EXHIBIT 10.9

 

I/OMagic Corporation 2001 Incentive and Nonstatutory Stock Option Plan

Dated

September 29, 2001

 

 

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I/OMagic Corporation

 

2001 INCENTIVE AND NONSTATUTORY STOCK OPTION PLAN

 

1.             Purpose

 

This Incentive and Nonstatutory Stock Option Plan (the “Plan”) is intended to
further the growth and financial success of I/OMagic Corporation, a Nevada
corporation (the “Corporation”) by providing additional incentives to selected
employees, directors, and consultants to the Corporation or parent corporation
or subsidiary corporation of the Corporation as those terms are defined in
Sections 424(e) and 424(f) of the Internal Revenue Code of 1986, as amended (the
“Code”) (such parent corporations and subsidiary corporations hereinafter
collectively referred to as “Affiliates”) so that such employees and consultants
may acquire or increase their proprietary interest in the Corporation.  Stock
options granted under the Plan (hereinafter “Options”) may be either “Incentive
Stock Options,” as defined in Section 422A of the Code and any regulations
promulgated under said Section, or “Nonstatutory Options” at the discretion of
the Board of Directors of the Corporation (the “Board”) and as reflected in the
respective written stock option agreements granted pursuant hereto.

 

2.             Administration

 

The Plan shall be administered by the Board of Directors of the Corporation;
provided however, that the Board may delegate such administration to a committee
of not fewer than three (3) members (the “Committee”), at least two (2) of whom
are members of the Board and all of whom are disinterested administrators, as
contemplated by Rule 16b-3 promulgated under the Securities Exchange Act of
1934, as amended (“Rule 16b-3”); and provided further, that the foregoing
requirement for disinterested administrators shall not apply prior to the date
of the first registration of any of the securities of the Corporation under the
Securities Act of 1933, as amended.

 

Subject to the provisions of the Plan, the Board and/or the Committee shall have
authority to (a) grant, in its discretion, Incentive Stock Options in accordance
with Section 422A of the Code or Nonstatutory Options; (b) determine in good
faith the fair market value of the stock covered by an Option; (c) determine
which eligible persons shall be granted Options and the number of shares to be
covered thereby and the term thereof; (d) construe and interpret the Plan; (e)
promulgate, amend and rescind rules and regulations relating to its
administration, and correct defects, omissions, and inconsistencies in the Plan
or any Option; (f) consistent with the Plan and with the consent of the
optionee, as appropriate, amend any outstanding Option or amend the exercise
date or dates thereof; (g) determine the duration and purpose of leaves of
absence which may be granted to optionholders without constituting termination
of their employment for the purpose of the Plan; and (h) make all other
determinations necessary or advisable for the Plan’s administration.  The
interpretation and construction by the Board of any provisions of the Plan or of
any Option it shall be conclusive and final.  No member of the Board or the
Committee shall be liable for any action or determination made in good faith
with respect to the Plan or any Option.

 

3.                                       Eligibility

 

The persons who shall be eligible to receive Options shall be employees,
directors, or consultants of the Corporation or any of its Affiliates
(“Optionees”).  The term consultant shall mean any person who is engaged by the
Corporation to render services and is compensated for such services, and any
director of the Corporation whether or not compensated for such services;
provided that, if the Corporation registers any of its securities pursuant to
the Securities Act of 1933, as amended (the “Act”), the term consultant shall
thereafter not include directors who are not compensated for their services or
are paid only a director fee by the Corporation.

 

(a)           Incentive Stock Options.  Incentive Stock Options may only be
issued to employees of the

 

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Corporation or its Affiliates.  Incentive Stock Options may be granted to
officers, whether or not they are directors, but a director shall not be granted
an Incentive Stock Option unless such director is also an employee of the
Corporation.  Payment of a director fee shall not be sufficient to constitute
employment by the Corporation.  Any grant of option to an officer or director of
the Corporation subsequent to the first registration of any of the securities of
the Corporation under the Act shall comply with the requirements of Rule 16b-3. 
An optionee may hold more than one Option.

 

The Corporation shall not grant an Incentive Stock Option under the Plan to any
employee if such grant would result in such employee holding the right to
exercise for the first time in any one calendar year, under all options granted
to such employee under the Plan or any other stock option plan maintained by the
Corporation or any Affiliate, with respect to shares of stock having an
aggregate fair market value, determined as of the date of the Option is granted,
in excess of one hundred thousand dollars ($100,000).  Should it be determined
that an Incentive Stock Option granted under the Plan exceeds such maximum for
any reason other than a failure in good faith to value the stock subject to such
option, the excess portion of such option shall be considered a Nonstatutory
Option.  If, for any reason, an entire option does not qualify as an Incentive
Stock Option by reason of exceeding such maximum, such option shall be
considered a Nonstatutory Option.

 

(b)           Nonstatutory Option.  The provisions of the foregoing Section 3(a)
shall not apply to any option designated as a “Nonstatutory Stock Option
Agreement” or which sets forth the intention of the parties that the option be a
Nonstatutory Option.

 

4.                                       Stock

 

The stock subject to Options shall be the shares of the Corporation’s authorized
but unissued or reacquired Common Stock (the “Stock”).

 

(a)           Number of Shares.  Subject to adjustment as provided in Paragraph
5(h) of this Plan, the total number of shares of Stock which may be purchased
through exercise of Options granted under this Plan shall not exceed three
million five hundred thousand (3,500,000) shares.  If any Option shall for any
reason terminate or expire, any shares allocated thereto but remaining
unpurchased upon such expiration or termination shall again be available for the
grant of Options with respect thereto under this Plan as though no Option had
been granted with respect to such shares.

 

(b)           Reservation of Shares.  The Corporation shall reserve and keep
available at all times during the term of the Plan such number of shares as
shall be sufficient to satisfy the requirements of the Plan.  If, after
reasonable efforts, which efforts shall not include the registration of the Plan
or Options under the Act, the Corporation is unable to obtain authority from any
applicable regulatory body, which authorization is deemed necessary by legal
counsel for the Corporation for the lawful issuance of shares hereunder, the
Corporation shall be relieved of any liability with respect to its failure to
issue and sell the shares for which such requisite authority was so deemed
necessary unless and until such authority is obtained.

 

5.             Terms and Conditions of Options

 

Options granted hereunder shall be evidenced by agreements between the
Corporation and the respective Optionees, in such form and substance as the
Board or Committee shall from time to time approve.  Such agreements need not be
identical, and in each case may include such provisions as the Board or
Committee may determine, but all such agreements shall be subject to and limited
by the following terms and conditions:

 

(a)           Number of Shares:  Each Option shall state the number of shares to
which it pertains.

 

(b)           Option Price:  Each Option shall state the Option Price, which
shall be determined as follows:

 

(i)            Any Option granted to a person who at the time the Option is
granted owns (or is deemed to own pursuant to Section 424(d) of the Code) stock
possessing more than ten percent (10%) of the total combined voting power of
value of all classes of stock of the Corporation, or of any Affiliate, (“Ten
Percent Holder”) shall have an Option Price of no less than $1.10 per share; and

 

(ii)           Incentive Stock Options granted to a person who at the time the
Option is granted is

 

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not a Ten Percent Holder shall have an Option price of no less than $1.00 per
share

 

(iii)          Nonstatutory Options granted to a person who at the time the
Option is granted is not a Ten Percent Holder shall have an Option Price
determined by the Board as of the date of grant.

 

(c)           Medium and Time of Payment:  To the extent permissible by
applicable law, the Option price shall be paid, at the discretion of the Board,
at either the time of grant or the time of exercise of the Option (i) in cash or
by check, (ii) by delivery of other common stock of the Corporation, provided
such tendered stock was not acquired directly or indirectly from the
Corporation, or, if acquired from the Corporation, has been held by the Optionee
for more than six (6) months, (iii) by the Optionee’s promissory note in a form
satisfactory to the Corporation and bearing interest at a rate determined by the
Board, in its sole discretion, but in no event less than 6% per annum, or (iv)
such other form of legal consideration permitted by State law as may be
acceptable to the Board.

 

(d)           Term and Exercise of Options:  Any Option granted to an Employee
of the Corporation shall become exercisable over a period of no longer than ten
(10) years, and no less than twenty percent (20%) of the shares covered thereby
shall become exercisable annually.  No Option shall be exercisable, in whole or
in part, prior to one (1) year from the date it is granted unless the Board
shall specifically determine otherwise, as provided herein.  In no event shall
any Option be exercisable after the expiration of ten (10) years from the date
it is granted.  Unless otherwise specified by the Board or the Committee in the
resolution authorizing such option, the date of grant of an Option shall be
deemed to be the date upon which the Board or the Committee authorizes the
granting of such Option.

 

Each Option shall be exercisable to the nearest whole share, in installments or
otherwise, as the respective option agreements may provide.  During the lifetime
of an Optionee, the Option shall be exercisable only by the Optionee and shall
not be assignable or transferable by the Optionee, and no other person shall
acquire any rights therein.  To the extent not exercised, installments (if more
than one) shall accumulate, but shall be exercisable, in whole or in part, only
during the period for exercise as stated in the option agreement, whether or not
other installments are then exercisable.

 

Each Option granted hereunder shall not be exercisable, unless and until the
Corporation lists upon a national stock exchange.

 

(e)           Termination of Status as Employee, Director, or Consultant:  If
Optionee’s status as an employee, director, or consultant shall terminate for
any reason other than Optionee’s death, then the Optionee (or if the Optionee
shall die after such termination, but prior to exercise, Optionee’s personal
representative or the person entitled to succeed to the Option) shall have the
right to exercise any vested Options, in whole or in part, at any time within
thirty (30) days after such termination (or in the event Optionee’s termination
was caused by permanent disability (within the meaning of Section 22(e)(3) of
the Code) this 30-day period shall be extended to six (6) months) or the
remaining term of the Option, whichever is the lesser; provided, however, that
with respect to Nonstatutory Options, the Board may specify such longer period,
not to exceed six (6) months, for exercise following termination as the Board
deems reasonable and appropriate.  The Option may be exercised only with respect
to installments that the Optionee could have exercised at the date of
termination of employment.  Nothing contained herein or in any Option granted
pursuant hereto shall be construed to affect or restrict in any way the right of
the Corporation to terminate the employee of an Optionee with or without cause.

(f)            Death of Optionee: If an Optionee dies while employed or engaged
as a director or consultant by the Corporation or an Affiliate, the portion of
such Optionee’s Option or Options which were exercisable at the date of death
may be exercised, in whole or in part, by the estate of the decedent or by a
person succeeding to the right to exercise such Option or Options, at any time
within the remaining term of the Option, but only to the extent, that Optionee
could have exercised the Option as of the date of Optionee’s death; provided, in
any case, that the Option may be so exercised only to the extent that the Option
has not previously been exercised by Optionee.

 

(g)           Nontransferability of Option: No Option shall be transferable by
the Optionee, except by will or by the laws of descent and distribution.

 

(h)           Recapitalization:  Subject to any required action by the
stockholders, the number of shares of common stock covered by each outstanding
Option, and the price per share thereof set forth in each such Option, shall be

 

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proportionately adjusted for any increase or decrease in the number of issued
shares of common stock of the Corporation resulting from a subdivision or
consolidation of shares or the payment of a stock dividend, or any other
increase or decrease in the number of such shares affected without receipt of
consideration by the Corporation.

 

Subject to any required action by the stockholders, if the Corporation shall be
the surviving entity in any merger or consolidation, each outstanding Option
thereafter shall pertain to and apply to the securities to which a holder of
shares of common stock equal to the shares subject to the Option would have been
entitled by reason of such merger or consolidation.  A dissolution or
liquidation of the Corporation or a merger or consolidation in which the
Corporation is not the surviving entity shall cause each outstanding Option to
terminate on the effective date of such dissolution, liquidation, merger or
consolidation.  In such event, if the entity which shall be the surviving entity
does not tender to Optionee an offer, for which it has no obligation to do so,
to substitute for any unexercised Option a stock option or capital stock of such
surviving entity, as applicable, which on an equitable basis shall provide the
Optionee with substantially the same economic benefit as such unexercised
Option, then the Board may grant to such Optionee, but shall not be obligated to
do so, the right for a period commencing thirty (30) days prior to and ending
immediately prior to such dissolution, liquidation, merger or consolidation or
during the remaining term of the Option, whichever is the lesser, to exercise
any unexpired Option or Options, without regard to the installment provisions of
Paragraph 5(d) of this Plan; provided, that any such right granted shall be
granted to all Optionees not receiving an offer to substitute on a consistent
basis, and provided further, that any such exercise shall be subject to the
consummation of such dissolution, liquidation, merger or consolidation.

 

In the event of a change in the common stock of the Corporation as presently
constituted, which is limited to a change of all of its authorized shares
without par value into the same number of shares with a par value, the shares
resulting from any such change shall be deemed to be the common stock within the
meaning of this Plan.

 

To the extent that the foregoing adjustments relate to stock or securities of
the Corporation, such adjustments shall be made by the Board, whose
determination in that respect shall be final, binding and conclusive.  Except as
expressly provided in this Paragraph 5(h), the Optionee shall have no rights by
reason of any subdivision or consolidation of shares of stock or any class or
the payment of any stock dividend or any other increase or decrease in the
number of shares of stock of any class, and the number or price of shares of
common stock subject to any Option shall not be affected by, and no adjustment
shall be made by reason of, any dissolution, liquidation, merger or
consolidation, or any issue by the Corporation of shares of stock of any class
or securities convertible into shares of stock of any class.

 

The grant of an Option pursuant to the Plan shall not affect in any way the
right or power of the Corporation to make any adjustments, reclassifications,
reorganizations or changes in its capital or business structure or to merge,
consolidate, dissolve, or liquidate or to sell or transfer all or any part of
its business or assets.

 

(i)            Rights as a Stockholder:  An Optionee shall have no rights as a
stockholder with respect to any shares covered by an Option until the date of
the issuance of a stock certificate to Optionee for such shares.  No adjustment
shall be made for dividends (ordinary or extraordinary, whether in cash,
securities or other property) or distributions or other rights for which the
record date is prior to the date such stock certificate is issued, except as
expressly provided in Paragraph 5(h) hereof.

 

(j)            Modification, Acceleration, Extension, and Renewal of Options: 
Subject to the terms and conditions and within the limitations of the Plan, the
Board may modify an Option, or once an Option is exercisable, accelerate the
rate at which it may be exercised, and may extend or renew outstanding Options
granted under the Plan or accept the surrender of outstanding Options (to the
extent not theretofore exercised) and authorize the granting of new Options in
substitution for such Options, provided such action is permissible under Section
422A of the Code and state law.

 

Notwithstanding the foregoing provisions of this Paragraph 5(j), however, no
modification of an Option shall, without the consent of the Optionee, alter to
the Optionee’s detriment or impair any rights or obligations under any Option
theretofore granted under the Plan.

 

(k)           Investment Intent:  Unless and until the issuance and sale of the
shares subject to the Plan are registered under the Act, each Option under the
Plan shall provide that the purchases of stock thereunder shall be for
investment purposes and not with a view to, or for resale in connection with,
any distribution thereof.  Further, unless the

 

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issuance and sale of the stock have been registered under the Act, each Option
shall provide that no shares shall be purchased upon the exercise of such Option
unless and until (i) any then applicable requirements of state and federal laws
and regulatory agencies shall have been fully complied with to the satisfaction
of the Corporation and its counsel, and (ii) if requested to do so by the
Corporation, the person exercising the Option shall (i) give written assurances
as to knowledge and experience of such person (or a representative employed by
such person) in financial and business matters and the ability of such person
(or representative) to evaluate the merits and risks of exercising the Option,
and (ii) execute and deliver to the Corporation a letter of investment intent,
all in such form and substance as the Corporation may require.  If shares are
issued upon exercise of an Option without registration under the Act, subsequent
registration of such shares shall relieve the purchaser thereof of any
investment restrictions or representations made upon the exercise of such
Options.

 

(l)            Exercise Before Exercise Date:  At the discretion of the Board,
the Option may, but need not, include a provision whereby the Optionee may elect
to exercise all or any portion of the Option prior to the stated exercise date
of the Option or any installment thereof.  Any shares so purchased prior to the
stated exercise date shall be subject to repurchase by the Corporation upon
termination of Optionee’s employment as contemplated by Paragraphs 5(e), 5(f)
and 5(g) hereof prior to the exercise date stated in the Option and such other
restrictions and conditions as the Board or Committee may deem advisable.

 

(m)          Other Provisions:  The Option agreements authorized under this Plan
shall contain such other provisions, including, without limitation, restrictions
upon the exercise of the Options, as the Board or the Committee shall deem
advisable.  Shares shall not be issued pursuant to the exercise of an Option, if
the exercise of such Option or the issuance of shares thereunder would violate,
in the opinion of legal counsel for the Corporation, the provisions of any
applicable law or the rules or regulations of any applicable governmental or
administrative agency or body, such as the Act, the Securities Exchange Act of
1934, the rules promulgated under the foregoing or the rules and regulations of
any exchange upon which the shares of the Corporation are listed.

 

6.             Availability of Information

 

During the term of the Plan and any additional period during which an Option
granted pursuant to the Plan shall be exercisable, the Corporation shall make
available, not later than one hundred and twenty (120) days following the close
of each of its fiscal years, such financial and other information regarding the
Corporation as is required by the bylaws of the Corporation and applicable law
to be furnished in an annual report to the stockholders of the Corporation.

 

7.             Effectiveness of Plan; Expiration

 

Subject to approval by the stockholders of the Corporation, this Plan shall be
deemed effective as of the date it is adopted by the Board.  The Plan shall
expire on December 31, 2001, but such expiration shall not affect the validity
of outstanding Options.

 

8.             Amendment and Termination of the Plan

 

The Board may, insofar as permitted by law, from time to time, with respect to
any shares at the time not subject to Options, suspend or terminate the Plan or
revise or amend it in any respect whatsoever, except that without the approval
of the stockholders of the Corporation, no such revision or amendment shall (i)
increase the number of shares subject to the Plan, (ii) decrease the price at
which Options may be granted, (iii) materially increase the benefits to
Optionees, or (iv) change the class of persons eligible to receive Options under
this Plan; provided, however, no such action shall alter or impair the rights
and obligations under any Option outstanding as of the date thereof without the
written consent of the Optionee thereunder.  No Option may be granted while the
Plan is suspended or after it is terminated, but the rights and obligations
under any Option granted while the Plan is in effect shall not be impaired by
suspension or termination of the Plan.

 

9.             Indemnification of Board

 

In addition to such other rights or indemnifications as they may have as
directors or otherwise, and to the extent allowed by applicable law, the members
of the Board and the Committee shall be indemnified by the Corporation against
the reasonable expenses, including attorneys’ fees, actually and necessarily
incurred in connection with the defense of any

 

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claim, action, suit or proceeding, or in connection with any appeal thereof, to
which they or any of them may be a party by reason of any action taken, or
failure to act, under or in connection with the Plan or any Option granted
thereunder, and against all amounts paid by them in settlement thereof (provided
such settlement is approved by independent legal counsel selected by the
Corporation) or paid by them in satisfaction of a judgment in any such claim,
action, suit or proceeding, except in any case in relation to matters as to
which it shall be adjudged in such claim, action, suit or proceeding that such
Board member is liable for negligence or misconduct in the performance of  his
or her duties; provided that within sixty (60) days after institution of any
such action, suit or Board proceeding the member involved shall offer the
Corporation, in writing, the opportunity, at its own expense, to handle and
defend the same.

 

10.           Application of Funds

 

The proceeds received by the Corporation from the sale of common stock pursuant
to the exercise of Options will be used for general corporate purposes.

 

11.           No Obligation to Exercise Option

 

The granting of an Option shall impose no obligation upon the Optionee to
exercise such Option.

 

12.           Notices

 

All notice, requests, demand, and other communications pursuant this Plan shall
be in writing and shall be deemed to have been duly given on the date of service
if served personally on the party to whom notice is to be given, or on the third
day following the mailing thereof to the party to whom notice is to be given, by
first class mail, registered or certified, postage prepaid.

 

13.           Financial Statements

 

Optionees under this Plan shall receive financial statements annually regarding
the Corporation during the period the options are outstanding.  The financial
statements provided need not comply with Title 10, Section 260.613 of the Nevada
Code of Regulations.

 

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* * * * *

The foregoing Incentive and Nonstatutory Stock Option Plan was duly adopted and
approved by the Board of Directors on September 29, 2001.

 

 

 

  /s/ Tony Shahbaz

 

 

Tony Shahbaz, Secretary

 

 

 

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NUMBER

I/OMagic Corporation

 

NONSTATUTORY STOCK OPTION AGREEMENT

 

This NONSTATUTORY STOCK OPTION AGREEMENT is made and entered into as of this
       day of                     , 2001, by and between I/OMagic Corporation, a
Nevada corporation (“Company”), and                                            
(referred to herein as the “Optionee”), with reference to the following recitals
of facts:

 

WHEREAS, the Board has authorized the granting to Optionee of a nonstatutory
stock option (“Option”) to purchase shares of common stock of the Company (the
“Shares”) upon the terms and conditions hereinafter stated; and

 

WHEREAS, the Board and stockholders of the Company have heretofore adopted a
2001 Incentive and Nonstatutory Stock Option Plan (the “Plan”), pursuant to
which this Option is being granted;

 

WHEREAS, it is the intention of the parties that this Option be a Nonstatutory
Stock Option;

 

NOW, THEREFORE, in consideration of the covenants herein set forth, the parties
hereto agree as follows:

 

1.             Shares; Price.  The Company hereby grants to Optionee the right
to purchase, upon and subject to the terms and conditions herein
stated,              Shares for cash (or other consideration acceptable to the
Board of Directors of the Company, in their sole and absolute discretion) at the
price of $        per Share, such price being determined in accordance with the
Plan.

 

2.             Term of Option; Continuation of Employment.  This Option shall
expire, and all rights hereunder to purchase the Shares shall terminate, ten
(10) years from the date hereof.  This Option shall earlier terminate subject to
Paragraphs 5 and 6 hereof if, and as of the date, Optionee ceases to be an
employee, director, or consultant of the Company.  Nothing contained herein
shall be construed to interfere in any way with the right of the Company to
terminate the employment or engagement, as applicable, of Optionee or to
increase or decrease the compensation of Optionee from the rate in existence at
the date hereof.

 

3.             Vesting of Option.  Subject to the provisions of Paragraphs 5 and
6 hereof, this Option shall vest and become exercisable during the term of
Optionee’s employment or engagement in whole or in part beginning on the date of
this Agreement.

 

4.             Exercise.  This Option shall be exercised by delivery to the
Company of (a) a written notice of exercise stating the number of Shares being
purchased (in whole shares only) and such other information set forth on the
form of Notice of Exercise attached hereto as Appendix A, (b) a check or cash in
the amount of the purchase price of the Shares covered by the notice, and (c) a
written statement as provided for in Paragraph 11 hereof.  This Option shall not
be assignable or transferable, except by will or by the laws of descent and
distribution, and shall be exercisable only by Optionee during his or her
lifetime.

 

5.             Termination of Employment or Engagement.  If Optionee shall cease
to serve as an employee, director, or consultant of the Company for any reason,
whether voluntarily or involuntarily, other than by his or her death or the
conclusion of the term of a written consulting agreement, provided such term
exceeds one year, Optionee shall have the right at any time within thirty (30)
days after date Optionee ceases to be an employee, director, or consultant of
the Company, or the remaining term of this Option, whichever is the lesser, to
exercise in whole or in part this Option to the extent, but only to the extent,
that this Option was exercisable as of the last day of employment or engagement,
as applicable, and had not previously been exercised; provided, however, that if
Optionee’s termination of employment or engagement was caused by permanent
disability disabled (within the meaning of Section 22(e)(3) of the Code), the
foregoing thirty (30) day period shall be extended to six (6) months.

 

Notwithstanding anything herein to the contrary, all rights under this Option
shall expire in any event on the date specified in Paragraph 2 hereof.

 

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6.             Death of Optionee.  If the Optionee shall die while an employee,
director, or consultant of the Company, Optionee’s personal representative or
the person entitled to Optionee’s rights hereunder may at any time during the
remaining term of this Option, exercise this Option and purchase Shares to the
extent, but only to the extent, that Optionee could have exercised this Option
as of the date of Optionee’s death; provided, in any case, that this Option may
be so exercised only to the extent that this Option has not previously been
exercised by Optionee.

 

7.             No Rights as Stockholder.  Optionee shall have no rights as a
stockholder with respect to the Shares covered by any installment of this Option
until the date of the issuance of a stock certificate to Optionee, and no
adjustment will be made for dividends or other rights for which the record date
is prior to the date such stock certificate or certificates are issued except as
provided in Paragraph 8 hereof.

 

8.             Recapitalization.  Subject to any required action by the
stockholders of the Company, the number of Shares covered by this Option, and
the price per Share thereof, shall be proportionately adjusted for any increase
or decrease in the number of issued Shares resulting from a subdivision or
consolidation of shares or the payment of a stock dividend, or any other
increase or decrease in the number of such shares affected without receipt of
consideration by the Company; provided however that the conversion of any
convertible securities of the Company shall not be deemed having been “effected
without receipt of consideration by the Company.”

 

In the event of a proposed dissolution or liquidation of the Company, a merger
or consolidation in which the Company is not the surviving entity, or a sale of
all or substantially all of the assets of the Company, this Option shall
terminate immediately prior to the consummation of such proposed action, unless
otherwise provided by the Board.  The Board may, at its sole and absolute
discretion and without obligation, declare that this Option shall terminate as
of a date fixed by the Board and grant Optionee the right for a period
commencing thirty (30) days prior to and ending immediately prior to such date,
or during the remaining term of this Option, whichever occurs sooner, to
exercise this Option as to all or any part of the Shares, without regard to the
installment provision of Paragraph 3; provided, however, that such exercise
shall be subject to the consummation of such dissolution, liquidation, merger,
consolidation or sale.

 

Subject to any required action by the stockholders of the Company, if the
Company shall be the surviving entity in any merger or consolidation, this
Option thereafter shall pertain to and apply to the securities to which a holder
of Shares equal to the Shares subject to this Option would have been entitled by
reason of such merger or consolidation, and the vesting provisions of Section 3
shall continue to apply.

 

In the event of a change in the Shares of the Company as presently constituted,
which is limited to a change of all of its authorized Shares without par value
into the same number of Shares with a par value, the Shares resulting from any
such change shall be deemed to be the Shares within the meaning of this
Agreement.

 

To the extent that the foregoing adjustments relate to shares or securities of
the Company, such adjustments shall be made by the Board, whose determination in
that respect shall be final, binding and conclusive.  Except as hereinbefore
expressly provided, Optionee shall have no rights by reason of any subdivision
or consolidation of share of stock of any class or the payment of any stock
dividend or any other increase or decrease in the number of shares of stock of
any class, and the number and price of shares subject to this Option shall not
be affected by, and no adjustments shall be made by reason of, any dissolution,
liquidation, merger or consolidation, or any issue by the Company of shares of
stock of any class or securities convertible into shares of stock of any class.

 

The grant of this Option shall not affect in any way the right or power of the
Company to make adjustments, reclassifications, reorganizations or changes in
its capital or business structure or to merge, consolidate, dissolve or
liquidate or to sell or transfer all or any part of its business or assets.

 

9.             Taxation upon Exercise of Option.  Optionee understands that,
upon exercise of this Option, Optionee may recognize income, for federal and
state income tax purposes, in an amount equal to the amount by which the fair
market value of the Shares, determined as of the date of exercise, exceeds the
exercise price.  The acceptance of the Shares by Optionee shall constitute an
agreement by Optionee to report such income in accordance with then applicable
law and to cooperate with Company in establishing the amount of such income and
corresponding deduction to the Company for its income tax purposes.  Withholding
for federal or state income and employment tax purposes will be made, if and as
required by law, from Optionee’s then current compensation, or, if such current
compensation is

 

2

--------------------------------------------------------------------------------

 

insufficient to satisfy withholding tax liability, the Company may require
Optionee to make cash payment to cover such liability as a condition of the
exercise of this Option.

 

10.           Modification, Extension and Renewal of Options.  The Board may
modify, extend or renew this Option or accept the surrender thereof (to the
extent not theretofore exercised) and autho0rize the granting of a new option in
substitution therefore (to the extent not theretofore exercised), subject at all
times to the Plan.  Notwithstanding the foregoing provisions of this Paragraph
10, no modification shall, without the consent of the Optionee, alter to the
Optionee’s detriment or impair any rights of Optionee hereunder.

 

11.           Investment Intent; Restrictions on Transfer.  Optionee represents
and agrees that if Optionee exercises this Option in whole or in part, Optionee
will in each case acquire the Shares upon such exercise for the purpose of
investment and not with a view to, or for resale in connection with, any
distribution thereof; and that upon such exercise of this Option in whole or in
part, Optionee (or any person or persons entitled to exercise this Option under
the provisions of Paragraphs 5 and 6 hereof) shall furnish to the Company a
written statement to such effect, satisfactory to the Company in form and
substance.  The Company, at its option, may include a legend on each certificate
representing Shares issued pursuant to any exercise of this Option, stating in
effect that such Shares have not been registered under the Securities Act of
1933, as amended (the “Act”), and that the transferability thereof is
restricted.  If the Shares represented by this Option are registered under the
Act, either before or after the exercise of this Option in whole or in part, the
Optionee shall be relieved of the foregoing investment representation and
agreement and shall not be required to furnish the Company with the foregoing
written statement.

 

Optionee further represents that Optionee has had access to the financial
statements or books and records of the Company, has had the opportunity to ask
questions of the Company concerning its business, operations and financial
condition, and to obtain additional information reasonably necessary to verify
the accuracy of such information, and further represents that Optionee has
either such experience and knowledge in investment, financial and business
matters or has investments similar to the stock of the Company such that
Optionee is capable of evaluating the merits and risks thereof and has the
capacity to protect his or her own interest in connection therewith.

 

12.           Registration Rights.

 

a.             Piggyback Registration Rights.  If the Company at any time
proposes to register any of its securities under the Act, including under an S-8
Registration Statement, an SB-2 Registration Statement or otherwise, it will
each such time give written notice to all holders of outstanding or exercised
options of its intention so to do.  Upon the written request of a holder or
holders of any such outstanding or exercised options given within thirty (30)
days after receipt of any such notice, the Company will use its best efforts to
cause all such outstanding or exercised options, the holders of which shall have
so requested registration thereof, to be registered under the Act (with the
securities which the Company at the time propose to register), all to the extent
requisite to permit the sale or other disposition by the prospective Sellers of
the outstanding or exercised options so registered; provided, however, that the
Company may, as a condition precedent to its effecting such registration,
require each prospective Seller to agree with the Company and the managing
underwriter or underwriters of the offering to be made by the Company in
connection with such registration that such Seller will not sell any securities
of the same class or convertible into the same class as those registered by the
Company (including any class into which the securities registered by the Company
are convertible) for such reasonable period after such registration becomes
effective as shall then be specified in writing by such underwriter or
underwriters if in the opinion of such underwriter or underwriters the Company’s
offering would be materially adversely affected in the absence of such an
agreement.

 

b.             Procedures.  In connection with the registration of any
securities pursuant to Section 12.a. hereof, the Company and the Optionee
covenant and agree as follows:

 

(i)            The Company shall pay all costs, fees, and expenses incurred by
the Company and the Optionee in connection with the Registration Statement and
the offering thereunder including, without limitation, the Company’s legal fees
and expenses of counsel, accounting fees, printing expenses, and blue sky fees
and expenses (but excluding discounts or selling commissions of any underwriter
or broker dealer acting on behalf of the company or the Optionee).

 

3

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(ii)           The Company shall take all necessary action which may be
reasonably required in qualifying or registering the securities included in the
Registration Statement for offering and sale under the securities or blue sky
laws of all states reasonably requested by Optionee, provided that the Company
shall not be obligated to qualify as a foreign corporation to do business under
the laws of any such jurisdiction.

 

(iii)          The Company shall indemnify Optionee and each person, if any, who
controls Optionee within the meaning of Section 15 of the Act or Section 20(a)
of the Securities Exchange Act of 1934 (the “Exchange Act”), against all loss,
claim, damage, expense or liability (including all expenses reasonably incurred
in investigating, preparing or defending against any claim whatsoever) to which
any of them may become subject under the Act, the Exchange Act or otherwise,
arising from the Registration Statement.

 

(iv)          The Company shall, as soon as practicable after the effective date
of the Registration Statement, and in any event within fifteen (15) months
thereafter, make “generally available to its security holders” (within the
meaning of Rule 158 under the Act) an earnings statement  (which need not be
audited) complying with Section 11(a) of the Act and covering a period of at
least twelve (12) consecutive months beginning after the effective date of the
Registration Statement.

 

(v)           The Company shall (A) deliver promptly to Optionee and its
counsel, upon request, copies of all correspondence between the Commission and
the Company, its counsel, or auditors and all memoranda relating to discussions
with the Commission or its staff with respect to the Registration Statement; and
(B) permit Optionee and its counsel to perform such investigation, upon
reasonable advance notice, with respect to information contained in or omitted
from the Registration Statement, as it deems reasonably necessary to comply with
applicable securities laws or rules of the National Association of Securities
Dealers, Inc.  Such investigation shall include, but not be limited to, access
to financial and accounting information and opportunities to discuss the
business of the Company with the Company’s officers and independent auditors,
all to such reasonable extent, at such reasonable times and as often as Optionee
and its counsel shall reasonably request.

 

(vi)          The Company shall cause all securities of Optionee registered
pursuant to a Registration Statement to be listed on any national securities
exchange or quoted on any automated quotation system on which similar securities
of the Company are listed or quoted.

 

13.           Stand-off Agreement.  Optionee agrees that in connection with any
registration of the Company’s securities, that upon the request of the Company
or any underwriter managing an underwritten offering of the Company’s
securities, that Optionee shall not sell, short any sale of, loan, grant an
option for, or otherwise dispose of any of the Shares (other than Shares
included in the offering) without the prior written consent of the Company or
such managing underwriter, as applicable, for a period of at least one hundred
eighty (180) days following the effective date of registration of such offering.

 

14.           Notices.  Any notice required to be given pursuant to this Option
or the Plan shall be in writing and shall be deemed to be delivered upon receipt
or, in the case of notices by the Company, five (5) days after deposit in the
U.S.  mail, postage prepaid, addressed to Optionee at the address last provided
to the Company by Optionee for his or her employee records.

 

15.           Agreement Subject to Plan; Applicable Law.  This Agreement is made
pursuant to the Plan and shall be interpreted to comply therewith.  A copy of
such Plan is available to Optionee, at no charge, at the principal office of the
Company.  Any provision of this Agreement inconsistent with the Plan shall be
considered void and replaced with the applicable provision of the Plan.  This
Agreement has been granted, executed and delivered in the State of California,
and the interpretation and enforcement shall be governed by the laws thereof and
subject to the exclusive jurisdiction of the courts therein.

 

IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the
date first above written.

 

I/OMagic Corporation

 

 

 

 

 

 

 

 

 

 

 

BY: Tony Shahbaz, President

 

,Optionee

 

 

4

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Appendix A

 

NOTICE OF EXERCISE

 

I/OMagic Corporation

1300 Wakeham

Santa Ana, California 92705

 

 

 

 

 

 

(date)

 

 

Re:  Nonstatutory Stock Option

 

Notice is hereby given pursuant to Section 4 of my Nonstatutory Stock Option
Agreement that I elect to purchase the number of shares set forth below at the
exercise price set forth in my option agreement:

 

Stock Option dated:

 

 

 

 

 

Number of shares being purchased:

 

 

 

 

 

Option Exercise Price:

 

$

 

 

A check in the amount of the aggregate price of the shares being purchased is
attached.

 

I hereby confirm that such shares are being acquired by me for my own account
for investment purposes, and not with a view to, or for resale in connection
with, any distribution thereof.

 

Further, I understand that, as a result of this exercise of rights, I will
recognize income in an amount equal to the amount by which the fair market value
of the Shares exceeds the exercise price.  I agree to report such income in
accordance with then applicable law and to cooperate with Company in
establishing the withholding and corresponding deduction to the Company for its
income tax purposes.

 

I agree to provide to the Corporation such additional documents or information
as may be required pursuant to the Corporation’s 2001 Incentive and Nonstatutory
Stock Option Plan.

 

 

 

 

 

(Signature)

 

 

 

 

 

 

 

 

(Name of Optionee)

 

 

--------------------------------------------------------------------------------

 

I/OMagic Corporation

 

Number

INCENTIVE STOCK OPTION AGREEMENT

 

This INCENTIVE STOCK OPTION AGREEMENT is made and entered into as of this      
day of                , 2001, by and between I/OMagic Corporation, a Nevada
corporation (“Company”), and                                (referred to herein
as the “Optionee”), with reference to the following recitals of facts:

 

WHEREAS, the Board has authorized the granting to Optionee of an incentive stock
option (“Option”) to purchase shares of common stock of the Company (the
“Shares”) upon the terms and conditions hereinafter stated; and

 

WHEREAS, the Board and stockholders of the Company have heretofore adopted a
2000 Incentive and Nonstatutory Stock Option Plan (the “Plan”), pursuant to
which this Option is being granted;

 

WHEREAS, it is the intention of the parties that this Option be an Incentive
Stock Option (a Qualified Stock Option);

 

NOW, THEREFORE, in consideration of the covenants herein set forth, the parties
hereto agree as follows:

 

1.             Shares; Price.  The Company hereby grants to Optionee the right
to purchase, upon and subject to the terms and conditions herein stated,        
Shares for cash (or other consideration acceptable to the Board of Directors of
the Company, in their sole and absolute discretion) at the price of $     per
Share, such price being not less than the fair market value per share of the
Shares covered by these Options as of the date hereof and as determined by the
Board of Directors of the Company.

 

2.             Term of Option; Continuation of Employment.  This Option shall
expire, and all rights hereunder to purchase the Shares shall terminate, ten
(10) years from the date hereof.  This Option shall earlier terminate subject to
Paragraphs 5 and 6 hereof if, and as of the date, Optionee ceases to be an
employee of the Company.  Nothing contained herein shall be construed to
interfere in any way with the right of the Company to terminate the employment
or engagement, as applicable, of Optionee or to increase or decrease the
compensation of Optionee from the rate in existence at the date hereof.

 

3.             Vesting of Option.  Subject to the provisions of Paragraphs 5 and
6 hereof, this Option shall vest and become exercisable during the term of
Optionee’s employment or engagement in whole or in part beginning on the date of
this Agreement.

 

4.             Exercise.  This Option shall be exercised by delivery to the
Company of (a) a written notice of exercise stating the number of Shares being
purchased (in whole shares only) and such other information set forth on the
form of Notice of Exercise attached hereto as Appendix A, (b) a check or cash in
the amount of the purchase price of the Shares covered by the notice, and (c) a
written statement as provided for in Paragraph 11 hereof.  This Option shall not
be assignable or transferable, except by will or by the laws of descent and
distribution, and shall be exercisable only by Optionee during his or her
lifetime.

 

5.             Termination of Employment or Engagement.  If Optionee shall cease
to serve as an employee of the Company for any reason, whether voluntarily or
involuntarily, other than by his or her death or the conclusion of the term of a
written consulting agreement, provided such term exceeds one year, Optionee
shall have the right at any time within thirty (30) days after date Optionee
ceases to be an employee of the Company, or the remaining term of this Option,
whichever is the lesser, to exercise in whole or in part this Option to the
extent, but only to the extent, that this Option was exercisable as of the last
day of employment or engagement, as applicable, and had not previously been
exercised; provided, however, that if Optionee’s termination of employment or
engagement was caused by permanent disability (within the meaning of Section
22(e)(3) of the Code), the foregoing thirty (30) day period shall be extended to
six (6) months; or

 

--------------------------------------------------------------------------------

 

Notwithstanding anything herein to the contrary, all rights under this Option
shall expire in any event on the date specified in Paragraph 2 hereof.

 

6.             Death of Optionee.  If the Optionee shall die while an employee
of the Company, Optionee’s personal representative or the person entitled to
Optionee’s rights hereunder may at any time during the remaining term of this
Option, exercise this Option and purchase Shares to the extent, but only to the
extent, that Optionee could have exercised this Option as of the date of
Optionee’s death; provided, in any case, that this Option may be so exercised
only to the extent that this option has not previously been exercised by
Optionee.

 

7.             No Rights as Stockholder.  Optionee shall have no rights as a
stockholder with respect to the Shares covered by any installment of this Option
until the date of the issuance of a stock certificate to Optionee, and no
adjustment will be made for dividends or other rights for which the record date
is prior to the date such stock certificate or certificates are issued except as
provided in Paragraph 8 hereof.

 

8.             Recapitalization.  Subject to any required action by the
stockholders of the Company, the number of Shares covered by this Option, and
the price per Share thereof, shall be proportionately adjusted for any increase
or decrease in the number of issued Shares resulting from a subdivision or
consolidation of shares or the payment of a stock dividend, or any other
increase or decrease in the number of such shares affected without receipt of
consideration by the Company; provided however that the conversion of any
convertible securities of the Company shall not be deemed having been “effected
without receipt of consideration by the Company.”

 

In the event of a proposed dissolution or liquidation of the Company, a merger
or consolidation in which the Company is not the surviving entity, or a sale of
all or substantially all of the assets of the Company, this Option shall
terminate immediately prior to the consummation of such proposed action, unless
otherwise provided by the Board.  The Board may, at its sole and absolute
discretion and without obligation, declare that this Option shall terminate as
of a date fixed by the Board and grant Optionee the right for a period
commencing thirty (30) days prior to and ending immediately prior to such date,
or during the remaining term of this Option, whichever occurs sooner, to
exercise this Option as to all or any part of the Shares, without regard to the
installment provision of Paragraph 3; provided, however, that such exercise
shall be subject to the consummation of such dissolution, liquidation, merger,
consolidation or sale.

 

Subject to any required action by the stockholders of the Company, if the
Company shall be the surviving entity in any merger or consolidation, this
Option thereafter shall pertain to and apply to the securities to which a holder
of Shares equal to the Shares subject to this Option would have been entitled by
reason of such merger or consolidation, and the vesting provisions of Section 3
shall continue to apply.

 

In the event of a change in the Shares of the Company as presently constituted,
which is limited to a change of all of its authorized Shares without par value
into the same number of Shares with a par value, the Shares resulting from any
such change shall be deemed to be the Shares within the meaning of this
Agreement.

 

To the extent that the foregoing adjustments relate to shares or securities of
the Company, such adjustments shall be made by the Board, whose determination in
that respect shall be final, binding and conclusive.  Except as hereinbefore
expressly provided, Optionee shall have no rights by reason of any subdivision
or consolidation of share of stock of any class or the payment of any stock
dividend or any other increase or decrease in the number of shares of stock of
any class, and the number and price of shares subject to this Option shall not
be affected by, and no adjustments shall be made by reason of, any dissolution,
liquidation, merger or consolidation, or any issue by the Company of shares of
stock of any class or securities convertible into shares of stock of any class.

 

The grant of this Option shall not affect in any way the right or power of the
Company to make adjustments, reclassifications, reorganizations or changes in
its capital or business structure or to merge, consolidate, dissolve or
liquidate or to sell or transfer all or any part of its business or assets.

 

9.             Taxation upon Exercise of Option.  Optionee understands that,
upon exercise of this Option, Optionee may recognize income, for federal and
state income tax purposes, in an amount equal to the amount by which the fair
market value of the Shares, determined as of the date of exercise, exceeds the
exercise price.  The acceptance of the Shares by Optionee shall constitute an
agreement by Optionee to report such income in accordance with then applicable
law and to cooperate with Company in establishing the amount of such income and
corresponding deduction to the

 

2

--------------------------------------------------------------------------------

 

Company for its income tax purposes.  Withholding for federal or state income
and employment tax purposes will be made, if and as required by law, from
Optionee’s then current compensation, or, if such current compensation is
insufficient to satisfy withholding tax liability, the Company may require
Optionee to make cash payment to cover such liability as a condition of the
exercise of this Option.

 

10.           Modification, Extension and Renewal of Options.  The Board may
modify, extend or renew this Option or accept the surrender thereof (to the
extent not theretofore exercised) and authorize the granting of a new option in
substitution therefore (to the extent not theretofore exercised), subject at all
times to the Plan.  Notwithstanding the foregoing provisions of this Paragraph
10, no modification shall, without the consent of the Optionee, alter to the
Optionee’s detriment or impair any rights of Optionee hereunder.

 

11.           Investment Intent; Restrictions on Transfer.  Optionee represents
and agrees that if Optionee exercises this Option in whole or in part, Optionee
will in each case acquire the Shares upon such exercise for the purpose of
investment and not with a view to, or for resale in connection with, any
distribution thereof; and that upon such exercise of this Option in whole or in
part, Optionee (or any person or persons entitled to exercise this Option under
the provisions of Paragraphs 5 and 6 hereof) shall furnish to the Company a
written statement to such effect, satisfactory to the Company in form and
substance.  The Company, at its option, may include a legend on each certificate
representing Shares issued pursuant to any exercise of this Option, stating in
effect that such Shares have not been registered under the Securities Act of
1933, as amended (the “Act”), and that the transferability thereof is
restricted.  If the Shares represented by this Option are registered under the
Act, either before or after the exercise of this Option in whole or in part, the
Optionee shall be relieved of the foregoing investment representation and
agreement and shall not be required to furnish the Company with the foregoing
written statement.

 

Optionee further represents that optionee has had access to the financial
statements or books and records of the Company, has had the opportunity to ask
questions of the Company concerning its business, operations and financial
condition, and to obtain additional information reasonably necessary to verify
the accuracy of such information, and further represents that Optionee (either
such experience and knowledge in investment, financial and business matters in
investments similar to the stock of the Company that Optionee is capable of
evaluating the merits and risks thereof and has the capacity to protect his or
her own interest in connection therewith.

 

12.           Registration Rights.

 

a.             Piggyback Registration Rights.  If the Company at any time
proposes to register any of its securities under the Act, including under an S-8
Registration Statement, an SB-2 Registration Statement or otherwise, it will
each such time give written notice to all holders of outstanding or exercised
options of its intention so to do.  Upon the written request of a holder or
holders of any such outstanding or exercised options given within thirty (30)
days after receipt of any such notice, the Company will use its best efforts to
cause all such outstanding or exercised options, the holders of which shall have
so requested registration thereof, to be registered under the Act (with the
securities which the Company at the time propose to register), all to the extent
requisite to permit the sale or other disposition by the prospective Sellers of
the outstanding or exercised options so registered; provided, however, that the
Company may, as a condition precedent to its effecting such registration,
require each prospective Seller to agree with the Company and the managing
underwriter or underwriters of the offering to be made by the Company in
connection with such registration that such Seller will not sell any securities
of the same class or convertible into the same class as those registered by the
Company (including any class into which the securities registered by the Company
are convertible) for such reasonable period after such registration becomes
effective as shall then be specified in writing by such underwriter or
underwriters if in the opinion of such underwriter or underwriters the Company’s
offering would be materially adversely affected in the absence of such an
agreement.

 

b.             Procedures.  In connection with the registration of any
securities pursuant to Section 12.a. hereof, the Company and the Optionee
covenant and agree as follows:

 

(i)            The Company shall pay all costs, fees, and expenses incurred by
the Company and the Optionee in connection with the Registration Statement and
the offering thereunder including, without limitation, the Company’s legal fees
and expenses of counsel, accounting fees, printing expenses, and blue sky fees
and expenses (but excluding discounts or selling commissions of any underwriter
or broker dealer acting on behalf of the company or the Optionee).

 

3

--------------------------------------------------------------------------------

 

(ii)           The Company shall take all necessary action which may be
reasonably required in qualifying or registering the securities included in the
Registration Statement for offering and sale under the securities or blue sky
laws of all states reasonably requested by Optionee, provided that the Company
shall not be obligated to qualify as a foreign corporation to do business under
the laws of any such jurisdiction.

 

(iii)          The Company shall indemnify Optionee and each person, if any, who
controls Optionee within the meaning of Section 15 of the Act or Section 20(a)
of the Securities Exchange Act of 1934 (the “Exchange Act”), against all loss,
claim, damage, expense or liability (including all expenses reasonably incurred
in investigating, preparing or defending against any claim whatsoever) to which
any of them may become subject under the Act, the Exchange Act or otherwise,
arising from the Registration Statement.

 

(iv)          The Company shall, as soon as practicable after the effective date
of the Registration Statement, and in any event within fifteen (15) months
thereafter, make “generally available to its security holders” (within the
meaning of Rule 158 under the Act) an earnings statement  (which need not be
audited) complying with Section 11(a) of the Act and covering a period of at
least twelve (12) consecutive months beginning after the effective date of the
Registration Statement.

 

(v)           The Company shall (A) deliver promptly to Optionee and its
counsel, upon request, copies of all correspondence between the Commission and
the Company, its counsel, or auditors and all memoranda relating to discussions
with the Commission or its staff with respect to the Registration Statement; and
(B) permit Optionee and its counsel to perform such investigation, upon
reasonable advance notice, with respect to information contained in or omitted
from the Registration Statement, as it deems reasonably necessary to comply with
applicable securities laws or rules of the National Association of Securities
Dealers, Inc.  Such investigation shall include, but not be limited to, access
to financial and accounting information and opportunities to discuss the
business of the Company with the Company’s officers and independent auditors,
all to such reasonable extent, at such reasonable times and as often as Optionee
and its counsel shall reasonably request.

 

(vi)          The Company shall cause all securities of Optionee registered
pursuant to a Registration Statement to be listed on any national securities
exchange or quoted on any automated quotation system on which similar securities
of the Company are listed or quoted.

 

13.           Stand-off Agreement.  Optionee agrees that in connection with any
registration of the Company’s securities, that upon the request of the Company
or any underwriter managing an underwritten offering of the Company’s
securities, that Optionee shall not sell, short any sale of, loan, grant an
option for, or otherwise dispose of any of the Shares (other than Shares
included in the offering) without the prior written consent of the Company or
such managing underwriter, as applicable, for a period of at least one hundred
eighty (180) days following the effective date of registration of such offering.

 

14.           Notices.  Any notice required to be given pursuant to this Option
or the Plan shall be in writing and shall be deemed to be delivered upon receipt
or, in the case of notices by the Company, five (5) days after deposit in the
U.S. mail, postage prepaid, addressed to Optionee at the address last provided
to the Company by Optionee for his or her employee records.

 

15.           Agreement Subject to Plan; Applicable Law.  This Agreement is made
pursuant to the Plan and shall be interpreted to comply therewith.  A copy of
such Plan is available to Optionee, at no charge, at the principal office of the
Company.  Any provision of this Agreement inconsistent with the Plan shall be
considered void and replaced with the applicable provision of the Plan.  This
Agreement has been granted, executed and delivered in the State of California,
and the interpretation and enforcement shall be governed by the laws thereof and
subject to the exclusive jurisdiction of the courts therein.

 

IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the
date first above written.

 

I/OMagic Corporation

 

 

 

 

 

 

 

BY: Tony Shahbaz, President

 

, Optionee

 

 

4

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Appendix A

 

NOTICE OF EXERCISE

 

I/OMagic Corporation

1300 Wakeham

Santa Ana, California 92705

 

 

 

 

 

(date)

 

 

Re: Incentive Stock Option

 

Notice is hereby given pursuant to Section 4 of my Incentive Stock Option
Agreement that I elect to purchase the number of shares set forth below at the
exercise price set forth in my option agreement:

 

Stock Option dated:

 

 

 

 

 

Number of shares being purchased:

 

 

 

 

 

Option Exercise Price:

 

$

 

 

A check in the amount of the aggregate price of the shares being purchased is
attached.

 

I hereby confirm that such shares are being acquired by me for my own account
for investment purposes, and not with a view to, or for resale in connection
with, any distribution thereof.

 

Further, I understand that, as a result of this exercise of rights, I will
recognize income in an amount equal to the amount by which the fair market value
of the Shares exceeds the exercise price.  I agree to report such income in
accordance with then applicable law and to cooperate with Company in
establishing the withholding and corresponding deduction to the Company for its
income tax purposes.

 

I agree to provide to the Corporation such additional documents or information
as may be required pursuant to the Corporation’s 2001 Incentive and Nonstatutory
Stock Option Plan.

 

 

 

 

 

(Signature)

 

 

 

 

 

 

 

 

(Name of Optionee)

 

 

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONTENTS

December 31, 2001

 

 

 

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Consolidated Balance Sheets

 

Consolidated Statements of Operations

 

Consolidated Statements of Stockholders’ Equity

 

Consolidated Statements of Cash Flows

 

Notes to Consolidated Financial Statements

 

SUPPLEMENTAL INFORMATION

 

Report of Independent Certified Public Accountants on Financial Statement
Schedules

 

Valuation and Qualifying Accounts - Schedule II

 

--------------------------------------------------------------------------------

 

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

 

To the Board of Directors

I/OMagic Corporation and subsidiary

Santa Ana, California

 

We have audited the accompanying consolidated balance sheets of I/OMagic
Corporation and subsidiary as of December 31, 2001 and 2000, and the related
consolidated statements of operations, stockholders’ equity and cash flows for
each of the three years in the period ended December 31, 2001. 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, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
I/OMagic Corporation and subsidiary as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001 in conformity with accounting principles
generally accepted in the United States of America.

 

 

SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

 

Los Angeles, California

February 15, 2002

 

The accompanying notes are an integral part of these financial statements.

 

F-1

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31,

 

ASSETS

 

 

 

 

 

 

 

 

2001

 

2000

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

4,423,623

 

$

3,502,546

 

Accounts receivable, net of allowance for doubtful
accounts of $2,679,118 and $2,106,518

 

27,844,543

 

18,109,794

 

Accounts receivable from related parties

 

—

 

84,710

 

Inventory, net of allowance for obsolete inventory
of $558,703 and $1,834,427

 

10,377,287

 

6,783,715

 

Inventory in transit

 

1,634,420

 

13,011,000

 

Current portion of deferred income taxes

 

1,556,000

 

1,556,000

 

Income tax receivable

 

34,311

 

34,311

 

Prepaid expenses and other current assets

 

2,292,424

 

184,523

 

 

 

 

 

 

 

Total current assets

 

48,162,608

 

43,266,599

 

 

 

 

 

 

 

Property and equipment, net

 

1,266,216

 

1,427,772

 

Trademark, net of accumulated amortization
of $3,375,976 and $1,446,852

 

6,269,703

 

8,198,827

 

Deferred income taxes, net of current portion

 

165,000

 

165,000

 

Other assets

 

40,240

 

40,240

 

 

 

 

 

 

 

Total assets

 

$

55,903,767

 

$

53,098,438

 

 

The accompanying notes are an integral part of these financial statements.

 

F-2

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31,

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

2001

 

2000

 

Current liabilities

 

 

 

 

 

Line of credit

 

$

9,622,241

 

$

6,996,969

 

Current portion of capital lease obligations

 

10,978

 

27,121

 

Accounts payable and accrued expenses

 

12,027,498

 

5,584,951

 

Accounts payable to related parties

 

5,521,720

 

6,586,761

 

Reserves for customer returns and allowances

 

2,605,679

 

2,232,087

 

 

 

 

 

 

 

Total current liabilities

 

29,788,116

 

21,427,889

 

 

 

 

 

 

 

Capital lease obligations, net of current portion

 

—

 

10,978

 

 

 

 

 

 

 

Total liabilities

 

29,788,116

 

21,438,867

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Redeemable convertible preferred stock
10,000,000 shares authorized, $0.001 par value

Series A, 1,000,000 shares authorized
875,000 and 875,000 shares issued and outstanding

 

875

 

875

 

Series B, 1,000,000 shares authorized
250,000 and 250,000 shares issued and outstanding

 

250

 

250

 

Additional paid-in capital

 

8,998,875

 

8,998,875

 

 

 

 

 

 

 

Total redeemable convertible preferred stock

 

9,000,000

 

9,000,000

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Class A common stock, $0.001 par value
100,000,000 shares authorized
67,930,291 and 67,917,791 shares issued and outstanding

 

67,931

 

67,918

 

Additional paid-in capital

 

31,493,957

 

31,493,345

 

Deferred compensation

 

—

 

(3,100

)

Accumulated deficit

 

(14,446,237

)

(8,898,592

)

 

 

 

 

 

 

Total stockholders’ equity

 

17,115,651

 

22,659,571

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

55,903,767

 

$

53,098,438

 

 

The accompanying notes are an integral part of these financial statements.

 

F-3

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

For the Years Ended December 31,

 

 

 

 

2001

 

2000

 

1999

 

Net sales

 

$

67,788,959

 

$

60,805,437

 

$

36,661,092

 

 

 

 

 

 

 

 

 

Cost of sales

 

62,776,334

 

53,126,489

 

31,419,757

 

 

 

 

 

 

 

 

 

Gross profit

 

5,012,625

 

7,678,948

 

5,241,335

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

Selling, marketing, and advertising

 

1,487,828

 

2,180,685

 

1,295,189

 

General and administrative

 

6,461,112

 

6,276,761

 

2,490,272

 

Depreciation and amortization

 

2,231,899

 

1,668,665

 

51,832

 

 

 

 

 

 

 

 

 

Total operating expenses

 

10,180,839

 

10,126,111

 

3,837,293

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

(5,168,214

)

(2,447,163

)

1,404,042

 

 

 

 

 

 

 

 

 

Other income (expense)

 

 

 

 

 

 

 

Interest income

 

31,780

 

59,600

 

16,087

 

Interest expense

 

(418,381

)

(1,272,079

)

(13,994

)

Forgiveness of amounts due from related party

 

—

 

(3,802,917

)

—

 

Income from related party

 

—

 

—

 

24,000

 

Other income

 

10,170

 

52,110

 

4,163

 

 

 

 

 

 

 

 

 

Total other income (expense)

 

(376,431

)

(4,963,286

)

30,256

 

 

 

 

 

 

 

 

 

Income (loss) before provision for (benefit from) income taxes

 

(5,544,645

)

(7,410,449

)

1,434,298

 

 

 

 

 

 

 

 

 

Provision for (benefit from) income taxes

 

3,000

 

(999,600

)

(428,500

)

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(5,547,645

)

$

(6,410,849

)

$

1,862,798

 

 

 

 

 

 

 

 

 

Basic and diluted earnings (loss) per share

 

$

(0.08

)

$

(0.16

)

$

0.06

 

 

 

 

 

 

 

 

 

Basic weighted-average shares outstanding

 

67,925,120

 

39,448,410

 

31,757,039

 

 

 

 

 

 

 

 

 

Diluted weighted-average shares outstanding

 

67,925,120

 

39,448,410

 

31,880,921

 

 

The accompanying notes are an integral part of these financial statements.

 

F-4

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

For the Years Ended December 31,

 

 

 

 

 

 

Additional
Paid-In
Capital

 

 

 

 

 

 

 

 

 

 

 

Class A Common Stock

 

 

Deferred
Compensation

 

 

 

Accumulated
Deficit

 

 

 

 

 

Shares

 

Amount

 

 

 

Treasury Stock

 

 

Total

 

Balance, December 31, 1998

 

14,879,546

 

$

14,880

 

$

5,305,681

 

$

(27,900

)

$

(165,000

)

$

(4,350,541

)

$

777,120

 

Issuance of common stock in connection with the exercise of warrants and stock
options

 

760,826

 

762

 

106,383

 

 

 

 

 

 

 

107,145

 

Common stock issued for inventory

 

16,666,667

 

16,667

 

4,983,333

 

 

 

 

 

 

 

5,000,000

 

Amortization of deferred compensation

 

 

 

 

 

 

 

12,400

 

 

 

 

 

12,400

 

Tax benefit related to the exercise of non-statutory stock options

 

 

 

 

 

116,500

 

 

 

 

 

 

 

116,500

 

Net income

 

 

 

 

 

 

 

 

 

 

 

1,862,798

 

1,862,798

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 1999

 

32,307,039

 

32,309

 

10,511,897

 

(15,500

)

(165,000

)

(2,487,743

)

7,875,963

 

Issuance of common stock in connection with the exercise of warrants

 

82,858

 

82

 

52,933

 

 

 

 

 

 

 

53,015

 

Common stock issued for inventory

 

11,362,262

 

11,362

 

12,988,638

 

 

 

 

 

 

 

13,000,000

 

Common stock issued for cash

 

632,912

 

633

 

1,999,367

 

 

 

 

 

 

 

2,000,000

 

Common stock issued for legal services

 

40,000

 

40

 

59,960

 

 

 

 

 

 

 

60,000

 

Common stock issued for services rendered

 

42,720

 

42

 

—

 

 

 

 

 

 

 

42

 

Treasury stock retired

 

(550,000

)

(550

)

(164,450

)

 

 

165,000

 

 

 

—

 

Common stock issued in connection with the acquisition of IOM Holdings, Inc.

 

24,000,000

 

24,000

 

5,976,000

 

 

 

 

 

 

 

6,000,000

 

Amortization of deferred compensation

 

 

 

 

 

 

 

12,400

 

 

 

 

 

12,400

 

Tax benefit related to the exercise of non-statutory stock options

 

 

 

 

 

69,000

 

 

 

 

 

 

 

69,000

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

(6,410,849

)

(6,410,849

)

 

The accompanying notes are an integral part of these financial statements.

 

F-5

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Years Ended December 31,

 

 

 

 

Class A Common Stock

 

Additional

 

Deferred

 

 

 

Accumulated

 

 

 

 

 

Shares

 

Amount

 

 Paid-In Capital

 

Compensation

 

TreasuryStock

 

Deficit

 

Total

 

Balance, December 31, 2000

 

67,917,791

 

$

67,918

 

$

31,493,345

 

$

(3,100

)

$

—

 

$

(8,898,592

)

$

22,659,571

 

Issuance of common stock in connection with the exercise of warrants

 

12,500

 

13

 

612

 

 

 

 

 

 

 

625

 

Amortization of deferred compensation

 

 

 

 

 

 

 

3,100

 

 

 

 

 

3,100

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

(5,547,645

)

(5,547,645

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2001

 

67,930,291

 

$

67,931

 

$

31,493,957

 

$

—

 

$

—

 

$

(14,446,237

)

$

17,115,651

 

 

The accompanying notes are an integral part of these financial statements.

 

F-6

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31,

 

 

 

2001

 

2000

 

1999

 

Cash flows from operating activities

 

 

 

 

 

 

 

Net income (loss)

 

$

(5,547,645

)

$

(6,410,849

)

$

1,862,798

 

Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities

 

 

 

 

 

 

 

Depreciation and amortization

 

302,775

 

221,813

 

51,832

 

Amortization of trademark

 

1,929,124

 

1,446,852

 

—

 

Amortization of deferred compensation

 

3,100

 

12,400

 

12,400

 

Provision for allowance for doubtful accounts

 

572,600

 

212,993

 

24,821

 

Reserves for customer returns and allowances

 

373,592

 

1,086,519

 

922,189

 

Provision for obsolete inventory

 

(1,275,724

)

575,722

 

3,363

 

Forgiveness of amounts due from related party

 

—

 

3,802,917

 

—

 

Interest imputed on notes payable

 

—

 

477,181

 

—

 

Provision for deferred income taxes

 

—

 

(1,070,000

)

(651,000

)

Note payable to related party

 

—

 

—

 

(345,500

)

Tax effect of exercised options

 

—

 

69,000

 

116,500

 

(Increase) decrease in

 

 

 

 

 

 

 

Accounts receivable

 

(10,307,349

)

(5,219,800

)

(6,363,758

)

Accounts receivable from related parties

 

84,710

 

4,342,607

 

(6,561,738

)

Inventory

 

9,058,732

 

3,853,216

 

2,412,050

 

Prepaid expenses and other current assets

 

(2,107,901

)

(135,403

)

11,588

 

Due from related party

 

—

 

(2,108,220

)

—

 

Other assets

 

—

 

(18,752

)

(328

)

Increase (decrease) in

 

 

 

 

 

 

 

Accounts payable and accrued expenses

 

6,442,547

 

3,774,351

 

7,526,956

 

Income taxes payable

 

—

 

(140,311

)

106,000

 

Due to related parties

 

(1,065,041

)

(4,898,948

)

1,735,377

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

(1,536,480

)

(126,712

)

863,550

 

 

 

 

 

 

 

 

 

Cash flows from investing activities

 

 

 

 

 

 

 

Purchase of property and equipment

 

(141,219

)

(220,242

)

(174,290

)

 

 

 

 

 

 

 

 

Net cash used in investing activities

 

(141,219

)

(220,242

)

(174,290

)

 

 

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

 

 

Net borrowings on line of credit

 

2,625,272

 

118,634

 

—

 

Payments on capital lease obligations

 

(27,121

)

(17,804

)

(5,787

)

Payments on notes payable

 

—

 

(247,909

)

(250,000

)

Proceeds from issuance of stock

 

—

 

2,000,000

 

—

 

Proceeds from exercise of warrants

 

625

 

53,057

 

107,145

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

2,598,776

 

1,905,978

 

(148,642

)

 

The accompanying notes are an integral part of these financial statements.

 

F-7

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31,

 

 

 

2001

 

2000

 

1999

 

 

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

$

921,077

 

$

1,559,024

 

$

540,618

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of year

 

3,502,546

 

1,943,522

 

1,402,904

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of year

 

$

4,423,623

 

$

3,502,546

 

$

1,943,522

 

 

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest paid

 

$

396,868

 

$

794,898

 

$

13,994

 

 

 

 

 

 

 

 

 

Income taxes paid

 

$

3,000

 

$

27,500

 

$

800

 

 

Supplemental schedule of non-cash investing and financing activities

During the year ended December 31, 2000, the Company entered into the following
non-cash transactions:

 

•                  Received $5,000,000 in inventory for 6,250,000 shares of
common stock.

 

•                  Received $8,000,000 in inventory for 5,112,262 shares of
common stock.

 

•                  Received $5,011,000 in inventory and a reduction in accounts
payable of $989,000 for 125,000 shares of IOM Holdings, Inc., which were later
converted into 4,800,000 shares of I/OMagic Corporation.

 

•                  Received $1,003,413 in inventory in exchange for a reduction
in accounts receivable of the same amount.

 

•                  Issued 1,125,000 shares of preferred stock in exchange for
$9,000,000 of debt.

 

•                  Received $60,000 in legal services for 40,000 shares of
common stock.

 

•                  Cancelled 550,000 shares of treasury stock outstanding
totaling $165,000.

 

•                  Issued 24,000,000 shares of common stock in exchange for 100%
of the issued and outstanding shares of IOM Holdings, Inc.

 

 

The accompanying notes are an integral part of these financial statements.

 

F-8

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31,

 

During the year ended December 31, 1999, the Company entered into the following
non-cash transactions:

 

•                  Received $5,000,000 in inventory for 16,666,667 shares of
common stock.

 

•                  Reflected the reduction of a related party note payable as a
reduction to cost of sales of $345,500.

 

 

The accompanying notes are an integral part of these financial statements.

 

F-9

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2001

 

NOTE 1 - ORGANIZATION AND BUSINESS

 

I/OMagic Corporation (“I/OMagic”), a Nevada corporation, and its subsidiary
(collectively, the “Company”) develop, manufacture through subcontractors,
market, and distribute multimedia and communication card devices for portable
and desktop computers.  The Company sells its products in the United States to
distributors and retail customers.

 

In March 1996, I/OMagic Corporation, a California corporation (“I/OMagic
California”), originally incorporated on September 30, 1993, entered into a Plan
of Exchange and Acquisition Agreement (the “Acquisition Agreement”) with
Silvercrest International, Inc. (“Silvercrest”), a Nevada corporation.
 Silvercrest subsequently changed its name to I/OMagic Corporation, a Nevada
corporation.

 

ACQUISITIONS

 

Hi-Val, Inc.

On March 29, 2000, IOM Holdings, Inc. (“IOMH”) acquired certain assets of
Hi-Val, Inc. (“Hi-Val”) for the benefit of Hi-Val’s creditors pursuant to
Section 493.010 of the California Code of Civil Procedures. The purchase price
for the assets was $15,878,335; however, total consideration was adjusted to
$15,401,154, based on imputed interest.  The purchase price was paid as follows:
(i) $6,878,335 through the revolving line of credit, (ii) $7,000,000 notes
payable at 0% interest (imputed to $6,522,819 based on 9.5% interest), and (iii)
$2,000,000 notes payable at prime (9.5% as of December 31, 2000), plus 0.5%
issued to IOMH’s lending institution.  IOMH recorded $9,645,679 in excess of
cost over fair value of net assets acquired, identified as a trademark, which is
being amortized on a straight-line basis over five years.  The acquisition was
accounted for by the purchase method.

 

For financial statement purposes, the acquisition occurred on April 1, 2000. 
The assets acquired were as follows:

 

Accounts receivable

 

$

2,987,637

 

Inventory

 

1,890,818

 

Due from related party

 

563,689

 

Property and equipment

 

1,173,654

 

Liabilities assumed

 

(860,323

)

Trademark

 

9,645,679

 

 

 

 

 

Total

 

$

15,401,154

 

 

F-10

--------------------------------------------------------------------------------

 

IOM Holdings, Inc.

On December 31, 2000, I/OMagic acquired 100% of the issued and outstanding
shares of IOM Holdings, Inc., a Nevada corporation, for 24,000,000 restricted
shares of common stock.  The entities were under common control; therefore, the
acquisition has been accounted for in a manner similar to a
pooling-of-interests.

 

 

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

The consolidated financial statements include the accounts of I/OMagic
Corporation and its subsidiary, IOM Holdings, Inc.  All material intercompany
accounts and transactions have been eliminated.

 

Revenue Recognition

For transactions satisfying the conditions for revenue recognition under
Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue
Recognition when Right of Return Exists,” product revenue is recorded at the
time of shipment, net of estimated allowances and returns.  For transactions not
satisfying the conditions for revenue recognition under SFAS No. 48, product
revenue is deferred until the conditions are met, net of an estimate for cost of
sales.  For the years ended December 31, 2001, 2000, and 1999, the Company had
reserves for sales returns totaling $861,831, $315,015, and $191,326,
respectively.

 

The Company performs periodic credit evaluations of its customers and maintains
allowances for potential credit losses based on management’s evaluation of
historical experience and current industry trends.  Although the Company expects
to collect amounts due, actual collections may differ.

 

Comprehensive Income

The Company utilizes SFAS No. 130, “Reporting Comprehensive Income”.  This
statement establishes standards for reporting comprehensive income and its
components in a financial statement.  Comprehensive income as defined includes
all changes in equity (net assets) during a period from non-owner sources. 
Examples of items to be included in comprehensive income, which are excluded
from net income, include foreign currency translation adjustments and unrealized
gains and losses on available-for-sale securities.  For the years ended December
31, 2001, 2000, and 1999, comprehensive income is not presented in the Company’s
financial statements since the Company did not have any of the items of
comprehensive income in any period presented.

 

F-11

--------------------------------------------------------------------------------

 

Cash and Cash Equivalents

For purposes of the statements of cash flows, the Company considers all highly
liquid investments purchased with original maturities of three months or less to
be cash equivalents.

 

Inventory

Inventory is stated at the lower of cost, using the weighted-average method,
which approximates the first-in, first-out method or market.

 

Property and Equipment

Property and equipment are recorded at cost, less accumulated depreciation and
amortization.  Depreciation and amortization are provided using the
straight-line method over estimated useful lives as follows:

 

Computer equipment and software

 

5 years

Warehouse equipment

 

7 years

Office furniture and equipment

 

5 to 7 years

Equipment under capital leases

 

5 years

Vehicles

 

5 years

Leasehold improvements

 

Estimated useful life or lease term
whichever is shorter

 

Expenditures for major renewals and betterments that extend the useful lives of
property and equipment are capitalized.  Expenditures for maintenance and
repairs are charged to expense as incurred.

 

Depreciation expense on assets acquired under capital leases is included with
depreciation expense on owned assets.

 

TRADEMARK

The trademark is being amortized over a five-year period.  The Company
continually evaluates whether events or circumstances have occurred that
indicate the remaining estimated value of the trademark may not be recoverable. 
When factors indicate that the value the trademark may be impaired, the Company
estimates the remaining value and reduces the trademark to that amount.

 

F-12

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Accounting for the Impairment of Long-Lived Assets

The Company adopted SFAS No. 121, “Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of.”  SFAS No. 121 requires
impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets’ carrying amount. 
Management determined that there was not any impairment of long-lived assets
during the years ended December 31, 2001, 2000, and 1999.

 

Fair Value of Financial Instruments

The Company measures its financial assets and liabilities in accordance with
generally accepted accounting principles.  For certain of the Company’s
financial instruments, including cash and cash equivalents, accounts receivable,
and accounts payable and accrued expenses, the carrying amounts approximate fair
value due to their short maturities.  The amounts shown for capital lease
obligations also approximate fair value because interest rates offered to the
Company for debt of similar maturities are substantially the same.

 

Stock-Based Compensation

SFAS No. 123, “Accounting for Stock-Based Compensation,” establishes and
encourages the use of the fair value based method of accounting for stock-based
compensation arrangements under which compensation cost is determined using the
fair value of stock-based compensation determined as of the date of grant and is
recognized over the periods in which the related services are rendered. The
statement also permits companies to elect to continue using the current implicit
value accounting method specified in Accounting Principles Bulletin (“APB”)
Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for
stock-based compensation issued to employees. The Company has elected to use the
implicit value based method and has disclosed the pro forma effect of using the
fair value based method to account for its stock-based compensation.  For
stock-based compensation issued to non-employees, the Company uses the fair
value method of accounting under the provisions of SFAS No. 123.

 

ADVERTISING COSTS

The Company expenses advertising costs as incurred.  For the years ended
December 31, 2001, 2000, and 1999, advertising costs were $120,577, $218,956,
and $11,345, respectively.

 

F-13

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Income Taxes

Deferred income taxes are recognized for the tax consequences in future years of
differences between the tax basis of assets and liabilities and their financial
reporting amounts at each period end, based on enacted tax laws and statutory
tax rates applicable to the periods in which the differences are expected to
affect taxable income. Valuation allowances are established, when necessary, to
reduce deferred tax assets to the amount expected to be realized. The provision
for income taxes represents the tax payable for the period, if any, and the
change during the period in deferred tax assets and liabilities.

 

Earnings (Loss) Per Share

The Company calculates earnings (loss) per share in accordance with SFAS No.
128, “Earnings Per Share.”  SFAS No. 128 replaced the presentation of primary
and fully diluted earnings (loss) per share with the presentation of basic and
diluted earnings (loss) per share.  Basic earnings (loss) per share excludes
dilution and is calculated by dividing income (loss) available to common
stockholders by the weighted-average number of common shares outstanding for the
period.  Diluted earnings (loss) per share includes the potential dilutive
effects that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock (“potential common stock”) that
would then share in the earnings (loss) of the Company.

 

As of December 31, 1999, the Company had potential common stock as follows:

 

Weighted-average common shares outstanding during the period

 

31,757,039

 

 

 

 

 

Incremental shares assumed to be outstanding since the beginning
of the period related to stock options and warrants outstanding

 

123,882

 

 

 

 

 

Fully diluted weighted-average common shares and potential common stock

 

31,880,921

 

 

Since the Company had net losses for the years ended December 31, 2001 and 2000,
basic and diluted shares are the same.

 

Reclassifications

Certain amounts included in the 2000 and 1999 financial statements have been
reclassified to conform with the current year presentation.  Such
reclassification did not have any effect on reported net income (loss).

 

F-14

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Estimates

The preparation of financial statements 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 financial
statements and the reported amounts of revenue and expenses during the reporting
period.  Actual results could differ from those estimates.

 

Recently Issued Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
141, “Business Combinations.”  This statement addresses financial accounting and
reporting for business combinations and supersedes APB Opinion No. 16, “Business
Combinations,” and SFAS No. 38, “Accounting for Pre-Acquisition Contingencies of
Purchased Enterprises.” All business combinations in the scope of this statement
are to be accounted for using one method, the purchase method.  The provisions
of this statement apply to all business combinations initiated after June 30,
2001.  Use of the pooling-of-interests method for those business combinations is
prohibited.  This statement also applies to all business combinations accounted
for using the purchase method for which the date of acquisition is July 1, 2001
or later.

 

In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible
Assets.”  This statement addresses financial accounting and reporting for
acquired goodwill and other intangible assets and supersedes APB Opinion No. 17,
“Intangible Assets.”  It addresses how intangible assets that are acquired
individually or with a group of other assets (but not those acquired in a
business combination) should be accounted for in financial statements upon their
acquisition.  This statement also addresses how goodwill and other intangible
assets should be accounted for after they have been initially recognized in the
financial statements.  It is effective for fiscal years beginning after December
15, 2001.  Early application is permitted for entities with fiscal years
beginning after March 15, 2001, provided that the first interim financial
statements have not been issued previously.

 

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement
Obligations.”  This statement applies to legal obligations associated with the
retirement of long-lived assets that result from the acquisition, construction,
development, and/or the normal operation of long-lived assets, except for
certain obligations of lessees.  This statement is not applicable to the
Company.

 

F-15

--------------------------------------------------------------------------------

 

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or
Disposal of Long-Lived Assets.”  This statement addresses financial accounting
and reporting for the impairment or disposal of long-lived assets.  This
statement replaces SFAS No. 121, “Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of,” the accounting and
reporting provisions of APB No. 30, “Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual, and Infrequently Occurring Events and Transactions,” for the disposal
of a segment of a business, and amends Accounting Research Bulletin No. 51,
“Consolidated Financial Statements,” to eliminate the exception to consolidation
for a subsidiary for which control is likely to be temporary.    The Company
does not expect adoption of SFAS No. 144 to have a material impact, if any, on
its financial position or results of operations.

 

NOTE 3 - RISKS AND UNCERTAINTIES

 

Technological Obsolescence

The computer industry is characterized by rapid technological advancement and
change. Should demand for the Company’s products prove to be significantly less
than anticipated, the ultimate realizable value of such products could be
substantially less than the amounts reflected in the accompanying balance
sheets.

 

Reliance on Independent and Related Party Manufacturers/Subcontractors

The Company does not maintain its own manufacturing or production facilities and
does not intend to do so in the foreseeable future.  The Company anticipates
that its products will be manufactured, and independent companies, some of which
are stockholders of the Company, will supply its raw materials and components. 
Many of these independent companies may manufacture and supply products for the
Company’s existing and potential competitors.  As is customary in the
manufacturing industry, the Company does not have any material ongoing licensing
or other supply agreements with its manufacturers and suppliers.  Typically, the
purchase order is the Company’s “agreement” with the manufacturer.  Therefore,
any of these companies could terminate its relationship with the Company at any
time.  In the event the Company was to have difficulties with its present
manufacturers and suppliers, the Company could experience delays in supplying
products to its customers.

 

F-16

--------------------------------------------------------------------------------

 

Reliance on Retail Distributors

The Company’s success will depend to a significant extent upon the ability to
develop and maintain a multi-channel distribution system with retail
distributors to sell the Company’s products in the marketplace.  There can be no
assurance that the Company will be successful in obtaining and retaining the
retail distributors it requires to continue to grow and expand its marketing and
sales efforts.

 

NOTE 4 - CONCENTRATIONS OF RISK

 

Cash and Cash Equivalents

The Company maintains its cash and cash equivalent balances in several banks
located in Southern California and a financial institution that from time to
time exceed amounts insured by the Federal Deposit Insurance Corporation up to
$100,000 per bank and by the Securities Investor Protection Corporation up to
$3,000,000 per financial institution. As of December 31, 2001 and 2000, balances
totaling $4,904,747 and $3,563,908, respectively, were uninsured.  The Company
has not experienced any losses in such accounts and believes it is not exposed
to any significant credit risk on cash.

 

In connection with the Company’s revolving line of credit, the Company has
agreed to a compensating balance of $750,000.

 

CUSTOMERS

 

During the year ended December 31, 2001, the Company had net sales to four major
customers that represented 36%, 20%, 15%, and 14% of net sales.  As of December
31, 2001, the Company had four customers that accounted for 25%, 23%, 18%, and
15% of accounts receivable.

 

During the year ended December 31, 2000, the Company had net sales to four major
customers that represented 27%, 19%, 15%, and 14% of net sales.  As of December
31, 2000, the Company had three customers that accounted for 27%, 19%, and 18%
of accounts receivable.

 

During the year ended December 31, 1999, the Company had sales to three major
customers that represented 32%, 26%, and 17% of net sales.  During the year
ended December 31, 1999, the Company had sales to two related party customers
that represented 23% and 16% of net sales.  As of December 31, 1999, the Company
had three customers that accounted for 19%, 17%, and 12% of accounts receivable.

 

F-17

--------------------------------------------------------------------------------

 

Suppliers

During the year ended December 31, 2001, the Company purchased inventory from
two related party vendors that represented 26% and 14% of purchases.  As of
December 31, 2001, there were two suppliers that represented 51% and 42% of
accounts payable.

 

During the year ended December 31, 2000, the Company purchased inventory from
one related party vendor that represented 47% of purchases.  As of December 31,
2000, there was one supplier that represented 32% of accounts payable.

 

During the year ended December 31, 1999, the Company purchased inventory from
two related party vendors that represented 28% and 20% of purchases.  As of
December 31, 1999, there were two suppliers that represented 11% and 14% of
accounts payable.

 

NOTE 5 - INVENTORY

 

Inventory as of December 31 consisted of the following:

 

 

 

2001

 

2000

 

Component parts

 

$

5,243,285

 

$

5,343,713

 

Finished goods

 

5,692,705

 

3,256,203

 

Work in process

 

—

 

18,226

 

Reserves for inventory

 

(558,703

)

(1,834,427

)

 

 

 

 

 

 

Total

 

$

10,377,287

 

$

6,783,715

 

 

NOTE 6 - PROPERTY AND EQUIPMENT

 

Property and equipment as of December 31 consisted of the following:

 

 

 

2001

 

2000

 

Computer equipment and software

 

$

957,079

 

$

817,823

 

Warehouse equipment

 

78,465

 

69,673

 

Office furniture and equipment

 

161,339

 

168,168

 

Equipment under capital lease

 

94,136

 

94,136

 

Vehicles

 

6,707

 

6,707

 

Leasehold improvements

 

651,187

 

651,187

 

 

 

 

 

 

 

 

 

1,948,913

 

1,807,694

 

Less accumulated depreciation and amortization

 

682,697

 

379,922

 

 

 

 

 

 

 

Total

 

$

1,266,216

 

$

1,427,772

 

 

F-18

--------------------------------------------------------------------------------

 

For the years ended December 31, 2001, 2000, and 1999, depreciation and
amortization expense was $302,775, $221,813, and $51,832, respectively.

 

 

NOTE 7 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

 

Accounts payable and accrued expenses as of December 31 consisted of the
following:

 

 

 

2001

 

2000

 

Accounts payable

 

$

363,192

 

$

2,514,712

 

Accrued rebates and marketing

 

10,365,995

 

2,086,418

 

Accrued compensation and related benefits

 

452,517

 

546,170

 

Other

 

845,794

 

437,651

 

 

 

 

 

 

 

Total

 

$

12,027,498

 

$

5,584,951

 

 

NOTE 8 - LINE OF CREDIT

 

The Company maintains a revolving line of credit with a financial institution
that allows it to borrow a maximum of $14,000,000 with a sub-limit of
$13,000,000.  The line of credit originally expired April 9, 2002; however,
subsequent to December 31, 2001, the line of credit was extended to December 31,
2002.  The line is secured by a UCC filing on substantially all of the Company’s
assets.

 

Within the sub-limit, up to $13,000,000 is available with maturities up to 150
days, $10,000,000 is available with maturities of up to 60 days, and $6,000,000
is available for issuance of letters of credit against 50% of eligible inventory
with maturities of up to 60 days.  Each advance over a total outstanding line
balance of $4,000,000 is subject to the above maturity periods.

 

Within the line of credit, a sub-line of $1,000,000 is available for uncollected
funds availability.

 

The availability of the line of credit is subject to the borrowing base, which
is 65% of eligible receivables.  Advances on the line of credit bear interest at
the Wall Street Journal Prime (4.75% as of December 31, 2001), plus 0.25%.  As
of December 31, 2001, the outstanding balance under the revolving line of credit
was $9,622,241.

 

F-19

--------------------------------------------------------------------------------

 

The line of credit provides for the maintenance of certain financial covenants
and a compensating cash balance of $750,000, of which the Company was in
compliance at December 31, 2001.

 

At December 31, 2000, the Company maintained a credit facility with a financial
institution that allowed it to borrow a maximum of $20,000,000.  The line was
secured by a UCC filing on substantially all of the Company’s assets.  The line
of credit expired April 25, 2001.

 

NOTE 9 - NOTE PAYABLE TO RELATED PARTY

 

The Company had a note payable to a related party that represented a convertible
promissory note to a stockholder for inventory purchases.  The note bore
interest at 8% and matured March 1, 1997.  In March 1999, the statute of
limitations for collection on this note expired.

 

During the year ended December 31, 1999, the Company reflected a reduction to
cost of sales of $345,500 of the total debt and related interest.  Management
does not believe any litigation will arise and has had no contact with the
counter-party.

 

Pursuant to the terms of the note payable, in the event the Company or its
assets were sold or the Company commenced an offering of common stock, as
defined, the note holder had the right to convert the outstanding balance,
including all accrued interest thereon, into shares of the Company’s common
stock.  The conversion factor was defined as either the price per share in the
event of sale or the initial public offering price, as defined, divided by 1.5.

 

NOTE 10 - CREDIT LINES FROM RELATED PARTIES

 

In connection with a 1997 Strategic Alliance Agreement (the “1997 Strategic
Alliance Agreement”), the Company also has available a line of credit through
another stockholder and supplier for borrowings up to $2,000,000. Borrowings are
non-interest-bearing and are due 75 days from the date of the borrowing. The
credit agreement can be mutually terminated at any time.  As of December 31,
2001 and 2000, the line of credit was unused.

 

F-20

--------------------------------------------------------------------------------

 

In connection with an April 1999 subscription agreement, the Company also has
available an additional line of credit through a stockholder and supplier that
provides a trade credit facility of up to $5,000,000 carrying net 75 day terms,
as defined.  As of December 31, 2001 and 2000, there was $2,993,578 and
$6,586,761, respectively, outstanding under this arrangement, which is included
in accounts payable to related parties in the accompanying balance sheets.

 

NOTE 11 - COMMITMENTS AND CONTINGENCIES

 

Leases

The Company leases its facilities from an officer of the Company and certain
equipment under non-cancelable, operating lease agreements, which require
initial minimum monthly payments of $44,584 and expire through March 2010.  For
the years ended December 31, 2001, 2000, and 1999, rent expense was $529,653,
$467,572, and $119,257, respectively, and is included in general and
administrative expenses in the accompanying statements of operations.

 

Future aggregate minimum annual lease payments under operating lease
arrangements were as follows as of December 31, 2001:

 

Year Ending December 31,

 

 

 

2002

 

$

434,132

 

2003

 

384,738

 

2004

 

385,323

 

2005

 

382,296

 

2006

 

410,970

 

Thereafter

 

1,596,084

 

 

 

 

 

Total

 

$

3,593,543

 

 

Capital lease obligations at December 31 consisted of the following:

 

 

 

2001

 

2000

 

14.4% equipment lease - payable in monthly
installments of $1,661 including interest and
maturing in January 2002.

 

$

1,661

 

$

19,880

 

 

 

 

 

 

 

 

 

14.4% equipment lease - payable in monthly
installments of $911 including interest and
maturing in November 2002.

 

$

9,317

 

$

18,219

 

 

 

 

 

 

 

 

 

10,978

 

38,099

 

Less current portion

 

10,978

 

27,121

 

 

 

 

 

 

 

Long-term portion

 

$

—

 

$

10,978

 

 

F-21

--------------------------------------------------------------------------------

 

 

Future minimum payments under the capital lease obligations at December 31, 2001
were as follows:

 

Year Ending December 31,

 

 

 

2002

 

$

11,682

 

Less amount representing interest

 

704

 

 

 

 

 

Present value of future minimum lease payments

 

$

10,978

 

 

The following is an analysis of the leased equipment under capital leases as of
December 31, which is included in property and equipment:

 

 

 

2001

 

2000

 

Equipment

 

$

94,136

 

$

94,136

 

Less accumulated depreciation

 

32,948

 

14,120

 

 

 

 

 

 

 

Total

 

$

61,188

 

$

80,016

 

 

Interest expense was insignificant for the years ended December 31, 2001, 2000,
and 1999.

 

F-22

--------------------------------------------------------------------------------

 

Service Agreements

Periodically, the Company enters into various agreements for services including,
but not limited to, public relations, financial consulting, and manufacturing
consulting.  The agreements generally are ongoing until such time they are
terminated, as defined. Compensation for services is paid either on a fixed
monthly rate or based on a percentage, as specified, and may be payable in
shares of the Company’s common stock.  During the years ended December 31, 2001,
2000, and 1999, the Company was party to one such agreement. During the years
ended December 31, 2001, 2000, and 1999, the Company incurred $383,395,
$350,457, and $217,167, respectively, in connection with such arrangements. 
Such is included in general and administrative expenses in the accompanying
statements of operations.

 

License and Operating Agreement

In September 2000, the Company entered into a license and operating agreement
with a related party.  The terms of the agreement allow the Company to liquidate
the inventory currently owned by the related party in exchange for 50% of the
profits.  The agreement terminates upon the liquidation of 100% of the
inventory, at which time the Company will have the option to purchase the trade
name from the related party for $100.

 

Employment Contract

I/OMagic California has entered into an employment contract with one of its
officers, which expires upon written termination.  The agreement calls for a
minimum base salary and provides for certain expense allowances.  In addition,
the agreement provides for a bonus based on the “net profits” of I/OMagic
California, as defined.  The bonus amount ranges from $20,000 to $70,000 for net
profits up to $500,000.  For net profits in excess of $500,000, the bonus is 7%
of such excess.  For the years ended December 31, 2001, 2000, and 1999, bonuses
totaling $0, $165,396, and $0, respectively, were paid under the terms of this
agreement.  As of December 31, 2001 and 2000, the accrued bonuses were
approximately $98,000 for each year and are included in accounts payable and
accrued expenses in the accompanying balance sheets.

 

Retail Agreements

In connection with certain retail agreements, the Company has agreed to pay for
certain marketing development and advertising on an ongoing basis.  Marketing
development and advertising costs are generally agreed upon at the time of the
event.  The Company also records a liability for co-op marketing based on
management’s evaluation of historical experience and current industry and
Company trends.

 

F-23

--------------------------------------------------------------------------------

 

In May 2001, the Company entered into an agreement to provide marketing and
promotional funds to a customer up to 10% of the net sales to this customer for
a 24-month period, which subsequently has been adjusted to 17%.  During the year
ended December 31, 2001, the Company paid $6,068,479, of which $3,874,944 was
expensed based on 17% of the net sales related to this agreement.  The remaining
payment of $2,193,535 is included in prepaid expenses and other current assets
in the accompanying consolidated balance sheet.

 

For the years ended December 31, 2001, 2000, and 1999, the Company incurred
$2,890,502, $1,386,261, and $1,218,423, respectively, related to these
agreements. These amounts are netted against revenue in the accompanying
statements of operations.

 

Litigation

The Company and its President have been named as defendants in a lawsuit
relating to an Asset Purchase Agreement executed by IOMH and Hi-Val in June 1999
for the purchase and sale of Hi-Val’s assets to IOMH.  The causes of action are
for breach of contract, fraud, and negligent misrepresentation.  The allegations
are that IOMH and other defendants failed to deliver the consideration due under
the Asset Purchase Agreement after taking control of Hi-Val.  The fraud and
negligent misrepresentation claims are based on alleged representations made by
IOMH and others to induce Hi-Val and its President to enter into the Asset
Purchase Agreement.  The damages claimed by the plaintiffs in the causes of
action are for $27,000,000.  Punitive damages are claimed on the fraud cause of
action.

 

The Company has vigorously denied the claims and intends to aggressively defend
the action.  Based on the assertion of the Company’s legal counsel, the action
of the plaintiffs is at an early stage of litigation, and only limited discovery
has been conducted. Accordingly, an estimate of the outcome of the action cannot
be made at this time.

 

F-24

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NOTE 12 - REDEEMABLE CONVERTIBLE PREFERRED STOCK

 

During December 2000, the Company amended its Articles of Incorporation to
authorize 10,000,000 shares of preferred stock, of which 1,000,000 shares are
designated as Series A preferred stock.  These stockholders have no voting
powers and are entitled to receive dividends on an equal basis with the holders
of common stock of the Company. In the event of a liquidation, dissolution, or
winding up of the Company, the holders of each share of preferred stock will be
entitled to be paid out of the assets of the Company available for distribution
to stockholders prior to any distribution to any class of shares at a
liquidation preference per share equal to the stated value of the preferred
stock, plus accrued dividends.

 

Each share of preferred stock may be converted by the holder based upon the
weighted-average trading price during the 20 trading days prior to the date of
the Company receiving notice.  However, the weighted-average trading price will
not be less than $2.50 per share nor greater than $7 per share.  The Company has
the right to force conversion of the preferred stock on the date on which the
Company’s common stock closed at or above a bid price of $3 per share during 15
consecutive trading days.  However, the conversion will not be less than $2.50
per share nor greater than $7 per share.  Finally, if the issued shares of
preferred stock have been outstanding for three years, the Company will be
obligated to redeem any issued shares at the stated value of $8 per share.

 

In addition, the Company designated 1,000,000 shares as Series B preferred
stock.  The Series B stockholder has the same rights as the Series A holders,
except the Company will be obligated to redeem any issued shares which have been
outstanding for two years.

 

On January 22, 2001, the Company issued 875,000 shares of Series A preferred
stock to its financial institution for $7,000,000 in exchange for amounts owed
under long-term debt.  As of December 31, 2000, the shares were presented as
outstanding on the balance sheet, and the related debt was eliminated.

 

On January 22, 2001, the Company issued 250,000 shares of Series B preferred
stock to its financial institution for $2,000,000 in exchange for amounts owed
under long-term debt.  As of December 31, 2000, the shares were presented as
outstanding on the balance sheet, and the related debt was eliminated.

 

F-25

--------------------------------------------------------------------------------

 

NOTE 13 - COMMON STOCK

 

Amendment to Articles of Incorporation

On January 12, 2001, the Company amended its Articles of Incorporation to
increase the number of authorized common shares from 50,000,000 to 100,000,000.

 

Common Stock Issued for Services

During the year ended December 31, 2000, the Company issued 40,000 shares of
common stock for $60,000 in legal services, which represented the fair market
value of the services rendered.

 

COMMON STOCK ISSUED IN CONNECTION WITH THE EXERCISE OF WARRANTS

During the year ended December 31, 2001, the Company issued an aggregate of
12,500 shares of common stock in connection with the exercise of warrants for
cash of $625, or at a per share price of $0.05.

 

During the year ended December 31, 2000, the Company issued an aggregate of
82,858 restricted shares of common stock in connection with the exercise of
warrants for cash of $53,015, or at a per share price ranging from $0.05 to $2
per share.

 

During the year ended December 31, 1999, the Company issued an aggregate of
760,826 restricted shares of common stock in connection with the exercise of
warrants for cash totaling $107,145, or at a per share price ranging from $0.01
to $0.70 per share.

 

Common Stock Issued in Exchange for Inventory

On February 3, 1999, the Company issued 16,666,667 shares of restricted common
stock to a stockholder and supplier valued at $0.30 per share for $5,000,000 of
inventory, as defined (valued at transferor’s cost basis).  In connection with
this transaction, the stockholder and vendor established a $5,000,000 line of
credit.  No value was assigned to the establishment of the line of credit as
such line was deemed to not carry any market value.

 

On January 4, 2000, the Company issued 6,250,000 shares of restricted common
stock to a stockholder and vendor, valued at $0.80 per share, for $5,000,000 of
inventory, as defined (valued at transferor’s cost basis).

 

On December 10, 2000, the Company issued 5,112,262 shares of restricted common
stock to a stockholder and vendor, valued at $1.56 per share, for $8,000,000 of
inventory, as defined (valued at transferor’s cost basis).

 

F-26

--------------------------------------------------------------------------------

 

Common Stock Issued for Cash

On March 7, 2000, the Company issued 632,912 shares of restricted common stock
to a stockholder and vendor, valued at $3.16, for $2,000,000 in cash.

 

Generally, all new issuances of common stock made by the Company carry
registration rights.

 

NOTE 14 - WARRANTS AND STOCK OPTIONS

 

Warrants

In connection with an October 1995 private placement of notes payable and
warrants, the Company issued 805,000 A Warrants to purchase common stock for
$0.05 per share exercisable for five years from the date of issuance, and
805,000 B Warrants to purchase common stock for $0.95 per share exercisable for
five years from the date of issuance.  For every 30 days the B Warrants were
outstanding, commencing six months from the date of issuance, the B Warrant
holders were entitled to a $0.04 discount on the exercise price per month to a
minimum exercise price of $0.50 per share.  Interest expense ascribed to the
warrants was deemed to be insignificant and recording such was not deemed
appropriate by management as the value of the Company was nominal prior to the
effective date of the Acquisition Agreement, the consummation of which was not
assured.  During the years ended December 31, 2001, 2000, and 1999, A Warrants
aggregating 12,500, 25,000, and 360,513, respectively, have been exercised.
Through December 31, 2001, A Warrants aggregating 803,013 have been exercised. 
As of December 31, 2001, the remaining 1,987 outstanding warrants expired.

 

In connection with an October 1995 private placement for placement agent
services, the Company issued 125,125 A Warrants to purchase common stock for
$0.10 per share exercisable for five years from the date of issue and 125,125 B
Warrants to purchase common stock for $1.10 per share exercisable for five years
from the date of issue. During the years ended December 31, 2001, 2000, and
1999, 0, 17,858, and 5,313, respectively, of these A Warrants were exercised. 
Through December 31, 2000, 95,715 of these A Warrants were exercised.  As of
December 31, 2000, the remaining 29,410 outstanding warrants expired.

 

F-27

--------------------------------------------------------------------------------

 

In October 1995, the Company issued to an officer 340,000 warrants to purchase
restricted shares of common stock for $0.01 per share exercisable for five years
from the date of grant.  No compensation expense was charged to operations as
the fair value of the shares and services received was nominal. Fair value was
determined by management to be the amount that would have been paid had the
Company paid cash for such services.  In addition, expense was not deemed
appropriate by management as the value of the Company was nominal prior to the
effective date of the Acquisition Agreement, the consummation of which was not
assured. These warrants carry piggyback registration rights, as defined.  During
the years ended December 31, 2001, 2000, and 1999, warrants totaling 0, 0, and
140,000, respectively, were exercised.

 

Through December 31, 1996, the Company issued an aggregate 100,000 warrants to
purchase restricted shares of common stock for $1.65 per share exercisable five
years from the date of grant to a consultant for services provided. Compensation
expense related to these warrants, as determined by management to be the fair
value of services received had the Company paid cash, was insignificant.  For
the years ended December 31, 2000 and 1999, none of these warrants have been
exercised.  As of December 31, 2000, none of the remaining warrants were
exercised, and such warrants expired.

 

During the year ended December 31, 1997, the Company issued to outside parties
162,465 warrants to purchase restricted shares of common stock at a per share
price ranging from $1 to $2.24 exercisable up to five years from the date of
grant. These warrants carry registration rights, as defined.  The Company
recorded $42,465 of legal and consulting expense to reflect the fair value of
the services received. During the years ended December 31, 1999 and 1998,
warrants totaling 127,465 and 35,000, respectively, expired.

 

During the year ended December 31, 1998, the Company issued to outside
consultants 30,000 warrants to purchase restricted shares of common stock at a
per share price of $0.01 or $1 exercisable up to five years from the date of
grant.  These warrants carry registration rights, as defined.  The Company
recorded $20,163 of consulting expense to reflect the fair value of the services
received, of which $5,163 represents the difference between the fair market
value of the underlying common shares and the exercise price of the warrants,
and the remaining $15,000 represents the fair value of the services received had
the Company paid cash for such services. During the year ended December 31,
1998, warrants to purchase 15,000 shares of common stock at $0.01 were
exercised.  During the year ended December 31, 1999, warrants to purchase 5,000
shares of common stock were exercised, and warrants to purchase 5,000 shares of
common stock expired.

 

F-28

--------------------------------------------------------------------------------

 

During the years ended December 31, 2001, 2000, and 1999, the Company issued
options to purchase 120,000, 40,000, and 200,000 shares, respectively, of
restricted common stock to the Company’s law firm and a consultant,
respectively.  The options are exercisable at prices ranging from $0.30 to $2
(fair market value or higher) per share for one year. Management of the Company
determined that no additional amounts would have been paid to such law firm for
services as invoiced services are paid in cash.  Accordingly, the Company
recorded no legal or consulting expense. During the years ended December 31,
2001, 2000, and 1999, 0, 40,000, and 200,000 options, respectively, were
exercised.

 

During the year ended December 31, 2000, the Company issued warrants to purchase
150,000 shares of common stock to a public relations firm.  The warrants are
exercisable at prices ranging from $2 to $4 (fair market value or higher). 
Warrants for 60,000 of these shares are restricted.  The warrants expire between
six and 12 months from the date of grant.  During the years ended December 31,
2001 and 2000, 60,000 and 90,000 warrants, respectively, expired.

 

Stock Option Plans

The Company has six incentive stock option and non-qualified stock option plans
(the “Plans”), as amended for directors, officers, key employees, and
consultants.  The Plans are the 1996, 1997, 1998, 1999, 2000, and 2001 Incentive
and Non-Statutory Stock Option Plans.  The total number of shares which may be
purchased through the exercise of options granted through the Plans will not
exceed 750,000, 1,000,000, 1,401,976, 1,500,000, 1,000,000 and 3,500,000,
respectively.  The Plans are intended to further the growth and financial
success of the Company by providing additional incentives to selected employees
of and consultants to the Company.

 

The Plans provide for the granting of options for common shares at exercise
prices equal to or exceeding the fair market value at the date of grant as
determined by the Board of Directors.  Options become exercisable over a period
of three to five years from the date of grant, and not less than 20% will become
exercisable annually as determined by the Board of Directors.  None of the
options granted are exercisable prior to one year from the date of grant unless
specified by the Board of Directors.  Options are not to be exercisable after 10
years from the date of grant for any reason.

 

F-29

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Options granted under the Plans may be either “incentive stock options,” within
the meaning of Section 422 of the Internal Revenue Code, or “non-qualified stock
options,” as determined by the Board of Directors at the time of grant. 
Incentive stock options may not be granted to any person who owns stock
possessing more than 10% of the combined voting power of all classes of the
Company’s stock or its parent (“10% Stockholders”) unless the exercise price is
at least equal to 110% of fair market value on the date of grant.

 

The exercise price in the case of incentive stock options granted under the
Plans must be at least equal to the fair market value of the common stock as of
the date of grant.  Incentive stock options may not be granted to an optionee
under the Plans if the aggregate fair market value, as determined on the date of
grant, of the stock with respect to which incentive stock options are
exercisable by such optionee in any calendar year under the Plans exceeds
$100,000.

 

Under the 1996, 1997, and 1998 Plans, incentive stock options granted to a 10%
Stockholder is not exercisable after the expiration of five years.

 

In April 1996, the Company issued options to purchase restricted shares of
common stock at $0.01 per share, which was below market, to two employees,
resulting in the Company recording deferred compensation of $124,000, which was
being amortized over five years, the vesting period of the options.  During the
year ended December 31, 1997, one of the employees left the Company and
forfeited his options.  Accordingly, the Company reversed the deferred
compensation relating to this employee.  During the years ended December 31,
2001 and 2000, 0 and 50,000, respectively, of these options were exercised.

 

As of December 31, 2001, 2000, and 1999, the balance of deferred compensation
totaled $0, $3,100, and $15,500, respectively.

 

F-30

--------------------------------------------------------------------------------

 

The following summarizes options and warrants granted and outstanding through
December 31, 2001:

 

 

 

Number of Shares

 

Total

 

Weighted-
Average
Exercise
Price

 

Employee

 

Non-
Employee

Outstanding, December 31, 1998

 

700,000

 

2,744,234

 

3,444,234

 

$

1.80

 

Granted

 

—

 

200,000

 

200,000

 

$

0.30

 

Exercised

 

(50,000

)

(710,826

)

(760,826

)

$

0.11

 

Expired, cancelled

 

(50,000

)

(1,654,828

)

(1,704,828

)

$

2.10

 

 

 

 

 

 

 

 

 

 

 

Outstanding, December 31, 1999

 

600,000

 

578,580

 

1,178,580

 

$

2.30

 

Granted

 

1,682,500

 

532,500

 

2,215,000

 

$

2.19

 

Exercised

 

—

 

(82,858

)

(82,858

)

$

0.64

 

Expired, cancelled

 

—

 

(625,722

)

(625,722

)

$

3.22

 

 

 

 

 

 

 

 

 

 

 

Outstanding, December 31, 2000

 

2,282,500

 

402,500

 

2,685,000

 

$

2.03

 

Granted

 

1,753,000

 

200,000

 

1,953,000

 

$

1.03

 

Exercised

 

—

 

(12,500

)

(12,500

)

$

0.05

 

Expired, cancelled

 

(115,000

)

(60,000

)

(175,000

)

$

3.06

 

 

 

 

 

 

 

 

 

 

 

Outstanding,
December 31, 2001

 

3,920,500

 

530,000

 

4,450,500

 

$

1.55

 

 

 

 

 

 

 

 

 

 

 

Exercisable,
December 31, 2001

 

1,447,341

 

157,976

 

1,605,317

*

$

1.74

 

 

--------------------------------------------------------------------------------

*                                         Included in the exercisable options at
December 31, 2001 are 271,250 options which have vested, but are not exercisable
until the Company has a NASDAQ listing.

 

F-31

--------------------------------------------------------------------------------

 

The following table is a summary of the stock options and warrants as of
December 31, 2001:

 

Range of
Exercise
Prices

 

Stock Options
and Warrants
Outstanding

 

Stock Options
and Warrants
Exercisable

 

Weighted-
Average
Remaining
Contractual
Life

 

Weighted-
Average
Exercise
Price of
Options and
Warrants
Outstanding

 

Weighted-
Average
Exercise
Price of
Options and
Warrants
Exercisable

 

$

1.00 - 1.82

 

2,553,000

 

767,250

 

3.85 years

 

$

1.13

 

$

1.32

 

$

2.00 - 2.25

 

1,747,500

 

762,067

 

3.21 years

 

$

2.03

 

$

2.03

 

$

3.00 - 3.50

 

150,000

 

76,000

 

3.21 years

 

$

3.03

 

$

3.03

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4,450,500

 

1,605,317

 

 

 

 

 

 

 

 

Pro forma information regarding net loss and loss per share is required by SFAS
No. 123 and has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123.  The fair value for
these options was estimated at the date of grant using the Black-Scholes option
pricing model with the following weighted-average assumptions for the years
ended December 31, 2001 and 2000:  risk free interest rates of 4.6% and 6.4%,
respectively; dividend yields of 0% and 0%, respectively; expected volatility of
100% and 70%, respectively; and expected lives of four and four years,
respectively.  For the years ended December 31, 2001 and 2000, 1,953,000 and
2,215,000 options, respectively, were granted.  For the year ended December 31,
1999, no options were granted.

 

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable.  In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility.  Because
the Company’s employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management’s
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.

 

F-32

--------------------------------------------------------------------------------

 

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options vesting period.  Adjustments are made
for options forfeited prior to vesting.  The effect on compensation expense, net
loss, and net loss per common share had compensation costs for the Company’s
stock option plans been determined based on a fair value at the date of grant
consistent with the provisions of SFAS No. 123 for the years ended December 31,
2001 and 2000 is as follows:

 

 

 

2001

 

2000

 

Net loss

 

 

 

 

 

As reported

 

$

(5,547,645

)

$

(6,410,849

)

Pro forma

 

$

(5,880,664

)

$

(6,790,152

)

Basic and diluted loss per common share

 

 

 

 

 

As reported

 

$

(0.08

)

$

(0.16

)

Pro forma

 

$

(0.09

)

$

(0.17

)

 

For the year ended, December 31, 1999, there was not any effect on compensation
expense.

 

NOTE 15 - INCOME TAXES

 

The components of the income tax provision (benefit) for the years ended
December 31 were as follows:

 

 

 

2001

 

2000

 

1999

 

Current

 

$

3,000

 

$

2,400

 

$

222,500

 

Deferred

 

—

 

(1,002,000

)

(651,000

)

 

 

 

 

 

 

 

 

Total

 

$

3,000

 

$

(999,600

)

$

(428,500

)

 

F-33

--------------------------------------------------------------------------------

 

Income tax expense (benefit) for the years ended December 31 differed from the
amounts computed applying the federal statutory rate of 34% to pre-tax income as
a result of:

 

 

 

2001

 

2000

 

1999

 

Computed “expected” tax  expense (benefit)

 

$

(1,885,000

)

$

(2,520,000

)

$

488,000

 

Income in income taxes resulting from
Expenses not deductible for tax purposes

 

18,000

 

12,000

 

4,000

 

Change in beginning of the year balance of the valuation allowance for deferred
tax assets allocated to income tax expense

 

2,090,000

 

1,789,000

 

(986,000

)

State and local income taxes, net of tax benefit

 

(220,000

)

(280,600

)

65,500

 

 

 

 

 

 

 

 

 

Total

 

$

3,000

 

$

(999,600

)

$

(428,500

)

 

Significant components of the Company’s deferred tax assets and liabilities for
federal income taxes at December 31 consisted of the following:

 

 

 

2001

 

2000

 

Deferred tax assets

 

 

 

 

 

Net operating loss carryforward

 

$

3,833,000

 

$

2,818,000

 

Allowance for doubtful accounts

 

367,000

 

122,000

 

Allowances for sales returns

 

369,000

 

135,000

 

Allowances for price protection

 

747,000

 

732,000

 

Accrued compensation

 

91,000

 

68,000

 

Amortization of trademark

 

964,000

 

413,000

 

Inventory

 

423,000

 

231,000

 

Other

 

4,000

 

3,000

 

Valuation allowance

 

(4,709,000

)

(2,580,000

)

 

 

 

 

 

 

Total deferred tax assets

 

2,089,000

 

1,942,000

 

 

 

 

 

 

 

Deferred tax liabilities

 

 

 

 

 

State tax

 

353,000

 

221,000

 

Other

 

15,000

 

—

 

 

 

 

 

 

 

Total deferred tax liabilities

 

368,000

 

221,000

 

 

 

 

 

 

 

 

 

1,721,000

 

1,721,000

 

Less current portion

 

1,556,000

 

1,556,000

 

 

 

 

 

 

 

Long-term portion

 

$

165,000

 

$

165,000

 

 

F-34

--------------------------------------------------------------------------------

 

As of December 31, 2001 and 2000, the valuation allowance for deferred tax
assets, totaled approximately $4,709,000 and $2,580,000, respectively.  For the
years ended December 31, 2001, 2000, and 1999, the net change in the valuation
allowance was $2,129,000 (increase), $2,270,000 (increase), and $996,000
(decrease), respectively.

 

As of December 31, 2001, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $10,000,000.  The net operating
loss carryforwards expire through 2021.  The utilization of net operating loss
carryforwards may be limited due to the ownership change under the provisions of
Internal Revenue Code Section 382 and similar state provisions.

 

NOTE 16 - RELATED PARTY TRANSACTIONS

 

During the year ended December 31, 1999, the Company had sales totaling
$6,943,495 to related parties.

 

During the years ended December 31, 2001, 2000, and 1999, the Company had
purchases from related parties totaling $22,031,190, $31,004,756, and
$15,870,093, respectively.

 

During the year ended December 31, 1999, the Company purchased inventory
totaling $2,382,252 on behalf of a related party.  During the year ended
December, 31, 1999, such inventory was sold at cost plus handling expenses
resulting in other income to the Company of $24,000.

 

NOTE 17 - SUBSEQUENT EVENT

 

On February 12, 2002, the Company announced approval by the Board of Directors
of the Company to redeem its own stock in open market transactions of up to
$500,000.

 

F-35

--------------------------------------------------------------------------------

 

SUPPLEMENTAL INFORMATION

 

F-36

--------------------------------------------------------------------------------

 

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

ON FINANCIAL STATEMENT SCHEDULES

 

To the Board of Directors

I/OMagic Corporation and subsidiary

Santa Ana, California

 

Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole.  The consolidated
supplemental schedule II is presented for purposes of complying with the
Securities and Exchange Commission’s rules and is not a part of the basic
consolidated financial statements.  This schedule has been subjected to the
auditing procedures applied in our audits of the basic consolidated financial
statements and, in our opinion, is fairly stated in all material respects in
relation to the basic consolidated financial statements taken as a whole.

 

 

SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

 

Los Angeles, California

February 15, 2002

 

F-37

--------------------------------------------------------------------------------

 

I/OMAGIC CORPORATION

AND SUBSIDIARY

VALUATION AND QUALIFYING ACCOUNTS - SCHEDULE II

For the Years Ended December 31,

 

 

 

 

Balance,
Beginning
of Year

 

Additions
(Deductions)
Charged to
Operations

 

Additions
(Deductions)
from
Reserve

 

Balance,
End
of Year

 

Allowance for doubtful accounts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2001

 

$

2,106,518

 

$

850,937

 

$

(278,337

)

$

2,679,118

 

 

 

 

 

 

 

 

 

 

 

December 31, 2000

 

$

71,193

 

$

2,420,210

 

$

(384,885

)

$

2,106,518

 

 

 

 

 

 

 

 

 

 

 

December 31, 1999

 

$

46,372

 

$

24,821

 

$

—

 

$

71,193

 

 

 

 

 

 

 

 

 

 

 

Reserve for inventory

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2001

 

$

1,834,427

 

$

410,000

 

$

(1,685,724

)

$

558,703

 

 

 

 

 

 

 

 

 

 

 

December 31, 2000

 

$

138,007

 

$

2,716,303

 

$

(1,019,883

)

$

1,834,427

 

 

 

 

 

 

 

 

 

 

 

December 31, 1999

 

$

134,644

 

$

192,363

 

$

(189,000

)

$

138,007

 

 

F-38

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