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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31,2008**

 

**Commission File Number: 0-21123**

 

 

**SRS LABS, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**  (State of incorporation)                                                  |   | **33-0714264**  (I.R.S. Employer Identification No.) |
|-----------------------------------------------------------------------------------------|--------|------------------------------------------------------|
| ** **                                                                              |   | ** **                                           |
| **2909 Daimler  Street, Santa Ana, California**(Address of principal executive offices) |   | **92705**  (Zip Code)                                |

 

**(949) 442-1070**

(Registrant’stelephone number, including area code)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 
| **Title of  each class**                  | ** ** | **Name of  each exchange on which registered**            |
|-------------------------------------------|------------|-----------------------------------------------------------|
| Common  Stock, Par Value $0.001 Per Share |       | The NASDAQ  Stock Market LLC  (NASDAQ Global Market) |

 

Indicate bycheck mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o  No x

 

Indicate bycheck mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o  No x

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (§229.405 of this chapter) is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See the definitionsof “large accelerated filer,” “accelerated filer” and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act:

 
| Large  accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o                  |   | Smaller  reporting company o |
|---------------------------------|--------|---------------------------|--------|------------------------------------------------|--------|-----------------------------------|
|                            |   |                      |   | (Do not check if a smaller  reporting company) |   |                              |

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  No x

 

The aggregatemarket value of the registrant’s voting common stock held by non-affiliates ofthe registrant was approximately $83,892,280 (computed using the closing priceof $6.45 per share of common stock on June 30, 2008, as reported by theNASDAQ Stock Market).

 

As of February 2,2009, 14,419,418 shares of the registrant’s common stock, par value $0.001 pershare, were outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions ofthe registrant’s definitive proxy statement prepared in connection with theAnnual Meeting of Stockholders to be held in 2009 are incorporated by referencein Part III of this Form 10-K.

 

 

 

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**SRS LABS, INC.**

**Annual Report on Form 10-K**

**Table of Contents**

 
| ** **        | ** **                                                                                                         | **Page** |
|-------------------|--------------------------------------------------------------------------------------------------------------------|----------|
| **PART I**   |
| Item 1.      | Business                                                                                                           | 3        |
| Item 1A.     | Risk Factors                                                                                                       | 10       |
| Item 1B.     | Unresolved Staff Comments                                                                                          | 14       |
| Item 2.      | Properties                                                                                                         | 14       |
| Item 3.      | Legal Proceedings                                                                                                  | 14       |
| Item 4.      | Submission of Matters to a Vote of Security  Holders                                                               | 15       |
| **PART II**  |
| Item 5.      | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 15       |
| Item 6.      | Selected Financial Data                                                                                            | 18       |
| Item 7.      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        | 19       |
| Item 7A.     | Quantitative and Qualitative Disclosures  About Market Risk                                                        | 28       |
| Item 8.      | Financial Statements and Supplementary Data                                                                        | 28       |
| Item 9.      | Changes in and Disagreements With  Accountants on Accounting and Financial Disclosures                             | 28       |
| Item 9A.     | Controls and Procedures                                                                                            | 28       |
| Item 9B.     | Other Information                                                                                                  | 29       |
| **PART III** |
| Item 10.     | Directors, Executive Officers and Corporate  Governance                                                            | 30       |
| Item 11.     | Executive Compensation                                                                                             | 30       |
| Item 12.     | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    | 30       |
| Item 13.     | Certain Relationships and Related  Transactions, and Director Independence                                         | 30       |
| Item 14.     | Principal Accounting Fees and Services                                                                             | 30       |
| **PART IV**  |
| Item 15.     | Exhibits and Financial Statement Schedule                                                                          | 31       |
| Signatures        |                                                                                                               | 34       |

 

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As used herein, the “Company,”“SRS Labs,” “SRS,” “we,” “us,” or “our” means SRS Labs, Inc., itswholly-owned subsidiaries, SRSWOWcast.com, Inc., and ShenzhenRepresentative Office of SRS Labs, Inc., and for the applicable periods,its former subsidiary, ValenceTech Limited (collectively with its direct andindirect wholly-owned subsidiaries, “Valence”), and the former joint venturewith Coming Home Studios LLC, CHS/SRS LLC. SRS®, Circle Surround®,Circle Surround IITM, CS AutoTM, Xspace 3DTM, SRS WOW®, SRS WOW XTTM, SRS WOW HDTM,SRS TruBass®, SRS FOCUSTM, SRS HeadphoneTM, SRS Dialog ClarityTM, SRSTruSurround® XT, TruSurround® HD, SRS 3D®, SRS AutoTM, VIPTM, TruSurround HD4TM,CircleCinemaTM, iWOWTM, SRS Circle Surround XtractTM, SRS Headphone 360TM, SRSMobile HDTM, SRS Premium SoundTM, SRS TruChatTM, SRS TruGamingTM, SRS TruMediaTM,SRS TruToolsTM, SRS TruVoiceTM, SRS XTractTM, TruVolumeTM, TruThunderTM, SRSTruSpeakTM, Cinema SoundTM, SRS Noise ReductionTM, SRS Audio Sandbox® and SRSHeadphone Pro® are our U.S. trademarks. All other trademarks and trade namesappearing are the property of their respective owners.

 

**SPECIAL NOTE REGARDING FORWARD-LOOKINGSTATEMENTS**

 

Some of thestatements in this Annual Report on Form 10-K contain forward-lookingstatements regarding our assumptions, projections, expectations, targets,intentions or beliefs about future events, which involve risks anduncertainties. All statements other than statements of historical factsincluded in this Annual Report, including statements relating to expectation offuture financial performance and capital requirements, continued growth,changes in economic conditions or capital markets, changes in customer usagepatterns and preferences and the impact of recent accounting pronouncements,are forward-looking statements. In some cases, you can identify forward-lookingstatements by terms such as may, will, should, expect, plan, intend, forecast,anticipate, believe, estimate, predict, potential, continue or the negative ofthese terms or other comparable terminology. The forward-looking statementscontained in this Annual Report involve known and unknown risks, uncertaintiesand situations that may cause our or our industry’s actual results, level ofactivity, performance or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these statements. Factors that might cause actual events or resultsto differ materially from those indicated by these forward-looking statementsmay include the matters listed in this Annual Report, including, but notlimited to, those listed under “Risk Factors” in Item 1A.

 

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**PART I**

 

**Item 1. Business**

 

**Overview**

 

We are therecognized global leader in the practical application of psychoacoustics*,* the science behind how the human ear operates, andin the post processing segment of the market for audio delivery.  Our award-winning audio enhancementtechnologies and solutions dramatically restore audio and voice to its natural state, the way it was originally recorded, in both dimension andclarity, thus providing a superiorconsumer experience for a wide variety of consumer electronic (“CE”)devices such as televisions, personal computers and mobile phones.

 

Our mission isto be the dominant worldwide provider of audio and voice solutions that allowconsumers to effortlessly experience rich, natural sound, the way their earswere meant to hear it.

 

Our operationsare conducted through SRS Labs, Inc., the parent company, and itswholly-owned subsidiaries, SRSWOWcast.com, Inc. and ShenzhenRepresentative Office of SRS Labs, Inc. (a Chinese company). Our businessis focused on developing and licensing audio, voice and surround soundtechnology solutions to many of the world’s leading original equipmentmanufacturers (“OEMs”), software providers and semiconductor companies, andlimited sales and marketing of standalone software and hardware productsthrough the Internet.

 

Prior to September 29,2006, we were also a developer and provider of application specific integratedcircuits and standard integrated circuits through our former wholly-ownedsubsidiary, Valence.

 

**DiscontinuedOperations**

 

*Valence:* Through our former subsidiary, Valence, we operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog integrated circuits, digital signal processors (“DSPs”), andmixed signal integrated circuits primarily to OEMs and original designmanufacturers (“ODMs”) in the Asia Pacific region.  On February 23, 2006, our Board ofDirectors (the “Board”) approved a plan to sell Valence in order to focusmanagement’s attention and financial resources on our licensing business. On July 14,2006, we entered into a definitive Sale and Purchase Agreement to sell Valenceto Noblehigh Enterprises Inc. The sale transaction was completed on September 29,2006 and, accordingly, the results of the operations of Valence through thedate of sale are included as discontinued operations in the accompanyingconsolidated statements of operations for all periods presented.

 

*CHS/SRS LLC:*  In September 2004, we entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to use and promoteSRS Labs’ technologies, to promote CHS productions and to promote each company’srespective brands. In connection with the strategic alliance, SRS and CHSestablished a joint venture, CHS/SRS, LLC (the “Joint Venture”), toproduce and distribute nine concert videos featuring our Circle Surround technology.On February 23, 2006, the Board authorized management to take allreasonable steps to divest our entire equity interest in the Joint Venture. On June 30,2006, we completed the sale of our interest in the Joint Venture to CHS and,accordingly, the results of the operations of the Joint Venture through thedate of sale are included as discontinued operations in the accompanyingconsolidated statements of operations for all periods presented.

 

Furtherfinancial information for mix of revenues by market sectors, geographic areasand customer concentration is included in this Annual Report on Form 10-Kunder “Item 8. Financial Statements and Supplemental Data” and inNotes 1 and 8 to the Notes to Consolidated Financial Statements. Referencealso is made to “Item 1A. Risk Factors” for a discussion relating tocertain risks relating to our business.

 

We wereincorporated in the State of California on June 23, 1993 andreincorporated in the State of Delaware on June 28, 1996. Our executiveoffices are located at 2909 Daimler Street, Santa Ana, California 92705. Ourtelephone number is (949) 442-1070.

 

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**Our Products and Technologies**

 

Our licensingbusiness is focused on developing and marketing audio rendering, voice andsurround sound technologies and solutions to OEMs, ODMs, semiconductormanufacturers, and software providers in the home entertainment, personal computers,personal telecommunications, automotive, portable media devices and broadcastmarkets. Our portfolio of licensable technologies includes a wide range oftechniques for the processing and delivery of audio, voice and surround sound,including the following:

 

·                  *SurroundSound*—Our surround sound technologies include SRS TruSurround XT,TruSurround HD, TruSurround HD4, Circle Surround, Circle Surround II and CircleSurround Automotive.  Circle Surround, isa complete encoding and decoding format. Circle Surround *encoding* enables the distribution of up to6.1 channels of audio over existing two-channel carriers such as digital mediafiles, standard definition and high-definition television, FM radio and CDs.Circle Surround *decoding* decodesCircle Surround encoded material for multi-channel playback or creates up to6.1 channels of audio from older formats of material, including mono, stereo,4-channel surround or other matrix surround formats.

 

·                  *AudioRendering*—Our audio rendering technologies optimize device audiooutput and enable the presentation of 3D and multichannel audio content overtwo speakers. These technologies include the ability to render 5.1 multichannelcontent over two speakers, to create a wider sound stage for more naturalaudio, to improve the perceived bass response in small speakers, to dynamicallyposition audio sources in a virtual 3D space using headphones, and toreposition the audio image for non-optimally placed speakers. Our audiotechnologies include SRS Xspace 3D, SRS WOW, SRS WOW XT, SRS WOW HD, SRSTruBass, SRS FOCUS, SRS Headphone, SRS DialogClarity, TruVolume (alsoknown as VIQ), and SRS 3D Sound.

 

·                  *VoiceProcessing*—Our TruVoice (also known as VIP and VIP+) and NoiseReduction technologies dramatically reduce noise to produce a much clearer andcrisper dialog over wireless communication devices and improve theintelligibility of the human voice in a variety of listening situations,including high ambient background environments.

 

·                  *Solutions**Suite*—Oursolutions suites combine several of our technologies in order to deliver acomprehensive, easier to deploy package of post processing audio enhancementproducts. Solution suites also enable us to impact the performance of the OEMproducts by employing multiple technologies and techniques to enhance andcontrol the overall audio fidelity and performance of the product. Our solutionsuites include SRS Premium Sound and SRS Premium Voice for personal computers,TruMedia, TruVoice, and TruTools for mobile phones, and CinemaSound for homeentertainment products among others

 

Our portfolio of technologies and solution suites addresses a broadspectrum of product applications within the vertical markets that we havetargeted. Our technologies may be implemented in a variety of methods,including discrete analog components, chip modules, analog semiconductors,digital signal processors (“DSPs”) and software. These various implementationoptions offer customers flexibility when incorporating our technologies intoproducts.

 

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**OurCustomers and Markets**

 

We license ourtechnologies both in the U.S. and internationally. The following table presentsour revenue by geographic area. Licensing-related revenue is summarized basedon the location of the licensee’s corporate headquarters. For standalonesoftware and hardware product and online sales, revenue is allocated to theAmericas.

 
| ** **                     | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                    | ** ** | **%** | ** ** | **2007** | ** ** | **%** | ** ** | **2006** | ** ** | **%** | ** ** |
| ***Geographic Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Korea                          |       | $                                           | 9,624,459  |   | 52 | % | $ | 7,834,730 |   | 42 | % | $ | 5,652,550 |   | 30 | % |
| Japan                          |       | 5,357,286                                   |       | 29 |   | 7,346,548 |   | 39 |   | 8,115,378 |   | 44 |   |
| Americas                       |       | 1,744,502                                   |       | 10 |   | 1,837,096 |   | 9 |   | 1,534,421 |   | 8 |   |
| China                          |       | 838,754                                     |       | 5 |   | 843,931 |   | 5 |   | 2,032,690 |   | 11 |   |
| Asia Pacific                   |       | 430,598                                     |       | 2 |   | 805,660 |   | 4 |   | 1,132,882 |   | 6 |   |
| Europe                         |       | 337,079                                     |       | 2 |   | 183,975 |   | 1 |   | 79,608 |   | 1 |   |
| Total                          |       | $                                           | 18,332,678 |   | 100 | % | $ | 18,851,940 |   | 100 | % | $ | 18,547,529 |   | 100 | % |

 

Through ourlicensing business, we market our portfolio of technologies and solution suitesto the following markets: home entertainment, personal computers, personaltelecommunications, automotive and portable media devices. Our licenseagreements typically have multi-year or automatic renewal terms, and eitherrequire: (a) per-unit royalty payments for all products implementing ourtechnologies and/or solutions; (b) fixed annual or quarterly royaltypayments; or (c) a minimum fixed annual or quarterly royalty payment,which allows the licensee to ship up to a predetermined number of units duringthe specified time period with additional per-unit royalty payments thereafter.The license agreements also generally specify the use of our trademarks andlogos on the product, within the packaging and in the user’s manual, andrequire our review and approval of the product to guarantee the quality of thetechnology implementation and the correct usage of our logos and trademarks. Webelieve these terms ensure the quality and consistency of the technology andelevate the awareness of the SRS brand in the marketplace. We also sell some ofour products and solutions via the Internet. Revenues associated with those sales are recognized upon shipment havenot historically been material.

 

The followingchart shows the percentage of our licensing revenue we received in 2008 and2007 from each of these markets.

 

 

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**HomeEntertainment**

 

Homeentertainment products represent the largest current market for ourtechnologies and have, in recent years, been the largest revenue contributor.Manufacturers in this market utilize our technologies and solutions to improvefunctionality and product performance and/or to differentiate their productsfrom their competitors.  In manyinstances, manufacturers license multiple technologies from us for multipleproduct lines and divisions. Product categories within this market include flatpanel televisions (such as LCD and Plasma televisions) and set-top boxes (“STBs”).

 

*Televisions.* Our audio technologies and solution suites are widely used by televisionmanufacturers as a solution to audio challenges that manufacturers encounter intoday’s flat panel television designs and/or as a differentiating feature. Astelevision makers continue to migrate to models with thinner digital displays,they are finding that they have less room for speakers, which may compromisethe overall audio quality of the television. We provide manufacturers withpatented solutions for accurately presenting surround sound, improving bassresponse, increasing dialog clarity, automatic volume control, and creating amore natural sound stage. These solutions improve the audio quality of thetelevision set without the expense of additional equipment or designing forlarger speakers. During 2008, we signed contracts to license audio enhancementtechnologies to Vizio, General Displays and Technologies, TCL Electronics Ltdand Nexgen Mediatech, among others.

 

*Set-top Boxes.* Although STBs receive and present surround sound content, they aretypically connected to televisions with two-channel speakers. Our SRSTruSurround XT technology creates a surround sound experience over any existingtwo-speaker system, including the internal speakers of a television. Thistechnology also creates a virtual surround experience from stereomaterial.  Our TruVolume technologycreates a level volume user experience to offset decibel fluctuations duringchannel changes, changes among different input devices and changes between theprogram and commercial.

 

**Portable Media**

 

MP3 (audio)and MP4 (audio and video) players and other portable media players enableconsumers to enjoy audio and video content while on the go. The audio contents arestored in a compressed industry standard MP3 audio standard. As such, when thecontents are decoded and played back through miniature earphones, the contentsgenerally suffer loss of audio quality. Our technologies, such as SRS WOW andSRS WOW HD, are capable of improving the audio quality during playback. OurMobile HD technologies also enable rendering of surround sound throughearphones when playing back surround sound encoded contents often used alongwith contemporary video contents. Associated with the increasing popularity ofMP3 and MP4 players, there has been a noticeable growth in the market foraccessories, such as portable media adapters, docking stations and miniaturespeaker systems. The small footprint of these devices limits speaker size andspeaker spacing. Our solutions enable vendors of these devices to increase thequality of their audio output generally without increasing hardware componentcosts.

 

**Personal Telecommunications**

 

We provide thepersonal telecommunications market (mobile phones) with both voice and audiorendering technologies and solution suites. Mobile phones are incorporatingmore multimedia features and functionality at a rapid pace. New servicesinclude digital music downloads, ring-tones and true-tones, streaming video,gaming and television viewing. Our strong presence in the home entertainmentmarket, our suite of voice technologies, and our entry into the mobile marketwith customers like NEC present growth opportunities for us. Our solutionsaddress specific needs in the mobile market. For example, our technologiesaddress needs like voice intelligibility in noisy environments, clarity ofdialog in video content, poor bass-response of small speakers, hampered stereoimaging in narrow-set speakers, and 3D positioning audio for interactivegaming. Our technologies are licensed by telecommunications companies such asMotorola, Samsung and NEC.

 

**Automotive**

 

We haveinvested in research to create solutions specific to the needs of theautomotive market. Within vehicles, audio and video content is played frommultiple sources and then presented on both speakers and headphones. Stereocontent from sources like CDs, MP3 players, mobile television and radio needsto be presented on multiple speakers in the car, some of which may not beoptimally placed and may not have strong bass response. Surround sound contentfrom DVDs, radio and downloaded music needs to be rendered on both car speakersand on rear-seat headphones with a maximum sweet spot. Our automotive solutionssuch as SRS CS Auto, SRS Circle Surround II and SRS TruSurround XT meet theseneeds and provide manufacturers in this segment with a fully tunable solution.Our technologies are licensed by companies such as Fujitsu-ten, Panasonic,Clarion and Kenwood and used on automobiles manufactured by companies such asToyota, Subaru, Nissan and Honda.

 

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**Personal Computers**

 

Personal computers(“PCs”) and in particular mobile PCs such as laptops, notebooks and the newgenre of Ultra Mobile Devices (also known as netbooks) have become very popularas more users utilize their PCs as their main entertainment device at home oron the go. At home, PCs are often used as media hubs. PC users can enjoy andmanage collections of music and movies, along with downloaded and recordedtelevision programming. This content is now being distributed through the homeusing networked media adapter products. Throughout these systems, there is aneed for optimizing playback on the computer speakers, presenting a closerassimilation to a typical home theater experience but on a laptop includingtransmitting surround sound around the home and enjoying content on headphones.On the go, users have to rely on the audio output capabilities of their PCswhich are often inadequate given the inherent challenges in today’s tiny PCenclosures. We believe our technology solutions are well positioned to fill theneed to deliver better sound, with deeper base, clarity and volume.  During 2008, we signed contracts to provideaudio enhancement technology suites to Hewlett Packard, NEC, and BenQ, amongothers.

 

**CustomerConcentration**

 

For fiscalyear 2008 and 2007, Samsung accounted for approximately 42% and 28%,respectively, of our consolidated revenues. For fiscal year 2006, Samsung and Sony each accounted for approximately17% and 11% of our consolidated revenues, respectively.  Given the significant amount of revenues derivedfrom Samsung, the loss of such customer or the uncollectibility of relatedreceivables could have a material adverse effect on our consolidated financialcondition and consolidated results of operations.  During 2007, we were informed by Sony thatthey were no longer using our technology in the majority of their televisions.We are working with Sony to re-establish this relationship; however, we cannotguarantee that we will be successful in regaining any significant business fromSony.

 

**Our Strategy**

 

Our salesstrategy is to identify high-growth markets, develop needed technologysolutions and features, and work with software and semiconductor platformpartners to make these technologies widely available and easy to implement byOEMs and ODMs. We believe that we will continue to strengthen ourmarket position as the leader in audio and voice technologies by employing thestrategy of providing a stream of patented audio and voice technologies,penetrating new licensing accounts, expanding relationships with existinglicensees, creating a broad platform of software and semiconductor partners,and developing strong awareness of the SRS brand.

 

The mission ofour licensing platform efforts is to achieve broad coverage for our technologysolutions within all of our targeted product markets in order to expand salesand licensing opportunities. By developing strong relationships with leadingsoftware and semiconductor companies, we believe our audio technologies andsolution suites can be delivered to customers worldwide across high growth andhigh volume product applications.

 

We worktogether with our platform partners (leading semiconductor manufacturers andmiddleware or firmware software providers) to provide our mutual customers withthe technology that best fits their needs. We also together solicit other newcustomers to consider using the platform. Many times, a platform will becomeenabled with our technology due to customer requests.

 

As atechnology licensing company, the strength of our brand is an important asset.Since brand recognition drives licensing sales, we have invested in strategiesdesigned to increase consumer awareness of SRS Labs with the ultimate goal ofestablishing our brand with both product manufacturers and consumers around theworld as a recognized symbol for high-quality audio. The four primary vehiclesthat we use to further the proliferation of our brand are: (a) placementof the SRS logo by OEMs on products and in co-marketing programs; (b) publicrelations and New Media outreach programs; c) online branding programs; and (d) use,and recognition of use, of SRS technology by content and broadcastprofessionals

 

*OEM Marketing Programs.*  In the majority of products that use SRStechnologies, our logo is either prominently displayed on the product itselfor, in the case of software products and mobile phones, featured in thegraphical user interface. We believe this logo exposure is a key tool inreaching consumers worldwide. In addition, we work with our OEM customers asthey prepare for launching new products that feature SRS technologies bysupplying complete SRS corporate and technology tool kits with a wide array ofmaterial, including SRS logos, illustrations, technology explanations andsuggested demonstration material.

 

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*Public Relations (“PR”) and New Media Outreach Programs.*We believe in the endorsement power ofopinion leaders and expert groups in the CE and IT industries. As such, we havean active and expanding PR program, both online and in print, to promote SRStechnologies and solutions found in our own products or products of OEMs thatfeature SRS technologies and solutions. Similarly, we have found the viralnature of the New Media very effective in promoting our brand and innovationsand therefore, have recently focused on multiple programs to systematicallyreach and work with bloggers and relevant social networks.

 

*Online Branding Programs.*  Online exposure has also been an importantpart of our branding strategy. One benefit of our relationship with Microsoftis that the SRS logo displayed in the audio control panel of Microsoft’sWindows Media Player links to an SRS technology page. As a result, we havereceived significant traffic and opportunities to create brand awareness withconsumers and educate consumers on the benefits of our technology. Our onlineefforts also include the direct sale of the iWOW family of products includingplug-in software for both the PC and Mac platforms, as well as a unique adapterfor the Apple iPod. Revenue from the sale of these products has not beensignificant historically, but we believe gives us a valuable demonstrationplatform to showcase our audio technologies.

 

*Use of SRS Technology by Content and Broadcast Professionals.*  We develop, license and sell professionalhardware and software products to enable content companies, broadcasters andmusic publishers to encode their material using our Circle Surround technology.When Circle Surround is professionally used, the SRS and Circle Surround logosare often displayed within the content itself, on the packaging material or, inthe case of radio, an announcement that the broadcast is being delivered in SRSCircle Surround. We have concentrated on three key market sectors in theprofessional audio space: television, radio and music; and we have developed aline of hardware and software products to address these markets. These productsare sold directly to professional customers and are also available fromselected dealers and distributors servicing the professional audio andbroadcast markets. We did not generate significant revenue from the sale ofprofessional hardware equipment in 2008; however, we believe that thesefacilitate the licensing of our technology to OEMs that benefit fromenhanced audio transmissions.

 

**Sales andMarketing**

 

We have twoprimary types of revenue agreements with our licensees—direct and non-direct.Under a non-direct agreement, royalty revenue may be collected by our platformpartner, who include and enable our technology within their solution, at thetime the chip is sold to an OEM or ODM. The platform partner remits the royaltyto us on behalf of the licensee. Most often, however, we license ourtechnologies to OEMs and ODMs under direct agreements and collectrevenue directly from them. These licensing arrangements with OEMs orODMs authorize them to design, build and sell products containing ourtechnology. Under this licensing approach, the licensees are free to choose asemiconductor solution from the platform partner that best suits theirtechnical and cost requirements. We receive royalties directly from thelicensed OEM or ODM for the use of our technologies in licensed productsmanufactured and shipped by the OEM or ODM. Many major OEMs have licensesor purchase products manufactured by a licensed ODM for the use of one or moreof our technologies and for the use and display of our trademarks.

 

Our processfor selecting particular platform partners for distributing our technologies isbased on several criteria including: (a) segment leadership—we targetplatform partners that hold preeminent positions in market segmentscharacterized by high growth, volume and/or margins; (b) volume—we seekplatforms that will maximize exposure of our technologies to a large number ofpotential OEMs; (c) synergy—we seek platforms which serve to position ourtechnologies with compatible and additive technologies for integrated delivery;and (d) convergence potential—we target arrangements that will enable usto establish a presence on platforms that intersect several functionalfeatures.

 

To implementour licensing sales strategy within our identified markets, we have establisheda direct sales force and an international network of independent sales agents.In North America, we employ a direct sales force to market our portfolio ofaudio and voice technologies to the OEM community. Internationally, we maintainoffices in Japan, Taiwan, China, Spain and Korea to support our multi-nationalOEM customers. We actively promote the use of our trademarks and logos andrequire customers to prominently display the appropriate SRS technology orsolution logos on products and packaging and in advertising. We plan tocontinue to work closely with our licensees to enhance their success in sellingfinished products and semiconductor products that incorporate our technologiesthrough a variety of licensee support programs. These programs include engineeringsupport, sales training, tradeshow support, publicity and media relationsprograms, customized marketing materials, advertising, and support at speakingengagements and industry conferences, as well as, conducting in-persontechnology demonstrations or presentations for the press and other companies topromote our technologies and products.

 

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We alsoregularly participate in tradeshows and conferences to increase awareness ofwho we are and what we do and to market our technologies and products. We workclosely with our licensees and platform partners to actively explore additionalopportunities to place our technologies in new products and/or markets.

 

**Researchand Development**

 

We license ourproducts in markets that are characterized by rapidly changing technology andcontinuous improvements in products and services. Our research and developmentexpenditures in 2008, 2007 and 2006 were $3,747,495, $3,107,482 and $2,572,577,respectively. These expenses generally consist of salaries and related costs ofemployees and consultants engaged in ongoing research, design and developmentactivities and costs for engineering materials and supplies.

 

As of December 31,2008, we had 20 employees in our research and development group, representing36% of our total employees. Our software, hardware and application engineersfocus on developing intellectual property, technology solutions and consumerproducts. All engineers are based in the U.S. and support our licensingbusiness.

 

**Competition**

 

Competition inthe audio, voice and surround sound technology licensing business includesother licensing companies who offer competing technologies as well as theinternal engineering departments of our current or prospective licensees, whomay develop audio technologies for use in their own products.

 

In the fieldof audio improvement, we compete directly with other audio providers, includingDolby, DTS and Emersys. Additionally, some of our OEM customers maintain theirown audio improvement technologies. Because our audio technologies work withany existing recorded material, whether mono, stereo or surround sound, most ofour audio technologies can be used either as an alternative or as a complementto most competing audio technologies.

 

Many of ourcompetitors have, or may have, substantially greater resources than us todevote to advancing their existing technologies and developing and marketingnew products and technologies. We believe that we compete based primarily onthe quality, efficiency, and performance of our proprietary technologies, brandname awareness, the ease, customization capabilities, and cost of implementingour technologies, the ability to meet OEMs’ needs to differentiate theirproducts, and the strength of our licensee relationships. We believe we competefavorably based on these factors; however, we cannot guarantee that we willcontinue to be competitive with the existing or future products or technologiesof our competitors.

 

**Intellectual Property Rights and ProprietaryInformation**

 

We operate inindustries where innovation, investment in new ideas and protection ofintellectual property rights are important for success. We rely on a variety ofintellectual property protections for our products and services, includingpatent, copyright, trademark and trade secret laws and contractual obligations.We pursue a policy of enforcing such rights. We cannot guarantee, however, thatour intellectual property rights will adequately protect our competitiveposition or that competitors will not be able to produce non-infringingcompetitive products or services. We cannot guarantee that third parties willnot assert infringement claims against us, or that if required to obtain anythird party licenses as a result of an infringement dispute, we will be able toobtain such licenses.

 

In order toprotect the underlying technology concepts, we have filed and/or obtainedpatents for all of our marketed technologies including technologies marketedunder the following trademarks: TruSurround XT, Circle Surround, SRS WOW,TruVoice, TruMedia and TruVolume. In addition, we have numerous issued patentsand patents pending for speaker and other acoustic reproduction technologies.We pursue a general practice of filing patent applications for our technologiesin the United States and various foreign countries where our licensees manufacture,distribute or sell licensed products. We continue to update and add newapplications to our patent portfolio to address changing worldwide marketconditions and our new technological innovations. The range of expiration datesfor our patents extend between the years 2009 to 2018. We have multiple patentscovering unique aspects and improvements for many of our technologies.Accordingly, the expiration of any single patent should not significantlyaffect our intellectual property position or the ability to generate licensingrevenue.

 

We alsoroutinely file U.S. federal and foreign trademark applications for thevarious word names and logos used to market our technology solutions tolicensees and the general public. The duration of the U.S. and foreignregistered trademarks can typically be maintained indefinitely, provided thatproper maintenance fees are paid and the trademarks are continually used orlicensed by us.

 

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**Seasonality**

 

Due to thedependence on the consumer electronics market, we experience seasonalfluctuation in sales and earnings. In particular, we believe that our businessexperiences seasonality relating to the holiday season, resulting in higherrevenues in the fourth and first quarters. As we have moved toward diversifyingour key market segments in the consumer electronics industry, we expect ourbusiness to be less seasonal.

 

**Employees**

 

As of December 31,2008, we employed 55 persons, including 12 in finance and administration,20 in research and development, engineering and product development, and23 in sales and marketing. None of our employees are covered by acollective bargaining agreement or are presently represented by a labor union.We have not experienced a work stoppage and believe we have good relationswith our employees.

 

**Available Information**

 

Our Internetaddress is *www.srslabs.com*. Ourannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and any amendments to those reports, are availablefree of charge on our website as soon as reasonably practicable after weelectronically file such material with or furnish it to the Securities andExchange Commission (“SEC”). Our SEC reports can be accessed through theinvestor relations section of our website. Additionally, the Company’s Code ofEthics and Committee Charters are available on our website.  The information found on our website is notincorporated in and is not part of this or any other report we file with orfurnish to the SEC.

 

**Item 1A. Risk Factors**

 

You shouldcarefully consider the risk factors described below, as well as the otherinformation included in this Annual Report on Form 10-K, prior to making adecision to invest in our securities. The risks and uncertainties describedbelow are not the only ones facing our company. Additional risks anduncertainties not presently known or that we currently believe to be lesssignificant may also adversely affect us.

 

***We are exposed torisks in our licensing business related to product and customer concentration.***

 

Currently, wegenerate a majority of our revenue in the home entertainment market,principally through the inclusion of SRS technology inside flat panel LCD andplasma televisions. We expect that the consumer home entertainment market willcontinue to account for a significant portion of our licensing revenues for theforeseeable future. In addition to significant fluctuations in consumerspending on consumer electronic products, retail prices for certain consumerelectronics products that include our audio technology have decreasedsignificantly. We expect that this trend will continue for the foreseeable future.In addition, from time to time, certain of our OEM and semiconductormanufacturer customers may account for a significant portion of our revenues.For example, for the year ended December 31, 2008, Samsung accounted forapproximately 42% of our consolidated revenues. These manufacturers coulddevelop their own technologies or decide to exclude our audio renderingtechnology from their products altogether in an effort to reduce cost.  For example, during 2007, we were informed bySony that they were no longer using our technology in the majority of theirtelevisions.  The loss of any keycustomer could have a material adverse affect on our financial condition andresults of operations.

 

***General economic conditions may reduce our revenues and harm our business.***

 

Ourbusiness is exposed to adverse changes in general economic conditions, becauseproducts that incorporate our technologies are entertainment-oriented andgenerally discretionary goods. The current slowdown or decline in U.S. andforeign economic growth has adversely affected consumer confidence, disposableincome and spending. As a result, sales by our licensees of consumerelectronics and other products incorporating our technologies may not grow asrapidly as in prior periods or may even decrease, which could adversely affectour licensing revenue.

 

***Our business ishighly dependent on the consumer electronics market, which is characterized byshort product life cycles, fluctuations in demand and seasonality, and issubject to risks related to product transitions and supply of other components.***

 

The consumerelectronics market is characterized by intense competition, rapidly evolvingtechnology, and ever-changing consumer preferences. These factors result in thefrequent introduction of new products, short product life cycles andsignificant price competition. As a result, we may need to develop new productsor technologies to integrate with the new 

 

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products and technologiesdeveloped by our customers. If we are unable to develop the necessarytechnologies to meet the changing needs of our customers or provide suchtechnologies at competitive prices, our customers may reduce their use of ourtechnologies and our revenues may decline. In addition, the dynamic nature ofthis market limits our ability and the ability of our customers to accuratelyforecast quarterly and annual sales. If we, or our customers, are unable toadequately manage product transitions, our business and results of operationscould be negatively affected.

 

***We depend on the sale by our licensees of products that incorporate ourtechnologies, and a reduction in those sales would adversely affect ourlicensing revenue.***

 

Wederive most of our revenue from the licensing of our technologies to consumerelectronics product manufacturers. We do not manufacture consumer electronicsproducts ourselves and our licensing revenue is dependent on sales by ourlicensees of products that incorporate our technologies. We cannot controlthese manufacturers’ product development or commercialization efforts orpredict their success. In addition, our license agreements, which typicallyrequire manufacturers of consumer electronics products and media softwarevendors to pay us a specified royalty for every electronics product shippedthat incorporates our technologies, do not require these manufacturers toinclude our technologies in any specific number or percentage of units, andonly a few of these agreements guarantee us a minimum aggregate licensing fee.Accordingly, if our licensees sell fewer products incorporating ourtechnologies, decline to actively market products incorporating our technologiesor otherwise face significant economic difficulties, our revenue will decline.Changes in consumer tastes or trends, changes in industry standards or adversechanges in business and economic conditions may also adversely affect ourlicensing revenue.

 

***Pricing pressures onthe consumer electronics product manufacturers, who incorporate ourtechnologies into their products, could limit the licensing fees we charge forour technologies, which could reduce our revenues.***

 

The marketsfor the consumer electronics products in which our technologies areincorporated are intensely competitive and price sensitive. Retail prices forconsumer electronics products that include our technologies have decreasedsignificantly, and we expect prices to continue to decrease for the foreseeablefuture. In response, manufacturers have sought to reduce their product costs,which can result in downward pressure on the licensing fees we charge ourcustomers who incorporate our technologies into their products. Alternatively,our customers may seek to eliminate our technologies in their products in favorof internally developed technologies. A decline in the licensing fees we chargecould materially and adversely affect our operating results.

 

***We face intensecompetition from companies with greater brand recognition and resources.***

 

The digitalaudio, consumer electronics and entertainment markets are intenselycompetitive, subject to rapid change, and significantly affected by new productintroductions and other market activities of industry participants

 

Many of ourcurrent and potential competitors enjoy notable competitive advantages,including:

 

·                  greater name recognition;

 

·                  a longer operating history;

 

·                  more developed distribution channelsand deeper relationships with consumer electronics products designers andmanufacturers;

 

·                  a more extensive customer base;

 

·                  broader product and serviceofferings;

 

·                  greater resources for competitiveactivities, such as research and development, strategic acquisitions,alliances, joint ventures, sales and marketing, and lobbying industry andgovernment standards; and

 

·                  more technicians and engineers.

 

As a result,these current and potential competitors may be able to respond more quickly andeffectively than we can to new or changing opportunities, technologies,standards, or customer requirements.

 

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***Inaccurate licensee royalty reporting andunauthorized use of our intellectual property could materially adversely affectour operating results.***

 

Ourlicensing revenue is generated primarily from consumer electronics productmanufacturers who license our technologies and incorporate them in theirproducts. Under a significant percentage of our existing arrangements, theselicensees typically pay us a specified royalty for every product they ship thatincorporates our technologies. We rely on our licensees to accurately reportthe number of units shipped that incorporate our technologies. We calculate ourlicense fees, prepare our financial reports, projections and budgets, anddirect our sales and product development efforts based on these reports wereceive from our licensees. However, it can be difficult for us toindependently determine whether or not our licensees are reporting shipmentsaccurately. This is especially true with respect to software incorporating ourtechnologies because software can be copied relatively easily and we often donot have easy ways to determine how many copies have been made. Most of ourlicense agreements permit us to audit our licensees’ records, but audits aregenerally expensive and time consuming and initiating audits could harm ourcustomer relationships. We expect that we will continue to be subject tounderstatement and non-reporting of royalty bearing revenues by licensees,which could adversely affect our operating results. Conversely, to the extentthat our licensees overstate the number of products incorporating our technologies,negative corrections could result in reductions of royalty revenue insubsequent periods. Some of our licensees may begin to more closely scrutinizetheir past licensing statements which may result in an increased receipt ofnegative corrective statements.

 

Wealso may experience problems with non-licensee consumer electronics productmanufacturers and media software vendors, particularly in emerging economies,incorporating our technologies or incorporating our technologies and trademarksinto their products without our authorization and without paying us anylicensing fees. This unauthorized use of our intellectual property couldadversely affect our operating results.

 

***Our business and future prospectsdepend upon the strength of our brand. Awareness of our brand depends to asignificant extent upon decisions by our customers to display our trademarks ontheir products, and if our customers do not display our trademarks on theirproducts, our ability to increase our brand awareness may be harmed.***

 

Becausewe engage in relatively little direct brand advertising, the promotion of ourbrand depends upon consumer electronics industry participants displaying ourtrademarks on their products that incorporate our technologies.  Although we do generally require ourcustomers to place our brand on their products, some are not required to do so.Maintaining the SRS brand and our position as an industry standard is criticalto maintaining and expanding our licensing revenues and entering into new orbroadening existing licensing relationships. If our customers choose for any reason not to display our trademarks ontheir products, our ability to maintain or increase our brand awareness may beharmed, which would have an adverse effect on our business and prospects. Inaddition, if we fail to maintain high quality standards for our products, orthe products that incorporate our technologies through the quality controlevaluation process that we require of our licensees, the strength of our brandcould be adversely affected.

 

***Licensee products that incorporateour technologies, from time to time, experience quality problems that coulddamage our brand, decrease revenues and increase operating expenses.***

 

Licenseeproducts that incorporate our technologies often are complex and sometimescontain undetected software or hardware errors, particularly when firstintroduced or when new versions are released. In addition, those products areoften combined with, or incorporated into, products from other companies, sometimesmaking it difficult to identify the source of a problem. Any negative publicityor negative impact relating to these product problems (even if unrelated to ourtechnologies) could adversely affect the perception of our brand. In addition,these errors could result in loss of, or delay in, market acceptance of thoseproducts or our technologies, or cause delays in delivering them and meetingcustomer demands, any of which could reduce our revenue and raise significantcustomer relations issues. Although we generally attempt to contractually limitour liability for our licensees’ defective products, we may elect to helpreengineer those products, which could increase our expenses and adverselyaffect our operating results.

 

***We are subject torisks associated with substantial international operations.***

 

We conductsales and customer support operations in a number of countries throughout theworld that require refinement to adapt to the changing market conditions on aregional basis. In addition, many of our significant customers areheadquartered in the Asia Pacific region, particularly Korea and Japan.Approximately 88%, 90% and 91% of our revenues were derived from customers withheadquarters located in the Asia Pacific markets during the years ended December 31,2008, 2007 and 2006, respectively. We expect to continue to derive asignificant portion of our revenues from sales to customers in these marketsfor the foreseeable future. Also, a substantial number of productsincorporating our technologies are manufactured, assembled and tested by thirdparties in Asia. As a result, we are subject to a number of risks of conducting

 

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business outside of the UnitedStates, any of which could have a material adverse impact on our business andresults of operations, including:

 

·                  global economic downturn;

 

·      political,social and economic instability, and the risk of war, terrorist activities orother international incidents in Asia and elsewhere abroad;

 

·      currencyfluctuations;

 

·                  difficulties and costs of staffingand managing foreign operations;

 

·                  unexpected changes in, or impositionsof, government requirements;

 

·                  adverse changes in tariffs and otherprotectionist laws and business practices that favor local competitors;

 

·                  potentially longer payment cycles andgreater difficulty in collecting receivables from foreign entities;

 

·                  the burdens of complying with avariety of non-U.S. laws and reduced protection of our intellectual property insome countries;

 

·                  potentially adverse tax consequencesand the complexities of foreign value added tax systems; and

 

·                  other factors beyond our control,including natural disasters and major health concerns.

 

***We have a long andunpredictable sales cycle, which can result in uncertainty and delays ingenerating additional revenues.***

 

Historically,because of the complexity of our technologies, it can take a significant amountof time and effort to explain the benefits of our technologies to potential newcustomers and to negotiate a sale. For example, it typically takes six to ninemonths after our first contact with a prospective customer before we startlicensing our technology to that customer and another six to nine months tobegin generating revenues. In addition, purchases of our products are usuallymade in connection with new design starts by our customers, the timing of whichis outside of our control. Accordingly, we may be unable to predict accuratelythe timing of any significant future sales of our products. We may also spendsubstantial time and management attention on potential license agreements thatare not consummated, or in which the consumer electronic product ultimatelydoes not sell in large quantities, thereby foregoing other higher revenueopportunities.

 

***If our patents andother intellectual property rights do not adequately protect our products, wemay lose market share to our competitors and be unable to operate our businessprofitably.***

 

Our ability tocompete may be affected by our ability to protect our proprietary information.We have filed numerous U.S. and foreign patent applications and to date have anumber of issued U.S. and foreign patents covering various aspects of ourtechnologies. We cannot guarantee that the steps taken by us to protect ourintellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology. In addition,the laws of certain foreign countries may not protect our intellectual propertyrights to the same extent as do the laws of the U.S. It is possible that thirdparties may assert claims or initiate litigation against us or our customerswith respect to existing or future products. In addition, we may initiateclaims or litigation against third parties for infringement of our proprietaryrights or to determine the scope and validity of our proprietary rights.Litigation in the technology industry is common.  Claims and litigation brought against us orinitiated by us could be costly and time consuming and could divert ourmanagement from our business. The outcome of any litigation is uncertain andcould require us to pay significant damages or could prevent us from licensingsome or all of our technologies, which could significantly harm our businessand results of operations.

 

***If we lose theservices of our key personnel, or if we are unable to attract and retain otherkey personnel, we may not be able to manage our operations or meet our growthobjectives.***

 

Our futuresuccess depends to a large extent upon the continued service of key personnel,including engineering, sales and administrative staff. We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel can be intense, and it is possible that we may not be able to recruitand retain necessary personnel to operate our business and support futuregrowth.

 

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***The market price ofour common stock is volatile and your investment in our common stock couldsuffer a decline in value.***

 

The tradingprice of our common stock has been, and will likely continue to be, subject towide fluctuations in response to quarterly variations in our operating results,announcements of new products or technological innovations by us or ourcompetitors, strategic alliances between us and third parties, general marketfluctuations and other events and factors. Changes in earnings estimates madeby brokerage firms and industry analysts relating to the markets in which we dobusiness, or relating to us specifically, have in the past resulted in, andcould in the future result in, an immediate and adverse effect on the marketprice of the common stock. Even though our stock is quoted on the NASDAQ GlobalMarket, our stock has had and may continue to have low trading volume and highvolatility. The historically low trading volume of our stock makes it morelikely that a severe fluctuation in volume, either up or down, willsignificantly impact the stock price. Because of the relatively low tradingvolume of our stock, our stockholders may have difficulty selling our commonstock. In addition, the stock market in general, and the NASDAQ GlobalMarket and the market for technology and small market cap companies inparticular, has experienced extreme price and volume fluctuations that haveoften been unrelated or disproportionate to the operating performance of thosecompanies. Further, the market prices of securities of technology companieshave been particularly volatile. These broad market and industry factors maymaterially harm the market price of our common stock, regardless of ouroperating performance.

 

***Our certificate ofincorporation and bylaws as well as Delaware law contain provisions that coulddiscourage transactions resulting in a change in control, which may negativelyaffect the market price of our common stock.***

 

Ourcertificate of incorporation, our bylaws and Delaware law contain provisionsthat might enable our management to discourage, delay or prevent a change incontrol. In addition, these provisions could limit the price that investorswould be willing to pay in the future for shares of our common stock.

 

**Item 1B. Unresolved Staff Comments.**

 

None.

 

**Item 2. Properties**

 

Our worldwideheadquarters are located in Santa Ana, California, in a 23,400 square footfacility consisting of office and warehouse space. The lease for the facilityexpires in May 2013.  We lease thisfacility from Daimler Commerce Partners, L.P., the general partner ofwhich is Conifer Investments, Inc. (“Conifer”). The sole shareholders ofConifer are Thomas C.K. Yuen, our Chairman, Chief Executive Officer andPresident, and his spouse, Misako Yuen, as co-trustees of the Thomas YuenFamily Trust. Mr. and Mrs. Yuen also serve as the executive officersof Conifer. Mr. and Mrs. Yuen, as co-trustees of the trust,beneficially own a significant amount of our outstanding shares of commonstock. We paid the Daimler Commerce Partners rent of $235,170, $230,256, and$230,256 in 2008, 2007, and 2006, respectively. We believe the terms andconditions of the lease are competitive based on a review of similar propertiesin the area with similar terms and conditions.

 

Additionally,we entered into three new leases in 2008 for our international operations inTaiwan, China, and Japan.  The leases forour offices in Taiwan and Japan expire in April 2009 and October 2009,respectively, and the lease term for our office in China expires in April 2013.  In total, we paid rent of $294,702, $230,256and $230,256 during 2008, 2007 and 2006, respectively, for all of ourfacilities.  We believe that our currentfacilities are adequate to support our current requirements.

 

**Item 3. Legal Proceedings**

 

On June 8,2007, we sent a letter to Sony Corporation (“Sony”) relating to the possibleinfringement of several SRS patents by Sony’s S-Force technology. Sonyresponded to the letter by filing a Complaint for Declaratory Relief in theU.S. District Court in the Southern District of New York on July 6, 2007.In November 2007, Sony and SRS entered into a standstill agreement for thepurpose of conducting discussions towards an amicable resolution of thedispute, and the Complaint for Declaratory Relief was dismissed.  Whilethe standstill agreement has expired, the parties continue to negotiateregarding this matter.  In October 2008, the outside patent counselhired to evaluate the Sony S-Force technology informed us that they hadcompleted their evaluation based on the information provided by Sony. Based on their study, they confirmed 

 

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our position that theS-Force technology infringes our patents.  The basis for thisinfringement position has been provided to Sony for their review.  Wecannot assure you that we will prevail in this matter and are unable todetermine at this time the impact that this matter may have, if any, on ourconsolidated financial position, results of operations or cash flows.

 

From time to time,we may be involved in other litigation matters and disputes arising in thenormal course of business. Any such matters and disputes could be costly andtime consuming, subject us to damages or equitable remedies, and divert ourmanagement and key personnel from our business operations.

 

**Item 4. Submission of Matters to a Vote of Security Holders**

 

None.

 

**PART II**

 

**Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities**

 

**Market for Common Stock**

 

Our commonstock trades on the NASDAQ Global Market under the symbol “SRSL”. The tablebelow reflects the high and low sales prices of our common stock as reported byThe NASDAQ Stock Market for the periods indicated.

 
| ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------|------------|----------|------------|---------|------------|
| **Fiscal 2008** |       |     |       |    |       |
| First Quarter   |       | $        | 5.50       |    | $          | 3.90 |   |
| Second Quarter  |       | $        | 7.25       |    | $          | 5.29 |   |
| Third Quarter   |       | $        | 6.19       |    | $          | 2.75 |   |
| Fourth Quarter  |       | $        | 5.55       |    | $          | 3.55 |   |
|            |       |     |       |    |       |
| **Fiscal 2007** |       |     |       |    |       |
| First Quarter   |       | $        | 14.06      |    | $          | 9.09 |   |
| Second Quarter  |       | $        | 15.70      |    | $          | 9.00 |   |
| Third Quarter   |       | $        | 11.89      |    | $          | 6.91 |   |
| Fourth Quarter  |       | $        | 7.65       |    | $          | 5.10 |   |

 

At February 2,2009, the closing sale price of our common stock was $4.98 per share.

 

**Holders**

 

At February 2,2009, there were 399 stockholders of record.

 

**Dividend Policy**

 

We have neverpaid cash dividends on our common stock. We currently intend to retain ouravailable funds for future growth and, therefore, we do not anticipate payingany dividends in the foreseeable future.

 

**Securities Authorized for Issuance UnderEquity Compensation Plans**

 

The followingequity compensation plans have been approved by our stockholders: the SRS Labs, Inc.Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the“1993 Plan”), the SRS Labs, Inc. Amended and Restated 1996 Long-TermIncentive Plan (the “1996 Plan”), the SRS Labs, Inc. Amended and Restated1996 Non-employee Directors’ Stock Option Plan (the “Non-employee DirectorsPlan”) and the SRS Labs, Inc. 2006 Stock Incentive Plan (the “2006 Plan”).A description of the material features of each of these plans is included inNote 7 to the Notes to Consolidated Financial Statements under the caption“Stock Award/Option Plans/Warrants.” The 1993 Plan expired on December 10,2003 and no options or other rights to acquire equity are outstanding underthat plan. On June 22, 2006, our stockholders voted to approve the 2006Plan, and to discontinue the issuance of any awards under the 1996 Plan. We donot have any equity compensation plans other than those approved by ourstockholders. The following table sets forth information regarding the numberof shares of our common stock that may be issued pursuant to our equitycompensation plans or arrangements as of December 31, 2008.

 

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**EquityCompensation Plan Information**

 
| ** **                                              | ** ** | **(a)**                                                                                                                                          | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                        | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                  | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities  reflected in column(a))** | ** ** |
| Equity compensation plans approved by  security holders |       | 2,879,538                                                                                                                                        | (1)        | $                                                                                                           | 5.83       |                                                                                                                                                                                                           | 2,172,660  | (2) |
|                                                         |            |                                                                                                                                                  |            |                                                                                                             |            |                                                                                                                                                                                                                |            |  |

 

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(1)                                  Representsshares of common stock that may be issued pursuant to outstanding optionsgranted under the following plans: 1,344,698 shares under the 1996 Plan,147,500 shares under the Non-employee Directors Plan and 1,387,340 shares underthe 2006 Plan.

 

(2)                                  Representsshares of common stock that may be issued pursuant to future grants under thefollowing plans: 310,000 shares under the Non-employee Directors Plan and1,862,660 shares under the 2006 Plan.

 

**Issuer Purchases of Equity Securities**

 

On November 3,2008, our Board of Directors approved a stock repurchase program. Under thestock repurchase program, we may acquire up to $15.0 million of ouroutstanding common stock. The stock repurchase program commenced November 7,2008 and is expected to continue for a six month period. As of December 31,2008, total purchases under the program since inception were 1,456,944 sharesat an average purchase price of $5.18 per share, or an aggregate repurchaseprice of $7,541,563,.

 

The followingtable details the repurchases that were made under the program during the threemonths ended December 31, 2008:

 
| **Period**                            | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number (or  Approximate Dollar  Value) of Shares that  May Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1–October 31   |       | —                                           |       | —                                           |       | —                                                                                                                           |       | —                                                                                                                                                                            |       |
| November 1–November 30 |       | 1,415,013                                        |       | $                                                | 5.22       |                                                                                                                             | 1,415,013  |                                                                                                                                                                              | $          | 7,620,406 |   |
| December 1–December 31 |       | 41,931                                           |       | $                                                | 3.86       |                                                                                                                             | 41,931     |                                                                                                                                                                              | $          | 7,458,437 |   |
| Total                                 |       | 1,456,944                                        |       | $                                                | 5.18       |                                                                                                                             | 1,456,944  |                                                                                                                                                                              | $          | 7,458,437 |   |

 

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** **

**StockPrice Performance Graph**

** **

The followinggraph illustrates a comparison of the total return of our common stock with thetotal return for the S & P Smallcap 600 Index and a peer groupselected by us for the five year period ended December 31, 2008. Thecomparison assumes $100 was invested on December 31, 2003 in our commonstock and in each of the indices shown and assumes that all of the dividendswere reinvested.

 

Thecomparisons in the table are required by the SEC and are not intended toforecast or be indicative of possible future performance of our common stock.This graph shall not be deemed “filed” for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended (“Exchange Act”) or otherwisesubject to the liabilities under that of Securities Act of 1933, as amended, orthe Exchange Act.

 

 

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*                                         $100invested on 12/31/03 in stock or index-including reinvestment of dividends.Fiscal year ended is December 31.

 

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**Item 6. Selected Financial Data**

** **

The followingselected financial information as of and for the dates and periods indicatedhave been derived from our audited consolidated financial statements. Theinformation set forth below is not necessarily indicative of results of futureoperations, and should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” in Part II,Item 7 of this Annual Report on Form 10-K and our consolidatedfinancial statements and related notes included elsewhere in this Report.

 
| ** **                                                                              | ** ** | **Years Ended December 31,**        | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                              | ** ** | **2008**                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | **(In thousands except per share data)** | ** ** |
| **Consolidated Statement of Operations Data:**                                          |       |                                     |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                |       | $                                        | 18,333     |   | $ | 18,852 |   | $ | 18,547 |   | $ | 14,608 |   | $ | 10,832 |   |
| Cost of sales                                                                           |       | 144                                      |       | 164 |   | 171 |   | 236 |   | 228 |   |
| Gross profit                                                                            |       | 18,189                                   |       | 18,688 |   | 18,376 |   | 14,372 |   | 10,604 |   |
| Operating expenses:                                                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                     |       | 9,415                                    |       | 6,718 |   | 7,345 |   | 5,192 |   | 4,550 |   |
| Research and development                                                                |       | 3,748                                    |       | 3,107 |   | 2,573 |   | 2,224 |   | 2,262 |   |
| General and administrative                                                              |       | 5,913                                    |       | 5,444 |   | 5,660 |   | 5,170 |   | 4,622 |   |
| Total operating expenses                                                                |       | 19,076                                   |       | 15,269 |   | 15,578 |   | 12,586 |   | 11,434 |   |
| Operating (loss) income                                                                 |       | (887                                     | )          | 3,419 |   | 2,798 |   | 1,786 |   | (830 | ) |
| Other income, net                                                                       |       | 1,275                                    |       | 2,041 |   | 1,136 |   | 673 |   | 595 |   |
| Income (loss) from continuing operations  before income taxes                           |       | 388                                      |       | 5,460 |   | 3,934 |   | 2,459 |   | (235 | ) |
| Income taxes                                                                            |       | 117                                      |       | 46 |   | 868 |   | 796 |   | 523 |   |
| Income (loss) from continuing operations                                                |       | 271                                      |       | 5,414 |   | 3,066 |   | 1,663 |   | (758 | ) |
| Discontinued operations:                                                                |       |                                     |       |   |   |   |   |   |   |   |   |
| Income (loss) from discontinued operations,  net of income taxes (benefit)              |       | —                                   |       | — |   | 1,017 |   | (3,087 | ) | 2,337 |   |
| Gain on disposal of discontinued operations                                             |       | —                                   |       | — |   | 625 |   | — |   | — |   |
| Income (loss) from discontinued operations                                              |       | —                                   |       | — |   | 1,642 |   | (3,087 | ) | 2,337 |   |
| Net income (loss)                                                                       |       | $                                        | 271        |   | $ | 5,414 |   | $ | 4,708 |   | $ | (1,424 | ) | $ | 1,579 |   |
| Income (loss) from continuing operations  per common share:                             |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                        | 0.02       |   | $ | 0.34 |   | $ | 0.21 |   | $ | 0.12 |   | $ | (0.05 | ) |
| Diluted                                                                                 |       | $                                        | 0.02       |   | $ | 0.32 |   | $ | 0.20 |   | $ | 0.11 |   | $ | (0.05 | ) |
| Income (loss) from discontinued operations  per common share:                           |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                        | 0.00       |   | $ | 0.00 |   | $ | 0.11 |   | $ | (0.22 | ) | $ | 0.17 |   |
| Diluted                                                                                 |       | $                                        | 0.00       |   | $ | 0.00 |   | $ | 0.11 |   | $ | (0.22 | ) | $ | 0.15 |   |
| Net income (loss) per common share:                                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                        | 0.02       |   | $ | 0.34 |   | $ | 0.31 |   | $ | (0.10 | ) | $ | 0.11 |   |
| Diluted                                                                                 |       | $                                        | 0.02       |   | $ | 0.32 |   | $ | 0.30 |   | $ | (0.10 | ) | $ | 0.10 |   |
| Weighted average number of common shares  used in the calculation of per share amounts: |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | 15,589                                   |       | 16,154 |   | 14,956 |   | 14,118 |   | 13,950 |   |
| Diluted                                                                                 |       | 15,842                                   |       | 16,990 |   | 15,466 |   | 15,199 |   | 15,781 |   |
| **Consolidated Balance Sheet Data:**                                                    |       |                                     |       |   |   |   |   |   |   |   |   |
| Working capital                                                                         |       | $                                        | 37,519     |   | $ | 39,272 |   | $ | 34,697 |   | $ | 8,849 |   | $ | 7,192 |   |
| Total assets                                                                            |       | 46,882                                   |       | 51,383 |   | 45,049 |   | 35,065 |   | 35,502 |   |
| Stockholders’ equity                                                               |       | 43,769                                   |       | 49,007 |   | 42,744 |   | 30,813 |   | 32,431 |   |

 

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**Item 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

** **

**Overview**

** **

We are therecognized global leader in the practical application of psychoacoustics*,* the science behind how the human ear operates, andin the post processing segment of the market for audio delivery.  Our award-winning audio enhancement technologiesand solutions dramatically restore audio and voice to its natural state, the way it was originally recorded, in both dimension andclarity, thus providing a superiorconsumer experience for a wide variety of CE devices such astelevisions, personal computers and mobile phones.

 

Our mission isto be the dominant worldwide provider of audio and voice solutions that allowconsumers to effortlessly experience rich, natural sound, the way their earswere meant to hear it.

 

Our operationsare conducted through SRS Labs, Inc., the parent company, and its wholly-ownedsubsidiaries, SRSWOWcast.com, Inc. and Shenzhen Representative Office ofSRS Labs, Inc. (a Chinese company). Our business is focused on developing andlicensing audio, voice and surround sound technology solutions to many of theworld’s leading OEMs, software providers and semiconductor companies, and limitedsales and marketing of stand alone software and hardware products through theInternet.

 

Prior toSeptember 29, 2006, we were also a developer and provider of applicationspecific integrated circuits and standard integrated circuits through ourformer wholly-owned subsidiary, Valence.

 

**Discontinued Operations**

** **

*Valence:* Through our former subsidiary, Valence, we operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog integrated circuits, digital signal processors and mixed signalintegrated circuits primarily to OEMs and ODMs in the Asia Pacificregion.  On February 23, 2006, ourBoard approved a plan to sell Valence in order to focus management’s attentionand financial resources on our licensing business. On July 14, 2006, weentered into a definitive Sale and Purchase Agreement to sell Valence toNoblehigh Enterprises Inc. (“Noblehigh”). The sale transaction wascompleted on September 29, 2006, and accordingly, the results of theoperations of Valence through the date of sale were included as discontinuedoperations in the accompanying consolidated statement of operations for theyear ended December 31, 2006.

 

*CHS/SRS LLC:*  In September 2004, we entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to use and promoteSRS Labs’ technologies, to promote CHS productions and to promote each company’srespective brands. In connection with the strategic alliance, SRS and CHSestablished a joint venture, CHS/SRS, LLC (the “Joint Venture”), toproduce and distribute nine concert videos featuring our Circle Surroundtechnology. On February 23, 2006, our Board authorized management to takeall reasonable steps to divest our entire equity interest in the Joint Venture.On June 30, 2006, we completed the sale of our interest in the JointVenture to CHS and, accordingly, the results of the operations of the JointVenture through the date of sale were included as discontinued operations inthe accompanying consolidated statements of operations for all periodspresented.

 

**CriticalAccounting Policies**

** **

Our discussionand analysis of our results of operations and liquidity and capital resourcesare based on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.

 

The preparationof these financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, anddisclosure of contingent assets and liabilities. We base our estimates onhistorical and anticipated results and trends and on various other assumptionsthat we believe are reasonable under the circumstances, including assumptionsas to future events. These estimates form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily apparent fromother sources. By their nature, estimates are subject to an inherent degree ofuncertainty. Actual results may differ from our estimates.

 

The followingrepresents a summary of our critical accounting policies, defined as thosepolicies that we believe are: (a) the most important to the portrayal ofour financial condition and results of operations, and (b) that requiremanagement’s most difficult, subjective or complex judgments, often as a resultof the need to make estimates about the matters that are

 

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inherently uncertain. Our mostcritical accounting estimates include revenue recognition; valuation ofaccounts receivable, which impacts operating expenses; valuation of intangible,capitalization of software and long lived assets, which primarily impactsoperating expenses when we impair assets or accelerate their depreciation;recognition and measurement of current and deferred income tax assets andliabilities, which impacts our tax provision; and share-based compensation,which impacts operating expenses. We discuss each of these policies below, aswell as the estimates and judgments involved. We also have other policies thatwe consider key accounting policies; however, these policies do not meet thedefinition of critical accounting estimates, because they do not generallyrequire us to make estimates or judgments that are difficult or subjective.

 

*Revenue Recognition*

* *

Our licenseagreements typically have multi-year or automatic renewal terms, and eitherrequire: a) per-unit royalty payments for all products implementing ourtechnologies and/or solutions; b) fixed annual or quarterly royalty payments;or c) a minimum fixed annual or quarterly royalty payment, which allows thelicensee to ship up to a pre-determined number of units during the specifiedtime period, with additional per-unit royalty payments thereafter.  Royalties for per-unit arrangements arereported in the quarter following shipment of the consumer electronics deviceand are therefore recognized by us one quarter following shipment by theOEM.  Revenues associated with fixedroyalty payments are recognized ratably over the term of the agreement.  We also sell some of our products andsolutions via the Internet.  Revenuesassociated with those sales are recognized upon shipment and are not material.

 

*Accounts Receivable*

* *

We performongoing credit evaluations of our customers and adjust credit limits based uponpayment history, the customer’s current credit worthiness and various otherfactors, as determined by our review of their current credit information. Wecontinuously monitor collections and payments from our customers and maintainallowances for doubtful accounts based upon specific customer circumstances,current economic trends, historical experience and the age of past duereceivables. While such credit losses have historically been within our expectationsand the provisions established, we cannot guarantee that we will continue toexperience the same credit loss rates that we have in the past. Unanticipatedchanges in the liquidity or financial position of our customers may requireadditional provisions for doubtful accounts.

 

*Intangible Assets and Impairment of Long-LivedAssets*

* *

Costs paid bythe Company related to the establishment and purchase of patents, primarilylegal costs, are capitalized and amortized, depending on the estimated life of thetechnology patented. These assets are being amortized over ten years. TheCompany evaluates the recoverability of long-lived assets with finite lives inaccordance with Statement of Financial Accounting Standard (“SFAS”)No. 144, *Accounting for the Impairmentor Disposal of Long-Lived Assets* (“SFAS No. 144”). The Companyassesses potential impairments to its long-lived assets when there is evidencethat events or changes in circumstances indicate that the carrying amount of anasset may not be recovered. An impairment loss is recognized when the carryingamount of the long-lived asset is not recoverable and exceeds its fair value.The carrying amount of a long-lived asset is not recoverable if it exceeds thesum of the undiscounted cash flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. Based upon the most recent assessment as ofDecember 31, 2008, the Company has determined there was no impairment inthe value of long-lived assets.

 

*Income Taxes*

* *

In preparingour consolidated financial statements, we estimate our income taxes in each ofthe countries in which we operate. The process used to make these estimatesincludes an assessment of the current tax expense, the results from taxexaminations and the effects of temporary differences resulting from thedifferent treatment of transactions for tax and financial accounting purposes.These differences result in deferred tax assets and liabilities, which areincluded in our consolidated balance sheet. We account for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes* (“SFAS No. 109”), which requires that deferredtax assets and liabilities be recognized using enacted tax rates for the effectof temporary differences between the book and tax bases of recorded assets andliabilities. SFAS No. 109 also requires that deferred tax assets bereduced by a valuation allowance if it is more likely than not that someportion or all of the deferred tax asset will not be realized. We evaluate thereliability of our deferred tax assets by assessing our valuation allowance andby adjusting the amount of such allowance, if necessary. At December 31,2008, we had net deferred tax assets primarily resulting from temporarydifferences between the book and tax bases of assets and liabilities, and loss andcredit carry forwards. We continue to provide a valuation allowance ourdeferred tax assets based on an assessment of the likelihood of theirrealization. In reaching our conclusion, we evaluated certain relevant criteriaincluding deferred tax liabilities that can be

 

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used to offset deferred taxassets, estimates of future taxable income of appropriate character within thecarry-forward period available under the tax law, and tax planning strategies.Our judgments regarding future taxable income may change due to marketconditions, changes in U.S. or international tax laws, and other factors. Thesechanges, if any, may require material adjustments to these deferred tax assets,resulting either in a tax benefit, if it is estimated that future taxableincome is likely, or a reduction in the value of the deferred tax assets, if itis determined that their value is impaired, resulting in a reduction in netincome or an increase in net loss in the period when such determinations aremade.

 

Our income taxprovision is based on calculations and assumptions that will be subject toexamination by the taxing authorities in the jurisdictions in which we operate.Should the actual results differ from our estimates, we would have to adjustthe income tax provision in the period in which the facts and circumstancesthat give rise to the revision become known. Tax law and rate changes arereflected in the income tax provision in the period in which such changes areenacted.

 

*Share-Based Compensation*

* *

OnJanuary 1, 2006, we adopted the provisions of SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123R”)using the modified prospective application transition method. SFASNo. 123R requires measurement of all employee share-based compensationawards using a fair-value method and recording of such expense in theconsolidated financial statements over the requisite service period. In 2008, 2007and 2006, we recorded share-based compensation expense of $1,777,468,$1,727,017 and $1,460,910, respectively, under the fair-value provisions ofSFAS No. 123R.

 

To determine the expected term of our employee stock options granted infiscal 2008, we examined the historical term for our stock options and those ofour peers. To determine the risk-free interest rate, we utilized an averageinterest rate based on U.S. Treasury instruments whose term was consistent withthe expected term of our awards. To determine the expected stock pricevolatility, we examined the historical volatilities for our common stock andthose of our peers. See Note 7 (“Stockholders’ Equity and Share-BasedCompensation”) of our Notes to Consolidated Financial Statements for furtherdiscussion.

 

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**Resultsof Operations**

** **

The followingtable sets forth certain consolidated operating data as a percentage ofrevenues for the years ended December 31, 2008, 2007 and 2006:

 

**Percentage of Total Revenue**

 
| ** **                                               | ** ** | **Years Ended  December 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                               | ** ** | **2008**                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                 |       | 100                                | %          | 100 | % | 100 | % |
| Cost of sales                                            |       | 1                                  |       | 1 |   | 1 |   |
| Gross margin                                             |       | 99                                 |       | 99 |   | 99 |   |
| Operating expenses:                                      |       |                               |       |   |   |   |   |
| Sales and marketing                                      |       | 51                                 |       | 36 |   | 39 |   |
| Research and development                                 |       | 21                                 |       | 16 |   | 14 |   |
| General and administrative                               |       | 32                                 |       | 29 |   | 31 |   |
| Total operating expenses                                 |       | 104                                |       | 81 |   | 84 |   |
| Operating (loss) income                                  |       | (5                                 | )          | 18 |   | 15 |   |
| Other income, net                                        |       | 7                                  |       | 11 |   | 6 |   |
| Income from continuing operations before  income taxes   |       | 2                                  |       | 29 |   | 21 |   |
| Income taxes                                             |       | 1                                  |       | 0 |   | 5 |   |
| Income from continuing operations                        |       | 1                                  |       | 29 |   | 16 |   |
| Discontinued operations:                                 |       |                               |       |   |   |   |   |
| Income from discontinued operations net of  income taxes |       | —                             |       | — |   | 6 |   |
| Gain on disposal of discontinued operations              |       | —                             |       | — |   | 3 |   |
| Income from discontinued operations                      |       | —                             |       | — |   | 9 |   |
| Net income                                               |       | 1                                  | %          | 29 | % | 25 | % |

 

**YearEnded December 31, 2008 Compared to Year Ended December 31, 2007**

** **

*Revenues*

* *

Total revenuesfor fiscal 2008 were $18,332,678 compared to $18,851,940 in fiscal 2007, a decreaseof $519,262, or 3%. This decrease was primarily attributable to decreases inroyalties related to the sales of personal computers, set top boxes, CRTtelevisions and personal media devices containing our technologies.  The decrease in revenues in the personalcomputer market from fiscal 2007 to fiscal 2008 was $649,153, of which $594,378related to decreased royalties from Toshiba, while revenues in the personalmedia devices market decreased by $155,086 during the same period, related to severalcustomers. We expect that during 2009, our revenues in the personal computersegment will increase, primarily due to the signing of several new licensees,including Hewlett Packard, NEC Computers and BenQ.  In the home entertainment market, total revenuesdecreased $209,120 from fiscal 2007 to fiscal 2008.  Within this market, revenues related toset-top boxes decreased $139,219 and revenues from CRT televisions decreased$124,062.  Some of these decreases wereoffset by increased revenues in the amount of $145,942 related to flat paneltelevisions and monitors.  The majorityof the increase in flat panel televisions and monitors revenues were the directresult of our receipt of larger royalty payments from some of the multi-nationaltelevision OEMs, including Samsung, offset by a decrease in revenues from Sony,Toshiba and LG. While we continue to have good relationships with many of themajor global television OEMs, we cannot guarantee that we will be successful ingrowing or maintaining this market of our business.  Home entertainment continues to represent ourlargest revenue market and we anticipate that during fiscal 2009 this trendwill continue.  While there may bechanges in the royalty amounts reported from each of our licensees in thissegment, we are pleased that we have been able to enter into license agreementswith several new television licensees during 2008, such as Vizio and GeneralDisplays and Technologies.  Revenues inthe automotive market increased by $160,356 in 2008 as compared to 2007primarily due to increased revenues from several customers in Japan who provideline install, dealer option and after market automotive audio systems to manyof the significant Japanese automotive manufactures, including Toyota, Honda,Subaru and Nissan. In the personal telecommunications segment, revenuesincreased $298,741 from 2007 to 2008. This increase was primarily due to increased revenues from SamsungMobile.  We anticipate that during 2009we will continue to experience increased revenues in this segment as comparedto 2008.  This was in large part due tothe signing of several new licensees, including Samsung and BBK.  During the second half of 2008 and continuinginto 2009, there have been many news reports of a slow down in the global economyand decreased purchasing by consumers. We continue to monitor relevant information regarding consumer

 

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purchasing and informationprovided by industry observers and others. At this time we can not determine the impact that may result from theseevents. Our goals include working with our existing licensees to continue to providevalue to them, while attempting to obtain new licensees to increase our marketpenetration in all of our segments. While we continue to pursue these goals, there can be no assurance thatthey will be met.

 

The followingtable represents our mix of licensing revenues by market source:

 

| ** **                                                | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| Home entertainment (TV, set-top box)                      |       | 69                                 | %          | 68 | % |
| Portable media devices (digital media  player, headphone) |       | 9                                  |       | 9 |   |
| Personal telecommunications (mobile phone,  PDA)          |       | 9                                  |       | 7 |   |
| Automotive                                                |       | 8                                  |       | 7 |   |
| PC (software, hardware)                                   |       | 5                                  |       | 9 |   |
|                                                      |       | 100                                | %          | 100 | % |

* *

*Sales and Marketing*

* *

Sales andmarketing expenses consist primarily of employee salaries, sales consultants’fees and related expenses, sales commissions and costs associated with brandingactivities. Sales and marketing expenses were $9,415,238 for fiscal year 2008,as compared to $6,717,906 for fiscal year 2007. Overall sales and marketingexpenses were $2,697,332, or 40%, higher in fiscal 2008.  This increase was primarily attributable tohigher payroll and related costs, including one-time recruitment and severancecosts of approximately $525,000, associated with hiring an additional elevensales and marketing employees and full-time consultants in 2008 including ourVice President of Sales and our Vice President of Marketing.  In addition to increasing the sales and marketingpersonnel, we have also increased our branding efforts. In 2009, we expect thatsales and marketing expenses will increase as we hire additional salespersonnel to penetrate target markets and key regions and as we continue toincrease our marketing efforts to cultivate and elevate the SRS brand globally.  We recorded $458,610 in share-basedcompensation expense for sales and marketing personnel during 2008 as comparedto $495,132 in 2007. As a percentage of total revenues, sales and marketingexpenses increased from 36% for fiscal year 2007 to 51% for fiscal year 2008.

 

*Research and Development*

* *

Research anddevelopment expenses consist of salaries and related costs of employees engagedin ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were $3,747,495for fiscal year 2008, as compared to $3,107,482 for fiscal year 2007. Theoverall increase in research and development expenses of $640,013, or 21%, wasprimarily attributable to hiring an additional five engineers in 2008, as wellas incurring additional travel costs associated with supporting our globallicensees. We recorded $399,630 in share-based compensation expense for engineeringpersonnel during 2008 as compared to $428,516 in 2007. We expect that researchand development expenses will increase as we continue to expand ourintellectual property portfolio, which we believe is critical to our business,and as we seek to accelerate the implementation of our technology with agreater number of customers and devices. As a percentage of total revenues,research and development expenses increased from 16% for fiscal year 2007 to 21%for fiscal year 2008.

 

*General and Administrative*

* *

General andadministrative expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property, and otherprofessional fees and costs associated with being a publicly held company.General and administrative expenses were $5,913,081 for fiscal year 2008 ascompared to $5,443,735 for fiscal year 2007. The overall increase of $469,346,or 9%, was primarily attributable to an increase in professional fees andexpenses of $166,000, associated with our Dutch Auction repurchase program,which was terminated in September 2008. We also incurred increased professional and legal fees associated withcorporate matters and an increase in share-based compensation expense.  We recorded $919,228 in stock-basedcompensation expense during 2008 as compared to $803,369 in 2007. As apercentage of total revenues, general and administrative expenses increasedfrom 29% for fiscal year 2007 to 32% for fiscal year 2008.

 

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*Interest Income*

 

Interest income was $1,275,047 for fiscal year 2008, compared to$2,041,288 for fiscal year 2007, a decrease of $766,242, or 38%. This decreasewas primarily attributable to the decrease in interest income due to lowerinterest rates and lower cash balances.

 

*Provision for Income Taxes*

 

The income tax provision for fiscal 2008 was $117,543 compared to$45,558 for fiscal 2007, representing an increase of $71,985, or 158%. Thecurrent and prior year provision consists primarily of estimated taxes payableto the state of California. The increase in the provision is the result ofchange in California tax law in fiscal 2008, whereby net operating loss carryforwardsmay not be used in 2008 or 2009 and research and development credits arelimited to 50% of the Company’s net tax.

 

We had federal and state net operating loss carryforwards at December 31,2008 of $11,239,216 and $5,598,943, respectively. The net operating losscarryforwards began to expire in 2005 and will continue through 2028. Inaddition, we had federal foreign tax credit carryforwards of approximately$5,125,790 at December 31, 2008, which begin to expire in 2014, andfederal and state tax capital loss carryforwards of approximately $16,219,585,which begin to expire in 2011. As of December 31, 2008, we continued tohave a valuation allowance of $13,944,301 against our deferred tax assets,which was established primarily due to our cumulative losses in recent yearsand based on our assessment of our future ability to realize certain deferredtax assets.

 

**Year Ended December 31, 2007 Compared toYear Ended December 31, 2006**

 

*Revenues*

 

Total revenues for fiscal 2007 were $18,851,940 compared to $18,547,529in fiscal 2006, an increase of $304,411, or 2%. This increase was primarilyattributable to increases in royalties related to the sales of flat paneltelevisions and monitors, which grew by $2,699,310, or 31%, and increases inthe automotive market, which grew by $275,793, or 26%. The majority of theincreases in flat panel televisions and monitors revenues were the directresult of our receipt of larger royalty payments from many of the multinationaltelevision OEMs, including Samsung, LG and Toshiba, or their respective chipmanufacturers, offset by a decrease in revenues from Sony. Additionally, duringthe second half of 2007, we established direct relationships with many of theChina based TV manufacturers which require such companies to pay royaltiesdirectly to SRS, rather than through an Integrated Chip (“IC”) provider. Thishad a negative impact on our revenues during this time period as royalties wereearned at the time that TVs were shipped to retail, rather than when the ICswere shipped to manufacturing.  Revenuesin the automotive market also increased in 2007 as compared to 2006. Thisincrease was primarily due to increased revenues from several customers inJapan who provide line install, dealer option and after market automotive audiosystems to many of the significant Japanese automotive manufactures, includingToyota, Honda, Subaru and Nissan. Revenues in our portable media devicessegment and personal telecommunications segments fell by 39% and 13%,respectively. The decrease in revenue in portable media devices was primarilyattributable to the loss of one customer. Revenues from that customer continuedin the first and second quarters of fiscal 2006 but no substantive revenueswere received from that customer in the third and fourth quarters of 2006 orduring the first three quarters of 2007. However, during 2007, we were able tosecure a new design win from this customer and started to receive limitedroyalties during the fourth quarter of 2007. The decrease in personal telecommunicationsrevenues was primarily attributable to one customer who has experienced adecrease in its sales of handset units. We continue to be included in thecustomer’s products; however, sales of these products were at lower levels in2007 than during 2006. The following table represents our mix of licensingrevenues by market source:

 
| ** **                                                | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                | ** ** | **2007**                                | ** ** | **2006** | ** ** |
| Home entertainment (TV, set-top box)                      |       | 68                                      | %          | 61 | % |
| Portable media devices (digital media  player, headphone) |       | 9                                       |       | 16 |   |
| PC (software, hardware)                                   |       | 9                                       |       | 9 |   |
| Personal telecommunications (mobile phone,  PDA)          |       | 7                                       |       | 8 |   |
| Automotive                                                |       | 7                                       |       | 6 |   |
|                                                      |       | 100                                     | %          | 100 | % |

 

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*Sales and Marketing*

 

Sales and marketing expenses consist primarily of employee salaries,sales consultants’ fees and related expenses, sales commissions and costsassociated with branding activities. Sales and marketing expenses were$6,717,906 for fiscal year 2007, as compared to $7,345,133 for fiscal year2006. Overall sales and marketing expenses were $627,227, or 9%, lower infiscal 2007 due in large part to a decrease in headcount and payroll relatedcosts in the marketing department, reduced sales commissions and reducedcompany wide bonuses. We recorded $495,132 in stock-based compensation expensefor sales and marketing personnel during 2007 as compared to $515,762 in 2006.As a percentage of total revenues, sales and marketing expenses decreased from39% for fiscal year 2006 to 36% for fiscal year 2007.

 

*Research and Development*

 

Research and development expenses consist of salaries and related costsof employees engaged in ongoing research, design and development activities andcosts for engineering materials and supplies. Research and development expenseswere $3,107,482 for fiscal year 2007, as compared to $2,572,577 for fiscal year2006. The overall increase in research and development expenses of $534,905, or21%, was primarily attributable to hiring an additional three engineers in2007, as well as incurring additional expenditures as a result of expanding ourintellectual property portfolio. We recorded $428,516 in stock-basedcompensation expense for engineering personnel during 2007 as compared to$331,480 in 2006.  As a percentage oftotal revenues, research and development expenses increased from 14% for fiscalyear 2006 to 16% for fiscal year 2007.

 

*General and Administrative*

 

General and administrative expenses consist primarily ofemployee-related expenses, legal costs associated with the administration ofintellectual property, and other professional fees and costs associated withbeing a publicly held company. General and administrative expenses were$5,443,735 for fiscal year 2007 as compared to $5,660,260 for fiscal year 2006.The overall decrease of $216,525, or 4%, was primarily attributable to adecrease in consultants’ fees and costs associated with the separation of ourformer Chief Financial Officer in the first quarter of 2006, coupled withreduced bonus expense. These decreases in costs were offset partially by anincrease in stock-based compensation expense due to stock option grants in2007. We recorded $803,369 in stock-based compensation expense for corporateemployees and directors during 2007 as compared to $512,525 in 2006. As apercentage of total revenues, general and administrative expenses decreasedfrom 31% for fiscal year 2006 to 29% for fiscal year 2007.

 

*Interest Income*

 

Interest income was $2,041,288 for fiscal year 2007, compared to$1,135,870 for fiscal year 2006, an increase of $905,418, or 80%. This increasewas primarily attributable to the increase in interest income due to higherinterest rates and higher cash balances.

 

*Provision for Income Taxes*

 

The income tax provision for fiscal 2007 was $45,558 compared to$868,203 for fiscal 2006, representing a decrease of $822,645, or 95%. Thefiscal 2007 provision consisted primarily of estimated sales tax payable to thestate of California. The fiscal 2006 provision consisted primarily of taxespaid on licensing revenues sourced from countries requiring foreign taxwithholdings, principally Korea and Taiwan.

 

We had federal and state net operating loss carryforwards at December 31,2007 of $13,596,056 and $5,206,235, respectively. The net operating losscarryforwards began to expire in 2005 and will continue through 2026. Inaddition, we had federal foreign tax credit carryforwards of approximately$3,412,608, at December 31, 2007, which begin to expire in 2014, andfederal and state tax capital loss carryforwards of approximately $16,219,585,which begin to expire in 2011. As of December 31, 2007, we continued tohave a valuation allowance of $13,935,219 against our deferred tax assets,which was established primarily due to our cumulative losses in recent yearsand based on our assessment of our future ability to realize certain deferredtax assets.

 

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**SelectedQuarterly Operating Results**

 

The following table sets forth certain quarterly summary consolidatedfinancial data for the eight quarters in the period ended December 31,2008. The quarterly information is based upon financial statements prepared byus on a basis consistent with our audited consolidated financial statementsand, in management’s opinion, includes all adjustments, consisting only ofnormal recurring adjustments necessary for a fair presentation of theinformation for the periods presented. This information should be read inconjunction with our audited consolidated financial statements and notesthereto appearing elsewhere in this Report. Our quarterly operating resultshave varied significantly in the past and are expected to vary significantly inthe future. Due to rounding differences, the quarters in a given year may notadd precisely to the annual numbers for that year.

 
| ** **                          | ** ** | **Three Months Ended**                                     | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                          | ** ** | **Mar 31,  2008**                                               | ** ** | **June 30,  2008** | ** ** | **Sep 30,  2008** | ** ** | **Dec 31,  2008** | ** ** | **Mar 31,  2007** | ** ** | **June 30,  2007** | ** ** | **Sep 30,  2007** | ** ** | **Dec 31,  2007** | ** ** |
| ** **                          | ** ** | **(In thousands except per share amounts)** | ** ** |
| Revenues                            |       | $                                                                    | 4,941      |   | $ | 4,178 |   | $ | 4,319 |   | $ | 4,894 |   | $ | 5,072 |   | $ | 4,695 |   | $ | 4,769 |   | $ | 4,315 |   |
| Gross profit                        |       | 4,915                                                                |       | 4,138 |   | 4,297 |   | 4,839 |   | 5,034 |   | 4,654 |   | 4,732 |   | 4,267 |   |
| Operating expenses                  |       | 4,509                                                                |       | 4,864 |   | 4,924 |   | 4,779 |   | 4,115 |   | 3,874 |   | 3,586 |   | 3,693 |   |
| Net income (loss)                   |       | $                                                                    | 858        |   | $ | (408 | ) | $ | (316 | ) | $ | 137 |   | $ | 1,412 |   | $ | 1,289 |   | $ | 1,674 |   | $ | 1,040 |   |
| Net income (loss) per common share: |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                               |       | $                                                                    | 0.05       |   | $ | (0.03 | ) | $ | (0.02 | ) | $ | 0.01 |   | $ | 0.09 |   | $ | 0.08 |   | $ | 0.10 |   | $ | 0.06 |   |
| Diluted                             |       | $                                                                    | 0.05       |   | $ | (0.03 | ) | $ | (0.02 | ) | $ | 0.01 |   | $ | 0.08 |   | $ | 0.08 |   | $ | 0.10 |   | $ | 0.06 |   |

 

**Liquidity and Capital Resources**

 

At December 31, 2008, cash and cash equivalents, short-terminvestments and investments available for sale were $39,435,087 compared to$45,067,166 as of December 31, 2007, a decrease of $5,632,079. Our cashand cash equivalents were $31,599,087 as of December 31, 2008, a decreaseof $8,016,204 from cash and cash equivalents of $39,615,291 held at December 31,2007. The decrease in cash and cash equivalents was primarily a result of thepurchase of treasury stock and short-term investments, partially offset againstthe proceeds received from the sale of the investments available for sale andpositive cash flow generated by operating activities.  Cash and cash equivalents generally consistof cash, certificates of deposits, money market funds and other money market instrumentswith original maturities of three months or less. The money market funds areprimarily invested in US government obligations.  The cash and certificates of deposit are FDICinsured. We held $7,836,000 in short-term investments at December 31,2008.  Short-term investments consist ofcertificates of deposit with original maturities ranging from 6 to 12months.  In fiscal 2008, 2007 and 2006,operations were funded primarily from cash from operating activities.

 

Net cash provided by operating activities was$2,629,133 and $6,558,565 for 2008 and 2007, respectively. The $3,929,432decrease in net cash provided by operating activities in fiscal 2008, comparedto fiscal 2007, was primarily a result of a decrease in net income, from$5,414,435 during the year ended December 31, 2007 to $270,887 for theyear ended December 31, 2008. Offsetting the decrease in net income, accounts receivable decreased by$794,524 during the year ended December 31, 2008 compared to an increaseof $65,867 during the same period in the prior year, due to increasedcollection efforts in 2008. Additionally, accrued liabilities increased $306,960 during the yearended December 31, 2008 as compared to decreasing $605,928 in the sameperiod in the prior year.  The increasein accrued liabilities in 2008 primarily relates to the timing of payments tovendors and an increase in accrued commissions, due to hiring additional salesrepresentatives in 2008.

 

Net cash used in investing activities was $3,310,826 and $850,927 in2008 and 2007, respectively. The $2,459,899 increase in cash used in investingactivities in 2008, compared to 2007, was primarily due to the purchase of$7,836,000 in short-term investments offset by the sale of investmentsavailable for sale of $5,500,000.

 

Net cash used in financing activities was $7,334,511 and $1,103,772during 2008 and 2007, respectively. The $6,230,739 increase in cash used infinancing activities in 2008, compared to 2007, was primarily due to anincrease in treasury stock repurchased offset by a decrease in stock optionexercises.  We expect to continue to usea portion of our cash to conduct market repurchases under the stock repurchaseprogram approved by our Board of Directors on November 3, 2008.  Under the stock repurchase program, we areseeking to acquire up to $15.0 million of the Company’s outstanding stock.  To date, we have repurchased 1.5 millionshares of our common stock at an aggregate purchase price of $7.5 million underthe program.  The repurchase programcommenced on November 7, 2008 and will remain open for a period of up tosix months.

 

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We believe our existing cash, cash equivalents and short-terminvestment balances together with cash generated from operating activities willbe sufficient to meet our anticipated cash needs for at least the next twelvemonths. Our future capital requirements will depend on many factors, includingour level of revenues, the timing and extent of spending to support productdevelopment efforts, the expansion of sales and marketing activities, thetiming of introductions of new products and the continuing market acceptance ofour products.

 

**Contractual Cash Obligations and ContingentLiabilities and Commitments**

 

We have contractual obligations and commitments with regards tooperating lease arrangements. The following table quantifies our expectedcontractual obligations and commitments subsequent to December 31, 2008:

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **More than  3 years** | ** ** |
| Operating lease obligations      |       | $                                         | 1,400,097  |   | $ | 413,130 |   | $ | 869,896 |   | $ | 117,071 |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

**Recent Accounting Pronouncements**

 

InMay 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 162,*Hierarchy of Generally Accepted AccountingPrinciples* (“SFAS No. 162”). This statement is intended toimprove financial reporting by identifying a consistent framework, orhierarchy, for selecting accounting principles to be used in preparingfinancial statements of nongovernmental entities that are presented inconformity with generally accepted accounting principles. This statement becameeffective on November 15, 2008.  Theadoption of SFAS No. 162 did not have a material impact on ourconsolidated financial position or results of operations.

 

In April 2008,the FASB issued FASB Staff Position (“FSP”) SFAS No. 142-3, *Determination of the Useful Life of Intangible Assets*(“FSP No. 142-3”).This FSP amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset under FASB Statement No. 142, *Goodwill and Other Intangible Assets*(“SFAS No. 142”).The intent of this FSP is to improve the consistency between the useful life ofa recognized intangible asset under SFAS No. 142 and the period ofexpected cash flows used to measure the fair value of the asset under SFAS 141(revised 2007), *Business Combinations*(“SFAS No. 141(R)”)andother GAAP. This FSP is effective for financial statements issued for fiscalyears beginning after December 15, 2008, and interim periods within thosefiscal years. Early adoption was prohibited. We are currently evaluating theimpact of SFAS FSP 142-3, but does not expect the adoption of thispronouncement will have a material impact on its consolidated financialposition, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141(R), whichreplaces SFAS No. 141. SFAS No. 141(R) retains the purchasemethod of accounting for acquisitions, but requires a number of changes,including changes in the way assets and liabilities are recognized in thepurchase accounting. It also changes the recognition of assets acquired andliabilities assumed arising from contingencies, requires the capitalization ofin-process research and development at fair value, and requires the expensingof acquisition-related costs as incurred. SFAS No. 141R became effectivefor us beginning January 1, 2009 and will be applied prospectively tobusiness combinations completed on or after that date.

 

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS No. 159”). SFAS No. 159permits entities to choose to measure financial assets and liabilities (exceptfor those that are specifically scoped out of the Statement) at fair value. Theelection to measure a financial asset or liability at fair value can be made onan instrument-by-instrument basis and is irrevocable. The difference betweencarrying value and fair value at the election date is recorded as a transitionadjustment to opening retained earnings. Subsequent changes in fair value arerecognized in earnings. The effective date for this statement was as of thebeginning of an entity’s first fiscal year that began after November 15,2007. Accordingly, we adopted SFAS No. 159 effective January 1, 2008.The adoption of SFAS No. 159 did not have a material effect on ourconsolidated financial position or results of operations.

 

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS No. 157”).The purpose of SFAS No. 157 is to define fair value, establish a frameworkfor measuring fair value and enhance disclosures about fair value measurements.The measurement and disclosure requirements became effective for us beginning January 1,2008. The adoption of SFAS No. 157 did not have a material effect on ourconsolidated financial position or results of operations.

 

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**Item 7A. Quantitative and Qualitative Disclosures About Market Risk**

 

Our exposure to market risk includes changes in interest rates, whichrelates primarily to our invested balances of cash, cash equivalents andinvestments. Our investment policy specifies excess funds are to be invested ina manner that preserves capital, provides liquidity and generates the highestavailable after-tax return. To limit exposure to market risk, we place our cashin banks, cash equivalents in certificates of deposits with original maturitiesof three months or less and money market funds, which are primarily invested inUS government obligations.  Short-term investmentsconsist of certificates of deposits with original maturities ranging from 6 to12 months.  We do not invest in anyderivative instruments. All cash, cash equivalents and investments are carriedat fair value, which approximates cost.

 

**Item 8. Financial Statements and Supplementary Data**

 

The financial statement information, including the Report ofIndependent Registered Public Accounting Firm, required by this Item 8 isset forth on pages 37 to 56 of this Annual Report on Form 10-K and ishereby incorporated into this Item 8 by reference. The quarterly financialinformation required by this Item 8 is set forth in Item 7 of thisAnnual Report on Form 10-K and is hereby incorporated into thisItem 8 by reference.

 

**Item 9. Changes in and Disagreements with Accountants onAccounting and Financial Disclosures**

 

None.

 

**Item 9A.   Controls and Procedures**

 

*Evaluation of Disclosure Controls andProcedures*

 

We maintain “disclosure controls and procedures,” as such term isdefined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act,that are designed to ensure that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in SEC rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating our disclosure controls and procedures, managementrecognized that disclosure controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the disclosure controls and procedures are met.Additionally, in designing disclosure controls and procedures, our managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures. The design of anydisclosure controls and procedures also is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions.

 

Subject to the limitations noted above, our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the year covered by this Annual Reporton Form 10-K. Based on that evaluation, the Chief Executive Officer andChief Financial Officer have concluded that, as of such date, our disclosurecontrols and procedures were effective to meet the objective for which they weredesigned and operate at the reasonable assurance level.

 

*Management’s Report on Internal Control overFinancial Reporting*

 

Our management is responsible for establishing and maintaining adequateinternal control over financial reporting for the Company as defined in Rule 13a-15(f) or15d-15(f) of the Exchange Act. Internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles, andincludes those policies and procedures that: (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that our receipts and expenditures are being madeonly in accordance with authorizations of our management and directors; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton our financial statements.

 

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Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

 

Our management assessed the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2008 using thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission in its report, *InternalControl-Integrated Framework*. Based on this assessment and thosecriteria, management concluded that our internal control over financialreporting was effective as of December 31, 2008.

 

*Attestation Report of Independent RegisteredPublic Accounting Firm*

 

Our internal control over financial reporting has been audited bySquar, Milner, Peterson, Miranda & Williamson, LLP, anindependent registered public accounting firm, as stated in their report, whichis included herein on page 35.

 

*Changes in Internal Controls*

 

There have been no changes in our internal controls over financialreporting that occurred during our fourth quarter ended December 31, 2008that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

**Item 9B. Other Information**

 

None.

 

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**PART III**

 

**Item 10. Directors, Executive Officers and Corporate Governance**

 

The information set forth under the captions “Election of Directors,” “InformationAbout the Board of Directors and Committees of the Board,” “Executive Officers”and “Transactions with Management and Others—Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement (the “ProxyStatement”) for the Annual Meeting of Stockholders that is scheduled to occurin June 2009 is incorporated herein by reference. The Proxy Statement willbe filed with the SEC no later than 120 days after the end of fiscal year2008.

 

**Item 11. Executive Compensation**

 

Except as specifically provided, the information set forth under thecaptions “Compensation of Executive Officers” and “Information About the Boardof Directors and Committees of the Board—Compensation of Directors” in theProxy Statement is incorporated herein by reference. The Proxy Statement willbe filed with the SEC no later than 120 days after the end of fiscal year2008.

 

**Item 12. Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters**

 

Information regarding security ownership of certain beneficial ownersand management is incorporated by reference to the information set forth underthe caption “Security Ownership of Certain Beneficial Owners and Management” inthe Proxy Statement. The Proxy Statement will be filed with the SEC no laterthan 120 days after the end of fiscal year 2008.

 

Information regarding equity compensation plans required by thisItem 12 is included in Item 5 of Part II of this Annual Reporton Form 10-K and is incorporated into this Item by reference.

 

**Item 13. Certain Relationships and Related Transactions, and DirectorIndependence**

 

The information set forth under the captions “Transactions withManagement and Others” and “Information About the Board of Directors andCommittees of the Board” in the Proxy Statement is incorporated herein byreference. The Proxy Statement will be filed with the SEC no later than120 days after the end of fiscal year 2008.

 

**Item 14. Principal Accounting Fees and Services**

 

Information regarding principal accounting fees and services isincorporated by reference to the information set forth under the caption “Relationshipof the Company with Independent Registered Public Accounting Firm” in the ProxyStatement. The Proxy Statement will be filed with the SEC no later than120 days after the end of fiscal year 2008.

 

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**PART IV**

 

**Item 15. Exhibits and Financial Statement Schedule**

 

**(1)****                                 FinancialStatements**

 
| ** **                                                                                                                                | **Page** |
|-------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Report of Independent Registered Public  Accounting Firm—Squar, Milner, Peterson, Miranda &  Williamson, LLP           | 35       |
| Consolidated Balance Sheets as of  December 31, 2008 and 2007                                                                        | 37       |
| Consolidated Statements of Operations for  the years ended December 31, 2008, 2007 and 2006                                          | 38       |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income for the years  ended December 31, 2008, 2007 and 2006 | 39       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2008, 2007 and  2006                                         | 40       |
| Notes to  Consolidated Financial Statements                                                                                               | 41       |

 

**(2)****                                 FinancialStatement Schedule**

 
| ** **                                                                                                                       | **Page** |
|----------------------------------------------------------------------------------------------------------------------------------|----------|
| Schedule II—Valuation  and Qualifying Accounts and Reserves for the years ended December 31,  2008, 2007 and 2006 | 56       |

 

The financialstatement schedule included on page 56 to this Annual Report on Form 10-Kand in Part II, Item 8 herein is filed as part of this Annual Reporton Form 10-K. All other schedules are omitted because they are notapplicable or the required information is shown in the consolidated financialstatements or related notes.

 

**(3)****                                 Exhibits**

 

The exhibitslisted below are hereby filed with the SEC as part of this Annual Report on Form 10-K.We will furnish a copy of any exhibit upon request, but a reasonable fee willbe charged to cover our expenses in furnishing such exhibit.

** **
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Certificate of Incorporation of the  Company, previously filed with the SEC as Exhibit 3.1 to the Company’s  Registration Statement on Form SB-2, specifically included in Amendment  No. 1 to such Registration Statement filed with the SEC on July 3,  1996 (File No. 333-4974-LA) (the “Registration Statement Amendment  No. 1”), which is incorporated herein by reference. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 3.2                 |       | Bylaws of the Company, previously filed  with the SEC as Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-Q for the period ended September 30, 1999, filed with the  SEC on November 12, 1999, which is incorporated herein by reference.                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| ** **          | ** ** | **Material Contracts Relating to Management Compensation Plans or  Arrangements**                                                                                                                                                                                                                                                                                                                                              |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.1                |       | Employment Agreement dated July 1,  1996, between the Company and Thomas C.K. Yuen, previously filed with the SEC  as Exhibit 10.8 to the Registration Statement Amendment No. 1,  which is incorporated herein by reference.                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.2                |       | Amendment to Employment Agreement dated as  of March 14, 1997, between the Company and Thomas C.K. Yuen, previously  filed with the SEC as Exhibit 10.2 to the Company’s Annual Report on  Form 10-KSB for the fiscal year ended December 31, 1996, filed with  the SEC on March 31, 1997 (the “1996 Annual Report”), which is  incorporated herein by reference.                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.3                |       | Employment Agreement dated July 1,  1996, between the Company and Alan D. Kraemer, previously filed with the SEC  as Exhibit 10.11 to the Registration Statement Amendment No. 1,  which is incorporated herein by reference.                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.4                |       | SRS Labs, Inc. Amended and Restated  1996 Non-employee Directors Stock Option Plan, as amended, previously filed  with the SEC as Appendix B to the Company’s Definitive Proxy Statement  dated and filed with the SEC on April 30, 2003, which is incorporated  herein by reference.                                                                                                                      |

 

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5                |       | Form of Indemnification Agreement,  previously filed with the SEC as Exhibit 10.20 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6                |       | Non-employee Director Compensation Policy  adopted by the Company’s Board of Directors on January 28, 2005,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Non-Employee Directors’ Stock Option Plan (Initial Appointment), previously  filed with the SEC as Exhibit 10.2 to the Company’s Current Report on  Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Non-Employee Directors’ Stock Option Plan (Re-Election), previously filed  with the SEC as Exhibit 10.3 to the Company’s Current Report on  Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Long-Term Incentive Plan, previously filed with the SEC as Exhibit 10.4  to the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.10               |       | Form of Nonqualified Stock Option  Agreement under the SRS Labs, Inc. Amended and Restated 1996 Long-Term  Incentive Plan dated March 29, 2005 (Current participants under this  plan include the following officers: Thomas C.K. Yuen, Ulrich E. Gottschling,  Sarah Yang and Alan D. Kraemer), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed with  the SEC on April 4, 2005, which is incorporated herein by reference. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.11               |       | SRS Labs, Inc. 2005 Change in Control  Protection Plan approved April 27, 2005, previously filed with the SEC  as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  with the SEC on May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.12               |       | Form of Participation Agreement under  the SRS Labs, Inc. 2005 Change in Control Protection Plan for Selected  Executive Officers (Current participants under this plan include the  following officers: Thomas C.K. Yuen, Ulrich E. Gottschling, Sarah Yang, Jeff  Klass and Alan D. Kraemer) previously filed with the SEC as Exhibit 10.2  to the Company’s Current Report on Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.13               |       | SRS Labs, Inc. Amended and Restated  1996 Long-Term Incentive Plan, as amended, approved April 27, 2005,  previously filed with the SEC as Exhibit 10.5 to the Form 8-K filed  with the SEC on May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.14               |       | Employment Letter Agreement dated  June 24, 2005 by and between the Company and Michael Franzi, previously  filed with the SEC as Exhibit 10.1 to the Company’s Current Report on  Form 8-K filed with the SEC on August 18, 2005, which is  incorporated herein by reference.                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.15               |       | Offer Letter dated April 22, 2008 by and  between the Company and Jeff Klaas.                                                                                                                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.16               |       | Employment Letter Agreement dated  December 21, 2005 by and between the Company and Ulrich E. Gottschling,  previously filed with the SEC as Exhibit 99.1 to the Company’s Current  Report on Form 8-K filed with the SEC on December 29, 2005, which  is incorporated herein by reference.                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.17               |       | Form of Nonqualified Stock Option  Agreement under the SRS Labs, Inc. 1996 Amended and Restated Long-Term  Incentive Plan, as amended, previously filed with the SEC as  Exhibit 99.8 to the Company’s Current Report on Form 8-K filed with  the SEC on January 18, 2006, which is incorporated herein by reference.                                                                                                                                                          |

 

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18               |       | SRS Labs, Inc. Profit Sharing and  Bonus Plan, as amended on June 20, 2007, previously filed with the SEC  as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  with the SEC on June 25, 2007, which is incorporated herein by  reference.                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.19               |       | SRS Labs, Inc. 2006 Stock Incentive Plan,  as amended on December 17, 2007, previously filed with the SEC as Exhibit 10.1  to the Company’s Current Report on Form 8-K filed with the SEC on  December 21, 2007, which is incorporated herein by reference.                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.20               |       | Form of Stock Option Award Agreement  under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously filed  with the SEC as Exhibit 10.9 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on September 22,  2006, which is incorporated herein by reference.                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.21               |       | Form of Restricted Share Award  Agreement under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously  filed with the SEC as Exhibit 10.10 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.22               |       | Form of Restricted Share Unit Award  Agreement under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously  filed with the SEC as Exhibit 10.11 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.23               |       | Form of SAR Award Agreement under the  SRS Labs, Inc. 2006 Stock Incentive Plan, previously filed with the SEC  as Exhibit 10.12 to Amendment No. 1 to the Company’s Quarterly  Report on Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.24               |       | SRS Labs, Inc. Patent Reward Program,  previously filed as Exhibit 10.2 to the Company’s Form 8-K filed  with the SEC on June 28, 2006, which is incorporated herein by  reference.                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| ** **          | ** ** | **Other Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.25               |       | Industrial Real Estate Lease dated  May 27, 2008, between the Company and Daimler Commerce  Partners, L.P.                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.26               |       | Stock Divestment Agreement dated  July 1, 1996, between the Company, Thomas C.K. Yuen, Stephen V. Sedmak  and Walter W. Cruttenden III, previously filed with the SEC as  Exhibit 10.17 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 2 to such Registration Statement  file with the SEC on August 2, 1996 (File No. 333-4974-LA), which  is incorporated herein by reference. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| ** **          | ** ** | **Other  Exhibits**                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21                  |       | Subsidiaries of the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 23.1                |       | Consent of Independent Registered Public  Accounting Firm, Squar, Milner, Peterson, Miranda &  Williamson, LLP, dated February 23, 2009.                                                                                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.1                |       | Certification of the Chief Executive  Officer of SRS Labs, Inc., pursuant to Section 302 of the Sarbanes-  Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.2                |       | Certification of the Chief Financial  Officer of SRS Labs, Inc., pursuant to Section 302 of the Sarbanes-  Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.1                |       | Certification of Chief Executive Officer of  SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.2                |       | Certification of Chief Financial Officer of  SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                             |

 

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                          | SRS Labs, Inc. |
|-------------------------------|---------------------|
|                          |                |   |
|                          |                |   |
| Dated: February 24, 2009 | By:                 | /S/ THOMAS  C.K. YUEN |
|                          |                | *Chairman of the Board and Chief Executive  Officer* |

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **Name**                | ** ** | **Capacity**                                                                               | ** ** | **Date**                |
|-------------------------|------------|--------------------------------------------------------------------------------------------|------------|-------------------------|
| ** **              | ** ** | ** **                                                                                 | ** ** | ** **              |
| /s/ THOMAS  C.K. YUEN   |       | Director, Chairman of the Board and Chief Executive Officer  (Principal Executive Officer) |       | February 24,  2009 |
| Thomas C.K.  Yuen       |       |                                                                                       |       |
|                    |       |                                                                                       |       |                    |
| /s/ ULRICH  GOTTSCHLING |       | Chief Financial Officer (Principal Financial and Accounting Officer)                       |       | February 24,  2009 |
| Ulrich  Gottschling     |       |                                                                                       |       |
|                    |       |                                                                                       |       |                    |
| /s/ DAVID R.  DUKES     |       | Director                                                                                   |       | February 24,  2009 |
| David R.  Dukes         |       |                                                                                       |       |                    |
|                    |       |                                                                                       |       |                    |
| /s/ WINSTON  E. HICKMAN |       | Director                                                                                   |       | February 24,  2009 |
| Winston E.  Hickman     |       |                                                                                       |       |                    |
|                    |       |                                                                                       |       |                    |
| /s/ CAROL L.  MILTNER   |       | Director                                                                                   |       | February 24,  2009 |
| Carol L.  Miltner       |       |                                                                                       |       |                    |
|                    |       |                                                                                       |       |                    |
| /s/ SAM YAU             |       | Director                                                                                   |       | February 24,  2009 |
| Sam Yau                 |       |                                                                                       |       |                    |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors andStockholders

SRS Labs, Inc.

Santa Ana, California

 

We haveaudited the accompanying consolidated balance sheets of SRS Labs, Inc. andSubsidiaries (collectively the Company) as of December 31, 2008 and 2007,and the related consolidated statements of operations, stockholders’ equity andcomprehensive income, and cash flows for each of the three years in the periodended December 31, 2008. We also have audited the Company’s internalcontrol over financial reporting as of December 31, 2008, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. Our audit also included the financialstatement schedule listed in Item 15(2) herein. The Company’smanagement is responsible for these financial statements, for maintainingeffective internal control over financial reporting, and for its assessment ofthe effectiveness of internal control over financial reporting included inItem 9A. Our responsibility is to express an opinion on these financialstatements and an opinion on the Company’s internal control over financialreporting based on our audits.

 

We conductedour audits in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the financialstatements are free of material misstatement and whether effective internalcontrol over financial reporting was maintained in all material respects. Ouraudits of the financial statements included examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. Our audit ofinternal control over financial reporting included obtaining an understandingof internal control over financial reporting, assessing the risk that amaterial weakness exists, and testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk. Our audits alsoincluded performing such other procedures as we considered necessary in thecircumstances. We believe that our audits provide a reasonable basis for ouropinions.

 

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control overfinancial reporting includes those policies and procedures that (a) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (b) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (c) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of SRS Labs, Inc.and Subsidiaries as of December 31, 2008 and 2007, and the consolidatedresults of their operations and their cash flows for each of the years in thethree-year period ended December 31, 2008, in conformity with accountingprinciples generally accepted in the United States of America. Also in ouropinion, the Company maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2008, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission.

 

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Also, in ouropinion, the aforementioned financial statement schedule, when considered inrelation to the basic consolidated financial statements taken as a whole,presents fairly, in all material respects, the financial information set forththerein.

 
| /s/ SQUAR,  MILNER, PETERSON, MIRANDA & WILLIAMSON, LLP |   |
|-----------------------------------------------------------------------|--------|
| Squar,  Milner, Peterson, Miranda & Williamson, LLP     |   |

 

Newport Beach, California

February 23, 2009

 

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**SRS LABS, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                  | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                  |       |                        |       |                        |       |
| **Current Assets**                                                                                                                                                                                          |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                   |       | $                           | 31,599,087 |                        | $          | 39,615,291 |   |
| Accounts receivable, net                                                                                                                                                                                    |       | 332,711                     |       | 1,138,425                   |       |
| Prepaid expenses and other current assets                                                                                                                                                                   |       | 864,095                     |       | 893,388                     |       |
| Short-term investments                                                                                                                                                                                      |       | 7,836,000                   |       | —                      |       |
| **Total Current Assets**                                                                                                                                                                                    |       | 40,631,893                  |       | 41,647,104                  |       |
|                                                                                                                                                                                                        |       |                        |       |                        |       |
| Investments available for sale                                                                                                                                                                              |       | —                      |       | 5,451,875                   |       |
| Property and equipment, net                                                                                                                                                                                 |       | 423,921                     |       | 309,727                     |       |
| Intangible assets, net                                                                                                                                                                                      |       | 2,354,725                   |       | 2,197,616                   |       |
| Deferred income taxes, net                                                                                                                                                                                  |       | 3,471,421                   |       | 1,776,202                   |       |
| **Total Assets**                                                                                                                                                                                            |       | $                           | 46,881,960 |                        | $          | 51,382,524 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                              |       |                        |       |                        |       |
|                                                                                                                                                                                                        |       |                        |       |                        |       |
| **Current Liabilities**                                                                                                                                                                                     |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                                            |       | $                           | 314,382    |                        | $          | 529,063 |   |
| Accrued liabilities                                                                                                                                                                                         |       | 996,268                     |       | 689,308                     |       |
| Deferred revenue                                                                                                                                                                                            |       | 1,802,024                   |       | 1,156,836                   |       |
| **Total Current Liabilities**                                                                                                                                                                               |       | 3,112,674                   |       | 2,375,207                   |       |
|                                                                                                                                                                                                        |       |                        |       |                        |       |
| Commitments and contingencies (Note 5)                                                                                                                                                                 |       |                        |       |                        |       |
|                                                                                                                                                                                                        |       |                        |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                                               |       |                        |       |                        |       |
| Preferred stock—$0.001 par value; 2,000,000  shares authorized; no shares issued and outstanding                                                                                                       |       | —                      |       | —                      |       |
| Common stock—$0.001 par value; 56,000,000  shares authorized; 14,419,418 and 16,946,377 shares issued; 14,419,418 and  15,778,715 shares outstanding at December 31, 2008 and 2007,  respectively |       | 14,420                      |       | 16,947                      |       |
| Additional paid-in capital                                                                                                                                                                                  |       | 62,639,075                  |       | 74,143,772                  |       |
| Accumulated other comprehensive loss                                                                                                                                                                        |       | —                      |       | (48,125                     | )          |
| Accumulated deficit                                                                                                                                                                                         |       | (18,884,209                 | )          | (19,155,096                 | )          |
| Treasury stock at cost, 1,167,662 shares at  December 31, 2007                                                                                                                                         |       | —                      |       | (5,950,181                  | )          |
| **Total Stockholders’ Equity**                                                                                                                                                                         |       | 43,769,286                  |       | 49,007,317                  |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                         |       | $                           | 46,881,960 |                        | $          | 51,382,524 |   |

 

Seeaccompanying notes to the consolidated financial statements

 

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**SRS LABS, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                   | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                   | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                     |       | $                                           | 18,332,678 |   | $ | 18,851,940 |   | $ | 18,547,529 |   |
| Cost of sales                                                |       | 143,481                                     |       | 164,112 |   | 171,094 |   |
| Gross profit                                                 |       | 18,189,197                                  |       | 18,687,828 |   | 18,376,435 |   |
| Operating expenses:                                          |       |                                        |       |   |   |   |   |
| Sales and marketing                                          |       | 9,415,238                                   |       | 6,717,906 |   | 7,345,133 |   |
| Research and development                                     |       | 3,747,495                                   |       | 3,107,482 |   | 2,572,577 |   |
| General and administrative                                   |       | 5,913,081                                   |       | 5,443,735 |   | 5,660,260 |   |
| Total operating expenses                                     |       | 19,075,814                                  |       | 15,269,123 |   | 15,577,970 |   |
| Operating (loss) income                                      |       | (886,617                                    | )          | 3,418,705 |   | 2,798,465 |   |
| Interest income                                              |       | 1,275,047                                   |       | 2,041,288 |   | 1,135,870 |   |
| Income from continuing operations before  income taxes       |       | 388,430                                     |       | 5,459,993 |   | 3,934,335 |   |
| Income taxes                                                 |       | 117,543                                     |       | 45,558 |   | 868,203 |   |
| Income from continuing operations                            |       | 270,887                                     |       | 5,414,435 |   | 3,066,132 |   |
| Discontinued operations (Note 10):                      |       |                                        |       |   |   |   |   |
| Income from discontinued operations, net of  income taxes    |       | —                                      |       | — |   | 1,017,079 |   |
| Gain on disposal of discontinued operations                  |       | —                                      |       | — |   | 624,646 |   |
| Income from discontinued operations                          |       | —                                      |       | — |   | 1,641,725 |   |
| Net income                                                   |       | $                                           | 270,887    |   | $ | 5,414,435 |   | $ | 4,707,857 |   |
| Income from continuing operations per  common share:         |       |                                        |       |   |   |   |   |
| Basic                                                        |       | $                                           | 0.02       |   | $ | 0.34 |   | $ | 0.21 |   |
| Diluted                                                      |       | $                                           | 0.02       |   | $ | 0.32 |   | $ | 0.20 |   |
| Income from discontinued operations per  common share:       |       |                                        |       |   |   |   |   |
| Basic                                                        |       | $                                           | —     |   | $ | — |   | $ | 0.11 |   |
| Diluted                                                      |       | $                                           | —     |   | $ | — |   | $ | 0.11 |   |
| Net income per common share:                                 |       |                                        |       |   |   |   |   |
| Basic                                                        |       | $                                           | 0.02       |   | $ | 0.34 |   | $ | 0.31 |   |
| Diluted                                                      |       | $                                           | 0.02       |   | $ | 0.32 |   | $ | 0.30 |   |
| Weighted averaged shares used in the per  share calculation: |       |                                        |       |   |   |   |   |
| Basic                                                        |       | 15,588,815                                  |       | 16,154,313 |   | 14,955,889 |   |
| Diluted                                                      |       | 15,842,336                                  |       | 16,989,839 |   | 15,465,822 |   |

 

Seeaccompanying notes to consolidated financial statements

 

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**SRS LABS, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

 

**AND COMPREHENSIVE INCOME**

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated**        | ** ** | **Treasury** | ** ** | ** ** | ** **  | **Comprehensive** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|------------------------|------------|--------------|------------|------------|-------------|-------------------|------------|
| ** **                                                                 | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income (Loss)** | ** ** | **Deficit**  | ** ** | **Stock**  | ** **  | **Total**         | ** ** | **Income** | ** ** |
| BALANCE,  January 1, 2006                                             |       | 14,279,592            |       | $                       | 14,955     |                                  | $          | 63,574,518             |       | $            | (496,021   | )          | $           | (29,277,388       | )          | $ | (3,003,445 | ) | $ | 30,812,619 |   |   |   |
| Proceeds from  exercise of stock options                                   |       | 1,607,346             |       | 1,607                   |       | 6,501,799                             |       | —                 |       | —       |       | —     |        | 6,503,406         |       |   |   |
| Proceeds from  exercise of Valence management stock options (Note 10) |       | 357,625               |       | 358                     |       | 1,151,177                             |       | —                 |       | —       |       | —     |        | 1,151,535         |       |   |   |
| Purchase of  treasury stock                                                |       | —                |       | —                  |       | —                                |       | —                 |       | —       |       | (2,114,586 | )           | (2,114,586        | )          |   |   |
| Cancellation of  treasury stock                                            |       | (357,625              | )          | (358                    | )          | (2,114,228                            | )          | —                 |       | —       |       | 2,114,586  |        | —            |       |   |   |
| Share-based  compensation                                                  |       | —                |       | —                  |       | 1,460,910                             |       | —                 |       | —       |       | —     |        | 1,460,910         |       |   |   |
| Currency translation  adjustment                                           |       | —                |       | —                  |       | —                                |       | 81,303                 |       | —       |       | —     |        | 81,303            |       | 81,303 |   |
| Unrealized gain  on investments available for sale, net of tax             |       | —                |       | —                  |       | —                                |       | 141,423                |       | —       |       | —     |        | 141,423           |       | 141,423 |   |
| Net income                                                                 |       | —                |       | —                  |       | —                                |       | —                 |       | 4,707,857    |       | —     |        | 4,707,857         |       | 4,707,857 |   |
| BALANCE,  December 31, 2006                                           |       | 15,886,938            |       | 16,562                  |       | 70,574,176                            |       | (273,295               | )          | (24,569,531  | )          | (3,003,445 | )           | 42,744,467        |       | 4,930,583 |   |
| Proceeds from  exercise of stock options                                   |       | 385,341               |       | 385                     |       | 1,842,579                             |       | —                 |       | —       |       | —     |        | 1,842,964         |       |   |   |
| Purchase of  treasury stock                                                |       | (493,564              | )          | —                  |       | —                                |       | —                 |       | —       |       | (2,946,736 | )           | (2,946,736        | )          |   |   |
| Share-based  compensation                                                  |       | —                |       | —                  |       | 1,727,017                             |       | —                 |       | —       |       | —     |        | 1,727,017         |       |   |   |
| Unrealized gain  on investments available for sale, net of tax             |       | —                |       | —                  |       | —                                |       | 225,170                |       | —       |       | —     |        | 225,170           |       | 225,170 |   |
| Net income                                                                 |       | —                |       | —                  |       | —                                |       | —                 |       | 5,414,435    |       | —     |        | 5,414,435         |       | 5,414,435 |   |
| BALANCE,  December 31, 2007                                           |       | 15,778,715            |       | 16,947                  |       | 74,143,772                            |       | (48,125                | )          | (19,155,096  | )          | (5,950,181 | )           | 49,007,317        |       | 5,639,605 |   |
| Proceeds from  exercise of stock options                                   |       | 116,847               |       | 117                     |       | 329,051                               |       | —                 |       | —       |       | —     |        | 329,168           |       |   |   |
| Purchase of  treasury stock                                                |       | (1,476,144            | )          | —                  |       | —                                |       | —                 |       | —       |       | (7,663,679 | )           | (7,663,679        | )          |   |   |
| Cancellation of  treasury stock                                            |       | —                |       | (2,644                  | )          | (13,611,216                           | )          | —                 |       | —       |       | 13,613,860 |        | —            |       |   |   |
| Share-based  compensation                                                  |       | —                |       | —                  |       | 1,777,468                             |       | —                 |       | —       |       | —     |        | 1,777,468         |       |   |   |
| Unrealized gain  on investments available for sale, net of tax             |       | —                |       | —                  |       | —                                |       | 48,125                 |       | —       |       | —     |        | 48,125            |       | 48,125 |   |
| Net income                                                                 |       | —                |       | —                  |       | —                                |       | —                 |       | 270,887      |       | —     |        | 270,887           |       | 270,887 |   |
| BALANCE,  December 31,2008                                            |       | 14,419,418            |       | $                       | 14,420     |                                  | $          | 62,639,075             |       | —       |       | $          | (18,884,209 | )                 | —     |   | $ | 43,769,286 |   | $ | 319,012 |   |
|                                                                            |            |                       |            |                         |            |                                       |            |                        |            |              |            |            |             |                   |            |  |  |  |  |  |  |  |  |  |

 

Seeaccompanying notes to consolidated financial statements

 

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**SRS LABS, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Cash Flows from Operating Activities:**                                          |       |                              |       |   |   |   |   |
| Net income                                                                         |       | $                                 | 270,887    |   | $ | 5,414,435 |   | $ | 4,707,857 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                              |       |   |   |   |   |
| Depreciation and amortization                                                      |       | 660,954                           |       | 733,873 |   | 727,773 |   |
| Provision for doubtful accounts                                                    |       | 11,190                            |       | 108,321 |   | (19,594 | ) |
| Deferred taxes                                                                     |       | (1,695,219                        | )          | (1,389,790 | ) | (6,025 | ) |
| Accretion of discount on investments available for sale                            |       | —                            |       | — |   | (1,904 | ) |
| Net realized gain on investments available for sale                                |       | —                            |       | — |   | (3,125 | ) |
| Share-based compensation                                                           |       | 1,777,468                         |       | 1,727,017 |   | 1,359,767 |   |
| Loss on disposition of furniture, fixtures and equipment                           |       | —                            |       | 10,459 |   | 1,582 |   |
| Write-off of intangible assets                                                     |       | 42,569                            |       | 34,058 |   | 12,072 |   |
| Gain on disposal of discontinued operations                                        |       | —                            |       | — |   | (624,646 | ) |
| Changes in operating assets and liabilities:                                       |       |                              |       |   |   |   |   |
| Accounts receivable                                                                |       | 794,524                           |       | (65,867 | ) | 725,495 |   |
| Prepaid expenses and other current assets                                          |       | 29,293                            |       | (84,448 | ) | (206,093 | ) |
| Accounts payable                                                                   |       | (214,681                          | )          | (80,836 | ) | (131,912 | ) |
| Accrued liabilities                                                                |       | 306,960                           |       | (605,928 | ) | 493,338 |   |
| Deferred revenue                                                                   |       | 645,188                           |       | 757,271 |   | (138,071 | ) |
| Net cash used in operating activities of discontinued operations                   |       | —                            |       | — |   | (1,945,807 | ) |
| Net cash provided by operating activities                                          |       | 2,629,133                         |       | 6,558,565 |   | 4,950,707 |   |
| **Cash Flows from Investing Activities:**                                          |       |                              |       |   |   |   |   |
| Proceeds from sale of investments available for sale                               |       | 5,500,000                         |       | — |   | 11,996,917 |   |
| Purchase of short-term investments                                                 |       | (7,836,000                        | )          | — |   | — |   |
| Purchase of property and equipment                                                 |       | (302,602                          | )          | (147,466 | ) | (214,459 | ) |
| Expenditures related to intangible assets                                          |       | (672,224                          | )          | (703,461 | ) | (520,881 | ) |
| Proceeds from sale of Valence                                                      |       | —                            |       | — |   | 4,300,000 |   |
| Proceeds from sale of equity interest in CHS/SRS LLC                          |       | —                            |       | — |   | 387,021 |   |
| Net cash used in investing activities of discontinued operations                   |       | —                            |       | — |   | (180,216 | ) |
| Net cash (used in) provided by investing activities                                |       | (3,310,826                        | )          | (850,927 | ) | 15,768,382 |   |
| **Cash Flows from Financing Activities:**                                          |       |                              |       |   |   |   |   |
| Purchase of treasury stock                                                         |       | (7,663,679                        | )          | (2,946,736 | ) | (2,114,586 | ) |
| Proceeds from exercise of stock options                                            |       | 329,168                           |       | 1,842,964 |   | 7,654,583 |   |
| Net cash (used in) provided by financing activities                                |       | (7,334,511                        | )          | (1,103,772 | ) | 5,539,997 |   |
| **Net (Decrease) Increase in Cash and Cash  Equivalents**                          |       | (8,016,204                        | )          | 4,603,866 |   | 26,259,086 |   |
| **Cash and Cash Equivalents, Beginning of Year**                                   |       | 39,615,291                        |       | 35,011,425 |   | 8,752,339 |   |
| **Cash and Cash Equivalents, End of Year**                                         |       | $                                 | 31,599,087 |   | $ | 39,615,291 |   | $ | 35,011,425 |   |
| **Supplemental Disclosures of Cash Flow  Information:**                            |       |                              |       |   |   |   |   |
| Cash paid during the year for:                                                     |       |                              |       |   |   |   |   |
| Income taxes                                                                       |       | $                                 | 2,377,114  |   | $ | 1,392,197 |   | $ | 856,841 |   |
| **Supplemental Disclosure of Non-Cash Investing/Financing  Activities:**           |       |                              |       |   |   |   |   |
| Unrealized gain on investments, net                                                |       | $                                 | 48,125     |   | $ | 225,170 |   | $ | 141,423 |   |
| Retirement of treasury stock                                                       |       | $                                 | 13,613,860 |   | $ | — |   | $ | 2,114,586 |   |

 

See accompanying notes toconsolidated financial statements

 

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**SRS LABS, INC. AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Organization and Significant Accounting Policies**

 

*Organization*

 

SRS Labs, Inc.(collectively with its subsidiaries, the “Company,” “SRS Labs,” “SRS”, “us”, “we”or “our”) is the recognized global leader in the practical application of psychoacoustics*,* the science behind how the human ear operates, andin the post processing segment of the market for audio delivery.  Our award-winning audio enhancementtechnologies and solutions dramatically restore audio and voice to its natural state, the way it was originally recorded, in both dimension andclarity, thus providing a superiorconsumer experience for a wide variety of consumer electronic devicessuch as televisions, personal computers and mobile phones.

 

Our operations are conductedthrough SRS Labs, Inc., the parent company, and its wholly-ownedsubsidiaries, SRSWOWcast.com, Inc. and Shenzhen Representative Office ofSRS Labs, Inc. (a Chinese company). Our business is focused on developingand licensing audio, voice and surround sound technology solutions to many ofthe world’s leading original equipment manufacturers (“OEMs”), softwareproviders and semiconductor companies, and limited sales and marketing ofstandalone software and hardware products through the Internet.

 

Prior to September 29,2006, we were also a developer and provider of application specific integratedcircuits and standard integrated circuits through our former wholly-ownedsubsidiary, Valence Tech Limited (“Valence”).

 

*DiscontinuedOperations:*

 

*Valence:*  Through its former wholly-owned subsidiary,Valence, the Company operated a fabless semiconductor business which developed,designed and marketed standard and custom analog ICs, digital signalprocessors, and mixed signal integrated circuits primarily to OEMs andoriginal design manufacturers (“ODMs”) in the Asia Pacific region.  On February 23, 2006, the Company’sBoard of Directors (the “Board”) approved a plan to sell Valence in order tofocus management’s attention and financial resources on the Company’s licensingbusiness. On July 14, 2006, the Company entered into a definitive Sale andPurchase Agreement to sell Valence to Noblehigh Enterprises Inc. The saletransaction was completed on September 29, 2006 and, accordingly, theresults of the operations of Valence through the date of sale were included asdiscontinued operations in the accompanying consolidated statements ofoperations for all periods presented. See Note 11.

 

*CHS/SRS LLC:*  In September 2004, SRS entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to use and promoteSRS Labs’ technologies, to promote CHS productions and to promote each company’srespective brands. In connection with the strategic alliance, SRS and CHSestablished a joint venture, CHS/SRS, LLC (the “Joint Venture”), toproduce and distribute nine concert videos featuring SRS’ Circle Surround technology.On February 23, 2006, the Board authorized management to take allreasonable steps to divest the Company’s entire equity interest in the JointVenture. On June 30, 2006, SRS completed the sale of its interest in theJoint Venture to CHS and, accordingly, the results of the operations of theJoint Venture through the date of sale were included as discontinued operationsin the accompanying consolidated statements of operations for all periodspresented. See Note 11.

 

*Basis ofPresentation*

 

The consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America and include the Company andits wholly-owned subsidiaries SRSWOWcast, Shenzhen Representative Office of SRSLabs, Inc. and the activities of its previously wholly-owned subsidiaryValence through the date of disposal (September 29, 2006) and the JointVenture through the date of disposal (June 30, 2006) after elimination ofall intercompany accounts and transactions. Certain amounts in the notes to the consolidated financial statementshave been reclassified in order to conform to the current year presentation.

 

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*Use ofEstimates*

 

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the financial statements and the reported revenues and expenses during thereporting periods. Some of the estimates needed to be made by managementinclude the allowance for doubtful accounts, estimated useful lives of propertyand equipment and intangible assets, share-based compensation and the valuationallowance for the Company’s deferred tax asset. Actual results could materiallydiffer from these estimates.

 

*Cash andCash Equivalents and Short-term Investments*

 

Cash and cash equivalentsgenerally consist of cash, certificates of deposit, and money market funds withoriginal maturities of three months or less at the date of purchase.  The money market funds are primarily investedin U.S. government obligations. Short-term investments consist of certificates of deposit with originalmaturities ranging from 6 to 12 months.

 

*InvestmentsAvailable for Sale*

 

The Company accounts for availablefor sale investments in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*. Investments,consisting primarily of U.S. government securities, are classified as availablefor sale investments and are reported at fair value, based on quoted marketprices, in the accompanying consolidated balance sheets. Those securities witha maturity date of one year or more were classified as long-term assets.   Unrealized gains and losses, net ofapplicable income taxes, are reported as a separate component of stockholders’equity.

 

*Propertyand Equipment*

 

Property and equipment arestated at cost, net of accumulated depreciation and amortization. The cost ofadditions and improvements are capitalized, while repairs and maintenance areexpensed as incurred. Depreciation and amortization are calculated using thestraight-line method, which amortizes cost over the lesser of the estimateduseful lives of the respective assets or the term of the related lease. Usefullives range from three to five years.

 

*IntangibleAssets*

 

Costs paid by the Companyrelated to the establishment and transfer of patents, primarily legal costs,are capitalized and amortized, depending on the estimated useful life of thetechnology patented. These assets are being amortized over ten years.

 

*Impairmentof Long-Lived Assets*

 

The Company evaluates therecoverability of long-lived assets with finite lives in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets* (“SFAS No. 144”). The Company assessespotential impairments to its long-lived assets when there is evidence thatevents or changes in circumstances indicate that the carrying amount of anasset may not be recovered. An impairment loss is recognized when the carryingamount of the long-lived asset is not recoverable and exceeds its fair value.The carrying amount of a long-lived asset is not recoverable if it exceeds thesum of the undiscounted cash flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. Based upon the most recent assessment as of December 31,2008, the Company has determined there was no impairment in the value oflong-lived assets.

 

*RevenueRecognition*

 

Our license agreementstypically have multi-year or automatic renewal terms, and either require: a)per-unit royalty payments for all products implementing our technologies and/orsolutions; b) fixed annual or quarterly royalty payments; or c) a minimum fixedannual or quarterly royalty payment, which allow the licensee to ship up to apre-determined number of units during the specified time period, withadditional per-unit royalty payments thereafter.  Royalties for per-unit arrangements arereported in the quarter following shipment of the consumer electronics deviceand are therefore recognized 

 

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by us one quarter following shipment by theOEM.  Revenues associated with fixedroyalty payments are recognized ratably over the term of the agreement.  We also sell some of our products andsolutions via the Internet.  Revenues associatedwith those sales are recognized upon shipment and are not material.

 

*Researchand Development*

 

Research and developmentexpenses include costs and expenses associated with the development of ourdesign methodology and the design and development of new products, includinginitial nonrecurring engineering and product verification charges. Research anddevelopment is expensed as incurred.

 

*IncomeTaxes*

 

The Company accounts forincome taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*(“SFAS No. 109”). Deferred taxes on income result fromtemporary differences between the reporting of income for financial statementand tax reporting purposes. A valuation allowance related to a deferred taxasset is recorded when it is more likely than not that some or all of thedeferred tax asset will not be realized.

 

The Company adopted theprovisions of FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109*(“FIN 48”),at thebeginning of fiscal year 2007. FIN 48 provides a comprehensive model forthe financial statement recognition, measurement, presentation and disclosureof uncertain tax positions taken or expected to be taken in income tax returns.Unrecognized tax benefits represent tax positions for which reserves have beenestablished.

 

*DiscontinuedOperations*

 

In accordance with SFAS No. 144,the Company accounts for the results of operations of a component of an entitythat has been disposed or that meets all of the “held for sale” criteria, asdiscontinued operations, if the component’s operations and cash flows have been(or will be) eliminated from the ongoing operations of the entity as a resultof the disposal transaction and the Company will not have any significantcontinuing involvement in the operations of the component after the disposaltransaction. The “held for sale” classification requires having the appropriateapprovals by the Company’s management, Board, and stockholders, as applicable,and meeting other criteria. When all of these criteria are met, the componentis then classified as “held for sale” and its operations reported asdiscontinued operations.

 

Valence and the JointVenture are included as discontinued operations for all periods presented. Forthe years ended December 31, 2008, 2007 and 2006, the Company’s continuingoperations represent the licensing business activities.

 

*Income PerCommon Share*

 

The Company applies SFAS No. 128,*Earnings per Share* (“SFAS No. 128”),which requires the disclosure of basic and diluted net income or loss per sharefor all current and prior periods. Basic net income or loss per common share iscomputed by dividing net income or loss available to common stockholders by theweighted average number of common shares outstanding during each year. Dilutednet income or loss per common share reflects the maximum dilution, based on theaverage price of our common stock each period and is computed similar to basicincome or loss per share except that the denominator is increased to includethe number of additional shares that would have been outstanding if potentiallydilutive stock options and warrants had been exercised.

 

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Basic and diluted net incomeper share computed in accordance with SFAS No. 128 for the years ended December 31,2008, 2007 and 2006 are as follows:

 
| ** **                                              | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **2008**                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| BASIC EPS                                               |       |                              |       |   |   |   |   |
| Numerator:                                              |       |                              |       |   |   |   |   |
| Income from continuing operations                       |       | $                                 | 270,887    |   | $ | 5,414,435 |   | $ | 3,066,132 |   |
| Income from discontinued operations                     |       | —                            |       | — |   | 1,641,725 |   |
| Net income                                              |       | $                                 | 270,887    |   | $ | 5,414,435 |   | $ | 4,707,857 |   |
| Denominator: Weighted average common shares outstanding |       | 15,588,815                        |       | 16,154,313 |   | 14,955,889 |   |
| Income from continuing operations per share             |       | $                                 | 0.02       |   | $ | 0.34 |   | $ | 0.21 |   |
| Income from discontinued operations per share           |       | $                                 | —     |   | $ | — |   | $ | 0.11 |   |
| Net income per share                                    |       | $                                 | 0.02       |   | $ | 0.34 |   | $ | 0.31 |   |
| DILUTED EPS                                             |       |                              |       |   |   |   |   |
| Numerator:                                              |       |                              |       |   |   |   |   |
| Income from continuing operations                       |       | $                                 | 270,887    |   | $ | 5,414,435 |   | $ | 3,066,132 |   |
| Income from discontinued operations                     |       | —                            |       | — |   | 1,641,725 |   |
| Net income                                              |       | $                                 | 270,887    |   | $ | 5,414,435 |   | $ | 4,707,857 |   |
| Denominator: Weighted average common shares outstanding |       | 15,588,815                        |       | 16,154,313 |   | 14,955,889 |   |
| Common equivalent shares outstanding: Dilutive options  |       | 253,521                           |       | 835,526 |   | 509,933 |   |
| Total diluted common shares                             |       | 15,842,336                        |       | 16,989,839 |   | 15,465,822 |   |
| Income from continuing operations per share             |       | $                                 | 0.02       |   | $ | 0.32 |   | $ | 0.20 |   |
| Income from discontinued operations per share           |       | $                                 | —     |   | $ | — |   | $ | 0.11 |   |
| Net income per share                                    |       | $                                 | 0.02       |   | $ | 0.32 |   | $ | 0.30 |   |

 

There were optionsoutstanding at December 31, 2008, 2007 and 2006 to purchase 2,201,570,542,660 and 1,196,763 shares of the Company’s common stock, respectively, thatwere not included above because they would be anti-dilutive.

 

*Share-BasedCompensation*

 

On January 1, 2006, theCompany adopted the provisions of SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”),using the modified prospective application transition method. SFAS No. 123(R) requiresmeasurement of all employee stock-based compensation awards using a fair-valuemethod and recording of such expense in the consolidated financial statementsover the requisite service period. We recorded stock-based compensation expenseof $1,777,468, $1,727,017 and $1,460,910 in 2008, 2007 and 2006, respectively,under the fair-value provisions of SFAS No. 123(R).  See Note 7.

 

*Fair Valueof Financial Instruments*

 

EffectiveJanuary 1, 2008, we adopted SFAS No. 157, *Fair Value Measurements (“SFAS No. 157”),*which definesfair value as the exchange price that would be received for an asset or paid totransfer a liability in the principal or most advantageous market for the assetor liability in an orderly transaction between market participants at themeasurement date. The standard describes three levels of inputs that may beused to measure fair value:

 

·                  *Level 1 inputs:* Level 1 inputs are quoted market pricesin active markets for identical assets or liabilities that are accessible atthe measurement date.

 

·                  *Level 2 inputs:* Level 2 inputs are from other thanquoted market prices included in Level 1 that are observable for the asset orliability, either directly or indirectly.

 

·                  *Level 3 inputs:* Level 3 inputs are unobservable andshould be used to measure fair value to the extent that observable inputs arenot available.

 

The hierarchy noted above requires us to minimize the use ofunobservable inputs and to use observable market data, if available, whendetermining fair value.

 

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Financial assets carried atfair value as of December 31, 2008 are classified below:

 
| ** **              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Money market funds      |       | $           | 29,524,312 |        | $          | —      |       | $         | —     |   | $ | 29,524,312 |   |
| Certificates of deposit |       | —      |       | 9,433,000   |       | —      |       | 9,433,000 |       |
| Total                   |       | $           | 29,524,312 |        | $          | 9,433,000   |       | $         | —     |   | $ | 38,957,312 |   |

 

The adoption of SFAS No. 157did not have a material effect on our consolidated financial position orresults of operations.

 

*CustomerConcentration*

 

For fiscal years 2008 and2007, Samsung accounted for approximately 42% and 28%, respectively, of theCompany’s consolidated revenues.  Forfiscal year 2006, Samsung and Sony each accounted for approximately 17% and11%, respectively, of the Company’s consolidated revenues, respectively.  Given the significant amount of revenuesderived from Samsung, the loss of such customer or the uncollectibility ofrelated receivables could have a material adverse effect on our consolidatedfinancial condition and consolidated results of operations.  See Note 5.

 

*Concentrationsof Credit Risk*

 

Financial instruments, whichpotentially subject the Company to concentrations of credit risk, consistprimarily of cash equivalents, investments and accounts receivable. The Companyplaces its cash in banks and its cash equivalents in certificates of depositand money market funds at certain financial institutions in excess of amountsinsured by federal agencies. The Company does not believe that it is subject toany unusual financial risk beyond the normal risk associated with commercialbanking relationships. The Company performs periodic evaluations of therelative credit standing of these financial institutions.  Short-term investments consist ofcertificates of deposit with original maturities ranging from 6 to 12months.  The Company has not experiencedany significant losses on its cash equivalents or investments.

 

The Company’s accountsreceivables are derived from sales to OEMs, ODMs and platform partnersprimarily in Asia, North America and Europe. Customers’ headquarters geographicallylocated in the Asia Pacific markets accounted for approximately 88%, 90% and91%, of the Company’s revenues in 2008, 2007 and 2006, respectively, and areexpected to continue to account for a substantial percentage of revenues in thefuture. The Company makes periodic evaluations of the creditworthiness of itscustomers and manages its exposure to losses from bad debts by limiting theamount of credit extended whenever deemed necessary and generally does notrequire collateral. The Company maintains an allowance for estimateduncollectible accounts receivable, as appropriate, and such losses havehistorically been minimal and within management’s expectations.

 

*RecentAccounting Pronouncements*

 

In May 2008,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 162, *Hierarchy of Generally Accepted Accounting Principles* (“SFASNo. 162”). This statement is intended to improve financial reporting byidentifying a consistent framework, or hierarchy, for selecting accountingprinciples to be used in preparing financial statements of nongovernmentalentities that are presented in conformity with generally accepted accountingprinciples. This statement became effective on November 15, 2008.  The adoption of SFAS No. 162 did nothave a material impact on the Company’s consolidated financial position orresults of operations.

 

In April 2008,the FASB issued FASB Staff Position (“FSP”) SFAS No. 142-3, *Determination of the Useful Life of Intangible Assets*(“FSP No. 142-3”).This FSP amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset under FASB Statement No. 142, *Goodwill and Other Intangible Assets*(“SFAS No. 142”).The intent of this FSP is to improve the consistency between the useful life ofa recognized intangible asset under SFAS No. 142 and the period ofexpected cash flows used to measure the fair value of the asset under SFAS 141(revised 2007), *Business Combinations*(“SFAS No. 141(R)”)andother GAAP. This FSP is effective for financial statements issued for fiscalyears beginning after December 15, 2008, and interim periods within thosefiscal years. Early adoption was prohibited. We are currently evaluating theimpact of SFAS FSP 142-3, but does not expect the adoption of thispronouncement will have a material impact on its consolidated financialposition, results of operations or cash flows.

 

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In December 2007, theFASB issued SFAS No. 141(R), which replaces SFAS No. 141. SFAS No. 141(R) retainsthe purchase method of accounting for acquisitions, but requires a number ofchanges, including changes in the way assets and liabilities are recognized inthe purchase accounting. It also changes the recognition of assets acquired andliabilities assumed arising from contingencies, requires the capitalization ofin-process research and development at fair value, and requires the expensingof acquisition-related costs as incurred. SFAS No. 141R became effectivefor us beginning January 1, 2009 and will apply prospectively to businesscombinations completed on or after that date.

 

In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS No. 159”).SFAS No. 159 permits entities to choose to measure financial assets andliabilities (except for those that are specifically scoped out of theStatement) at fair value. The election to measure a financial asset orliability at fair value can be made on an instrument-by-instrument basis and isirrevocable. The difference between carrying value and fair value at theelection date is recorded as a transition adjustment to opening retainedearnings. Subsequent changes in fair value are recognized in earnings. Theeffective date for this statement is as of the beginning of an entity’s firstfiscal year that begins after November 15, 2007. Accordingly, we adoptedSFAS No. 159 effective January 1, 2008. The adoption of SFAS No. 159did not have a material effect on our consolidated financial position orresults of operations.

 

**2. Investments Available forSale**

 

Investmentswith maturities greater than one year from the balance sheet date wereclassified as long-term investments. The Company invested its excess cash inU.S. Treasury and agency securities rated “AAA”, and tax-exempt securities withapproved financial institutions with a minimum investment grade of “A1.” Theinvestments available for sale consisted of bonds and included only marketablesecurities with secondary or resale markets to ensure portfolio liquidity.

 

InMarch 2008, the investment available for sale was called by the bondissuer prior to its stated maturity date. The proceeds from the sale were $5,500,000 (par value).  The proceeds were immediately re-invested ina money market fund and are included in cash equivalents as of December 31,2008.  There was no realized gain or lossrecognized on the transaction.

 

The following tablesummarizes the Company’s investment securities available for sale:

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| U.S. Government securities available for sale: |       |                  |       |   |   |
| Cost                                           |       | $                     | —     |   | $ | 5,500,000 |   |
| Unrealized losses                              |       | —                |       | (48,125 | ) |
| Estimated fair value                           |       | $                     | —     |   | $ | 5,451,875 |   |

 

The following tablesummarizes sales of available for sale securities for the years ended December 31,2008, 2007 and 2006. Realized gains are included in other income, net in theaccompanying consolidated statements of operations. Specific identification wasused to determine costs in computing realized gains or losses.

 
| ** **         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------|------------|---------------------------------------------|------------|
| ** **         | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| Proceeds from sale |       | $                                           | 5,500,000  |   | $ | — |   | $ | 11,996,917 |   |
| Realized gains     |       | $                                           | —     |   | $ | — |   | $ | 3,125 |   |

 

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**3. Property and Equipment**

 

Property and equipment, net,consist of the following:

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Property and equipment                         |       | $                     | 1,299,121  |   | $ | 1,170,737 |   |
| Computer equipment                             |       | 534,960               |       | 989,078 |   |
| Leasehold improvements                         |       | 202,854               |       | 134,894 |   |
|                                           |       | 2,036,935             |       | 2,294,709 |   |
| Less accumulated depreciation and amortization |       | (1,613,014            | )          | (1,984,982 | ) |
|                                           |       | $                     | 423,921    |   | $ | 309,727 |   |

 

Depreciation andamortization expense for property and equipment totaling $188,407, $216,948 and$246,098 for the years ended December 31, 2008, 2007 and 2006,respectively, is reflected in general and administrative expenses.

 

**4. Intangible Assets**

 

Intangible assets, netconsist of the following:

 
| ** **                                                 | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Patents                                                    |       | $                     | 3,618,338  |   | $ | 3,315,343 |   |
| Accumulated amortization                                   |       | (1,785,531            | )          | (1,622,954 | ) |
| Patents, net                                               |       | 1,832,807             |       | 1,692,389 |   |
| Other intangibles:                                         |       |                  |       |   |   |
| License agreements acquired in purchase of SRSWOWcast      |       | 640,071               |       | 640,071 |   |
| Capitalized software and hardware for several technologies |       | 582,800               |       | 663,310 |   |
| Total other intangibles                                    |       | 1,222,871             |       | 1,303,381 |   |
| Accumulated amortization, other intangibles                |       | (700,953              | )          | (798,154 | ) |
| Other intangibles, net                                     |       | 521,918               |       | 505,227 |   |
| Intangible assets, net                                     |       | $                     | 2,354,725  |   | $ | 2,197,616 |   |

 

Amortization periods rangefrom three to ten years depending on the estimated useful life of the asset.Amortization expense consists of the following:

 
| ** **                                                 | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| Patents                                                    |       | $                                           | 284,244    |   | $ | 296,118 |   | $ | 233,468 |   |
| Other intangibles:                                         |       |                                        |       |   |   |   |   |
| License agreements acquired in purchase of SRSWOWcast      |       | 64,007                                      |       | 64,007 |   | 64,007 |   |
| Capitalized software and hardware for several technologies |       | 124,296                                     |       | 156,800 |   | 181,800 |   |
| Total intangible amortization expense                      |       | $                                           | 472,547    |   | $ | 516,925 |   | $ | 479,275 |   |

 

As of December 31,2008, the weighted average remaining useful life of the Company’s patents andintangible assets was approximately 6.7 years. The following table showsthe estimated amortization expense for those assets for each of the fivesucceeding fiscal years and thereafter.

 

| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2009                                         |       | $          | 444,814    |   |
| 2010                                         |       | 408,249    |       |
| 2011                                         |       | 371,302    |       |
| 2012                                         |       | 307,004    |       |
| 2013                                         |       | 239,569    |       |
| Thereafter                                   |       | 583,787    |       |
| Total                                        |       | $          | 2,354,725  |   |

 

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**5. Commitments and Contingencies**

 

*Leases*

 

The Company leases officespace and certain equipment under non-cancelable operating leases expiringthrough 2009. The Company leases its corporate office and storage facilitieslocated in Santa Ana, California, under a lease agreement with a partnershipthat is affiliated with a principal stockholder, who is also an executiveofficer and a director, of the Company. The lease term was renewed in 2008until May 2013.  We paid rent of$235,170, $230,256, and $230,256 in 2008, 2007, and 2006, respectively underthis lease agreement.

 

Additionally, we enteredinto three new leases in 2008 for our international operations in Taiwan,China, and Japan.  The leases for ouroffices in Taiwan and Japan expire in April 2009 and October 2009,respectively, and the lease term for our office in China expires in April 2013.  In total, the Company paid rent of $294,702,$230,256 and $230,256 during 2008, 2007 and 2006, respectively, for all ourfacilities.

 

Future annual minimum leasepayments under non-cancelable operating leases for the remaining periods at December 31,2008 are as follows:

 
| **Years Ending December 31,** | ** ** | **Facility** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|--------------|------------|-----------------------|------------|-----------|------------|
| 2009                                         |       | $            | 394,025    |                  | $          | 19,105    |       | $ | 413,130 |   |
| 2010                                         |       | 277,504      |       | 17,393                |       | 294,897   |       |
| 2011                                         |       | 284,055      |       | 2,208                 |       | 286,263   |       |
| 2012                                         |       | 288,736      |       | —                |       | 288,736   |       |
| 2013                                         |       | 117,071      |       | —                |       | 117,071   |       |
| Total                                        |       | $            | 1,361,391  |                  | $          | 38,706    |       | $ | 1,400,097 |   |

 

*Litigation*

 

OnJune 8, 2007, we sent a letter to Sony Corporation (“Sony”) relating tothe possible infringement of several SRS patents by Sony’s S-Force technology.Sony responded to the letter by filing a Complaint for Declaratory Relief inthe U.S. District Court in the Southern District of New York on July 6,2007. In November 2007, Sony and SRS entered into a standstill agreementfor the purpose of conducting discussions towards an amicable resolution of thedispute, and the Complaint for Declaratory Relief wasdismissed.  While the standstill agreement has expired, the partiescontinue to negotiate regarding this matter.  In October 2008, theoutside patent counsel hired to evaluate the Sony S-Force technology informedus that they had completed their evaluation based on the information providedby Sony.  Based on their study, they confirmed SRS’ position that theS-Force technology infringes on the Company’s patents.  The basis forthis infringement position has been provided to Sony for theirreview.  SRS cannot assure that it will prevail in this matter and isunable to determine at this time the impact that this matter may have, if any,on its consolidated financial position, results of operations or cash flows.

 

Fromtime to time, the Company may be involved in other litigation matters anddisputes arising in the normal course of business. Any such matters anddisputes could be costly and time consuming, subject the Company to damages orequitable remedies, and divert our management and key personnel from ourbusiness operations.

 

*Indemnifications*

 

The Company enters intostandard license agreements in its ordinary course of business. Pursuant tothese agreements, the Company agrees to indemnify its customers for lossessuffered or incurred by them as a result of any patent, copyright, or otherintellectual property infringement claim by any third party with respect to theCompany’s products. These agreements generally have perpetual terms. Themaximum amount of indemnification the Company could be required to make underthese agreements is generally limited to the license fees received by theCompany. The Company estimates the fair value of its indemnification obligationas insignificant, based upon its history of litigation concerning product andpatent infringement claims. Accordingly, the Company has no liabilitiesrecorded for indemnification under these agreements as of December 31,2008 and 2007.

 

The Company has agreementswhereby its officers and directors are indemnified for certain events oroccurrences while the officer or director is, or was, serving at our request insuch capacity. The maximum potential amount of future payments the Companycould be required to make under these indemnification agreements is unlimited;however, the 

 

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Company has a directors and officers’ insurance policy that reduces itsexposure and enables the Company to recover a portion of any future amountspaid. As a result of the insurance policy coverage, the Company believes theestimated fair value of these indemnification agreements is minimal. Currently,the Company has no liabilities recorded for these agreements as of December 31,2008 and 2007.

 

*Warranties*

 

The Company offers itscustomers a warranty that its software products will substantially conform totheir functional specifications. To date, there have been no payments ormaterial costs incurred related to fulfilling these warranty obligations.Accordingly, the Company has no liabilities recorded for these warranties as ofDecember 31, 2008 and 2007.

 

*Employment Contracts*

 

The Company has employmentagreements with its Chief Executive Officer and four other employees(collectively “Agreements”). Each of the Agreements was entered into for aninitial term that has since expired and all are now automatically renewedannually on various anniversary dates. Under the terms of each of theAgreements, the Company may be obligated to pay a severance payment rangingfrom one to two years of the respective employee’s base salary, depending onthe date of termination, if the employee is terminated by the Company withoutcause.

 

*Change in Control Plan*

 

The Compensation Committeeof the Board, the sponsor of the Company’s 2005 Change in Control ProtectionPlan (the “Change in Control Plan”), has designated certain of its executiveofficers as participants in the Change in Control Plan. The Change in ControlPlan generally provides that if a participant’s employment is terminatedwithout cause or if the participant resigns for good reason during a two-yearperiod following a change in control, as defined in the Change in Control Plan,the participant will be entitled to receive a severance payment. Under theChange in Control Plan, the size of the severance payment that would be due toa participant upon the occurrence of a covered termination ranges from to oneto two times the participant’s average taxable income during the five yearspreceding the change in control, depending on the participant’s position withthe Company. The Change in Control Plan also provides that the Company will paya participant’s COBRA premiums for a period of 18 months following acovered termination.

 

**6. Income Taxes**

 

The components of incomefrom continuing operations before income taxes are as follows:

 
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| United States |       | $                                          | 388,430    |   | $ | 5,459,993 |   | $ | 3,934,335 |   |
|               |            |                                            |            |  |  |  |  |  |  |  |

 

The provision for incometaxes on continuing operations consists of the following:

 
| ** **                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Current:                           |       |                                       |       |   |   |   |   |
| Federal                            |       | $                                          | —     |   | $ | — |   | $ | (42,970 | ) |
| State                              |       | 144,923                                    |       | 45,558 |   | — |   |
| Foreign                            |       | 1,667,839                                  |       | 1,389,372 |   | 905,148 |   |
| Total                              |       | 1,812,762                                  |       | 1,434,930 |   | 862,178 |   |
| Deferred:                          |       |                                       |       |   |   |   |   |
| Federal                            |       | (1,704,301                                 | )          | (234,654 | ) | 768,341 |   |
| State                              |       | —                                     |       | — |   | 52,673 |   |
| Foreign                            |       | —                                     |       | — |   | 6,025 |   |
| Change in valuation allowance, net |       | 9,082                                      |       | (1,154,718 | ) | (821,014 | ) |
| Total                              |       | (1,695,219                                 | )          | (1,389,372 | ) | 6,025 |   |
| Total income tax provision         |       | $                                          | 117,543    |   | $ | 45,558 |   | $ | 868,203 |   |

 

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The reconciliation of theincome tax expense computed at U.S. federal statutory rates to the provisionfor income taxes is as follows:

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Tax at U.S. federal statutory rates        |       | $                                          | 179,821    |   | $ | 1,856,398 |   | $ | 1,377,017 |   |
| State income taxes, net of federal benefit |       | 30,857                                     |       | 151,796 |   | 226,067 |   |
| Nondeductible expenses                     |       | 32,692                                     |       | 9,983 |   | 13,137 |   |
| Change in valuation allowance, net         |       | 9,082                                      |       | (1,154,718 | ) | 821,014 |   |
| Research and development credit            |       | (131,768                                   | )          | (110,996 | ) | (220,712 | ) |
| Foreign tax rate differential and other    |       | (3,141                                     | )          | (706,905 | ) | (1,348,320 | ) |
| Total income tax expense                   |       | $                                          | 117,543    |   | $ | 45,558 |   | $ | 868,203 |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of theCompany’s deferred tax assets are as follows:

 
| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Deferred tax assets:             |       |                  |       |   |   |
| Depreciation and amortization    |       | $                     | 705,430    |   | $ | 627,281 |   |
| Accruals                         |       | 915,872               |       | 553,051 |   |
| Net operating loss carryforwards |       | 883,338               |       | 1,895,156 |   |
| Tax credit carryforwards         |       | 6,553,617             |       | 4,919,261 |   |
| Capital loss carryforwards       |       | 6,460,261             |       | 6,460,261 |   |
| Other                            |       | 1,897,204             |       | 1,256,411 |   |
| Valuation allowance              |       | (13,944,301           | )          | (13,935,219 | ) |
| Total net deferred tax assets    |       | $                     | 3,471,421  |   | $ | 1,776,202 |   |

 

The Company has federal andstate net operating loss carryforwards at December 31, 2008 of $11,239,216and $5,598,943, respectively. These net operating loss carryforwards began toexpire in 2005 and will continue to expire through 2028. The Company also hasfederal and state research credits of approximately $921,881 and $505,946,respectively, which will begin to expire in 2011 and will continue to expirethrough 2028 for federal and indefinitely for state. In addition, the Companyhas federal foreign tax credit carryforwards of $5,125,790 at December 31,2008, which will begin to expire in 2014 and will continue to expire through2018. The Company also has federal and state capital loss carryforwards at December 31,2008 of $16,219,585, which will expire in 2011.

 

As of December 31,2008, a valuation allowance of $13,944,301 has been provided based on theCompany’s assessment of the future realizability of deferred tax assets. Thevaluation allowance on deferred tax assets relates to future deductibletemporary differences, capital loss carryforwards, foreign tax credit carryforwards,research and development credit carryforwards, and net operating losscarryforwards for which the Company has concluded it is more likely than notthat these items will not be realized in the ordinary course of operations.Management periodically evaluates the recoverability of the deferred tax assetsand recognizes the tax benefit only as reassessment demonstrates they arerealizable. At such time it is determined that it is more likely than not thatthe deferred tax assets are realizable, the valuation allowance is adjusted.This assessment is based on projections of future taxable income, which isimpacted in future periods by income before taxes and stock option exercises.The amount of the net deferred tax assets considered realizable, however, couldbe reduced in the near term if actual future earnings are lower than estimated,or if there are differences in the timing or amount of future reversals ofexisting taxable temporary differences. As a result of SFAS No. 123R, theCompany’s deferred tax assets at December 31, 2008 do not includeapproximately $3.2 million of excess tax benefits from employee stockoption exercises that are a component of the Company’s net operating losscarryovers. Equity will be increased by approximately $3.2 million if andwhen such excess tax benefits are ultimately realized.

 

The use of loss carryforwards and tax credit carry forwards may becomelimited in the event of an ownership change as defined under Internal RevenueCode section 382.The Company commissioned a section 382 studyin 2008, which confirmed that there have been no ownership changes through2007.  Further, due to a change inCalifornia tax law in fiscal 2008, net operating loss carryforwards may not beused in 2008 or 2009 and research and development credits are limited to fiftypercent of the Company’s net tax.

 

The Company adopted theprovisions of FIN 48 at the beginning of fiscal year 2007. Upon adoptionof FIN 48, no adjustment to the consolidated financial statements wasrequired. The Company determined that it did not have any unrecorded taxcontingencies and therefore a rollforward of the tax contingency reserve thatreconciles the beginning and ending balance of the reserve was not necessary asthere was no tax contingency reserve. The Company will recognize interest andpenalties related to unrecognized tax benefits within the income tax expenseline in the accompanying consolidated statement of operations. As of December 31,2008, the Company has not recognized liabilities for penalty and interest asthe Company does not have liability for unrecognized tax benefits. The taxyears 2004 through 2007 remain open to examination by the major taxingjurisdictions.

 

**7. Stockholders’ Equity and Share-Based Compensation**

 

*Stock Repurchases*

 

On September 29, 2006,the Company repurchased from certain members of management of Valence 357,625shares of SRS common stock, which were obtained by them through the exercise ofvested employee stock options, for an aggregate repurchase price of $2,114,586.Such shares were immediately canceled and were therefore not outstanding as of

 

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December 31, 2006. Therepurchase price per share paid for such shares was equal to the averageclosing price of SRS common stock for the seven trading days ending three daysprior to the closing date of the sale of Valence. See Note 11.

 

On November 6,2007, the Company announced that the Board authorized the repurchase of up to$10,000,000 of its outstanding common stock for a period from November 12,2007 to May 11, 2008. The Company repurchased 498,564 shares at a cost of$2,971,186 under this repurchase program.

 

On May 19, 2008, the Board authorized the repurchase of up to$10,000,000 of the Company’s common stock for a period from May 20, 2008to November 19, 2008.   In total,the Company repurchased a total of 14,200 shares of the Company’s outstandingcommon stock under the program, all in the second fiscal quarter.  On August 29, 2008, the Companysuspended this repurchase program and announced it would conduct a Dutchauction tender offer, pursuant to which the Company could purchase up to$10,000,000 of shares of its common stock (the “Dutch Auction”). On September 30,2008, the Dutch Auction was terminated and withdrawn as a result of the Company’sreceipt of an unsolicited inbound offer to purchase all of the Company’s commonstock for consideration with a stated value per share in excess of therepurchase price set forth in the Offer to Purchase for the Dutch Auction.  As a result, SRS did not repurchase anyshares under the Dutch Auction.

 

On November 3,2008, the Board authorized the repurchase of up to $15,000,000 of the Company’scommon stock for a period from November 7, 2008 to May 6, 2009.  As of December 31, 2008, the Companyrepurchased 1,456,944 shares at a cost of $7,541,626 under this repurchaseprogram.

 

*Stock Award/Option Plans/Warrants*

 

In July 1996,the Board adopted and the Company’s stockholders approved the 1996 Long-TermIncentive Plan (as amended and restated, the “1996 Plan”), for which 1,000,000shares of the Company’s common stock were reserved for issuance to officers,employees and consultants of the Company. Prior to the adoption of the 2006Plan (defined below), if any award granted under the 1996 Plan expires,terminates or is forfeited before the exercise thereof or the payment in fullthereof, the shares covered by the unexercised or unpaid portion would havebecome available for new grants under the 1996 Plan. In June 1997, theBoard and the Company’s stockholders approved the amendment and restatement ofthe 1996 Plan, including an increase to the number of shares reserved forissuance under the plan by 1,000,000. In June 1998, the Board and theCompany’s stockholders approved an amendment to the 1996 Plan to increase thenumber of shares reserved for issuance under the plan by 2,500,000. Also in June 1998,in a separate amendment, the Board and the Company’s stockholders approved anamendment to allow all directors of the Company and any subsidiary of theCompany to participate in the 1996 Plan. In June 2000, the Board adoptedand the Company’s stockholders approved an amendment to the 1996 Plan toincrease the number of shares reserved for issuance under the plan by2,500,000. In June 2003, the Board and the Company’s stockholders approvedan amendment to the 1996 Plan to increase the number of shares reserved forissuance under the plan by 1,500,000. The Compensation Committee or, in theabsence of a Compensation Committee, the Board, as a whole, has been appointedto administer the 1996 Plan. Options issued under the 1996 Plan vest in themanner prescribed by the Compensation Committee or the Board, as applicable. Asof December 31, 2008, options to purchase 1,344,698 shares of the Company’scommon stock were outstanding under the 1996 Plan. No additional options willbe granted under the 1996 Plan as of December 31, 2008.

 

In July 1996,the Board adopted and the Company’s stockholders approved the 1996 Non-employeeDirectors Stock Option Plan (the “Non-employee Directors Plan”), anon-discretionary formula plan for which 120,000 shares of the Company’s commonstock were reserved for issuance to the Company’s non-employee directors. Acommittee consisting of all directors who are not eligible to participate inthe Non-employee Directors Plan administers the Non-employee Directors Plan.With the exception of the initial option granted to a non-employee director,which vests immediately, options granted under the Non-employee Directors Planvest over a three-year period, the first installment vesting on the date ofgrant. In June 1999, the Company’s stockholders approved the Amended andRestated 1996 Non-employee Directors’ Stock Option Plan (the “AmendedNon-employee Directors Plan”). Among the changes set forth in the Amended Non-employeeDirectors Plan was to increase by 130,000 the number of shares of common stockthat may be issued under the plan. In June 2001, the Board adopted and theCompany’s stockholders approved an amendment to the Amended Non-employeeDirectors Plan to increase the number of shares reserved for issuance under theplan by 250,000. As of December 31, 2008, options to purchase 147,500shares of common stock were outstanding under the Amended Non-employeeDirectors Plan. There are 310,000 shares of common stock available for grantunder the Non-employee Directors Plan as of December 31, 2008.

 

On June 22,2006, the Board adopted and the Company’s stockholders approved the 2006 StockIncentive Plan (the “2006 Plan”), for which 1,500,000 shares of the Company’s commonstock has been reserved for issuance under the plan provided that the Companyshall not make additional awards under the 1996 Plan. Either the Board or acommittee appointed 

 

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by the Board (the “Committee”)will administer the 2006 Plan. The Compensation Committee is currently actingas the Committee for purposes of the 2006 Plan. Under the 2006 Plan, theCommittee may grant options that are intended to qualify as incentive stockoptions. Additionally, the Committee may also grant share appreciation rights,restricted shares, restricted share units, unrestricted shares, deferred shareunits, and performance awards. The vesting period is dependent on the type ofaward granted and may be determined by the Committee. In June 2008, theBoard adopted and the Company’s stockholders approved an amendment to the 2006Plan to increase the number of shares reserved for issuance under the plan by1,750,000. As of December 31, 2008, options to purchase 1,387,340 sharesof common stock were outstanding under the 2006 Plan. There are 1,862,660shares of common stock available for grant under the 2006 Plan as of December 31,2008.

 

*Share-Based Compensation*

 

On January 1,2006, the Company adopted SFAS No. 123(R) using the modifiedprospective application method, which requires the Company to recordcompensation expense for all awards granted after the date of adoption, and forthe unvested portion of previously granted awards that remain outstanding atthe date of adoption.

 

Totalcompensation cost recognized in 2008 and 2007 pursuant to SFAS No. 123(R) isas follows:

 
| ** **                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| Sales and marketing                |       | $                                           | 458,610    |   | $ | 495,132 |   |
| Research and development           |       | 399,630                                     |       | 428,516 |   |
| General and administrative         |       | 919,228                                     |       | 803,369 |   |
| Total compensation cost recognized |       | $                                           | 1,777,468  |   | $ | 1,727,017 |   |

 

Option awardsare granted with an exercise price equal to the market price of the Company’sstock at the date of grant. Option awards generally have a term of10 years and vest and become exercisable over a four-year service period.

 

The fair valueof each share-based award is estimated on the grant date using the Black-Scholes-Merton(“BSM”) option-pricing model. Expected volatilities are based on the historicalvolatility of the Company’s stock price. The expected term of options grantedsubsequent to the adoption of SFAS No. 123(R) is derived using thesimplified method as defined in the SEC’s Staff Accounting Bulletin 107, *Implementation of FASB 123(R) *for fiscal years 2007 and 2006.  The expected term for options granted in 2008was calculated based upon the historical term of the Company’s option grantsand review of the terms of the Company’s peers. The risk-free rate for periods within the contractual life of theoption is based on the U.S. Treasury interest rates in effect at the time ofgrant. The fair value of options granted was estimated using the followingweighted-average assumptions:

 
| ** **               | ** ** | **Years Ended  December 31,** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **2008**                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected term (in years) |       | 4.67                                    |       | 6.25 |   | 6.25 |   |
| Expected volatility      |       | 56                                      | %          | 56 | % | 57 | % |
| Risk-free interest rate  |       | 3.4                                     | %          | 4.8 | % | 4.9 | % |
| Dividend yield           |       | 0.00                                    | %          | 0.00 | % | 0.00 | % |

 

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The followingtable summarizes the weighted-average fair value of stock options granted andthe total intrinsic value of stock options exercised during the years ended December 31,2008, 2007 and 2006:

 
| ** **                                    | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| Weighted-average fair value at date of  grant |       | $                                           | 2.80       |   | $ | 5.66 |   | $ | 3.50 |   |
| Intrinsic value of options exercised          |       | $                                           | 192,314    |   | $ | 2,846,841 |   | $ | 6,267,399 |   |

 

A summary ofoption activity under the stock option plans and changes during the year ended December 31,2008 is presented below:

 
| ** **                                  | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | ** **                                          | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **Shares** | ** ** | **Exercise  Price**  | ** ** | **Remaining  Contractual  Term (in Yrs)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Outstanding, January 1, 2008           |       | 2,442,868  |       | $                    | 5.90       |                                                |       |   |   |   |
| Granted                                     |       | 889,020    |       | 5.40                 |       |                                                |       |   |   |
| Cancelled/Forfeited                         |       | (335,503   | )          | 6.23                 |       |                                                |       |   |   |
| Exercised                                   |       | (116,847   | )          | 2.82                 |       |                                                |       |   |   |
| Outstanding, December 31, 2008         |       | 2,879,538  |       | $                    | 5.83       |                                                | 6.72       |   | $ | 1,073,635 |   |
| Options exercisable, December 31, 2008 |       | 1,605,034  |       | $                    | 5.41       |                                                | 5.09       |   | $ | 1,006,056 |   |

 

A summary of theactivity of the Company’s non-vested shares during the year ended December 31,2008 is presented below:

 
| ** **                        | ** ** | ** ** | ** ** | ** **                           | ** ** | **Remaining**                          | ** ** |
|-----------------------------------|------------|------------|------------|--------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted-Average**                 | ** ** | **Unrecognized**                       | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Grant Date  Fair Value** | ** ** | **Remaining  Years to Vest** | ** ** | **Compensation  Cost** | ** ** |
| Nonvested, January 1, 2008   |       | 949,976    |       | $                                    | 4.65       |                                   |       |   |   |   |
| Granted                           |       | 889,020    |       | 2.66                                 |       |                                   |       |   |   |
| Vested                            |       | (429,674   | )          | 4.57                                 |       |                                   |       |   |   |
| Forfeited                         |       | (134,818   | )          | 3.51                                 |       |                                   |       |   |   |
| Nonvested, December 31, 2008 |       | 1,274,504  |       | $                                    | 3.41       |                                   | 2.78       |   | $ | 3,809,074 |   |
|                                   |            |            |            |                                      |            |                                        |            |  |  |  |  |

 

The followingtable summarizes information concerning currently outstanding and exercisableoptions and warrants at December 31, 2008:

 
| **Range of Exercise Prices** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Exercisable  As of  12/31/2008** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| $1.91–$3.80                            |       | 513,389                                  |       | 2.5                                                                      |       | $                                          | 2.96       |                                    | 513,389    |                                       | $          | 2.96 |   |
| $3.81–$5.70                            |       | 990,744                                  |       | 8.0                                                                      |       | 4.90                                       |       | 344,854                                 |       | 4.82                                       |       |
| $5.71–$7.60                            |       | 887,205                                  |       | 7.2                                                                      |       | 6.19                                       |       | 524,270                                 |       | 6.03                                       |       |
| $7.61–$9.50                            |       | 323,200                                  |       | 8.0                                                                      |       | 9.29                                       |       | 142,521                                 |       | 9.29                                       |       |
| $9.51–$11.40                           |       | 145,000                                  |       | 8.0                                                                      |       | 10.62                                      |       | 60,000                                  |       | 10.61                                      |       |
| $17.10–$19.00                          |       | 20,000                                   |       | 1.2                                                                      |       | 19.00                                      |       | 20,000                                  |       | 19.00                                      |       |
|                                        |       | 2,879,538                                |       | 6.7                                                                      |       | $                                          | 5.83       |                                    | 1,605,034  |                                       | $          | 5.41 |   |

 

The totalshares subject to options exercisable as of December 31, 2008, 2007 and2006 were 1,605,034, 1,492,892 and 1,538,920, respectively, with weightedaverage exercise prices of $5.41, $4.67 and $4.67, respectively.

 

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**8. Segment Information**

 

The Companypreviously operated in two business segments—semiconductors and licensing.However, as a result of selling Valence, the semiconductor business, in 2006the Company now has continuing operations in only one business segment,licensing. The Company’s revenue from continuing operations is solely derivedfrom licensing related revenue.

 

The followingschedule presents the Company’s revenue by geographic area. For product sales,revenue is allocated based on the country to which product was shipped.Licensing-related revenue is summarized based on the location of the licensee’scorporate headquarters. For product and online sales, revenue is allocated tothe Americas. The Americas region includes North, Central and South America. In2008, the Greater China region was broken down into the China and Asia Pacificregion. The China region includes all licensees with their corporateheadquarters located in mainland China. The Asia Pacific region includes all licensees with their corporateheadquarters located in Taiwan and Hong Kong.

 
| ** **                     | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                    | ** ** | **%** | ** ** | **2007** | ** ** | **%** | ** ** | **2006** | ** ** | **%** | ** ** |
| ***Geographic Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Korea                          |       | $                                           | 9,624,459  |   | 52 | % | $ | 7,834,730 |   | 42 | % | $ | 5,652,550 |   | 30 | % |
| Japan                          |       | 5,357,286                                   |       | 29 |   | 7,346,548 |   | 39 |   | 8,115,378 |   | 44 |   |
| Americas                       |       | 1,744,502                                   |       | 10 |   | 1,837,096 |   | 10 |   | 1,534,421 |   | 8 |   |
| China                          |       | 838,754                                     |       | 5 |   | 843,931 |   | 4 |   | 2,032,690 |   | 11 |   |
| Asia Pacific                   |       | 430,598                                     |       | 2 |   | 805,660 |   | 4 |   | 1,132,882 |   | 6 |   |
| Europe                         |       | 337,079                                     |       | 2 |   | 183,975 |   | 1 |   | 79,608 |   | 1 |   |
| Total                          |       | $                                           | 18,332,678 |   | 100 | % | $ | 18,851,940 |   | 100 | % | $ | 18,547,529 |   | 100 | % |

 

**9. Employee Benefit Plan**

 

The Company’semployees based in the United States may participate in a salary deferral plan(the “401(k) Plan”) in which eligible employees can contribute up to 75%of their eligible compensation. The Company also may contribute on adiscretionary basis. The Company’s matching contribution vests ratably over afour year period. During the years ended December 31, 2008, 2007 and 2006,the Company contributed approximately $121,723, $126,675 and $114,372,respectively, to the 401(k) Plan.

 

**10. Discontinued Operations**

 

*Valence:* Through its former subsidiary, Valence, the Company operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog ICs, digital signal processors, and mixed signal integratedcircuits primarily to OEMs and ODMs in the Asia Pacific region.

 

On February 23,2006, the Board of Directors approved a plan to sell Valence in order to focusmanagement’s attention and the Company’s financial resources on its licensingbusiness. On July 14, 2006, the Company entered into a definitive Sale andPurchase Agreement to sell Valence to Noblehigh Enterprises Inc. (“Noblehigh”).Noblehigh is owned by Willas Array Electronics (Holding) Limited as well ascertain members of management of Valence (the “Management Buyers”). The saletransaction was completed on September 29, 2006 and, accordingly, theresults of the operations of Valence and its cash flows through the date ofsale are reported as discontinued operations in all periods presented. Thetransaction did not require approval by SRS’s stockholders.

 

The sale toNoblehigh was effected through two simultaneous transactions: (1) therepurchase by Valence of approximately 74% of the outstanding shares of Valencefrom SRS using its existing cash and (2) the purchase by Noblehigh of theremaining outstanding shares of Valence from SRS for $4.3 million. Thesale resulted in a gain on the disposal, which is reflected in the accompanyingconsolidated financial statement of operations for 2006, calculated as follows:

 
| Cash proceeds from sale |   | $          | 4,300,000 |   |
|-------------------------|--------|------------|-----------|--------|
| Less: Transaction costs |   | (924,450   | )         |
| Net proceeds            |   | 3,375,550  |      |
| Net assets sold         |   | (3,137,925 | )         |
| Gain on sale of Valence |   | $          | 237,625   |   |

 

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Additionally,the Company repurchased from the Management Buyers 357,625 shares of SRS commonstock, which were obtained by the Management Buyers through the exercise ofvested employee stock options, for an aggregate repurchase price of $2,114,586.Such shares were immediately canceled and were therefore not outstanding as of December 31,2006.

 

*CHS/SRS LLC:*  In September 2004, the Company enteredinto a strategic alliance with Coming Home Studios LLC, to promote eachcompany’s respective brands. In connection with the strategic alliance, theCompany and CHS established a joint venture, CHS/SRS, LLC, to produce anddistribute nine concert videos featuring SRS Labs’ Circle Surround technology.

 

On February 23,2006, the Board authorized management to divest its entire equity interest inthe Joint Venture. The transaction did not require approval by SRSstockholders. As a result of its decision to sell its interest in the JointVenture, the Company has accounted for the Joint Venture as a discontinuedoperation in the consolidated financial statements for all periods presented.On June 30, 2006, the Company completed the sale of its interest in theJoint Venture to CHS in exchange for $200,000, the rights to all cash assets ofthe Joint Venture, and a promissory note in the amount of $175,000. The Companyrecorded a gain on disposal of its interest in the Joint Venture of $387,021 inthe Company’s accompanying consolidated statement of operations for the yearended December 31, 2006. Any amounts related to the promissory note andaccrued interest thereon will be recorded at the time the cash is received bySRS.

 

Income fromdiscontinued operations consists of direct revenues and direct expenses ofValence and the Joint Venture. General corporate overhead costs have not beenallocated to discontinued operations. A summary of the operating results ofValence and the Joint Venture included in discontinued operations in theaccompanying consolidated statements of operation is as follows:

 
| ** **                                                 | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                               | ** ** |
| **Valence:**                                               |       |                                   |       |
| Revenues                                                   |       | $                                      | 7,682,931  |   |
| Cost of sales                                              |       | 3,562,750                              |       |
| Gross margin                                               |       | 4,120,181                              |       |
| Total operating expenses                                   |       | 3,193,519                              |       |
| Income from operations                                     |       | 926,662                                |       |
| Other income, net                                          |       | 31,669                                 |       |
| Income before income tax expense                           |       | 958,331                                |       |
| Income tax expense                                         |       | 33,632                                 |       |
| **Net income from Valence**                                |       | 924,699                                |       |
| **Net income from Joint Venture**                          |       | 92,380                                 |       |
| **Net income from discontinued operations,  net of taxes** |       | 1,017,079                              |       |
| **Gain on disposal of discontinued operations**            |       | 624,646                                |       |
| **Income from discontinued operations**                    |       | $                                      | 1,641,725  |   |

 

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**SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS AND RESERVES**

 
| ** **                                 | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  Charged to  Expense** | ** ** | **Deductions** | ** ** | **Balance  at End  of Period** | ** ** |
|--------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| For the year ended December 31, 2008: |       |                                           |       |                                    |       |           |       |                                     |       |
| Allowance for doubtful accounts            |       | $                                              | 72,714     |                                    | $          | 11,189         |       | $                                        | 83,903     |   | $ | — |   |
| For the year ended December 31, 2007: |       |                                           |       |                                    |       |           |       |                                     |       |
| Allowance for doubtful accounts            |       | $                                              | 39,256     |                                    | $          | 108,321        |       | $                                        | 74,863     |   | $ | 72,714 |   |
| For the year ended December 31, 2006: |       |                                           |       |                                    |       |           |       |                                     |       |
| Allowance for doubtful accounts            |       | $                                              | 38,011     |                                    | $          | 19,594         |       | $                                        | 18,349     |   | $ | 39,256 |   |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Certificate of Incorporation of the  Company, previously filed with the SEC as Exhibit 3.1 to the Company’s  Registration Statement on Form SB-2, specifically included in Amendment  No. 1 to such Registration Statement filed with the SEC on July 3,  1996 (File No. 333-4974-LA) (the “Registration Statement Amendment  No. 1”), which is incorporated herein by reference.                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2                 |       | Bylaws of the Company, previously filed  with the SEC as Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-Q for the period ended September 30, 1999, filed with the  SEC on November 12, 1999, which is incorporated herein by reference.                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| ** **          | ** ** | **Material Contracts Relating to Management Compensation Plans or  Arrangements**                                                                                                                                                                                                                                                                                                                                                                                                                            |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1                |       | Employment Agreement dated July 1,  1996, between the Company and Thomas C.K. Yuen, previously filed with the SEC  as Exhibit 10.8 to the Registration Statement Amendment No. 1,  which is incorporated herein by reference.                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2                |       | Amendment to Employment Agreement dated as  of March 14, 1997, between the Company and Thomas C.K. Yuen, previously  filed with the SEC as Exhibit 10.2 to the Company’s Annual Report on  Form 10-KSB for the fiscal year ended December 31, 1996, filed with  the SEC on March 31, 1997 (the “1996 Annual Report”), which is  incorporated herein by reference.                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3                |       | Employment Agreement dated July 1,  1996, between the Company and Alan D. Kraemer, previously filed with the SEC  as Exhibit 10.11 to the Registration Statement Amendment No. 1,  which is incorporated herein by reference.                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.4                |       | SRS Labs, Inc. Amended and Restated  1996 Non-employee Directors Stock Option Plan, as amended, previously filed  with the SEC as Appendix B to the Company’s Definitive Proxy Statement  dated and filed with the SEC on April 30, 2003, which is incorporated  herein by reference.                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.5                |       | Form of Indemnification Agreement,  previously filed with the SEC as Exhibit 10.20 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6                |       | Non-employee Director Compensation Policy  adopted by the Company’s Board of Directors on January 28, 2005,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Non-Employee Directors’ Stock Option Plan (Initial Appointment), previously  filed with the SEC as Exhibit 10.2 to the Company’s Current Report on  Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Non-Employee Directors’ Stock Option Plan (Re-Election), previously filed  with the SEC as Exhibit 10.3 to the Company’s Current Report on  Form 8-K filed with the SEC on February 3, 2005, which is  incorporated herein by reference.                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9                |       | Form of Non-Employee Director Stock  Option Agreement under the SRS Labs, Inc. Amended and Restated 1996  Long-Term Incentive Plan, previously filed with the SEC as Exhibit 10.4  to the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.10               |       | Form of Nonqualified Stock Option  Agreement under the SRS Labs, Inc. Amended and Restated 1996 Long-Term  Incentive Plan dated March 29, 2005 (Current participants under this  plan include the following officers: Thomas C.K. Yuen, Ulrich E. Gottschling,  Sarah Yang and Alan D. Kraemer), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed with  the SEC on April 4, 2005, which is incorporated herein by reference. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.11               |       | SRS Labs, Inc. 2005 Change in Control  Protection Plan approved April 27, 2005, previously filed with the SEC  as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  with the SEC on May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.12               |       | Form of Participation Agreement under  the SRS Labs, Inc. 2005 Change in Control Protection Plan for Selected  Executive Officers (Current participants under this plan include the  following officers: Thomas C.K. Yuen, Ulrich E. Gottschling, Sarah Yang, Jeff  Klass and Alan D. Kraemer) previously filed with the SEC as Exhibit 10.2  to the Company’s Current Report on Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.       |

 

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13               |       | SRS Labs, Inc. Amended and Restated  1996 Long-Term Incentive Plan, as amended, approved April 27, 2005,  previously filed with the SEC as Exhibit 10.5 to the Form 8-K filed  with the SEC on May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.14               |       | Employment Letter Agreement dated  June 24, 2005 by and between the Company and Michael Franzi, previously  filed with the SEC as Exhibit 10.1 to the Company’s Current Report on  Form 8-K filed with the SEC on August 18, 2005, which is  incorporated herein by reference.                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.15               |       | Offer Letter dated April 22, 2008 by and  between the Company and Jeff Klaas.                                                                                                                                                                                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.16               |       | Employment Letter Agreement dated  December 21, 2005 by and between the Company and Ulrich E. Gottschling,  previously filed with the SEC as Exhibit 99.1 to the Company’s Current  Report on Form 8-K filed with the SEC on December 29, 2005, which  is incorporated herein by reference.                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.17               |       | Form of Nonqualified Stock Option  Agreement under the SRS Labs, Inc. 1996 Amended and Restated Long-Term  Incentive Plan, as amended, previously filed with the SEC as  Exhibit 99.8 to the Company’s Current Report on Form 8-K filed with  the SEC on January 18, 2006, which is incorporated herein by reference.                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.18               |       | SRS Labs, Inc. Profit Sharing and  Bonus Plan, as amended on June 20, 2007, previously filed with the SEC  as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  with the SEC on June 25, 2007, which is incorporated herein by  reference.                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.19               |       | SRS Labs, Inc. 2006 Stock Incentive Plan,  as amended on December 17, 2007, previously filed with the SEC as Exhibit 10.1  to the Company’s Current Report on Form 8-K filed with the SEC on  December 21, 2007, which is incorporated herein by reference.                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.20               |       | Form of Stock Option Award Agreement  under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously filed  with the SEC as Exhibit 10.9 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.21               |       | Form of Restricted Share Award  Agreement under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously  filed with the SEC as Exhibit 10.10 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.22               |       | Form of Restricted Share Unit Award  Agreement under the SRS Labs, Inc. 2006 Stock Incentive Plan, previously  filed with the SEC as Exhibit 10.11 to the Company’s Quarterly Report on  Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.23               |       | Form of SAR Award Agreement under the  SRS Labs, Inc. 2006 Stock Incentive Plan, previously filed with the SEC  as Exhibit 10.12 to Amendment No. 1 to the Company’s Quarterly  Report on Form 10-Q, Amendment No. 1, filed with the SEC on  September 22, 2006, which is incorporated herein by reference.                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.24               |       | SRS Labs, Inc. Patent Reward Program,  previously filed as Exhibit 10.2 to the Company’s Form 8-K filed  with the SEC on June 28, 2006, which is incorporated herein by  reference.                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| ** **          | ** ** | **Other Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.25               |       | Industrial Real Estate Lease dated  May 27, 2008, between the Company and Daimler Commerce  Partners, L.P.                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.26               |       | Stock Divestment Agreement dated July 1,  1996, between the Company, Thomas C.K. Yuen, Stephen V. Sedmak and Walter W.  Cruttenden III, previously filed with the SEC as Exhibit 10.17 to the  Company’s Registration Statement on Form SB-2, specifically included in  Amendment No. 2 to such Registration Statement file with the SEC on  August 2, 1996 (File No. 333-4974-LA), which is incorporated herein  by reference. |
|                     |            |                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  |

 

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                        |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | **Other  Exhibits**                                                                                                                                                                    |
| ** **          | ** ** | ** **                                                                                                                                                                             |
| 21                  |       | Subsidiaries of the Company.                                                                                                                                                           |
|                |       |                                                                                                                                                                                   |
| 23.1                |       | Consent of Independent Registered Public  Accounting Firm, Squar, Milner, Peterson, Miranda &  Williamson, LLP, dated February 23, 2009.                            |
|                |       |                                                                                                                                                                                   |
| 31.1                |       | Certification of the Chief Executive  Officer of SRS Labs, Inc., pursuant to Section 302 of the Sarbanes-  Oxley Act of 2002.                                                |
|                |       |                                                                                                                                                                                   |
| 31.2                |       | Certification of the Chief Financial  Officer of SRS Labs, Inc., pursuant to Section 302 of the Sarbanes-  Oxley Act of 2002.                                                |
|                |       |                                                                                                                                                                                   |
| 32.1                |       | Certification of Chief Executive Officer of  SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                                                   |
| 32.2                |       | Certification of Chief Financial Officer of  SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                     |            |                                                                                                                                                                                        |  |

 

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