarding retailers preferences to stock sequels to successful brands; o our expectations regarding the sufficiency of our cash reserves and of our future cash requirements; o our expectations regarding cash flow from operations and our available credit facilities; o our expectations regarding our ability to renew licensing agreements with our principal licensors, including Sony and Nintendo; o our expectations regarding operating expenses; o our expectations that as more advanced platforms are introduced, consumer demand for software for older platforms may decline; and o our expectation that we have adequate legal defenses for legal actions arising out of the ordinary course of business and that the ultimate outcome of these actions will not have a material effect on our financial position. OVERVIEW We are a developer and publisher of branded interactive entertainment software. Historically we have developed products for several multimedia platforms including personal computers, the PlayStation 2 computer entertainment system, the PlayStation game console, the Nintendo Game Boy Color hand-held game system, the Nintendo Game Boy Advance hand-held game system, the Nintendo 64 game system, and the Internet. We are also developing software, but have not shipped, for other next generation video game consoles including the Nintendo Game Cube and the Microsoft Xbox. We plan to continue to extend our popular brands across multiple categories, or "genres," and platforms. These brands currently include Army Men, Cubix, Heroes of Might and Magic, High Heat Baseball, and Might and Magic, many of which have won industry awards. Our software products cover a variety of genres, including action, strategy, adventure/role playing, sports and family entertainment. We develop the majority of our software internally in our company-owned studios. Periodically, we utilize external developers and contractors who possess specific skills to supplement our internal development efforts when management deems it cost effective. Revenues consist of the sale of software titles published and distributed by us in North America and Europe as well as license fees for software developed by us and manufactured, marketed and distributed by third party licensees in Europe, Latin America, Asia and 16 Australia. At the end of March 2002, 3DO Europe Ltd began a change in distribution, shifting from direct distribution of its products for the United Kingdom and distribution agreements throughout Europe, to a series of licensing agreements covering all European countries. Software publishing revenue is net of allowances for returns, price protection and discounts. Software publishing revenue is recognized at the time of receipt of our goods by our customers based on the agreed upon shipping terms, provided that we have no related outstanding obligations. In the three months ended December 31, 2002, sales to Cokem Internationl, Ltd. represented 44% of our total software publishing revenues. In addition, sales to our largest five customers accounted for approximately 64% of our software publishing revenues in the third quarter of fiscal 2003. Our video game and computer software products are now sold in international markets both principally through licensees, primarily in, the United Kingdom and other European countries, and, to a lesser extent, in Asia and Latin America. International software publishing revenue represented 12% of our fiscal 2003 third quarter revenues. Software licensing revenue, which represented 14% of our fiscal 2003 third quarter revenues, is typically recognized when we fulfill our obligations, such as delivery of the product master under a licensing agreement. Per-copy royalties that exceed guaranteed minimum royalty levels are recognized upon being reported to us. Cost of revenues-product costs consist primarily of direct costs associated with software titles, including manufacturing costs and royalties payable to platform developers such as Sony and Nintendo. Cost of revenues-product costs for interactive entertainment software varies significantly by platform. Cost of revenues-product costs for video game console titles is typically higher than cost of revenues-product costs for personal computer titles due to relatively higher manufacturing and royalty costs associated with these products. Cost of revenues-product costs for personal computer titles primarily consist of the cost of the CD-ROM and packaging. Cost of revenues-royalties and software development amortization consists of the amortization of software development costs and, to a lesser extent, royalties payable to third-party developers and licensors. The amortization of capitalized software costs is recognized on a straight-line basis over the estimated economic lives of the related products or the amount computed using the ratio of current gross revenues for a title to the total of current and anticipated future gross revenues for that product, whichever is greater, and is included in cost of revenues. During the third quarter of fiscal 2003, we capitalized $4.6 million and amortized $0.1 million of capitalized software development costs. Research and development expenses relate to the development of new products and consist primarily of direct and indirect salaries and wages of software research and development personnel, direct research and development expenses, and amounts paid to outside developers. Software development costs that are not capitalized are expensed as incurred. Gross research and development expenses decreased to $8.3 million in the three months ended December 31, 2002, from $10.5 million for the same period of the prior year. This decrease was primarily due to fewer games in development, partially offset by increased staffing on internal development projects. We have capitalized internal and external software development costs. Costs capitalized for internally developed software include salary and overhead associated with development. Capitalized external development costs primarily include costs for contract developers and product localization costs. At December 31, 2002, we had approximately $16.2 million of costs capitalized related to these costs. Capitalization of internal software development costs begins upon establishment of technological feasibility and ceases when the product is available for general release to customers. Technological feasibility is established by the completion of a detailed program design, or in its absence, a working model of the product. The establishment of technological feasibility for internal development projects substantially coincided with general release of the products prior to fiscal 2001, and we had not capitalized any software development costs on internal development projects, as the eligible costs were determined to be insignificant. During the third quarter of fiscal 2003, we capitalized approximately $3.8 million for games developed for a specific platform, due to significant costs being incurred after technological feasibility was reached. For these games, the code from prior games was essentially retained intact and revisions were made primarily to the artwork and storyline. We therefore considered that the games had already achieved technological feasibility as the engines had been ready for marketplace introduction, and we therefore capitalized the costs associated with this development until they were ready for general release. External development costs are capitalized once technological feasibility is established or if the development costs have an alternative future use. The criteria for establishing technological feasibility for external development projects is consistent with that used for internal development projects noted above. In some overseas territories, where localization was required, this localization was historically performed by external developers who were directly contracted by our distributors. Where this occurred we shipped our `gold master product' to the distributor and our agreements with these distributors specified that the distributor was responsible for all localization costs and no product return rights were granted to the distributors. In this case, we capitalized no costs in relation to localization as these costs were not borne by us or re-billed to us. During fiscal 2001, we began to assume the responsibility and cost of providing localized versions of many of our overseas products. This 17 localization typically consists of taking an established product, retaining the same game engine, which we consider to be a working model, and translating the product into a local language. This localization is typically performed by external developers contracted to us and responsible to us. Technological feasibility of the translated and localized products was established by existing products as the game engine was already available for general release within the United States, and consequently we capitalize these localization costs to the point that the product is localized sufficiently to be available for general release in the relevant overseas territory. As a result, we capitalized less than $0.1 million of external development costs related to localization during the second quarter of fiscal 2003. Sales and marketing expenses consist primarily of advertising and retail marketing support, sales commissions, sales and marketing personnel costs and other costs. General and administration expenses consist primarily of administrative expenses related to finance, accounting, legal, operations, information technology, customer service and other associated costs. We expect to continue to incur substantial expenditures to develop our business in the future. We expect that our operating results will fluctuate as a result of a wide variety of factors, including the factors described in "Risk Factors." CRITICAL ACCOUNTING POLICIES The discussion an analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principals in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosures of contingent assets and liabilities. On an on going basis, we evaluate our estimates, including those related to revenue recognition, valuation allowances, accounting for income taxes and valuation of capitalized software development costs. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believer our critical accounting policies are as follows: o Revenue recognition; o Estimating valuation allowances, specifically sales returns, price protections, the allowance for doubtful accounts and other allowances and; o Valuation of capitalized software development costs. Revenue Recognition We recognize revenue in accordance with Statement of Position 97-2 "Software Revenue Recognition." Revenue from the sale of software titles published and distributed by us is recognized at the time of receipt of our goods by the customer based on the agreed upon shipping terms. We permit our customers to exchange software titles published and distributed by the Company, within certain specified periods, and provide price protection on certain unsold merchandise. Software publishing revenue is reflected net of allowances for returns, price protection and discounts. Software licensing revenue is recognized upon persuasive evidence of an arrangement, fulfillment of our obligations (e.g., delivery of the product golden master) under any such licensing agreement, and determination that collection of a fixed or determinable license fee is considered reasonably assured. Per-copy royalties on sales that exceed the minimum guarantee are recognized upon being reported to the Company. Revenue from our on-line service was recognized monthly based on usage. We establish allowances for expected product returns based on historical trends, in accordance with Statement of Financial Accounting Standard No. 48, " Revenue Recognition When Right of Return Exists". In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. SAB 101 provides guidance on applying generally accepted accounting principles to revenue recognition issues in financial statements. In October 2000, the SEC Staff released a frequently asked questions document to provide additional guidance on implementing SAB 101. We adopted SAB 101 and changed our revenue recognition policy accordingly, effective April 1, 2000, based on guidance provided therein to recognize revenue based on agreed upon shipping terms. Prior to our adoption of Staff Accounting Bulletin No. 101 on April 1, 2000, revenue from the sales of software titles published and distributed by us was recognized at the time of shipment. We now recognize revenue at the point products are received by our customers. We estimate that our products typically take on average, three days from the point of shipment to their arrival at our customers' site. 18 Sales returns, price protection, allowance for doubtful accounts and other allowances The preparation of financial statements requires our management to make estimates and assumptions that effect the reported amounts of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, our management must make estimates of potential future product returns, price protection and allowances for doubtful accounts related to current period product revenue. Management analyzes historical returns, current sell through of product and retailer inventory, current economic trends, changes in consumer demand and acceptance of our products when evaluating the adequacy of our sales returns and other allowances. Significant management judgments and estimates must be used in connection with establishing the sales returns and other allowances in any accounting period. Material differences may result in the amount and the timing of our revenue for any period if management made different judgments or utilized different estimates. Similarly management must make estimates of the uncollectibility of our accounts receivables. Management specifically analyses accounts receivable and analyses historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts. Capitalized Software Development Costs We have capitalized internal and external software development costs in accordance with Statement of Financial Accounting Standard No. 86 "Accounting for the Costs of Computer Software to be Sold, Licensed, or Otherwise Marketed". Costs capitalized for internally developed software include salary and overhead associated with development. Capitalized external developed software costs primarily include costs for contract developers and product localization costs. Capitalization of internal software development costs begins upon establishment of technological feasibility and ceases when the product is available for general release to customers. Technological feasibility is established by the completion of a detailed program design, or in its absence, a working model of the product. Historically, the establishment of technological feasibility for internal development projects has substantially coincided with the general release of the products and we have not capitalized any software development costs on internal development projects, as the eligible costs were determined to be insignificant. During fiscal 2001, we incurred significant costs subsequent to the establishment of technological feasibility due to the development of a second wave of games for a specific platform. For these games, the code was essentially retained intact and revisions were made primarily to the artwork and storyline. Accordingly, we consider the games to have achieved technological feasibility as the engines had been commercially proven in the marketplace and as such constitute a working model of the products. External development costs are capitalized upon technological feasibility being established or if the development costs have an alternative future use. The criteria for establishing technological feasibility for external development projects is consistent with that used for internal development projects noted above. In some overseas territories, where localization was required, this localization was historically performed by external developers who were directly contracted by our distributors. Where this occurred the Company shipped a product master to the distributor and our agreements with these distributors specified that the distributor was responsible for all localization costs and no product return rights were granted to the distributors. In this case, we capitalized no costs in relation to localization as these costs were not borne by us or re-billed to us. During fiscal year 2001, we began incurring development costs for development of localized products. This localization typically consists of taking an established product, retaining the same game engine, which we consider to be a working model and translating the product into a local language. This localization is typically performed by external developers contracted by and reporting to us. Technological feasibility of the localized products is established by existing products when the game engine is already available for general release within the USA, and consequently we capitalize these localization costs to the point that the product is localized sufficiently to be available for general release in the relevant overseas territory. Amortization of capitalized software costs is recognized on a straight-line basis over the estimated economic lives of the related products or the amount computed using the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues for that product, whichever is greater, and is included in cost of revenues. At each balance sheet date, we assess the recoverability of our unamortized capitalized software costs by determining whether the amortization of the asset balance over its remaining life can be recovered through future operating cash flows. The amount of write-down, if any, is recognized to the extent that the carrying value exceeds the projected net realizable value, as specified in SFAS No. 86. In addition, when it is no longer probable that computer software being developed will be placed in service, any capitalized costs will be written off. 19 RESULTS OF OPERATIONS Revenues. Publishing revenues decreased to $3.4 million for the three months ended December 31, 2002,from $15.2 million for the same period of the prior year. This decrease was due primarily to a 76% decrease in units sold during the third quarter of fiscal 2003 due to no new titles being released during the period, while the same period of the prior year had 6 products released. The unit decrease was most significant on the PlayStation platform (86% decrease), PlayStation2 platform (73% decrease) and the Game Boy Color platform (100% decrease). Our international publishing revenues were approximately $0.5 million and $2.5 million, or 12% and 17% of total revenues for the three months ended December 31, 2002 and 2001, respectively. Publishing revenues decreased to $15.2 million for the nine months ended December 31, 2002, from $37.9 million for the same period of the prior year. This decrease was due primarily to a 58% decrease in units sold during the first nine months of fiscal 2003 due to one new title being released during the period, while the same period of the prior year had 11 products released. The unit decrease was most significant on the PlayStation platform (68% decrease), the Game Boy Color platform (87% decrease) and the Playstation 2 platform (53% decrease). Our international publishing revenues were approximately $3.2 million and $9.8 million, or 16% and 25% of total revenues for the nine months ended December 31, 2002 and 2001, respectively. Licensing revenue increased to $0.6 million in the three months ended December 31, 2002 from less than $0.1 million in the same period of the prior year. This was primarily due to the continuing international licensing of our Heroes of Might and Magic IV title during the three months ended December 31, 2002. For the nine months ended December 31, 2002 licensing revenue increased to $4.8 million from $0.5 million in the same period of the prior year. The increase was primarily due to the international licensing of our Heroes of Might and Magic III, Heroes of Might and Magic IV and Might and Magic IX. The following table shows the consolidated platform revenue and revenue by source:

Cost of revenues-product costs. Cost of revenues-product costs decreased to $2.0 million in the three months ended December 31, 2002, from $10.0 million for the same period of fiscal 2002. The decrease was primarily due to a 77% decrease in units sold and a shift in product mix. Cost of revenues-product costs as a percentage of publishing revenues decreased to 57% in the three months ended December 31, 2002, from 66% in the same period of the prior year due to a product mix shift toward higher margin PC products, which have a lower associated product cost, from console products. Cost of revenues-product costs decreased to $8.1 million in the nine months ended December 31, 2002, from $22.2 million for the same period of fiscal 2002. The decrease was primarily due to a 58% decrease in units sold and a shift in product mix. Cost of revenues-product costs as a percentage of publishing revenues decreased to 53% in the nine months ended December 31, 2002, from 59% in the same period of the prior year due to a product mix shift toward higher margin PC products, which have a lower associated product cost, from console products. Cost of revenues-royalties and software development amortization. Cost of revenues related to the amortization of royalties and capitalized software decreased to $0.1 million in the three months ended December 31, 2002, from $4.8 million for the same period of fiscal 2002. The decrease of $4.7 million was due to the lack of capitalized products released during the third quarter of fiscal 2003. The same period of the prior year had several releases of products with capitalized development costs and, as such, had greater amortization during the period those costs were amortized. Cost of revenues related to the amortization of royalties and capitalized software decreased to $3.1 million in the nine months ended December 31, 2002, from $6.9 million for the same period of the prior year. The decrease of $3.8 million was due to fewer titles released with capitalized software development costs over the same period of the prior year. Research and development. Gross research and development expenses decreased to $8.3 million in the three months ended December 31, 2002, from $10.5 million in the same period of the prior year. This decrease was primarily due to a decrease in personnel related costs of $1.3 million and a decrease in overhead of $0.8 million. Amortization of capitalized development costs is charged to cost of revenues. Gross research and development expenses decreased to $25.4 million in the nine months ended December 31, 2002, from $35.7 million in for the same period of the prior year. This decrease was primarily due to a decrease in personnel related costs of $6.4 million, a decrease in overhead of $2.2 million and a decrease in external development of $0.9 million. The remaining decrease of $0.8 million was made up of several miscellaneous reductions in research and development expenses. Amortization of capitalized development costs is charged to cost of revenues. 21 The table below sets forth gross research and development expenses, capitalized software development costs, and research and development expenses in dollar and percentage of revenue amounts:

Sales and marketing. Sales and marketing expenses decreased to $0.5 million in the three months ended December 31, 2002, from $2.8 million for the same period of fiscal 2002. This decrease was primarily due to a decrease in advertising for products of $0.8 million, a decrease of $0.2 million in sales commissions and a decrease of personnel expenses of $0.6 million. The remaining decrease of $0.7 million was made up of several miscellaneous reductions in sales and marketing expenses. Sales and marketing expenses decreased to $2.8 million in the nine months ended December 31, 2002, from $8.4 million for the same period of fiscal 2002. This decrease was primarily due to a decrease in advertising for products of $1.4 million, a decrease in overhead costs of $0.5 million, a decrease of $0.4 million in sales commissions, a decrease of $0.2 million in package design costs and a decrease of personnel expenses of $2.0 million. The remaining decrease of $1.1 million was made up of several miscellaneous reductions in sales and marketing expenses. General and administrative. General and administrative expenses decreased to $2.6 million in the three months ended December 31, 2002, from $2.7 million for the same period of fiscal 2002. The decrease was primarily due to a decrease in administrative labor of $0.2 million. General and administrative expenses decreased to $5.6 million in the first nine months of fiscal 2003, from $9.7 million for the same period of fiscal 2002. The decrease was primarily due to the reversal of the straight line rent accrual of $1.5 million related to our headquarters lease renegotiation, a decrease of $0.3 million in bad debt expense, administrative labor of $0.9 million and overhead expenses of $0.7 million. The remaining decrease was due to decreases in amortization of goodwill and decrease in miscellaneous other expenses. Restructuring charge. During the first quarter of fiscal 2003, we reversed the restructuring accrual related to lease costs of $4.7 million on our headquarters in Redwood City, California. The reversal occurred as a result of renegotiation of our lease, which significantly reduced our lease liability. During the first quarter of fiscal 2002, we had previously revised our estimate of the costs of finding a suitable subtenant for our headquarters. 22 The table below sets forth the activity in restructuring costs:

The remaining $0.3 million liability at December 31, 2002, represent accrued lease costs for office furniture and equipment that we lease, but do not plan to utilize for remainder of the lease period. Remeasurement of warrant liability. As the conversion ratio of Preferred Stock, described in Note 5 to the condensed consolidated financial satements, did not include a specified lower floor during the Alternative Conversion Period, we have followed the provisions of EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and recorded the warrants issued with the common stock financing on October 9, 2001, and the warrants issued with the Preferred Stock financing on December 10, 2001, as liabilities. The reclassification was performed during fiscal 2002 and the warrants were marked to market at June 14, 2002. The effect of the mark to market on the three months ended December 31, 2001, was to increase other income by $0.6 million. The effect of the mark to market on the nine months ended December 31, 2002, was to increase other income by $0.8 million. Due to the expiration of the Alternative Conversion Period on June 15, 2002, we were able to determine that sufficient common shares were authorized and available for all outstanding warrants, with the exception of the Investment Bank Warrants, and as such was able to reclassify the warrants from a liability to equity. We continue to remeasure the value of the Investment Bank Warrants and have determined the value of these warrants to be insignificant at December 31, 2002. Net interest and other income(expense). Net interest and other income (expense) decreased to an expense of $2.6 million during the three months ended December 31, 2002, from net interest and other income of $0.8 million in the same period of the prior year. The decrease in net interest and other income (expense) was primarily due to the prior year containing an adjustment to income for the remeasurement of warrant liabilities, a $0.5 million charges during the three months ended December 31, 2002, associated with the early termination of our line of credit, and a non-cash charge of $2.2 million to record the issuance of warrants issued in conjunction with the Note and Warrant Purchase Agreement with Mr. Hawkins during the third quarter of fiscal 2003. Net interest and other income (expense) decreased to an expense of $2.4 million during the nine months ended December 31, 2002, from net interest and other income of $1.1 million in the same period of the prior year. The decrease in net interest and other income (expense) was primarily due to the prior year containing an adjustment to income for the remeasurement of warrant liabilities, a $0.5 million charge during the three months ended December 31, 2002, associated with the early termination of our line of credit, and a non-cash charge of $2.2 million to record the issuance of warrants issued in conjunction with the Note and Warrant Purchase Agreement with Mr. Hawkins during the third quarter of fiscal 2003. LIQUIDITY AND CAPITAL RESOURCES Discussion of results Our principal sources of liquidity are cash and cash equivalent balances, which were $0.4 million at December 31, 2002, and $5.7 million at March 31, 2002. The decrease was primarily due to the $16.4 million cash used in operating activities and $4.5 million in cash provided by investing activities, offset by $6.3 million provided by financing activities. The $16.4 million in cash used in operating activities was primarily due to an net loss of $10.1 million and cash used in operating activities including: an increase in capitalized software costs of $16.5 million, a reduction of $1.8 million in other liabilities, a reduction of $5.4 million in accrued liabilities, an increase of $1.2 million in prepaids and other assets, and a decrease of $5.0 million in the provision for bad debts, discounts and returns. This was offset by cash provided from operating activities including: decreases in inventory of $2.1 million, a decrease in accounts receivable of $17.1 million and other non-cash items of $4.4 million. 23 The $4.5 of cash provided by investing activities primarily was due to the use of restricted cash of $5.2 to pay our rent as a result of that renegotiation, offset by purchases of computer equipment and software of $0.7 million. The $6.3 million of cash provided by financing activities was primarily due and increase in short term debt of $6.2 million. Short Term Debt In April 2000, we entered into a revolving line of credit with a bank. The credit facility allowed us to borrow the lesser of $30.0 million, or 85% of qualified accounts receivables, with an interest rate at the bank's prime rate plus 0.25% to 1.25% per annum, depending on the our tangible net worth. On April 5, 2002, the credit facility agreement expired and was not renewed. On June 27, 2002, we entered into a Loan and Security Agreement (the "Loan Agreement") with a financial institution. Under the Loan Agreement, eligible receivable monies collected were paid into an account of the financial institution. On December 5, 2002, we notified the financial institution that we were terminating the Loan Agreement. On October 1, 2002, we entered into a transaction where we borrowed $3.0 million from our CEO, William M. Hawkins, III. The bridge note bears interest at a rate of 9.5% per year and is payable quarterly. We granted Mr. Hawkins a security interest in all of our property and assets as security for its obligations under the bridge note. On December 27, 2002, we entered into a Note and Warrant Purchase Agreement with Mr. Hawkins, whereby he agreed to lend us up to $8.0 million through June 30, 2002. The outstanding note balance bears interest at a rate of 9.5% per year and is payable quarterly. Notes issued under the Note and Warrant Purchase Agreement are collateralized by all of our property and assets and are payable upon five days notice by Mr. Hawkins or upon an event of default. An event of default includes, but is not limited to, a failure to pay interest or principal due under the notes, or upon bankruptcy or insolvency proceedings. Pursuant to the Note and Warrant Purchase Agreement, we amended and restated the October 1, 2002 bridge note with Mr. Hawkins to be included as part of the Note and Warrant Purchase Agreement. Additionally, during December 2002, we issued two additional notes under the Note and Warrant Purchase Agreement with an aggregate principal amount of $3.2 million. At December 31, 2002, the total indebtedness to Mr. Hawkins under the note was $6.2 million. In connection with this transaction, we granted Mr. Hawkins certain registration rights on all issued and issuable shares of common stock held by him. Additionally, we issued to Mr. Hawkins a warrant to purchase 2,000,000 shares of common stock with an exercise price of $2.52 per share. We estimated the fair value of the warrants to be approximately $2.2 million using the Black-Scholes valuation model and the following assumptions: dividend yield of 0%, volatility of 78.9%, risk free interest rate of 2.49%, and a term of 4 years. As the notes issued under the Note and Warrant Purchase Agreement are payable upon five days notice by Mr. Hawkins, the value of the warrants were expensed immediately to interest during the quarter ended December 31, 2002. Pursuant to the Note and Warrant Purchase Agreement, if we complete an equity or debt financing prior to March 31, 2003, we have the option to convert up to $3.0 million of principal and accrued interest due to Mr. Hawkins into securities issued under the future contemplated equity or debt financing. During January 2003, we borrowed the remaining $1.8 million available under the Note and Warrant Purchase Agreement from Mr. Hawkins. On January 30, 2003, we borrowed an additional $4.0 million from our CEO, William M. Hawkins, III. The note bears interest at a rate equal to the amount of interest payable by Mr. Hawkins to his bank or, if Mr. Hawkins does not owe any obligations to his bank, the note bears interest at 9.5%. The note is payable upon 5 days written notice by Mr. Hawkins or immediately if there is an event of default. An event of default includes, but is not limited to, failure to pay interest or principal on the note, or upon bankruptcy or insolvency proceedings. Interest is payable when interest is payable by Mr. Hawkins to his bank, or quarterly if no obligations are outstanding to his bank. All of our property and assets are collateral under the note. 24 Common Stock On August 22, 2002, we effected a one-for-eight reverse stock split of outstanding common shares. All common stock prices and amounts in the accompanying financial statements have been retroactively adjusted to reflect the reverse stock split. The reverse stock split did not affect the number of shares of outstanding Preferred Stock. On October 9, 2001 we sold 591,626 shares of common stock at $16.48 per share. As part of the transaction, we issued warrants to purchase 177,488 of our common stock, which were fully exercisable, with an exercise price of $18.16 per share. Our Chief Executive Officer and Chairman of the Board, William M. (Trip) Hawkins III, purchased 491,626 of these shares and was issued warrants to purchase 147,488 of our common stock on terms equivalent with third party purchasers. As of December 31, 2002, none of these warrants have been exercised. We have never declared or paid any dividends on its common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future. On January 16, 17 and 21, 2003, we sold an aggregate of 423,528 shares of our common stock at $1.70 per share for gross proceeds of approximately $720,000. As part of the transaction, we issued warrants to purchase 105,880 shares of our common stock. The warrants have an exercise price of $2.525 per share and are exercisable for four years, but may not be exercised for a period of 180 days after the issue date. We also paid approximately $43,200 and issued warrants to purchase 28,797 shares of our common stock as consideration of the services of an investment bank in connection with the transaction. Our common stock trades on the Nasdaq National Market, which specifies certain requirements for the continued listing of common stock. One of these requirements is that the minimum closing bid price per share not fall below $1.00 for an extended period of time. On March 22, 2002, the NASDAQ Staff notified us that the bid price of our common stock had closed at less than $1.00 per share over the previous 30 consecutive trading days, and as a result, we did not comply with Marketplace Rule 4450(a)(5). Therefore, in accordance with the Marketplace Rule 4450(e)(2), we were provided 90 calendar days, or until June 20, 2002, to regain compliance with the Rule. On June 21, 2002, NASDAQ notified us that it had not regained compliance with Marketplace Rule 4450(e)(2) and as a result our securities would be delisted from The Nasdaq National Market upon the opening of business on July 1, 2002. We requested and were granted a hearing on August 8, 2002, regarding the Nasdaq staff's determination. We presented our plan of action, which included the one-for-eight reverse stock split, to maintain compliance with the Nasdaq National Market continued listing standards. On September 9, 2002, we were notified that the Nasdaq Panel determined to continue the listing of our common stock on the Nasdaq National Market and the hearing file was closed. On October 23, 2002, we filed a tender offer statement on Schedule TO related to an offer by us to employees to exchange certain qualifying options. The offer allowed option holders the ability to cancel outstanding options to purchase up to an aggregate of approximately 2,480,000 shares of our common stock in exchange for a promise to grant new options on a 1 to 1 basis no earlier than 6 months and 1 day from the offer's final acceptance date. The offer was applicable to holders of options with exercise prices greater than or equal to $5.76 per share that were outstanding under our 1993 Incentive Stock Plan. Additionally, option holders were required to cancel all options that were received in the prior 6 months to be eligible to participate in the exchange offer. Option holders were allowed to accept the offer of exchange up until November 21, 2002. As of that date options to purchase 2,383,426 shares of common stock were exchanged and are eligible for future grants. Future grants are expected to have an exercise price equal to the common stock price on the date of the grant. Redeemable convertible preferred stock On December 10, 2001, we issued a total of 15,820 shares of redeemable convertible Series A Preferred Stock ("Preferred Stock") for an aggregate purchase price of $15.8 million. Associated with the issuance of the Preferred Stock, we issued immediately exercisable warrants to acquire common stock. The $15.0 million in net proceeds were allocated to the Preferred Stock and the warrants resulting in $12.2 million and $2.8 million assigned to Preferred Stock and warrants, respectively. Voting Holders of Preferred Stock do not have voting rights, except as required by law, including but not limited to the Delaware General Corporation Law. 25 Conversion Initially, each share of Preferred Stock has a stated value of $1,000 and was convertible into common stock at an initial conversion price of $22.16 per share, which was 120% of the weighted average price of our common stock during the 10 trading days preceding the initial issuance date. During the period starting February 15, 2002, and ending on June 14, 2002 ("Alternative Conversion Period"), the Preferred Stock was convertible at 90% of the weighted average price of our common stock during the 20 trading days preceding conversion. On June 15, 2002, the conversion price was fixed at $6.220848, which was 120% of the weighted average price of our common stock during the 20 trading days immediately prior to the adjustment date. This fixed conversion price is subject to adjustment in the event we issue common shares (or instruments that may become common shares) at a price per share that is less than the fixed conversion price. The fixed conversion price may also be adjusted in the event of a sale of the Company and certain other specified changes in ownership. Due to the issuance of a warrants to purchase common stock on December 27, 2002 at a price below the fixed conversion price, the fixed conversion price was reduced to $5.4829983. The fixed conversion price was subsequently reduced to $5.2943362 in conjunction with a January 2003 equity financing. In connection with the issuance of the Preferred Stock, we calculated a beneficial conversion feature and recorded the associated charge over the beneficial conversion period ended on June 15, 2002. That charge, in the amount of approximately $2.5 million, was based on the difference between the most favorable conversion price and the market price of our common stock on the date the Preferred Stock was issued. As a result of the adjustment of the preferred stock fixed conversion price in connection with the December 27, 2002 financing and warrant issuance, an additional beneficial conversion feature charge was calculated and expensed during the quarter ended December 31, 2002. That charge, in the amount of approximately $9.7 million, was based on the difference between the fair market value of common stock conversion price at the inception of the December 10, 2001 Preferred Stock financing and the new fixed conversion price on December 27, 2002 and was limited to the total proceeds allocated to the Preferred Stock at the time of the Preferred Stock financing. As of December 31, 2002, 4,952 shares of the Preferred Stock had been converted into 944,454 shares of common stock. We recorded accretion of the Preferred Stock discount during the three and nine months ended December 31, 2002, of $0.2 million and $2.7 million, respectively. Additionally, we recorded dividends for the three and nine months ended December 31, 2002, of $0.1 million and $0.4 million, respectively. Liquidation In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company, the holders of the Preferred Stock shall be entitled to receive cash from the liquidation of assets before any amount is paid to the holders of our common stock. The liquidation amount due per Preferred Stock share is equal to the conversion amount. If the liquidation funds are insufficient to pay the full amount due to the holders of Preferred Stock, then each holder of Preferred Stock, shall receive an allocated percentage of the liquidation funds based on the number of shares held by the holder of Preferred Stock. Redemption At the option of the holders of Preferred Stock, shares are convertible at any time and become mandatorily redeemable at $1,000 per share stated value plus any unpaid accrued dividends on December 10, 2004. Redemption may be in cash or common stock, at our option, subject to certain limitations. The Preferred Stock is redeemable at the option of the holder upon the occurrence of a `triggering event' which includes breaches of agreements, delisting from the Nasdaq National Market and other similar events. The redemption price in such case is the greater of (i) 125% of the stated value plus accrued but unpaid dividends and (ii) the product of (x) the number of shares of common stock into which the shares of Preferred Stock are convertible into multiplied by (y) the volume weighted average price of our common stock on the trading day immediately preceding the triggering event. Upon a change of control and certain other changes in ownership, each holder of Preferred Stock has an option to require us to redeem all or a portion of such holder's shares at a price equal to the greater of (i) 110% of the stated value plus accrued but unpaid dividends and (ii) the product of (x) the number of shares of common stock which would otherwise be issuable upon conversion of the shares at the time the holder delivers a notice of redemption to us and (y) the average daily volume weighted average price of our common stock on the trading day immediately preceding such change of control. In addition, we may redeem the Preferred Stock on the first and second anniversaries of their issuance at 110% and 105% of the stated value and accrued but unpaid dividends, respectively, if certain conditions are met. 26 Dividends Holders of the Preferred Stock are entitled to a cumulative 5% per annum dividend, payable quarterly in cash or common stock, at our option, subject to certain limitations. On April 1, 2002, July 1, 2002 and October 1, 2002, we issued dividends of 37,105, 30,009 and 89,260 shares of our common stock to Preferred Stockholders. For the three months ended December 31, 2002, we recorded dividends payable to holders of Preferred Stock of $0.1 million. For the nine months ended December 31, 2002, we recorded dividends payable to holders of Preferred Stock of $0.4 million. Warrants for common stock The Preferred Stock investors received immediately exercisable warrants to purchase 256,949 shares of our common stock at an exercise price of $22.16 per share. The warrants have a three year term. The exercise price of the warrants is subject to adjustment in the event we issue common shares (or instruments that may become common shares) at a price per share that is less than the initial exercise price. In conjunction with the issuance of common stock warrants on December 27, 2002, the warrant exercise price was reduced to $17.1002616. As of December 31, 2002, none of these warrants have been exercised. In conjunction with the January 2003 financing, the warrant exercise price was subsequently reduced to $16.46961268. We also issued immediately exercisable warrants to acquire 38,355 shares of its common stock at an exercise price of $19.84 per share to an investment banking firm in partial payment of the placement fee for the Preferred Stock. The warrant has a five year term and we recorded the warrant as a reduction of the proceeds received from the sale of the Preferred Stock. The exercise price and number of warrants to purchase common stock is subject to adjustment in the event we issue shares (or instruments that may become common shares) at a price per share that is less than the initial exercise price. In conjunction with the issuance of common stock warrants on December 27, 2002, the warrant exercise price was reduced to $18.350093 and the number of warrants was adjusted to 44,500. As of December 31, 2002, none of these warrants have been exercised. In conjunction with the January 2003 financing, the warrant exercise price was subsequently reduced to $17.507549 and increased the number of warrants to 46,202. As the conversion ratio of Preferred Stock, described above, did not include a specified lower floor during the Alternative Conversion Period, we have followed the provisions of EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and recorded the warrants issued with the common stock financing on October 9, 2001, and the warrants issued with the Preferred Stock financing on December 10, 2001, as liabilities. The reclassification was performed during fiscal 2002 and the warrants were marked to market at June 14, 2002. The effect of the mark to market on the three months ended December 31, 2001, was to increase other income by $0.6 million. The effect of the mark to market on the nine months ended December 31, 2002, was to increase other income by $0.8 million. Due to the expiration of the Alternative Conversion Period on June 15, 2002, we were able to determine that sufficient common shares were authorized and available for all outstanding warrants, and as such was able to reclassify the warrants from a liability to equity. Liquidity risk We will need to obtain additional financing in addition to the equity already raised through the sale of common stock and short term debt financing. We believe that additional financing is needed to provide us with sufficient working capital to execute on our plans for the year ending March 31, 2003. Additional financing, whether through public or private equity or debt financing, collaborative or other arrangements with corporate sources or stockholders or other sources to fund operations, may not be available, or if available, may be on terms unacceptable to us. Our ability to maintain sufficient liquidity is dependent on our ability to raise additional capital, successfully achieving our product release schedules, and attaining our forecasted sales objectives during such periods. If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock. Debt incurred by us would be senior to equity in the ability of debt holders to make claims on our assets. The terms of any debt issued could impose restrictions on our operations. If adequate funds are not available to satisfy either short or long-term capital requirements, we may be required to implement further expense reduction measures, including, but not limited to, the sale of assets, the consolidation of operations, workforce reductions, and/or the delay, cancellation or reduction of certain product development, marketing, licensing, or otherwise curtail our operations significantly, or to seek funds through arrangements with strategic partners or other parties that may require us to relinquish material rights to certain of our products, technologies or potential markets. There can be no assurance that we will be able to make additional financing arrangements on terms that we would find satisfactory, and our operations and liquidity could be materially adversely affected and we could become insolvent and be forced to cease operations. 27 On May 14, 2002, we amended the lease on our headquarters facility. The amendment substantially changed the terms of the original lease agreement, which now expires in April 2006. Under the terms of the amendment, we have significantly reduced the monthly cash payments, the term of the lease and the amount of square footage leased. Under the terms of the original agreement dated June 12, 1999, we needed to maintain restricted cash of $5.2 million and a deposit with the lessor of $0.4 million. The amendment granted authorization to use the restricted cash and deposit as follows: $3.8 million will be used for fiscal 2003 rent and operating expenses, $0.7 million for fiscal 2004 rent and operating expenses and $1.1 million in termination fees. RISK FACTORS You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, our business, financial condition and results of operations could be harmed. In that case, the trading price of our common stock could decline, and you could lose all or part of your investment. Risks and Uncertainties Relating to our Business and Operations Our ability to continue as a "going concern" is uncertain Our consolidated financial statements have been prepared on the assumption that we will continue as a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business. The independent accountants' report on our financial statements as of and for the fiscal year ended March 31, 2002, includes an explanatory paragraph which states that we have suffered recurring losses from operations and have a net capital deficiency that raise substantial doubt about our ability to continue as a going concern. We need to raise additional capital or we will be insolvent. During the three months ended December 31, 2002, we borrowed $6.2 million from William M. Hawkins, III, our Chief Executive Officer and Chairman of the Board. Subsequent to December 2002, we raised an additional $0.7 million through the sale of common stock and warrants and obtained an additional $5.8 million loan from Mr. Hawkins. We are currently exploring raising additional debt or equity financing, although we do not have definitive plans for sources of funding. Our ability to maintain sufficient liquidity in the future is dependent on us raising additional capital, successfully achieving our product release schedules, and attaining our forecasted sales objectives. In any event, we will need to raise capital to meet our planned capital needs. Such capital may not be available on acceptable terms, if at all. We may also require additional capital to acquire or invest in complementary businesses or products or obtain the right to use complementary technologies. If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock. Debt incurred by us would be senior to equity in the ability of debt holders to make claims on our assets. For example, Mr. Hawkins has a security interest in all of our property and assets as collateral for the $12.0 million that we have borrowed from him. The terms of any debt issued could impose restrictions on our operations. If adequate funds are not available to satisfy either short or long-term capital requirements, we may be required to curtail our operations significantly or to seek funds through arrangements with strategic partners or other parties that may require us to relinquish material rights to certain of our products, technologies or potential markets, or we may become insolvent. Our common stock could be delisted from the Nasdaq National Market. Our common stock trades on the Nasdaq National Market, which specifies certain requirements for the continued listing of common stock. One of these requirements, codified in Marketplace Rule 4450(a)(3), states that a Maintenance Standard 1 company, like us, must maintain stockholders' equity of at least $10 million. As of December 31, 2002, our stockholders' equity has fallen to $7.1 million, and thus fails to meet the National Market's continued listing requirements for Maintenance Standard 1. As a result of this deficiency, our common stock is subject to delisting from the National Market, and we expect that the Nasdaq staff will shortly notify us of their decision to delist our common stock. When we receive this delisting notification, we will have the option to appeal the delisting decision to a Nasdaq Listing Qualifications Panel. If we choose to appeal, Nasdaq will continue listing our common stock on the National Market until the appeal process is resolved. We are currently engaged in efforts to secure additional funding or engage in other transactions sufficient to raise our stockholders' equity above the National Market's $10 million minimum. In January 2003, we raised approximately $720,000 through the sale of common stock and warrants that has decreased the amount of the deficiency. We may also exercise our right to cause Mr. Hawkins 28 to purchase, through cancellation of principal and accrued interest on outstanding loans, up to $3 million of equity securities in a financing before March 31, 2003 at the same price and on the same terms as other investors in the financing. Furthermore, if our plans to become profitable in the future are successful, our retained earnings would increase, which would also increase the amount of stockholders' equity. Based upon these efforts, we may choose to appeal the Nasdaq staff's determination to delist our common stock. There can be no assurance, however, that our efforts to secure additional funding or engage in other transactions will be successful, or that we will choose to appeal the Nasdaq decision to delist our common stock. Even if we choose to appeal Nasdaq's decision to delist, there can be no assurance that the Nasdaq Listing Qualifications Panel will grant our request to remain listed on the National Market. Another continued listing requirement is that the minimum closing bid price per share not fall below a specified level for an extended period of time. On March 22, 2002, the Nasdaq staff notified us that the bid price of our common stock had closed at less than $1.00 per share over the previous 30 consecutive trading days, and as a result, did not comply with Marketplace Rule 4450(a)(5). Therefore, in accordance with the Marketplace Rule 4450(e)(2), we were provided 90 calendar days, or until June 20, 2002, to regain compliance with the Rule. On June 21, 2002, the Nasdaq staff notified us that we had not regained compliance with Marketplace Rule 4450(e)(2) and as a result our securities would be delisted from the Nasdaq National Market at the opening of business on July 1, 2002. We were granted a hearing on August 8, 2002, regarding the Nasdaq staff's determination. We presented our plan of action, which included a one-for-eight reverse stock split, to maintain compliance with the Nasdaq National Market continued listing standards. We completed our reverse stock split at the close of business on August 22, 2002. On September 9, 2002, we were notified that the Nasdaq Listing Qualifications Panel determined to continue the listing of our common stock on the Nasdaq National Market and the hearing file was closed. However, there can be no assurance that our common stock will continue to be listed if we violate the listing requirements of the Nasdaq National Market in the future. In the event our shares are delisted from the Nasdaq National Market, we will attempt to have our common stock traded on the Nasdaq SmallCap Market. Moving to the Nasdaq SmallCap Market could allow holders of our Series A Convertible Preferred Stock to force the redemption of their shares at 125% of the original issue price plus dividends. We might not have the funds to redeem those shares at that time and we could become insolvent. In additional, if our common stock was delisted, it would seriously limit the liquidity of our common stock and impair our ability to raise future capital through the sale of our common stock, which could have a material adverse effect on our business. Delisting could reduce the ability of holders of our common stock to purchase or sell shares as quickly and as inexpensively as they have done historically, and may have an adverse effect on the trading price of our common stock. Delisting could also adversely affect our relationships with vendors and customers. Our ability to meet cash requirements and preserve liquidity is dependent on timely product releases, attainment of our sales and licensing objectives and maintaining tight controls over spending. If our cash requirements cannot be satisfied from operational cash flows, we may be forced to sell assets, refinance existing indebtedness, or further reduce our business, operations and related activities. Due to these factors, we may need to combine with another company in order to obtain additional resources to remain competitive. We recorded a net loss attributable to common stockholders of $50.5 million on revenues of $53.7 million for fiscal year 2002 and also sustained significant losses for the fiscal year ended 2001. At December 31, 2002, we had an accumulated deficit of $262.0 million. These circumstances raise substantial doubt about our ability to continue as a going concern. We cannot provide assurances that future cash flows from operations will be sufficient to meet operating requirements and allow us to service debt and dividend requirements and repay any underlying indebtedness at maturity. If we do not achieve the cash flows that are anticipated from our plan to raise capital, our planned product release schedules and attainment of our forecast sales objectives, we may not be able to meet our cash requirements from operational cash flows. We will require additional financing to fund on-going and planned operations and may need to implement further expense reduction measures, including, but not limited to, the sale of assets, the consolidation of operations, workforce reductions, and/or the delay, cancellation or reduction of certain product development, marketing, licensing, or other operational programs. Some of these measures will require third-party consents or approvals, and we cannot provide assurances that such consents or approvals will be obtained. There can be no assurance that we will be able to make additional financing arrangements on satisfactory terms, if at all, and our operations and liquidity would be materially adversely affected and we could be forced to cease operations. We may be forced to sell assets, refinance existing indebtedness, further reduce our business and operations, or combine with another company. Although actions we have taken, including recent reductions of workforce, spending reductions in marketing and renegotiation of the lease of our headquarters facility, which are expected to contribute to returning our operations to profitability, we cannot assure our stockholders and investors that we will achieve profitability in fiscal 2003 and beyond, nor can we provide assurances that we will 29 successfully complete the development of products planned for release or achieve the sales necessary to avoid further expense reductions in the future. If the popularity of our brands lessens, revenues could decline. Significant portions of our historical revenues have been derived from a limited number of brands. A decline in the popularity of one or more of these brands could adversely affect revenues from operations, and require us to revise the forecasts of our future business. Our product strategy is to extend our established interactive entertainment software brands across multiple genres and platforms in order to better differentiate our products to consumers and retailers. Each of our current brands is based on a well-defined computer game environment, or "fantasy world." We create fantasy worlds in our products that allow users to engage in activities that they otherwise may be unable to perform, in settings to which they may not otherwise have access. We develop products in the most popular genres, which include action, strategy, adventure/role playing, sports and family entertainment. We believe that consumers who have enjoyed game playing in a distinctive fantasy world are more likely to buy other products based on the same or a similar fantasy world. We offer consumers of our products both sequels and line extensions of games they already own, as well as new game experiences in different genres within a familiar fantasy world. Our brands include Army Men, Cubix, Heroes of Might and Magic, High Heat Baseball, and Might and Magic. We employ our branding strategy to leverage our marketing efforts so longer-lived brands can yield results across multiple platforms and multiple years. If we do not introduce products on a timely basis, revenue, profit and cash flow could be negatively impacted. Since video games and computer software products have relatively short life cycles, with many products having a sales life cycle of less than nine months, we are continuously developing new products in order to generate revenues that can sustain our operations and allow us to achieve our business plans. The timely development and commercial release of a new video game or computer game depends on a variety of factors, including the creative design and development process, testing and debugging, obtaining the approvals of third-party content licensors, obtaining the approvals of hardware platform licensors (such as Sony and Nintendo), and manufacturing and assembly of production units of such products. The development of games for technically sophisticated next-generation interactive platforms is a relatively complex, expensive and time-intensive undertaking that requires the coordinated services of numerous employees and contractors working for us. Delays incurred in the development, approval or manufacturing processes may result in delays in the introduction of our products. Delay in the commercial release of a new product that results in that product's introduction slipping from one fiscal quarter to the next is likely to have an adverse effect on our resulting revenues for the affected quarter since initial shipments of a new product typically account for a high percentage of the product's total net revenues over its life. We have experienced significant delays in introducing some of our prior titles and these delays have adversely affected our results of operations. We cannot provide assurances that we will be able to complete the timely development and commercial release of new products in accordance with originally planned release schedules. In the event that we are unable to commercially release new products in accordance with operating plans for a particular quarter or longer period, these product delays would likely have an adverse effect on our revenues and results of operations during the affected quarter and cash flow during subsequent quarters. If we need to write down prepaid royalties or capitalized development costs below their current recorded value, our results of operations could be adversely affected. We typically enter into agreements with content licensors and external developers that require advance payments of royalties and/or guaranteed minimum royalty payments. We cannot provide assurance that the sales of products for which such royalties are paid or guaranteed payments are made will be sufficient to offset and effectively recoup the amount of these required advance payments. We capitalize our advances to licensors as a part of prepaid assets and advances to external developers as part of capitalized software costs. We also capitalize internally developed software once technological feasibility is established as part of capitalized software costs. We analyze these accounts quarterly, and take write-offs when, based on estimates, future individual product contribution will not be sufficient to recover our investment. These write-offs may be significant if we cancel development projects as a result of maintaining tight controls over spending. The concentration of our sales and accounts receivable in a limited number of customers increases our reliance on that limited number of customers. 30 In the nine months ended December 31, 2002, sales to Cokem International, Ltd. represented 14% and sales to Best Buy represented 11% of our total software publishing revenues. In addition, sales to our largest five customers accounted for approximately 44% of our software publishing revenues in the first nine months of fiscal 2003. Our sales are typically made on credit, with terms that vary depending upon the customer and the demand for the particular title being sold. We do not hold any collateral to secure payment by our customers. As a result, we are subject to credit risks, which are increased when our receivables represent sales to a limited number of retailers or distributors or are concentrated in foreign markets. Distributors and retailers in the computer industry have from time to time experienced significant fluctuations in their businesses, and there have been a number of business failures among these entities. The insolvency or business failure of any significant distributor or retailer of our products could result in reduced revenues and write-offs of accounts receivable. If we are unable to collect on accounts receivable as they become due, it could adversely affect our business, operating results and financial condition. Delays in new product development could result in loss of significant potential revenues. Most of our video game and computer software products have a relatively short life cycle and sell for a limited period of time after their initial release. We depend on the timely introduction of successful new products, including enhancements of or sequels to existing products and conversions of previously released products to additional platforms, to offset and replace declining net revenues from older products. Delays incurred during the development process may result in delays in the commercial release of the affected title. Delays in the release of any new product are likely to have an adverse effect on our revenues for the affected quarter. If external developers fail to perform satisfactorily, our operating results could be negatively affected. While we develop the majority of our titles internally, third-party developers develop many products. A delay in the work performed by a third-party developer may result in delay of our release of the affected product. As importantly, the work performed by third-party developers may not meet our quality standards, and, as a result, we may terminate the development contracts with some developers. Our hardware licensors (e.g., Sony and Nintendo) require that third-party developers obtain and maintain licensor authorization to develop games on our behalf that are compatible with the licensor's hardware platform. Through no fault of ours, a third-party developer's authorization to create a particular product for us may be terminated by the hardware platform licensor, at its sole discretion. An inability to obtain or retain valuable intellectual property licenses may prevent product releases or result in a decline in sales of our products. A number of our existing products and planned products are based on trade names, trademarks, logos, or copyrighted materials that are licensed from third parties (e.g., Major League Baseball, Major League Baseball Players Association, Jonny Moseley, and Cubix). License agreements for these third-party rights typically remain in effect for two to five years. In general, license agreements may be terminated by the licensors upon the occurrence of any of a number of events or circumstances, such as the failure to timely pay the sums that are owed to the licensor, material breach of other provisions of such agreements, or as a result of bankruptcy or insolvency. We cannot provide assurance that we will be able to obtain or will be able to extend the term of any third-party intellectual property licenses. An inability to obtain a desired license or the loss of existing license rights would prevent us from publishing particular products or could limit our sales of unlicensed versions of comparable products which would not feature the trademarks or other intellectual property rights of third-party licensors. Platform licensors can influence the number of video games that we publish on their respective platforms, as well as our product release schedules, and resulting revenues and gross margins. We depend heavily on non-exclusive licenses with Sony, Nintendo and Microsoft for the right to publish titles for their platforms and for the manufacture of our software products designed for use on their platforms. Our licenses require that we obtain their concept approval for each of the products that we would like to publish, as well as their approval of the completed games and associated manuals, packaging artwork and marketing materials. This approval process could cause a delay in our ability to release a new title and could cause us to incur additional expenses to modify our products in order to obtain such approvals. As a result, the number of titles that we are able to publish for these licensors' platforms may be limited or may be delayed from our originally planned product release schedules. Our licenses with Sony Computer Entertainment America, Sony Computer Entertainment Europe, Nintendo and Microsoft are limited in term. If any of these licenses should be terminated or not be renewed on acceptable terms, we would be unable to develop 31 and publish software titles for these platforms and our business would be significantly harmed. While we cannot guarantee that these platform licensors will agree to extend the term of their license agreements (some of which are scheduled to expire in the second half of 2002), we have previously been successful in negotiating comparable license extensions with platform licensors. Sony, Nintendo and Microsoft are the sole manufacturers of the titles that we publish under licenses from them. These license agreements provide that the manufacturer may raise the costs that it charges for the units that it manufactures at any time and allows the manufacturer substantial control over whether and when we can release new titles. Additionally, the two to six week manufacturing and delivery cycle for cartridge-based software products for the Game Boy Color and Game Boy Advance handheld game systems require us to accurately forecast retailer and consumer demand for our titles far in advance of planned product releases and expected sales of such software products. Nintendo cartridges are also more expensive to manufacture than CD-ROMs and DVDs, resulting in greater inventory risks for those titles. If product returns and pricing concessions exceed allowances, we may incur additional costs and potential losses. Our arrangements with retailers and distributors require us to accept returns for defective product units. We also provide pricing concessions and allowances to key retail customers whenever wholesale price adjustments are deemed necessary to support our relationship with retailers and maintain access to their retail channel customers. If consumer demand for a particular title does not fulfill expectations, or if consumer demand declines from a prior period, then a subsequent price concession may be provided in an effort to stimulate further sales of the affected titles. We establish an allowance for estimated future product returns and price concessions at the time of shipment, based on our historical sell through and return data, our specific minimum low price used for price protection, the level of channel inventory and units for the product previously shipped, and we recognize revenues net of these allowances. Management monitors and adjusts our product returns and pricing allowances throughout the year in order to reflect market acceptance of our products, retail and distributor inventory levels of our products, and results of our prior returns programs and pricing allowances. Our reserve allowance for product returns and pricing allowances was $1.7 million as of December 31, 2002. If we experience product return rates or provide pricing allowances that exceed our estimates based on historical experience, our operating results could be significantly and adversely affected. In addition, if future products should prove to be defective, we would lose potential revenues from sales of the affected product units and may incur an unplanned increase in expenses in connection with efforts to remedy the situation. If we do not post strong sales during the holiday season and subsequent quarter, our operating results could be negatively affected. Our sales of video game and computer software products are highly seasonal. Our peak shipments typically occur in the fourth and first calendar quarters as a result of increased demand for video games and computer software during the year-end holiday season and the after-holiday period. If we do not achieve strong sales in the second half of each fiscal year (each such fiscal year which ends on March 31st), our fiscal year results could be significantly and adversely affected and our ability to achieve profitability in the fiscal year could be negatively impacted. Our changes to international operations could adversely affect our business. Our video game and computer software products are now sold in international markets both principally through licensees, primarily in, the United Kingdom and other European countries, and, to a lesser extent, in Asia and Latin America. The percentage of our total revenues derived from international software publishing activities decreased to 16% in the nine months ended December 31, 2002. There can be no assurance that the recent move to a licensing model will generate similar levels of profitability operations. The insolvency or business failure of any significant licensee of our products could result in reduced revenues and write-offs of accounts receivable. These risks include the following: o rely almost exclusively on third parties for sales and distribution of our products; o increased credit risks and collection difficulties; o increased risk of piracy and disputes between licensees on distribution; o shipping delays; 32 o tariffs and duties; o fluctuations in foreign currency exchange rates; and o international political, regulatory and economic developments and conditions. The manufacturers of the software products may not have sufficient production capacity to satisfy our requirements. Both Sony and Nintendo publish software products that are designed for use with their own hardware platforms, as well as manufacture software products for their other licensees. If Sony or Nintendo experience an interruption in their manufacturing capabilities or if their manufacturing capacity is adversely impacted as a result of increased demand for third-party software products that compete with our products, these hardware licensors may choose to give priority to the manufacture of their own titles or to the manufacture of other third-party titles. These manufacturers may not have sufficient production capacity to satisfy our scheduling requirements during any period of sustained demand. If Sony and Nintendo are unable to supply us with production software units on acceptable terms and without unexpected delays, our business operations could be materially interrupted and our potential revenues from planned product releases could be significantly and adversely affected. Our quarterly operating results fluctuate significantly causing unpredictability regarding our revenues and income. We have experienced and expect to continue to experience wide fluctuations in quarterly operating results. We are unable to effectively control many of these factors, which include the following: o market acceptance of our titles; o the timing and number of new video game consoles; o delays in product acceptances by Sony, Nintendo or Microsoft; o the timing and number of new title introductions by our competitors; o increased marketing spending by our competitors relating to the introduction of new titles; o changes in pricing policies by our competitors and our actions to meet retailer requests; o product returns; o the timing of orders from distributors and major retail customers; o delays in production and shipment; and o the mix of sales of higher and lower margin product in a quarter. We typically earn a higher gross margin on sales of games that are designed for use with personal computers. Gross margins on sales of products for next generation game console platforms are generally lower because of license fees payable to platform licensors such as Sony, Nintendo and Microsoft, and higher manufacturing costs for game cartridge products for the Game Boy Color and Game Boy Advance handheld game systems. As a consequence, the mix of products sold during each fiscal quarter can significantly affect our gross margins. The timing of new title introductions can cause quarterly revenues and earnings to fluctuate substantially from quarter to quarter. A significant portion of our revenues in any fiscal quarter is typically achieved as a result of sales of new titles first introduced in the quarter. Our revenues and earnings will be negatively affected in a given fiscal quarter if we should be unable to complete the development of any particular title or titles in time to commercially release such product(s) during that quarter. 33 You should not rely on period-to-period comparisons of our financial results as indications of future results. Our future product releases, operating results, revenues, or profitability could fall below expectations of security industry analysts and investors. Any such shortfall in expectations could cause a decline in the market price of our common stock. Fluctuations in operating results are likely to increase the volatility of our common stock's price. The market price of our common stock has been volatile and is likely to continue to be highly volatile, and stockholders may not be able to recoup their investment. If we lose key personnel and are unable to replace them, our operating results could be negatively affected. Our business operations and prospects for commercial success are largely dependent on the personal efforts of key personnel, particularly Trip Hawkins, our Chairman and Chief Executive Officer. We rely heavily on our internal development studio to design and develop the majority of our products. The loss of any key developers or groups of developers may delay the release of our products. Our success is also dependent upon the ability to hire and retain additional qualified operating, marketing, technical, legal and financial personnel. Competition for personnel is intense, particularly in the San Francisco Bay area where we maintain our headquarters. The decline in stock price combined with salary reduction programs and related cost reductions could impact our ability to retain key personnel. Further, we cannot provide assurance that we will be able to successfully attract qualified replacement personnel. Risks and Uncertainties that Affect our Industry in General Industry competition is intensive and can impact our ability to attain retail shelf space. The interactive entertainment software industry is intensely competitive and is characterized by the frequent introduction of new hardware systems and software products. Our competitors vary in size from small companies to very large corporations, which have significantly greater financial, marketing and product development resources than us. Due to these greater resources, some of our competitors are better able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, pay higher licensing fees to third-party content licensors which control desirable properties, and pay higher advances and development fees to third-party software developers. Our competitors include the following: o Other publishers of interactive entertainment software for personal computers and video game consoles, including Acclaim Entertainment, Activision, BAM Entertainment, Eidos, Electronic Arts, Infogrames, Interplay, Lucas Arts, Midway, Sega, Take-Two Interactive, THQ, Ubi Soft International and Vivendi Universal. Integrated video game console hardware/software companies such as Sony, Microsoft and Nintendo, who compete directly with us in the development of software titles for their respective platforms. o Large diversified entertainment or software companies, such as The Walt Disney Company, many of which own substantial libraries of available content and have substantially greater financial resources than us, who may decide to compete directly with us or to enter into exclusive relationships with our competitors. . Retailers of our products typically have a limited amount of shelf space and promotional resources. Publishers of interactive entertainment software products compete intensely for high quality retail shelf space and promotional support from mass merchant resellers and other retailers. To the extent that the number of consumer software products increases, competition for shelf space may intensify and may require us to increase our marketing expenditures. If more mass merchants establish exclusive buying arrangements, or if retailers terminate their relationship with us, our sales and gross margins would be adversely impacted. Mass merchants have become the most important distribution channels for retail sales of interactive entertainment software. Our revenues and operating results may be significantly and adversely affected if any of the mass merchants with whom we conduct business elect to terminate their relationship with us or significantly reduce the amount of business they do with us. A number of these mass merchants, including Wal-Mart, have entered into exclusive buying arrangements with other software developers or distributors, which prevent us from selling our PC products directly to that mass merchant. If the number of mass merchants entering into exclusive buying arrangements with software distributors were to increase, our ability to sell to those merchants would be restricted to selling 34 through the exclusive distributor. Because we typically earn a lower gross margin on sales to distributors than on direct sales to retailers, this would have the effect of lowering our gross margins. Our business depends on "hit" products, so if we fail to anticipate changing consumer preferences and produce "hits", we could suffer declining revenues. The market for interactive entertainment software is largely "hits" driven. Few such entertainment software products achieve sustained market acceptance and are regarded as "hits," and yet the products that are "hits" account for a substantial portion of revenues in the video game and computer software industry. Our future results from operations, profitability and financial condition could be negatively impacted if we fail to publish or distribute "hit" titles for popular interactive platforms. We cannot provide assurance that we will be able to publish "hit" titles in the future. Our ability to develop a "hit" title or titles is dependent on a variety of factors, many of which are beyond our control, including: o public tastes and preferences change rapidly and are hard to predict; o the timing and pricing of new interactive entertainment products published by us; o the brands, timing and pricing of new interactive entertainment products published by our competitors; o critical previews and reviews of our products; and o the availability, appeal and pricing of other forms of entertainment. If we fail to accurately predict or promptly respond to these factors, our sales could decline. Additionally, in the event that we do not achieve adequate market acceptance of a particular product, we could be forced to accept substantial product returns or grant significant markdown allowances in order to maintain a good working relationship with retailers to ensure access to their distribution channels. Introduction of next-generation platforms leads to a decline in sales of software products for prior platforms. Historically, the anticipation or introduction of next-generation video game platforms has resulted in decreased sales of interactive entertainment software for prior platforms. Sony introduced its PlayStation 2 computer entertainment system in October 2000. More recently, in November 2001, Microsoft introduced its new Xbox entertainment system and Nintendo introduced its new Game Cube console. In prior fiscal years on-going sales of our software products for Sony's original PlayStation game console or for Nintendo's N64 game console have been adversely affected as a result of consumer preferences shifting to newer video game systems. In future years we expect this trend to continue when the next generation of video game systems is announced and until one or more new platforms achieve a widely installed base of consumers. Obsolescence of software for prior interactive platforms could leave us with increased inventories of unsold titles and limited amounts of new titles to sell to consumers. Delays in the introduction of new platforms adversely affect potential revenue. Our ability to effectively sell our products depends in large part on platform licensors' timely introduction of their next-generation interactive systems and the licensors' achievement of market acceptance for their platforms. Our ability to continue to sell software products that are compatible with older target platforms are dependent upon the platform licensors' efforts to continue to encourage resellers' and end users' ongoing interest in such older platforms. Limited availability of older platforms as part of a manufacturer's efforts to prepare for the commercial introduction of a new platform (e.g., the limited availability of PlayStation consoles in the United States during the first half of 2000 in preparation for Sony's launch of the PlayStation 2 in the Fall of 2000) adversely affects our sales of software products for such older interactive platforms and resulting revenues from operations. Similarly, delays in the introduction of new interactive platforms or the limited availability of hardware following the introduction of a new interactive platform (as occurred, for example, following the commercial release of the PlayStation 2 computer entertainment system in the United States) also adversely affect our revenues, and result in significant uncertainty about our quarterly and fiscal year results. 35 Our business could be adversely affected by the illegal copying of our software or by infringement claims brought by or against us. Although we use copy-protection devices, unscrupulous individuals or entities may be able to make unauthorized copies of our products or otherwise obtain and use our proprietary information and related intellectual property rights. In the event of the occurrence of a significant amount of illegal copying of the software products published or distributed by us, our resulting revenues from operations could be significantly and adversely affected. Although we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, we cannot provide assurances that claims of infringement will not be made against us. Any such claims, with or without merit, can be time consuming and expensive to defend. If Internet-based game play becomes popular, we may need to quickly develop products and establish a viable Internet business model to remain competitive. A number of software publishers have developed or are currently developing server-based Internet games for consumers to access and enjoy over the Internet. If the Internet becomes a more popular venue for interactive video games and computer software, in order to remain competitive, we may need to rapidly develop and release additional games for the Internet, and continue to refine our business models for Internet-based games. In December 1999, we were issued a U.S. patent that could allow us to create a new genre of Internet-based games and related business models for such entertainment products. However, in order to fully develop the patents potential, investment would be required in research and development or to obtain rights to complementary Internet-related technologies. Without the required investment in research and development or without obtaining rights to technologies that would allow us to exploit our Internet-related patent, we cannot be certain that we will be able to fully utilize the patent in a commercially successful manner. In addition, even if we are able to use the patent in connection with the development of new Internet games or other forms of interactive entertainment that are intended to be experienced through the Internet, the development of such products will require additional investments by us. We cannot be certain that such products will be commercially successful, nor can we even be certain that our investments in developing and marketing such products will be recouped by our sales or licenses of such potential future products. Rating systems for interactive entertainment software, government censorship, or retailer resistance to violent games could inhibit our sales or increase our costs. The home video game industry requires interactive entertainment software publishers to identify products within defined rating categories and communicate these ratings to consumers through appropriate package labeling and through advertising and marketing presentations consistent with each product's rating. If we do not comply with these requirements, it could delay our product introductions and require us to remove products from the market. Legislation is currently pending at both the federal and state level in the United States and in certain foreign jurisdictions to establish mandatory video game rating systems. Mandatory government-imposed ratings systems for interactive entertainment software products may eventually be adopted in many countries. Due to the uncertainties inherent in the implementation of such rating systems, confusion in the marketplace may occur and publishers may be required to modify or remove products from the market. However, we are unable to predict what effect, if any, such rating systems would have on our business. Many foreign countries have laws that permit governmental entities to censor the content of certain works, including interactive entertainment software. As a result, we may be required to modify some of our products or remove them from the market that could result in loss of revenues and additional costs to remedy such situation. Certain retailers have in the past declined to stock some software products because they believed that the content of the packaging artwork or the underlying products themselves would be offensive to these retailers' customer bases. Although such actions have not yet affected us, we cannot be certain that our distributors or retailers will not take such actions in the future. If the U.S. economy continues to weaken, our business and results from operations could be adversely affected. We are subject to risks arising from adverse changes in consumer spending patterns. Because of the recent economic slowdown in the United States, many consumers may delay or reduce purchases of non-essential products and services. If the 36 economic slowdown in the United States leads to decreased consumer spending on entertainment products, sales of our products would likely decline and revenues and results from operations could be significantly and adversely affected. Risks Related to our Securities Anti-takeover provisions may prevent an acquisition. Provisions of our restated certificate of incorporation (including the certificate of designations, preferences and rights of the Series A redeemable convertible preferred stock), bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Our Chairman and Chief Executive Officer may be able to influence stockholder actions. Trip Hawkins, our Chairman and Chief Executive Officer, beneficially owns approximately 42.9 percent of our outstanding common stock. Mr. Hawkins is able to significantly influence all matters that require approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Shares eligible for future sale may negatively affect our stock price. If our stockholders sell substantial amounts of common stock (including shares issued upon the exercise of options or issued upon conversion of our Series A redeemable convertible preferred stock) in the public market, the market price of our common stock could fall. The perception that such sales may occur could cause the market price of our common stock to fall on or before the date those shares are sold. Such sales also might make it more difficult for us to sell securities in the future at a time and price that we deem appropriate. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default, market and reinvestment risk. We classify our cash equivalents and short-term investments as fixed-rate if the rate of return on such instruments remains fixed over their term. These fixed-rate investments include fixed-rate U.S. government securities, municipal bonds, time deposits and certificates of deposit. We classify our cash equivalents, short-term investments and restricted cash as variable-rate if the rate of return on such investments varies based on the change in a predetermined index or set of indices during their term. These variable-rate investments primarily include money market accounts held at various securities brokers and banks. At December 31, 2002, all of our portfolio was held in cash. ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial office evaluated our "disclosure controls and procedures" (as defined in Rule 13a-14(c) of the Securities Exchange Act of 1934 (the "Exchange Act") as of a date within 90 days before the filing date of this quarterly report. They concluded that as of the evaluation date, our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. (b) Changes in internal controls. Subsequent to the date of their evaluation, there were no significant changes in our internal controls or in other factors that could significantly affect these controls. There were no significant deficiencies or material weaknesses in our internal controls so no corrective actions were taken. 37 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We engage in certain legal actions arising in the ordinary course of business. We believe we have adequate legal defenses and that the ultimate outcome of these actions will not have a material effect on our financial position or results of operations, although there can be no assurance as to the outcome of such litigation. ITEM 2. Changes in Securities and Use of Proceeds On December 27, 2002, we issued to our CEO, William M. Hawkins, III, a warrant to purchase 2,000,000 shares of common stock, exercisable for four years, with an exercise price of $2.52 per share in connection with an agreement to lend us up to $8,000,000 through June 30, 2003. These shares were exempt from registration under Rule 506 of the Securities Act because the sale was to our CEO, an accredited investor, as defined in Rule 501 of the Securities Act. In connection with this transaction, we have granted Mr. Hawkins certain registration rights on all issued and issuable shares of common stock held by him. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On October 16, 2002, at the Company's Annual Meeting of Stockholders, the holders of the Common Stock of the Company elected William A. Hall and Rich S.F. Lehrberg as directors of the Company, approved the 2002 Stock Plan, approved of an increase to the number of shares of common stock reserved for issuance under the 1994 Employee Stock Purchase Plan and confirmed the appointment of PricewaterhouseCoopers LLP as independent auditors for the fiscal year ending March 31, 2003. The voting on each matter is set forth below. 1. Votes cast for the election of W.M. (Trip) Hawkins III as a member of the Company's Board of Directors: Nominee Votes for Nominee Votes Withheld from Nominee ------------------------ ------------------ --------------------------- William A. Hall 7,379,246 63,245 Richard S.F. Lehrberg 7,379,468 63,023 2. Votes cast to approve the 2002 Stock Plan: For Against Abstain Broker Non-Vote ---------------- ---------------- ------------ ---------------------- 2,792,888 456,503 17,190 4,175,910 3. Votes cast to approve of an increase to the number of shares of common stock reserved for issuance under the 1994 Employee Stock Purchase Plan: For Against Abstain Broker Non-Vote ---------------- ---------------- ------------ ---------------------- 2,893,195 361,196 12,260 4,175,910 4. Votes cast to confirm the appointment of PricewaterhouseCoopers LLP as independent accountants for the fiscal year ending March 31, 2003: For Against Abstain Broker Non-Vote ---------------- ---------------- ------------ ---------------------- 7,380,532 52,849 9,110 N/A 38 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits have been filed with this report: Exhibit Number Exhibit Title ------ ------------- 99.1 Certification of Chief Executive Officer and Chief Financial Officer (b) A current report on Form 8-K was filed on October 7, 2002 , to report the issuance of a promissory note to our CEO, William M. Hawkins III. 39 SIGNATURE Pursuant to the requirements 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. THE 3DO COMPANY Dated: February 14, 2003 /s/ David F. Wittenkamp ------------------------------------------ David F. Wittenkamp Senior VP Finance, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) (Duly authorized officer) 40 I, William M. Hawkins III, certify that: 1. I have reviewed this quarterly report on Form 10-Q of The 3DO Company; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. THE 3DO COMPANY Dated: February 14, 2003 /s/ William M. Hawkins ----------------------------------- William M. Hawkins Chief Executive Officer and Chairman of the Board (Duly authorized officer) 41 I, David F. Wittenkamp, certify that: 1. I have reviewed this quarterly report on Form 10-Q of The 3DO Company; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. THE 3DO COMPANY Dated: February 14, 2003 /s/ David F. Wittenkamp ------------------------------------------ David F. Wittenkamp Senior VP Finance, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) (Duly authorized officer) 42

3DO CO 10-Q