10-K 1 c57040e10-k.txt FORM 10-K 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) FOR THE FISCAL YEAR ENDED APRIL 30, 2000, OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-24346 ------------------------ VIDEO UPDATE, INC. (Exact name of registrant as specified in its charter) DELAWARE 41-1461110 (State or other jurisdiction (I.R.S. employer of incorporation or organization) identification No.) 3100 WORLD TRADE CENTER 55101 30 EAST SEVENTH STREET (Zip Code) ST. PAUL, MINNESOTA (Address of principal executive offices)

(651) 312-2222 (Registrant's telephone number, including area code) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: CLASS A COMMON STOCK, $.01 PAR VALUE (Title of class) 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 Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Aggregate market value of registrant's voting stock held by non-affiliates as of September 7, 2000: Class A Common Stock, $.01 par value: $4,624,431 based on a closing price of $0.1719 per share. Number of shares outstanding of each of the registrant's classes of common stock, as of August 15, 2000: Class A Common Stock, $.01 par value: 29,278,457 shares. DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS: Note: The discussions in this Form 10-K contain forward looking statements that are subject to risks and uncertainties. The actual results of Video Update, Inc. and subsidiaries (the "Company") could differ significantly from those set forth herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as those discussed elsewhere in this Form 10-K. Statements contained in this Form 10-K that are not historical facts are forward looking statements that are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. A number of important factors could cause the Company's actual results for fiscal 2001 and beyond to differ materially from those expressed or implied in any forward looking statements made by, or on behalf of, the Company. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 2 PART I ITEM 1. BUSINESS GENERAL Video Update, Inc. ("Video Update" or the "Company") owns and operates video specialty stores throughout North America. As of April 30, 2000, the Company owned and operated 586 stores located in 29 states and five provinces in Canada and franchised 35 additional video specialty stores in the United States. As of April 30, 2000, 420, or approximately 92%, of the Company's stores in the United States, and 101, or approximately 80% of the Company's Canadian stores, were superstores, defined as retail video stores that carry more than 10,000 rental units. The Company believes that, as of the end of its most recent fiscal year, it is the fourth largest video specialty retailer in the United States and the third largest video specialty retailer in Canada based on the number of superstores it operates. Video Update stores in the United States and Canada offer on average approximately 13,500 and 12,600 rental units, respectively, including multiple copies of new and popular movie releases and video games, in a visually appealing and customer friendly layout. The Company franchised its first store in January 1983 and opened its first Company-owned store in September 1989. By July 1994, when the Company completed its initial public offering, it had grown to 15 Company-owned stores and 30 franchised stores. By the middle of the 1990's, the Company had developed a superstore format that distinguished it from other video retailers. The format provided the flexibility for the Company to expand into desirable sites in both small and large markets without compromising profitability, or decreasing the number of viable markets into which it could expand. Video Update subsequently accelerated its growth, and in March 1998 acquired Moovies, Inc., a 267-unit chain headquartered in Greenville, South Carolina, for $79 million (including the assumption of approximately $50 million in debt). During fiscal 2000, the Company opened two new video superstores, purchased one franchise operation, and closed 69 stores (see Notes to the Consolidated Financial Statements: Note 3 "Moovies, Inc. Acquisition" and Note 4 "Provision for Store Closings and Other Charges") for discussions on the store closings. Same store sales during fiscal 2000 decreased by approximately 6.6%. As of August 15, 2000, the Company failed to make principal and interest payments of approximately $6 million. Consequently, the Company is in default under its senior credit facility (as further described herein, the "Senior Facility"). In addition, the Company's ability to implement its operational and business strategy described herein is extremely limited because the Company has no available borrowings under its Senior Facility or any other similar facility. Accordingly, the Company's available cash for operational activities is severely restricted, and the Company likely will not be able to pursue its intended operational and business strategies in a manner that would normally be possible under circumstances in which the Company had not defaulted under the terms of the Senior Facility. In addition, the lenders under the Senior Facility may, but are not obliged to, take immediate legal action against the Company, including but not limited to, acceleration of payment of all borrowed funds and such other remedies as may be available under the loan documents or common or statutory law. Under these circumstances, a number of the Company's contracts and supply arrangements, including but not limited to its revenue sharing contracts, may be subject to termination or re-negotiation. These circumstances likely will have a material adverse effect on the Company's ability to increase revenues and income and may, therefore, have a material adverse effect upon the Company's business, financial condition and results of operations. The Company continues to evaluate opportunities to reduce costs and improve revenues, although no assurances can be given that such actions will be successful if implemented. In addition, it is evaluating various alternatives to raise capital, including the possible sale of assets. Prior to any default under the Senior Facility, the Company had endeavored to maintain satisfactory relationships with its primary product vendors and had negotiated extended payment terms with several of these vendors. No assurances can be given that the Company will be able to maintain such relationships, although it continues to be able to obtain product from various sources. Moreover, the loss of its primary product vendors could have a material adverse effect on the Company. The Company will continue to focus on reducing the aged accounts payable with payments, the extension of terms, and negotiated settlements. If the Company is unable to reduce the aged accounts payable to the satisfaction of the trade creditors, it could have a material adverse effect on the Company. The 1 3 Company is uncertain whether cash from operations, trade credits, equipment leases, and available revenue sharing arrangements will be sufficient to fund future inventory purchases and other working capital needs for the next twelve months. If the Company is unable to obtain additional financing or maintain its relationships with its vendors and trade creditors, the Company may be required to reduce its overall expenditures and the Company's ability to maintain or expand its current level of operations will be materially and adversely affected. Video Retail Industry Overview The home video retail industry has experienced significant growth over the last fifteen years. According to industry reports, gross U.S. rental revenues have grown from approximately $2.6 billion in 1985 to more than $8.6 billion in 1999, an increase of 231%, or 15.4% annually. Paul Kagan Associates, Inc. ("Kagan"), an independent market research firm, estimates rental revenues will increase an additional 15% to $9.9 billion by the year 2002. Convenience, limited out-of-pocket expense, reliability, product availability and satisfaction are all factors that make VCR's and video rentals the preferred medium of entertainment for millions of customers. Nearly one quarter of all Americans continue to make a trip to their video store at least once a week. According to Kagan and the Electronics Industry Association ("EIA"), over 85% of the approximately 105 million American households owning televisions have at least one VCR and over 40% of homes have two or more. Kagan and EIA projections indicate that by 2005 over 91% of the 105 million American households will have VCR's, with over 50% owning two or more. According to the EIA, a record 18 million VCR decks and an additional 2.9 million combination TV/ VCR units were shipped in 1998. According to the Consumer Electronics Association ("CEA"), VCR shipments increased 26% in 1999, and combination TV/VCR unit shipments were up an impressive 40%. The home video retail industry includes rentals and sales of both VHS movie cassettes and the rapidly growing digital videodisc ("DVD") format. The consumer market for the majority of video movies has primarily been a rental market. Movie studios determine the suggested retail prices of videos and through their pricing decisions, influence the relative levels of video rentals versus video sales. Videos released at relatively high prices, typically $60 or more, are generally low to middle dollar grossing theatrical box office performers (one million to $40 million dollars) or direct-to-video productions with no theatrical release. These releases make up the majority of new product and are purchased by video retailers then made available exclusively through video rentals. Exceptions to this "high price" rule exist primarily in the genres of children and family product. The mass appeal and acceptance of such content makes it attractive for mass merchants to purchase this product, therefore enticing the movie studios to release it at a lower price (i.e. "Tarzan", "Pokemon: The First Movie", and "Star Wars Episode 1: The Phantom Menace"). Videos released at relatively low prices, typically $15 to $30, are generally high grossing theatrical box office performers (over $40 million dollars). These releases are purchased by video retailers for both sale and rental and may be purchased by consumers at a variety of retail stores including video retailers, mass merchants, electronic superstores, sell-through only music/video specialty stores, grocery, convenience stores and various e-commerce sites. Low priced releases are attractive rentals to the video retailer because of the relatively few number of rentals required to recover their cost and provide a favorable return despite the extra sales competition from other retail channels. Exceptions to this "low price" rule exist when content is rated PG-13 or R and mass merchants notify the studios that they will not purchase the title. This exception is more frequent since a majority of high grossing theatrical releases are often of the comedy, drama, action and horror genres that include content of a mature adult theme. Most often, this mature theme makes them unacceptable for sale in the mass merchant environment (i.e. "American Pie", "There's Something About Mary" and "Saving Private Ryan"). These exceptions are attractive to video retailers since the high box office performers initially are only available for rent. 2 4 Highly Fragmented Industry The home video retail industry remains highly fragmented and has experienced significant consolidation as unprofitable stores close and larger regional and national superstore chains acquire smaller chains. As the regional and national chains grow through acquisition and new store openings, they gain market share and increase their operating leverage. Large superstore chains provide a wider breadth and depth of videos for rent or sale, cost effective advertising programs and better promotions to drive consumer traffic than independent operators provide. They also enjoy the advantages of access to working capital, marketing efficiencies, revenue sharing deals, title-depth programs, cost saving direct purchasing programs with movie studios, operating economies of scale and the ability to obtain superior retail locations. The Company believes the industry consolidation will continue as large chains get larger and small independent operators are forced to close or sell to a larger player. Video Stores are an Important Revenue Source for Studios According to Kagan, the home video retail industry remains the largest single source of revenue to movie studios accounting for approximately 50% of movie studios' total revenues. Of the many movies produced by major studios and released in the United States each year, relatively few are profitable for the studios based on box office revenue alone. Video specialty stores are an exceptionally important and reliable revenue source for studios since video specialty stores typically purchase movies on video that were not as successful at the box office in addition to purchasing box office hits. The Company believes that the customer is more likely to view movies that were not box office hits via rental (VHS or DVD) than on any other medium because video specialty stores provide an inviting opportunity to browse and make an impulse choice among a very broad selection of movie titles at a relatively low price. The rapid acceptance and growth of the DVD format should increase this revenue source to the studios. In addition, many of the major studios have entered into revenue sharing arrangements and other title-depth programs with a few of the larger national chains, including Video Update. The Company expects that such revenue sharing arrangements and title-depth programs will allow retailers to offer a greater quantity of titles to meet consumer demand, enhancing the interdependent relationship between the studios and the larger national chains. Emerging DVD Format Following an extended period of dual format, the Company anticipates that DVD's will eventually replace VHS videotapes as the new way of viewing entertainment products. Kagan reports indicate DVD sales are rapidly increasing. Over 31 million households are expected to own DVD hardware by 2005, up from 3.6 million in 1999. While most of these DVD units will be additions to the 105 million VCR households in 2005, the Company recognizes the 30% consumer acceptance rate of this new technology as a large opportunity. Currently, Video Update rents DVD video titles in over 50% of its stores and continues to add DVD rentals to stores as the installed equipment base in any market drives product demand. Despite the emergence of new competing technologies, there is little near-term threat to the video home market and specialty retailer. New technologies face the enormous hurdles of consumer acceptance, undefined technology costs, proven delivery methods, and most importantly, the guarantee of replacing or improving revenues to movie studios. Distribution Channel for Studios Historically, new technologies have led to the creation of additional distribution channels for movie studios. Movie studios seek to maximize their revenues by releasing movies in sequential release date "windows" to various movie distribution channels. These distribution channels currently include, in release date order, movie theaters, video specialty stores, pay-per-view (cable/satellite), cable television, and foreign, network and syndicated television. The Company believes that this method of sequential release has allowed movie studios to increase their total revenue with relatively little adverse effect on the revenue derived from previously established channels. Furthermore, the Company believes that movie studios will continue the practice of sequential release as new technology distribution channels become available. Historically, movie 3 5 studios provided an exclusive window on new releases for video specialty stores. Today, the window is approximately 50 days long, down from about 56 days two years ago. The shortened window benefits larger operators relative to smaller chains and single store operators due to the large operators' significant copy depth that more quickly satisfies consumer demand. In addition, the Company believes that the length of time between the movie theater release date and the release date to video specialty stores is getting shorter. The Company also believes that studios are starting to bypass the movie theaters by releasing high quality and popular movie sequels directly to video specialty stores. The Company believes that the addition and eventual transition to the DVD format should not greatly deviate from the movie studios' current practice with respect to release guidelines or pricing strategy. Today, most DVD product is being released on the same date ("day and date") as VHS cassettes at sell-through prices that are approximately five to ten dollars higher than VHS cassettes. This "day and date" strategy has led to increased sell-through competition from mass merchants, electronic superstores, sell-through only music/video specialty chains and e-commerce sites. Studios adopted this strategy to encourage the consumer transition and price acceptance of this new technology. There are no guarantees that this "day and date" sell-through price strategy will continue but it has served to fuel DVD consumer interest and enabled video retailers to add dual format rental inventory at a relatively low cost. The Company supports this pricing practice but could easily accept a two tier rental/sell-through strategy as currently exists in the VHS product lines. A two-tier strategy would eliminate competitiveness from e-commerce companies. Initially supporting only the rental of DVD, the Company has not experienced the negative impact of deep discount retail pricing or loss leader pricing of e-commerce. The rental of DVD product has provided the Company a return on investment ("ROI") similar to VHS product. Revenue Sharing Agreements The Company has negotiated revenue sharing partnerships with several major studios and most of the smaller studios to maximize its rental title depth, while reducing its initial inventory investment. Revenue sharing typically lowers the Company's initial cost of high priced rental product while sharing the revenue of each new release rented over an approximate six month period with the studios. This process compensates the studios as the Company generates revenues. Low priced rental and sell-through products are purchased outright and are not part of the revenue sharing process. In addition, the Company acknowledges that most studios not participating in revenue sharing programs have reduced initial costs of high priced new releases through various title-depth programs to remain competitive and ensure representation on new release shelves. The Company believes that small chains and single store owners do not have the information reporting systems or distribution facilities necessary to economically participate in direct studio relationships. Furthermore, the Company is continually renegotiating the terms of various revenue share programs to maximize return on investment and maintain appropriate purchase to revenue ratios. Over the past twelve months, the Company has renegotiated several revenue share agreements resulting in improved revenue splits for the Company. In addition, during the past twelve months, multiple new revenue share agreements have been implemented under these more attractive terms. The Company has also re-evaluated existing agreements with the major studios and has discontinued "output" programs. An "output" program required that the Company carry every new release distributed by the studio. It also requires a guaranteed amount of revenue due the studio for each release. For high box office titles, the "output" programs were generally profitable for the Company. However, mid to lower box office titles often did not earn back the minimum guarantee and actually increased the Company's costs. "Non-output" agreements do not require the Company to stock every new release from a studio, but instead permits the Company to either take a title in depth through the "non-output" agreement, or purchase a title in lesser quantity through a distributor. Even though the Company has reduced its participation with major studio output programs, the Company has been able to supplement title-depth by participating with more studios who do not require guarantees or offer other cost saving title-depth programs. The Company's two largest competitors, Blockbuster, Inc., a subsidiary of Viacom, Inc. ("Blockbuster") and Hollywood Entertainment Corporation ("Hollywood"), have announced the opening of smaller size stores 4 6 with limited catalog (older movie titles) and placing more emphasis on high box-office releases (censored versions) obtained through revenue sharing programs. Although revenue sharing remains a major component of the Company's current purchase depth advantage over smaller chains and single storeowners, the Company also increases revenues and maximizes profitability by providing product not typically carried by its largest competitors. The Company's differentiated product offering consists of the unrated or "Director's Cut" version of movies (e.g. "American Pie") as well as mature content videos. The Company believes that its unique product offerings help differentiate it from the competition and provides it with a generally higher margin profile (higher ROI). Even with the more mature content options cable and satellite TV programming offer, consumers have displayed reluctance to freely allow access of this programming into their homes. Video rentals and purchases provide a high consumer confidence level for necessary parental control over choice of program content. Not withstanding the foregoing, given the Company's current default under the Senior Facility, no assurances can be given that the Company will be able to maintain its revenue sharing partnerships on the current terms if at all. Previously Viewed Tapes The Company believes that its direct relationships with movie studios has also strengthened its previously viewed tapes ("PVT") category. Through revenue sharing agreements, the opportunity to purchase significantly more units, especially high box-office releases, has allowed the Company to sell PVT to its customers after it has recouped its initial investment and generated an acceptable ROI. PVT provides a consistent and profitable way to reduce the unit count of an older release so that it can be transitioned to its permanent catalog, and has allowed the Company to competitively price product with the mass merchants and electronic superstores who have dominated the sell-through market. PVT offers customers the opportunity to purchase their favorite rental movie at a reduced price and often before it is available at other stores for sale. Typically, previously viewed movies are an authorized part of revenue sharing after a specified "no sale" period. The Company expects that the added depth of product purchased through revenue sharing and title depth programs will continue to add significant sell-through revenues in the future. The Company also expects to add new "DVD's for sale" to top performing DVD rental locations. As with VHS movies the Company's goal will be to capitalize on impulse and customer convenience sales versus attempting to price compete with mass merchants and e-commerce. Video Games The video game industry set records for growth in 1999. According to the Interactive Digital Software Association ("IDSA"), game software sales grew 11% to $6.1 billion in 1999. The industry, which includes hardware, software and accessories, as a whole grew by more than $700 million, topping the $9 billion mark in total sales. Approximately 145 million Americans, ages six or older, say they routinely play computer or video games, and 43% of these players are female. Industry research from Game Business also shows that video gamers are getting older, with 40 % of the primary users of consoles over the age of 18. Of current game console owners, Sony "PlayStation" has a 53% market share. Both Nintendo and Microsoft have announced plans to have new 128 bit DVD based hardware "Dolphin" and "XBox" respectively, on the market by 2001. The Company continues to recognize the synergies that exist between the video and game industries. Game rentals support the Company's core video rental business by catering to the younger demographics of the game enthusiast. By providing breadth and depth of game rental hardware, new release and catalog software, the Company broadens its rental customer appeal to all family members and the ever growing "plugged-in" generation. The Company recognized the consumer interest of the new 128 bit game format and placed the new Sega "Dreamcast" hardware and software in all of its U.S. stores upon introduction in September of 1999. In the fall of 2000, Sony is expected to introduce their new 128 bit "PlayStation 2" hardware and software. The extremely strong consumer anticipation of the new "PlayStation 2" is driven by its incorporation of DVD playback capabilities and the backward compatibility to play the original "PlayStation" software. The Company believes that the added DVD feature will help ensure acceptance and growth of the DVD format by expediting the placement of units per household through a younger family demographic. In 5 7 addition, the Company believes that the backward compatibility will enhance consumer confidence of current "PlayStation" hardware and software owners who may have been reluctant to invest in new technology based on their current investment in existing technology. Additional Revenue Opportunities The Company believes that the combined video and game industry growth statistics and consumer acceptance of the DVD format for both movies and games offers continued evidence supporting the future of the retail rental industry. The Company believes that additional revenue opportunities will exist in related accessories for the DVD format such as blank discs for recording, various disc-care and player/console maintenance items, and industry magazines and strategy guides, although no assurances can be given. Related accessories have been sourced through a "pay-on-scan" arrangement with the Company's magazine supplier and a test with a game console accessory supplier. Pay-on-scan enables the Company to add related accessory items to store inventories with no initial cost. The Company's point-of-sale system records each store's sales by item and the Company only pays for items sold, typically with 30-day payable terms. These pay-on-scan purchasing programs produce comparable sell-through margins of 35% to 40% without the up-front inventory dollar investment. The Company intends to continue to pursue similar sell-through opportunities with manufacturers who are eager to have their products represented in a large chain of stores and will accept the inventory up-front risk in return for this representation. Pay-on-scan, as with revenue sharing, is a competitive purchase option/advantage for large chain stores such as Video Update. OPERATIONS The Company's management has substantial experience in the video retailing industry. The Company believes it has developed a superstore format that distinguishes the Company from other video retailers. Key elements of the Company's operating strategy are set forth below. At April 30, 2000, 420 or approximately 92%, of the Company's stores in the United States and 101, or approximately 80%, of the Company's Canadian stores were superstores. Superstores are defined as video rental stores that have more than 10,000 rental units. The Company believes that an extensive selection of rental product is a key determinant that consumers consider in choosing to visit and patronize a particular video store. The Company tailors the movies and games available for rent in a given store according to the market served by that store. Additionally, catalog movies (those in release for more than one year) are displayed in a library style (spine-out method) allowing for significantly more video cassettes per square footage of rental space. As a result, in part because of its direct revenue sharing relationships with movie studios, the Company believes that it is able to provide an extensive selection, yet retain greater flexibility than many of its competitors in terms of store size in which it can operate. The Company maintains an integrated point of sale ("POS") system that provides it with immediate access to information on movie and game rentals and sales, individual title performance, category rental sales performance, shrinkage and overdue rentals. The POS system is used to manage inventory turns, purchase new inventory, and balance customer demand and rental trends, all of which the Company believes maximizes each store's profitability. The Company converts the POS systems of acquired stores to that of the Company's as quickly as is practicable. The Company has redirected its marketing strategies from a broad, shotgun approach, to a more targeted database driven marketing program. The Company's primary goal is to retain its customers and increase the average transaction amount per visit. The Company uses competitive price strategies to increase revenue per customer, encouraging the customer to move up the rental pyramid to the top rental frequency position. In fiscal 2000, the Company implemented a multiple rental program in three areas: new releases, catalog titles, and video games. There remains upward room for additional pricing increases primarily due to regular theatre ticket price increases, rising cable television and pay-per-view costs, and the continued consumer appetite for big box-office releases. 6 8 In addition to revenues from new releases (which account for approximately 80% of revenues), during 1999 the Company introduced a new seven-day rental promotion that offered extended viewing periods on slower-turning matured new releases. The Company gains wide national brand awareness by co-branding with partners such as Pepsi Cola, Act II Popcorn, and Hershey's, as well as with all the major motion picture studios. The Company believes that co-branding is one of the most cost-effective means of building a national brand name. The in-store signage is updated frequently to keep messages fresh and direct customers to specials and high traffic areas. Signs alert customers to non-rental areas and programs, like the new release videos that can be pre-ordered, previously viewed movies and movies for sale. To support the store collateral, the in-store magazine Entertainment Magazine, reiterates rental specials, pre-order opportunities, and upcoming previously viewed movies for sale. Entertainment Magazine also serves as a newsletter informing customers about upcoming new releases and special store events. www.videoupdate.com is an informational site designed for the customer to retrieve video and game release dates, upcoming pre-sell titles, in-store specials, and allows customers to enter contests. The website lists store addresses and phone numbers that are easily accessed by clicking on the appropriate state or province. The Company believes that its geographic concentration of multiple stores in a market allows it to more easily monitor store operations through its regional management offices and to achieve operating efficiencies in inventory management, marketing, distribution, training and store supervision. The Company receives cooperative advertising credits for each store it operates, and by operating multiple stores in a single geographic market, it can more effectively use cooperative advertising credits to maximize the impact of its advertising. The Company strives to create a national presence and name recognition. To achieve this objective and to most efficiently and effectively operate its stores, the Company attempts to maintain consistency among its Company-owned and franchised stores. The Company strives to conform each store's signage, layout, marketing, management information systems and customer service. STORE OPERATIONS AND LOCATIONS Each Video Update store operates under substantially the same plan of operation. Company-owned stores are open 365 days a year with daily hours generally from 10:00 a.m. to 11:00 p.m. Sunday through Thursday and from 10:00 a.m. to 12:00 midnight Friday and Saturday. The Company's stores use a self-service system, whereby customers select products from the shelves and proceed to the checkout counter. Video Update stores in the United States and Canada average approximately 5,800 and 4,900 square feet in size, respectively. The Company seeks to locate its stores in geographic areas that will enable it to achieve operating efficiencies in inventory management, advertising, marketing, distribution, training and store supervision. The following table sets forth the locations of existing Company-owned and franchised stores as of April 30, 2000:

7 9

MANAGEMENT INFORMATION SYSTEMS The Company maintains information, updated daily, regarding revenue, current and historical sales and rental activity, demographics of store membership and videocassette rental patterns. This information can be organized by store, by region or for all operations. The Company maintains a national POS system and a corporate information system. All rental and sales transactions are recorded by the POS system when scanned at the time of customer checkout. Nightly, the POS system transmits each store's data from operations into the corporate information system. The systems track all rental and sales products from the videocassette distribution center to each store using scanned bar code information. The systems also maintains the detailed rental history of each customer and title. This information produces the reports used by the Company, including those used in making purchasing decisions on new releases. All of the Company's stores use the Company's POS system when opened or converted to the Video Update concept, in the case of an acquired store. PRODUCTS Videocassette Rental. The core of the Company's revenue is driven by the rental of videocassettes. New release one-day video prices generally range from $2.49-$3.49. New release seven-day prices range from $3.49-$3.99 and catalog movies rent for $1.49. The Company consistently completes market-pricing evaluations to maximize transaction revenue. Aggressive price competition from regional or national competitor 8 10 chains may reduce new release prices to $1.99 in some markets and reduce catalog videocassettes to as low as 47 cents. The Company believes that its rental prices are competitive with those of other video stores, and its videocassettes are available for one-day and multiple-day rentals to satisfy the shopping habits of all rental consumers. The Company's stores generally carry approximately 13,500 and 12,600 videos for rent in its United States and Canadian stores, respectively, representing approximately 8,700 and 6,800 titles, respectively. Movie titles are classified into at least 23 categories, such as "Action," "Drama," "Family," and "Children" and are displayed alphabetically within those categories. These categories are also easily identified by our in-store mask graphic elements. Each category mask graphic depicts a theatrical expression or element that bonds the graphic to the category. These graphic elements are used in promotional and advertising elements and create a unique brand identity for the Company's stores. Video Games. In addition to the videocassette rentals, stores also rent video games for use with "Sony PlayStation", "Nintendo 64", and "Sega Dreamcast,". A "game store" within the store itself is being developed as a test to further develop and maximize the growing game market. The concept is expected to include an expanded selection of games for rent and sale, game decks, game accessories, and a used "Buy, Sell and Trade" program. Additional Products. DVD for rental and sell-through is available in over 50% of its stores. Candy, popcorn and beverage concessions are prominently displayed by the service counter with impulse messaging. Concession add-on sales are assisting the Company to increase its average dollars per customer transaction. Test programs on magazines and related accessories items are ongoing. Once the test proves effective, the programs are then rolled out on a national level backed with advertising. FRANCHISE OPERATIONS The Company currently has 35 franchise superstores. The standard Company franchise agreement generally requires the franchisee to pay the Company a continuing monthly royalty fee equal to five percent of the franchisee's gross monthly rental revenue, as calculated under the terms of the franchise agreement. The franchisee is also generally obligated to pay a continuing monthly royalty fee of one percent of gross monthly product revenues derived specifically from the sale of certain video products. The monthly royalty fees are calculated and due from the date that the franchised superstore opens for business. In addition to the royalty payments, franchisees generally are also required to pay a monthly advertising fee equal to one percent of the franchisee's gross monthly revenue for the preceding month. Under the Company's current franchising program, the Company will grant to a franchise owner the right to develop one or a specified number of Video Update superstores at an approved location or future locations (within specific geographic areas) pursuant to the terms of a franchise agreement. The exclusivity accorded to a franchisee is individually negotiated but generally does not extend beyond a radius of one mile from the franchised location. Prior to the actual store opening, the Company provides advice to the franchisee on promotions, store displays and inventory control as well as a comprehensive five day training course. The Company monitors franchisees' compliance with ongoing obligations on the basis of monthly revenue reports and inventory reports. The franchise agreement generally also grants the Company the right to audit the franchisee's books, business records, sales reports, financial statements, and tax returns at any time. The franchise agreement allows the Company to terminate the franchise under certain conditions, including without limitation, failure to comply with the Company's operating guidelines, failure to obtain and maintain the necessary retail licenses and permits, operation of a competitive venture, and understatement of gross monthly revenues for any two operating periods by more than two percent. To date, the Company has experienced no material problems it is aware of relating to the understatement of revenues by franchisees. 9 11 MARKETING AND ADVERTISING The Company promotes new titles and promotions primarily through the use of radio, TV and direct mail. Radio campaigns are enhanced by on-air, store location or cross-promotions. A loyalty/reward direct mail campaign is used to solidify our customer base. During the holiday quarter (November to January) TV advertising enhances the business for both rental and sell-through. Cooperative movie advertising made available by studios or suppliers to promote certain videocassettes generally funds the cost of these campaigns. The in-house magazine, Entertainment Magazine, is published monthly. The magazine identifies the upcoming new releases, new games, sell-through titles and current marketing programs. This newly enhanced glossy magazine ties in the new store graphic elements, reinforcing the Company's identity. The in-store trailer tape played on several monitors reinforces the Company's quarterly promotions between professionally produced movie trailers. SUPPLIERS The Company acquires its inventory of videocassettes, DVD's, and video games and accessories from several different studios and distributors. The Company acquires its inventory of videocassettes (VHS), digital videodiscs (DVD), video games, related video accessories, magazines plus food and beverage concession products direct from several movie studios and distribution companies. Direct relationships exist with all studio revenue share partners, as well as several national concessionaires. Given the Company's defaults under the Senior Facility, no assurances can be given that such arrangements will not be terminated or re-negotiated. The videocassette, DVD's and game inventory in each Company-owned and franchised store consists of catalog titles and new release titles. The average cost to the Company to purchase new release rental videocassettes has continued to trend downwards over the past several years. This decrease is primarily due to the transition of the Company's revenue sharing agreements from "output" to "non-output" which has allowed the Company to maximize its purchasing efforts and continue its efforts to reduce tape costs on a release-by-release basis. Management believes that if its relationship with distributors or other sources were terminated, the Company may not be able to obtain its products directly from alternative suppliers at comparable prices and terms, which would have a material and adverse effect on the Company's business, financial condition and results of operations. In addition to traditional inventory purchasing, since fiscal 1999, the Company entered into direct license revenue-sharing agreements with several major motion picture studios, as well as many smaller studios. Under the terms of the agreements, the Company shares the greater of an agreed-upon percentage of the rental revenue or dollar amount per rental transaction, which percentage declines over a period of weeks following the release of the title for video rental. Some agreements include a nominal up front fee for units purchased or a specified guarantee amount. The Company believes that revenue sharing agreements are a cost-effective source for larger orders of an individual title, particularly new release titles. Such agreements enable the Company to order larger quantities of copies, (two to five times the normal order) of a particular title than would be cost-effective if the copies had otherwise been purchased. Given the Company's defaults under the Senior Facility, no assurances can be given that the Company will be able to continue to use such revenue sharing agreements to obtain the intended results. The Company believes that if any of its revenue sharing agreements were terminated, such termination would have a material and adverse impact on the Company's business, financial condition and results of operations. The Company also is a party to an agreement with Rentrak Corporation (the "Rentrak Agreement"), a distributor of prerecorded videocassettes and other media, which agreement superseded in all substantial respects a previous agreement between Rentrak and recently acquired Moovies, Inc. The Rentrak Agreement includes a requirement that the Company obtain a minimum annual dollar amount of new release titles from Rentrak. The minimum dollar amount is subject to increase or decrease depending on the Company's gross revenues from video rental/sales and the number of major studios participating in Rentrak. In addition, under the Rentrak Agreement the Company is allowed to choose which stores offer a title from Rentrak, but if a store obtains a copy of a new release title from Rentrak, it must obtain all copies of that title from Rentrak. 10 12 In 1998, the Company filed suit in federal court in Oregon against Rentrak, alleging that the Rentrak Agreement is in conflict with federal antitrust law, given Rentrak's position in the market and its exercise of monopoly power. Although the Company's claim is not pursuant to or arising from the Rentrak Agreement, a resolution of the action may affect some or all of the provisions of the agreement as well as similar agreements in the video industry or may leave the agreement unaffected. The Company has not ordered any titles from Rentrak under the agreement or otherwise. Further, the court in the action may determine that some or all of any monies paid to Rentrak under the Rentrak Agreement are subject to offset or recoupment (see "Item 3-Legal Proceedings"). INVENTORY New release videocassettes are ordered by the Company and delivered directly to stores where they are offered for rental or sale on the studio release date for the title. Previously viewed inventory for existing and new stores is received, processed and stored in the Company's approximately 34,000 square foot central distribution facility located in St. Paul, Minnesota. New release and previously viewed videocassettes and games are processed for rental according to uniform company-wide standards. Each videocassette is removed from its original carton and placed in a standard Video Update rental case with a magnetic security device. Bar codes are then affixed to each videocassette and video game. For previously viewed videocassettes, the artwork from the original carton is cut out and inserted into clear pockets on the standard Video Update rental case for shelf display. For new release videocassettes, the original carton is displayed separately in front of the standard Video Update rental case containing the videocassette. COMPETITION The video rental industry is highly competitive. The Company competes with other video retail stores, including Blockbuster and Hollywood, other video superstores, and with supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail order operations, vending machines and other retailers, as well as with noncommercial sources such as libraries. In addition to competing with other video retailers, the Company competes with other leisure-time activities, especially entertainment activities such as movie theaters, sporting events, network television and cable television. The Company also competes with other distribution channels for studio movies, including pay-per-view television on basic cable service, which currently offer only a limited number of channels and monthly movie selections. Recently developed digital compression technology combined with fiber optics and other technology will eventually permit cable companies, direct broadcast satellite companies and other telecommunications companies to transmit a much greater number of movies to homes at scheduled intervals throughout the day. Ultimately, these technologies could lead to the availability of movies on demand to the consumer. Certain cable and other telecommunications companies have tested and are continuing to test movie-on-demand services in some markets. The Company and its larger competitors, including Blockbuster and Hollywood, have entered into direct revenue sharing arrangements with several major motion picture studios. Such arrangements allow these competitors to order and stock a greater number of new release and other titles, thus increasing competition in those areas in which each of the Company and its competitors have retail locations and diminishing the potential benefits of similar revenue sharing arrangements entered into by the Company, which could have a material adverse effect on operations. The Company's franchise operations compete with numerous franchise operations in many industries that have significantly greater financial and human resources and more experience in selling franchises than does the Company. Potential franchisees may believe that these franchisers offer greater opportunities for success than the Company. 11 13 SERVICE MARKS The Company has a federal registration for its service mark "Video Update(R)" and logos that include its service mark. The Company also holds registrations in Canada for its service marks and logos. The Company considers its service marks to be important to its business and intends to actively protect them. GOVERNMENT REGULATION The Company is subject to various federal, state and local laws, including the Federal Videotape Privacy Protection Act and similar state laws that govern the disclosure and destruction of video rental records. The Company also must comply with various regulations affecting its business, including state and local licensing, zoning, land use, construction and environmental regulations. The Company has not made, nor does it anticipate making, any material capital expenditures in order to comply with environmental regulations. No assurance can be given, however, that new environmental regulations will not be adopted that will require the Company to make material capital expenditures for compliance. The Company also is subject to the Federal Trade Commission's Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures" (the "FTC Franchise Rule") and state laws and regulations that govern the offer and sale of franchises. To offer and sell franchises, the Company is required by the FTC Franchise Rule to furnish each prospective franchisee a current franchise offering circular prior to the sale of a franchise. In addition, a number of states require a franchisor to comply with registration or filing requirements prior to offering a franchise in the state and to provide a prospective franchisee with a current franchise offering circular complying with the state's laws, prior to the sale of the franchise. Although no assurance can be given, the Company intends to maintain a franchise offering circular that complies with all applicable federal and state franchise sales laws. However, if the Company is unable to comply with the franchise sales laws and regulations of any state that regulates the offer and sales of franchises, the Company will be unable to offer and sell franchises in such state. The Company is required to update its franchise offering circular to reflect material changes, under applicable law, regarding its franchise offering and to comply with changes in disclosure requirements. The occurrence of any such material changes may, from time to time, require the Company to stop offering and selling franchises until its franchise offering circular is updated. No assurance can be given that the Company's franchising program will not be adversely affected by its failure to register or file in certain states consistent with its expansion plans, or because compliance with applicable law necessitates that the Company cease offering and selling franchises in certain states until its franchise offering circular is updated, or because of its inability to comply with existing or future franchise laws. The Company also is subject to a number of state laws and regulations that regulate certain substantive aspects of the franchisor-franchisee relationship, including those governing the termination or nonrenewal of a franchise agreement (such as requirements that "good cause" exist as a basis for such termination and that a franchisee be given advance notice of, and a right to cure, a default prior to termination), requirements that the franchisor deal with its franchisees in good faith, prohibitions against interference with the right of free association among franchisees and those regulating discrimination among franchisees in charges, royalties or fees. Compliance with federal and state franchise laws is costly and time consuming, and no assurance can be given that the Company will not encounter difficulties or delays in this area or that it will not require significant capital for franchising activities. EMPLOYEES As of April 30, 2000, the Company employed 5,274 persons, including 5,115 in Company-owned stores and 159 in the Company's corporate, administrative and warehousing operations. Of the employees, approximately 1,010 were full-time and 4,264 were part-time. The typical required staffing for a Video Update store is 9 to 11 employees, including a store manager. Store managers are supervised by district managers who 12 14 in turn are supervised by regional managers. Regional managers report directly to the Company's Vice Presidents of Store Operations who in turn report to the Executive Vice President of Store Operations or the Chief Operations Officer. The Company believes that its employee relations are satisfactory. The Company has an incentive bonus plan under which store managers are eligible for monthly bonuses. The performance of each manager is evaluated on a variety of criteria, including store revenue, payroll, cash overages and shortages and inventory control. ITEM 2. PROPERTIES The Company leases substantially all of the sites (including buildings and improvements) where its Company-owned video stores are located. The occupancy expense for these sites for the years ended April 30, 1998, 1999 and 2000 was approximately $39,156,000, $65,434,000 and $59,413,000, respectively. These leases generally have a term of three to ten years and provide options to renew for periods ranging from three to five additional years. The Company is generally responsible for real estate taxes, insurance and utilities under all leases (see Note 11 of the Notes to Consolidated Financial Statements "Lease Agreements"). The Company expects that most future video superstores (if any) will also occupy leased premises. The Company owns four locations for Company-owned superstores, one of which is subject to a mortgage, (see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources"). The Company's franchisees enter into leases individually for their respective superstore locations. These leases are on terms substantially similar to the terms for Company-owned superstore leases. Generally, the Company does not guarantee and is not a party to such leases. The Company's corporate headquarters are located at 3100 World Trade Center, 30 East Seventh Street, St. Paul, Minnesota 55101 and consist of approximately 38,000 square feet of office space. The Company's central distribution facility is located at a different location in St. Paul, Minnesota and consists of approximately 34,000 square feet. The Company's headquarters and distribution facilities are leased pursuant to agreements that expire on October 31, 2001 and August 31, 2001, respectively. In addition, the Company maintains other locations for the offices of district and regional managers and for limited storage purposes. The Company expects that suitable additional space will be available in the Twin Cities area, when needed, on commercially reasonable terms. ITEM 3. LEGAL PROCEEDINGS In connection with the acquisition of the assets of Videoland, Inc. ("Videoland") in November 1995, the Company issued 239,163 shares of its Class A Common Stock (the "Videoland Shares") to the sellers of the assets of Videoland (the "Videoland Sellers"). With respect to the Videoland Shares, the Company agreed to make a deficiency payment in October 1996 to the Videoland Sellers if the gross proceeds received by such sellers from the sale of the Videoland Shares during the six months from March 1996 through September 1996 is not equal to the number of shares of Videoland Shares sold multiplied by $12.00. The Videoland Sellers were subject to certain "lockup" or sale restrictions as a condition to any deficiency payment. The Company initiated an action in federal district court in Minnesota for a declaratory judgment that the Videoland Sellers are not entitled to any deficiency payment in light of the failure by such sellers to comply with the lockup or sale restrictions. In January 1998, the court entered a judgment, payable in the Company's stock or cash, against the Company in the amount of $1,220,403 plus interest from October 1996, and attorney's fees; which is recorded in the consolidated balance sheets. The Company appealed the judgment to the Eighth Circuit. The appeal was denied. The Company is exploring further avenues of relief, including but not limited to the satisfaction of a portion of the judgment by a transfer of the Company's stock. A variety of aspects of such a settlement are now subject to litigation in the federal district court of Minnesota, the outcome of which no assurances can be given. The foregoing description is qualified in its entirety by reference to the full text of the complaint and papers on file in the action (Case No. 3-96 735). In May 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al) Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County, Michigan) claiming amounts due pursuant to post-closing adjustments contemplated in connection with an Asset Purchase Agreement among Monsour and 13 15 Moovies, Inc. dated as of March 14, 1997, and the alleged default on a Promissory Note among Monsour and Moovies, Inc. in the amount of $2,000,000. The trial court has ruled in favor of the plaintiffs on a motion for summary judgment, and a judgment for $2,370,195 has been entered against the Company. The $2,000,0000 note is recorded in notes payable and the remaining judgement of $370,195 is recorded in accrued expenses on the consolidated balance sheet at April 30, 2000. The Company believes it has meritorious grounds for its appeal which is currently pending, although assurances cannot be given as to the outcome of such action. The foregoing description is qualified in its entirety by reference to the full text of the complaint and papers on file in the action (Case No. 98-1998-CK). In August 1998, the Company filed suit in federal court in Oregon against Rentrak Corporation, an Oregon Corporation. The Company alleges that Rentrak has violated the federal antitrust law, given Rentrak's position in the market and its exercise of monopoly power. Rentrak has counter-claimed for amounts it alleges were owed by Moovies, Inc. prior to the acquisition of Moovies, Inc. by the Company and for amounts it claims are due under a contract with the Company; the Company has denied that such contract is valid or that any sums are due. Fact discovery in the matter is now largely completed. The Company intends to pursue its claims aggressively, although assurances cannot be given as to the outcome of this matter. The foregoing description is qualified in its entirety by reference to the full text of the complaint and papers on file in the action (Case No. CV 98-1013-HA). The Company is currently in the process of an Internal Revenue Service ("IRS") audit. Certain issues have been raised by the IRS for more detailed review and examination. Because the audit is still incomplete, the resolution of these or future issues and their impact on the Company's financial condition and results of operations cannot be determined at this time. During fiscal 2000, the Company had favorable settlements in certain litigation matters with two vendors. As part of each settlement, the Company converted trade payables to these vendors to structured notes payable of $1,336,000 and $6,500,000, respectively, (see Note 9 of the Notes to Consolidated Financial Statements) and recorded approximately $1,700,000 and $1,200,000, respectively, as a reduction of selling, general and administrative expense and as an adjustment of estimated liabilities in the consolidated financial statements. Also in fiscal 2000, the Company recorded a loss of approximately $1,600,000 resulting from a judgment on appeal in a legal matter with a vendor. The Company believes it has meritorious grounds for success and continues to pursue other avenues of relief. The Company is involved in various other legal proceedings arising during the normal course of conducting business. Management believes that the resolution of these proceedings will not have any material adverse impact on the Company's financial statements. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 14 16 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED MATTERS From May 1, 1995 until May 7, 1995, the Company's Class A Common Stock was traded on the NASDAQ Small Cap Market. From May 8, 1995 to October 18, 1999, the Company's Class A Common Stock was traded on the NASDAQ National Market System under the symbol "VUPDA." The Company's Class A Common Stock began trading on NASDAQ on July 20, 1994. On October 19, 1999, the Company was notified by the NASDAQ National Market that the Company's Class A Common Stock, $.01 par value per share, was delisted due to the Company's failure to meet certain maintenance criteria, including minimum bid price requirements. The Company's Class A Common Stock is now quoted on the NASDAQ OTC Bulletin Board. On April 28, 2000, the closing price for the Class A Common Stock as reported by the OTCBB was $0.2656 per share. For the period indicated, the following table sets forth the range of high and low sale prices for the Class A Common Stock using the prices reported on the NASDAQ National Market System until October 18, 1999 and on the OTCBB from October 19, 1999. CLASS A COMMON STOCK

As of April 30, 2000, there were 352 stockholders of record of the Company's Class A Common Stock. During the fiscal year ended April 30, 2000, the Company did not pay any dividends on its Common Stock and management does not anticipate the payment of any dividends to its stockholders in the foreseeable future. The Company currently intends to reinvest earnings, if any, in the development and expansion of its business. The declaration of dividends in the future will be at the discretion of the Board of Directors and will depend upon the earnings, capital requirements and financial position of the Company, general economic conditions and other pertinent factors, including covenants relating to bank indebtedness. 15 17 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

------------ (1) During the fourth quarter of fiscal 1996, the Company adopted a new method of amortizing videocassette rental inventory. The effect of the change for recognizing salvage value of base stock and the effect of the application of the new method of amortizing videocassette copies in excess of the base stock to May 1, 1995 had the impact, in total, of increasing amortization expense by $2,773,000 and decreasing net income by $1,604,000, or $0.15 per share, in fiscal 1996. (2) During the fourth quarter of fiscal 1998, the Company took significant charges of approximately $17 million. Exclusive of the one-time charges, the net loss would have been $2,701,000 or $0.11 per share. (3) During the fourth quarter of fiscal 1999, the Company took significant charges of approximately $16,135,000 (see Note 4 of the Notes to Consolidated Financial Statements) related to additional store closings and $50,629,000 (see Note 2 of the Notes to Consolidated Financial Statements) related to a change in amortization method for Video and Game Rental Inventory. Exclusive of the charges, the net loss would have been $43,607,000 or $1.49 per share. (4) During the fourth quarter of fiscal 2000, the Company took significant charges of approximately $7,354,000 related to goodwill impairment and of $4,314,000 related to fixed asset impairment (see Notes 5 and 8 of the Notes to Consolidated Financial Statements). Additionally, during fiscal 2000, the Company took significant gains of $5,420,000 related to store restructure reversals and $4,545,000 related to adjustments in estimated liabilities (see Notes 4 and 6 of the Notes to Consolidated Financial Statements). Exclusive of one-time charges and gains, the net loss would have been $34,446,000 or $1.18 per share. (5) The stores included in same store sales are Company-owned stores that have been owned and operated by the Company for more than 12 months. 16 18 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations should be read in conjunction with the Company's audited consolidated financial statements and notes thereto appearing elsewhere herein. OVERVIEW As of August 15, 2000, the Company failed to make principal and interest payments of approximately $6 million. Consequently, the Company is in default under its Senior Facility. In addition, the Company's ability to implement its operational and business strategy described herein is extremely limited because the Company has no available borrowings under its Senior Facility or any other similar facility. Accordingly, the Company's available cash for operational activities is severely restricted, and the Company likely will not be able to pursue its intended operational and business strategies in a manner that would normally be possible under circumstances in which the Company had not defaulted under the terms of the Senior Facility. In addition, the lenders under the Senior Facility may, but are not obliged to, take immediate legal action against the Company, including but not limited to, acceleration of payment of all borrowed funds and such other remedies as may be available under the loan documents or common or statutory law. Under these circumstances, a number of the Company's contracts and supply arrangements, including but not limited to its revenue sharing contracts, may be subject to termination or re-negotiation. These circumstances likely will have a material adverse effect on the Company's ability to increase revenues and income and may, therefore, have a material adverse effect upon the Company's business, financial condition and results of operations. The Company continues to evaluate opportunities to reduce costs and improve revenues, although no assurances can be given that such actions will be successful if implemented. In addition, it is evaluating various alternatives to raise capital, including the possible sale of assets. Prior to any default under the Senior Facility, the Company had endeavored to maintain satisfactory relationships with its primary product vendors and had negotiated extended payment terms with several of these vendors. No assurances can be given that the Company will be able to maintain such relationships, although it continues to be able to obtain product from various sources. Moreover, the loss of its primary product vendors could have a material adverse effect on the Company. The Company will continue to focus on reducing the aged accounts payable with payments, the extension of terms, and negotiated settlements. If the Company is unable to reduce the aged accounts payable to the satisfaction of the trade creditors, it could have a material adverse effect on the Company. The Company is uncertain whether cash from operations, trade credits, equipment leases, and available revenue sharing arrangements will be sufficient to fund future inventory purchases and other working capital needs for the next twelve months. If the Company is unable to obtain additional financing or maintain its relationships with its vendors and trade creditors, the Company may be required to reduce its overall expenditures and the Company's ability to maintain or expand its current level of operations will be materially and adversely affected. The Company franchised its first store in January 1983 and opened its first company-owned store in September 1989. By July 1994, when the Company completed its initial public offering, the Company had grown to 15 Company-owned stores and 30 franchised stores. Subsequently, the Company accelerated its growth and as of April 30, 2000, operates 586 Company-owned stores in 31 states and five provinces in Canada, and has 35 franchised stores in the United States. The majority of the Company's stores located in the United States are superstores. Superstores are video specialty stores that carry more than 10,000 rental units. In January 2000, the Company's Board of Directors approved a resolution changing the Company's fiscal year-end from April 30 to January 31, effective January 31, 2001. The Company generates revenues primarily from the rental of videocassettes and video games, from the sale of products, and from service fees from its franchisees. As reflected in the chart below, rental revenues at 17 19 Video Update stores have accounted for the substantial majority of the Company's revenues. The Company expects that this trend will continue.

Overall revenues, including same store sales, did not meet management's expectations for fiscal 2000, due in significant part to the re-negotiation of revenue sharing agreements and unseasonable weather throughout the year. Over the past twelve months, the Company has re-negotiated several revenue share agreements resulting in improved revenue splits for the Company. In addition, during the past twelve months, multiple new revenue share agreements have been implemented under these more attractive terms. The Company has also re-evaluated existing agreements with the major studios and has discontinued "output" programs. An "output" program required that the Company carry every new release distributed by the studio. It also requires a guaranteed amount of revenue due the studio for each release. For high box office titles, the "output" programs were generally profitable for the Company. However, middle to lower box office titles often did not earn back the minimum guarantee and actually increased the Company's costs. "Non-output" agreements do not require the Company to stock every new release from a studio, but instead permit the Company to either take a title in depth through the "non-output" agreement, or purchase a title in lesser quantity through a distributor. Even though the Company has reduced its participation with major studio output programs, the Company has been able to supplement title-depth by participating with more studios who do not require guarantees or offer other cost saving title-depth programs. The Company believes that if any of its primary supply or revenue sharing agreements were terminated, such termination would have a material and adverse impact on the Company's business, financial condition and results of operations. OPERATING RESULTS The table below sets forth the percentage of revenues represented by certain items included in the Company's statement of operations for the periods indicated.

18 20

FISCAL 2000 COMPARED TO FISCAL 1999 Rental revenue. Rental revenue was approximately $221,238,000 and $196,283,000, or 87.1% and 88.8% of total revenues for fiscal 1999 and 2000, respectively. The decrease in rental revenue of $24,955,000 was attributed to a change in the purchasing agreements with the studios, the closing of 69 under-performing stores, and unseasonable weather throughout the year. The change in the purchasing agreements consisted of a transition from "output" to "non-output" purchasing which eliminated mandatory tape purchases, and has allowed the Company to maximize its margins. Product sales. Product sales were approximately $31,915,000 and $23,580,000, or 12.6% and 10.7% of total revenues for fiscal 1999 and 2000, respectively. The decrease in product sales of $8,335,000 was primarily a result of the closing of under-performing stores, high "Titanic" video sales in fiscal 1999, as well as management's continued focus on the rental of videocassettes and DVD's due to their return on investment. Service fees. Service fees were approximately $943,000 and $1,099,000, or 0.3% and 0.5% of total revenues for fiscal 1999 and 2000, respectively. Continuing service fees and royalties from franchisees account for 85.7% and 87.0% of total service fees from fiscal 1999 and 2000, respectively. Store operating expenses. Store operating expenses consist primarily of compensation and related expenses, occupancy expenses, and the cost of rental tapes and video games. Operating expenses were approximately $232,287,000 and $198,538,000, or 91.4% and 89.9% of total revenues for fiscal 1999 and 2000, respectively. The decrease in store operating expenses of $33,749,000 was attributed to the closing of under-performing stores and other cost cutting measures, such as the reduction of management overhead, and the selected downsizing of stores. 19 21 Store operating expenses consist of the following (in 000's):

Cost of rental revenue was approximately $76,044,000 and $54,417,000, or 29.9% and 24.6% of total revenues for fiscal 1999 and 2000, respectively. Cost of rental revenue reflects the amortization of videocassettes and video games, revenue sharing expenses, and fees paid to videocassette and video game suppliers. The decrease of $21,627,000 was attributed to the decline in purchases that resulted from the transition from "output" to "non-output" revenue sharing agreements, and to the closing of 69 under-performing stores since April 30, 1999. Occupancy expenses were approximately $71,436,000 and $63,350,000, or 28.1% and 28.7% of total revenues for fiscal 1999 and 2000, respectively. The decrease of approximately $8,086,000 was primarily attributed to the closing of under-performing stores as well as the selected downsizing of stores. The expense as a percent of revenue increased as a result of occupancy expenses that are still being realized subsequent to the closing of 69 under-performing stores since April 30, 1999, as well as the decline in sales that resulted from the transition from "output" to "non-output" revenue sharing agreements. Compensation and related benefits were approximately $60,055,000 and $55,973,000, or 23.6% and 25.3% of total revenues for fiscal 1999 and 2000, respectively. The decrease of approximately $4,082,000 was primarily due to the closing of 69 under-performing stores. The expense as a percent of revenue increased primarily due to the decline in sales that resulted from the transition from "output" to "non-output" revenue sharing agreements. Furniture, fixtures, and equipment expenses consisting of depreciation of furniture and fixtures, computer leases, telephone expenses, and other related expenses were approximately $13,777,000 and $15,497,000, or 5.5% and 7.0% of total revenues for fiscal 1999 and 2000, respectively. The increase of $1,720,000 was primarily attributed to losses on equipment disposals and additional equipment leases resulting from the sale-leaseback transaction in fiscal 1999. These were offset slightly by less depreciation expense on fixed assets written off in fiscal 1999 related to store closings. Selling, general and administrative. Selling, general and administrative expenses were approximately $26,179,000 and $20,816,000 or 10.3% and 9.5% of total revenues for fiscal 1999 and 2000, respectively. The decrease of approximately $5,363,000 was attributed to the streamlining of administrative duties, continuing efforts towards automation, a reduction of head count, as well as the effect of the settlement with a vendor of approximately $1.7 million. Cost of product sales. Cost of product sales was approximately $20,257,000 and $14,637,000, or 8.0% and 6.6% of total revenues for fiscal 1999 and 2000, respectively. The cost of product sales as a percentage of total product sales revenue was approximately 63.5% and 62.1% for fiscal 1999 and 2000, respectively. The decrease in the cost of product sales was primarily attributed to management's continued focus on the rental of videocassettes and DVD's as the core source of revenue due to the higher margins that are realized in comparison to product sales. Store closing charge. During the fourth quarter of fiscal 1999, the Company adopted a business restructuring plan to close 70 under-performing stores. This resulted in the Company recording a pre-tax charge of approximately $9,535,000 to cover lease termination charges and miscellaneous closing costs for these stores. During the fiscal year ended April 30, 2000, 60 of the stores reserved were closed at a significantly 20 22 lower cost to the Company than originally planned due to successful lease terminations and which resulted in a reserve reversal of approximately $5,420,000, and ten stores were determined to remain open. In addition to the stores detailed above, nine stores were closed during fiscal 2000. Adjustment of estimated liabilities. During fiscal year 2000, the Company resolved various disputed vendor accounts, including a legal settlement (see Note 20 of the Notes to Consolidated Financial Statements). The positive resolution of these disputed amounts previously accrued resulted in a reduction of outstanding liabilities of approximately $5,550,000 of which $1,005,000 reduced fixed assets and $4,545,000 was recorded as a reduction of operating expenses. Fixed asset valuation charge. During fiscal 1999 and 2000, the Company recorded pretax charges of approximately $6,600,000 and $4,314,000, respectively, relating to the impairment of certain fixed assets held for use when it was determined that future undiscounted cash flows associated with those assets were insufficient to recover their carrying value. Goodwill valuation charge. During fiscal 2000, the Company recorded a pretax charge of $7,354,000 relating to the impairment of certain intangible assets when it was determined that future undiscounted cash flows associated with these assets were insufficient to recover their carrying value. Amortization of goodwill. Amortization of goodwill was approximately $4,471,000 and $4,299,000 for fiscal 1999 and 2000, respectively. Interest expense. Interest expense was approximately $13,695,000 and $17,804,000 or 5.4% and 8.1% of total revenues for fiscal 1999 and 2000, respectively. The increase of approximately $4,109,000 was primarily attributed to interest on increased borrowings under the Company's Senior Facility (as defined below), as well as higher interest rates. Other income (expense). Other income (expense) was approximately $677,000 and $686,000 for fiscal 1999 and 2000, respectively. FISCAL 1999 COMPARED TO FISCAL 1998 Rental revenue. Rental revenue was approximately $138,279,000 and $221,238,000, or 88.6% and 87.1% of total revenues for fiscal 1998 and 1999, respectively. The increase in rental revenue of $82,959,000 was derived primarily from the 267 video stores acquired from Moovies in March 1998 and a 2% increase in same store revenues at the Video Update locations. Rental revenues did not meet management's expectations for the 12 months ended April 30, 1999, primarily due to the conversion of the Moovies locations in several significant markets, which was completed during the third fiscal quarter, as well as the simultaneous impact during the period of revenue sharing arrangements and copy title depth obtained by competitors in markets where the Company's stores are located. Product sales. Product sales were approximately $17,075,000 and $31,915,000, or 10.9% and 12.6% of total revenues for fiscal 1998 and 1999, respectively. The increase in product sales of $14,840,000 was primarily a result of product sales by the Moovies video stores acquired in March 1998 and from the sale of videocassettes of the movie "Titanic." The increase as a percentage of total revenues was primarily due to a difference in product mix and high "Titanic" video sales. Service fees. Service fees were approximately $800,000 and $943,000, or 0.5% and 0.3% of total revenues of fiscal 1998 and 1999, respectively. Continuing service fees and royalties from franchisees account for 95% of total service fees from fiscal 1998 and 1999. The increase in service fees of $143,000 was primarily a result of franchises acquired with the Moovies acquisition in March 1998. Store operating expenses. Store operating expenses consist primarily of compensation and related expenses, occupancy expenses, and the cost of rental videos and games. Operating expenses were approximately $129,920,000 and $232,287,000, or 83.2% and 91.4% of total revenues for fiscal 1998 and 1999, respectively. Store operating expenses do not include a one-time charge to change the amortization policy for rental inventory (see Note 2 "Change in Amortization Method for Video and Game Rental Inventory" to the Consolidated Financial Statements). The increase in store operating expenses of $102,367,000 was primarily 21 23 the result of the Moovies video stores acquired in March 1998. The increase in store operating expenses as a percentage of total revenues was primarily due to: (i) a sales shortfall arising from the timing advantage of revenue sharing arrangements and copy title depth obtained by competitors in the markets where the Company's stores were located; (ii) revenues of a significant number of acquired Moovies locations not performing to management's expectations; and (iii) corresponding higher costs of new video stores prior to revenue reaching maturity during the first two years of operations. Cost of rental revenue were approximately $38,689,000 and $76,044,000, or 24.8% and 29.9% of total revenues for fiscal 1998 and 1999, respectively. Cost of rental revenue reflects the amortization of videocassettes and video games, revenue sharing expenses, and fees paid to videocassette and video game suppliers. The increase of $37,355,000 was primarily attributable to the addition of new release videocassette inventory for new, existing, and the acquired Moovies locations. Compensation and related expenses were approximately $38,424,000 and $60,055,000, or 24.6% and 23.6% of total revenues for fiscal 1998 and 1999, respectively. The increase of approximately $21,631,000 was primarily due to the Moovies locations acquired in March 1998. Occupancy expenses were approximately $41,596,000 and $71,436,000, or 26.6% and 28.1% of total revenues for fiscal 1998 and 1999, respectively. The increase of $29,840,000 was primarily the result of the video stores acquired during the period and the opening of 71 Company-owned video stores, net of closings, during fiscal 1998. Selling, general and administrative. Selling, general and administrative expenses were approximately $25,223,000 and $26,179,000, or 16.2% and 10.3% of total revenues for fiscal 1998 and 1999, respectively. During the fourth quarter of fiscal 1998, the Company recorded the following: (i) a $3,546,000 non-cash, non-tax deductible charge to compensation expense related to the release of 1,170,000 shares of Class B common stock from escrow (see Note 14 of the Notes to Consolidated Financial Statements); (ii) a $7,161,000 charge consisting of a $3,236,000 non-cash charge relating to the restated employment agreements for the Company's Chief Executive Officer and its President, representing amounts to be applied to their existing stock option related loan obligations, and $3,925,000 to be used by the executives primarily to pay income taxes arising from the stock option related transaction; and (iii) $700,000 for previously capitalized bank fees related to the Company's previous Revolving Credit Facility which was repaid prior to its maturity. After giving consideration to these items, expenses were $13,816,000 and $26,179,000, or 8.8% and 10.3% of total revenues for fiscal 1998 and 1999, respectively. The increase of $12,363,000 was primarily due to (i) additional finance and information systems personnel and related expenses to support the Company's growth; (ii) outside legal and accounting fees; (iii) maintenance costs on computer and phone systems; and (iv) bank service fees related to additional locations. The increase in selling, general and administrative expenses as a percent of total revenue was primarily due to (i) higher than expected costs incurred to integrate the Moovies locations; and (ii) sales shortfalls at Moovies locations as they were converted to the Video Update format. Cost of product sales. Cost of product sales was approximately $9,809,000 and $20,257,000, or 6.3% and 8.0% of total revenues for fiscal 1998 and 1999, respectively. The cost of product sales as a percentage of total product sales revenue was approximately 57.4% and 63.5% for fiscal 1998 and 1999, respectively. The increase in the cost of product sales as a percentage of product sales was primarily due to the sale of the "Titanic" video which was sold at a low margin due to industry competition. Store closing charge. During the fourth quarter of 1999, the Company began and completed an extensive analysis of its base store performance and adopted a business restructuring plan to close approximately 70 under-performing stores. This analysis resulted in the Company recording a pretax charge of approximately $9,535,000 to cover lease termination charges and miscellaneous closing costs for those stores. During the fourth quarter of fiscal 1998, the Company recorded a store closing reserve of approximately $2,700,000 of which approximately $1,337,000 was reversed in fiscal 1999 due to successful negotiation of lease terminations (see Note 4 of the Notes to Consolidated Financial Statements). 22 24 Amortization of goodwill. Amortization of goodwill was approximately $2,353,000 and $4,471,000, or 1.5% and 1.8% of total revenues for fiscal 1998 and 1999, respectively. The increase of $2,118,000 was primarily attributable to the acquisition of Moovies in March 1998. Interest expense. Interest expense was approximately $4,292,000 and $13,695,000, or 2.8% and 5.4% of total revenues for fiscal 1998 and 1999, respectively. The increase of $9,403,000 was primarily attributable to interest on increased borrowings under the Company's Senior Facility (as defined below). Other income (expense). Other income (expense) was approximately $(71,000) and $677,000, or (0.0)% and 0.3% of total revenues for fiscal 1998 and 1999, respectively. LIQUIDITY AND CAPITAL RESOURCES The Company has funded its operations through cash from operations, the proceeds of prior equity and debt offerings, borrowings under bank facilities, trade credit and equipment leases. The Company's principal capital requirements are for the purchase of rental inventory, payments related to store closings, and payments of interest and principal related to the Company's indebtedness. As of August 15, 2000, the Company failed to make principal and interest payments of approximately $6 million. Consequently, the Company is in default under its Senior Facility. In addition, the Company's ability to implement its operational and business strategy described herein is extremely limited because the Company has no available borrowings under its Senior Facility or any other similar facility. Accordingly, the Company's available cash for operational activities is severely restricted, and the Company likely will not be able to pursue its intended operational and business strategies in a manner that would normally be possible under circumstances in which the Company had not defaulted under the terms of the Senior Facility. In addition, the lenders under the Senior Facility may, but are not obliged to, take immediate legal action against the Company, including but not limited to, acceleration of payment of all borrowed funds and such other remedies as may be available under the loan documents or common or statutory law. Under these circumstances, a number of the Company's contracts and supply arrangements, including but not limited to its revenue sharing contracts, may be subject to termination or re-negotiation. These circumstances likely will have a material adverse effect on the Company's ability to increase revenues and income and may, therefore, have a material adverse effect upon the Company's business, financial condition and results of operations. The Company continues to evaluate opportunities to reduce costs and improve revenues, although no assurances can be given that such actions will be successful if implemented. In addition, it is evaluating various alternatives to raise capital, including the possible sale of assets. Prior to any default under the Senior Facility, the Company had endeavored to maintain satisfactory relationships with its primary product vendors and had negotiated extended payment terms with several of these vendors. No assurances can be given that the Company will be able to maintain such relationships, although it continues to be able to obtain product from various sources. Moreover, the loss of its primary product vendors could have a material adverse effect on the Company. The Company will continue to focus on reducing the aged accounts payable with payments, the extension of terms, and negotiated settlements. If the Company is unable to reduce the aged accounts payable to the satisfaction of the trade creditors, it could have a material adverse effect on the Company. The Company is uncertain whether cash from operations, trade credits, equipment leases, and available revenue sharing arrangements will be sufficient to fund future inventory purchases and other working capital needs for the next twelve months. If the Company is unable to obtain additional financing or maintain its relationships with its vendors and trade creditors, the Company may be required to reduce its overall expenditures and the Company's ability to maintain or expand its current level of operations will be materially and adversely affected. At April 30, 2000, the Company had cash and cash equivalents of approximately $1,763,000. The Company uses an unclassified balance sheet in its financial statements, and as a result, does not classify its assets or liabilities as current or non-current. If the Company were to use a classified balance sheet, a portion of videocassette rental inventories would be classified as non-current because they are not assets that are reasonably expected to be completely realized in cash or sold in one year. The acquisition cost of these inventories, however, would be reflected in current liabilities. The Company believes that classification of 23 25 videocassette rental inventories as non-current assets would be misleading because it would not indicate the level of assets expected to be converted into cash in the next year as a result of rentals or sales of these videocassettes. For the year ended April 30, 2000, net cash provided by operating activities was approximately $35,127,000. Net cash used in investing activities was approximately $37,382,000, consisting primarily of approximately $1,186,000 for the purchase of property and equipment and approximately $36,512,000 for the purchase of video and game rental inventory. Net cash generated from financing activities was approximately $4,243,000 due primarily to an additional $10,500,000 of term loans (see Note 9 of the Notes to Consolidated Financial Statements). In March 1998 the Company completed the acquisition of Moovies, Inc. ("Moovies"). The Company issued approximately 9.3 million shares of Class A Common Stock in exchange for Moovies common stock. The transaction was treated as a tax-free exchange for federal income tax purposes and recorded under the purchase method of accounting. Simultaneous with the closing of the Moovies transaction, a syndicate led by Banque Paribas extended the Company a $120 million senior credit facility (the "Senior Facility"). This Senior Facility replaced the Company's previous line of credit. The Senior Facility consisted of the following: (i) two term loans totaling $95 million; (ii) a $15 million capital expenditure line; and, (iii) a $10 million revolving line. The Company borrowed the $95 million of the two term loans in conjunction with the closing of the merger and the proceeds were used to: (i) refinance approximately $35,000,000 of outstanding indebtedness including accrued interest under the Company's previous line of credit; (ii) refinance approximately $50,000,000 of indebtedness of Moovies under Moovies' previous credit agreement; and (iii) pay transaction fees and expenses relating to the merger of approximately $10,000,000, (including legal fees, accounting fees, and registration fees). The capital expenditure line was primarily available to fund the conversion of the acquired Moovies stores and integration costs, the opening of new stores and selected acquisitions. During the second quarter of fiscal 1999, the Company and the bank syndicate amended the terms of the Senior Facility to, among other things: (i) reduce the Senior Facility from $120 million to $115 million; (ii) revise certain financial covenants; (iii) modify the terms of the capital expenditure line to allow usage for working capital needs; (iv) increase the overall interest rate by 0.5%; (v) add consent fees of $600,000 payable August 12, 1998 and $575,000 payable on August 12, 1999; and (vi) reprice warrants held by the bank syndicate to a more current market price. During the third quarter of fiscal 1999, the Company and the bank syndicate amended the terms of the Senior Facility to, among other things; (i) permit a sale-leaseback transaction; (ii) defer the January 31, 1999 principal payments to March 12, 1999; and (iii) increase the overall interest rate by 0.25%. During the fourth quarter of fiscal 1999, the Company and the bank syndicate amended the terms of the Senior Facility to, among other things; (i) defer the March 12, 1999 principal payments to May 31, 1999; (ii) revise certain financial covenants; and (iii) add consent fees of $57,500 due on April 30, 1999 and May 15, 1999. Effective May 28, 1999, the Company and the bank syndicate amended the terms of the Senior Facility to, among other things; (i) increase the overall Senior Facility with a new tranche of C Term loans in the aggregate amount of $10.5 million maturing June 2006, and bearing 12% interest; (ii) revise certain financial covenants; (iii) revise and defer certain principal payments; (iv) increase the overall interest rate by 0.75%; and (v) reflect the issuance of 7,481,250 warrants at $0.8719 per share expiring June 2006. The Company used proceeds of the new C Term loans for, among other things, the purchase of rental inventory, payments related to store closings, trade payables, and debt service. As of April 30, 2000, the Company had $15 million outstanding under the capital expenditure line and $5 million outstanding under the revolving line both of which are available to fund working capital needs. As of April 30, 2000 the Company had no further borrowing capacity available under its Senior Facility. In addition, the Company is presently in default under the terms of the Senior Facility for failure to make principal and interest payments due July 31, 2000 of approximately $6 million and to comply with certain financial covenants. Consequently, the Senior Facility lenders may take legal action against the Company, including but not limited to, the immediate acceleration of payment of borrowed funds, which could materially and adversely affect the Company's operations. The immediate 24 26 acceleration of debt thereunder or the lack of further borrowing capacity, in whole or in part, would have a material adverse effect on the Company's operations and financial condition. Amounts borrowed under the Senior Facility bear interest at variable rates based on the "base rate" (i.e., the higher of the federal funds rate, plus 1/2 of 1% or the prime commercial lending rate) or the inter-bank Eurodollar rate (approximately 9.00% and 6.18% per annum, respectively as of April 30, 2000) plus an applicable margin rate that could range from 0.50% to 5.25%. Amounts currently outstanding at April 30, 2000 had a weighted average rate of 11.32%. The Senior Facility includes negative, affirmative, and financial covenants including, but not limited to, minimum free cash flow, consolidated indebtedness to consolidated free cash flow, maximum leverage, minimum fixed charge coverage, a prohibition or restriction on capital expenditures, debt and guarantees, liens and encumbrances on any property, mergers, consolidations, investments, advances, divestitures, change of business or conduct of business, joint ventures, partnerships, the creation of new subsidiaries, dividends, distributions, repurchases or redemptions of outstanding stock (including options or warrants), the voluntary prepayment, repurchase redemption or defeasance of debt, and the acquisition, sale or transfer, lease or sale- leaseback of assets. The Senior Facility is secured by substantially all of the Company's assets as well as by pledges of its stock in its subsidiaries, which subsidiaries also have provided guarantees of the Company's obligations. As of April 30, 2000, the Company was in default of several of the above financial covenants. As of August 15, 2000, the Company is in default for non-payment of approximately $6 million in principal and interest. In May 1999, the Company provided a 12% interest bearing promissory note to a major vendor for $14,000,000 for the settlement of accounts payable, which is to be repaid in monthly installments through May 2002. The remaining balance at April 30, 2000 is approximately $11,402,000. The Company also issued warrants to purchase 1,000,000 shares of Class A common stock at $0.81 per share, which expires May 2004. Also in fiscal 2000, the Company provided a $6,500,000 interest bearing promissory note to a vendor for the settlement of accounts payable. The note bears interest of 8% and is payable in weekly installments through December 2002. Additionally, the Company provided a $1,336,000 note payable to a vendor for the settlement of accounts payable. The note is payable in monthly installments through August 2002. During fiscal 1996, each of Messrs. Potter and Bedard issued notes (at an interest rate of 8% per annum) to the Company (the "Recourse Notes") in connection with stock option exercises. In fiscal 1998, 1999, and 2000, Mr. Potter's Recourse Note accrued interest of $151,694, $147,097, and $69,273, respectively, and Mr. Bedard's Recourse Note accrued interest of $84,275, $81,721, and $79,593, respectively. At April 30, 1999 and 2000, Mr. Potter's Recourse Note balance was approximately $2,227,244 and $0, respectively, and Mr. Bedard's Recourse Note balance was approximately $1,237,358 and $1,212,000, respectively. The Company's Board of Directors has approved the accrual of bonuses to satisfy the Recourse Notes and interest thereon. During fiscal 2000, the Company paid all of its previously accrued payroll tax and other obligations related to Mr. Potter's Recourse Note and expects to complete its similar obligations with respect to Mr. Bedard's Recourse Note by December 31, 2000. The Company generally does not offer lines of credit or guarantees for the obligations of its franchisees, although on occasion, the Company has made short-term loans to current franchisees. The Company intends to evaluate the possibility of providing loans or limited guarantees for certain franchisee obligations, which in the aggregate are not expected to be material to the Company's financial condition. Substantially all Company-owned stores are in leased premises, except for four stores that are located on premises owned by the Company. The Company expects that most future stores will occupy leased premises. In November 1998, the Company entered into a sale-leaseback arrangement with respect to certain of its furniture, fixtures, equipment and signage used in selected retail locations. Under the arrangement the Company obtained approximately $5 million. This Annual Report on Form 10-K contains a number of forward looking statements. Any statements contained herein (including without limitation statements to the effect that the Company or its management 25 27 "believes," "expects," "anticipates," "plans" and similar expressions) that are not statements of historical fact should be considered forward looking statements. There are a number of important factors that could cause the Company's results to differ materially from those indicated by such forward looking statements. These factors include, without limitation, the following: Cash Requirements The Company has no further borrowing capacity under its Senior Facility and is currently in default thereunder for non-payment of approximately $6 million in principal and interest and failure to be in compliance with certain of the financial covenants of its Senior Facility. Consequently, the Senior Facility lenders may take legal action against the Company, including, but not limited to, the immediate acceleration of payment of borrowed funds, which could materially and adversely affect the Company's operations. The immediate acceleration of debt thereunder or the lack of further borrowing capacity, in whole or in part, would have a material adverse effect on the Company's operations and financial condition. Fluctuations in Quarterly Operating Results The Company has experienced in the past, and may continue to experience in the future, fluctuations in its quarterly operating results. No assurance can be given that the Company will have positive earnings in any quarter, or that earnings in any particular quarter will not fall short of either a prior fiscal quarter or investors' expectations. Factors such as the number of new store openings (newer stores generally are less profitable than mature stores), public acceptance and interest in new release titles, weather (particularly on weekends and holidays), the mix of products rented and sold, pricing actions of competitors, special or unusual events affecting retailers in general, the level of advertising and promotional expenses, seasonality, and one-time charges associated with acquisitions (if any) or other events could contribute to quarterly variability in operating results. In addition, the Company's expense levels are based in part on expectations of future sales levels, and a shortfall in expected sales could therefore result in a disproportionate decrease in net income. Significant Future Charges to Earnings Arising from Amortization of Goodwill At April 30, 2000, the Company had approximately $66,223,000 of goodwill on its balance sheet that resulted primarily from the acquisition of video rental stores, which will be amortized over 20 years. The Company expects that its operating results for future quarters over the next 20 years will reflect quarterly, non-cash charges of approximately $960,000 for amortization of goodwill from these acquisitions. The Company also anticipates that future acquisitions (if any) will involve the recording of a significant amount of goodwill on its balance sheet, which will be amortized over varying periods of time of up to 20 years. Competition The video rental industry is highly competitive. The Company competes with other video retail stores, including Blockbuster and Hollywood, other video superstores, and with supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail order operations, vending machines and other retailers, as well as with noncommercial sources such as libraries. In addition to competing with other video retailers, the Company competes with other leisure-time activities, especially entertainment activities such as movie theaters, sporting events, network television and cable television. The Company also competes with other distribution channels for studio movies, including pay-per-view television on basic cable service, which currently offer only a limited number of channels and monthly movie selections. Recently developed digital compression technology combined with fiber optics and other technology will eventually permit cable companies, direct broadcast satellite companies and other telecommunications companies to transmit a much greater number of movies to homes at scheduled intervals throughout the day. Ultimately, these technologies could lead to the availability of movies to the consumer on demand. Certain cable and other telecommunications companies have tested and are continuing to test movie-on-demand services in some markets. 26 28 The Company and its larger competitors, including Blockbuster and Hollywood, have entered into direct revenue sharing arrangements with major motion picture studios. Such arrangements allow these competitors to order and stock a greater number of new release and other titles, thus increasing competition in those areas in which each of the Company and its competitors have retail locations and diminishing the potential benefits of similar revenue sharing arrangements entered into by the Company, which could have a material adverse effect on operations. The Company's franchise operations compete with numerous franchise operations in many industries that have significantly greater financial and human resources and more experience in selling franchises than does the Company. Potential franchisees may believe that these franchisers offer greater opportunities for success than the Company. Possible Adverse Effect of New Technologies on the Video Rental Business The Company also currently competes with pay-per-view cable television systems. Recently developed digital compression technology combined with fiber optics and other technology will eventually permit cable companies, direct broadcast satellite companies and other telecommunications companies to transmit a much greater selection of movies to homes at scheduled intervals throughout the day. Ultimately, these technologies could lead to the availability of movies-on-demand to the consumer. Certain cable and other telecommunications companies have tested and are continuing to test movie on demand services in some markets. Technological advances could have a material adverse effect on the business of the Company. Changes in Studio Distribution and Pricing Changes in the manner in which movies are marketed by the studios that produce them, primarily related to an earlier release of movie titles to alternative distribution channels, could substantially decrease the demand for video rentals, which could have a material adverse effect on the Company's financial condition and results of operations. In addition, changes in the movie studios' wholesale pricing structure for videos could result in a competitive disadvantage for all video specialty stores, including those of the Company. Supply Relationships In addition to traditional inventory purchasing, since fiscal 1999, the Company entered into revenue sharing agreements with several major motion picture studios, as well as many smaller studios. Under the terms of the agreements, the Company shares the greater of an agreed-upon percentage of the rental revenue or flat dollar amount per rental transaction, which percentage declines over a period of time following the release of the title for video rental. Some agreements include a nominal up front fee for units acquired or a specified guarantee amount. The Company believes that revenue sharing agreements are a cost-effective source for larger orders of an individual title, particularly new release titles. Such agreements enable the Company to order larger quantities of copies, (two to five times the normal order) of a particular title than would be cost-effective if the copies had otherwise been purchased. Given the Company's defaults under the Senior Facility, no assurances can be given that the Company will be able to continue to use such revenue sharing agreements to obtain the intended results. The Company believes that if any of its primary revenue sharing agreements were terminated, such termination would have a material and adverse impact on the Company's business, financial condition and results of operations. Consumer Acceptance of New Release Movie Titles The Company depends significantly on availability and consumer acceptance of new release video titles available for rental. To the extent that available new release titles fail to stimulate consumer interest and retail traffic, operating results could be materially adversely affected. 27 29 Seasonality and Other Factors The video rental industry generally experiences revenue declines in April and May, due in part to the change to Daylight Savings Time and to improved weather, and in September and October, due in part to school openings and the introduction of new network and cable television programs. The Company's video rental business may be affected by other factors, including additional and existing competition, marketing programs, weather, special or unusual events, variations in the number of superstore openings, and other factors that may affect retailers in general. Franchise Sales The sale of franchises is regulated by various state laws as well as by the Federal Trade Commission (the "FTC"). The FTC requires that franchisors make extensive disclosure to prospective franchisees but does not require registration. A number of states require registration or disclosures in connection with franchise offers and sales. In addition, several states have "franchise relationship laws" or "business opportunity laws" that limit the ability of franchisors to terminate franchise agreements or to withhold consent to the renewal or transfer of these agreements. Although the franchising operations are not materially adversely affected, to date, by such existing regulations, the management of the Company cannot predict the effect any future legislation or regulation may have on its business operations or financial condition. Dependence on Key Personnel The Company's future success depends to a significant extent on the continued contributions of Daniel A. Potter, the Company's Chairman and Chief Executive Officer, John M. Bedard, the Company's President, Michael P. Gebauer, the Company's Chief Financial Officer, and Daniel C. Howard, the Company's Chief Operating Officer. The loss of the services of any of these officers could have a material adverse effect on the Company. The Company's continued growth and profitability also depends on its ability to attract, motivate, and retain other management personnel, including qualified store managers. No assurance can be given that the Company will be successful in attracting, motivating and retaining such personnel. Retention of Employees The success of the Company will depend in part upon the retention of key employees. Competition for qualified personnel in the video rental industry is very intense. Stock options, which generally become exercisable only over a period of several years of employment, serve as an important incentive for retaining key employees. Although the Company is engaged in ongoing efforts to retain key employees, retaining such employees may be more difficult in the future. Anti-takeover Effect; Shareholders' Rights Plan; Delaware Law and Certain Charter and Bylaw Provisions; Preferred Stock The Company's Board of Directors has the authority to issue up to five million shares of Preferred Stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of Class A Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any shares of Preferred Stock that may be issued in the future. The issuance of Preferred Stock could have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of the Company, thereby delaying, deferring or preventing a change of control of the Company. In addition, certain provisions in the Company's Certificate of Incorporation and Bylaws containing restrictions on calling special meetings of stockholders and restrictions on amendments to the Bylaws may discourage or make more difficult any attempt by a person or group of persons to obtain control of the Company. The Company is subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. In general, the statute prohibits a publicly held Delaware corporation from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the 28 30 transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. For purposes of Section 203, a "business combination" includes a merger, asset sale or other transaction resulting in a financial benefit to the interested stockholder, and an "interested stockholder" is a person who, together with affiliates and associates, owns (or within three years prior, did own) 15% or more of a corporation's voting stock. In addition, options issued pursuant to the Company's stock option plans generally will vest immediately upon a change in control as described in the option grant letters. In April 1998, the Company's Board of Directors adopted a Rights Agreement (the "Rights Agreement"). Under the Rights Agreement, a dividend of one right ("Right") to purchase a fraction of a share of newly created series of preferred stock, was declared for each share of Class A Common Stock and each Class B Warrant outstanding at the close of business on April 24, 1998. The Rights, which expire on April 24, 2008, may be exercised only if certain conditions are met, such as the acquisition (or the announcement of a tender offer the consummation of which would result in the acquisition) of a beneficial ownership of 15 percent or more of the Class A Common Stock by a person or affiliated group. The Rights, if exercised, would cause substantial dilution to a person or group of persons that attempts to acquire the Company without the prior approval of the Board of Directors. The Board of Directors may cause the Company to redeem the Rights for nominal consideration. The Rights Agreement may discourage or make more difficult any attempt by a person or group of persons to obtain control of the Company. Volatility of Stock Price The market price of the Company's Class A Common Stock has been, and may continue to be, extremely volatile. In addition, prices of stocks of most companies in the video store industry (including Video Update) have been subject to a generally declining trend over the past several years. Factors such as new product announcements by the Company or its respective competitors, new digital technologies such as near-video-on-demand and video-on-demand, quarterly fluctuations in operating results, challenges associated with integration of businesses, and general conditions in the data networking market may have a significant impact on the market price of Video Update Class A Common Stock. These conditions, as well as factors which generally affect the market for stocks of retail companies, could cause the price of Video Update Class A Common Stock to fluctuate substantially. On October 19, 1999, the Company was notified by the Nasdaq National Market that the Company's Class A Common Stock, $.01 par value per share, was delisted due to the Company's failure to meet certain maintenance criteria, including minimum bid price requirements. The Company's Class A Common Stock is now quoted on the Nasdaq OTC Bulletin Board. Inflation To date, inflation has not had a material effect on the Company's business. The Company anticipates that its business will be affected by general economic trends. Although the Company has not operated during a period of high inflation, it believes that it would generally be able to pass increased costs resulting from inflation on to customers. New Accounting Standards In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities", which provides guidance on accounting for derivative and hedge transactions. The statement is effective for the Company in fiscal year 2002. The Company does not anticipate that the adoption of this pronouncement will have a material impact on its reported financial position or operating results. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition". The statement is effective for the Company in fiscal year 2001. The Company does 29 31 not anticipate that the adoption of the guidelines in this pronouncement will have a material impact on reported operating results. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency. The Company is party to financial instruments to manage and reduce the impact of certain of these risks. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes (see Note 18 of the Notes to Consolidated Financial Statements). The Company is exposed to cash flow risk arising out of changes in interest rates with respect to its debt obligations. The Company currently has approximately $138,440,000 of debt outstanding at April 30, 2000, substantially all of which is variable rate debt and is currently due. The market risk inherent in the Company's debt instruments represents the increased interest costs arising from adverse changes in interest rates (primarily LIBOR rates). The weighted average interest rate on outstanding debt at April 30, 2000 is 11%. The Company has entered into an interest rate swap agreement with a major financial institution to exchange variable rate interest payment obligations for fixed rate obligations without the exchange of the underlying principal amounts. At April 30, 2000 the notional amount of the outstanding interest rate swap was $4,920,0000 and the fair market value was $49,000. The outstanding interest rate swap has a pay rate of 5.94% and a receive rate based on the three month LIBOR and expire in fiscal 2001. Due to the short-term nature of the interest rate swap agreement and the Company's outstanding borrowings, interest rate risk is not considered to be a material risk to the Company. Assuming interest rates increased 10%, the Company's impact on earnings would be approximately $1,400,000, net of tax. The Company operates internationally in Canada, and thus is subject to potentially adverse movements in foreign currency rate changes. The Company does not enter into foreign exchange forward contracts to reduce its exposure to foreign currency rate changes on intercompany foreign currency denominated balance sheet positions. Historically, the effect of movements in the exchange rates have been immaterial to the consolidated operating results of the Company. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements are filed as part of this report.

ITEM 9. CHANGES IN REGISTRANT'S CERTIFYING ACCOUNTANT Not applicable. 30 32 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. BACKGROUND The Directors and executive officers of the Company, their positions held in the Company, and their ages are as follows:

Each director is elected for a period of one year at the Company's annual meeting of stockholders and serves until his successor is duly elected by the stockholders. The following is a brief summary of the background of each director, executive officer, and significant employee of the Company: Daniel A. Potter, Chairman and Chief Executive Officer. Mr. Potter co-founded the Company in 1983 and has served as the Company's Chairman and Chief Executive Officer since its inception. Mr. Potter holds a B.A. degree from the University of Minnesota and a J.D. degree from William Mitchell College of Law. Mr. Potter is a member of the nominating committee. John M. Bedard, President and Director. Mr. Bedard co-founded the Company in 1983 with Mr. Potter and has served as the Company's President and as a Director since its inception. Mr. Bedard, together with Mr. Potter, devised and implemented the Company's real estate development program and operations. Mr. Bedard is the brother of Richard Bedard, an Executive Vice President of the Company. Daniel C. Howard, Chief Operations Officer and Director. Mr. Howard has served as the Company's Chief Operations Officer since 1990, has coordinated the Company's operations since 1983, and has served as a Director since August 1994. He holds a B.S. degree from the University of Minnesota School of Management. Mr. Howard is a member of the executive compensation committee. Michael P. Gebauer, Chief Financial Officer. Mr. Gebauer has served as the Chief Financial Officer since joining the Company in 1999. From 1998 to 1999, he was a Vice President of Merchant Banking for Banque Paribas, a multi-national investment bank. From 1989 to 1998, Mr. Gebauer was a Vice President for Fuji Bank, Ltd., where he served in various capacities including marketing, structuring, product development, analysis, and syndications. He holds a B.B.A. from the University of Massachusetts. Richard Bedard, Executive Vice President. Mr. Bedard has served as an Executive Vice President of the Company since September 1995. From 1986 to 1995, he served as the Company's Vice President of Franchise Development. Mr. Bedard is the brother of John M. Bedard, the Company's President and a Director. Michael G. Schifsky, Senior Vice President. Mr. Schifsky has served as Senior Vice President since 1998. Mr. Schifsky served as Vice President of Store Development since rejoining the Company in 1990 until 1998. 31 33 Mr. Schifsky served as Director of Franchise Sales from 1986 to 1988 and before that was a District Manager of the Company from 1984 to 1985. Paul M. Kelnberger, Director. Mr. Kelnberger has served as a Director since August 1994. Mr. Kelnberger has been a member of Johnson, West & Co., PLC ("Johnson, West & Co."), a certified public accounting firm with its principal offices in St. Paul, Minnesota, since 1975. In addition, since November 1995 Mr. Kelnberger has served as a Director of Leuthold Funds, a publicly held mutual fund. Johnson, West & Co. performed auditing services for the Company prior to the fiscal year ended April 30, 1993. Since that time, Johnson, West & Co. has provided and continues to provide to the Company accounting services in connection with the Company's acquisitions and sales and use tax planning. Mr. Kelnberger is a certified public accountant and holds a Certificate of Accounting from the Academy of Accountancy in Minneapolis, Minnesota. He chairs the Board's audit committee and is a member of the executive compensation committee. See "Certain Relationships and Related Transactions." Bernard R. Patriacca, Director. Mr. Patriacca has served as a Director since April 1997. Since November 1997, he has served as the Vice President and Controller of Summit Technology, Inc., a publicly held developer, manufacturer and seller of ophthalmic laser systems and related products designed to correct vision disorders. Since 1994, he also has served as Vice President of Errands Etc., Inc., a privately held homeowner's personal service company. From 1973 to 1991, Mr. Patriacca served in various capacities at Dunkin' Donuts Incorporated, including Chief Financial Officer and Director. From 1991 to 1994, Mr. Patriacca held senior financial management positions at several privately held consumer services companies. Mr. Patriacca is a certified public accountant and holds Bachelor's and Master's degrees in finance and accounting from Northeastern University. Mr. Patriacca is a member of the audit committee and executive compensation committee. Theodore J. Coburn, Director. Theodore J. Coburn has been a director of the Company since March 1998. Mr. Coburn served as a director of Moovies, Inc. from June 1995 to March 1998. Since 1991, Mr. Coburn has been a partner and a director of Brown, Coburn & Co., an investment banking firm. From 1986 until 1991, he was a Managing Director of Global Equity Transactions Group and a member of the Board of Directors of Prudential Securities. From 1983 to 1986 Mr. Coburn served as Managing Director of Merrill Lynch Capital Markets. Mr. Coburn serves as a director of Measurement Specialties, Inc., a publicly held company. Mr. Coburn also serves as a director of the Nicholas-Applegate Fund, Inc. He also serves as a director of the Emerging Germany Fund. Mr. Coburn received his B.S. from the University of Virginia in 1975 and an M.B.A. from Columbia University Graduate School of Business in 1978 and holds Master's degrees from Harvard University Graduate School of Education and its Divinity School. Mr. Coburn is a member of the nominating committee. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) ("Section 16(a)") of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires executive officers and directors, and persons who beneficially own more than ten percent (10%) of the Company's Common Stock, to file initial reports of ownership on Form 3 and reports of changes in ownership on Form 4 with the Securities and Exchange Commission (the "SEC") and any national securities exchange on which the Company's securities are registered. Executive officers, directors and greater than ten percent (10%) beneficial owners are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on a review of the copies of such forms furnished to the Company and written representations from the executive officers and directors that no other reports were required, the Company believes that during fiscal 2000, its executive officers, directors and greater than ten percent (10%) beneficial owners complied with all applicable Section 16(a) filing requirements except that each of the Company's directors and named executive officers filed untimely reports on Form 5. 32 34 ITEM 11. EXECUTIVE COMPENSATION. SUMMARY COMPENSATION TABLE Set forth below is a Summary Compensation Table concerning the compensation of the named executive officers for the last three completed fiscal years. SUMMARY COMPENSATION TABLE

------------ (1) Amounts shown indicate cash compensation earned and received by executive officers; no amounts were earned but deferred at the election of those officers. Executive officers participate in the Company's group health insurance plan. (2) Amounts shown in 1998 reflect the bonus amounts accrued by the Company in conjunction with Messrs. Potter and Bedard's restated employment agreements. Amounts totaling $524,945 and $291,635 were paid to Messrs. Potter and Bedard respectively in fiscal 1998 as reimbursement of previous payments of principal and interest on their recourse notes to the Company and accompanying tax liabilities. In 1999, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. In 2000, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. See Note 10 of Notes to Consolidated Financial Statements. (3) Amounts for fiscal 1998 reflect the release of 635,755, 513,698 and 20,547 shares of Class A Common Stock from escrow to Messrs. Potter, Bedard and Howard respectively, at the market price on the date of release. (4) Amounts shown reflect grants of options to purchase Class A Common Stock pursuant to the Company's Stock Option Plans. During fiscal years 1998 through 2000, the Company made no awards of restricted stock and did not have a long-term incentive plan. (5) Amounts shown reflect payment for automobile, insurance and other expenses. (6) Mr. Gebauer was appointed Chief Financial Officer of the Company on October 18, 1999. Mr. Gebauer's base salary was set at $248,000. The amount of $134,333 represents salary earned through April 30, 2000. 33 35 (7) Mr. Lauwagie was appointed Chief Financial Officer of the Company on November 16, 1998. Mr. Lauwagie's base salary was set at $175,000. The amount of $86,780 represents salary earned through October 31, 1999. Mr. Lauwagie vacated the position of Chief Financial Officer of the Company in October of 1999. OPTION GRANTS IN FISCAL YEAR 2000 Set forth below is an Option Grants table concerning individual grants of stock options made during the last completed fiscal year to each of the named executive officers. OPTION GRANTS IN FISCAL YEAR 2000

------------ (1) The dollar gains under these columns result from calculations assuming hypothetical growth rates as set by the Commission and are not intended to forecast future price appreciation of the Class A Common Stock. (2) In fiscal 2000 options to purchase a total of 1,788,000 shares of the Company's Class A Common Stock were granted to employees of the Company, including executive officers. (3) These options are subject to earlier termination upon certain events related to termination of employment. (4) Mr. Gebauer was appointed Chief Financial Officer of the Company on October 18, 1999. (5) Mr. Lauwagie vacated the position of Chief Financial Officer of the Company in October of 1999. 34 36 AGGREGATED OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUE TABLE Set forth below is a table concerning each exercise of stock options during the last completed fiscal year by each of the named executive officers and the fiscal year-end value of unexercised options. AGGREGATED OPTION EXERCISES FOR YEAR ENDED APRIL 30, 2000 AND FY-END OPTION VALUES

------------ (1) In-the-money options are those options for which the fair market value of the underlying Common Stock is greater than the exercise price of the option. On April 28, 2000, the fair market value of the Company's Class A Common Stock underlying the options (as determined by the last sale price quoted on the Nasdaq OTCBB) was $0.2656. (2) Mr. Gebauer was appointed Chief Financial Officer of the Company on October 18, 1999. (3) Mr. Lauwagie vacated the position of Chief Financial Officer of the Company in October of 1999. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Compensation decisions for the Company's Chief Executive Officer and President are made by the Executive Compensation Committee, comprised of Messrs. Kelnberger, Howard and Patriacca. None of the executive officers of the Company have served on the Board of Directors or compensation committee of any other entity that has had any of such entity's executive officers serve either on the Company's Board of Directors or compensation committee. During fiscal 2000, the Company paid approximately $370,000 to Johnson, West & Co. for accounting services in connection with the Company's acquisitions and for tax return preparation services. Mr. Kelnberger is a member of Johnson, West & Co. EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT, OFFICER LOANS AND CHANGE IN CONTROL ARRANGEMENTS In April 1998, the Company entered into restated employment agreements (the "Employment Agreements") with Daniel A. Potter, its Chairman and Chief Executive Officer and John Bedard, its President, each of whom also is a director through April 2001. Mr. Potter and Mr. Bedard are to receive salaries of $360,000 and $240,000, respectively. Such compensation may be increased and bonuses may be awarded at the discretion of the Board of Directors of the Company. Each of Messrs. Potter and Bedard have agreed to devote their full time and best efforts to fulfill their duties and responsibilities to the Company. Each of them will be entitled to participate in employee benefit plans. During fiscal 1996, each of Messrs. Potter and Bedard issued notes to the Company (the "Recourse Notes") in connection with stock option exercises. In fiscal 1998, 1999, and 2000, Mr. Potter's Recourse Note accrued interest of $151,694, $147,097, and $69,273, respectively, and Mr. Bedard's Recourse Note accrued interest of $84,275, $81,721, and $79,593, respectively. At April 30, 1999 and 2000, Mr. Potter's Recourse 35 37 Note balance was approximately $2,227,244 and $0, respectively, and Mr. Bedard's Recourse Note balance was approximately $1,237,358 and $1,212,000, respectively. In April of 1998, the Company's Board of Directors had approved the accrual of bonuses to satisfy the Recourse Notes and interest thereon, as well as the anticipated payroll tax liability to the executives as follows:

In fiscal 2000, the Company satisfied all of its payroll tax and other obligations to Mr. Potter's Recourse Note and expects to complete its similar obligations with respect to Mr. Bedard's Recourse Note by December 31, 2000. Amounts shown in 1998 reflect the bonus amounts accrued by the Company in conjunction with Messrs. Potter and Bedard's restated employment agreements. In 1999, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. In 2000, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. The resultant accrual for compensation expense has been recorded as an offset to the officers' loan obligations, with the balance of the accrual included in accrued compensation in the balance sheet as of April 30, 1999 and 2000. Under the Employment Agreements, the Company has a right to terminate each of the agreements for "cause" as defined in the agreements or as a result of the employee's disability. Except in the case of termination for cause, upon early termination of the agreements of the Company, each of Messrs. Potter and Bedard shall be entitled to receive their salary plus fringe benefits for 36 months from the date of termination. In addition, the Employment Agreements provide that any amount owed by Messrs. Potter or Bedard to the Company will be forgiven (with any necessary payment to cover any resulting tax liability incurred by such executive) if such executive leaves the Company while his Recourse Note remains outstanding. In the event of a change of control of the Company, Messrs. Potter and Bedard have the option to terminate their employment subject to the provisions of the employment agreements and to receive severance and fringe benefits for 36 months subject to the provisions of their agreements. A "change in control" includes an acquisition of 15% of the voting power of the securities of the Company by any person, certain changes in the composition of the Board of Directors, and an approval by the stockholders of the Company of a merger, consolidation, reorganization, liquidation, dissolution or sale of all or substantially all of the assets of the Company. Each of Messrs. Potter and Bedard has agreed not to disclose any confidential information of the Company during the term of his employment or to compete with the Company during the term of his employment or for a period of three years following termination of his employment except in accordance with the employment agreement. In January 1998, the Company entered into an employment agreement with Daniel C. Howard, its Chief Operating Officer and a director and stockholder. As compensation, Mr. Howard is to receive an annual base salary of $128,400, plus bonuses and stock options as determined by the Board of Directors. The agreement is for an initial term of two years, and is automatically renewed for successive one-year terms, unless terminated by the Company or Mr. Howard. Upon termination in accordance with the agreement, Mr. Howard is entitled to receive severance pay of at least 12 months' base salary and at most 24 months' base salary, less certain amounts provided in the agreement. In the event Mr. Howard's employment is terminated after a change in control, Mr. Howard is entitled to receive an amount equal to two times his average total annual compensation during the two years preceding the termination. A "change in control" occurs when any person or entity 36 38 acquires at least 51% of the voting power of the securities of the Company, the stockholders of the Company approve a plan of liquidation, or the Company engages in a merger, sale of assets or other business combination that results in the security holders of the Company holding less than a majority of the combined voting power after the transaction. Mr. Howard has agreed not to disclose any confidential information of the Company during his employment and thereafter, and not to compete with the Company during his employment and for two years thereafter, including soliciting customers and employees of the Company. In April 1999, the Company entered into employment agreements with Michael G. Schifsky, Senior Vice President, and Richard Bedard, Executive Vice President. As compensation, Mr. Schifsky and Mr. Bedard are to receive annual base salaries of $119,700 and $98,600, respectively, plus bonuses and stock options as determined by the Board of Directors. The agreements are substantially similar to the employment agreement of Mr. Howard, as described above. In October 1999, the Company entered into an employment agreement with Michael P. Gebauer, its Chief Financial Officer. As compensation, Mr. Gebauer is to receive an annual base salary of $248,000, plus bonuses and stock options as determined by the Board of Directors. The agreement is substantially similar to the employment agreement of Mr. Howard, as described above. Mr. Potter's brother-in-law Robert Yager, formerly a director of the Company, is employed as a Company vice president of franchise development. Mr. John Bedard is the brother of Richard Bedard and Glenn Bedard, Company executive vice presidents and Paul Bedard, a Company vice president. Each of the non-executive employees receives an annual compensation ranging from $69,800 to $98,700. COMPENSATION OF DIRECTORS Members of the Board of Directors who are not employees of the Company receive $3,000 for each meeting of the Board of Directors and for each committee meeting of the Board of Directors attended by such director, in addition to reimbursement of reasonable expenses incurred in attending such meetings, and receive $10,000 for each quarter of service as a director. Additionally, non-employee directors receive options under the Formula Plan, as follows: (i) all non-employee directors (currently Messrs. Patriacca, Kelnberger, and Coburn) each receive options annually to purchase 1,500 shares of Class A Common Stock, which vest in two equal annual installments on the first two anniversaries of the date of grant and which are exercisable at a price equal to the fair market value of the Class A Common Stock on the date of grant, provided that each of them is a director on the date of the grant and each of them has attended at least 75% of the meetings he or she was eligible to attend; and, (ii) any non-employee directors appointed in the future will receive on the date of such appointment, options to purchase 3,000 shares of Class A Common Stock, which will vest in three equal annual installments on the first three anniversaries of the date of grant and which will be exercisable at a price equal to the fair market value of the Class A Common Stock on the date of grant. 37 39 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of July 28, 2000 the number and approximate percentage of shares of Class A Common Stock beneficially owned by: (i) all persons known by the Company to be the beneficial owner of more than five percent (5%) of the outstanding Class A Common Stock; (ii) each "named executive officer" (as defined in Item 402 to Regulation S-K under the Securities Act of 1933, as amended) and director; and (iii) all directors and executive officers of the Company individually and as a group.

------------ * Less than one percent (1%) of the outstanding shares of Class A Common Stock. (1) The address of Messrs. Potter, John Bedard, Howard, Gebauer, Richard Bedard, Schifsky, Kelnberger, Coburn and Patriacca is c/o Video Update, Inc. 3100 World Trade Center, 30 East Seventh Street, St. Paul, Minnesota 55101. (2) Does not include 25,000 shares held by Dale E. Lauwagie who vacated the position of Chief Financial Officer of the Company in October of 1999. (3) For the purposes of this table, shares of Common Stock which, to the Company's knowledge, an individual or group has a right to acquire within sixty (60) days upon the exercise of options or warrants, are deemed outstanding for the purposes of computing the number and percentage of shares beneficially owned by such individual or group. Such shares are not deemed to be outstanding for the purpose of computing the percentage of shares beneficially owned by any other individual or group shown in the table. This table does not include an approximate aggregate amount of 32,580 shares of Common Stock held by the executive officers of the Company through the Company's 401(k) plan. (4) Includes an aggregate of 480,000 shares of Common Stock issuable on exercise of various stock options. Includes an aggregate of 36,947 shares of Common Stock held in custodial accounts for Mr. Potter's children. Excludes an aggregate of 360,000 shares of Common Stock issuable upon the exercise of various stock options that have not yet vested. Does not include 26,250 shares of Common Stock owned by Mr. Potter's father, in which Mr. Potter disclaims beneficial ownership. (5) Includes an aggregate of 265,000 shares of Common Stock issuable on exercise of various stock options. Includes 39,515 shares of Common Stock held by Mr. Bedard's mother, but subject to a voting trust of 38 40 which Mr. Bedard is a trustee. Excludes an aggregate of 200,000 shares of Common Stock issuable upon the exercise of stock options that have not yet vested. (6) Includes an aggregate of 181,468 shares of Common Stock issuable upon the exercise of various stock options. Excludes an aggregate of 182,032 shares of Common Stock issuable upon the exercise of various stock options that have not yet vested. (7) Includes an aggregate of 90,000 shares of Common Stock issuable upon the exercise of stock options that have vested. Excludes an aggregate of 180,000 shares of Common Stock issuable upon the exercise of stock options that have not yet vested. (8) Includes an aggregate of 118,000 shares of Common Stock issuable upon the exercise of various stock options that have vested. Excludes an aggregate of 41,000 shares of Common Stock issuable upon the exercise of stock options that have not vested. (9) Includes an aggregate of 129,500 shares of Common Stock issuable upon the exercise of various stock options that have vested. Excludes an aggregate of 38,500 shares of Common Stock issuable upon the exercise of stock options that have not vested. (10) Includes an aggregate of 40,083 shares of Common Stock issuable upon the exercise of various stock options that have vested. Excludes an aggregate of 67,417 shares of Common Stock issuable upon the exercise of stock options that have not vested. (11) Includes an aggregate of 39,833 shares of Common Stock issuable upon the exercise of various stock options that have vested. Excludes an aggregate of 68,417 shares of Common Stock issuable upon the exercise of stock options that have not vested. (12) Includes an aggregate of 38,583 shares of Common Stock issuable upon the exercise of various stock options that have vested. Excludes an aggregate of 67,417 shares of Common Stock issuable upon the exercise of stock options that have not vested. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Craig Belisle, the brother-in-law of John Bedard, the Company's President and a Director, owned a majority interest in two franchise stores as of April 30, 2000. The amount of service fees earned from these franchisees was approximately $92,710 for the year ended April 30, 2000. The amount due from Mr. Belisle, as a franchisee, at April 30, 2000 approximated $23,930. During the years ended April 30, 1998, 1999 and 2000, the Company paid approximately $561,000, $270,000, and $370,000 respectively, to Johnson, West & Co., PLC ("Johnson, West & Co.") for accounting and tax services. Paul Kelnberger, a Director of the Company, is a member of Johnson, West & Co. Constance Koppenhaver, the daughter of Mr. Kelnberger, owned an interest in one franchise store as of April 30, 1999. As of July 1, 1999, the Company acquired the franchise store and assumed ownership for a purchase price of $250,000. Robert Yager, formerly a director of the Company, is employed as a Company vice president of franchise development and is the brother-in-law of Mr. Potter. Richard Bedard and Glenn Bedard, Company executive vice presidents, and Paul Bedard, a Company vice president, are each the brother of Mr. John Bedard. In fiscal 2000, each of the non-executive employees received an annual compensation ranging from $69,800 to $98,700. Brown, Coburn & Co. ("Brown, Coburn"), a privately held investment banking firm of which Theodore J. Coburn, a director of the Company, is a principal, received $20,754 for consulting services provided to the Company for the fiscal year ended April 30, 2000. The Company intends to use Brown, Coburn's services during fiscal 2001. The Company believes that the above arrangements were on terms at least as favorable as could be obtained from unaffiliated parties. 39 41 During fiscal 1996, each of Messrs. Potter and Bedard issued notes (at an interest rate of 8% per annum) to the Company (the "Recourse Notes") in connection with stock option exercises. In fiscal 1998, 1999, and 2000, Mr. Potter's Recourse Note accrued interest of $151,694, $147,097, and $69,273, respectively, and Mr. Bedard's Recourse Note accrued interest of $84,275, $81,721, and $79,593, respectively. At April 30, 1999 and 2000, Mr. Potter's Recourse Note balance was approximately $2,227,244 and $0, respectively, and Mr. Bedard's Recourse Note balance was approximately $1,237,358 and $1,212,000, respectively. The Company's Board of Directors has approved the accrual of bonuses to satisfy the Recourse Notes and interest thereon. During fiscal 2000, the Company paid all of its previously accrued payroll tax and other obligations related to Mr. Potter's Recourse Note and expects to complete its similar obligations with respect to Mr. Bedard's Recourse Note by December 31, 2000. 40 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements All financial statements of the Company as set forth under Item 8 of this report. 2. Financial Statement Schedules No financial statement schedules have been included since they are either not applicable or the information is included elsewhere herein. 3. Exhibits The following exhibits are filed herewith:

41 43

42 44

43 45

44 46

45 47

46 48

------------ + Exhibits for which Company has sought confidential treatment for certain portions. The confidential material in Exhibits 10.39, 10.40, 10.41, 10.42 and 10.43 has been redacted and separately filed with the Securities and Exchange Commission. (b) Reports on Form 8-K The Company did not file any reports on Form 8-K during the last quarter of the period covered by this report. 47 49 SIGNATURES IN ACCORDANCE WITH SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. VIDEO UPDATE, INC. Date: September 11, 2000 By: /s/ DANIEL A. POTTER ------------------------------------ DANIEL A. POTTER CHAIRMAN AND CHIEF EXECUTIVE OFFICER In accordance with the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.

48 50 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

F-1 51 REPORT OF INDEPENDENT AUDITORS Board of Directors Video Update, Inc. We have audited the accompanying consolidated balance sheets of Video Update, Inc. and subsidiaries (the "Company") as of April 30, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for the years ended April 30, 2000 and 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Video Update, Inc. and subsidiaries at April 30, 2000 and 1999, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 2 to the consolidated financial statements, in 1999 the Company changed its method of accounting for the amortization of its video and game rental inventory. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's recurring losses from operations, stockholders' capital deficiency, and failure to comply with certain covenants and repayment provisions of its Senior Facility raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ DELOITTE & TOUCHE LLP Minneapolis, Minnesota September 1, 2000 F-2 52 REPORT OF INDEPENDENT AUDITORS Board of Directors Video Update, Inc. We have audited the accompanying consolidated statements of operations, stockholders' equity and cash flows of Video Update, Inc. for the year ended April 30, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion. In our opinion, these financial statements present fairly, in all material respects, the consolidated results of operations and cash flows of Video Update, Inc. for the year ended April 30, 1998, in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG LLP Minneapolis, Minnesota August 13, 1998 F-3 53 VIDEO UPDATE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)

See accompanying notes. F-4 54 VIDEO UPDATE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

See accompanying notes. F-5 55 VIDEO UPDATE, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS, EXCEPT SHARES)

See accompanying notes. F-6 56 VIDEO UPDATE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)

See accompanying notes. F-7 57 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED APRIL 30, 1998, 1999 AND 2000 1. COMPANY BACKGROUND AND SIGNIFICANT ACCOUNTING POLICIES Management's Plan to Continue as a Going Concern The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the ordinary course of business. As shown in the accompanying financial statements, the Company has incurred losses from operations of $14,480,000, $110,371,000, and $36,149,000 for the years ended April 30, 1998, 1999, and 2000, respectively, and as of April 30, 1999 and 2000 the Company had stockholders' capital deficiency of $3,095,000 and $35,798,000, respectively. In addition, as discussed in Note 9 of Notes to the Consolidated Financial Statements, as of April 30, 2000, the Company is not in compliance with certain of the financial covenants of its Senior Facility and on August 15, 2000, the Company defaulted on the payment of principal and interest due under the terms of its Senior Facility. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. The Company has no available borrowings under its Senior Facility or any other similar facility. The lenders under the Senior Facility may, but are not obliged to, take immediate legal action against the Company, including but not limited to, acceleration of payment of all borrowed funds and such other remedies as may be available under the loan documents or common or statutory law. The Company also has overdue liabilities and is engaged in litigation with several parties. Under these circumstances, a number of the Company's contracts and supply arrangements, including but not limited to its revenue sharing contracts, may be subject to termination. The Company is currently in discussions with its lenders regarding the default under its Senior Facility. In addition, it is evaluating various alternatives to raise cash, including the possible sale of assets. To date, the Company has been able to obtain product either directly from movie studios or independent distributors and management believes this will continue. The Company will continue to focus on reducing the aged accounts payable with payments, the extension of terms, and negotiated settlements. The Company has closed numerous stores that had an adverse impact on cash flows. The Company has restructured its revenue sharing arrangements to eliminate mandatory purchases of tapes that management does not believe will generate adequate rental volume. The Company has and continues to focus on cost reductions. The Company is uncertain whether cash from operations, trade credits, equipment leases, and available revenue sharing arrangements will be sufficient to fund future inventory purchases and other working capital needs for the next twelve months. If the Company is unable to obtain additional financing or maintain its relationships with its vendors and trade creditors, the Company may be required to reduce its overall expenditures and the Company's ability to maintain or expand its current level of operations will be materially and adversely affected. Given the foregoing, no assurances can be given that the Company will be able to maintain its current level of operations, or that its financial condition and prospects will not be materially and adversely effected over the next twelve months. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Nature of Business Video Update, Inc. and subsidiaries ("Video Update" or the "Company") own and operate retail video stores and sell and support retail video franchises. Company-owned stores are located in the United States and Canada with franchises located exclusively in the United States. The Company operates in one reportable operating segment. F-8 58 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Consolidation The accompanying financial statements present the consolidated financial position, results of operations and cash flows of the Company. All inter-company accounts and transactions have been eliminated. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The most significant estimates and assumptions relate to the amortization methods and useful lives of video and game rental inventory and goodwill. These estimates and assumptions could change and actual results could differ from these estimates. Basis of Presentation The Company utilizes an unclassified balance sheet presentation. This format was adopted on the basis that the video and game rental inventory represents assets used by the Company to generate current operating income, and management believes that to classify all of these costs as non-current would be misleading to the readers of the financial statements because it would not indicate the level of assets expected to be converted into cash in the next year as a result of the rentals of the videos and games. Service Fees The Company receives continuing monthly royalty and other fee revenue from its franchisees based on a percentage of the franchisees' gross monthly revenue. Royalty fee and other fee revenues will continue for the initial terms of the franchise agreements, after which the revenues will be based upon renewed franchise agreements. Cash Equivalents The Company considers all highly liquid investments with a remaining maturity of three months or less when purchased to be cash equivalents. Merchandise Inventory Merchandise inventory is stated at the lower of cost (first in, first out) or market. Inventory consists of videocassettes, DVD's, and games held for sale, supplies and concessions. Video and Game Rental Inventory Video rental inventory is stated at cost, and is amortized over the estimated economic life as follows:

Game rental inventory is amortized on a straight-line basis to $10.00 over 12 months then straight-line over six months to a salvage value of $4.00 per game. F-9 59 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Property and Equipment Furniture and equipment are recorded at cost and depreciated using the straight-line method over the estimated economic life of the asset of five to ten years. Leasehold improvements are recorded at cost and depreciated using the straight-line method over the lesser of the estimated economic life or the lease term. Goodwill Goodwill, consisting principally of excess cost over net assets from the acquisitions of businesses, is net of accumulated amortization of approximately $9,592,000 and $14,053,000 at April 30, 1999 and 2000, respectively and is being amortized on a straight-line basis over 20 years. Income Taxes The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes." Deferred income taxes are recorded to reflect the tax consequences of differences between the tax and financial reporting bases of assets and liabilities. A valuation allowance is established for deferred tax assets to the extent the realization of such benefits is not deemed more likely then not. Stock-based Compensation The Company has adopted the disclosure only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," for its employee based compensation plans. The Company has elected to recognize compensation expense for its stock based compensation plans in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, no compensation expense is recognized for stock options with exercise prices equal to, or in excess of, the market value of the underlying shares of stock at the date of grant. Impairment of Long-Lived Assets SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" prescribes the accounting treatment for long-lived assets, identifiable intangibles and goodwill related to those assets when there are indications that the carrying values of those assets may not be recoverable. In performing such review for recoverability, the Company compares the expected future cash flows to the carrying value of long-lived assets and identifiable intangibles. If the anticipated undiscounted future cash flows are less than the carrying amount of such assets (see Notes 4, 5, and 8 of the Notes to Consolidated Financial Statements), the Company's carrying amount will be reduced to its estimated fair value for assets held for use and reduced to its estimated fair value less cost to sell for assets held for sale. Fair Value of Financial Instruments At April 30, 1999 and 2000, the carrying value of financial instruments such as cash and cash equivalents, accounts receivable, accounts payable and notes payable approximated their fair values (see Note 18 of the Notes to Consolidated Financial Statements). Revenue Recognition Revenue on videos and games is recognized at the time of rental or sale. F-10 60 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Loss Per Share For the years ended April 30, 1998, 1999, and 2000, the Company had employee stock options to purchase Class A Common Shares at exercise prices from $0.25 to $10.00 of 2,202,702, 1,643,000, and 3,165,000, respectively. The effects of these options are anti-dilutive in all periods presented. As such, the amounts are not included in the calculation of diluted loss per share. Reclassification Certain reclassifications have been made to the prior year financial statements to conform with the 2000 presentation. New Accounting Standards In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities", which provides guidance on accounting for derivative and hedge transactions. The statement is effective for the Company in fiscal year 2002. The Company does not anticipate that the adoption of this pronouncement will have a material impact on its reported financial position or operating results. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition". The statement is effective for the Company in fiscal year 2001. The Company does not anticipate that the adoption of the guidelines in this pronouncement will have a material impact on reported operating results. 2. CHANGE IN AMORTIZATION METHOD FOR VIDEO AND GAME RENTAL INVENTORY Effective February 1, 1999, the Company changed the amortization policy for videos (see Note 1 of the Notes to Consolidated Financial Statements). The adoption of the new method of amortization has been accounted for as a change in accounting estimate effected by a change in accounting principle. Prior to February 1, 1999, base stock videos were amortized over 36 months on a straight-line basis to a salvage value of $6.00 per video; the fourth through ninth copies of each title per store were amortized straight-line over six months to a book value of $6.00 and then fully amortized straight-line over 30 months; the tenth and any succeeding copies of each title per store were amortized straight-line over six months to a book value of $6.00 and then fully amortized straight-line over three months. Video games were fully amortized straight-line over a period of 36 months. The new method accelerates the rate of amortization and has been adopted as a result of revenue sharing agreements with studios, which have increased the copy-depth, which is satisfying consumer demand over a shorter period of time. The Company believes accelerating expense recognition during the first three months more closely matches the new business model of higher revenue generated following a title's release. Under the new accounting method, the Company expenses revenue sharing payments as revenues are earned pursuant to contractual arrangements. The new method of accounting has been applied to rental inventory held as of February 1, 1999. The Company recorded a pre-tax charge of approximately $50,629,000 to operating expenses in the fourth quarter of fiscal 1999. The effect of the change had the impact of decreasing inventory and increasing amortization expense through a one-time charge. 3. MOOVIES, INC. ACQUISITION In March 1998 the Company completed the acquisition of Moovies, Inc. ("Moovies") in a tax-free reorganization, whereby Moovies stockholders received .75 shares of Video Update Class A Common Stock in F-11 61 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) exchange for each share of Moovies common stock. Video Update issued approximately 9.3 million shares in this transaction. The acquisition was accounted for under the purchase method of accounting and the excess of the cost over the estimated fair value of the assets acquired, estimated to be approximately $46,291,000, is being amortized over 20 years. In March 1998, in conjunction with the Moovies transaction, the stockholders approved the termination and cancellation of the Escrow Agreement by and among American Stock Transfer & Trust Company, Video Update and certain stockholders of Video Update. As a result: (i) 10% or 130,000 of the 1,300,000 shares of Class B Common Stock held in escrow were forfeited; (ii) the remaining 1,170,000 shares of common stock were released from escrow, resulting in a one-time compensation expense charge of approximately $3,546,000 which the Company recognized as selling, general and administrative expense in the fourth quarter of fiscal 1998; and, (iii) all 1,870,000 shares of Class B Common Stock were converted into Class A Common Stock and the preferential voting rights were eliminated. 4. PROVISION FOR STORE CLOSING AND OTHER CHARGES During the fourth quarter of fiscal 1998, the Company began and completed an extensive analysis of its base store performance and adopted a business restructuring plan to close approximately 24 of its stores. This analysis resulted in the Company recording a pretax charge of approximately $2,700,000 for future cash outlays for lease terminations and miscellaneous closing costs. Additionally, the Company recorded a pretax charge of approximately $1,600,000 and $800,000 for the impairment of certain fixed assets and of goodwill, respectively, related to these stores. Activity relating to the closing of these stores is summarized as follows:

As of April 30, 1999, 21 of these stores were closed and two stores were determined to remain open with related accruals reversed. During fiscal 2000, one additional store was determined to remain open and the related accrual was reversed. As of April 30, 2000, 19 stores had definitive lease obligation settlements and two stores had accruals for management's estimate of the cost to settle the outstanding lease obligation. During the fourth quarter of fiscal 1999, the Company began and completed an extensive analysis of each store's performance and adopted a business restructuring plan to close approximately 70 of its stores. This analysis resulted in the Company recording a pretax charge of approximately $9,535,000 for future cash outlays for lease terminations and miscellaneous closing costs and a pretax charge of approximately $6,600,000 for the impairment of furniture, equipment, and leasehold improvements related to these stores. Additionally, the Company reclassified approximately $891,000 of previously accrued rent to the restructure reserve at April 30, 1999. The revenues of stores identified for closure were approximately $11,592,000, $17,742,000 and F-12 62 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) $5,225,000 for the fiscal years ended April 30, 1998, 1999 and 2000, respectively. Activity relating to the closing of these stores is summarized as follows:

As of April 30, 2000, 60 of these stores had been closed and ten stores were determined to remain open with related accruals reversed. Of the stores closed, 55 had definitive lease obligation settlements and five had accruals for management's estimate of the cost to settle the outstanding lease obligation. 5. GOODWILL VALUATION CHARGE During the fourth quarter of fiscal 2000, during the course of the Company's strategic review of its prior acquisitions, the Company recorded a pretax charge of $7,354,000 relating to the impairment of certain intangible assets held for use when it was determined that future undiscounted cash flows associated with these assets were insufficient to recover their carrying value. The impaired assets principally represent the Company's ownership interest in the acquired stores. The assets were written down to fair market value, which was determined on the basis of the present value of future cash flows. 6. ADJUSTMENT OF ESTIMATED LIABILITIES During fiscal year 2000, the Company resolved various disputed vendor accounts, including a legal settlement (see Note 20 of the Notes to Consolidated Financial Statements). The positive resolution of these disputed amounts previously accrued as of April 30, 1999 resulted in a reduction of outstanding liabilities of approximately $5,550,000 of which $1,005,000 reduced fixed assets and $4,545,000 was recorded as a reduction of operating expenses. 7. VIDEO AND GAME RENTAL INVENTORY--NET

Amortization expense for video and game rental inventory, which is included in store operating expenses, was $37,614,000, $63,781,000 and $42,576,000 for the years ended April 30, 1998, 1999 and 2000, respectively. Accumulated amortization at April 30, 1999 and 2000 also includes $50,629,000 related to the valuation charge (see Note 2 of the Notes to Consolidated Financial Statements). F-13 63 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 8. PROPERTY AND EQUIPMENT--NET

Depreciation expense was $6,880,000, $11,370,000, and $10,369,000 for the years ended April 30, 1998, 1999 and 2000, respectively. In fiscal 2000, during the course of the Company's strategic review of its operations, the Company recorded a pretax charge of $4,314,000 relating to the impairment of furniture, equipment, and leasehold improvements to be held and used when it was determined that future undiscounted cash flows associated with these assets were insufficient to recover their carrying value. The assets were written down to fair market value, which was determined on the basis of future discounted cash flows. 9. NOTES PAYABLE Simultaneously with the closing of the Moovies transaction in March 1998 a syndicate lead by Banque Paribas extended a $120 million Senior Facility (the "Senior Facility"), which replaced the previous revolving credit facility. During fiscal year 1999 the Senior Facility was reduced to $115 million. In May 1999, the Company and the bank syndicate amended the terms of the Senior Facility to; (i) increase the overall Senior Facility with a new tranche of C Term loans (Term C Debt) in the aggregate amount of $10.5 million; (ii) revise certain financial covenants; (iii) revise and defer certain principal payments; (iv) increase the overall interest rate by 0.75%; and (v) reflect the issuance of 7,481,250 common stock warrants at $0.08719 per share expiring June 2006. The warrants were recorded as a discount on debt based on the Black Scholes assessed fair market value at the date of issuance. Loan fees paid of approximately $809,000 have been capitalized and are being amortized over the life of the Term C Debt. The notes payable balance consists of the following:

F-14 64 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The weighted-average interest rate on borrowings outstanding was 9.29%, 9.33% and 11.00% at April 30, 1998, 1999 and 2000, respectively. The aggregate maturities of the notes payable at April 30, 2000 are as follows:

The Senior Facility replaced the Company's previous $60 million revolving credit facility. At April 30, 2000, the Senior Facility consists of the following: (i) three term loans totaling $104.1 million; (ii) a $15 million capital expenditure line; and (iii) a $5 million revolving line. The Company borrowed the $95 million under the two term loans in conjunction with the closing of the Moovies merger and the proceeds were used to refinance the current indebtedness of Moovies and Video Update and pay transaction expenses. The capital expenditure line was primarily available to fund the conversion of the Moovies stores and integration costs, the opening of new stores and selected acquisitions. In fiscal year 1999, the Senior Facility was amended to modify the terms of the capital expenditure line to allow usage for working capital needs. The revolving line is available for normal working capital needs. The facility is secured by all of the Company's assets. In connection with the original Senior Facility, the Company also issued five year warrants to Banque Paribas to purchase 1,000,000 shares of the Company's Class A Common Stock at an exercise price of $2.68. F-15 65 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The warrants were valued at $1,730,000 and resulted in an increase in paid in capital and corresponding discount on debt. In fiscal year 1999, the warrants were repriced to a more current market price in conjunction with amendments to the Senior Facility as described above. This discount, as well as related loan fees of approximately $4,337,000, is being amortized over the life of the Senior Facility. The Senior Facility includes negative, affirmative and financial covenants including, but not limited to, minimum free cash flow, consolidated indebtedness to consolidated free cash flow, maximum leverage, minimum fixed charge coverage, a prohibition or restriction on capital expenditures, debt and guarantees, liens and encumbrances on any property, mergers, consolidations, investments, advances, divestitures, change of business or conduct of business, joint ventures, partnerships, the creation of new subsidiaries, dividends, distributions, repurchases or redemptions of outstanding stock (including options or warrants), the voluntary prepayment, repurchase redemption or defeasance of debt, and the acquisition, sale or transfer, lease or sale- leaseback of assets. The Senior Facility is secured by substantially all of the Company's assets as well as by pledges of its stock in its subsidiaries, which subsidiaries also have provided guarantees of the Company's obligations. As of April 30, 2000, the Company was in default of several of the above financial covenants. As of August 15, 2000, the Company is in default for non-payment of approximately $6 million in principal and interest. In May 1999, the Company provided a 12% interest bearing promissory note to a major vendor for $14,000,000 for the settlement of accounts payable, which is to be repaid in monthly installments through May 2002. The remaining balance at April 30, 2000 is approximately $11,402,000. The Company also issued warrants to purchase 1,000,000 shares of Class A common stock at $0.81 per share, which expires May 2004. The warrants were recorded as a discount on debt based on the Black Scholes assesses fair market value at the date of issuance. Also in fiscal 2000, the Company provided a $6,500,000 interest bearing promissory note to a vendor for the settlement of accounts payable. The note bears interest of 8% and is payable in weekly installments through December 2002, and has a remaining balance at April 30, 2000 of approximately $4,951,000. Additionally, the Company provided a $1,336,000 note payable to a vendor for the settlement of accounts payable. The note is payable in monthly installments through August 2002, and has a remaining balance at April 30, 2000 of approximately $832,000. 10. RELATED PARTY TRANSACTIONS Family members of certain stockholders and a Company director own a majority interest at April 30, 1998, 1999 and 2000 in three, three and two franchise stores, respectively. The amount of service fees earned from these franchisees was approximately $73,000, $103,000 and $93,000 for the years ended April 30, 1998, 1999 and 2000, respectively. The amount due from the franchisees at April 30, 1998, 1999 and 2000 approximated $73,000, $19,000 and $24,000, respectively. During the years ended April 30, 1998, 1999 and 2000, the Company incurred expenses of approximately $561,000, $270,000 and $370,000 respectively, to Johnson, West & Co., PLC ("Johnson, West & Co.") for accounting and tax services. A director of the Company is a member of Johnson, West & Co. During fiscal 1996, each of Messrs. Potter and Bedard issued notes (at an interest rate of 8% per annum) to the Company (the "Recourse Notes") in connection with stock option exercises. In fiscal 1998, 1999, and 2000, Mr. Potter's Recourse Note accrued interest of $151,694, $147,097, and $69,273, respectively, and Mr. Bedard's Recourse Note accrued interest of $84,275, $81,721, and $79,593, respectively. At April 30, 1999 and 2000, Mr. Potter's Recourse Note balance was approximately $2,227,244 and $0, respectively, and Mr. Bedard's Recourse Note balance was approximately $1,237,358 and $1,212,000, respectively. The F-16 66 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Company's Board of Directors has approved the accrual of bonuses to satisfy the Recourse Notes and interest thereon, as well as the anticipated payroll tax liability to the executives as follows:

During fiscal 2000, the Company paid all of its previously accrued payroll tax obligations related to Mr. Potter's Recourse Note and expects to complete its similar obligations with respect to Mr. Bedard's Recourse Note by December 31, 2000. Amounts shown in 1998 reflect the bonus amounts accrued by the Company in conjunction with Messrs. Potter and Bedard's restated employment agreements. In 1999, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. In 2000, the Company accrued bonus amounts for Messrs. Potter and Bedard intended to cover their respective obligations related to the Recourse Notes. The resultant accrual for compensation expense has been recorded as an offset to the officers' loan obligations, with the balance of the accrual included in accrued compensation in the balance sheet as of April 30, 1999 and 2000. Amounts totaling $524,945 and $291,635 were paid to Messrs. Potter and Bedard respectively in fiscal 1998 as reimbursement of previous payments of principal and interest on their recourse notes to the Company and accompanying tax liabilities. During fiscal 2000, the Company acquired a retail store previously operated by a Video Update franchisee who is a family member of a Company director. The purchase price for the store was $250,000. 11. COMMITMENTS AND CONTINGENCIES Lease Agreements The Company leases office and retail space under operating leases with terms of six to 204 months. These leases generally have a term of three to ten years and provide options to renew for periods ranging from three to five additional years. Under the leasing agreements, the Company is generally responsible for the real estate taxes, insurance, and other expenses related to the property. The leases expire at varying dates through 2015. The Company also leases vehicles and computer equipment. In November 1998, the Company entered into a sale-leaseback arrangement with respect to certain of its furniture, fixtures, equipment and signage used in selected retail locations. Under the arrangement the Company obtained approximately $5.0 million. The gain on the transaction was not significant. F-17 67 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At April 30, 2000, minimum annual rental commitments under non-cancelable operating leases are as follows:

Rent expense, principally retail and office space, under operating leases amounted to $28,180,000, $47,201,000 and $42,484,000 for the years ended April 30, 1998, 1999 and 2000, respectively, 12. INCOME TAXES Loss before income taxes consisted of the following:

Income tax (benefit) expense is as follows:

F-18 68 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Components of the net deferred tax asset, resulting from differences in book and income tax accounting methods, are as follows:

The reconciliation of the federal statutory rate (34%) to the Company's effective income tax rate is as follows:

Realization of the future tax benefits related to the deferred assets is dependent on many factors, including the Company's ability to generate taxable income within the net operating loss carryforward period. Management has considered these factors in reaching its conclusion as to the valuation allowance for financial reporting purposes. At April 30, 2000, the Company has United States federal and state tax loss carryforwards of approximately $118 million which expire between the years 2007 to 2015. Approximately $19 million of the net operating loss carryforward is limited to $1.5 million each year in accordance with the Internal Revenue Code. F-19 69 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 13. SUPPLEMENTAL CASH FLOW INFORMATION

Non-Cash Transaction In fiscal year 2000, the Company settled legal matters with three vendors resulting in the conversion of accounts payable of approximately $21,836,000 to notes payable. 14. STOCKHOLDERS' EQUITY (DEFICIT) Class A Common Stock; Class B Common Stock In connection with the Company's initial public offering, all of the holders of the Company's Class B Common Stock placed on a pro rata basis, an aggregate of 1,300,000 shares (the "Escrow Shares") into escrow. As a result of the Stockholders' vote to release 90% of the shares from escrow in fiscal 1998, the remaining 130,000 shares were forfeited. The shares released from escrow and the remaining 700,000 shares of Class B Common Stock outstanding were converted into Class A Common Stock. As a result, as of April 30, 1999 and 2000, there were no shares of Class B Common Stock outstanding. The Securities and Exchange Commission requires that the release of the Escrow Shares to officers, directors, employees and consultants of the Company be recognized as compensation expense in the statement of operations with a corresponding offset as an increase to additional paid-in capital. As such, stockholders' equity in total did not change. The expense of $3,546,000 was equal to the fair market value of the Escrow Shares on the date of release. Shareholders' Rights Agreement In April 1998, the Board of Directors approved the declaration of a dividend of one preferred share purchase right (a "Right") for each outstanding share of Class A Common Stock, par value $.01 per share (the "Common Shares") and for each outstanding Class B Warrant ("Warrants"), of the Company. The dividend was paid on April 24, 1998 (the "Record Date") to the stockholders and Class B Warrant holders of record on that date. Each Right entitles the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $.01 per share (the "Preferred Shares"), of the Company at a price of $20.00 per one one-hundredth of a Preferred Share (the "Purchase Price") subject to adjustment. Until the earlier to occur of (i) ten days following a public announcement that a person or group of affiliated or associated persons have acquired beneficial ownership of 15% or more of the outstanding Common Shares (an "Acquiring Person") or (ii) ten business days (or such later date as may be determined by action of the Board of Directors prior to such time as any person or group of affiliated persons becomes an Acquiring Person) following the commencement of, or announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 15% or more of the outstanding Common Shares (the earlier of such dates being called the "Distribution Date"), the Rights will be evidenced, with respect to any of the Common Shares or Warrant certificates outstanding as of the Record Date, by such Common Share certificate or such Warrant certificate, as the case may be. F-20 70 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In the event that any person or group or affiliated of associated persons becomes an Acquiring Person, proper provision shall be made so that each holder of a Right, other than Rights beneficially owned by the Acquiring Person (which will thereafter be void), will thereafter have the right to receive upon exercise--in lieu of Preferred Shares--that number of Common Shares having a market value of two times the exercise price of the Right. At any time after any person or group becomes an Acquiring Person and prior to the acquisition by such person or group of 50% or more of the outstanding Common Shares, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person or group which will have become void), in whole or in part, at an exchange ratio of one Common Share, or one one-hundredth of a Preferred Share (or of a share of a class or series of the Company's preferred stock having equivalent rights, preferences and privileges), per Right (subject to adjustment). Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. Warrants--Class A and B Each of the units sold in connection with the Company's public offerings consisted of one share of Class A Common Stock of the Company, one Class A Warrant and one Class B Warrant. The components of the units were separately transferable immediately. When issued, each Class A Warrant, upon its exercise, entitled the holder to purchase one share of the Company's Class A Common Stock and one Class B Warrant. The Class A Warrant exercise price was $6.50 per share subject to certain adjustments. In August 1995, the Company called for redemption of all its outstanding Class A Warrants. The redemption date set forth in the Notice of Redemption was September 7, 1995. Approximately 4,502,000 Class A Warrants were exercised resulting in net proceeds to the Company of approximately $28,414,000. At April 30, 1999, the Company had Class B Warrants outstanding enabling the holders the ability to purchase approximately 8,005,000 shares of Class A Common Stock at $8.75 per share. Such warrants expired in July 1999. In addition, there were 500,000 Class B Warrants outstanding that were issued by the Company in a 1994 bridge financing. These warrants provided the holders the ability to purchase the underlying Class A Common Stock of the Company at $8.75 per share and expired in July 1999. Blair Options At April 30, 1999 the Company had 117,500 shares of Class A Common Stock reserved for issuance upon exercise of the Unit Purchase Option (the "Initial Option") at an aggregate exercise price of $734,375, issued to D.H. Blair Investment Banking Corp. ("Blair") in connection with its services as underwriter of the Company's initial public offering; 230,550 shares of Class A Common Stock reserved for issuance upon exercise of the Unit Purchase Option (the "Subsequent Option") at an aggregate exercise price of $1,033,500, issued to Blair or its' affiliates in connection with its services as underwriter of the Company's subsequent public offering (collectively, the Initial Option and the Subsequent Option are referred to as the "Blair Options"); 348,050 shares of Class A Common Stock reserved for issuance upon exercise of the redeemable Class A Warrants (the "Class A Warrants") underlying the Blair Options, at an exercise price of $6.50 per share; and 696,100 shares of Class A Common Stock issuable upon exercise of the Class B Warrants underlying the Blair Options, at an exercise price of $8.75 per share. The issuable Class A Warrants and the issuable and outstanding Class B Warrants underlying the Blair Options expired in July 1999. 15. STOCK OPTION PLANS In April 1994, the Company established an incentive stock option plan (the "1994 Stock Plan") whereby 150,000 shares of Class A Common Stock have been reserved. The options can be either incentive stock options or non-qualified options, as defined by Section 422 of the Internal Revenue Code ("Section 422") to be granted to eligible individuals. The exercise price for the incentive stock options granted under the 1994 F-21 71 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Stock Plan may not be less than the fair market value of the Class A Common Stock on the date the option is granted. In September 1994, the Board of Directors approved the Formula Stock Option Plan (the "Formula Plan") whereby 50,000 shares of Class A Common Stock have been reserved. The Formula Plan provides for the granting of options to non-management directors of the Company. The exercise price for the incentive stock options granted under the plan may not be less than the fair market value of the Class A Common Stock on the date the option is granted. To date, none of these options have been exercised. In May 1995, the Company established an additional stock option plan (the "1995 Plan") whereby 850,000 shares were reserved for grant to eligible individuals to purchase Class A Common Stock of the Company. Options under the 1995 Plan may be incentive stock options or non-qualified options. The exercise price for the incentive stock options granted under the 1995 Plan may not be less than fair market value of the Class A Common Stock on the date the option is granted. In August 1995, options to purchase 420,000 shares were exercised by the CEO and President of the Company. In June 1996, the Board of Directors approved an additional stock option plan (the "1996 Plan"). The 1996 Plan provides for the granting of options to eligible individuals to purchase up to 820,000 shares of Class A Common Stock of the Company. Options under the 1996 Plan may be incentive stock options or non- qualified stock options. The exercise price for the incentive stock options granted under the plan, may not be less than the fair market value of the Class A Common Stock on the date the option is granted. To date, none of these options granted under such plan have been exercised. In January 1998, the Board of Directors approved an additional stock option plan (the "1998 Plan"). The 1998 Plan provides for the granting of options to eligible individuals to purchase up to 1,750,000 shares of Class A Common Stock of the Company. Options under the 1998 Plan may be incentive stock options or non-qualified stock options. The exercise price for the incentive stock options granted under the plan may not be less than the fair market value of the Class A Common Stock on the date the option is granted. To date, none of these options have been exercised. In August 1999, the Board of Directors approved the repricing of approximately 1,360,000 stock options to $1.06 per share. In accordance with FASB Interpretation No. 44 "Accounting for Certain Transactions involving Stock Compensation in interpretation of ABP Opinion No. 25", the Company will be required to record compensation expense over the vesting period of these options commencing on July 1, 2000 to the extent the market value of these shares increases. In fiscal 1997, the Company adopted the disclosure-only provision of SFAS No. 123 "Accounting for Stock-based Compensation." SFAS No. 123 allows companies to continue to account for employee stock based compensation plans using the accounting prescribed by APB Opinion 25, "Accounting for Stock Issued to Employees". The Company has elected to continue to account for employee stock-based compensation using APB 25, making pro forma disclosure of net earnings and earnings per share as if the fair value based method had been applied. Accordingly, no compensation expense has been recorded for the stock option plans. Had compensation expense for the stock option plans been determined based on the fair value at the date of grant for awards in fiscal 1998, 1999, and 2000, consistent with SFAS No. 123, the Company's net earnings and earnings per share for the fiscal years shown below would have been reported as follows:

F-22 72 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The fair market value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

The pro forma effect of net income and earnings per share is not representative of the pro forma earnings in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1996. The weighted average fair value for options granted during fiscal 1998, 1999 and 2000 is $1.45, $0.83 and $0.16 per share, respectively. Option activity is summarized as follows:

The following table summarizes information concerning currently outstanding and exercisable options:

F-23 73 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 16. ACQUISITIONS During fiscal year 1998, the Company acquired, in one transaction 267 video retail stores operated by an unaffiliated third party operator (the "Acquisition"). The purchase method of accounting was used to account for the Acquisition and the Acquisition is included in the Company's consolidated financial statements from the date of acquisition. There were no acquisitions in fiscal year 1999. During fiscal year 2000, the Company acquired one retail store previously operated by a Video Update franchisee (see Note 10 of the Notes to Consolidated Financial Statements). The purchase method of accounting was used to record this transaction, the pro forma impact of which was not material. The aggregate purchase price of the Acquisition totaled approximately $83,458,900 included approximately $50,171,200 in assumed indebtedness, approximately $5,087,500 in transaction costs, and 9,303,927 shares of Class A Common Stock valued at approximately $28,200,200. The excess of the cost over the estimated fair value of the assets acquired (goodwill) of approximately $46,291,000 is being amortized over 20 years on a straight-line basis. The following unaudited pro forma information presents the consolidated results of operations of the Company as if the fiscal year 1998 acquisition had been completed at the beginning of the year in which the acquisition occurred. There were no acquisitions in fiscal 1999. In the opinion of the Company's management, all adjustments necessary to present fairly such pro forma summary have been made based on the terms and structure of the transactions.

During fiscal 1998, cash deficiency payments were made with regard to one acquisition in the amount of $1,327,000. In addition, in fiscal 1998, 65,750 shares placed in escrow as a result of an acquisition were cancelled. In connection with an acquisition that the Company completed in fiscal 1996, the Company was obligated to make deficiency payments to the sellers equal to the difference between a guaranteed price for each share issued, and the actual market price obtained for such shares as of specified dates. During fiscal 1999, deficiency payments of approximately $181,000 were made with respect to this acquisition and in June 1999 a final payment of approximately $71,000 (including approximately $60,000 for deficiency payments) was made in full settlement of all obligations related to the sellers. The Company is currently disputing a deficiency payment allegedly due with respect to 239,163 shares which were issued to a seller in the Videoland acquisition in 1995 (see Note 20 of the Notes to Consolidated Financial Statements); the seller is claiming a deficiency payment of approximately $1,220,000 based on proceeds from the sale of Class A Common Stock during the six month period of March 1996 to September 1996. The Company has the option of satisfying approximately $1,220,000 (with respect to 239,163 shares) through the issuance of additional shares of Class A Common Stock. F-24 74 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 17. GEOGRAPHIC BUSINESS OPERATIONS The Company owns and operates retail video stores in the United States and in Canada. A summary of the Company's operations by geographic area is presented for fiscal 1998, 1999, and 2000. All inter-company revenues and expenses have been eliminated.

18. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND FAIR VALUE OF FINANCIAL INSTRUMENTS The Company is party to a swap agreement with off-balance-sheet risk which is entered into in the normal course of business to meet its financing needs and to manage its exposure to fluctuations in market rates. The swap agreement involves, to a varying degree, elements of credit and market risk in addition to amounts recognized in the financial statements. The Company does not hold or issue financial instruments for trading purposes. The swap agreement is a contract to exchange fixed and floating payments periodically over the life of the agreements without the exchange of the underlying notional amounts. The notional amounts of the agreement is used to measure amounts to be paid or received and do not represent the amount of the exposure to credit loss. The amounts to be paid or received under the swap agreement is accrued consistently with the terms of the agreement and market rates. The agreement is with a major financial institution which is currently expected to fully perform under the terms of the agreement. The Company continuously monitors the credit rating of the counter-party, and the likelihood of default is considered remote. The notional amount of the variable-to-fixed swap agreement as of April 30, 2000 is $4,920,000 which will be in effect beginning April 30, 2000, with a pay rate of 5.94% and a receive rate based on three month LIBOR. The agreement expires April 2001. F-25 75 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The carrying amounts and estimated fair values of the Company's swap instrument at April 30, 2000 is as follows (in thousands):

------------ (A) Carrying amount represents accrued payments under the swap agreement. The fair value represents the estimated amount that the Company would pay to the counter-party to terminate the swap agreement at April 30, 2000. 19. QUARTERLY FINANCIAL DATA (UNAUDITED) Subsequent to the issuance of the Company's interim financial statements for the period ended January 31, 2000, the Company's management determined that previously accrued store closing reserve and previously recorded asset impairments were inappropriately reversed within the third quarter. As a result, net income for the third quarter of fiscal 2000 was overstated by approximately $685,000. Accordingly, the results of operations for the third quarter of fiscal 2000 have been restated from the amounts previously reported. Selected quarterly financial data is as follows (in thousands, except per share data):

------------ (1) Certain reclassifications have been made to conform with the 2000 fiscal year-end presentation. During the fourth quarter of fiscal 2000, the Company decreased the carrying value of video and game rental inventory and merchandise inventory by approximately $3,000,000 as a result of a complete annual physical count and valuation. This annual counting and pricing was more comprehensive than that which had been conducted on an interim basis. As a result of inventory adjustments, the Company increased store operating expenses by approximately $3,000,000 in the fourth quarter of fiscal 2000. The Company is not able to determine the periods of the fiscal year to which these inventory adjustments relate. During the fourth quarter of fiscal 2000, the Company recorded impairment charges of $7,354,000 and $4,314,000 related to goodwill and fixed assets, respectively, as a result of a strategic review of its prior acquisitions and operations (see Notes 5 and 8 of Notes to the Consolidated Financial Statements). 20. LITIGATION In connection with the acquisition of the assets of Videoland, Inc. ("Videoland") in November 1995, the Company issued 239,163 shares of its Class A Common Stock (the "Videoland Shares") to the sellers of the F-26 76 VIDEO UPDATE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) assets of Videoland (the "Videoland Sellers"). With respect to the Videoland Shares, the Company agreed to make a deficiency payment in October 1996 to the Videoland Sellers if the gross proceeds received by such sellers from the sale of the Videoland Shares during the six months from March 1996 through September 1996 is not equal to the number of Videoland Shares sold multiplied by $12.00. The Videoland Sellers were subject to certain "lockup" or sale restrictions as a condition to any deficiency payment. The Company initiated an action in federal district court in Minnesota for a declaratory judgment that the Videoland Sellers are not entitled to any deficiency payment in light of the failure by such sellers to comply with the lockup or sale restrictions. In January 1998, the court entered a judgment, payable in the Company's stock or cash, against the Company in the amount of $1,220,403 plus interest from October 1996, and attorney's fees; which is recorded in the consolidated balance sheets. The Company appealed the judgment to the Eighth Circuit. The appeal was denied. The Company is exploring further avenues of relief, including but not limited to the satisfaction of a portion of the judgment by a transfer of the Company's stock. A variety of aspects of such a settlement are now subject to litigation in the federal district court of Minnesota, the outcome of which no assurances can be given. In May 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al) Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County, Michigan) claiming amounts due pursuant to post-closing adjustments contemplated in connection with an Asset Purchase Agreement among Monsour and Moovies, Inc. dated as of March 14, 1997, and the alleged default on a Promissory Note among Monsour and Moovies, Inc. in the amount of $2,000,000. The trial court has ruled in favor of the plaintiffs on a motion for summary judgment, and a judgment for $2,370,195 has been entered against the Company. The $2,000,000 note is recorded in notes payable and the remaining judgement of $370,195 is recorded in accrued expenses on the consolidated balance sheet at April 30, 2000. The Company believes it has meritorious grounds for its appeal which is currently pending, although assurances cannot be given as to the outcome of such action. In August 1998, the Company filed suit in federal court in Oregon against Rentrak Corporation, an Oregon Corporation. The Company alleges that Rentrak has violated the federal antitrust law, given Rentrak's position in the market and its exercise of monopoly power. Rentrak has counter-claimed for amounts it alleges were owed by Moovies, Inc. prior to the acquisition of Moovies, Inc. by the Company and for amounts it claims are due under a contract with the Company; the Company has denied that such contract is valid or that any sums are due. Fact discovery in the matter is now largely completed. As of April 30, 2000 the Company believes that it has adequately provided for its exposure under this litigation. During fiscal 2000, the Company had favorable settlements in certain litigation matters with two vendors. As part of each settlement, the Company converted trade payables to these vendors to structured note payables of $1,336,000 and $6,500,000, respectively, (see Note 9 of the Notes to Consolidated Financial Statements) and recorded approximately $1,700,000 and $1,200,000, respectively, as a reduction of selling, general and administrative expense and as an adjustment of estimated liabilities in the consolidated financial statements. Also in fiscal 2000, the Company recorded a loss of approximately $1,600,000 resulting from a judgment on appeal in a legal matter with a vendor. The Company believes it has meritorious grounds for success and continues to pursue other avenues of relief. The Company is involved in various other legal proceedings arising during the normal course of conducting business. Management believes that the resolution of these proceedings will not have any material adverse impact on the Company's financial statements. 21. CHANGE IN FISCAL YEAR-END In January 2000, the Company's Board of Directors approved a resolution changing the Company's fiscal year end from April 30 to January 31, effective January 31, 2001. F-27

VIDEO UPDATE INC 10-K