10-Q 1 f74972e10-q.txt FORM 10-Q QUARTERLY PERIOD ENDED JUNE 30,2001 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------- FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________________ to _________________ COMMISSION FILE NUMBER: 0-26516 EUPHONIX, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 77-0189481 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)

220 PORTAGE AVENUE, PALO ALTO, CALIFORNIA 94306 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (650) 855-0400 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 [ ] The number of shares outstanding of the registrant's common stock as of June 30, 2001 was 15,710,366 ($0.001 par value). ================================================================================ 2 EUPHONIX, INC. FORM 10-Q TABLE OF CONTENTS

-i- 3 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS EUPHONIX, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements. -1- 4 EUPHONIX, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements. -2- 5 EUPHONIX, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements. -3- 6 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1. - THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES THE COMPANY Euphonix, Inc. (the "Company") was incorporated on July 6, 1988 in the state of California. Euphonix develops, manufactures and supports networked digital audio systems for music, film and television post production, broadcast, sound reinforcement and multimedia applications. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated on consolidation. Investments in which the Company has between 20% and 50% ownership are accounted for using the equity method. USE OF ESTIMATES The preparation of the consolidated 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported period. Significant estimates made by management include allowance for doubtful accounts, inventory obsolescence, depreciation, amortization, taxes, contingencies and product warranty. Actual results could differ from those estimates. BASIS OF PRESENTATION The accompanying financial statements as of June 30, 2001 and for the three and six months ended June 30, 2001 and 2000 are unaudited and have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The December 31, 2000 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements should be read in conjunction with the Condensed Consolidated Financial Statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000, filed with the SEC on March 28, 2001. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position as of June 30, 2001, results of operations for the three and six months ended June 30, 2001 and 2000, and cash flows for the six months ended June 30, 2001 and 2000 have been made. The results of operations for the three and six months ended June 30, 2001 are not necessarily indicative of the operating results for the full fiscal year or any future periods. -4- 7 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (UNAUDITED) The Company believes that its available cash and cash equivalents, as well as its current borrowing facility, will not be sufficient to meet its anticipated needs for working capital and capital expenditures through the end of 2001. The Company will have to raise additional funds above and beyond current levels in order to meet its operating needs, to develop new or enhance existing products, to respond to competitive pressures, or to acquire or invest in complementary businesses, technologies, services or products, and the Company will be assessing that requirement within the next three months. In addition, in order to meet its long-term liquidity needs beyond the end of 2001, the Company will need to raise additional funds, establish a credit facility or seek other financing arrangements. Additional funding may not be available on favorable terms or at all. Moreover, the maturity dates of the Company's outstanding promissory notes will become due in early 2002. Although shareholders approved the notes for conversion into shares of common stock, there is no assurance that the investors will choose to convert their notes, and the Company may have to repay these loans in 2002. The financial statements have been presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amount and classification of liabilities or any adjustments that might be necessary should the Company be unable to continue as a going concern. RECLASSIFICATIONS Certain amounts from the previous periods have been reclassified to conform to the current period presentation. REVENUE RECOGNITION AND CHANGE IN ACCOUNTING PRINCIPLE Effective January 1, 2000, the Company changed its method of accounting for revenue recognition to comply with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. Previously, the Company had recognized revenue generally upon shipment to customers including cases when installation was a condition of payment, provided all other revenue recognition criteria were met. Under the new accounting method adopted retroactive to January 1, 2000, the Company now defers all revenue until installation is complete (in those cases where installation is a condition of payment), provided all other revenue recognition criteria are met. The effect of the retroactive application for the quarter ended June 30, 2000 is as follows:

-5- 8 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (UNAUDITED) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities, and is effective for fiscal years beginning after June 15, 2000, as amended by SFAS No. 137. In June 2000, the Financial Accounting Standards Board issued SFAS No. 138, "Accounting for Derivative Instruments and Hedging Activities - An Amendment of FASB Statement No. 133." SFAS No. 138 amends the accounting and reporting standards for certain derivatives and hedging activities such as net settlement contracts, foreign currency transactions and intercompany derivatives. The Company adopted SFAS No. 133 January 1, 2001. The adoption of SFAS No. 133 did not have an impact on the Company's financial position or results of operations. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. Management believes that the adoption of SFAS 141 will not have a significant impact on the Company's financial statements. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which is effective for fiscal years beginning after March 15, 2001. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. The Company will adopt SFAS 142 effective January 1, 2002. The adoption of SFAS 142 is not expected to have a material impact on the Company's financial statements. NOTE 2 - BALANCE SHEET COMPONENTS (IN THOUSANDS): (a) Inventories:

(b) Accrued liabilities:

-6- 9 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (UNAUDITED) (c) Other assets In accordance with FAS 121, the Company evaluates the recoverability of its long lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Due to continuing losses during the second quarter and other market conditions, the Company reviewed the expected future cashflows of Euphonix Europe to determine whether the related goodwill was impaired. Based on this review, the Company determined that future cashflows were not sufficient to recover the remaining goodwill and accordingly recorded a charge of $213,000. (d) Convertible notes payable: In July 1999, the Company executed a promissory note with an existing investor and other parties under which the Company was authorized to draw up to $2,100,000 through October 31, 1999. The note accrues interest at 7.75% per annum with principal and accrued interest originally due at July 30, 2001. The assets of the Company are pledged as collateral. The note contains a conversion feature to allow the holder to convert the note into common stock of the Company at a rate of $0.75 per share. At the date of issuance of the note, the quoted market price of the Company's common stock was $0.969 per share, resulting in a beneficial conversion feature charge in the amount of $613,000. The beneficial conversion feature charge was recorded as a credit to equity and a charge to interest expense. In March 2001, the Company and the investors agreed to extend the due date of the principal and accrued interest until March 31, 2002. On April 15, 2001, the investors in the July 1999 promissory note agreed to convert the entire amount of the principal of $2.1 million and accrued interest outstanding of $276,000 into 3,168,267 shares of common stock at the price of $0.75 per share. In February 2000, the Company executed promissory notes with existing investors under which the Company borrowed $1,500,000. The notes accrue interest at 10% per annum with principal and accrued interest due at February 22, 2002. The assets of the Company are pledged as collateral. The note contains a conversion feature to allow the holder to convert the note into common stock of the Company at a rate of $2.531 per share. In addition, this note provides that upon conversion, if such conversion occurs, the Company will issue warrants to purchase 1,185,185 shares of common stock at prices ranging from $3 to $5. The warrants, if issued, will be exercisable at any time and from time to time in part or in full on or before February 1, 2003. At the date of issuance of the note, the quoted market price of the Company's common stock was $2.531 per share, resulting in a beneficial conversion feature in the amount of $1,279,000. The beneficial conversion feature charge was recorded as a credit to equity and a charge to interest expense at the time the notes were issued in February 2000. In April 2000, the Company executed promissory notes with existing investors under which the Company borrowed $800,000. The notes accrue interest at 10% per annum with principal and accrued interest due at January 1, 2001. An amendment to the April 2000 note extended the due date to July 31, 2001. The assets of the Company are pledged as collateral. The notes contain a conversion feature, which was subject to shareholder approval allowing the holder to convert the note into common stock of the Company at a rate of $3.625 per share. Approval was obtained at the Company's annual meeting of shareholders' on June 19, 2001. There was no beneficial conversion feature charge, because the accounting conversion rate was higher than the fair market value of the Company's common stock on the date of shareholder approval. In March 2001, the Company and the investors agreed to extend the due date of the principal and accrued interest until March 31, 2002. -7- 10 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (UNAUDITED) In September 2000, the Company executed a promissory note with an existing investor under which the Company borrowed $400,000. The note accrues interest at 8% per annum with principal and accrued interest due on July 31, 2001. The assets of the Company are pledged as collateral. The notes contain a conversion feature, which was subject to shareholder approval allowing the holder to convert the note into common stock of the Company at a rate of $2.3562 per share. Approval was obtained at the Company's annual meeting of shareholders' on June 19, 2001. In addition this note provides that upon conversion, if such conversion occurs, the Company will issue warrants to purchase 181,988 shares of common stock at a rate of $2.3562 per share. The warrants, if issued, will be exercisable at any time and from time to time in part or in full before September 7, 2005. There was no beneficial conversion feature charge, because the accounting conversion rate was higher than the fair market value of the Company's common stock on the date of shareholder approval. In March 2001, the Company and the investors agreed to extend the due date of the principal and accrued interest until March 31, 2002. In December 2000, the Company executed promissory notes with existing investors under which the Company borrowed $1,800,000. The notes accrue interest at 8% per annum with principal and accrued interest due on July 31, 2001. The assets of the Company are pledged as collateral. The notes contain a conversion feature, which was subject to shareholder approval allowing the holder to convert the note into common stock of the Company at a rate of $1.26 per share. Approval was obtained at the Company's annual meeting of shareholders' on June 19, 2001. In addition this note provides that upon conversion, if such conversion occurs, the Company will issue warrants to purchase 1,502,963 shares of common stock at a rate of $1.26 per share. The warrants, if issued, will be exercisable at any time and from time to time in part or in full before December 29, 2005. There was no beneficial conversion feature charge, because the accounting conversion rate was higher than the fair market value of the Company's common stock on the date of shareholder approval. In March 2001, the Company and the investors agreed to extend the due date of the principal and accrued interest until March 31, 2002. In March 2001, the Company issued convertible promissory notes to existing investors under which the Company may borrow up to $3,500,000 in 2001. The notes accrue interest at 10% per annum with principal and accrued interest due March 31, 2002. The notes contain a conversion feature, which was subject to shareholder approval allowing the holder to convert the note into common stock of the Company at a rate of $0.75 per share. Approval was obtained at the Company's annual meeting of shareholders' on June 19, 2001. The Company will record a beneficial conversion feature charge of $190,000 over the life of the note, because the accounting conversion rate was lower than the fair market value of the Company's common stock on the date of shareholder approval. The beneficial conversion feature charged in the second quarter of 2001 was $7,000. The Company also issued 350,000 shares of common stock to these investors in return for their agreement to loan the Company $3,500,000. The commitment fee was valued at the fair market value of the common stock and is being amortized over the term of the loan commitment. As of June 30, 2001, $2,004,000 was drawn down. In July 2001, an additional $800,000 was drawn down, leaving $696,000 available under the facility. NOTE 3 - CONTINGENCIES From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future -8- 11 EUPHONIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (UNAUDITED) expenditures will be made and such expenditures can be reasonably estimated. In the opinion of management, there are no pending claims of which the outcome is expected to result in a material adverse effect in the financial position or results of operations of the Company. -9- 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements represent our expectations or beliefs concerning future events and include statements, among others, concerning: our cash and cash equivalents as well as our current borrowing facility will not be sufficient to meet our anticipated need for working capital and capital expenditures through the end of 2001; we will have to raise additional funds in order to meet our operating needs; and the impact of SFAS No. 133 on our financial position or results of operations. Our results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the section entitled "Risk Factors That May Affect Results of Operations and Financial Condition." RESULTS OF OPERATIONS Net Revenues Net revenues were $4.5 million in the second quarter in 2001 up from $4.2 million in the second quarter of 2000, representing an increase of 6.2%. The increase resulted primarily from increased unit sales of System 5 all digital mixing consoles into the film/post-production and broadcast segments of the market. International sales accounted for 56.5% of our second quarter 2001 revenues, compared to 41.4% in the second quarter of 2000. International sales increased by approximately $782,000, or 44.8% in the second quarter of 2001, as compared to the similar period in 2000. The increase was due to higher sales in Europe, South America and Canada. Net revenues were $9.1 million in the first half in 2001, up from $6.0 million in the first half of 2000, representing an increase of 50.7%. The increase in our net revenues during this period resulted primarily from increased unit sales of System 5 all digital mixing consoles in the first half of 2001 into the film/post-production and broadcast segments of the market. International sales accounted for 51.8% of our first half 2001 revenues, compared to 40.2% in the first half of 2000. International sales increased by approximately $2.3 million, or 94.2% in the first half of 2001. The increase reflected higher sales in the Pacific Rim, Europe, South America and Canada. Gross Margin Gross margin decreased to 31.8% in the second quarter of 2001 as compared to 34.6% in the second quarter of 2000. The decrease in gross margin was primarily due to a write off of obsolete inventory in the second quarter of 2001. Gross margins increased to 34.7% in the first six months of 2001, as compared to 25.6% in the first six months of 2000. The increase was primarily due to greater unit sales of System 5 all digital mixing consoles which has a higher gross margin. Research and Development Expenses Research and development expenses decreased 15.8% in the second quarter of 2001, as compared to the second quarter of 2000. The decrease was primarily due to the termination of the E-Deck program in the -10- 13 second quarter in 2001. As a percentage of revenues, research and development expenses decreased to 16.0% in the second quarter of 2001, down from 20.1% in the second quarter of 2000. The decrease was attributable primarily to higher revenues in the second quarter of 2001 as compared to 2000, as well as a decrease in E-Deck costs. Research and development expenses decreased 8.4% in the first half of 2001, as compared to the first half of 2000. The decrease was primarily due to the reduction in headcount at Spectral Inc., our wholly owned subsidiary, and the cost savings from the termination of the E-Deck program. As a percentage of revenues, research and development expenses decreased to 17.7% in the first half of 2001, down from 29.1% in the first half of 2000. The decrease was attributable primarily to higher revenues and lower costs in the first half of 2001 as compared to 2000. Sales and Marketing Expenses Sales and marketing expenses increased by approximately $117,000 in the second quarter of 2001 as compared to the same period in 2000. This increase was primarily due to increased expenditures on travel and tradeshows in the Pacific Rim and Japan. As a percentage of revenues, sales and marketing expenses increased to 34.3% in the second quarter of 2001, as compared to 33.6% in the second quarter of 2000. The percentage increase in marketing and selling expenses was due primarily to higher costs associated with international sales in the second quarter of 2001, as compared to the same period in 2000. Sales and marketing expenses increased by $229,000 in the first half of 2001 as compared to the first half of 2000. This increase was primarily due to increased expenditures on activities related to international sales and sales fees and commission. The increases were partially offset by the reduction in costs due to the realization of savings relating to the joint venture with Audio Export. As a percentage of revenues, marketing and selling expenses decreased to 32.2% in the first half of 2001, as compared to 44.8% in the first half of 2000. The percentage decrease in marketing and selling expenses was due primarily to higher revenues in the first half of 2001 as compared to 2000. General and Administrative Expenses General and administrative expenses decreased 10.5%, in the second quarter of 2001, as compared to the same period in 2000. As a percentage of revenues, general and administrative expenses decreased to 11.3% in the second quarter of 2001, as compared to 13.5% in the second quarter of 2000. The decrease resulted primarily from a decrease in legal and professional fees in the second quarter of 2001 compared to the second quarter of 2000. General and administrative expenses increased 29.5%, in the first half of 2001, as compared to the same period in 2000. As a percentage of revenues, general and administrative expenses decreased to 13.2% in the first half of 2001, as compared to 15.3% in the first half of 2000. The dollar increase in the first half of 2001 was primarily due to higher salary and benefits, additional personnel and bad debt expense, while the percentage decrease is attributable to higher revenues in the first half in 2001. Other Income/(Expense), Net Other income/(expense) charges were $0.3 million in the second quarter of 2001, as compared to $0.06 million in the second quarter of 2000. This represented an increase of 370.5% in the second quarter of 2001 as compared to the similar period in 2000. The increase is due primarily to interest charges on the notes payable and amortization of the commitment fee on the March 2001 notes payable. Other income/(expense) for the -11- 14 first half of 2001, as compared to the first half of 2000, decreased by 60.0%, which was primarily attributable to the charge of $1.3 million related to the beneficial conversion feature associated with a convertible promissory note and associated warrants issued on February 22, 2000. Equity in Net Loss of Investee The equity in net loss of investee for the three months ended June 30, 2001 is $305,000, as compared to $34,000 for the same period in 2000. The increase is primarily the result of the impairment charge relating to Euphonix Europe of $213,000, which we recorded during the three months ended June 30, 2001. The equity in net loss of investee for the six months ended June 30, 2001 is $346,000, as compared to $34,000 for the same period in 2000. The increase is primarily the result of the impairment charge relating to Euphonix Europe of $213,000, which we recorded during the three months ended June 30, 2001 and the fact that the joint venture in Euphonix Europe was entered into in the second quarter of 2000. Provision/(Benefit) for Income Taxes No provision for federal and state income taxes was recorded for the first half in 2001 and 2000 as we incurred net losses during the period. LIQUIDITY AND CAPITAL RESOURCES We have funded our operations primarily through the private sale of equity and debt securities. For the first half ended June 30, 2001, cash and cash equivalents decreased by $40,000 to approximately $547,000. In addition, during this period working capital decreased by $6.9 million to approximately $(0.6) million. Our operating activities used cash of approximately $2.4 million in the first half of 2001 and 2000. Cash used in operating activities for 2001 was comprised primarily of a net loss, a decrease in accounts payable and customer deposits offset partially by a decrease in accounts receivable. Cash used in operating activities for the first half of 2000 was comprised primarily of a net loss and a decrease in accounts payable and accrued liabilities. Our investing activities used cash of $101,000 in the first half of 2001 due to the purchase of property and equipment, and provided cash of $84,000 in the same period in 2000 due to the $152,000 sale offset by the $68,000 purchase of property and equipment. Our financing activities provided $2.5 million in the first half of 2001 and $3.2 million in the first half of 2000. We received proceeds from the issuance of convertible notes in the first half of 2001 of $2.5 million, which included $0.5 million from the December 2000 note and $2.0 million from the March 2001 note, as compared to $2.3 million in proceeds from the issuance of convertible notes and $800,000 from the sale of common stock in the first half of 2000. In March 2001, we issued convertible promissory notes to existing investors under which we may borrow up to $3,500,000 in 2001. The notes accrue interest at 10% per annum with principal and accrued interest due March 31, 2002. The notes contain a conversion feature, which was subject to shareholder approval allowing the holder to convert the note into our common stock at a rate of $0.75 per share. Approval was obtained at our annual meeting of shareholders' on June 19, 2001. We measured and will record a beneficial conversion feature charge of $190,000 over the life of the note, because the accounting conversion rate was lower than the fair market value of our common stock on the date of shareholder approval. The beneficial conversion feature charged in the second quarter of 2001 was $7,000. -12- 15 We also issued 350,000 shares of common stock to these investors in return for their agreement to loan us $3,500,000. The commitment fee was valued at the fair market value of the common stock and is being amortized over the term of the loan commitment. As of June 30, 2001, $2,004,000 was drawn down. In July 2001, an additional $800,000 was drawn down, leaving $696,000 available under the facility. We believe that our available cash and cash equivalents, as well as current borrowing facility, will not be sufficient to meet our anticipated needs for working capital and capital expenditures through the end of 2001. We will have to raise additional funds above and beyond current levels in order to meet our operating needs, to develop new or enhance existing products, to respond to competitive pressures, or to acquire or invest in complementary businesses, technologies, services or products, and we will be assessing that requirement within the next three months. In addition, in order to meet our long-term liquidity needs beyond the end of 2001, we will need to raise additional funds, establish a credit facility or seek other financing arrangements. Additional funding may not be available on favorable terms or at all. Moreover, the maturity dates of our outstanding promissory notes will become due in early 2002. Although shareholders approved the notes for conversion into shares of our common stock, there is no assurance that the investors will choose to convert their notes, and we may have to repay these loans in 2002. The financial statements have been presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amount and classification of liabilities or any adjustments that might be necessary should we be unable to continue as a going concern. Impact of Recently Issued Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities, and is effective for fiscal years beginning after June 15, 2000, as amended by SFAS No. 137. In June 2000, the Financial Accounting Standards Board issued SFAS No. 138, "Accounting for Derivative Instruments and Hedging Activities - An Amendment of FASB Statement No. 133." SFAS No. 138 amends the accounting and reporting standards for certain derivatives and hedging activities such as net settlement contracts, foreign currency transactions and intercompany derivatives. We adopted SFAS No. 133 January 1, 2001. The adoption of SFAS No. 133 did not have an impact on our financial position or results of operations. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. We believe that the adoption of SFAS 141 will not have a significant impact on our financial statements. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which is effective for fiscal years beginning after March 15, 2001. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other -13- 16 intangibles. We will adopt SFAS 142 effective January 1, 2002. The adoption of SFAS 142 is not expected to have a material impact on our financial statements. RISK FACTORS THAT MAY AFFECT RESULTS OF OPERATIONS AND FINANCIAL CONDITION A number of uncertainties exist that could affect our future operating results, including, without limitation, the following: IF WE DO NOT HAVE SUFFICIENT CAPITAL TO FUND OUR OPERATIONS, WE MAY BE FORCED TO IMPLEMENT SIGNIFICANT REDUCTIONS IN THE MANNER IN WHICH WE CONDUCT BUSINESS, INCLUDING WORKFORCE REDUCTIONS, AND FOREGO ATTRACTIVE BUSINESS OPPORTUNITIES We believe that our cash and cash equivalents, together with cash flow from operations and investor financing that we expect to obtain, will not provide sufficient capital to fund our operations through December 31, 2001 if our assumptions about our revenues and expenses are generally accurate. Our actual funding requirements may differ materially as a result of many factors, including the development of new products and technologies and the continued growth of the company. Even if we are successful funding our operations through December 31, 2001, we do not expect to be profitable by the end of the year, so we will likely need to raise additional funds in the future through public or private financings or other similar arrangements. The capital markets have become increasingly constrained since the beginning of this year, which has adversely affected the ability of many companies to raise capital. Additional financing may not be available on acceptable terms, if at all, and the inability to obtain that financing could adversely affect the continued operation of our business. Without the proceeds from future financings, we would likely continue to implement material changes to our business plan to conserve cash resources, including staff reductions and other spending reductions. If additional funds are raised through the issuance of equity securities or securities convertible into equity, dilution to existing stockholders may result and, if our stock price remains depressed, could be significant. If insufficient funds are available, we may not be able to continue to operate our business in an effective manner or to compete effectively. WE HAVE INCURRED SIGNIFICANT LOSSES FOR THE PAST FIVE YEARS, AND WILL NEED TO RAISE ADDITIONAL FUNDING IN ORDER TO FUND OUR OPERATIONS We incurred net losses of approximately $3.5 million in the first half of 2001, $8.3 million in 2000, $6.3 million in 1999, $5.2 million in 1998, $1.9 million in 1997, and $1.4 million in 1996, and we will continue to expend substantial funds to increase the versatility and functionality of the System 5 digital console in fiscal 2001. Although we received commitments from existing investors to loan us $3.5 million during 2001, we now believe that we will need to raise additional capital in order to fund operations in 2001. Although we believe that additional debt or equity financing will be available from existing investors and others, there can be no assurance as to the terms and conditions of any such financing and no certainty that funds would be available when needed. The inability to obtain additional financing would cause a severe negative impact, and we may be unable to fund operations. OUR COMMON STOCK MAY BE DELISTED FROM NASDAQ The shares of our common stock are currently listed on the Nasdaq SmallCap Market. Currently, however, we are not in compliance with Nasdaq's net tangible assets requirement because our net tangible -14- 17 assets are less than $2 million. In addition, we are not in compliance with Nasdaq's minimum bid requirement because the minimum bid per share of our common stock has been at or below $1.00 for over 30 consecutive business days. Consequently, Nasdaq informed us of its intention to delist the stock. This delisting, however, has been stayed pending the outcome of an oral hearing on August 17, 2001. If this appeal is denied, our stock will be delisted from Nasdaq. If our stock is delisted from Nasdaq, it would be much more difficult to purchase or sell our stock or obtain accurate quotations as to our stock price. OUR STOCK PRICE HAS RECENTLY TRADED FAR BELOW THE INITIAL OFFERING PRICE AND COULD REMAIN AT THIS LOW PRICE, WHICH COULD AFFECT OUR ABILITY TO ACQUIRE OTHER COMPANIES, LEAVE US VULNERABLE TO HOSTILE TAKE OVER ATTEMPTS AND RESULT IN SECURITIES CLASS ACTION LITIGATION The market price of our common stock has traded at or significantly below the initial offering price of $8.00 per share. If the price per share does not increase, our investors may incur a substantial loss on their investment. In addition, the sustained depression of the market price of our common stock hampers our ability to conduct business, and in particular, could make it more difficult to pursue acquisitions of potential complementary businesses, leave us vulnerable to hostile takeovers and result in securities class action litigation. OUR STOCK PRICE MAY CONTINUE TO BE DEPRESSED DUE TO BROAD ECONOMIC, MARKET AND INDUSTRY FACTORS BEYOND OUR CONTROL Until recently, the market demand, valuation and trading prices of high technology companies was high. Recently, however, the share prices of high-technology companies, such as ours, have significantly decreased, and these stocks are now trading far below their historical highs. Our stock price may continue to be depressed because the market may perceive us to be a high-technology company. In addition, a variety of other factors beyond our control, such as general economic conditions, could cause our stock price to remain extremely low, regardless of our performance. WE DERIVE ALL OF OUR REVENUES FROM SALES OF OUR DIGITALLY CONTROLLED AUDIO MIXING CONSOLE AND RECORDING SYSTEMS, AND ANY FACTOR THAT ADVERSELY IMPACTS THIS SYSTEM WILL SERIOUSLY HARM OUR BUSINESS Historically, we have derived virtually all of our revenues from sales of our digitally controlled audio mixing console system, which is based upon our hardware platform. We believe that sales of these systems, along with enhancements thereof, the System 5 digital console, CS3000 console and R-1 recorder will continue to constitute a significant portion of our revenues. It is expected for the foreseeable future that a greater proportion of our revenue will come from the System 5 digital console. Accordingly, any factor adversely affecting our base system, whether technical, competitive or otherwise, could significantly harm our business and results of operations. WE DEPEND UPON A LIMITED NUMBER OF CUSTOMERS FOR A SUBSTANTIAL PERCENTAGE OF OUR REVENUES. IF WE LOSE SIGNIFICANT CUSTOMERS, OR IF PURCHASES BY ONE OF OUR KEY CUSTOMERS DECREASES, OUR NET SALES WILL DECLINE AND OUR BUSINESS WILL BE HARMED Due to high average sales prices, we depend upon a limited number of customers for a substantial proportion of our revenues. If we lose one or more of our significant customers, or if purchases by one of our key customers decreases, our net sales will decline and our business will be harmed. In addition, the timing of revenue is influenced by a number of other factors, including the timing of individual orders and shipments, industry trade shows, seasonal customer buying patterns, changes in product development and sales and -15- 18 marketing expenditures, custom financing arrangements, production limitations and international sales activity. Moreover, our expense levels are based in part on our expectations of future revenue. Because our operating expenses are based on anticipated revenue levels and because a high percentage of our expenses are relatively fixed in the short term, variations in the timing of recognition of revenue could cause significant fluctuations in operating results from quarter to quarter and may result in unanticipated quarterly earnings shortfalls or losses. IF WE RAISE ADDITIONAL CAPITAL THROUGH THE ISSUANCE OF NEW SECURITIES, EXISTING STOCKHOLDERS WILL INCUR ADDITIONAL DILUTION If we raise additional capital through the issuance of new securities, our stockholders will be subject to additional dilution. In addition, any new securities issued may have rights, preferences or privileges senior to those securities held by our current stockholders. WE RELY ON DISTRIBUTORS AND SALES REPRESENTATIVES FOR A SUBSTANTIAL PORTION OF OUR INTERNATIONAL SALES In regions outside of the United States and Japan, we rely on distributors and sales representatives to sell our products. Any disruptions to these personnel may adversely affect our revenue and gross margins. WE MUST KEEP PACE WITH RAPID TECHNOLOGICAL CHANGE AND THE INTENSE COMPETITION OF THE HIGH TECH INDUSTRY IN ORDER TO SUCCEED The markets for our products are characterized by changing technologies and new product introductions. Our success will depend in part upon our continued ability to enhance our base system with features including new software and hardware add-ons and to develop or acquire and introduce new products and features which meet new market demands and changing customer requirements on a timely basis. We are currently designing and developing new products, primarily in the areas of recording, editing and mixing functions of sound production as well as digital audio processing and networking systems. There can be no assurance that products or technologies developed by others will not render our products or technologies non-competitive or obsolete. If this happens, our revenues will likely be lower and our business will suffer. CURRENT AND POTENTIAL COMPETITORS COULD DECREASE OUR MARKET SHARE AND HARM OUR BUSINESS The markets for our products are intensely competitive and characterized by significant price competition. We believe that our ability to compete depends on elements both within and outside our control, including the success and timing of new product development and introduction by us and our competitors, product performance and price, distribution, availability of lease or other financing alternatives, resale of used systems and customer support. In addition, although our products compete primarily with other mixing consoles in the high-end price range of our targeted market segments, we also believe that, as technology in the professional audio industry advances, prices for mixing consoles and other audio equipment, including our products, will decrease. As a result, our products may increasingly compete against lower-priced products, as well as products in the high-end price range. Although we believe that our audio mixing console has certain technological advantages over our competitors, maintaining such advantages will require continued investment by us in research and development, sales and marketing and customer service and support. There can be no assurance that we will have sufficient resources to be able to maintain such competitive advantages. There are numerous companies that compete in the professional audio market. Many of our competitors are larger and have greater financial, technical, manufacturing and marketing resources, broader -16- 19 product offerings, more extensive distribution networks and larger installed bases than ours. We believe that companies with large installed bases, in particular, may have a competitive advantage since many potential customers in our targeted markets are often reluctant to commit significant resources to replace their current products and to retrain operators to use new products despite technological advantages of such new alternative products. Some of our competitors also offer customers leasing or refinancing packages in connection with the purchase of their mixing consoles, which financing alternatives we do not generally offer. Furthermore, we compete with resellers of used mixing consoles and equipment who are able to sell high-end price range products at generally lower prices. WE DEPEND ON SINGLE AND LIMITED SOURCES FOR KEY COMPONENTS, AND IF WE LOSE ONE OR MORE OF THESE SOURCES, DELIVERY OF OUR PRODUCTS COULD BE DELAYED OR PREVENTED AND OUR BUSINESS COULD SUFFER We and our manufacturing vendors are dependent upon single or limited source suppliers, such as Analog Devices and Maxim Integrated Products, for numerous components and parts used in our products. Currently, we use many sole or limited source suppliers, some of which are critical to our continued uninterrupted production because they supply key components, such as integrated circuits, included in our base system. In particular, we rely on single vendors to manufacture major subassemblies for our products, and other components are critical to the integrated circuits included in our base system. There can be no assurance that these suppliers will continue to be able and willing to meet our requirements for any sole-sourced components. We generally purchase these single or limited source components pursuant to purchase orders and have no guaranteed supply arrangements with such suppliers. In addition, the availability of many components to our subcontractors is dependent in part on our ability to provide our subcontractors, and in turn the subcontractor's ability to provide their suppliers, with accurate forecasts of their future requirements. Major delays or terminations in supplies of such components could significantly adversely affect our timely shipment of our products, which in turn would adversely affect our business and results of operations. The process of qualifying suppliers or designing out certain parts could be lengthy, and no assurance can be given that any additional sources or product redesign would be available to us or implemented on a timely basis. From time to time in the past, we have experienced interruptions in the supply of certain key components from suppliers, which delayed product shipments and there can be no assurance that we will not experience significant shortages for these components in the future. We do not maintain an extensive inventory of such components and any extended interruption or reduction in the future supply or increases in prices of any key components currently obtained from a single limited source supplier could have a material adverse effect on our business and results of operations for any given period. If we encounter shortages in component supply, we may be forced to adjust our product designs and production schedules. The failure of one or more of our key suppliers or vendors to fulfill our orders in a timely manner could cause us to not meet our contractual obligations, could damage our customer relationships and could harm our business. OUR SUPPLIERS' ABILITY TO PRODUCE COMPONENTS IS DEPENDENT ON OUR AND OUR SUPPLIERS' ABILITY TO GENERATE ACCURATE FORECASTS, AND THE PROCESS OF QUALIFYING NEW SUPPLIERS IS LENGTHY Our suppliers rely on subcontractors to provide them with components, and their ability to timely procure such components is dependent in part on our ability to provide our subcontractors, and in turn the subcontractor's ability to provide their suppliers, with accurate forecasts of future requirements. The process of qualifying suppliers or designing out certain parts could be lengthy, and no assurance can be given that any additional sources or product redesign would be available to us or implemented on a timely basis. If we are unable to procure key components, shipments of our products would be delayed and revenues would fall. -17- 20 NEW LAWS COULD RESULT IN INCREASED EXPENDITURES, WHICH WOULD HARM OUR RESULTS OF OPERATIONS If different electrical, radiation or other standards applicable to our products are adopted in countries in which we sell our products, including the United States, we may have to increase our expenditures in order to make our products compliant with these laws. In addition, any failure to modify our products, if necessary, to comply with such standards would potentially subject us to fines and penalties, and would harm our business and results of operations. OUR INTELLECTUAL PROPERTY IS VERY IMPORTANT TO OUR BUSINESS, AND IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER We generally rely on a combination of trade secret, copyright law and trademark law, contracts and technical measures to establish and protect our proprietary rights in our products and technologies. We believe, however, that these measures provide only limited protection of our proprietary information, and there is no assurance that they will be adequate to prevent misappropriation. In addition, significant and protracted litigation may be necessary to protect our intellectual property rights, to determine the scope of the proprietary rights of others or to defend against claims of infringement. There can be no assurance that third-party claims alleging infringement will not be asserted against us in the future. Any such claims could seriously harm our business and results of operations. WE MUST CONTINUALLY ATTRACT AND RETAIN OUR MANAGEMENT AND TECHNICAL PERSONNEL OR WE WILL BE UNABLE TO EXECUTE OUR BUSINESS STRATEGY Our future success depends in part on our ability to attract, retain and motivate key management and technical employees. Competition for such personnel is intense in the high tech industry, especially in the Silicon Valley employment market, and we may be unable to successfully attract, integrate or retain sufficiently qualified personnel. We have experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled and qualified employees. WE MUST EFFECTIVELY MANAGE AND SUPPORT OUR GROWTH IN ORDER FOR OUR BUSINESS STRATEGY TO SUCCEED We will need to continue to increase revenues and grow in all areas of operation in order to execute our business strategy. Managing and sustaining our growth will place significant demands on management as well as on our administrative, operational and financial systems and controls. If we are unable to do this effectively, we would have to divert resources such as management time away from the continued growth of our business and implementation of our business strategy, and our business and results of operations will be adversely affected. WE RELY ON A CONTINUOUS POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND CALIFORNIA'S CURRENT ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND INCREASE OUR EXPENSES. California is in the midst of an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for the state of California fall below certain critical levels, California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout California. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruption in our power supply. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our California facilities. -18- 21 Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations. A DISASTER COULD SEVERELY DAMAGE OUR OPERATIONS A disaster could severely damage our ability to deliver our products to our customers. Our products depend on our ability to maintain and protect our facilities, which are primarily located in or near our principal headquarters in Palo Alto, California. Palo Alto may exist on or near a known earthquake fault zone. Although the facilities in which we host our computer systems are designed to be fault tolerant, the systems are susceptible to damage from fire, floods, earthquakes, power loss, telecommunications failures, and similar events. Although we maintain general business insurance against fires, floods and some general business interruptions, there can be no assurance that the amount of coverage will be adequate in any particular case. CHANGES IN EXCHANGE RATES COULD HURT OUR REVENUES Our wholly-owned sales and service subsidiary in Japan conducts its business in the local currency. Changes in the value of the Yen relative to the value of the U.S. dollar, therefore, could adversely affect future revenues and operating results. We have not hedged transactions with external parties. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Sales through our Japanese subsidiary are denominated in Japanese Yen. The receivables denominated in Yen are subject to foreign exchange risk, and we do not enter into hedging arrangements to mitigate the foreign currency risk with respect to such arrangements. An adverse change in the foreign exchange rate would have an effect on the price of our consoles sold in Japan and could result in foreign currency transaction losses. We believe that such losses may be material. -19- 22 PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS: At our Annual Stockholders' Meeting held on June 19, 2001, the following proposals were adopted by the margins indicated. Proposal 1: Election of Directors

The following directors, who were not up for election at the Annual Meeting, continued to serve as directors after the Annual Meeting: Dieter Meier, Richard Feldman and Steven Vining. Subsequent to the Annual Meeting, Messrs. Feldman and Kuhling resigned from the Board of Directors, and Martin Kloiber was appointed to the Board of Directors. Proposal 2: Approval of the Convertibility Feature of the Secured Promissory Note Issued in April 2000. For Against Abstain Broker Non-Vote 7,681,097 20,989 9,286 2,081,532 Proposal 3: Approval of the Convertibility Feature of Secured Promissory Note Issued in September 2000. For Against Abstain Broker Non-Vote 7,681,387 20,999 8,986 2,081,532 Proposal 4: Approval of the Convertibility Feature of Secured Promissory Note Issued in December 2000. For Against Abstain Broker Non-Vote 7,680,437 22,549 8,386 2,081,532 Proposal 5: Approval of the Convertibility Feature of Secured Promissory Note Issued in March 2001. For Against Abstain Broker Non-Vote 7,680,287 22,699 8,386 2,081,532 -20- 23 Proposal 6: Approval of the Increase in the Authorized Number of Shares of Common Stock from 20,000,000 to 35,000,000 For Against Abstain Broker Non-Vote 9,718,936 30,887 43,081 0 Proposal 7: Ratification of Independent Public Accountants For Against Abstain Broker Non-Vote 9,755,198 28,745 8,961 0 ITEM 5. OTHER INFORMATION. In July 2001, directors Richard Feldman and Robert Kuhling resigned from the Audit Committee and the Board of Directors. In July 2001, Martin Kloiber was appointed to the Board of Directors and to the Audit Committee, and James Dobbie was appointed to the Audit Committee. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) EXHIBITS. The exhibits listed in the accompanying Index to Exhibits immediately following the signature page are incorporated by reference as part of this Form 10-Q. (b) REPORTS ON FORM 8-K. We did not file any reports on Form 8-K during the quarter ending June 30, 2001. -21- 24 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Euphonix, Inc. Date: August 14, 2001 By: /s/ JEFFREY CHEW ----------------------------------------- Jeffrey Chew, Chief Executive Officer (Principal Executive and Financial Officer) -22- 25 INDEX TO EXHIBITS The following Exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K:

(1) Incorporated by reference to the exhibit filed with the Registrant's Registration Statement on Form SB-2 (File No. 33-994898-LA), effective August 21, 1995. -23-

EUPHONIX INC \CA\ 10-Q