**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20549**

**FORM 10-K**

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| ý | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934** |
|--------|---------------------------------------------------------------------------------------------|

**Forthe Fiscal Year Ended: December 31, 2001**

**OR**
| o | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934** |
|---|-------------------------------------------------------------------------------------------------|

 

**CommissionFile Number:****0-25520**

 

**CENTERSPAN COMMUNICATIONS CORPORATION**

(Exact name of registrantas specified in its charter)

 

| **Oregon**                                                                 |   | **93-1040330**                        |
|----------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization)            |   | (I.R.S. Employer  Identification No.) |
|                                                                       |   |                                  |
| **7175 NW Evergreen Parkway #400****Hillsboro,  Oregon**                   |   | **97124-5839**                        |
| (Address of principal  executive offices)                                  |   | (Zip Code)                            |
|                                                                       |   |                                  |
| Registrant’s telephone  number, including area code: **503-615-3200** |

 

Securitiesregistered pursuant to Section 12(b) of the Act:**None**

Securitiesregistered pursuant to Section 12(g) of the Act: **Common Stock**

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Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days: Yes ý      No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of Registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K, or anyamendment to this Form 10-K.   o

 

The aggregate market value of the voting stock held by non-affiliatesof the Registrant was $52,125,998 as of March 20, 2002 based upon the lastsales price ($8.15) as reported by the Nasdaq National Market System.

 

The number of shares outstanding of the Registrant’s common stock as ofMarch 20, 2002 was 9,736,774 shares.

 

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**Documents Incorporated by Reference**

The Registrant will incorporate into Part III of Form 10–K, byreference, portions of its Proxy Statement for its 2002 Annual Meeting ofShareholders.

 

 

 

**CENTERSPAN COMMUNICATIONS CORPORATION**

**2001 FORM 10-K ANNUAL REPORT**

**TABLE OFCONTENTS**

 

 
|       | **PART I**                                                                                  |
|------------|---------------------------------------------------------------------------------------------|
|       |                                                                                        |
| Item 1.    | Business                                                                                    |
|       |                                                                                        |
| Item 2.    | Properties                                                                                  |
|       |                                                                                        |
| Item  3.   | Legal Proceedings                                                                           |
|       |                                                                                        |
| Item 4.    | Submission  of Matters to a Vote of Security Holders                                        |
|       |                                                                                        |
|       | **PART II**                                                                                 |
|       |                                                                                        |
| Item 5.    | Market  for Registrant’s Common Equity and Related Stockholder Matters                 |
|       |                                                                                        |
| Item 6.    | Selected Financial Data                                                                     |
|       |                                                                                        |
| Item 7.    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|       |                                                                                        |
| Item  7A.  | Quantitative  and Qualitative Disclosures About Market Risk                                 |
|       |                                                                                        |
| Item 8.    | Consolidated  Financial Statements and Supplementary Data                                   |
|       |                                                                                        |
| Item 9.    | Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure       |
|       |                                                                                        |
|       | **PART III**                                                                                |
|       |                                                                                        |
| Item  10.  | Directors  and Executive Officers of the Registrant                                         |
|       |                                                                                        |
| Item  11.  | Executive Compensation                                                                      |
|       |                                                                                        |
| Item  12.  | Security  Ownership of Certain Beneficial Owners and Management                             |
|       |                                                                                        |
| Item  13.  | Certain Relationships  and Related Transactions                                             |
|       |                                                                                        |
|       | **PART IV**                                                                                 |
|       |                                                                                        |
| Item  14.  | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                            |
|       |                                                                                        |
| Signatures |                                                                                        |
|            |                                                                                             |  |

 

1

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**PART I**

 

*This Annual Report on Form 10-Kcontains “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. The Act provides a “safe harbor” for forward-looking statements toencourage companies to provide prospective information about themselves so longas they identify these statements as forward-looking and provide meaningfulcautionary statements identifying important factors that could cause actualresults to differ from the projected results. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,”“seeks,” “estimates,” and similar expressions identify forward-lookingstatements.  However, the absence ofthese words does not mean the statement is not forward-looking.  All statements other than statements ofhistorical fact that we make in this Annual Report on Form 10-K are forward-looking.  In particular, these forward-lookingstatements include statements regarding: the adequacy of funds to meet ourcurrent or future cash needs; the development and launch of contentdistribution products and services such as C-StarTM and ScourTM; future revenueand revenue sources and models; and upcoming research and engineering andselling, general and administrative expenses and capital expenditures.*

 

*We cannot guarantee any of theforward-looking statements, which are subject to risks, uncertainties and assumptionsthat are difficult to predict.  Actualresults may differ materially from those we forecast in forward-lookingstatements due to a variety of factors, including some of those set forth inthe Factors That May Affect Forward-Looking Statements section of this AnnualReport on Form 10-K.  We do not intendto update any forward-looking statements due to new information, future eventsor otherwise.  If we do update or correctone or more forward-looking statements, investors and others should not concludethat we will make additional updates or corrections with respect to otherforward-looking statements.*

 

**Item 1****.  Business**

 

**Overview**

 

CenterSpan Communications Corporation is a venture stage company thatdevelops and markets software that provides secure Internet content deliverysolutions for media and communications service providers and large corporatecustomers.  C-StarTM CDN Services 2.0,our current offering announced in February 2002, is a suite of modular,low-cost, content delivery solutions for delivering digital audio, video anddata files.  Components of C-StarTMenable content preparation, publishing, security, delivery and data analysisfor media and entertainment, communications service providers and largecorporate customers for their internal use.

 

Our C-StarTM CDN Services suite is targeted at the Content DistributionNetwork (CDN) market serving communications service providers such as telecomcompanies, Multiple Service Operators (MSOs) and Internet Service Providers(ISPs), and media service providers like movie studios, music labels,publishers, distributors and portals. We are also developing product solutions based on C-StarTM technology tosell to potential customers such as large corporations that desire to own andoperate their own content delivery network.

 

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**Background**

 

CenterSpan was originally incorporated in 1990 as ThrustMaster, Inc.,an Oregon corporation.  The ThrustMasterhardware business accounted for the bulk of revenues and expenses from ourfounding in 1990 through 1997, when we determined that we could not achieve theeconomies of scale necessary to be profitable in the game controller market inthe foreseeable future and concluded that we should sell the hardware businessand invest the proceeds in our software business.  The hardware business was sold in July 1999 for $15 million incash.  We changed our name to CenterSpanCommunications Corporation in October 1999.

 

In 1999, we began developing and marketing peer-to-peer Internetcommunication, collaboration and distribution solutions, releasing two retailsoftware products.  In 2000, we releasedSocket, our instant messaging product incorporating a “Launch and Connect”technology licensed from Intel Corporation, which allowed groups to launch andparticipate in online activities (e.g. multi-player online video games) whilecontinuing to communicate through voice or text conferencing over the Internet.The adoption rate of Socket was less than expected, we believe, primarily dueto a lack of open standards for communications between instant messagingproducts.  The revenue model for 2000for the Socket product was based on expected affiliate fees to be received frome-commerce partners for sales of multi-player applications, such as videogames, generated by comparison of capabilities of Socket users.  We discontinued distribution efforts relatedto Socket in the fourth quarter of 2000 and are no longer promoting ormarketing Socket.

 

**DigitalDistribution Solutions**

 

In the third quarter of 2000, we began development of a peer-to-peerfile sharing and search network utilizing digital rights management technology,code-named C-StarTM.  In December 2000, we purchased certain assetsof Scour, Inc. for $5.8 million in cash and 333,333 shares of our commonstock.  We began beta testing ofthe new ScourTM, which incorporates our C-StarTM technology, in March 2001 as ashowcase music and video distribution network, which provides digital contentfree to the end user.  The new ScourTM wasthe first application of C-StarTM representing a secure and legal digitaldistribution channel that integrates peer-to-peer technology with digitalrights management support.  In July2001, we began marketing C-StarTM as a digital distribution service.  We signed our first customer for theservice, Jewishstreet.com, in September 2001. We are currently working withJewishstreet.com to integrate their websites with C-StarTM CDN Services 2.0.

 

In February 2002, we entered into an agreement with Sony Music underwhich Sony will make recordings available from its catalog of musicperformances for us to digitally distribute via C-StarTM CDN Services 2.0 tovarious C-StarTM service provider customers and their subscribers in the UnitedStates and Canada.  The agreement allowsus to provide music from Sony Music Entertainment artists to a wide variety ofonline service providers seeking to offer their subscribers streaming anddownloadable music and to ScourTM.  TheSony agreement is the first step in our strategy to aggregate music and videocontent so that we may offer this content to potential C-StarTM service providercustomers to increase the value of our software solution.  We intend to enter into similar arrangementswith additional music labels and movie studios to obtain content.  Pursuant to the Sony agreement, we issued toSony 283,556 shares of our common stock and a warrant to purchase 189,037additional shares of our common stock at an exercise price of $8.11 per share.  We also agreed to pay

 

3

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an initial content integration fee of $500,000 in connection withexecution of the agreement and an additional content integration fee of$500,000 on September 1, 2002, as well as quarterly advance minimum servicefees of $250,000 for four quarters beginning September 1, 2002.

 

**ProductDevelopment and Technology**

 

To enable faster downloads and to deliver a better streaming experiencefor end users, C-StarTM uses advanced peer-to-peer (P2P) networking technologiesthat deliver digital content more efficiently and more cost-effectively thantraditional central server-based Content Distribution Network (CDN)systems.  Using C-StarTM, serviceproviders have the flexibility to cost effectively scale their offerings to fita variety of business models, including pay-per-use, downloadable or streamingcontent.  To safeguard copyrights andprotect digital files from tampering and viruses, C-StarTM includesmarket-leading tiered security solutions. Service providers can deliver fast, top quality rich media without largebandwidth and infrastructure costs. C-Star’sTM advanced networkinginfrastructure uses our Intelligent Caching technology to guarantee thatend-users obtain the fastest downloads and highest-quality streams. C-Star’sTM TieredSecurity provides the highest level of security available in the commercialmarket for all types of content.

 

C-StarTM CDN Enterprise, a software product scheduled for release laterin 2002, will enable organizations to more efficiently distribute corporatecommunications, eLearning and training materials, product demonstrations andother digital files to employees, customers, partners and investors.  C-StarTM enables the delivery of digitalmedia over the Internet or a company intranet. Enterprises will have the ability to deliver time-sensitivecommunications, training materials and documents, while reducing intranetbandwidth bottlenecks and controlling infrastructure costs through the use ofthis product.

 

**Research and Engineering**

 

Research and engineering expenses consist primarily of salaries andrelated expenses, consultant fees and the cost of software used in productdevelopment.  Research and engineeringexpenses were $8.4 million, $4.9 million and $3.3 million, respectively, in2001, 2000 and 1999.

 

Research and engineering expenses in 2001 primarily relate to thedevelopment of the C-StarTM technology and the development and beta launch ofthe new ScourTM.  Included in the $8.4million for 2001 is $580,000 for the impairment of technology that waspurchased from Scour, Inc. in December 2000. We determined that the $580,000 impairment charge was necessary becausewe are using the C-StarTM technology that we developed internally rather thanusing the technology purchased from Scour. The technology purchased from Scour is not expected to produce futurecash flows.  In addition, the 2001amount includes $750,000 for the value of common stock issued in exchange forcertain technology from Supertracks.com, Inc. in August 2001, which wasexpensed since the product in which the technology is being incorporated hadnot yet achieved technological feasibility and has no future alternativeuse.  We plan to make investments inresearch and engineering during 2002 similar to those made in 2001 to continuedeveloping the C-StarTM technology, develop the C-StarTM CDN Enterprise productand upgrade and maintain the new ScourTM technology showcase.

 

4

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**Sales,Distribution and Marketing**

 

We intend to use a combination of a direct sales group and marketingpartnerships with market leaders and system integrators with respect to serviceand technology product licensing.

 

We are pursuing two primary revenue opportunities utilizing the C-StarTMtechnology:

1.                    By providing the C-StarTM peer-to-peerdigital distribution solution to third parties as a service, C-StarTM CDN Service, in areas such as delivery of entertainment content (music and videofiles), primarily charging fees on a transaction basis; and

2.                    By sellingC-StarTM CDN Enterprise and other product solutions and related integrationservices.

 

In September 2001, we announced the first customer for C-StarTM digitaldistribution service.  Revenue from thisand other potential C-StarTM customers is expected to begin in the second halfof 2002.

 

In February 2002, we entered into an agreement with Sony Music underwhich Sony will provide us with certain musical content and otherservices.  We intend to resell the Sonymusic and any other music and video content to our C-StarTM CDN Servicecustomers to provide added value.  See *Digital Distribution Solutions*above.

 

Due to our emphasis on C-StarTM technology solutions as a result ofinterest by potential customers, and the lack of currently available digitalmusic and video content to launch a viable subscription service, we deferredthe launch of a ScourTM paid subscription service, which had been planned forthe fourth quarter of 2001.  We areevaluating whether to launch a ScourTM paid subscription service or to continueto use ScourTM as a technology showcase and as a means to attract more hosts forC-StarTM.

 

**Competition**

 

The Internet digital distribution businessis competitive and many of our competitors may have greater resources andexperience than we do.  We expectcompetition to increase in the future. Our principal competitors includeContent Distribution Network (CDN) service and product vendors, such as Akamai,Digital Island, Inktomi and Kontiki, Internet music distributors that usedigital download, peer-to-peer or streaming technologies, such as MP3.com,Napster, Liquid Audio, Press Play and Real Networks, music labels and moviestudios, as well as providers of digital entertainment services such asMusicNet, Listen.com and RioPort.  Manyof our competitors may have advantages over us, including:

•        Longeroperating histories;

•        Largercustomer bases;

•        Substantiallygreater financial, technical, sales and marketing resources;

•        Greatername recognition; and

•        Theability to more easily provide a comprehensive software solution.

 

5

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**IntellectualProperty**

 

Some of the intellectual property rights used in the development of oursoftware products, but that we no longer use, are licensed from IntelCorporation.  These licenses were expensedas research and development in prior years and expire August 21, 2005.  We have applied for registration of thenames CenterSpanTM, Scour ExchangeTM, ScourTM and C-StarTM.  We rely on patent, trademark and copyrightlaw, trade secret protection and confidentiality agreements with our employees,strategic partners and others to protect our proprietary rights.  In October 2001, we filed for two additionalpatents to protect multi-source peer streaming technology developedinternally.  We also have applicationsfiled for 12 provisional and utility patents surrounding technology.  Although we believe that our products,processes and trademarks do not infringe on the rights of others, third partiesmay assert infringement or other related claims against us in the future. Anyinfringement claim or related litigation against us, or any challenge to thevalidity of our own intellectual property rights, or the expense and effort ofdefending those claims, could materially and adversely affect our business,financial condition and results of operations.

 

**Employees**

 

As of December 31, 2001, we had a total of 67 full-time employees.  At times, we supplement our workforce withtemporary contract workers.  None of ouremployees are represented by a labor union. We have not experienced any workstoppages and consider our relations with our employees to be good.

 

**Item 2****.  Properties**

 

We maintain our headquarter facilities in Hillsboro, Oregon, inapproximately 22,000 square feet of leased space under a lease expiring in September2003.  We maintain our Los Angelesoffice in approximately 4,300 square feet of leased space under a leaseexpiring in April 2005.  We believe ourfacilities are adequate for our immediately foreseeable needs and that suitableadditional or alternative space will be available on commercially reasonableterms if needed.

 

In addition, we lease space for the storage of certain of our serversand related technology infrastructure under a three-year lease, which expiresJanuary 2005.  We can terminate thislease anytime after January 2003 without penalty with a 30-day written noticeto the lessor.

 

**Item 3****.  LegalProceedings**

 

In May 2001, Ingram Micro, Inc. filed a lawsuit against us in the U.S.District Court for Oregon.  The disputeconcerned Ingram’s ability to return our merchandise for which it acted as adistributor in 1999.  The amount of theclaim was approximately $450,000 plus pre-judgment interest.  We settled this matter in November 2001 for$225,000.  We paid  $100,000 on December 1, 2001 and $62,500 onFebruary 1, 2002 and will pay an additional $62,500 on April 1, 2002.

 

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

 

No matters were submitted to a vote of security holders during thequarter ended December 31, 2001.

 

6

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**PART II**

 

**Item 5****.  Marketfor the Registrant’s Common Equity and Related Stockholder Matters**

 

Our common stock is traded on the Nasdaq National Market under thesymbol CSCC.  The high and low salesprices for the two years in the period ended December 31, 2001 were as follows:

 

| **2000**  |   | **High** |   | **Low** |   |
|-----------|--------|----------|--------|---------|--------|
| Quarter 1 |   | $        | 32.50  |    | $      | 19.25 |   |
| Quarter 2 |   | 20.25    |   | 10.50   |   |
| Quarter 3 |   | 18.50    |   | 9.88    |   |
| Quarter 4 |   | 12.38    |   | 5.25    |   |
|           |        |          |        |         |        |  |  |

 

| **2001**  |   | **High** |   | **Low** | ** ** |
|-----------|--------|----------|--------|---------|------------|
| Quarter 1 |   | $        | 20.31  |    | $          | 11.00 |   |
| Quarter 2 |   | 17.71    |   | 9.02    |       |
| Quarter 3 |   | 13.64    |   | 5.15    |       |
| Quarter 4 |   | 11.72    |   | 6.00    |       |
|           |        |          |        |         |            |  |  |

 

The approximate number of beneficial shareholders and shareholders ofrecord at March 29, 2002 were 3,100 and 94, respectively.  There were no cash dividends declared orpaid in 2001 or 2000.  We do notanticipate declaring cash dividends in the foreseeable future.

 

In February 2002, we entered into an agreement with Sony Music pursuantto which we issued to Sony 283,556 shares of our common stock and a warrant topurchase 189,037 shares of our common stock at an exercise price of $8.11 pershare that is immediately exercisable and expires February 28, 2005 in exchangefor access to certain musical content for us to distribute digitally via ourC-StarTM content delivery network.  The283,556 shares of common stock had a value of $1.7 million, representing anapproximately 25% discount from the trailing 10-day volume-weighted averageprice of our common stock.  Sonyrepresented that it is an accredited investor within the meaning of Rule 501(a)under the Securities Act of 1933. In issuing these securities, we relied on anexemption from the registration requirements pursuant to Rule 506 under Section4(2) of the Securities Act of 1933.

 

In February 2002, we sold 662,667 units to a total of twelve accreditedinvestors for $6.00 per unit for total proceeds to us of $4.0 million.  The price per unit reflected anapproximately 25% discount from the trailing 10-day volume-weighted averageprice of our common stock, with a premium of approximately 35% for the attachedwarrant.  Each unit consists of oneshare of our common stock and a warrant to purchase one share of our commonstock for $10.67 per share.  Thewarrants are immediately exercisable and expire February 11, 2005.  The proceeds from the sale of these unitsare being used to fund current operations. None of the twelve accreditedinvestors purchased nor holds a significant position in our common stockfollowing this private placement.  Inissuing these securities, we relied on an exemption from the registrationrequirements pursuant to Rule 506 under Section 4(2) of the Securities Act of1933.

 

The twelve accredited investors were: AIG DKR SoundShore Holdings,Ltd., AIG DKR SoundShore Opportunity Holding Fund, Ltd., AIG DKR SoundShorePrivate Investors Holding Fund, Ltd., AIG DKR SoundShore Strategic Holding FundLtd., Louise G. Brooks IRA, Gryphon Master Fund, L.P., Frank G. Hausmann, Jr.,Langley Partners, L.P., Quantico Partners, L.P., Steelhead Investments Ltd.,Synapse Fund II, LLC and TCMP.  Eachinvestor represented that it is an “accredited investor” within the meaning ofRule 501(a) under the Securities Act of 1933.

 

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In March 2002, we sold 333,333 units to a total of six accredited investorsfor $6.00 per unit for total proceeds to us of $2.0 million.  The price per unit reflected anapproximately 25% discount from February’s trailing 10-day volume-weightedaverage price of our common stock, with a premium of approximately 35% for the attachedwarrant.  Each unit consists of oneshare of our common stock and a warrant to purchase one share of our commonstock for $10.67 per share.  Thewarrants are immediately exercisable and expire March 29, 2005.  The proceeds from the sale of these unitsare being used to fund current operations. None of the six accredited investors purchased nor holds a significantposition in our common stock following this private placement.  In issuing these securities, we relied on anexemption from the registration requirements pursuant to Rule 506 under Section4(2) of the Securities Act of 1933.

 

The six accredited investors were: AIG DKR SoundShore Holdings, Ltd.,AIG DKR SoundShore Opportunity Holding Fund, Ltd., AIG DKR SoundShore PrivateInvestors Holding Fund, Ltd., AIG DKR SoundShore Strategic Holding Fund Ltd.,Gryphon Master Fund, L.P. and Quantico Partners, L.P.  Each investor represented that it is an “accredited investor”within the meaning of Rule 501(a) under the Securities Act of 1933.

 

We have agreed to file a registration statement under the SecuritiesAct of 1933 to cover the resale of the shares issued with the units, the sharesissuable pursuant to the warrants included with the units, the shares issued toSony and the shares issuable pursuant to the warrant issued to Sony.  Once the registration statement becomeseffective, the shares will be freely tradable under the Securities Act of 1933so long as the registration statement remains in effect.

 

8

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**Item 6****.  Selected Financial Data**

 

The following selected consolidated financial data should be read inconjunction with our consolidated financial statements and the related notesthereto.  On July 26, 1999, our Board ofDirectors approved the sale of our hardware business assets. We have presentedthe hardware business as a discontinued operation in the selected consolidatedfinancial data presented below.

 
|                                                                                                                     |   | **Year Ended  December 31,**                 |    |
|--------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------|---------|
|                                                                                                                     |   | **2001**                                     |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                                                     |   | **IN  THOUSANDS (except per share amounts)** |    |
| ***Consolidated Statement of Operations Data***                                                                          |   |                                         |    |   |   |   |   |   |   |   |   |
| Revenues                                                                                                                 |   | $                                            | 51      |   | $ | 1 |   | $ | 787 |   | $ | — |   | $ | — |   |
| Cost of goods  sold                                                                                                      |   | —                                       |    | — |   | 569 |   | — |   | — |   |
| Gross profit                                                                                                             |   | 51                                           |    | 1 |   | 218 |   | — |   | — |   |
| Operating  expenses:                                                                                                     |   |                                         |    |   |   |   |   |   |   |   |   |
| Research and  engineering                                                                                                |   | 8,403                                        |    | 4,865 |   | 3,282 |   | 162 |   | — |   |
| Selling, general  and administrative                                                                                     |   | 13,521                                       |    | 5,499 |   | 2,474 |   | 935 |   | 495 |   |
| Total operating  expenses                                                                                                |   | 21,924                                       |    | 10,364 |   | 5,756 |   | 1,097 |   | 495 |   |
| Loss from  operations                                                                                                    |   | (21,873                                      | )       | (10,363 | ) | (5,538 | ) | (1,097 | ) | (495 | ) |
| Interest income                                                                                                          |   | 399                                          |    | 895 |   | 417 |   | 64 |   | 304 |   |
| Interest expense                                                                                                         |   | (62                                          | )       | — |   | — |   | — |   | — |   |
| Loss from  beneficial conversion feature                                                                                 |   | —                                       |    | — |   | (987 | ) | — |   | — |   |
| Loss from  continuing operations before income taxes                                                                     |   | (21,536                                      | )       | (9,468 | ) | (6,108 | ) | (1,033 | ) | (191 | ) |
| Provision for  income taxes                                                                                              |   | —                                       |    | — |   | (4,532 | ) | — |   | — |   |
| Loss from  continuing operations                                                                                         |   | (21,536                                      | )       | (9,468 | ) | (10,640 | ) | (1,033 | ) | (191 | ) |
| Income (loss)  from discontinued operations, net of tax provision (benefit) of $0, $0,  $(5,792), $1,615 and $1,370 |   | —                                       |    | — |   | (5,207 | ) | (8,023 | ) | 3,388 |   |
| Gain on disposal  of discontinued operations, net                                                                        |   | 674                                          |    | — |   | 6 |   | — |   | — |   |
| Net income  (loss)                                                                                                       |   | $                                            | (20,862 | ) | $ | (9,468 | ) | $ | (15,841 | ) | $ | (9,056 | ) | $ | 3,197 |   |
| Loss per share  from continuing operations:                                                                              |   |                                         |    |   |   |   |   |   |   |   |   |
| Basic and  diluted                                                                                                       |   | $                                            | (2.59   | ) | $ | (1.52 | ) | $ | (2.11 | ) | $ | (0.24 | ) | $ | (0.04 | ) |
| Income (loss)  per share from discontinued operations:                                                                   |   |                                         |    |   |   |   |   |   |   |   |   |
| Basic                                                                                                                    |   | $                                            | 0.08    |   | $ | — |   | $ | (1.03 | ) | $ | (1.83 | ) | $ | 0.79 |   |
| Diluted                                                                                                                  |   | $                                            | 0.08    |   | $ | — |   | $ | (1.03 | ) | $ | (1.83 | ) | $ | 0.73 |   |
| Net income  (loss) per share:                                                                                            |   |                                         |    |   |   |   |   |   |   |   |   |
| Basic                                                                                                                    |   | $                                            | (2.51   | ) | $ | (1.52 | ) | $ | (3.14 | ) | $ | (2.07 | ) | $ | 0.75 |   |
| Diluted                                                                                                                  |   | $                                            | (2.51   | ) | $ | (1.52 | ) | $ | (3.14 | ) | $ | (2.07 | ) | $ | 0.69 |   |
| Shares used in  per share calculations:                                                                                  |   |                                         |    |   |   |   |   |   |   |   |   |
| Basic                                                                                                                    |   | 8,309                                        |    | 6,231 |   | 5,038 |   | 4,380 |   | 4,268 |   |
| Diluted                                                                                                                  |   | 8,309                                        |    | 6,231 |   | 5,038 |   | 4,380 |   | 4,660 |   |

 
| **December  31,**                     |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|---------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| ***Consolidated Balance Sheet Data*** |   |     |   |     |   |     |   |     |   |     |   |
| Working capital                       |   | $        | 4,615  |     | $      | 6,998    |   | $        | 15,535 |     | $      | 10,685 |   | $ | 18,361 |   |
| Total assets                          |   | 11,308   |   | 20,855   |   | 19,357   |   | 25,954   |   | 26,092   |   |
| Total liabilities                     |   | 1,379    |   | 3,165    |   | 3,397    |   | 14,401   |   | 6,812    |   |
| Shareholders’  equity            |   | 9,929    |   | 17,690   |   | 15,960   |   | 11,553   |   | 19,280   |   |
|                                       |        |          |        |          |        |          |        |          |        |          |        |  |  |  |  |  |

 

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**Item 7****.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**General**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations should be read in conjunction with the consolidated financialstatements and notes thereto, included elsewhere in this Annual Report on Form10-K.

 

**ContinuingOperations**

 

We are a venture stage company.  Our continuing operations consist ofour software business, which began in mid-1998.

 

In the third quarter of 2000, we began development of a peer-to-peerfile sharing and search network utilizing digital rights management technology,code-named C-StarTM.  In December 2000, we purchased certain assetsof Scour, Inc. for $5.8 million in cash and 333,333 shares of our commonstock.  We began beta testing ofthe new ScourTM, which incorporates our C-StarTM technology, in March 2001 as ashowcase music and video distribution network, which provides digital contentfree to the end user.  The new ScourTMwas the first application of C-StarTM representing a secure and legal digitaldistribution channel that integrates peer-to-peer technology with digitalrights management support.  In July2001, we began marketing C-StarTM as a digital distribution service.  We signed our first customer for theservice, Jewishstreet.com, in September 2001. We are currently working withJewishstreet.com to integrate their websites with C-StarTM CDN Services2.0.  Revenue from Jewishstreet.com andother potential C-StarTM customers is expected to begin in the second half of2002.  At December 31, 2001, C-StarTMremained a beta release as technological feasibility had not yet been met.

 

In February 2002, we entered into an agreement with Sony Music, underwhich Sony will make recordings available from its catalog of musicperformances for us to digitally distribute via C-StarTM CDN Services 2.0 tovarious C-StarTM service provider customers and their subscribers in the UnitedStates and Canada.  In exchange, weissued Sony 283,556 shares of our common stock and a warrant to purchase189,037 shares of our common stock at an exercise price of $8.11 pershare.  In addition, we agreed to pay aninitial content integration fee of $500,000 in connection with execution of theagreement and an additional content integration fee of $500,000 on September 1,2002, as well as quarterly advance minimum service fees of $250,000 for fourquarters beginning September 1, 2002. The total value of the stock, warrants and cash was $3.7 million.

 

We intend to use a combination of a direct sales group and marketingpartnerships with market leaders and system integrators with respect to serviceand technology product licensing.  TheSony agreement is the first step in our strategy to aggregate music and videocontent so that we may offer this content to potential C-StarTM service providercustomers to increase the value of our software solution.  We intend to enter into similar arrangementswith additional music labels and movie studios to obtain content.

 

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We are pursuing two primary revenue opportunities utilizing the C-StarTMtechnology:

1.                    By providing the C-StarTM peer-to-peerdigital distribution solution to third parties as a service, C-StarTM CDN Service, in areas such as delivery of entertainment content (music and videofiles), primarily charging fees on a transaction basis; and

2.       Byselling C-StarTM CDN Enterprise and other product solutions and relatedintegration services

 

Due to our emphasis on C-StarTM technology solutions as a result ofinterest by potential customers, and the lack of currently available digitalmusic and video content to launch a viable subscription service, we deferredthe launch of a ScourTM paid subscription service, which had been planned forthe fourth quarter of 2001.  At thistime we are evaluating whether to launch a ScourTM paid subscription service orto continue to use ScourTM as a technology showcase and as a means to attractmore hosts for C-StarTM.

 

**CriticalAccounting Policies**

 

The preparation of our financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses. Our estimates are based on historical experience and on various otherassumptions that we believe are reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources.Pursuant to December 2001 Securities and Exchange Commission guidance, we haveprepared the following discussion of critical accounting policies.  See note 1 to our consolidated financialstatements, *Summaryof Significant Accounting Policies*, for additional information.

 

Our critical accounting policies include thefollowing:

 

•        Accountingfor intangible assets;

•        Revenuerecognition; and

•        Purchasedtechnology

 

An explanation of thesensitivity of financial statements to the methods, assumptions and estimatesunderlying their preparation and the interplay of specific uncertainties withaccounting measurements follows:

 

***Intangible Assets***

 

Intangible assets primarilyconsist of a customer list and a trade name purchased during 2000 from Scour,Inc. We reviewidentifiable intangibles for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. We determine impairment based on a comparison of the carryingamount of the assets to the estimated fair value of the assets, which isdetermined based on the discounted cash flow method or current market pricesfor similar assets when available.  Upon adoption of Statement of Financial AccountingStandards No. 142 “Goodwill and Other Intangible Assets” (SFAS No. 142) inJanuary 2002, intangible assets with estimable useful lives areamortized over their respective estimated useful lives to their estimated residualvalues, and reviewed for impairment in accordance with SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto be Disposed of.”  SFAS No. 121 isbeing superseded by SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived

 

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Assets,” effective January 1, 2002.  If we change the estimates used in theassessment of recoverability for intangible assets, such as our estimates ofanticipated future revenues or of the life of the associated technologies, wemay determine that our intangible assets have a lower net realizablevalue.  This, in turn, would increaseour reported operating expenses, and lower our net income, but have no effecton our cash flows.

 

***Revenue Recognition***

 

In compliance with the Securities and Exchange Commission (SEC) StaffAccounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” andSFAS 48, “Revenue Recognition When Right of Return Exists,” we recognize revenuewhen the earnings process is complete. The earnings process is considered complete when persuasive evidences ofan arrangement between the customer and us exists, when delivery and acceptancehas occurred or services have been rendered, when pricing is fixed ordeterminable, when any right of return lapses or is reasonably estimable, andwhen collectibility is reasonably assured. We consider differing market conditions such as the relative financialcondition of our customer.  Theseconditions do not impact the method by which we recognize revenues, howeversuch conditions could impact the allowance for returns or receivables.

 

***Research and Development, PurchasedTechnology and Software Development Costs***

 

We follow SFAS No. 2,“Accounting For Research and Development Costs,” and charge all research anddevelopment costs to expense as incurred. The costs of intangibles that are purchased from others for use inresearch and development activities and that have alternative future uses arecapitalized.  Those intangiblespurchased for research that do not have an alternative future use in otherresearch projects or otherwise are expensed as incurred.

 

We follow SFAS No. 86,“Accounting for the Costs of Computer Software to be Sold, Leased, or OtherwiseMarketed.”  Costs incurred for thedevelopment of computer software and enhancements to existing software productsthat will be sold, leased, or otherwise marketed are capitalized whentechnological feasibility has been established. To date, we have never capitalizedany computer software development costs.

 

**Resultsof Continuing Operations**

 

**YearEnded December 31, 2001 Compared to 2000**

 

***Revenues***

Total revenues were $51,000 in 2001 compared to $1,000 in 2000.  The revenue generated in 2001 relates toadvertising placed on the Scour.com website by third parties.  The revenue generated in 2000 relates toSocket, our Internet communication product, which we are no longer marketing.In September 2001, we announced the first customer for C-StarTM.  Revenue from this customer and otherpotential C-StarTM customers is expected to begin in the second half of2002.  Due to our emphasis on C-StarTM,and the lack of available digital music and video content to launch a viablesubscription service, we have deferred the launch of a paid subscriptionversion of ScourTM to at least the fourth quarter of 2002.  Potential customers’ interest in C-StarTM hascaused us to focus on achieving revenue from the sale of C-StarTM CDN Servicesand C-StarTM products under development. We may continue to use ScourTM as a showcase for C-StarTM and as a meansof maintaining hosts for the C-StarTM network, and we may never launch asubscription version.

 

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***Gross Profit***

Gross profit for 2001 was $51,000 (100% of revenue), which wasgenerated by advertising placed on the Scour.com website by third parties,compared to $1,000 (100% of revenue) in 2000, which was generated by affiliatefees from e-commerce partners relative to the SocketTM product.

 

***Research and Engineering***

Research and engineering expenses consist primarily of salaries andrelated expenses, consultant fees and the cost of purchased technology used inproduct development.  Research andengineering expenses were $8.4 million in 2001 compared to $4.9 million in2000.  Amounts incurred for research andengineering in 2001 primarily relate to the development and beta launch of thenew ScourTM in March 2001 and development of the C-StarTM technology.  The increase in 2001 compared to 2000 isprimarily due to a $2.0 million increase in salaries, contract labor andrelated costs for developing the C-StarTM technology, a $1.2 million increase indepreciation and other infrastructure costs related to C-StarTM, the impairmentof $580,000 of technology, which was purchased from Scour, Inc. in December2000, and the purchase of $750,000 of technology from Supertracks.com, Inc. inAugust 2001, which was expensed because the product into which the technologyis being incorporated had not yet achieved technological feasibility and thetechnology had no alternative future use. We determined that the $580,000 impairment charge was necessary becausewe are utilizing the C-StarTM technology that we developed internally ratherthan the technology purchased from Scour. The technology purchased from Scour is not expected to produce futurecash flows.

 

Included in research and engineering expense in 2000 is a $1.3 millioncharge related to the value of a warrant issued to Intel in exchange for theability to sublicense its Launch & Connect technology. This technology isno longer being utilized, nor are we attempting to sublicense the technology.

 

We anticipate incurring levels of research and engineering expense in2002 similar to the level incurred in 2001, except for the $580,000 impairmentcharge and the $750,000 purchase of technology, as we continue the developmentof our C-StarTM peer-to-peer digital distribution solution.  We had 41 employees in research andengineering functions at December 31, 2001, compared to 26 at December 31,2000.  The increased head count resultedfrom increased research and engineering activities in 2001 and the data centeroperations group of 5 people supporting research and engineering activities.The data center operations group previously supported selling, general, andadministrative activities.

 

***Selling, General and Administrative***

Selling, general and administrative expenses consist of salaries andrelated expenses for personnel engaged in direct sales, partner development,consultant fees, advertising, promotional materials, executive, legal,accounting and administrative personnel, professional services and generalcorporate expenses.  Selling, generaland administrative expenses increased to $13.5 million in 2001 from $5.5million in 2000.  Sales and marketingexpenditures in 2001 primarily focused on developing customers and markets forthe new ScourTM and our C-StarTM CDN Services. The increase in 2001 is primarily due to $2.5 million for the impairmentof certain intangible assets in the fourth quarter of 2001, $2.6 million ofamortization expense in 2001 related to the purchase of certain intangibleassets of Scour, Inc. in the fourth quarter of 2000, $1.2 million related tothe establishment of our Digital Media and Entertainment Group, which isresponsible for building long-term business

 

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relationships with content providers, $31,000 related to additionalinfrastructure costs for C-StarTM, $519,000 related to value of non-employeestock options issued in exchange for services, $317,000 in increased salariesand related expenses and public relations expense, and a $584,000 increase inlegal and related expenses for defending against legal claims and obtaining andprotecting patents and trademarks.

 

We anticipate incurring levels of general and administrative expensesin 2002 that are similar to those incurred in 2001.  We anticipate increased sales expense, not including the $2.5million charge related to the impairment of certain intangible assets, as wepromote and sell C-StarTM digital distribution solutions.  At December 31, 2001, we had 26 employees inselling, general and administrative functions compared to 27 at December 31,2000.  The decreased head count resultedfrom the data center operations group now supporting research and engineeringactivities, offset in part by the addition of various positions in the selling,general and administrative functions. The data center operations group previously supported selling, general,and administrative activities.

 

***Interest Income***

Interest income decreased to $399,000 in 2001 from $895,000 in 2000 as a result of lower interest rates in 2001compared to 2000 and higher cash balances in the first half of 2000. The highercash balances in the first half of 2000 resulted primarily from the saleof debt and equity securities in private placements during 1999 and the sale ofour hardware business in October 1999 for $15.0 million.  Our cash balances increased during the firsthalf of 2001 as a result of the sales of common stock to an individual investorfor proceeds of $5.0 million late in the fourth quarter of 2000 and $5.0million in the first quarter of 2001, and the sale of 569,177 units to nineinvestors for total proceeds of $6.4 million in the second quarter of 2001,which will result in interest income until utilized.

 

***Provision for Income Taxes***

A valuation allowance has been recorded for the full amount of deferredtax assets generated in 2001 and 2000 due to the uncertainty regarding theutilization of the net operating loss and credit carryforwards. We havefederal, state and foreign net operating loss carryforwards of $42.7 million,$50.7 million and $6.6 million, respectively, that expire through 2021.

 

**YearEnded December 31, 2000 Compared to 1999**

 

***Revenues***

Total revenues were $1,000 in 2000 compared to $787,000 in 1999.  At the end of the first quarter of 2000, wereleased a beta version of our Socket product and during the second quarter of2000 released Socket 1.0.  However, wedid not generate any revenues during the first, third or fourth quarters of2000 and only $1,000 in the second quarter of 2000 related to the Socketreleases.  We anticipated 2000 to be aninvestment year, in which the focus was on the distribution of Socket toend-users and did not expect to generate significant revenue.  The adoption rate of Socket was less thanexpected, primarily, we believe, due to a lack of open standards forcommunications between instant messaging products. We believe that the futureof Internet community, collaboration and communications will be driven by open,standards-based technology and solutions.

 

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The $787,000 of revenue generated in 1999 was from the retail sale ofTalk n’Play and iConference software products. We discontinued marketing and selling Talk n’Play and iConference during2000 when it was determined that such products would not generate sufficientrevenue to support our business.

 

***Gross Profit***

Gross profit for 2000 was $1,000 (100% of revenue), and was generatedfrom affiliate fees from e-commerce partners relative to the Socket product.

 

Gross profit for 1999 was $218,000 (27.7% of revenues) and wasgenerated from the retail sale of Talk n’Play and iConference products and isnet of the cost of production and inventory adjustments.

 

***Research and Engineering***

Research and engineering expenses consist primarily of salaries andrelated expenses, consultant fees and the cost of software used in productdevelopment.  Research and engineeringexpenses were $4.9 million in 2000 compared to $3.3 million in 1999.  Included in the amount for 2000 is a $1.3million non-cash charge related to the value of a warrant issued to Intel inexchange for the license of certain technology, which was used in productsunder development at that time. Included in the 1999 amount is a $2.5 million non-cash charge primarilyrelated to the value of a warrant issued to Intel in exchange for the licenseof certain technology, which was used in products under development at thattime.  We made significant investmentsin research and engineering in 2000 related to our Internet community,collaboration and communications software business.  We significantly increased the size of our engineering departmentduring 2000 and, at December 31, 2000, we had 26 in the engineering groupcompared to 16 at December 31, 1999. The increase in 2000 compared to 1999 is due to a $2.4 million increasein salaries, recruiting and related costs associated with the development ofSocket and C-StarTM and a $157,000 increase in depreciation.

 

***Selling, General and Administrative***

Selling, general and administrative expenses consist of salaries andrelated expenses for personnel engaged in direct sales, partner development,consultant fees, advertising, promotional materials, executive, legal,accounting and administrative personnel, professional services and generalcorporate expenses.  Selling, generaland administrative expenses increased to $5.5 million in 2000 from $2.5 millionin 1999, as a result of expanding our workforce and marketing activitiesrelated to the Internet community, collaboration and communications softwarebusiness.  We incurred $424,000 ofadditional marketing and advertising costs in 2000 for the launch of our Socketproduct.  We significantly increased thenumber of employees assigned to continuing operations in marketing, productdevelopment and administration and, as a result, salaries, recruitment andrelated costs increased $1.5 million in 2000 compared to 1999.  At December 31, 2000, we had 27 people inmarketing, product development and administration compared to 19 at December31, 1999.  We also incurred anadditional $415,000, including increased depreciation, related to improvedInternet infrastructure and bandwidth charges during 2000, primarily forsupport of the Socket product.    Theincreases in the selling and marketing activities in 2000 were undertaken withthe assumption that we would generate revenue from our Socket product tosupport such expenditures.  Whenrevenues did not materialize as anticipated, we reduced, and, by the end of2000, virtually eliminated, spending related to Socket.  In the fourth quarter of 2000, we beganfocusing our selling and marketing activities on the new ScourTM.

 

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***Interest Income***

Interest income increased to $895,000 in 2000 from $417,000 in 1999 asa result of increased cash balances, which resulted primarily from privateplacements of debt and equity securities during 1999 and the sale of ourhardware business in October 1999 for $15.0 million.

 

***Loss from Beneficial Conversion Feature***

On June 9, 1999, we issued and sold to two investors an aggregate of$6.0 million in principal of our zero coupon Convertible Debentures due June 9,2002 for $6.0 million in cash. The Convertible Debentures were recorded asdebt. The beneficial conversion feature was recorded as additional paid incapital and as a discount against long-term debt.  The beneficial conversion feature of $987,000 was recognized over90 days using the effective interest method. The debt was converted to equity prior to December 31, 1999.

 

***Provision for Income Taxes***

A valuation allowance has been recorded for the full amount of deferredtax assets generated in 2000 due to the uncertainty regarding the utilizationof the net operating loss and credit carryforwards.  Our tax provision for 1999 includes the establishment of a fullvaluation allowance of $8.4 million on our deferred tax asset due to the changein our business and the uncertainty regarding the realization of the assetbalance.

 

**Resultsof Discontinued Operations - Sale of the Hardware Business**

 

Our hardware business historically comprised the bulk of our revenuesand expenses. From our founding in 1990 through 1997, we were a leader indesigning and marketing innovative PC game controller products under the nameof ThrustMaster.  However, commencing in1997, many larger competitors, including Microsoft Corporation, Kensington(Gravis), Logitech International S.A., and InterAct Accessories, which hadgreater economies of scale, financial, technical and marketing resources thanus, entered the game controller market, creating an extremely competitiveenvironment characterized by declining prices and increased marketing costs.Our management determined that we could not achieve the economies of scalenecessary to be profitable in the game controller market and concluded that weshould sell the hardware business and invest the proceeds in our Internetcommunity, collaboration and communication business.

 

In October 1999, Guillemot Corporation S.A. (“Guillemot”) purchasedcertain of our assets for a total price of $15.0 million, of which $2.25million was retained in escrow and was to be released to us pursuant to anescrow agreement.  In June 2000, wefiled a lawsuit for breach of contract against Guillemot alleging thatGuillemot breached the terms of the escrow agreement by prohibiting thescheduled release of escrow funds to us. In March 2001, we entered in into a settlement agreement and mutualrelease with Guillemot, under which we received approximately $1.4 million ofrestricted cash from escrow. Guillemot received approximately $1.0 million fromescrow, consisting of approximately $318,000 collected on their behalf anddownward purchase price adjustments of approximately $682,000.  No amounts remained in escrow at December31, 2001.  The purchase priceadjustments made pursuant to the asset purchase agreement mainly related touncollected accounts receivable.  Inconnection with the release of the restricted cash and final settlement withGuillemot, we recognized a gain on disposal of discontinued operations in 2001of $674,000.

 

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The sale of the hardware business has been accounted for asdiscontinued operations and, accordingly, its operations are segregated in thestatements of operations included elsewhere in this Annual Report on Form10-K.  Revenues from discontinuedoperations were $13.5 million for the year ended December 31, 1999.  Certain expenses have been allocated tocontinuing operations, based on the number of employees remaining with thesoftware business, their related employee costs and overhead for facilities andother related costs and corporate overhead expenses that were expected torepresent continuing expenses.

 

Loss from discontinued operations was $5.2 million in 1999.  The loss from discontinued operationsrepresents the net activity of the discontinued hardware business, includingrevenues and associated expenses and the resulting tax benefit.

 

**Liquidityand Capital Resources**

 

At December 31, 2001, we had $4.6 million of working capital and acurrent ratio of 4.3 to 1.0.  Includedin working capital is $562,000 of restricted cash related to deposits forcertain contracts, a majority of which is scheduled to be paid in May2002.  We have financed our activitiessince the disposition of our hardware business in October 1999 primarily with acombination of proceeds from the sale of our hardware business and proceedsfrom the sale of equity securities.

 

In March 2002, we entered into an agreement with Peter Kellogg, whounconditionally agreed to purchase up to 833,333 shares of our common stock ata price of $6.00 per share, if requested to do so by us, in one or more privatetransactions representing total maximum proceeds to us of $5.0 million.  As compensation for entering into thiscommitment, we issued to Mr. Kellogg a three-year warrant to purchase 100,000shares of our common stock at $10.67 per share.  To the extent that Mr. Kellogg purchases more than 100,000 sharesof our common stock under this commitment, he will also receive a three-yearwarrant to purchase an equal number of shares of common stock at $10.67 pershare.

 

We also arranged a stand by line of credit in the amount of $1.0 millionon which we can draw after July 2002.

 

In March 2002, we sold 333,333 units to a total of six accreditedinvestors for $6.00 per unit for total proceeds to us of $2.0 million.  Each unit consists of one share of ourcommon stock and a warrant to purchase one share of our common stock for $10.67per share.

 

In February 2002, we sold 662,667 units to a total of twelve accreditedinvestors for $6.00 per unit for total proceeds to us of $4.0 million.  Each unit consists of one share of ourcommon stock and a warrant to purchase one share of our common stock for $10.67per share.

 

In June 2001, we sold 569,177 units, each consisting of one share ofour common stock and a warrant to purchase one share of our common stock at anexercise price of $18.68 per share, to nine accredited investors for $11.21 perunit (the 30-day trailing volume weighted average price of our common stock)for total proceeds to us of $6.4 million. In conjunction with this issuance, warrants covering an additional21,008 shares of our common stock were issued to certain finders at an exerciseprice of $18.68 per share.

 

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In March 2001, we entered into a settlement agreement and mutualrelease with Guillemot, under which we received approximately $1.4 million ofrestricted cash from escrow.  See Note 5to the consolidated financial statements.

 

In February 2001, we sold 714,286 shares of our common stock to anaccredited investor for $7.00 per share for total proceeds to us of $5.0 million.  In conjunction with this issuance we issuedwarrants exercisable for an aggregate of 85,000 shares of our common stock tofive designees of the investor’s financial consultant. The warrants areimmediately exercisable at a price of $9.063 per share and expire inDecember 2005.

 

Cash decreased $2.4 million in 2001 primarily as a result of $12.9million used in operations, $865,000 for the purchase of equipment and $450,000for payments on a capital lease, offset by total proceeds of $11.8 million fromthe issuance of equity securities.

 

Accrued liabilities decreased $2.0 millionto $603,000 at December 31, 2001, from $2.6 million at December 31, 2000primarily due to our final settlement with Guillemot in connection with therelease of restricted cash from escrow.

 

During the second quarter of 2001, weentered into a one-year capital lease obligation for $675,000 for thepurchase of certain information systems software for our C-StarTM platform.  As of December 31, 2001, we owed $225,000 onthis obligation.

 

We spent $1.5 million on capital expenditures in 2001, including the$675,000 financed with a capital lease, primarily for engineering andinformation systems equipment and software. We anticipate spendingapproximately $1.1 million on capital expenditures during 2002 primarily foradditional server hardware and software and engineering development tools.

 

In connection with our agreement with Sony in February 2002, which isdescribed above, we agreed to pay an initial content integration fee of$500,000 in connection with execution of the agreement and an additionalcontent integration fee of $500,000 on September 1, 2002, as well as quarterlyadvance minimum service fees of $250,000 for four quarters beginning September1, 2002.

 

Based on current estimates, we anticipateutilizing $3.5 to $4.0 million of cash on a quarterly basis to fund ouroperations during 2002.  Cashexpenditures during 2002 will primarily be for continued selling and marketingand research and engineering expenses related to C-StarTM digital distributionsolutions.  In addition, we willcontinue to incur expenses, although at lower levels than during 2001, relatedto ScourTM, as we further develop ScourTM as a showcase for C-StarTM and asa part of our content hosting network. We may also incur costs to convert ScourTM to a subscription service during 2002.  Given current cash requirement estimates andcash and cash equivalents available at December 31, 2001 plus $6.0 million ofproceeds received from private placements of our equity securities in Februaryand March 2002 and commitments for up to an additional $6.0 million, weanticipate that we have sufficient cash to fund our operations at projectedlevels for at least the next twelve months. However, any projections of future cash needs and cash flows are subjectto substantial uncertainty. Additionally, there can be no assurance that current cash and cashequivalent balances will be sufficient to satisfy liquidity requirements.  We may not be able to obtain adequate orfavorable financing and any financing we obtain may dilute the ownershipinterest of our shareholders prior to the financing.  In addition, we may, from time to time, consider the acquisitionof, or investment in, complementary

 

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businesses, products, services andtechnologies, which might impact our liquidity requirements or cause us toissue additional equity or debt securities.

 

***New Accounting Pronouncements***

 

In June 2000, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 138, “Accounting for Certain DerivativeInstruments and Certain Hedging Activities-an amendment of FASB Statement No.133” (“SFAS No. 138”).  In June 1999,the FASB issued Statement of Financial Accounting Standards No. 137,“Accounting for Derivative Instruments and Hedging Activities” (“SFAS No.137”).  SFAS No. 137 is an amendment toStatement of Financial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities.” SFAS Nos. 137 and 138 establish accounting and reporting standards forall derivative instruments.  SFAS Nos.137 and 138 are effective for fiscal years beginning after June 15, 2000.  We do not currently have any derivativeinstruments and, accordingly, the adoption of SFAS Nos. 133, 137 and 138 in thefirst quarter of 2001 did not have an impact on our financial position, resultsof operations or cash flows.

 

In July 2001, the FASB issued SFAS No. 141, Business Combinations, andStatement No. 142, Goodwill and Other Intangible Assets.  SFAS No. 141 requires that the purchasemethod of accounting be used for all business combinations completed after June30, 2001.  SFAS No. 141 also specifiescriteria that intangible assets acquired in a purchase method businesscombination must meet to be recognized and reported apart from goodwill, notingthat any purchase price allocable to an assembled workforce may not beaccounted for separately.  SFAS No. 142requires that goodwill and intangible assets with indefinite useful lives nolonger be amortized, but instead tested for impairment at least annually inaccordance with the provisions of SFAS No. 142.  SFAS No. 142 also requires that intangible assets with estimableuseful lives be amortized over their respective estimated useful lives to theirestimated residual values, and reviewed for impairment in accordance with SFASNo. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed of.”  SFAS No. 121is being superseded by SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” effective January 1, 2002.

 

We adopted the provisions of SFAS No. 141July 1, 2001 and the provisions of SFAS No. 142 on January 1, 2002.  SFAS No. 141 requires, upon adoption of SFASNo. 142, that we evaluate our existing intangible assets that were acquired inprior purchase business combinations, and make any necessary reclassificationsin order to conform with the new criteria in SFAS No. 141 for recognition ofseparately identifiable intangible assets. Upon adoption of SFAS No. 142, we are required to reassess the usefullives and residual values of all intangible assets acquired and make anynecessary amortization period adjustments by the end of the first quarter of2002.  In addition, to the extent anintangible asset is identified as having an indefinite useful life, we arerequired to test the intangible asset for impairment in accordance with theprovisions of SFAS No. 142 within the first quarter of 2002.  Any impairment loss will be measured as ofthe date of adoption and recognized as the cumulative effect of a change inaccounting principle in the first interim period.

 

At December 31, 2001, we did not have anygoodwill, but had unamortized identifiable intangible assets in the amount of$2.6 million.  We anticipate that wewill continue to amortize all of our identifiable intangible assets.  Amortization expense related to identifiableintangibles was $2.6 million in 2001 and $0 in both 2000 and 1999.  In 2001, we recorded

 

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impairment charges of $3.08 million relatedto our intangible assets.  We do notanticipate recording an additional impairment charge in the first quarter of2002 upon adoption of SFAS No. 142.

 

In August 2001, the FASB approved SFAS No. 143, “Accounting for AssetRetirement Obligations” (“SFAS No. 143”), which we adopted January 1,2002.  SFAS No. 143 addresses thefinancial accounting and reporting for obligations associated with theretirement of tangible long-lived assets and the associated asset retirementcosts.  In October 2001, the FASBapproved SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets” (“SFAS No. 144”), which supersedes SFAS No. 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of”(“SFAS No. 121”) and the accounting and reporting provisions of APB No. 30,“Reporting the Results of Operations – Reporting the Effects of Disposal of aSegment of a Business, and Extraordinary, Unusual and Infrequently OccurringEvents and Transactions” for the disposal of a segment of a business.  SFAS No. 144 retains many of the fundamentalprovisions of SFAS No. 121, but resolves certain implementation issues.  SFAS No. 144 was also adopted January 1,2002.  Although we have not completedthe evaluation of the affects of the adoption of SFAS Nos. 143 and 144, we donot believe that the adoption of SFAS Nos. 143 and 144 will have a materialaffect on our financial condition or results of operations.

 

**FactorsThat May Affect Forward-Looking Statements**

 

***If our solutions are not adopted by potential customers, we may notachieve or maintain profitability.***

 

We began our software business inmid-1998.  Accordingly, we have alimited operating history with which you can evaluate our current business andprospects.  Our business is new and willnot be successful unless potential customers adopt wide usage of our productsand services and revenues are generated from our services and productofferings. We derived insignificant revenues from the Socketproduct and are no longer developing orpromoting it.  We have not launched aScourTM subscription service and may continue to operate ScourTM as a freebeta service to showcase C-StarTM. Wehave only signed one customer for C-StarTM CDN Services to date.  In addition, our prospects must beconsidered in light of the risks and uncertainties encountered by early stagecompanies in new and rapidly evolving markets such as the Internet digitaldistribution markets.

 

***We incurred substantial losses from continuing operations in oursoftware business in 2001, 2000 and 1999 and continued losses may deplete ourcapital resources.***

 

We have derived insignificant revenues fromour software business and have incurred substantial losses from continuingoperations******of$21.5 million in 2001, $9.5 million in 2000 and $10.6 million in1999, and in every quarter since we began our software operations.  We cannot predict when, if ever, we willachieve profitability.  In addition, weplan to increase our operating expenses to market, sell and implement ourpeer-to-peer digital distribution solution through increased staffing andorganizational expenses, marketing costs, capital expenditures and other expenses.  As a result, we expect to incur significantoperating losses on a quarterly and annual basis for the foreseeable future.Continued losses would impair our capital resources, which in turn may requirethat we raise additional capital or curtail our business activities.

 

20

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***We may need to raise additional funds to finance ongoing operations,which may require us to commit significant amounts of capital to debt serviceand could result in dilution to our shareholders.***

 

We believe that our current cash and cashequivalent balances and committed funds will satisfy our projected workingcapital and capital expenditure requirements through the next12 months.  However, any projectionsof future cash needs and cash flows are subject to substantialuncertainty.  Additionally, there can beno assurance that current cash and cash equivalent balances will be sufficientto satisfy liquidity requirements. We may not be able to obtain adequate orfavorable financing and any financing we obtain may dilute the ownershipinterest of our shareholders prior to the financing.  In addition, we may, from time to time, consider the acquisitionof, or investment in, complementary businesses, products, services andtechnologies, which could impact our liquidity requirements or cause us toissue additional equity or debt securities.

 

***If we are not successful in selling our C-Star***TM***digital distribution solutions to several large customers,we may not be able to generate significant revenue, which could lead tocontinued operating losses.***

 

Our revenue expectations include significanttransaction-based service provider and product sales revenues to be receivedfrom customers of C-StarTM digital distribution solutions. If we are not successfulin selling C-StarTM digital distribution solutions to several large customers inthe form of a service or product, we may not be able to generate significantrevenue, which could lead to continued operating losses.

 

***If we fail to secure access to additional popular music and videofiles, we may not be able to generate significant revenue from selling C-StarTMdigital distribution services******, which could lead to continuedoperating losses.***

 

Our revenue model for 2002 is based in largepart on digital distribution service fees from C-StarTM. In February 2002, we entered into a digitalmusic distribution agreement with Sony Music, which allows us to digitallydistribute their catalog.  If we fail tosecure access to additional popular music and video files from more than onemajor music label or movie studio, we may not be able to generate significantC-StarTM CDN Servicesrevenue from customers wishing to offer a consumer entertainment service.

 

***If we fail to attract a significant number of subscribers to ScourTM, wemay not achieve anticipated revenues, which could lead to continued operatinglosses.***

 

Part of our strategy in building out theC-StarTM network is to attract consumers to actively use the ScourTMshowcase service and act as hosts for digital files.  The larger the network of digital hosts, the stronger the value ofthe C-StarTM CDN Services network.  If wefail to attract a significant number of subscribers to ScourTM, we may not beable to achieve anticipated C-StarTM CDN Services revenue.

 

21

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***If consumers are able to get music and video files for free, we may notbe able to achieve anticipated revenue, which could lead to continued operatinglosses.***

 

In March 2001, the largest Internetfile sharing network, Napster, was ordered by a federal court to block theexchange of copyrighted music identified by the music labels.  Our revenue expectations include significantC-StarTM CDN Servicesrevenue from customers operating subscription based entertainment services. Third-party surveys of Napster and otherfree peer-to-peer exchange users indicate a willingness to pay for digitalmusic files on a subscription basis by a majority of users if the files are notavailable for free. The record industry and the motion picture industrycontinue to attack several forms of illegal exchange of copyrighted files. Ifinnovative software providers are able to develop alternative technologies forfree file sharing, it may be difficult for our customers to attract and retainpaying subscribers to subscription entertainment services.

 

***If we are unable to successfully develop new C-StarTM products and newcapabilities for C-Star***TM***CDN Services, we may not be able togenerate anticipated revenues, which could lead to continued operating losses.***

 

We believe that the C-StarTM search andpeer-to-peer file distribution technology, which is the basis of C-StarTM CDN Services and ScourTM, can be applied invertical markets outside of media and entertainment. For some vertical markets,such as the enterprise market, a product offering must be developed.  For others, we are pursuing a serviceprovider, transaction-based licensing strategy to generate revenue from the useof the C-StarTM digital distribution channel. If we are unable to develop new products and service capabilities forC-StarTM CDN Services, we maynot achieve anticipated revenues or profitability.

 

***If we are not able to compete effectively, we may not be able togenerate anticipated subscription, service and product sale revenues, whichcould lead to continued operating losses.***

 

The Internet digital distribution businessis competitive.  Many of our competitorsmay have greater resources and experience us. We expect competition to increase in the future. Our principalcompetitors include Content Distribution Network (CDN) service and productvendors, such as Akamai, Digital Island, Inktomi and Kontiki, Internet musicdistributors that use digital download, peer-to-peer or streaming technologies,such as MP3.com, Napster, Liquid Audio, Press Play and Real Networks, musiclabels and movie studios, as well as providers of digital entertainmentservices such as MusicNet, Listen.com and RioPort.

 

Many of our current and future competitorsmay have advantages over us, including:

•        Longeroperating histories;

•        Largercustomer bases;

•        Substantiallygreater financial, technical, sales and marketing resources;

•        Greatername recognition; and

•        Theability to more easily provide a comprehensive software solution.

 

Our current and potential competitors mayestablish cooperative relationships among themselves or with third parties thatwould increase their ability to compete with us. In addition, competitors maybe able to adapt more quickly than we can to new or emerging technologies andchanges in customer needs, or to devote more resources to promoting and

 

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selling their products.  If we fail to adapt to market demands and tocompete successfully with existing and new competitors, our ability to generateservice and product revenues will suffer.

 

***If we lose key personnel, we may not be able to timely deploy productsand services based on C-Star***TM***, which maydelay or decrease anticipated revenues and lead to continued operating losses.***

 

Our success depends largely upon thecontinued services of our executive officers and other key management anddevelopment personnel. The loss of the services of one or more of our executiveofficers, engineering personnel, or other key employees could have a materialadverse effect on our ability to timely deploy products and services based onC-StarTM, which may delay or decrease anticipated revenues and profitability.  Our employees are employed on an “at will”basis and could terminate their employment with us at any time. We do notmaintain key person life insurance policies on any of our employees.

 

***If we are not able to attract and retain additional personnel, we maynot be able to timely market, sell and deploy products and services based onC-Star***TM***, which may delay or decreaseanticipated revenues and lead to continued operating losses.***

 

Our future success also depends on ourability to attract and retain highly qualified personnel to market, sell anddeploy products and services based on C-StarTM. We may not be successful inattracting or retaining qualified personnel, which could have a materialadverse effect on our ability to timely deploy services and products, which maydelay or decrease anticipated revenues and profitability. The competition forqualified personnel is intense.  We maybe unable to attract, assimilate, or retain additional highly qualifiedpersonnel in the future. We attempt to hire engineers with high levels ofexperience in marketing, selling, designing and developing software intime-pressured environments. There are a limited number of qualified personnelin our geographic location, resulting in intense competition for theirservices.

 

***We may not be able to establish partnerships to sell products andservices based on C-StarTM in new vertical markets, which may delay or decreaserevenues.***

 

We do not currently have adequate marketingand sales personnel to sell products and services based on C-StarTM in verticalmarkets outside of media and entertainment. Rather than hire significant additional personnel, we are employing abusiness development strategy of partnering with market leaders in productsales and system integrators to sell into specific vertical markets, such asenterprise communications and storage, eLearning and digital media distributionfor medical applications.  We may not beable to establish partnerships with market leaders in product sales or systemintegrators in some or any vertical markets, which may delay or decrease expectedrevenues.

 

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***We may not be able to make desired acquisitions or integrate acquiredassets into our operations, which could result in limited stock priceappreciation or shareholder dilution.***

 

A component of our growth strategy is toselectively acquire complementary companies, products or technologies.  We may not be successful in completing andintegrating any future acquisitions.  Inaddition, we may not be able to complete acquisitions on terms acceptable tous.  We have limited experience withcompleting and integrating acquisitions as a team.  Our failure to effectively integrate any acquired businessescould adversely affect us. In connection with any acquisitions, we could:

•        Issuestock that would dilute our current shareholders’ percentage ownership;

•        Incurdebt and assume liabilities, which may increase our leverage and cash requiredto service debt; and

•        Incuramortization expenses related to intangible assets or incur large and immediatewrite-offs.

 

Future acquisitions could also pose numerousadditional risks to our operations, including:

•        Problemsintegrating the purchased operations, technologies or products;

•        Unanticipatedcosts;

•        Diversionof management’s attention from our core business;

•        Adverseeffects on existing business relationships with strategic partners andcustomers;

•        Enteringmarkets in which we have no or limited prior experience; and

•        Potentialloss of key employees, particularly those of the purchased organization.

 

***If we are unable to increase the size of our systems and managementresources related to our operations, we may not achieve anticipated C-Star***TM***or ScourTM revenues, which could lead to continued operatinglosses.***

 

We are currently beta testing the C-StarTM2.0 infrastructure, utilizing computer infrastructure that we expect to becapable of supporting several hundred thousand registered users. To support acombined C-StarTM CDNServices and ScourTM service that could have more than a million subscribers, weintend to hire additional management resources with experience in this area andincrease the size and capacity of our computer infrastructure.  If we are unsuccessful in hiring additionalmanagement resources with experience in this area, or if we are unable tosuccessfully increase the capacity of our computer systems, we may be unable tosupport enough subscribers to achieve anticipated revenues or profitability.

 

***If we are unable to protect our intellectual property, competitorscould obtain access to proprietary information, which could have a materialadverse impact on our service and product sales revenues.***

 

We regard elements of C-StarTM as proprietaryand are attempting to protect them by relying on patent, trademark, servicemark, trade dress, copyright, and trade secret laws and restrictions, as wellas confidentiality procedures and contractual provisions.  Protecting our intellectual property may betime consuming and expensive.  Inaddition, despite our efforts, we may be unable to prevent third parties frominfringing upon or misappropriating our intellectual property.  Any infringement or misappropriation couldhave a material adverse effect on our subscription and licensing revenues. Newpatent applications may not provide

 

24

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us with any competitive advantages, or maybe challenged by third parties. Effective trademark, copyright, and tradesecret protection may not be available in every country in which our servicesand products are used. In addition, our competitors may independently developsimilar technology that substantially limits the value of our intellectualproperty.

 

***Others may bring intellectual property infringement claims against us,which could require significant resources to defend and could lead torestrictions on our current operations.***

 

In addition to the technology we havedeveloped internally, we have acquired or licensed technologies from othercompanies including Intel, Microsoft, Oracle and Cognos. Our internallydeveloped technology, or the technology we acquired or licensed, may infringeon a third party’s intellectual property rights and third parties may bringclaims against us alleging infringement of their intellectual propertyrights.  Any infringement or claim of infringementcould have a material adverse effect on our business, resulting in suspensionof revenue generating activities or the payment of cash.

 

In recent years, there has been significantlitigation in the United States involving patents and other intellectualproperty rights. We are not currently involved in any intellectual propertylitigation.  However, we may be a partyto litigation in the future to protect our intellectual property or as a resultof an alleged infringement of others’ intellectual property. These potentialclaims and any resulting litigation could subject us to significant liabilityfor damages and invalidation of our proprietary rights. Any litigationinvolving intellectual property, regardless of its success, likely would betime-consuming and expensive to defend and would divert management time andattention.  Any potential intellectualproperty litigation could also force us to do one or more of the following:

•                       Cease selling, incorporating, or usingproducts or services that incorporate the challenged intellectual property;

•                       Obtain a license to sell or use the relevanttechnology from the holder of the infringed intellectual property right, whichlicense may not be available on reasonable terms, or at all; and

•        Redesignthose products or services that incorporate the technology at issue.

 

***Software defects could inhibit our ability to attract customers orcause losses of customers, which would adversely affect our revenues.***

 

Our software may contain undetected errors,or “bugs”, when first introduced or as new versions or enhancements arereleased.  Despite our internal testing,these errors may be discovered only after our software has been installed andused by customers. These undetected errors may relate to components supplied tous.  Our services and products under developmentare complex as a result of factors including:

•        Advancedfunctionality;

•        Thediverse operating environments in which the products may be deployed; and

•        Themultiple versions of our products that will need to be supported for diverseoperating platforms and standards.

 

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The complexity of our services and productsunder development increases the likelihood that they may contain errors whenintroduced. Problems encountered by customers or software recalls couldmaterially adversely affect our ability to attract and retain potentialcustomers of C-Star CDN ServicesTM and related products.

 

***The market price for our common stock, like other technology stocks,may be volatile, and a decrease could adversely affect us.***

 

The market price of CenterSpan’s commonstock could decline due to the impact of any of the following factors:

•        Variationsin our actual and anticipated operating results;

•        Changesin our earnings estimates by analysts; and

•        Ourfailure to meet investors’ and analysts’ performance expectations.

 

In addition, the stock markets have recentlyexperienced price and volume volatility that has affected stock prices for manycompanies in the technology sector. General stock market trends may continue to be negative for this sectorand this may adversely affect the market price of our common stock even thoughour business prospects may be good.

 

If the market price of our common stockdecreases, it may become more difficult for us to raise needed additionalcapital through the sale of equity securities and may result in increaseddilution to our existing shareholders.

 

***We may experience an adverse impact from future sales of our stock.***

 

Sales of substantial amounts of our commonstock in the public market by existing stockholders or holders of options orwarrants could cause the price of our common stock to decline.

 

As of March 28, 2002, 3,819,041 shares ofour common stock were subject to outstanding stock options under our stockoption plans at a weighted average exercise price of approximately $11.10 pershare.  As of March 28, 2002, 2,037,643shares were issuable upon exercise of outstanding warrants at a weightedaverage exercise price of $13.99 per share.

 

We have filed registration statements onForms S-8 under the Securities Act to register for resale a total of5,917,100 shares of common stock under our stock option plans, 3,819,041 ofwhich are issuable upon exercise of outstanding stock options and 757,386 ofwhich are reserved for future grant.  Inaddition, we have effective registration statements on Form S-3 under theSecurities Act of 1933 to register for resale a total of 2,148,722 shares ofour common stock, including shares issuable upon exercise of warrants.  An additional 4,105,452 shares of our commonstock, including shares issuable upon exercise of warrants, are held byshareholders with demand registration rights. Approximately 5,500,000 shares not covered by an effective registrationstatement are freely tradable under the federal securities laws subject tovolume limitations under Rule 144 or are freely tradable under the federalsecurities laws to the extent they are not held by our affiliates or are notsubject to certain contractual volume restrictions.

 

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In general, under Rule 144 as currentlyin effect, any person (or persons whose shares are aggregated) who hasbeneficially owned restricted securities for at least one year is entitled tosell, within any three-month period, a number of shares that does not exceedthe greater of:

•        1%of the then outstanding shares of the issuer’s common stock, and

•        theaverage weekly trading volume during the four calendar weeks preceding suchsale

provided that certain public informationabout the issuer as required by Rule 144 is then available and the sellercomplies with certain other requirements.

 

A person who:

•        isnot an affiliate,

•        hasnot been an affiliate within three months prior to sale, and

•        hasbeneficially owned the restricted securities for at least two years

 

is entitled to sell such shares underRule 144(k) without regard to any of the limitations described above.

 

**Item 7A****.  Quantitative and QualitativeDisclosures About Market Risk**

 

As of December 31, 2001, substantially all of our liquid investmentswere at fixed interest rates and had original maturities of 90 days orless.  As a result, we believe that themarket risk arising from our holdings of financial instruments is minimal.

 

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

 

**IndependentAuditors’ Report**

 

The Board of DirectorsCenterSpan Communications Corporation

 

We have audited the accompanying consolidated balance sheets ofCenterSpan Communications Corporation and subsidiaries as of December 31,2001 and 2000, and the related consolidated statements of operations, changesin shareholders’ equity, and cash flows for each of the three years in theperiod ended December 31, 2001.  Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of CenterSpanCommunications Corporation and subsidiaries as of December 31, 2001 and2000, and the results of their operations and their cash flows for each of thethree years in the period ended December 31, 2001 in conformity with accountingprinciples generally accepted in the United States of America.

 

 
| /s/ KPMG LLP                                       |   |
|----------------------------------------------------|--------|
|                                               |
| Portland, Oregon                                   |
| February 15, 2002, except for Note 16, as to which |
| the date is March 29, 2002                         |

 

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**CENTERSPAN COMMUNICATIONS CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(Dollars in thousands)**

 
|                                                                                                             |   | **December 31,** |       |
|------------------------------------------------------------------------------------------------------------------|--------|------------------|------------|
|                                                                                                             |   | **2001**         |       | **2000** |   |
| **ASSETS**                                                                                                       |   |             | ** ** |   | ** ** |
| Current assets:                                                                                                  |   |             |       |   |   |
| Cash and cash equivalents                                                                                        |   | $                | 5,276      |   | $ | 7,701 |   |
| Restricted cash                                                                                                  |   | 562              |       | 2,420 |   |
| Prepaid expenses and other                                                                                       |   | 156              |       | 42 |   |
| Total current assets                                                                                             |   | 5,994            |       | 10,163 |   |
|                                                                                                             |   |             |       |   |   |
| Plant and equipment, net                                                                                         |   | 2,677            |       | 2,409 |   |
| Other assets, net                                                                                                |   | 2,637            |       | 8,283 |   |
| Total assets                                                                                                     |   | $                | 11,308     |   | $ | 20,855 |   |
|                                                                                                             |   |             |       |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                   |   |             | ** ** |   | ** ** |
| Current liabilities:                                                                                             |   |             |       |   |   |
| Capital lease obligation                                                                                         |   | $                | 225        |   | $ | — |   |
| Accounts payable                                                                                                 |   | 551              |       | 608 |   |
| Accrued liabilities                                                                                              |   | 603              |       | 2,557 |   |
| Total current liabilities                                                                                        |   | 1,379            |       | 3,165 |   |
|                                                                                                             |   |             |       |   |   |
| Commitments and contingencies                                                                                    |   |             |       |   |   |
|                                                                                                             |   |             |       |   |   |
| Shareholders’ equity:                                                                                       |   |             |       |   |   |
| Preferred stock, no par value, 5,000,000 shares authorized;  none issued or outstanding                          |   | —           |       | — |   |
| Common stock, no par value, 25,000,000 shares authorized;  8,786,925 and 7,303,351 shares issued and outstanding |   | 52,572           |       | 42,318 |   |
| Common stock warrants                                                                                            |   | 7,677            |       | 4,830 |   |
| Accumulated deficit                                                                                              |   | (50,320          | )          | (29,458 | ) |
| Total shareholders’ equity                                                                                  |   | 9,929            |       | 17,690 |   |
| Total liabilities and shareholders’ equity                                                                  |   | $                | 11,308     |   | $ | 20,855 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CENTERSPAN COMMUNICATIONS CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**

 
|                                                                     |   | **Year Ended December 31,** |    |
|--------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                     |   | **2001**                    |    | **2000** |   | **1999** | ** ** |
| Revenue                                                                  |   | $                           | 51      |   | $ | 1 |   | $ | 787 |   |
| Cost of goods sold                                                       |   | —                      |    | — |   | 569 |   |
| Gross profit                                                             |   | 51                          |    | 1 |   | 218 |   |
|                                                                     |   |                        |    |   |   |   |   |
| Operating expenses:                                                      |   |                        |    |   |   |   |   |
| Research and engineering                                                 |   | 8,403                       |    | 4,865 |   | 3,282 |   |
| Selling, general and administrative                                      |   | 13,521                      |    | 5,499 |   | 2,474 |   |
|                                                                     |   | 21,924                      |    | 10,364 |   | 5,756 |   |
| Loss from operations                                                     |   | (21,873                     | )       | (10,363 | ) | (5,538 | ) |
|                                                                     |   |                        |    |   |   |   |   |
| Interest income                                                          |   | 399                         |    | 895 |   | 417 |   |
| Interest expense                                                         |   | (62                         | )       | — |   | — |   |
| Expense from beneficial conversion feature                               |   | —                      |    | — |   | (987 | ) |
|                                                                     |   | 337                         |    | 895 |   | (570 | ) |
| Loss from continuing operations before taxes                             |   | (21,536                     | )       | (9,468 | ) | (6,108 | ) |
| Provision for income taxes                                               |   | —                      |    | — |   | 4,532 |   |
| Loss from continuing operations                                          |   | (21,536                     | )       | (9,468 | ) | (10,640 | ) |
| Discontinued operations:                                                 |   |                        |    |   |   |   |   |
| Loss from discontinued operations, net of tax benefit of $0, $0, and  $0 |   | —                      |    | — |   | (5,207 | ) |
| Gain from disposal of discontinued operations, net                       |   | 674                         |    | — |   | 6 |   |
| Net loss                                                                 |   | $                           | (20,862 | ) | $ | (9,468 | ) | $ | (15,841 | ) |
|                                                                     |   |                        |    |   |   |   |   |
| Basic and diluted loss per share from continuing operations              |   | $                           | (2.59   | ) | $ | (1.52 | ) | $ | (2.11 | ) |
|                                                                     |   |                        |    |   |   |   |   |
| Basic and diluted gain (loss) per share from discontinued operations     |   | $                           | 0.08    |   | $ | — |   | $ | (1.03 | ) |
|                                                                     |   |                        |    |   |   |   |   |
| Basic and diluted net loss per share                                     |   | $                           | (2.51   | ) | $ | (1.52 | ) | $ | (3.14 | ) |
|                                                                     |   |                        |    |   |   |   |   |
| Shares used for per share calculations                                   |   | 8,309                       |    | 6,231 |   | 5,038 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CENTERSPAN COMMUNICATIONS CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Dollarsin thousands)**

 
|                                                                                             |   | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                             |   | **2001**                    |       | **2000** |   | **1999** | ** ** |
| Cash flows from Operating Activities:                                                            |   |                        |       |   |   |   |   |
| Net loss                                                                                         |   | $                           | (20,862    | ) | $ | (9,468 | ) | $ | (15,841 | ) |
|                                                                                             |   |                        |       |   |   |   |   |
| Adjustments to reconcile net loss to net cash flows provided by (used  in) operating activities: |   |                        |       |   |   |   |   |
| (Gain) loss from discontinued operations                                                         |   | (674                        | )          | — |   | 5,201 |   |
| Amortization                                                                                     |   | 2,599                       |       | — |   | — |   |
| Impairment of intangibles                                                                        |   | 3,058                       |       | — |   | — |   |
| Depreciation                                                                                     |   | 1,253                       |       | 445 |   | 607 |   |
| Net loss on retirement of assets                                                                 |   | —                      |       | 13 |   | — |   |
| Deferred income taxes                                                                            |   | —                      |       | — |   | 4,677 |   |
| Beneficial conversion feature on debt                                                            |   | —                      |       | — |   | 987 |   |
| Stock options issued for services provided                                                       |   | 519                         |       | — |   | — |   |
| Non-cash expenses                                                                                |   | 750                         |       | 1,300 |   | 2,500 |   |
| Changes in operating assets and liabilities                                                      |   |                        |       |   |   |   |   |
| Restricted cash                                                                                  |   | 1,858                       |       | (138 | ) | (2,282 | ) |
| Accounts receivable                                                                              |   | —                      |       | 4 |   | (4 | ) |
| Prepaid expenses and other assets                                                                |   | (124                        | )          | 150 |   | 363 |   |
| Income taxes receivable                                                                          |   | —                      |       | — |   | 2,078 |   |
| Accounts payable and accrued liabilities                                                         |   | (1,319                      | )          | (232 | ) | (5,152 | ) |
| Net cash used in operating activities                                                            |   | (12,942                     | )          | (7,926 | ) | (6,866 | ) |
|                                                                                             |   |                        |       |   |   |   |   |
| Cash flows from investing activities:                                                            |   |                        |       |   |   |   |   |
| Payments for purchase of plant and equipment                                                     |   | (865                        | )          | (2,467 | ) | (172 | ) |
| Purchase of intangibles                                                                          |   | —                      |       | (4,771 | ) | — |   |
| Proceeds from sale of hardware business                                                          |   | —                      |       | — |   | 15,000 |   |
| Net cash provided by (used in) investing activities                                              |   | (865                        | )          | (7,238 | ) | 14,828 |   |
|                                                                                             |   |                        |       |   |   |   |   |
| Cash flows from financing activities:                                                            |   |                        |       |   |   |   |   |
| Payments on capital lease obligation                                                             |   | (450                        | )          | — |   | — |   |
| Proceeds from (payments on) operating line of credit, net                                        |   | —                      |       | — |   | (5,821 | ) |
| Proceeds from issuance of convertible debt                                                       |   | —                      |       | — |   | 6,000 |   |
| Proceeds from issuance of common stock and warrants                                              |   | 11,832                      |       | 6,398 |   | 10,330 |   |
| Net cash provided by financing activities                                                        |   | 11,382                      |       | 6,398 |   | 10,509 |   |
|                                                                                             |   |                        |       |   |   |   |   |
| Cash used in discontinued operations                                                             |   | —                      |       | — |   | (2,464 | ) |
|                                                                                             |   |                        |       |   |   |   |   |
| Increase (decrease) in cash and cash equivalents                                                 |   | (2,425                      | )          | (8,766 | ) | 16,007 |   |
|                                                                                             |   |                        |       |   |   |   |   |
| Cash and cash equivalents:                                                                       |   |                        |       |   |   |   |   |
| Beginning of period                                                                              |   | 7,701                       |       | 16,467 |   | 460 |   |
| End of period                                                                                    |   | $                           | 5,276      |   | $ | 7,701 |   | $ | 16,467 |   |
|                                                                                             |   |                        |       |   |   |   |   |
| Cash paid during the year for:                                                                   |   |                        |       |   |   |   |   |
| Interest                                                                                         |   | $                           | 60         |   | $ | — |   | $ | — |   |
|                                                                                             |   |                        |       |   |   |   |   |
| Supplemental cash flow information:                                                              |   |                        |       |   |   |   |   |
| Stock issued in connection with purchase of assets                                               |   | $                           | —     |   | $ | 3,500 |   | $ | — |   |
| Assets purchased with capital lease                                                              |   | 675                         |       | — |   | — |   |
| Purchase of technology with equity instruments                                                   |   | 750                         |       | 1,300 |   |   |   |
| Purchase of goods and services with equity instruments                                           |   | 519                         |       | — |   | 2,500 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CENTERSPAN COMMUNICATIONS CORPORATION**

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER’S EQUITY**

**(In thousands)**

 
|                                                   |   | **Common Stock** |   | **Common   Stock** |   | **Accumulated** |   | **Accumulated  Other Comprehensive** |   | **Total Shareholders** |    |
|--------------------------------------------------------|--------|------------------|--------|--------------------|--------|-----------------|--------|--------------------------------------|--------|------------------------|---------|
|                                                   |   | **Shares**       |   | **Amount**         |   | **Warrants**    |   | **Deficit**                          |   | **Income (Loss)**      |    | **Equity** |   |
| **Balance at December 31, 1998**                       |   | 4,597            |   | $                  | 14,846 |            | $      | —                               |   | $                      | (3,262  | ) | $ | (31 | ) | $ | 11,553 |   |
| Proceeds from issuance of common stock                 |   | 848              |   | 9,270              |   | 1,030           |   | —                               |   | —                 |    | 10,300 |   |
| Tax benefits from stock options exercised              |   | —           |   | 30                 |   | —          |   | —                               |   | —                 |    | 30 |   |
| Beneficial conversion feature on debt                  |   | —           |   | 987                |   | —          |   | —                               |   | —                 |    | 987 |   |
| Conversion of convertible debt                         |   | 492              |   | 6,000              |   | —          |   | —                               |   | —                 |    | 6,000 |   |
| Exercise of warrants                                   |   | 13               |   | 203                |   | —          |   | (203                                 | )      | —                 |    | — |   |
| Warrants issued in exchange for goods and services     |   | —           |   | —             |   | 2,500           |   | —                               |   | —                 |    | 2,500 |   |
| Non-cash compensation expense                          |   | —           |   | 400                |   | —          |   | —                               |   | —                 |    | 400 |   |
| Cumulative translation adjustment                      |   | —           |   | —             |   | —          |   | —                               |   | 31                     |    | 31 |   |
| Net loss                                               |   | —           |   | —             |   | —          |   | (15,841                              | )      | —                 |    | (15,841 | ) |
| **Balance at December 31, 1999**                       |   | 5,950            |   | 31,736             |   | 3,530           |   | (19,306                              | )      | —                 |    | 15,960 |   |
| Exercise of stock options                              |   | 240              |   | 1,398              |   | —          |   | —                               |   | —                 |    | 1,398 |   |
| Exercise of warrants                                   |   | 66               |   | 684                |   | —          |   | (684                                 | )      | —                 |    | — |   |
| Warrant issued in exchange for technology              |   | —           |   | —             |   | 1,300           |   | —                               |   | —                 |    | 1,300 |   |
| Common stock issued in exchange for specific assets    |   | 333              |   | 3,500              |   | —          |   | —                               |   | —                 |    | 3,500 |   |
| Common stock issued in private placement               |   | 714              |   | 5,000              |   | —          |   | —                               |   | —                 |    | 5,000 |   |
| Net loss                                               |   | —           |   | —             |   | —          |   | (9,468                               | )      | —                 |    | (9,468 | ) |
| **Balance at December 31, 2000**                       |   | 7,303            |   | 42,318             |   | 4,830           |   | (29,458                              | )      | —                 |    | 17,690 |   |
| Exercise of stock options                              |   | 80               |   | 592                |   | —          |   | —                               |   | —                 |    | 592 |   |
| Exercise of warrants                                   |   | 53               |   | 279                |   | (279            | )      | —                               |   | —                 |    | — |   |
| Common stock and warrants issued in private placements |   | 1,284            |   | 8,114              |   | 3,126           |   | —                               |   | —                 |    | 11,240 |   |
| Stock option issued in exchange for services           |   | —           |   | 519                |   | —          |   | —                               |   | —                 |    | 519 |   |
| Common stock issued in exchange for technology         |   | 67               |   | 750                |   | —          |   | —                               |   | —                 |    | 750 |   |
| Net loss                                               |   | —           |   | —             |   | —          |   | (20,862                              | )      | —                 |    | (20,862 | ) |
| **Balance at December 31, 2001**                       |   | 8,787            |   | $                  | 52,572 |            | $      | 7,677                                |   | $                      | (50,320 | ) | $ | — |   | $ | 9,929 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**CENTERSPAN COMMUNICATIONS CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1.  The Company**

 

CenterSpan Communications Corporation (“CenterSpan” or the “Company”)was originally incorporated in 1990 as ThrustMaster, Inc., an OregonCorporation.  The Company changed itsname to CenterSpan Communications Corporation in October 1999.

 

Until 1999, the Company was a developer and marketer of realistic, highquality game controllers for the home personal computer (“PC”) and videoconsole markets, which comprised the Company’s hardware business.  CenterSpan sold this portion of its businessin July 1999.  See Note 5.

 

CenterSpan currently develops and markets secure Internet contentdelivery solutions for media and communications service providers and theenterprise.  C-StarTM CDN Services 2.0,the Company’s current offering announced in February 2002, is a suite ofmodular content delivery solutions for delivering digital audio, video and datafiles.  Components of C-StarTM enablecontent preparation, publishing, security, delivery and analytics for media andentertainment, communications service providers and large corporate customers.

 

The Company’s C-StarTM CDN Services suite is targeted at the Content DistributionNetwork (“CDN”) market serving communications service providers such as telecomcompanies, Multiple Service Operators (“MSO’s”) and Internet Service Providers(“ISP’s”), and media service providers like movie studios, music labels,publishers, distributors and portals. The Company is also developing product solutions based on C-StarTMtechnology to sell to potential customers such as large corporate customersthat desire to own and operate their own content delivery network.

 

The market for CenterSpan’s products is characterized by rapidlychanging technology, evolving industry standards, and changing customerneeds.  CenterSpan believes that itsfuture success will depend, in part, upon its ability to enhance its currentproducts and develop new products on a timely and cost-effective basis, and torespond to changing customer needs and technological developments.  An inability of CenterSpan to generatedemand for its products, whether as a result of competition, technologicalchange or other factors, could have a material adverse affect on the Company’sfinancial condition, results of operations and liquidity.

 

The consolidated financial statements include the accounts ofCenterSpan Communications Corporation, an Oregon corporation, and itswholly-owned subsidiaries, ThrustMaster (Europe) Limited, ThrustMaster(Deutschland) GmbH and CSCC Corporation. All inter-company transactions have been eliminated.

 

**NOTE 2.  SignificantAccounting Policies**

 

*Cash and Cash Equivalents.*  Cashequivalents consist of highly liquid debt instruments purchased with anoriginal maturity of three months or less.

 

*Restricted Cash. *Restricted cash includes $562,000 related to deposits for certaincontracts, a majority of which is scheduled to be paid in May 2002.

 

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*Fair Value of Financial Instruments. *CenterSpan’s financial instruments consist of accounts payable.  For the periods presented, the fair value ofCenterSpan’s accounts payable is equal to its carrying value.

 

*Plant and Equipment.*  Plant andequipment are stated at cost and are depreciated using the straight–linemethod over the estimated useful lives (three to seven years).  Capital leases are amortized over the lifeof the leases.  Replacements andimprovements that extend the useful lives are capitalized.  Maintenance and repairs and routinereplacements are expensed as incurred. Upon disposal, costs and related accumulated depreciation of the assetsare removed from the accounts and resulting gains and losses are reflected inoperations.

 

*Other Assets. *Other assets primarily consist of intangibleassets purchased during 2000 in conjunction with the purchase of certain assetsof Scour, Inc. See Note 4.  At December31, 2001, the intangible assets include a customer list and a trade name, whichare amortized on the straight–line basis over the expected periodto be benefited of three years.  SeeNote 3.

 

*IncomeTaxes*. Deferred tax assets and liabilities are recognized forthe future tax consequences attributable to differences between the financialreporting and tax bases of assets and liabilities and operating loss and taxcredit carryforwards.  Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period of change.  The Company has recorded a valuationallowance for its entire deferred tax asset balance since it is uncertainwhether it will be able to recognize the related tax benefits as a result ofcontinuing losses.

 

*Revenue Recognition.*  InDecember 1999, the Securities Exchange Commission (“SEC”) issued Staff AccountingBulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” whichprovides guidance in applying generally accepted accounting principles forrevenue recognition in financial statements. SAB 101 was effective beginning in the fourth quarter of 2000 and didnot have a material impact on our financial statements.

 

Revenue is recorded when the following criteria are met: persuasiveevidence of an arrangement exists; delivery has occurred or services have beenrendered; the seller’s price to the buyer is fixed or determinable, andcollectibility is reasonably assured. Revenue related to advertising has been recognized when services havebeen provided.

 

*Research and Engineering Expense.*  CenterSpan follows SFAS No. 2, “AccountingFor Research and Development Costs,” and charge all research and developmentcosts to expense as incurred.  The costof intangibles that are purchased from others for use in research anddevelopment activities and that have alternative future uses arecapitalized.  Intangibles purchased forresearch that do not have an alternative future use in other research projectsor otherwise are expensed as incurred.

 

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*Software Development Costs*.  CenterSpan**follows SFAS No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased, or OtherwiseMarketed.”  Costs incurred for thedevelopment of computer software and enhancements to existing software productsthat will be sold, leased, or otherwise marketed are capitalized whentechnological feasibility has been established.  Accordingly, developmentcosts related to software products are expensed until technological feasibilityof the product has been established. Based on CenterSpan’s product development process, technologicalfeasibility is established upon completion of a working model.  Costs incurred by CenterSpan betweencompletion of the working model and the point at which the product is ready forgeneral release have not been significant, and, accordingly, no costs have beencapitalized.

 

*Advertising.*Advertising costs, which include direct advertising, cooperativeadvertising and marketing development funds, are expensed as incurred andtotaled $23,000, $462,000 and $159,000 for continuing operations in 2001, 2000and 1999, respectively.

 

*StockBased Compensation.*CenterSpan accounts for stock-basedemployee compensation arrangements in accordance with provisions of AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB No. 25”) and complies with the disclosure provisions of SFAS No. 123,“Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense is based on the difference, ifany, on the date of grant between the exercise price of the instrument grantedand the fair value of the underlying stock.     Non-employeestock-based compensation is determined in accordance with SFAS No. 123,utilizing the Black Scholes valuation methodology.  Stock-based compensation is amortized over the vesting period ofthe related securities.  The Companyaccounts for stock and stock options issued to non-employees in accordance withthe provisions of Emerging Issues Task Force Consensus on Issue No. 96-18,Accounting for Equity Instruments that are Issued to Other than Employees forAcquiring, or in Conjunction with Selling, Goods or Services.

 

*EarningsPer Share Data.* Basic earnings per common share is computedusing the weighted average number of shares of common stock outstanding for theperiod.  Diluted earnings per common shareis computed using the weighted average number of shares of common stock anddilutive common equivalent shares outstanding during the year.  Common equivalent shares from stock optionsand other common stock equivalents are excluded from the computation when theireffect is antidilutive.

 

Shares used for basic and diluted earnings per share (“EPS”) are thesame for all periods presented since CenterSpan was in a loss position.  Potentiallydilutive securities that were not included in the diluted net loss per sharecalculations because they would be antidilutive were as follows (in thousands):

 
|           |   | **Year Ended  December 31,** |   |
|----------------|--------|------------------------------|--------|
|           |   | **2001**                     |   | **2000** |   | **1999** | ** ** |
| Stock options  |   | 3,673                        |   | 2,143 |   | 1,181 |   |
| Stock warrants |   | 1,185                        |   | 599 |   | 479 |   |
| Total          |   | 4,858                        |   | 2,742 |   | 1,660 |   |

 

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*Comprehensive Income (Loss).* CenterSpan has adopted the accounting treatment prescribed byFinancial Accounting Standards Board SFAS No. 130, “Reporting ComprehensiveIncome” (“SFAS 130”). SFAS 130 establishes standards for reportingcomprehensive income (loss) and its components in financial statements.Comprehensive income (loss), as defined, includes all changes in equity duringa period from non-owner sources.  Comprehensiveloss was the same as the net loss for 2001 and 2000 and was $15.8 million forthe year ended December 31, 1999.

 

*Use of Estimates.*The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.

 

*Reclassifications.*  Certain reclassifications, noneof which affected operating or net loss, have been made to the 1999 amounts toconform to the current presentation.

 

**Note 3.  New Accounting Pronouncements**

 

In June 2000, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 138, “Accounting for Certain DerivativeInstruments and Certain Hedging Activities-an amendment of FASB Statement No.133” (“SFAS No. 138”).  In June 1999,the FASB issued Statement of Financial Accounting Standards No. 137,“Accounting for Derivative Instruments and Hedging Activities” (“SFAS No.137”).  SFAS No. 137 is an amendment toStatement of Financial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities.” SFAS Nos. 137 and 138 establish accounting and reporting standards forall derivative instruments.  SFAS Nos.137 and 138 are effective for fiscal years beginning after June 15, 2000.  CenterSpan does not currently have anyderivative instruments and, accordingly, the adoption of SFAS Nos. 133, 137 and138 in the first quarter of 2001 did not have an impact on its financialposition, results of operations or cash flows.

 

In July 2001, the FASB issued SFAS No. 141, Business Combinations, andStatement No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 141 requires that the purchasemethod of accounting be used for all business combinations completed after June30, 2001.  SFAS No. 141 also specifiescriteria that intangible assets acquired in a purchase method businesscombination must meet to be recognized and reported apart from goodwill, notingthat any purchase price allocable to an assembled workforce may not beaccounted for separately.  SFAS No. 142requires that goodwill and intangible assets with indefinite useful lives nolonger be amortized, but instead tested for impairment at least annually inaccordance with the provisions of SFAS No. 142.  SFAS No. 142 also requires that intangible assets with estimableuseful lives be amortized over their respective estimated useful lives to theirestimated residual values, and reviewed for impairment in accordance with SFASNo. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed of.”  SFAS No. 121is being superseded by SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” effective January 1, 2002.

 

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The Company adopted the provisions of SFASNo. 141 July 1, 2001 and will adopt the provisions of SFAS No. 142 on January1, 2002.  SFAS No. 141 requires, uponadoption of SFAS No. 142, that the Company evaluate its existing intangibleassets that were acquired in prior purchase business combinations, and make anynecessary reclassifications in order to conform with the new criteria in SFASNo. 141 for recognition of separately identifiable intangible assets.  Upon adoption of SFAS No. 142, the Companyis required to reassess the useful lives and residual values of all intangibleassets acquired and make any necessary amortization period adjustments by theend of the first interim period after adoption.  In addition, to the extent an intangible asset is identified ashaving an indefinite useful life, the Company will be required to test theintangible asset for impairment in accordance with the provisions of SFAS No.142 within the first interim period. Any impairment loss will be measured as of the date of adoption andrecognized as the cumulative effect of a change in accounting principle in thefirst interim period.

 

At December 31, 2001, the Company did nothave any goodwill, but had unamortized identifiable intangible assets in theamount of $2.6 million.  The Company anticipatesthat it will continue to amortize all of its identifiable intangibleassets.  Amortization expense related toidentifiable intangibles was $2.6 million in 2001 and $0 in both 2000 and 1999.  In 2001, the Company recorded impairment charges totaling $3.1 millionrelated to its intangible assets.  TheCompany does not anticipate recording an additional impairment charge in thefirst quarter of 2002 upon adoption of SFAS No. 142.

 

In August 2001, the FASB approved SFAS No. 143, “Accounting for Asset RetirementObligations” (“SFAS No. 143”), which became effective January 1, 2002.  SFAS No. 143 addresses the financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs.  In October 2001, the FASB approved SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFASNo. 144”), which supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to be Disposed of” (“SFAS No. 121”)and the accounting and reporting provisions of APB No. 30, “Reporting theResults of Operations – Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions”for the disposal of a segment of a business. SFAS No. 144 retains many of the fundamental provisions of SFAS No. 121,but resolves certain implementation issues. SFAS No. 144 will be adopted January 1, 2002.  Although we have not completed the evaluation of the affects ofthe adoption of SFAS Nos. 143 and 144, we do not believe that the adoption ofSFAS Nos. 143 and 144 will have a material affect on our financial condition orresults of operations.

 

**NOTE4.  Purchase of Certain Assets of Scour,Inc.**

 

In December 2000, the Company purchased certain assets of Scour, Inc.for $5.8 million in cash and 333,333 shares of its common stock, which had avalue of $10.50 per share, for total consideration of $9.3 million.  The assets consisted of the following (inthousands):

 
| Customer list                  |   | $     | 5,253  |   |
|--------------------------------|--------|-------|--------|--------|
| Trade name                     |   | 2,438 |   |
| Purchased  technology          |   | 580   |   |
| Property, plant  and equipment |   | 1,016 |   |
|                           |   | $     | 9,287  |   |

 

37

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The Company reviews long-lived assets andidentifiable intangibles for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable as discussed in Note 7.

 

**NOTE5.  Discontinued Operations: Disposal ofHardware Business Assets**

 

In October 1999, Guillemot Corporation S.A. (“Guillemot”) purchasedcertain CenterSpan assets for a total price of $15.0 million, of which $2.25million was retained in escrow and was to be released to CenterSpan pursuant toa schedule provided in the parties’ escrow agreement.  In June 2000, CenterSpan filed a lawsuit for breach of contractagainst Guillemot.  CenterSpan allegedthat Guillemot breached the terms of the escrow agreement by prohibiting thescheduled release of escrow funds to CenterSpan. In March 2001, CenterSpan andGuillemot entered into a settlement agreement and mutual release under whichCenterSpan received approximately $1.4 million of restricted cash from escrow.Guillemot received approximately $1.0 million from escrow, consisting ofamounts collected on their behalf of approximately $318,000 and downwardpurchase price adjustments of approximately $682,000.  No amounts remained in escrow at December 31, 2001.  The purchase price adjustments made pursuantto the asset purchase agreement mainly related to uncollected accountsreceivable.  In connection with therelease of the restricted cash and final settlement with Guillemot, CenterSpanrecognized a gain on disposal of discontinued operations in 2001 of $674,000.

 

The sale of the hardware business has been accounted for asdiscontinued operations and, accordingly, its operations are segregated in thestatements of operations.  Revenues fromdiscontinued operations were $13.5 million for the year ended December 31,1999.  Certain expenses have beenallocated to continuing operations, based on the number of employees remainingwith the software business, their related employee costs and overhead forfacilities and other related costs and corporate overhead expenses that wereexpected to represent continuing expenses.

 

Loss from discontinued operations was $5.2 million in 1999.  The loss from discontinued operationsrepresents the net activity of the discontinued hardware business, includingrevenues and associated expenses and the resulting tax benefit.

 

**NOTE 6.  Plant and Equipment**

 

Plant and equipment consists of the following atDecember 31 (in thousands):

 
|                                                  |   | **2001** |   | **2000** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|
| Computers and other equipment                         |   | $        | 4,232  |     | $      | 2,765 |   |
| Tooling                                               |   | 3        |   | 3        |   |
| Furniture and  fixtures                               |   | 538      |   | 495      |   |
| Leasehold  improvements                               |   | 165      |   | 160      |   |
|                                                  |   | 4,938    |   | 3,423    |   |
| Less:  Accumulated depreciation and amortization |   | (2,261   | )      | (1,014   | )      |
|                                                  |   | $        | 2,677  |     | $      | 2,409 |   |

 

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**NOTE 7.  Other Assets**

 

Other assets consists of the following at December31 (in thousands):

 
|                                 |   | **2001** |   | **2000** |   |
|--------------------------------------|--------|----------|--------|----------|--------|
| Customer List                        |   | $        | 2,775  |     | $      | 5,253 |   |
| Trade name                           |   | 2,438    |   | 2,438    |   |
| Purchased  technology                |   | —   |   | 580      |   |
| Other                                |   | 23       |   | 12       |   |
|                                 |   | 5,236    |   | 8,283    |   |
| Less:  Accumulated amortization |   | (2,599   | )      | —   |   |
|                                 |   | $        | 2,637  |     | $      | 8,283 |   |

 

The Company reviews long-lived assets andidentifiable intangibles for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. The Company determines impairment based on a comparison of thecarrying amount of the assets to the estimated fair value of the assets, whichis determined based on the discounted cash flow method or current market pricesfor similar assets when available. Based on these analyses, the Company recorded impairment chargestotaling $3.1 million in 2001 related to the purchased technology and thecustomer list.

 

**NOTE 8.  Accrued Liabilities**

 

Accrued liabilities consist of the following at December 31 (inthousands):

 
|                                                       |   | **2001** |   | **2000** |   |
|------------------------------------------------------------|--------|----------|--------|----------|--------|
| Accrued bonuses                                            |   | $        | 397    |     | $      | 500 |   |
| Other accrued  expenses related to discontinued operations |   | —   |   | 1,944    |   |
| Accrued vacation                                           |   | 163      |   | 92       |   |
| Other  liabilities                                         |   | 43       |   | 21       |   |
|                                                       |   | $        | 603    |     | $      | 2,557 |   |

 

**NOTE 9.  Commitments, Contingencies and Factors That Could Affect FutureResults**

 

***Commitments***

CenterSpan leases facilities and equipment undernon–cancelable operating leases. Certain of the facility leases contain escalation clauses.  The following is a schedule by year, throughexpiration of the facilities leases, of future minimum lease payments requiredunder these leases as of December 31, 2001 (in thousands):

 

| **For the  year ending December 31,** |   |   |   |
|---------------------------------------|--------|--------|--------|
| **2002**                              |   | $      | 888    |   |
| **2003**                              |   | 821    |   |
| **2004**                              |   | 647    |   |
| **2005**                              |   | 122    |   |
|                                  |   | $      | 2,478  |   |

 

Commitments under capital leases are $225,000 in2002.  Under the agreements for thelease of its office facilities, CenterSpan is obligated to the lessors for itsshare of certain expenses related to the use, operation, maintenance andinsurance of the property.  Theseexpenses, payable monthly in addition to the base rent, are not included in theamounts shown above.

 

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Rental expense totaled $441,000, $222,000 and$222,000 for the years ended December 31, 2001, 2000 and 1999, respectively.

 

***Factors That CouldAffect Future Results***

The revenue and profit potential related to CenterSpan’s C-Starätechnology and C-StarTM CDN Services and other applications for its C-Starätechnology are unproven.  These andother technologies to be developed may not achieve widespread customeracceptance, which would adversely affect CenterSpan’s future results ofoperations and liquidity.

 

The markets for CenterSpan’s products and services are characterized byfrequent new product introductions and product obsolescence.  These factors typically result in shortproduct life cycles.  If CenterSpan doesnot successfully introduce new products within a given product cycle, its saleswill be adversely affected for that cycle and possibly for subsequentcycles.  Failure to timely introducethese products could also impair CenterSpan’s brand name and ability tomaintain relationships with strategic partners.  In addition, each new product cycle presents new opportunitiesfor competitors to gain a product advantage or increase their market share.

 

**Note10.  Legal Proceedings**

 

In May 2001, Ingram Micro, Inc. filed a lawsuit against the Company inthe U.S. District Court for Oregon.  Thedispute concerned Ingram’s ability to return CenterSpan merchandise for whichit acted as a distributor in 1999.  Theamount of the claim was approximately $450,000 plus pre-judgment interest.  The Company settled this matter in November2001 for $225,000.  The Companypaid  $100,000 on December 1, 2001 and$62,500 on February 1, 2002 and will pay an additional $62,500 on April 1,2002.

 

**NOTE 11.  Changes in Equity**

 

In August 2001, CenterSpan purchased certain assets fromSupertracks.com, Inc. for total consideration of 66,905 shares of the Company’scommon stock with a total value of $750,000 on the date of purchase.  The $750,000 was recorded as research andengineering expense as the technology is being used in a product currentlyunder development and for which no alternative use exists.

 

In June 2001, CenterSpan sold 569,177 units, each consisting of oneshare of its common stock and a warrant to purchase one share of its commonstock for an exercise price of $18.68 per share, to nine accredited investorsfor $11.21 per unit (the 30-day trailing volume weighted average price of theCompany’s common stock) for proceeds to the Company of $6.4 million.  In conjunction with this issuance, warrantscovering an additional 21,008 shares of the Company’s common stock were issuedto the investors and certain finders with an exercise price of $18.68 pershare.  The warrants are immediatelyexercisable and expire in June 2004. The warrants were valued using the Black-Scholes model using thefollowing assumptions: expected dividends, 0%; risk-free interest rate, 4.4%;volatility, 90%; and contractual life, 3 years.  The relative fair value of the 569,177 warrants was $2.0 million.

 

In December 2000 and February 2001, CenterSpan sold an aggregate of1,428,572 shares of its common stock to an accredited investor for $7.00 pershare for total proceeds of $10.0 million. In conjunction with these issuances, the Company issued warrantsexercisable for an aggregate of 170,000 shares of its common stock to fivedesignees of the investor’s

 

40

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financial consultant.  Thewarrants are immediately exercisable at a price of $9.063 per share and expirein December 2005. The warrants were valued using the Black-Scholes modelusing the following assumptions: expected dividends, 0%; risk-free interestrate, 5.9%; volatility, 90%; and contractual life, 5 years.  The relative fair value of the 170,000warrants issued was $1.0 million.

 

In December 2000, CenterSpan issued 333,333 shares of its common stockin connection with the purchase of the assets of Scour, Inc.  The shares were valued at $10.50 per share.

 

In April 2000, CenterSpan issued a warrant to purchase 125,000 sharesof its common stock at $13.41 per share, which represented a 15% discount to anaverage of the preceding 10 day closing stock price, to Intel Corp. in exchangefor certain technology. The warrant vested immediately and is exercisable untilApril 21, 2005.  The warrant was valuedusing the Black-Scholes model using the following assumptions: expecteddividends, 0%; risk-free interest rate, 5.9%; volatility, 83%; and contractuallife, 5 years.  The fair value of thewarrant was $1.3 million.

 

On August 31, 1999, CenterSpan sold 273,853 shares of its common stockfor $18.258 per share to a single investor, receiving $5.0 million inproceeds.  In connection with the sale,the Company issued a warrant for 30,000 shares of its common stock to theinvestor’s financial consultant as a finder’s fee. The exercise price for thiswarrant is $18.258 per share and it is exercisable at any time before August30, 2004. The warrant was valued using the Black-Scholes model using thefollowing assumptions: expected dividends, 0%; risk-free interest rate, 5.9%;volatility, 78%; and contractual life, 5 years.  The fair value of the warrant was $450,000.

 

In August 1999, CenterSpan issued a warrant to acquire 200,000 sharesof its common stock for $18.09 per share, which represented a 15% discount toan average of the preceding 20-day closing stock price, to Intel Corp. inexchange for certain technology.  Thewarrant is exercisable until August 9, 2004. The warrant was valued using theBlack-Scholes model using the following assumptions: expected dividends, 0%;risk-free interest rate, 5.0%; volatility, 78%; and contractual life, 5years.  The fair value of the warrantwas $2.2 million.

 

On June 9, 1999, CenterSpan issued and sold to two investors $6.0million aggregate principal amount of its zero coupon Convertible Debenturesdue June 9, 2002 (the “Debentures”). The Debentures were converted into 492,011shares of CenterSpan’s common stock in December 1999.

 

On January 28, 1999, CenterSpan issued to three investors an aggregateof 250,000 shares of its common stock and warrants to acquire 70,754 shares ofits common stock for an aggregate of $4.0 million.  The exercise price applicable to 50% of the shares issuable uponexercise of the warrants is $20.00 per share; the exercise price for theremaining warrant shares is $22.40 per share. The common stock warrants are exercisable until January 28, 2004. Thewarrant was valued using the Black-Scholes model using the followingassumptions: expected dividends, 0%; risk-free interest rate, 4.6%; volatility,76%; and contractual life, 5 years.  Therelative fair value of the warrant was $580,000.

 

41

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**NOTE 12.  Stock Option Plans and Warrants**

 

***Options***

CenterSpan has adopted a stock option plan for employees and directors(as amended, the “1998 Plan”) and has reserved 4.1 million shares of commonstock for issuance thereunder. The 1998 Plan provides for incentive stockoptions and nonqualified options to be granted.  CenterSpan previously made grants under the 1994 Stock OptionPlan, the 1994 Directors’ Stock Option Plan, and a nonqualified plan adopted in1990, under which a total of 1.2 million shares had been reserved.  In May 1998, any ungranted options and anyfuture forfeitures under the 1994 and 1990 option plans were transferred to the1998 Stock Option Plan.  At December 31,2001, CenterSpan had 2,720,797 shares of its common stock reserved for issuanceunder the 1998 Plan and all previous plans combined.

 

CenterSpan has also issued options covering 510,000 shares of commonstock outside of the 1998 Plan, for which it had 510,000 shares of common stockreserved for issuance at December 31, 2001.

 

During 2000, the Board of Directors adopted the 2000 Nonqualified StockOption Plan (the “2000 Nonqualified Plan”) and approved the reservation of900,000 shares of the Company’s common stock for issuance thereunder.  At December 31, 2001, 861,138 shares of theCompany’s common stock remained reserved for issuance.

 

During 2001, the Board of Directors adopted anon-employee stock option plan and reserved 500,000 shares of the Company’scommon stock for issuance thereunder. At December 31, 2001, 490,000 shares of the Company’s common stockremained reserved for issuance.

 

Except for the 2000 Nonqualified Plan, the stockoption plans generally require the price of options to be at the estimated fairmarket value of the stock at the date of grant.  Options have a maximum duration of ten years (five years undercertain circumstances) and may be exercised in varying amounts over the vestingperiods.

 

The following table summarizes all stock option transactions in thelast three fiscal years (in thousands, except per share amounts):

 

 
|                            |   | **Shares   Available for   Grant** |   | **Shares  Subject to  Options** |   | **Weighted   Average   Exercise   Price   Per Share** |   |
|---------------------------------|--------|------------------------------------|--------|---------------------------------|--------|-------------------------------------------------------|--------|
| **Balances, December 31, 1998** |   | 830                                |   | 1,046                           |   | $                                                     | 4.11   |   |
| Additional  shares reserved     |   | 50                                 |   | —                          |   | —                                                |   |
| Options granted                 |   | (752                               | )      | 752                             |   | 14.31                                                 |   |
| Options  cancelled              |   | 293                                |   | (293                            | )      | 7.87                                                  |   |
| Options exercised               |   | —                             |   | (324                            | )      | 4.35                                                  |   |
| **Balances, December 31, 1999** |   | 421                                |   | 1,181                           |   | 10.01                                                 |   |
| Additional  shares reserved     |   | 1,425                              |   | —                          |   | —                                                |   |
| Options granted                 |   | (1,412                             | )      | 1,412                           |   | 13.38                                                 |   |
| Options  cancelled              |   | 210                                |   | (210                            | )      | 16.50                                                 |   |
| Options  exercised              |   | —                             |   | (240                            | )      | 5.91                                                  |   |
| **Balances, December 31, 2000** |   | 644                                |   | 2,143                           |   | 11.99                                                 |   |
| Additional  shares reserved     |   | 1,873                              |   | —                          |   | —                                                |   |
| Options granted                 |   | (2,125                             | )      | 2,125                           |   | 11.16                                                 |   |
| Options  cancelled              |   | 515                                |   | (515                            | )      | 13.93                                                 |   |
| Options  exercised              |   | —                             |   | (80                             | )      | 7.41                                                  |   |
| **Balances, December 31, 2001** |   | 907                                |   | 3,673                           |   | $                                                     | 11.31  |   |

 

42

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The following table summarizes information aboutstock options outstanding at December 31, 2001 (in thousands, except per shareamounts):

 
| **Options  Outstanding**                       |   | **Options  Exercisable** |   |
|------------------------------------------------|--------|--------------------------|--------|
| **Range of  Exercise   Prices**                |   | **Number  Outstanding**  |   | **Weighted   Average   Remaining  Contractual   Life (years)** |   | **Weighted   Average   Exercise   Price** |   | **Number of   Shares   Exercisable** |   | **Weighted   Average   Exercise Price** | ** ** |
| $2.45  –   $5.34           |   | 742                      |   | 8.3 |   | $ | 4.40 |   | 277 |   | $ | 3.14 |   |
| 6.00  –     9.88 |   | 796                      |   | 9.1 |   | 8.21 |   | 187 |   | 7.72 |   |
| 10.50  –   13.69           |   | 1,262                    |   | 9.1 |   | 12.54 |   | 95 |   | 13.29 |   |
| 14.25  –   18.00           |   | 651                      |   | 8.5 |   | 16.12 |   | 175 |   | 15.49 |   |
| 23.88  –   27.25           |   | 222                      |   | 8.1 |   | 24.35 |   | 56 |   | 24.35 |   |
| $2.43 – $27.25                            |   | 3,673                    |   | 8.8 |   | $ | 11.31 |   | 790 |   | $ | 9.68 |   |

 

At December 31, 2000 and 1999, 475,284 and 556,388 options,respectively, were exercisable at weighted average exercise prices of $7.74 pershare and $5.04 per share, respectively.

 

***Warrants***

All warrants are immediately exercisable for shares of the Company’scommon stock.  The following tablesummarizes warrant transactions (in thousands, except per share amounts):

 
| **Date  Issued** |   | **Shares   Subject to Warrant** |   | **Warrant   Shares   Cancelled** |   | **Shares********Acquired********Upon   Exercise** |   | **Warrant   Shares  Outstanding   at December   31, 2001** |   | **Expiration   Date** |   | **Weighted   Average   Exercise   Price   Per Share** |   |
|------------------|--------|---------------------------------|--------|----------------------------------|--------|---------------------------------------------------|--------|------------------------------------------------------------|--------|-----------------------|--------|-------------------------------------------------------|--------|
| 12/04/98         |   | 89                              |   | 36                               |   | 53                                                |   | —                                                     |   | —                |   | $                                                     | — |   |
| 08/09/99         |   | 200                             |   | —                           |   | —                                            |   | 200                                                        |   | 08/09/04              |   | 18.09                                                 |   |
| 08/30/99         |   | 30                              |   | —                           |   | —                                            |   | 30                                                         |   | 08/30/04              |   | 18.26                                                 |   |
| 01/28/99         |   | 35                              |   | —                           |   | —                                            |   | 35                                                         |   | 01/28/04              |   | 20.00                                                 |   |
| 01/28/99         |   | 35                              |   | —                           |   | —                                            |   | 35                                                         |   | 01/28/04              |   | 22.40                                                 |   |
| 04/21/00         |   | 125                             |   | —                           |   | —                                            |   | 125                                                        |   | 04/21/05              |   | 13.41                                                 |   |
| 12/18/00         |   | 85                              |   | —                           |   | —                                            |   | 85                                                         |   | 12/18/05              |   | 9.06                                                  |   |
| 02/23/01         |   | 85                              |   | —                           |   | —                                            |   | 85                                                         |   | 12/18/05              |   | 9.06                                                  |   |
| 06/20/01         |   | 501                             |   | —                           |   | —                                            |   | 501                                                        |   | 06/20/04              |   | 18.68                                                 |   |
| 06/22/01         |   | 89                              |   | —                           |   | —                                            |   | 89                                                         |   | 06/20/04              |   | 18.68                                                 |   |
|             |   |                            |   |                             |   |                                              |   | 1,185                                                      |   |                  |   | $                                                     | 16.79  |   |

 

***SFAS 123***

CenterSpan applies APB opinion No. 25 and relatedinterpretations in accounting for its stock based compensation plans.  However, in accordance with SFAS 123, proforma disclosures as if CenterSpan adopted the fair value method requirementsunder SFAS 123 for all awards subsequent to January 1, 1995, are presentedbelow.

 

The weighted average per share fair value of options and warrantsgranted during 2001, 2000 and 1999 was $8.76, $6.65 and $6.37, respectively.  The fairvalue of each option and warrant granted during the years ended 2001, 2000 and1999 was estimated on the date of grant using the Black-Scholes option pricingmodel with the following assumptions:

 
|                     |   | **Year ended  December 31,** |   |
|--------------------------|--------|------------------------------|--------|
|                     |   | **2001**                     |   | **2000** |   | **1999** | ** ** |
| Risk-free  interest rate |   | 2.8%-4.8                     | %      | 5.2%-6.8 | % | 4.6%-5.9 | % |
| Expected  dividend yield |   | 0                            | %      | 0 | % | 0 | % |
| Expected lives  (years)  |   | 5                            |   | 5 |   | 5 |   |
| Volatility               |   | 93                           | %      | 89 | % | 76%-78 | % |

 

43

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Had compensation cost for CenterSpan’s stock option plans and warrantsbeen determined consistent with SFAS 123, CenterSpan’s net loss would have beenadjusted to the following pro forma amounts (in thousands, except per shareamounts):

 
|                                                            |   | **Year Ended  December 31,** |    |
|-----------------------------------------------------------------|--------|------------------------------|---------|
|                                                            |   | **2001**                     |    | **2000** | ** ** | **1999** | ** ** |
| Loss from  continuing operations:                               |   |                         |    |   |   |   |   |
| As reported                                                     |   | $                            | (21,536 | ) | $ | (9,468 | ) | $ | (10,640 | ) |
| Pro forma                                                       |   | (30,300                      | )       | (14,143 | ) | (11,277 | ) |
| Basic and  diluted loss per share from continuing operations:   |   |                         |    |   |   |   |   |
| As reported                                                     |   | (2.59                        | )       | (1.52 | ) | (2.11 | ) |
| Pro forma                                                       |   | (3.65                        | )       | (2.27 | ) | (2.24 | ) |
| Gain (loss) from  discontinued operations:                      |   |                         |    |   |   |   |   |
| As reported                                                     |   | 674                          |    | — |   | (5,201 | ) |
| Pro forma                                                       |   | 674                          |    | — |   | (5,340 | ) |
| Basic and  diluted loss per share from discontinued operations: |   |                         |    |   |   |   |   |
| As reported                                                     |   | 0.08                         |    | — |   | (1.03 | ) |
| Pro forma                                                       |   | 0.08                         |    | — |   | (1.06 | ) |
| Net loss:                                                       |   |                         |    |   |   |   |   |
| As reported                                                     |   | (20,862                      | )       | (9,468 | ) | (15,841 | ) |
| Pro forma                                                       |   | (29,626                      | )       | (14,143 | ) | (16,617 | ) |
| Basic and  diluted net loss per share:                          |   |                         |    |   |   |   |   |
| As reported                                                     |   | (2.51                        | )       | (1.52 | ) | (3.14 | ) |
| Pro forma                                                       |   | (3.57                        | )       | (2.27 | ) | (3.30 | ) |
|                                                                 |        |                              |         |  |  |  |  |  |  |  |

 

The effect of applying SFAS 123 in this pro formadisclosure is not indicative of future amounts.

 

**NOTE 13.  Income Taxes**

 

The provision for income taxes from continuing operations is as follows(in thousands):

 
|      |   | **Year ended  December 31,** |   |
|-----------|--------|------------------------------|--------|
|      |   | **2001**                     |   | **2000** |   | **1999** |   |
| Current:  |   |                         |   |   |   |   |   |
| Federal   |   | $                            | — |   | $ | — |   | $ | (145 | ) |
| State     |   | —                       |   | — |   | — |   |
|      |   | —                       |   | — |   | (145 | )  |
| Deferred: |   |                         |   |   |   |   |   |
| Federal   |   | —                       |   | — |   | 4,166 |   |
| State     |   | —                       |   | — |   | 511 |   |
|      |   | —                       |   | — |   | 4,677 |   |
|      |   | $                            | — |   | $ | — |   | $ | 4,532 |   |

 

The provision for income taxes differs from theamount of income taxes determined by applying the statutory federal income taxrate to income from continuing operations due to the following:

 
|                                      |   | **Year Ended  December 31,** |   |
|-------------------------------------------|--------|------------------------------|--------|
|                                      |   | **2001**                     |   | **2000** |   | **1999** |   |
| Statutory  federal income tax rate        |   | (34.0                        | )%     | (34.0 | )% | (34.0 | )% |
| State taxes, net  of federal income taxes |   | (4.5                         | )      | (4.4 | ) | (4.4 | ) |
| Change in  valuation allowance            |   | 41.7                         |   | 38.4 |   | 108.0 |   |
| Other, net                                |   | (3.2                         | )      | — |   | — |   |
| Effective tax  rate                       |   | —                       | %      | — | % | 69.6 | % |

 

44

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Deferred tax assets (liabilities) are comprised of the followingcomponents (in thousands):

 
|                                              |   | **December  31,** |   |
|---------------------------------------------------|--------|-------------------|--------|
|                                              |   | **2001**          |   | **2000** |   |
| Deferred tax  assets:                             |   |              |   |   |   |
| Expenses and  allowances not currently deductible |   | $                 | 122    |   | $ | 616 |   |
| Net operating  loss carryforwards                 |   | 20,034            |   | 10,993 |   |
| Credit carryforwards                              |   | 739               |   | 581 |   |
| Net deferred  income taxes                        |   | 20,895            |   | 12,190 |   |
| Valuation  allowance                              |   | (20,895           | )      | (12,190 | ) |
|                                              |   | $                 | — |   | $ | — |   |

 

The net change in total valuation allowance for the years endedDecember 31, 2001, 2000 and 1999 was an increase of $8.7 million, $3.8 millionand $8.4 million, respectively.

 

The Company has established a valuation allowance for its deferred taxassets.  Such a valuation allowance isrecorded when it is more likely than not that some portion of the deferred taxassets will not be realized.  Theportion of the valuation allowance for deferred tax assets for whichsubsequently recognized tax benefits will be applied directly to contributedcapital is $3.8 million as of December 31, 2001.  This amount is attributable to differences between financial andtax reporting of employee stock option transactions.

 

CenterSpan has federal, state and foreign netoperating loss carryforwards of $42.7 million, $50.7 million and $6.6 million,respectively, and research and experimentation credits of $576,000 that expirethrough 2021.  CenterSpan also hasAlternative Minimum Tax (AMT) credits in the amount of $163,000, which may becarried forward indefinitely.

 

**NOTE 14.  401(k) Plan**

 

CenterSpan has a 401(k) Plan coveringsubstantially all employees meeting minimum service requirements. The 401(k)Plan allows CenterSpan to make discretionary matching contributions.  CenterSpan provided discretionarycontributions of $41,000, $36,000, and $30,000 for the years ended December 31,2001, 2000, and 1999, respectively.

 

45

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**NOTE 15.  QuarterlyFinancial Data (Unaudited)**

 

Selected unaudited quarterly financial data**for each of the eightquarters in the two-year period ended December 31, 2001 is as follows:

 
|                                  |   | **1st Quarter**                         |         | **2nd Quarter** |         | **3rd Quarter** |         | **4th Quarter** |   |
|---------------------------------------|--------|-----------------------------------------|--------------|-----------------|--------------|-----------------|--------------|-----------------|--------|
|                                  |   | **In thousands, except per share data** |         |
| **2000**                              |   |                                    | *** *** |            | *** *** |            | *** *** |            |   |
| Revenue                               |   | $                                       | —       |            | $            | 1               |         | $               | — |   | $ | — |   |
| Gross profit                          |   | —                                  |         | 1               |         | —          |         | —          |   |
| Net loss                              |   | (1,380                                  | )            | (3,430          | )            | (2,410          | )            | (2,248          | )      |
| Basic and  diluted net loss per share |   | (0.23                                   | )            | (0.55           | )            | (0.39           | )            | (0.35           | )      |
|                                       |        |                                         |              |                 |              |                 |              |                 |        |  |  |  |  |

 
| **2001**                                                                   |   | **1st Quarter** |   | **2nd Quarter** |   | **3rd Quarter** |   | **4th Quarter** | *** *** |
|----------------------------------------------------------------------------|--------|-----------------|--------|-----------------|--------|-----------------|--------|-----------------|--------------|
| Revenue                                                                    |   | $               | 12     |            | $      | —          |   | $               | 39           |   | $ | — |   |
| Gross profit                                                               |   | 12              |   | —          |   | 39              |   | —          |         |
| Loss from  continuing operations                                           |   | (4,494          | )      | (4,931          | )      | (5,648          | )      | (6,463          | )            |
| Gain on disposal  of discontinued operations                               |   | 604             |   | —          |   | —          |   | 70              |         |
| Net loss                                                                   |   | (3,890          | )      | (4,931          | )      | (5,648          | )      | (6,393          | )            |
| Basic and  diluted loss per share from continuing operations               |   | (0.59           | )      | (0.61           | )      | (0.65           | )      | (0.74           | )            |
| Basic and  diluted gain per share from disposal of discontinued operations |   | 0.08            |   | —          |   | —          |   | 0.01            |         |
| Basic and  diluted net loss per share                                      |   | (0.51           | )      | (0.61           | )      | (0.65           | )      | (0.73           | )            |
|                                                                            |        |                 |        |                 |        |                 |        |                 |              |  |  |  |  |

 

In the fourth quarter of 2001, the Company recorded an impairmentcharge of $2.5 million related to the customer list, as discussed in Note 7.

 

**NOTE 16.  Subsequent Events**

 

In February 2002, CenterSpan sold 662,667 units of the Company (the“units”) to a total of twelve accredited investors for $6.00 per unit for totalproceeds to the Company of $4.0 million. Each unit consists of one share of the Company’s common stock and awarrant to purchase one share of the Company’s common stock for $10.67 pershare.  The warrants are immediatelyexercisable and expire February 11, 2005. The warrants were valued using the Black-Scholes model using thefollowing assumptions: expected dividends, 0%; risk-free interest rate, 3.6%;volatility, 92.7%; and contractual life, 3 years.  The relative fair value of the warrants was $1.5 million.

 

In February 2002, CenterSpan entered into an agreement with Sony Musicwherein Sony will provide CenterSpan with certain musical content for it todistribute digitally via its C-StarTM content delivery network to variousC-StarTM service provider customers and their subscribers in the U.S. and Canada.  In exchange, CenterSpan issued to Sony283,556 shares of its common stock and a warrant to purchase 189,037 shares ofits common stock.  In addition,CenterSpan agreed to pay an initial content integration fee of $500,000 inconnection with execution of the agreement and an additional contentintegration fee of $500,000 on September 1, 2002, as well as quarterly advanceminimum service fees of $250,000 for four quarters beginning September 1, 2002.

 

The 283,556 shares of common stock issued to Sony had a value of $1.7million, representing an approximately 25% discount from the trailing 10-dayvolume-weighted average price of the Company’s common stock.  The warrant to purchase 189,037 shares ofCenterSpan’s common stock has an exercise price of $8.11 per share and wasvalued using the Black-Scholes model using the following assumptions: expecteddividends, 0%; risk-free interest rate, 3.6%; volatility, 92.7%; andcontractual life, 3 years.  The fairvalue of the warrant was $1.0 million.

 

46

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In March 2002, CenterSpan entered into an agreement with an investorwho unconditionally agreed to purchase up to 833,333 shares of CenterSpan’scommon stock at a price of $6.00 per share, if requested to do so by thecompany, in one or more private transactions representing total maximumproceeds to the Company of $5.0 million. As compensation for entering into this commitment, the Company issued tothe investor a three-year warrant to purchase 100,000 shares of CenterSpan’scommon stock at $10.67 per share.  Tothe extent the investor purchases more than 100,000 shares of CenterSpan’scommon stock under this commitment, he will also receive a three-year warrantto purchase an equal number of shares of common stock at $10.67 per share.

 

CenterSpan has also arranged a stand by line of credit in the amount of$1.0 million on which the Company can draw after July 2002.

 

In March 2002, CenterSpan sold 333,333 units of the Company (the“units”) to a total of six accredited investors for $6.00 per unit for totalproceeds to the Company of $2.0 million. Each unit consists of one share of the Company’s common stock and awarrant to purchase one share of the Company’s common stock for $10.67 pershare.  The warrants are immediatelyexercisable and expire March 29, 2005. The warrants were valued using the Black-Scholes model using thefollowing assumptions: expected dividends, 0%; risk-free interest rate, 3.6%;volatility, 92.7%; and contractual life, 3 years.  The relative fair value of the warrants was $800,000.

 

**Item 9****.  Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

 

None.

 

**PART III**

 

**Item 10****.  Directorsand Executive Officers of the Registrant**

 

Information required by this item will be included under the captions *Election ofDirectors,**Executive Officers* and *Section16(a) Beneficial Ownership Reporting Compliance,* respectively, inCenterSpan’s Proxy Statement for its 2002 Annual Meeting of Shareholders and isincorporated herein by reference.

 

**Item 11****.  ExecutiveCompensation**

 

The information required by this item will be included under thecaption *ExecutiveCompensation* in CenterSpan’s Proxy Statement for its 2002 AnnualMeeting of Shareholders and is incorporated herein by reference.

 

**Item 12****.  Security Ownership of CertainBeneficial Owners and Management**

 

The information required by this item will be included under thecaption *SecurityOwnership of Certain Beneficial Owners and Management* inCenterSpan’s Proxy Statement for its 2002 Annual Meeting of Shareholders and isincorporated herein by reference.

 

**Item 13****.  Certain Relationships and RelatedTransactions**

 

None.

 

47

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**PART IV**

 

**Item 14.****  Exhibits,Financial Statement Schedules and Reports on Form 8-K**

 

**FinancialStatements and Schedules**

The Consolidated Financial Statements, together with the report thereonof KPMG LLP, are included on the pages indicated below:

 
|                                                                                                        |
|-------------------------------------------------------------------------------------------------------------|
| Independent Auditors’  Report                                                                          |
|                                                                                                        |
| Consolidated Balance Sheets  as of December 31, 2001 and 2000                                               |
|                                                                                                        |
| Consolidated  Statements of Operations for the years ended December 31, 2001, 2000 and 1999                 |
|                                                                                                        |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999                 |
|                                                                                                        |
| Consolidated  Statements of Shareholders’ Equity for the years ended December 31, 2001,  2000 and 1999 |
|                                                                                                        |
| Notes to  Consolidated Financial Statements                                                                 |

 

There are no schedules required to be filed herewith.

 

**Reportson Form 8-K**

No reports on Form 8-K were filed during the quarter ended December 31,2001.

 

**Exhibits**

The following exhibits are filed herewith and this list is intended toconstitute the exhibit index:

 
| **Exhibit  No.** |   |                                                                                                                                                                                                 |   |
|------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 2.1(1)           |   | Asset Purchase Agreement dated July 26, 1999 among  Guillemot Corporation, S.A., as the Purchaser, and Thrustmaster, Inc., as the  Seller                                                            |
|             |   |                                                                                                                                                                                                 |
| 2.2(2)           |   | Asset Purchase Agreement dated December 18, 2000  between CenterSpan and Scour, Inc.                                                                                                                 |
|             |   |                                                                                                                                                                                                 |
| 2.3(3)           |   | Asset Purchase Agreement  between CenterSpan and Supertracks.com, Inc. dated August 3, 2001                                                                                                          |
|             |   |                                                                                                                                                                                                 |
| 3.1              |   | Articles of Incorporation, as amended                                                                                                                                                                |
|             |   |                                                                                                                                                                                                 |
| 3.2(4)           |   | Amended and Restated Bylaws                                                                                                                                                                          |
|             |   |                                                                                                                                                                                                 |
| 10.1*            |   | 1998 Stock Option Plan, as amended                                                                                                                                                                   |
|             |   |                                                                                                                                                                                                 |
| 10.2(5)*         |   | 2000 Nonqualified Stock Option Plan                                                                                                                                                                  |
|             |   |                                                                                                                                                                                                 |
| 10.3(6)*         |   | Directors’ Nonqualified Stock Option Plan, dated  July 19, 1994, as amended                                                                                                                     |
|             |   |                                                                                                                                                                                                 |
| 10.4(6)*         |   | 1994 Stock Option Plan, dated July 19, 1994, as  amended                                                                                                                                             |
|             |   |                                                                                                                                                                                                 |
| 10.5(4)          |   | Leases, dated March 13, 1996, between Pacific Realty  Associates, L.P. and the Company, as amended                                                                                                   |
|             |   |                                                                                                                                                                                                 |
| 10.6(7)*         |   | Form of Change-in-Control Agreement for all officers  of CenterSpan Communications Corporation                                                                                                       |
|             |   |                                                                                                                                                                                                 |
| 10.7(8)          |   | Software Development and License Agreement dated  August 9, 1999 between Intel Corporation and the Company, as amended  (confidential treatment requested for portions of this exhibit)              |
|             |   |                                                                                                                                                                                                 |
| 10.8(9)          |   | Settlement Agreement and Mutual Release dated March  27, 2001 between CenterSpan Communications Corporation and Guillemot Corporation,  S.A.                                                         |
|             |   |                                                                                                                                                                                                 |
| 10.9(10)+        |   | Form of Unit Purchase  Agreement dated June 20, 2001                                                                                                                                                 |
|             |   |                                                                                                                                                                                                 |
| 10.10(10)+       |   | Form of Common Stock Purchase Warrant dated June 20,  2001                                                                                                                                           |
|             |   |                                                                                                                                                                                                 |
| 10.11(9)         |   | License Agreement dated April 12, 2001 and Term  License Lease Schedule between Oracle Corporation and CenterSpan  Communications Corporation.                                                       |
|             |   |                                                                                                                                                                                                 |
| 10.12(11)        |   | Securities Purchase Agreement dated as of January  28, 1999 among the Company and the Purchasers party thereto                                                                                       |
|             |   |                                                                                                                                                                                                 |
| 10.13(11)        |   | Form of Callable Warrant                                                                                                                                                                             |
|             |   |                                                                                                                                                                                                 |
| 10.14(11)        |   | Registration Rights Agreement dated as of January  28, 1999 among the Company and the Purchasers party thereto                                                                                       |
|             |   |                                                                                                                                                                                                 |
| 10.15(6)         |   | Common Stock Purchase Agreement, dated as of August  6, 1999, between the Company and Peter R. Kellogg                                                                                               |
|             |   |                                                                                                                                                                                                 |
| 10.16(6)         |   | Form of Warrant issued to Lucas Capital Management                                                                                                                                                   |
|             |   |                                                                                                                                                                                                 |
| 10.17            |   | Content Integration Agreement dated as of February  27, 2002 between CenterSpan and Sony Music, a group of Sony Entertainment,  Inc. (confidential treatment requested for portions of this exhibit) |
|             |   |                                                                                                                                                                                                 |
| 10.18(12)        |   | Common Stock Purchase Agreement dated December 18,  2000                                                                                                                                             |
|             |   |                                                                                                                                                                                                 |
| 10.19(12)        |   | Form of Common Stock Purchase Warrant dated December  18, 2000                                                                                                                                       |
|             |   |                                                                                                                                                                                                 |
| 21(5)            |   | Subsidiaries of the Registrant                                                                                                                                                                       |
|             |   |                                                                                                                                                                                                 |
| 23               |   | Consent of KPMG LLP                                                                                                                                                                                  |
|             |   |                                                                                                                                                                                                 |
| 24               |   | Power of Attorney (included on signature page)                                                                                                                                                       |

 

----

*  Management compensatory plan

+ A Schedule attached tothis exhibit identifies all other documents not required to be filed asexhibits because such other documents are substantially identical to thisexhibit. The schedule also sets forth material details by which the omitteddocuments differ from this exhibit.

 

(1)                                  Incorporatedby reference to the Company’s definitive proxy statement for the September 27,1999 Special Meeting of Shareholders filed with the Securities and ExchangeCommission on September 13, 1999.

(2)                                  Incorporatedby reference to the Company’s Current Report on Form 8-K filed with theSecurities and Exchange Commission on January 3, 2001.

(3)                                  Incorporatedby reference to a registration statement on Form S-3 (File No. 333-68192) asfiled with the Securities and Exchange Commission on August 22, 2001.

(4)                                  Incorporatedby reference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1996.

(5)                                  Incorporated by reference to the Company’sAnnual Report on Form 10-K for the year ended December 31, 2000.

(6)                                  Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for the quarterended September 30, 1999.

(7)                                  Incorporatedby reference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1999.

(8)                                  Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for the quarterended June 30, 2000.

(9)                                  Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for the quarterended March 31, 2001.

(10)                            Incorporated by reference to the Company’sQuarterly Report on Form 10-Q for the quarter ended June 30, 2001.

(11)                            Incorporatedby reference to the Company’s Current Report on Form 8-K filed with theSecurities and Exchange Commission on February 16, 1999.

(12)                            Incorporatedby reference to the Company’s definitive proxy statement for the February 22,2001 Special Meeting of Shareholders filed with the Securities and ExchangeCommission on January 31, 2001.

 

48

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, hereunto duly authorized.

 
| Date:  March  29, 2002 | CENTERSPAN COMMUNICATIONS CORPORATION                         |
|-----------------------------|---------------------------------------------------------------|
|                        |                                                          |
|                        | By                                                            | /s/ Frank G. Hausmann, Jr. |   |
|                        | Frank G. Hausmann, Jr.                                        |
|                        | President, Chief Executive Officer and Chairman of  the Board |

 

**POWER OFATTORNEY**

 

Each person whose signature appears below constitutes and appointsFrank G. Hausmann, Jr. and Mark Conan, either of whom may act without thejoinder of the other, as his true and lawful attorneys-in-fact and agents withfull power of substitution and resubstitution, for him, and in his name, placeand stead, in any and all capacities to sign any and all amendments to thisAnnual Report on Form 10-K, and to file the same, with all exhibits thereto,and all other documents in connection therewith, with the Securities andExchange Commission, granting unto said attorneys-in-fact and agents full powerand authority to do and perform each and every act and thing requisite andnecessary to be done, as fully to all intents and purposes as he might or coulddo in person, hereby ratifying and confirming all that said attorneys-in-factand agents or their substitute or substitutes may lawfully do or cause to bedone by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities indicated on March 29, 2002:

 
| **Signature**              |                                                 | **Title**                                                      |   |
|----------------------------|------------------------------------------------------|----------------------------------------------------------------|--------|
|                       |                                                 |
| /s/ Frank G. Hausmann, Jr. |                                                 | President, Chief Executive Officer and                         |
| Frank G. Hausmann, Jr.     | Chairman of the Board (Principal Executive Officer)  |
|                       |                                                 |
| /s/ Mark B. Conan          |                                                 | Vice President of Finance, Administration and Chief  Financial |
| Mark B. Conan              | Officer (Principal Financial and Accounting Officer) |
|                       |                                                 |
| /s/ David Billstrom        |                                                 | Director                                                       |
| David Billstrom            |                                                 |
|                       |                                                 |
| /s/ Merrill A. McPeak      |                                                 | Director                                                       |
| Merrill A. McPeak          |                                                 |
|                       |                                                 |
| /s/ Jerome J. Meyer        |                                                 | Director                                                       |
| Jerome J. Meyer            |                                                 |
|                       |                                                 |
| /s/ G. Gerald Pratt        |                                                 | Director                                                       |
| G. Gerald Pratt            |                                                 |
|                       |                                                 |
| /s/ Frederick M. Stevens   |                                                 | Director                                                       |
| Frederick M. Stevens       |                                                 |

 

49

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