<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

(Mark One)

     [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
          EXCHANGE ACT OF 1934

          For the Fiscal period ended September 30, 2001

                                       OR

     [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
          EXCHANGE ACT OF 1934

          Commission File Number                    1-14007

                               SONIC FOUNDRY, INC.
             (Exact name of registrant as specified in its charter)

                  MARYLAND                           39-1783372
         (State or other jurisdiction of             (I.R.S. Employer
         incorporation or organization)              Identification No.)

             1617 Sherman Avenue, Madison, WI 53704  (608)256-3133
         (Address of principal executive offices)    (Issuer's telephone number)

Securities registered pursuant to Section 12(b) of the Act:               None

Securities registered pursuant to Section 12(g) of the Act:

                     Common stock par value $0.01 per share

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                                    Yes /x/          No
                                       -----           -----

The aggregate market value of the voting stock held by non-affiliates of the
Issuer's was approximately $50,900,000 based on the last sale price on December
18, 2001.

The number of shares outstanding of the issuer's common equity was 26,182,504 as
of December 18, 2001.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2001 Annual Meeting of Stockholders are
incorporated by reference into Part III. A definitive Proxy Statement pursuant
to Regulation 14A will be filed with the Commission no later than January 28,
2002.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes /x/      No
              -----       -----

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001


                                TABLE OF CONTENTS

                                                                        PAGE NO.

                                     PART I

Item 1.   Business .........................................................3
Item 2.   Properties ......................................................13
Item 3.   Legal Proceedings ...............................................14
Item 4.   Submission of Matters to a Vote of Security Holders .............14


                                     PART II

Item 5.   Market for Registrant's Common Equity and Related
          Stockholder Matters .............................................15
Item 6.   Selected Financial Data .........................................16
Item 7.   Management's Discussion and Analysis of Financial
          Condition and Results of Operations .............................17
Item 7A   Quantitative and Qualitative Disclosures About Market Risk ......33
Item 8.   Financial Statements and Supplementary Data:
          Report of Ernst & Young LLP, Independent Auditors ...............35
          Balance Sheets ..................................................36
          Statements of Operations ........................................38
          Statements of Stockholders' Equity ..............................39
          Statements of Cash Flows ........................................40
          Notes to Financial Statements ...................................42
Item 9.   Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure .............................59


                                    PART III

Item 10.  Directors and Executive Officers of the Registrant. .............59
Item 11.  Executive Compensation ..........................................59
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management ......................................................59
Item 13.  Certain Relationships and Related Transactions ..................59
Item 14.  Exhibits, Financial Statement Schedules and Reports
          on Form 8-K. ....................................................60
          Signatures ......................................................64

                                       2

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                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                                     PART I

IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT ON FORM 10-K CONTAINS
FORWARD-LOOKING STATEMENTS SUCH AS STATEMENTS OF THE COMPANY'S EXPECTATIONS,
PLANS, OBJECTIVES AND BELIEFS. THESE STATEMENTS USE SUCH WORDS AS "MAY", "WILL",
"EXPECT", "ANTICIPATE", "BELIEVE", "PLAN", AND OTHER SIMILAR TERMINOLOGY. ACTUAL
RESULTS COULD DIFFER MATERIALLY DUE TO CHANGES IN THE MARKET ACCEPTANCE OF SONIC
FOUNDRY'S PRODUCTS, MARKET INTRODUCTION OR PRODUCT DEVELOPMENT DELAYS, GLOBAL
AND LOCAL BUSINESS CONDITIONS, LEGISLATION AND GOVERNMENTAL REGULATIONS,
COMPETITION, THE COMPANY'S ABILITY TO EFFECTIVELY MAINTAIN AND UPDATE ITS
PRODUCT PORTFOLIO, SHIFTS IN TECHNOLOGY, POLITICAL OR ECONOMIC INSTABILITY IN
LOCAL MARKETS, AND CURRENCY AND EXCHANGE RATES.

ITEM 1. BUSINESS

                   COMPANY OPPORTUNITY, EVOLUTION AND STRATEGY

The Opportunity of the Analog to Digital Transition

Twenty years ago, consumers obtained information and media content through
analog delivery methods such as cassette tapes, beta cassettes and rabbit ear
antennas. Today, CDs, DVDs and digital cable and direct broadcast satellite
(DBS), offer digital content with greatly improved clarity, variety, flexibility
and quality. The Internet, utilizing various compression technologies, already
provides convenience and selection unmatched by even the digital methods
mentioned above.

The analog to digital transition provides significant monetary benefits to
corporations and media and entertainment groups in the form of operating
efficiencies and new revenue sources and channels. Videos of training seminars
and other assets will be posted on corporate intranets allowing for significant
reductions in training and travel costs. Media and entertainment groups will
distribute and review content via intranet sites rather than incurring the
shipping, handling and storage costs of video tape. Once in a digital format,
the asset libraries of these entities will extend the life of, and therefore the
revenue streams associated with, knowledge and entertainment assets.

In order to fully realize the benefits, corporations and media and entertainment
groups must develop media management solutions that:

     .    Capture, restore, digitize and encode content;
     .    Store, index, search and retrieve the content; and finally,
     .    Deliver and publish the content to employees and consumers.

                                       3

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                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Sonic Foundry intends to become the premier provider of the tools and services
that allow corporations, entertainment groups and other asset owners to carry
out their media management strategies.

Sonic Foundry Evolution

Sonic Foundry was founded in 1991, incorporated in Wisconsin in March 1994 and
merged into a Maryland corporation of the same name in October 1996. We conduct
our business through Sonic Foundry, Inc. and three subsidiaries: Sonic Foundry
Media Services, Inc., International Image Services Corporation, Inc. d/b/a Sonic
Foundry Media Services and Sonic Foundry Systems Group, Inc. d/b/a Sonic Foundry
Media Systems, which was created as the result of an acquisition completed in
October 2001. Our executive offices are located at 1617 Sherman Avenue, Madison,
Wisconsin, 53704 and our telephone number is (608) 256-3133. Our corporate
website is http://www.sonicfoundry.com.

Since the early 90's, Sonic Foundry has been writing software code and
developing solutions for the creation, manipulation and delivery of digital
media. Our initial efforts, which resulted in a Windows-based editing tool for
sound editing, have grown into a full suite of software products utilized by all
levels of consumers, from producers of music to consumers of music, from
corporate sales teams to web page developers, and from the world's top film and
broadcast entertainment companies to proud parents sharing videos with family
via the web. Our engineering and sales efforts have established Sonic Foundry as
the only end-to-end provider of digital media tools on the Microsoft Windows(R)
platform.

In 1999, many entertainment and corporate users of our products began to request
digital media solutions beyond our commercially available technology. Like the
many companies who outgrew their initial off-the-shelf accounting program, these
entities desired more robust, automated digital media solutions. In many cases,
the parties looked to outsource the process in order to save time and resources.

To capitalize on the growing demand for advanced solutions, we first
established, in October 1999, a media services division to provide format
conversion and digital encoding solutions to content owners. The media services
division incorporates our existing technology and a wide array of audio and
video signal processing algorithms, including our unreleased proprietary
automation tools. Primary services include translating analog or digital tapes,
CDs, films and other audio and video media into various compression and Internet
streaming file formats, including multiple compression rates. Add-on services
involve cleaning or filtering recordings for improved quality.

The acquisition of STV Communications, Inc. ("STV") in April 2000 accelerated
our media services growth, especially in the Internet space. STV offered
additional expertise in providing value-added services such as broadcast, live
event web casting, production, hosting and encoding of media into various
streaming formats.

                                       4

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Our August 2000 acquisition of International Image Services Corporation, Inc.
("II") enabled us to penetrate many of the high-end content producers. II, with
offices in Hollywood and Toronto, is one of North America's leading suppliers of
technical services to the television program distribution market. These services
include a number of preprocessing algorithms and technologies used for standards
conversions as well as improving analog to digital conversions. II's servicing
of popular series such as "Ally McBeal" and "Friends" has established a brand
and reputation that has attracted major studios such as Warner, MGM, 20th
Century Fox, Paramount and DreamWorks as well as leading independent production
companies including Alliance Atlantis, Carsey-Warner, Hallmark, Endemol, HBO and
MTV. In December 2000, the California operations of STV and II were consolidated
into Sonic Foundry Media Services, Inc.

Recent Acquisition

On October 15, 2001, our wholly-owned subsidiary, Sonic Foundry Systems Group,
Inc. acquired the assets and assumed certain liabilities of MediaSite, Inc.
("MediaSite"), a global pioneer in providing automated rich media publishing,
management and access solutions. MediaSite derived its core technology from a
Carnegie Mellon University research effort funded by leading government agencies
and private corporations. MediaSite's proven technology (hereafter, the "Media
Systems technology") provides for the indexing, searching and retrieving of
digital media. In addition, we believe MediaSite's existing corporate, education
and government client base provides immediate marketing opportunities in the
media management area.

Our internally developed software code, coupled with our acquired systems
technology and entertainment relationships/reputation position us as a leading
media management solutions provider to major motion picture studios, television
networks, government agencies, educational institutions and other broadcasters
and producers.

Sonic Foundry's Strategy

We intend to become the premier provider of tools, services and systems for
content owners' digital media production and publishing needs. We will
accomplish this goal by:

     .    Providing solutions for the media management initiatives of
          corporations, media and entertainment groups, educational institutions
          and governmental agencies
     .    Developing software technology that: a) replaces traditional, and
          often more costly, hardware dependent processes; and b) creates new
          service opportunities to our current entertainment customers.
     .    Promoting brand recognition, brand loyalty and productive utilization
          of, and consumption of, digital media in various vertical software
          channels

                                       5

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                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Solutions for Media Management Initiatives

Capture, restore, digitize and encode existing content
In a digital world, content must exist in a digital format. Scratches, hisses
and distortions must be removed from original masters in order to provide the
highest quality base for digital conversion. Once digitized, content must be
formatted or compressed into various formats to enable delivery or storage. Such
formats include MPEG, .WAV, .AVI, MP3, RealNetworks RealMedia and Microsoft
Windows Media.

Many content owners currently have - by virtue of purchasing our commercial
software - the ability to capture, restore and encode media in a Windows
environment. What they lack, however, is the in-house expertise and technology
to perform those functions efficiently particularly on larger scales. We have
developed certain automation and processing technology, including batching - the
simultaneous processing of multiple files that is used exclusively through our
service offering- that provides numerous competitive advantages to our
clientele. Because many content companies need to ingest large volumes of
existing data quickly and accurately in order to enter the digital realm, we
believe they will pay a premium for our automation tools either in the form of
systems or services.

Store, index, search and retrieve content
Once digitized, content must be stored and retrieved in an efficient manner.
Existing search functions for video or audio can provide not only inaccurate
results, but also an unwieldy volume of search results, each of which must be
viewed or listened to from beginning to end. A true media management solution
must allow users to quickly and accurately find a reasonable number of results,
winnow such results down further based on specific criteria, and then find
specific sections of video or audio as easily as searching documents for words.

Our Media System technology offers a solutions suite that turns traditional
video into interactive video. Content owners can use this offering to catalogue,
index and search their video content and convert it into an interactive and
searchable medium. This proven approach uses combined speech, language and image
understanding technology to transcribe, segment and index linear video.
Innovations include rapid retrieval of "video paragraphs," which satisfies an
arbitrary subject query based on words in the soundtrack, closed-captioning or
other annotations and "video skimming," that enables an accelerated viewing of
the key video and audio sequences without the perceptual disturbance of simply
speeding up the frame rate and audio.

Deliver and publish the content
The final function of a media management system is to efficiently distribute the
content to users and consumers through numerous distribution methods. Content
will be available both live and on-demand. Some content may have embedded
marketing along with interactivity allowing for highly targeted programming and
data collection. Vertical markets such as the government, education and
corporate markets will benefit through targeted distribution. Sonic Foundry's
strategic mission is to facilitate this process through a combination of
product, service and system offerings.

                                       6

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

The Sonic Foundry solution is based on enabling an enterprise to capitalize on
digital media distribution techniques. Here, the process of managing and
automating the workings of the entertainment industry is a key focus. Various
technologies have been developed that allow for the tracking of media in a
vault, automatically duplicating the content and facilitating the distribution
of that content to entertainment distributors. Our solutions help improve the
operating margins of entertainment customers who seek out expanded forms of
distribution at lower costs. We believe we can leverage our technology and
reputation to continue to service the distribution and/or hosting of knowledge
and entertainment assets.

Other key vertical markets are demanding similar capabilities and have less
demands on the quality of the media, thereby making today's streaming media
technology very appropriate. In particular, the corporate, education and
government markets are key vertical market focus areas for our system and
service offerings. In government, archiving, searching and retrieving media,
both audio and video are becoming a crucial component of surveillance, counter
espionage and defense applications. The automated solutions developed through
our Media Systems division offer all of these capabilities and justifies
migration to a digital media management solution. Similarly, in the education
markets, both traditional and corporate, on-line learning has lacked a key
component (the effective indexing and cataloging of information for retrieval),
which our solution set specifically addresses. Finally, corporate customers have
a need to archive and organize large volumes of collected information varying
from sales and marketing information to convention presentations. Once
collected, this information needs to be viewable and accessible in order to
create value. The Sonic Foundry solution is concentrated on extracting value
from media.

Promotion and Development of Traditional Software Tools

We believe we have established ourselves as a leader in the development of media
editing, production and encoding software and we intend to build upon our
reputation for quality and innovation by expanding the features and breadth of
our software products and services. We have broadened our in-house technology by
supporting emerging streaming media standards, licensing a tool for encoding
streaming media to Microsoft and developing our own "loss less" audio
compression/decompression algorithm (a "codec"). We incorporated our expertise
in audio and digital editing into our first professional video-editing product,
Vegas(R) Video, in fiscal 2000. Leveraging the Vegas Video technology and early
professional acclaim, we introduced a scaled down consumer version,
VideoFactory(TM), in September 2000. Through our rapport with professional users
and our investment in product development, we believe we will stay on the
leading edge of development.

We believe a number of digital media savvy employees of our targeted media
management audience use our software offerings purchased through commercial and
direct channels. Therefore, this component of our strategy is a vital marketing
bridge to the media management service and system offering.

                                       7

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

A final piece of our software strategy is to promote digital media
entertainment. This goal is addressed by our Acidplanet website and our
affiliation with Sony Pictures Digital Entertainment (Sony). Our relationship
with Sony involves an investment by Sony in our common stock and web enabled
Sonic Foundry products on Sony's Screenblast website.

Commitment to Current Customers Analog Needs and Internal Media Services
Operating Efficiencies

The transition to a digital world will not be complete for many years. Over this
time period, we plan to continue offering new services and capabilities that
keep our customers at the forefront of the transition effort. Our Media
Services' customers still need to duplicate, convert and distribute analog
content. In order to maintain and build our relationships with these content
rich enterprises, we intend to provide our traditional services while offering
more cost effective and innovative long term solutions. We believe that this
will open larger market opportunities as our customer base becomes more
comfortable with new forms of distribution.

Our recent work for Metro-Goldwyn-Mayer Studios (MGM) is an example of
enhancement opportunities with existing clients. MGM has adopted our Media
Collective(TM) technology in managing their film and video re-mastering jobs.
Internet browser based technologies have been custom designed to provide job
tracking and inventory management of their important media assets. Media
Collective demonstrates how databases, web interfaces and report generation will
greatly improve the operating margins of our key entertainment customers. The
objective of this offering and future technologies is to: 1) provide content
owners with easier access to and control over their assets and 2) to ultimately
expand distribution opportunities. Other technologies currently being developed
include automated restoration technologies, software-based dubbing modules and
improved on-line searching and retrieval modules.

Sonic Foundry's Reportable Segments

In accordance with disclosure requirements for segment reporting, the SEC's
guidance has been to present financial information in a format that is used by
the Company's management to make decisions. For the year ended September 30,
2001, we had two primary revenue centers reported in our financial statements; a
software license fee division and a media services division. We analyze these
two revenue centers, along with their respective production costs, independently
from each other. However, because the majority of our operating expenses support
both revenue centers, we analyze all items below gross margin on a combined
basis.

With the recent acquisition of MediaSite, we will be adding a third segment,
which we will refer to as "Media Systems" in our financial statements. In our
press releases, we describe these three segments as Sonic Foundry Media
Software, Sonic Foundry Media Services and Sonic Foundry Media Systems. We will
continue to analyze all items below gross margin on a combined basis.

Please see footnote 12 for financial information regarding segments and
geographic areas.

                                       8

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                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

1.  Software

Our software division develops sophisticated software tools for the creation,
editing and publishing of digital multimedia. Production professionals use our
Sound Forge(R), ACID(TM), Vegas(R) Video and Vegas(R) Audio tools worldwide for
everything from music creation and mastering, to non-linear digital video
editing and streaming media development. We distribute our products through
retail, direct and OEM channels. Delivery into the direct channel includes both
boxed product and electronic download. Generally, software product ships the
same day. The production of our software products includes CD duplication,
component purchases (manuals, boxes, and inserts) and final packaging. Third
parties produce, assemble and fulfill all domestic and international orders. We
satisfy OEM arrangements by providing the manufacturer with a single master CD
and list of serial numbers. We believe there are numerous sources and
alternatives to the existing production process. To date, we have not
experienced any material difficulties or delays in the manufacture and assembly
of our products, or material returns due to product defects. We also provide
customer sales and technical support during business hours and maintain a user
group forum on our website.

Included in software revenue are sales to one distributor, Navarre Corporation,
of 18%, 16% and 2% for the fiscal years ended September 30, 2001, 2000 and 1999.

We categorize our software offerings into the following three groups:

Creation Products

Creation products consist of the ACID product line, which includes ACID Pro,
ACID Style, Super Duper Music Looper(TM) and our catalog of over 70 loop
libraries. The ACID product line offers both musicians and non-musicians an easy
way to create and play back music via a computer in a multi-track format. ACID
allows users to mix and merge audio "loops," which are audio files of drums,
guitars, pianos, or any other audio information, into another audio file to
create music, all on a royalty-free basis. ACID allows the user to change tempo,
change keys, add new rhythms and add vocals by embedding samples wherever
desired, all in real-time. The user can then record finished songs to a CD or
encode into various compression formats for Internet delivery or transfer to a
portable MP3 device. In May 2001, we released version 3.0 of ACID Pro, which is
marketed to professional producers of digital multi-media. In August 2001, we
released version 3.0 of ACID Music, ACID Techno and ACID DJ, which we market to
the more casual consumer of digital multi-media. In fiscal 2001, we released 20
new loop libraries to support both ACID Pro and ACID Style. Revenues from
creation products represented 44%, 48% and 51% of total software revenues for
the fiscal years ended September 30, 2001, 2000 and 1999.

Editing Products

Vegas, Sound Forge and Sound Forge XP are non-linear media editing systems.
Vegas and Sound Forge are generally used by professionals for a variety of
digital audio and video media editing needs while VideoFactory and Sound Forge
XP are designed with a simplified user interface and features for consumer
users. Just as a word-processor can store, edit and transfer textual data more
effectively and efficiently than a typewriter, our editors can store, edit,
manipulate, and transfer audio or video data more effectively and efficiently
than traditional analog editing tools such as a

                                       9

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                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

tape recorder. In February 2001, we released version 5.0 of Sound Forge and in
November 2001, we released version 3.0 of Vegas Video. Revenues from editing
products represented 52%, 35% and 27% of total software revenues for the fiscal
years ended September 30, 2001, 2000 and 1999.

Delivery Products

Delivery products consist of CD Architect, Soft Encode, Stream Anywhere and
Siren. While sales from these products were strong in fiscal 1999, demand began
to decline in 2000 due to increased competition, resulting in the discontinuance
of virtually the entire line. Revenues from delivery products represented 4%,
17% and 22% of total software revenues for the fiscal years ended September 30,
2001, 2000 and 1999.

2.  Sonic Foundry Media Services

Sonic Foundry Media Services is a pre-eminent supplier of digitization,
management and delivery solutions for various industries, with emphasis placed
on services for the entertainment sector. Traditional fulfillment services
consist of duplication, conversion, reformatting and encoding of television,
film and audio content for multiple delivery platforms. We also offer, and are
continuing to develop, the Media Collective, as described earlier and below, and
Digital Media Asset Management solutions, which will provide the infrastructure
for storage, management and delivery of digital media content.

Our traditional fulfillment services enable clients to meet the demands of
distributing audio, video and media content to global markets. Fulfillment
includes a detailed, comprehensive assessment of our client's original content
to determine its readiness for international distribution. Once this process is
complete, we optimize the content and perform international format conversions
for traditional broadcast distribution as well as MPEG-1 and -2 conversions for
broadband and video-on-demand distribution. In 2001, 98% of our Media Services
revenue related to duplication, conversion and reformatting while the remaining
2% related to encoding.

Our Media Asset Management efforts launched MediaCollective(TM), a
browser-based, custom job-tracking and inventory management tool in September
2001. MGM adopted MediaCollective to manage and coordinate their film and video
re-mastering initiatives. We anticipate our Media Asset Management efforts will
include several additional tools to assist MGM and other media content owners in
the future.

Although media services relies on several major studios, the two largest
customers combined for 23% of 2001 media services revenue.

The traditional fulfillment services are seasonal and volume tends to mirror
that of the television industry with busier periods in the fall and January
through March. In our time of ownership of II, two major events have occurred -
the Summer Olympics in September 2000 and the events of September 11, 2001 -
which have caused the television seasons to stray from their normal periods.
Barring any unforeseen events, we anticipate experiencing the usual seasonality
in future years.

                                       10

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Media service's traditional fulfillment services do not have significant
backlog. Jobs are often completed within a week of receiving master tapes. After
completing duplication, conversion or reformatting, the original master tapes
are either stored in our on-site vaults or returned to the studios. The
duplicated or repurposed tapes are either sent to the studios or distributed
around the globe to broadcasters.

3.  Sonic Foundry Media Systems

Sonic Foundry Media Systems (formerly MediaSite) provides customized development
of automated rich-media applications and scalable solutions that allow media and
entertainment companies, as well as enterprises and government organizations, to
deploy, manage and distribute video content on IP-based networks. We are
currently targeting a number of government organizations and believe they will
make up a significant portion of future media systems revenue.

The Media Systems business should not experience significant revenue swings
related to seasonality.

Other Information

Competition

Numerous companies offer products or services competing directly or indirectly
with our services and software. However, none of these companies can
independently offer a matching product line competing one for one with our
product line. Also, we do not believe any of our competitors provide the unique
combination of technology, relationships and expertise as they relate to media
management opportunities.

Our primary competitors in the media management arena are Convera and Virage.
Our primary competitors in the services space are the leading post-production
houses and web-oriented encoding businesses such as Liberty Livewire's Four
Media Company, Loudeye and point.360. Our software offerings compete against
products from Roxio, Adobe, MGI Software, Apple, Avid Technology, Autodesk
(Media 100), Microsoft and RealNetworks.

The markets for our products are intensely competitive. Pricing pressure, rapid
development, feature upgrades and undefined new technologies characterize the
industry. Most of our competitors or potential competitors have significantly
greater financial, management, technical and marketing resources than we do. We
could also face future competition from other large companies such as IBM,
Oracle, Corel or Macromedia. Each of these potential competitors has
substantially greater resources than we do and could become a significant
competitor.

                                       11

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

The primary factors on which we compete are quality, pricing, product features,
cross-platform file support, brand marketing and customer support. The relative
importance of each factor is dependent on the market and customer group
targeted. We believe we compete favorably with respect to these factors, but
there can be no assurance that we will continue to do so.

Intellectual Property

Our inability to protect our proprietary rights, and the costs of doing so,
could harm our business. Our success and ability to compete partly depends on
the superiority, uniqueness or value of our technology, including both
internally developed technology and technology licensed from third parties. To
protect our proprietary rights, we rely on a combination of trademark, patent,
copyright and trade secret laws, confidentiality agreements with our employees
and third parties and "shrink wrap" licenses. Recently, we have undertaken
additional efforts to identify which of our proprietary processes and algorithms
may be patentable, and we currently have several patent applications pending
with the U.S. Patent and Trademark Office. There can be no assurances that we
will ultimately receive issued patents as a result of any of these applications,
or to the extent that we do, that we can always afford to enforce them.

Despite our efforts to protect our proprietary rights, unauthorized parties may
copy or infringe aspects of our technology, products, services or trademarks, or
obtain and use information we regard as proprietary. In addition, others may
independently develop technologies that are similar or superior to ours, which
could reduce the value of our intellectual property.

Companies in the computer industry have frequently resorted to litigation
regarding intellectual property rights. We may have to litigate to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of other parties' proprietary rights. From time to time,
other parties' proprietary rights, including patent rights, have come to our
attention and on several occasions we have received notice of claims of
infringement of other parties' proprietary rights, and we may receive such
notices in the future.

Because we have historically protected our proprietary rights with a combination
of trademark, copyright and trade secret laws, confidentiality agreements with
our employees and third parties, and "shrink wrap" licenses and only recently
have begun to apply for patents, our intellectual property may unintentionally
infringe upon the proprietary rights of others. If a third party's claim of
intellectual property right infringement were to prevail, we could be forced to
pay damages, comply with injunctions, or halt distribution of our products while
we re-engineer them or seek licenses to necessary technology, which might not be
available on reasonable terms. We could also be subject to claims for
indemnification resulting from infringement claims made against our customers
and strategic partners, which could increase our defense costs and potential
damages. In addition, we have agreed to indemnify certain distributors and
original equipment manufacturers, or OEMs, for infringement claims of other
parties. If these other parties sue the distributors or OEMs, we may be
responsible for defending the lawsuit and for paying any judgment that may
result. Any of these events could harm our business.

                                       12

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

We rely upon licenses from third parties and strategic partners for some of our
technologies. These companies that license the technologies to us may decide to
discontinue the licenses at any time. If they do so, our business may suffer.

Further, the Internet and software industries have experienced substantial
consolidation and a proliferation of strategic transactions. We expect this
consolidation and strategic partnering to continue. Acquisitions or strategic
relationships could harm us in a number of ways. For example:

     .    Our competitors could acquire or form partnerships with companies with
          which we have strategic relationships and discontinue our
          relationship, resulting in the loss of distribution opportunities for
          our products and services or the loss of certain enhancements or
          value-added features to our products and services; or

     .    A party with significant resources and experience could acquire a
          competitor of ours, increasing the ability of the competitor to
          compete with our products and services.

Research and Development

During the fiscal years ended September 30, 2001, 2000 and 1999, the Company
spent $8.0 million, $7.9 million and $2.9 million on research and development
activities. These amounts represent 30%, 30% and 21% of total revenues in each
of those years.

Employees

As of September 30, 2001, 2000 and 1999, we had 239, 445 and 160 full-time
employees, respectively. The December 2000 restructuring plan resulted in a
decline in employees from 2000 to 2001. The continued integration of STV and II
identified a number of duplicative positions as well as efforts not core to our
strategy. In response, we announced a layoff of approximately 40 employees in
November 2000. Slow sales in the personal computer and software markets and
narrowing of our strategy required an additional reduction of 160 employees in
December 2000. The majority of employees affected by the December layoff
received severance pay and health insurance for 60 days following termination.
Our employees are not represented by a labor union, nor are they subject to a
collective bargaining agreement. We have never experienced a work stoppage and
believe that our employee relations are satisfactory.

ITEM 2. PROPERTIES

In July 2000, the Company relocated its Madison, Wisconsin operations from one
owned property and several small leased facilities to a 45,000 sq. ft. leased
facility. This facility serves as our corporate headquarters, accommodating our
software division as well as our G&A, R&D and Sales and Marketing departments.
Due to the restructuring in December 2000 (See footnote 15), approximately one
quarter of the Madison facility is not being utilized and we are seeking to
sublet this space. We sold our owned property in March 2001 and have
successfully sublet all but one floor or terminated the majority of leased
properties in Madison that are no longer necessary for our

                                       13

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

operations. The assembly and fulfillment for our software division has been
outsourced to a third-party vendor located in Milwaukee, Wisconsin. We also
lease a small software engineering office in Waterloo, Ontario.

In addition, we lease production facilities for our media services division in
Santa Monica, California and Toronto, Canada. In California, we sublet the space
previously occupied by the former STV and moved these operations into the 12,000
sq. ft. II facility. Approximately 50% of this space is an undeveloped
warehouse, which we are currently seeking to sublet. The Toronto facility is
fully utilized.

In October 2001, we acquired certain assets and assumed certain liabilities of
MediaSite (See footnote 16). At the time of the closing they occupied three
floors of a leased facility in downtown Pittsburgh, Pennsylvania. In November
2001, we amended the lease to include only one of the three floors in the
current location as a sales and engineering office. We believe these facilities
are adequate and suitable and do not expect further consolidation.

ITEM 3. LEGAL PROCEEDINGS

In January 2001, the Company withheld paying $4 million note due to the former
shareholders of International Image pending the resolution of certain disputed
representations made during the acquisition. In January 2001 the note holders
initiated litigation against us in Toronto for payment of the note and in March
2001, we initiated a counter action for damages incurred. In April 2001, we paid
certain shareholders $500,000 in full settlement of $700,000 of the note plus
accrued interest originally owed. Litigation with the remaining shareholders is
still pending. In October 2001, pursuant to an agreement with the plaintiffs,
the Company deposited $1,000,000 with the Ontario Superior Court of Justice to
be held in trust until settlement of the suit. The $1,000,000 will be classified
as restricted cash in balance sheets subsequent to September 30, 2001.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no stockholder actions during the fourth quarter ended September 30,
2001.

                                       14

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock was initially traded on the American Stock Exchange under the
symbol "SFO," beginning with our initial public offering in April of 1998. On
April 24, 2000, our common stock began trading on the NASDAQ National Market
under the symbol "SOFO." The following table sets forth, for the periods
indicated, the high and low sale prices per share of our common stock as
reported on the NASDAQ National Market. Price per share data and share data set
forth below and elsewhere in this filing reflect a two-for-one stock split
distributed to stockholders of record on April 7, 2000.

                                                        High               Low

Year Ended September 30, 2002:                       $    4.44           $  1.01
------------------------------

First Quarter (through December 18, 2001)

Year Ended September 30, 2001:

First Quarter                                             8.94              0.91
Second Quarter                                            6.00              1.25
Third Quarter                                             2.59              1.13
Fourth Quarter                                            2.40              1.10


Year Ended September 30, 2000:

First Quarter                                            12.75              4.25
Second Quarter                                           64.97             11.34
Third Quarter                                            49.63              9.38
Fourth Quarter                                           20.81              5.75


The Company has not paid any cash dividends and does not intend to pay any cash
dividends in the foreseeable future.

At December 18, 2001 there were 371 common stockholders of record. Many shares
are held by brokers and other institutions on behalf of shareholders.

RECENT SALES OF UNREGISTERED SECURITIES

On October 15, 2001, the Company issued 3,780,000 shares of its common stock in
connection with the purchase of MediaSite, Inc. (see footnote 16). These
issuances were made in reliance upon the exemption from registration set forth
in Section 4(2) of the Securities Act, relating to sales by an issuer not
involving a public offering. A registration statement on Form S-3 relating to
these securities is expected to be filed with the Securities and Exchange
Commission prior to December 31, 2001.

                                       15

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

ITEM 6.  SELECTED FINANCIAL DATA

The selected financial and operating data as of and for the years ended
September 30, 2001, 2000, 1999 and 1998 and the nine months ended September 30,
1997 were derived from our financial statements that have been audited by Ernst
& Young LLP, independent auditors. The selected financial data set forth below
is qualified in its entirety by, and should be read in conjunction with,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our financial statements and notes thereto appearing elsewhere
in this annual report on Form 10-K.

<TABLE>
<CAPTION>
                                                                                  Twelve months    Nine Months
                                                Years Ended September 30,             Ended           Ended
                                         --------------------------------------   September 30,   September 30,
(in thousands except per share data)       2001       2000      1999      1998        1997            1997
                                         ----------------------------------------------------------------------
                                                                                   (Unaudited)
<S>                                      <C>        <C>        <C>       <C>      <C>             <C>
Statement of Operations Data:
Total net revenues                       $ 26,284   $ 26,307   $13,682   $7,470      $3,061          $2,242
Total cost of revenues                     12,920     10,670     3,390    2,028         580             407
 Gross profit                              13,364     15,637    10,292    5,442       2,481           1,835
Selling and marketing expenses             11,554     18,822     9,336    3,231       1,772           1,445
General and administrative
   expenses                                10,153      9,982     4,253    1,878       1,084             835

Product development expenses                7,986      7,868     2,875    1,046         461             374
Restructuring and impairment
   charge                                   5,973      1,000         -        -           -               -

Amortization of goodwill                   27,478     14,300         -        -           -               -
Loss before extraordinary item            (49,860)   (34,922)   (5,997)    (583)       (881)           (839)

Pro forma Loss per common share:
      Basic and diluted                   $  (2.25)  $  (1.89)  $ (1.06)  $ (.22)     $(3.07)         $(2.58)

Weighted average common shares             22,129     18,503      5,687   2,713         288             326
</TABLE>

<TABLE>
<CAPTION>
                                                               September 30,
                                        ----------------------------------------------------------
                                         2001         2000         1999          1998        1997
                                        ----------------------------------------------------------
<S>                                     <C>         <C>           <C>           <C>          <C>
   Balance Sheet Data:
   Cash and cash equivalents            $ 7,809     $ 21,948      $ 5,889       $ 9,940      $ 115
   Working capital                        4,421       22,153        8,843        11,156       (265)
   Total assets                          71,683      126,825       16,709        15,950      2,333
   Total indebtedness                     5,989        8,409        5,283           714        993
   Stockholders' equity                  61,231      110,366        8,747        14,091        684
</TABLE>

                                       16

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The financial and business analysis below provides information that the Company
believes is relevant to an assessment and understanding of the Company's
consolidated financial position and results of operations. This financial and
business analysis should be read in conjunction with the consolidated financial
statements and related notes.

In addition to historical information, this discussion contains forward-looking
statements such as statements of our expectations, plans, objectives and
beliefs. These statements use such words as "may," "will," "expect,"
"anticipate," "believe," "plan," and other similar terminology. Actual results
could differ materially due to changes in the market acceptance of our products
and services, market introduction or product development delays, our ability to
effectively integrate acquired businesses, global and local business conditions,
legislation and governmental regulations, competition, our ability to
effectively maintain and update our product portfolio, shifts in technology,
political or economic instability in local markets, and currency and exchange
rates. The Company also faces several risk factors, which are outlined below.

                                  RISK FACTORS

Operating History Risks

We have a history of losses and we may never attain profitability.

We have incurred significant losses since our inception, $49.9 million in 2001;
$34.9 million in 2000; $6.0 million in 1999; and $0.6 million in 1998, and we
may never become profitable. As of September 30, 2001, we had an accumulated
deficit of $92 million. We cannot assure you that we will achieve or maintain
profitability in the future.

We have a limited operating history upon which you can evaluate our business and
our future prospects and our operating results will likely fluctuate
significantly.

We were incorporated in March 1994 and we have a limited operating history and
limited financial results upon which you can assess our future success. We have
a very limited history of digital media services operations upon which you can
evaluate our digital media services business model and the prospects for that
business. As a result of our limited operating history and the rapidly changing
nature of the markets in which we compete, our quarterly and annual revenues and
operating results are difficult to predict and may fluctuate significantly from
quarter to quarter and from year to year. You should therefore not rely upon our
revenues and our operating results for any one quarter or year as an indication
of our future revenues or operating results. Our stock price has been and will
in all likelihood continue to be extremely volatile. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses and difficulties frequently encountered by growing
companies in new and rapidly evolving markets.

Industry Risks

The market for our products and services is relatively new, and we cannot assure
you that the market will develop as we expect.

Because the market for our products and services is relatively new and rapidly
changing, it is difficult to predict future financial results. Our research and
development and sales and marketing efforts, and business expenditures are
partially based on predictions regarding certain developments for products and
services. To the extent that these

                                       17

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

predictions prove inaccurate, we may not achieve the level of revenues and
operating expenses that we expect at the time that we expect them and our
revenues and operating expenses may fluctuate.

Our markets are highly competitive, and we may not be able to compete
effectively in our business.

Competition in the markets for digital media systems and services is intense. We
compete with several companies engaged in the software and digital media
businesses and we expect competition to increase as new companies enter the
market and our current competitors expand their products and services. This
could mean lower prices or reduced demand for our products and services. Many of
our current and potential competitors have longer operating histories, greater
name recognition, more employees and significantly greater financial, technical,
marketing, public relations and distribution resources than we do, and we may
not be able to successfully compete with them. Any of these developments would
have an adverse effect on our operating results.

Lack of commercial acceptance of, or decreased demand for, complementary
products and technologies developed by third parties may lead to a decreased
demand for our digital media products and systems services.

The success of some of our digital media software products and planned digital
media services depends, in part, upon the commercial acceptance of products, the
Internet and technologies developed by other companies that our digital media
software products and services may complement, including compact disc recorders,
Digital Versatile Disc players and compression technology for streaming or
storing media files. These complementary products help drive the demand for
digital media and if businesses and consumers do not accept these products, the
demand for our products and services may decrease or fail to grow and our
business may suffer.

The success of our business depends, in part, upon strategic relationships that
we have with other companies and institutions.

Our business depends, in part, upon relationships that we have with strategic
partners such as Microsoft, RealNetworks, Sony, Carnegie Mellon University and
Fraunhofer Institute. We rely, in part, on strategic relationships to help us:

     .    Maximize the acceptance of our products by customers through
          distribution arrangements;

     .    Increase the amount and availability of compelling media content on
          the Internet to help boost demand for our products and services;

     .    Increase awareness of our Sonic Foundry and MediaSite brands; and

     .    Increase the performance and utility of our products and services.

We would be unable to realize many of these goals without the cooperation of
these partners. We anticipate that the efforts of our strategic partners will
become more important as the availability and use of multimedia content on the
Internet increases. For example, we may become more reliant on strategic
partners to provide multimedia content, provide more secure and easy-to-use
electronic commerce solutions and build out the necessary infrastructure for
media delivery. The loss of these strategic relationships, the inability to find
other strategic partners or the failure of our existing relationships to achieve
meaningful positive results could harm our business.

We rely upon a number of distributors to increase our market penetration
domestically and internationally.

We rely upon 30 distributors in 30 countries to sell and market our digital
media software products internationally. We generally do not have contracts with
these distributors. If these distributors were to cease the sale and marketing
of our products, our international sales may decrease.

Although we focused efforts to direct marketing we maintain contracts with
Navarre Corporation, and other U.S. companies, that distribute our software
products to various computer resellers, value-added resellers, catalog

                                       18

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

distributors and smaller retail outlets. Our contracts with these distributors
require us to accept the return of any of our products that they do not sell and
to credit them for the value of these products. Our contracts also protect
certain distributors for the value of inventory in the event that we lower our
prices. If these distributors fail to continue to carry our products, return
large quantities of our products to us, or competitive pressures require us to
lower the prices of the products that we supply to them, our business will
suffer.

The growth of our business depends upon the increased use of the Internet or
convergence of TV and Internet, for communications, commerce and advertising.

The growth of our software and services business depends upon the continued
growth of the Internet as a medium for communications. The Internet may not be
accepted as a viable commercial medium for broadcasting digital and multimedia
content or digital media delivery for a number of reasons, including:

     .    Potentially inadequate development of the necessary infrastructure to
          accommodate growth in the number of users and Internet traffic;

     .    Unavailability of compelling multimedia content; and

     .    Delays in the development or adoption of new technological standards
          and protocols or increased governmental regulations, which could
          inhibit the growth and use of the Internet.

In addition, we believe that other Internet-related issues, including security
of transactions, reliability of data transmission, cost and ease of use, are not
fully resolved and may affect the amount of business that is conducted over the
Internet.

Technology Risks

We depend upon access to third party software codes to develop our digital media
software products.

Quick access to Microsoft's software codes enables us to develop Microsoft
Windows-based software products in a timely manner. Although, in the past,
Microsoft consistently has given us quick access to its software codes,
Microsoft is under no obligation to do so and may refuse us this access in the
future at its discretion. If we do not continue to receive quick access to
Microsoft's software codes, the development of our software products will be
delayed and our business may suffer.

MediaSite's core technology is dependent on licensed technology from Carnegie
Mellon University. As part of the MediaSite transaction we assumed a License
Agreement pursuant to which Carnegie Mellon granted MediaSite a worldwide,
nonexclusive license to use certain technology. We are currently in the process
of re-negotiating the License Agreement for an exclusive license in a defined
field of use. This business is dependent on the continuation of the License
Agreement and the availability to us of the technology licensed hereunder. If we
are unsuccessful in obtaining an exclusive license, there is a risk that
Carnegie Mellon could license the technology to another party, including a
competitor. Moreover, if the License Agreement were to terminate, our business,
results of operations and prospects would be adversely affected.

We may not be successful in our attempts to keep pace with rapid technological
change and evolving industry standards.

The markets for digital media products and digital media services are
characterized by rapidly changing customer requirements, evolving technologies
and industry standards, and frequent new product and service introductions. Our
future success will depend, in part, upon our ability to:

     .    Use leading technologies effectively;
     .    Enhance our current software products and services;

                                       19

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     .    Identify, develop, and market new software products and service
          opportunities; and
     .    Influence and respond to emerging industry standards and other
          technological changes.

We must accomplish these objectives in a timely and cost-effective manner. We
have experienced development delays and cost overruns in our development efforts
in the past and we may encounter such problems in the future. Delays and cost
overruns could affect our ability to respond to technological changes, evolving
industry standards, competitive developments or customer requirements. Our
products also may contain undetected errors that could cause increased
development costs, loss of revenues, adverse publicity, reduced market
acceptance of those products or lawsuits by customers. If we fail to develop
products that achieve widespread market acceptance or that fail to generate
significant revenues to offset development costs, our business and operating
results would suffer. We may not timely and successfully identify, develop and
market new product and service opportunities. If we introduce new products and
services, they may not attain broad market acceptance or contribute meaningfully
to our revenues or profitability. Any of these developments would have an
adverse effect on our operating results.

Demand for our digital media software products might decrease or fail to grow if
commercial acceptance of the Microsoft Windows computer operating system
declines.

Our digital media software products work exclusively on the Microsoft Windows
computer operating system. Some of our competitors offer products for the Apple
Macintosh and other computer operating systems. If the Macintosh computer
operating system, which is popular with many musicians and videographers, or
other competing operating systems, including Linux and Java, were to become
dominant in the marketplace at the expense of the Microsoft Windows computer
operating system, demand for our digital media software products may decrease or
fail to grow. Moreover, if we were unable to adapt our current digital media
software products or develop new digital media software products in a timely and
cost-effective manner to work on these different operating systems, our business
might suffer.

Development of new standards for the electronic delivery of digital media could
significantly affect our growth and the way we do business.

The onset of competing industry standards for the electronic delivery of digital
media could slow the growth of our business or force us to adjust the way in
which we do business. If standard delivery technology does not achieve
widespread commercial acceptance and we are unable to adapt our digital media
software products accordingly in a timely and cost-effective manner, our
business may suffer.

Our business will suffer if our systems fail or become unavailable.

A reduction in the performance, reliability and availability of our website and
network infrastructure will harm our ability to market and distribute our
products and services to our users, as well as our reputation and ability to
attract and retain users, customers, advertisers and content providers. Our
systems and operations could be damaged or interrupted by fire, flood, power
loss, telecommunications failure, Internet breakdown, earthquake and similar
events. Our systems are also subject to break-ins, sabotage, intentional acts of
vandalism and similar misconduct. We do not have fully redundant systems or a
formal disaster recovery plan, and we do not carry adequate business
interruption insurance to compensate us for losses that may occur from a system
outage.

Our electronic commerce and digital distribution activities are managed by
sophisticated software and computer systems. We are in the process of
integrating our enterprise resource planning system, which handles all of our
accounting, operations, sales and information systems at business units acquired
last year. We may encounter delays in adopting this or other systems that we
use. Furthermore, these systems may contain undetected errors that could cause
the systems to fail. Any system error or failure that causes interruption in
availability of products or content or an increase in response time could result
in a loss of potential or existing business services customers. If we suffer
sustained or repeated interruptions, our products, services and website could be
less attractive and our business may suffer.

                                       20

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

A sudden and significant increase in traffic on our website could strain the
capacity of the software, hardware and telecommunications systems that we deploy
or use. This could lead to slower response times or system failures. We depend
on Web browsers, ISPs and online service providers to provide Internet users
access to our website. Many of these providers have experienced significant
outages in the past, and could experience outages, delays and other difficulties
due to system failures unrelated to our systems.

Intellectual Property Risks

We may not be successful in protecting our intellectual property and proprietary
rights.

Our inability to protect our proprietary rights, and the costs of doing so,
could harm our business. Our success and ability to compete partly depends on
the superiority, uniqueness or value of our technology, including both
internally developed technology and technology licensed from third parties. To
protect our proprietary rights, we rely on a combination of trademark, patent,
copyright and trade secret laws, confidentiality agreements with our employees
and third parties and "shrink wrap" licenses. Recently, we have undertaken
additional efforts to identify which of our proprietary processes and algorithms
may be patentable, and we currently have several patent applications pending
with the U.S. Patent and Trademark Office. There can be no assurances that we
will ultimately receive issued patents as a result of any of these applications,
or to the extent that we do, that we can always afford to enforce them.

Despite our efforts to protect our proprietary rights, unauthorized parties may
copy or infringe aspects of our technology, products, services or trademarks, or
obtain and use information we regard as proprietary. In addition, others may
independently develop technologies that are similar or superior to ours, which
could reduce the value of our intellectual property.

Companies in the computer industry have frequently resorted to litigation
regarding intellectual property rights. We may have to litigate to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of other parties' proprietary rights. From time to time,
other parties' proprietary rights, including patent rights, have come to our
attention and on several occasions we have received notice of claims of
infringement of other parties' proprietary rights, and we may receive such
notices in the future.

Our intellectual property may infringe the rights of others.

Because we have historically protected our proprietary rights with a combination
of trademark, copyright and trade secret laws, confidentiality agreements with
our employees and third parties and "shrink wrap" licenses and only recently
have begun to apply for patents, our intellectual property may unintentionally
infringe upon the proprietary rights of others. If a third party's claim of
intellectual property right infringement were to prevail, we could be forced to
pay damages, comply with injunctions, or halt distribution of our products while
we re-engineer them or seek licenses to necessary technology, which might not be
available on reasonable terms. We could also be subject to claims for
indemnification resulting from infringement claims made against our customers
and strategic partners, which could increase our defense costs and potential
damages. In addition, we have agreed to indemnify certain distributors and
original equipment manufacturers, or OEMs, for infringement claims of other
parties. If these other parties sue the distributors or OEMs, we may be
responsible for defending the lawsuit and for paying any judgment that may
result. Any of these events could harm our business.

We may be unable to retain technology licensed or obtained from third parties
and strategic partners.

We rely upon licenses from third parties and strategic partners for some of our
technologies. These companies that license the technologies to us may decide to
discontinue the licenses at any time. If they do so, our business may suffer.

Further, the Internet and software industries have experienced substantial
consolidation and a proliferation of strategic transactions. We expect this
consolidation and strategic partnering to continue. Acquisitions or strategic
relationships could harm us in a number of ways. For example:

                                       21

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     .    Our competitors could acquire or form partnerships with companies with
          which we have strategic relationships and discontinue our
          relationship, resulting in the loss of distribution opportunities for
          our products and services or the loss of certain enhancements or
          value-added features to our products and services; or

     .    A party with significant resources and experience could acquire a
          competitor of ours, increasing the ability of the competitor to
          compete with our products and services.

Management Risks

Our business could suffer if we lose the services of key personnel.

Our success depends in significant part upon a number of key management and
technical employees. The loss of the services of one or more key employees,
particularly Rimas Buinevicius, our Chairman of the Board and Chief Executive
Officer, Monty R. Schmidt, our President, and Curtis Palmer, our Chief
Technology Officer, could seriously impede our success. Although we have
employment agreements with each of these individuals, a state court may
determine not to enforce, or to only partially enforce, these agreements. We do
not have employment agreements with any other of our key employees. Our success
also depends upon our ability to retain highly skilled technical, managerial,
marketing, and customer service personnel. Competition for highly skilled
personnel is intense. Our failure to retain these personnel could adversely
affect our business. In addition, due to the recent significant drop in our
stock price, our ability to attract and retain experienced employees may be
reduced.

Risks Associated With Acquisitions

We may pursue acquisitions and investments that could adversely affect our
business.

If we identify an acquisition candidate, we may not be able to successfully
negotiate or finance the acquisition or integrate the acquired businesses,
products or technologies into our existing business and products. Future
acquisitions could result in potentially dilutive issuances of equity
securities, the incurrence of debt and contingent liabilities, amortization
expenses or write-downs of acquired assets including goodwill and other
intangible assets. Other than the MediaSite transaction, we currently have no
commitments or agreements with respect to any business acquisitions or
investments.

Our acquisition of the assets of MediaSite, Inc. involves risks.

On October 15, 2001, the Company completed the acquisition of certain assets,
and the assumption of certain liabilities, of MediaSite, Inc. Although the
Company purchased the assets of MediaSite primarily to benefit from its existing
customer relationships and technology, there can be no assurance that revenues
from these relationships will materialize or that competitors won't develop
technologies superior to those acquired. Due to these and other factors, such as
MediaSite's history of losses, there can be no assurance that we will obtain
benefits from the purchase of the assets of MediaSite.

In addition, although the Company purchased only certain scheduled liabilities
of MediaSite, and in fact obtained indemnification from MediaSite with respect
to all unscheduled liabilities, it is possible that an unforeseen liability may
arise and result in a claim against the Company.

Our past and future acquisitions may involve the write down of intangible
assets.

In the first quarter of fiscal 2002, the Company plans to adopt new accounting
rules regarding business combinations and the amortization of intangible assets.
Under the new rules, the Company would cease the amortization of goodwill and
would annually assess its carrying value causing potential impairment charges to
be necessary. See footnote 1, Accounting Pronouncements for further details.

                                       22

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Risks Associated With The Operation Of Our Business

Our international operations involve risks.

We are subject to the normal risks of doing business internationally. These
risks include:

     .    Unexpected changes in regulatory requirements.

     .    Export and import restrictions.

     .    Tariffs and trade barriers and limitations on fund transfers.

     .    Longer payment cycles and problems in collecting accounts receivable.

     .    Potential adverse tax consequences.

     .    Exchange rate fluctuations.

     .    Increased risk of piracy and limits on our ability to enforce our
          intellectual property rights.

Any of these factors could harm our business. We do not currently hedge our
foreign currency exposure.

We may be subject to assessment of sales and other taxes for the sale of our
products, license of technology or provision of services.

We may have to pay past sales or other taxes that we have not collected from our
customers. We do not currently collect sales or other taxes on the sale of our
products, license of technology or provision of services in states and countries
other than Wisconsin. The federal Internet Tax Freedom Act, passed in 1998,
imposes a three-year moratorium on discriminatory sales taxes on electronic
commerce, and this law was recently extended for two additional years. We cannot
assure you that this moratorium will be re-extended. Further, foreign countries
or, following the moratorium, one or more states, may seek to impose sales or
other tax obligations on companies that engage in such activities within their
jurisdictions. Our business would suffer if one or more states or any foreign
country were able to require us to collect sales or other taxes from current or
past sales of products, licenses of technology or provision of services,
particularly because we would be unable to go back to customers to collect sales
taxes for past sales and may have to pay such taxes out of our own funds.

Corporate Governance Risks

Stockholders may be unable to exercise control because our management controls a
large percentage of our stock.

Our directors, officers and affiliated persons own nearly 30% of our outstanding
common stock and have significant influence over stockholder voting matters. If
our directors, officers and affiliated persons act together, they will be able
to influence the composition of our board of directors, and will continue to
have significant influence over our affairs in general.

Provisions of our charter documents and Maryland law could discourage an
acquisition of our company that would benefit our stockholders.

Provisions of our articles of incorporation and by-laws may make it more
difficult for a third party to acquire control of our company, even if a change
in control would benefit our stockholders. Our articles authorize our board of
directors, without stockholder approval, to issue one or more series of
preferred stock, which could have voting and conversion rights that adversely
affect or dilute the voting power of the holders of common stock. Furthermore,
our articles of incorporation provide for classified voting, which means that
our stockholders may vote upon the retention of only one

                                       23

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

or two of our six directors each year. Moreover, Maryland corporate law
restricts certain business combination transactions with "interested
stockholders."

OVERVIEW

In accordance with disclosure requirements on segment reporting, the SEC's
guidance has been to present financial information in a format that is used by
the Company's management to make decisions. The Company is a digital media
solutions provider with two primary revenue centers; a software product division
and a media services division. We analyze these two revenue centers, along with
their respective production costs, independently from each other. However,
because the majority of our operating expenses support both revenue centers, we
analyze all items below gross margin on a combined basis.

With the recent acquisition of Mediasite, we will be adding a third segment. In
future filings and press releases, we will be referring to our three revenue
centers as software, services and systems. We will continue to analyze all items
below gross margin on a combined basis.

RESULTS OF OPERATIONS

The following table has been presented to add clarification only and should be
read in conjunction with the audited financial statements. At the beginning of
fiscal 2001, the Company adopted EITF No. 00-14, "Accounting for Certain Sales
Incentives." For comparison purposes, cash rebates previously accounted for as a
marketing expense in 2000 and 1999 have been reclassified as a reduction of
software license fees (See footnote 1, Accounting Pronouncements).

<TABLE>
<CAPTION>
                                                    For the Years Ended September 30,
                                           2001               2000               1999
                                          -----------------------------------------------------
<S>                                       <C>        <C>     <C>        <C>     <C>        <C>
Software license fees                     $15,550    100%    $21,455    100%    $13,682    100%
Cost of software license fees               5,187     33       5,493     26       3,390     25
                                          -----------------------------------------------------
  Gross margin - software license fees    $10,363     67%    $15,962     74%    $10,292     75%

Media services                            $10,734    100%    $ 4,852    100%          -      -
Cost of media services                      7,733     72       5,177    107           -      -
                                          -----------------------------------------------------
  Gross margin - media services           $ 3,001     28%    $  (325)    (7)%         -      -
</TABLE>

Total Net Revenue

Year ended September 30, 2001 ("2001") compared to the year ended September 30,
2000 ("2000")

Total net revenues remained relatively unchanged, decreasing by $23 to $26,284
in 2001 from $26,307 in 2000. Although total revenues remained flat, the
contribution from the two segments changed significantly. In 2000 sales from
software license fees contributed 82% to total revenues while the newly
developed media services division contributed 18%. 2000 media services revenue,

                                       24

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

however, only includes revenue contributed from the former STV Communications,
Inc. ("STV") and International Image, Inc. ("II") since the effective dates of
acquisition (See footnote 13).

           2000 compared to the year ended September 30, 1999 ("1999")

Total net revenues increased $12,625, or 92%, from $13,682 in 1999 to $26,307 in
2000. Revenue from software license fees increased $7,773, or 57%, and the
addition of the media services division contributed $4,852.

Revenue from Software License Fees

                              2001 Compared to 2000

Revenue from software license fees decreased $5,905 or 28%, from 2000 to 2001.
This net change resulted from the following items:

     .    Revenue from our retail channel declined $4,837 from 2000 to 2001. The
          overall weakening in the retail market primarily impacted sales of
          ACID (ACID Pro, ACID Style and ACID loops) and Siren. Strong sales
          following the launch of ACID Pro 3.0 in Q3-2001 partially offset weak
          consumer demand for ACID Style. However, sales from ACID Loops, which
          are supplemental content CD's for ACID Pro and ACID Style, increased
          25% from 2000 to 2001 while sales for the ACID product line declined
          32% from 2000 to 2001. Increased competition in the PC jukebox market
          resulted in a decline in sales from Siren of 81% from 2000 to 2001. We
          do not intend to offer a future version of Siren at this time.

     .    Revenue generated from our OEM partners declined $4,086 from 2000 to
          2001.

     .    Revenues from our direct channel increased $3,018 from 2000 to 2001 or
          89%. This increase was driven by the release of Sound Forge 5.0 in
          February 2001 and ACID Pro 3.0 in June 2001, which were heavily
          marketed and aggressively priced to our direct channel through a
          number of email-based promotional offers as well as through our
          direct-mail catalog. The majority of this growth has been through
          downloads, which were 54% of direct sales in 2001 versus only 19% in
          2000.

                           2001 Quarterly Comparison

                                     Q4-2001    Q3-2001    Q2-2001    Q1-2001
                                     ----------------------------------------
Revenue from Software License Fees    $2,868     $4,161     $4,534     $3,988


Revenue from software license fees in Q4-2001 was significantly lower compared
to previous quarters. Normally, we record sales to distributors net of an
estimate for returns at the time of shipment. However, given the current
economic uncertainty and weak retail market, we elected to treat a $1,727
shipment to one of our distributors as a consignment sale and defer the
recording of revenue until the time our distributor ships product to the retail
stores. Continued economic weakness resulted in the return of the majority of
this inventory in Q1-2002.

                                       25

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                              2000 compared to 1999

Revenue from software license fees increased $7,773, or 57%, from 1999 to 2000.
This net change resulted from the following items:

     .    Revenue from our retail channel increased $3,723 from 1999 to 2000.
          This increase was driven by strong sales of our ACID products, which
          grew 85% from 1999 to 2000, and also the introduction of Vegas Video
          and Video Factory, which accounted for 20% of the overall increase in
          revenue from software license fees. Offsetting this increase was the
          discontinuance of Audio Anywhere and CD Architect. Combined sales for
          these two products equaled 23% in 1999 compared to 1% in 2000.

     .    Revenue from our OEM channel increased $2,103 from 1999 to 2000.
          Ongoing relationships with Hewlett Packard and Creative Labs as well
          as a new agreement with Sony Pictures in March 2000 accounted for the
          majority of the increase.

     .    Revenue from our direct channel increased $1,947 from 1999 to 2000,
          which resulted from the emergence of our direct catalog effort in
          2000.

     .    Pricing on all products remained relatively stable throughout 2000.

Gross Margin from Software License Fees

                              2001 Compared to 2000

Gross margin equaled 67% of software license fees in 2001 versus 74% in 2000.
While revenue from software license fees declined 28% from 2000 to 2001, cost of
software license fees only declined 6%. Included in costs of software license
fees are product material costs, assembly labor, freight, royalties on third
party technology or intellectual content, and amortization of previously
capitalized product development and localization costs. Contributing to the
decline in gross margin are the following items:

     .    Revenues from high margin OEM partners have declined significantly.
          There are virtually no material or labor costs associated with OEM
          revenue.

     .    The use of third-party technology, such as MP3 compression, in our
          products as well as the royalties paid for this technology continues
          to increase.

     .    Weak consumer sales and new product introductions contributed to
          increased obsolete and slow-moving inventory and resulting write offs
          in 2001.

                                       26

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                              2000 compared to 1999

Gross margin as a percentage of software license fees decreased slightly from
75% in 1999 to 74% in 2000. Primarily a greater revenue mix of lower margin
consumer products, such as Siren, ACID and Video Factory, drove this decrease.

Revenue from Media Services

Revenue from media services includes tape duplication for broadcast
distribution, broadcast standard conversions, audio and video encoding, as well
as fees for consulting services. Revenue from media services increased $5,882,
or 121%, from 2000 to 2001. However, 2000 media services revenue only includes
revenue contributed from STV since April 2000 and from II since June 2000. On a
quarterly comparison, Q4-2001 revenues decreased $282 to $2,541 from $2,823 in
Q4-2000. The collapse of the dot.com encoding industry at the beginning of
fiscal 2001 as well as revenue from a one-time consulting arrangement in Q4-2000
contributed to the decrease. Revenues from II's traditional conversion and
duplication services increased 22% from Q4-2000 to Q4-2001.

Gross Margin from Media Services

Gross margin from media services improved significantly to 28% in 2001 from (7)%
in 2000. While revenue from media services increased 121% from 2000 to 2001,
costs of media services only increased 49%. Costs of media services include
compensation, benefits and other expenses associated with production personnel
as well as depreciation on production equipment. The improvement in gross margin
was led by the Q1-2001 elimination of duplicate positions, operational and
process improvements, a switch to a temporary labor force for encoding services
and a reduction in depreciation expense in Q3-2001 from the write-off and
disposal of underutilized leased assets no longer needed for the business.

                                       27

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

Operating Expenses

The following chart is provided to add clarification by presenting items as a
percentage of total revenues. This should be read in conjunction with the
audited financial statements.

<TABLE>
<CAPTION>
                                               For the years ended September 30,
                                               ---------------------------------
                                               2001          2000         1999
                                               ---------------------------------
<S>                                            <C>           <C>          <C>
Total revenues                                  100 %         100 %        100 %
Cost of revenues                                 49            41           25
                                               ---------------------------------
   Gross margin                                  51            59           75
Operating expenses
 Selling and marketing expenses                  44            72           68
 General and administrative expenses             39            38           31
 Product development expenses                    30            30           21
                                               ---------------------------------
                                                113           140          120
 Restructuring and other charges                 23             4            0
 Amortization of goodwill and other purchase
  intangibles                                   104            54            0
                                               ---------------------------------
   Total operating expenses                     240           198          120
                                               ---------------------------------
   Loss from operations                        (189)%        (138)%        (45)%
</TABLE>


Selling and Marketing Expenses

Selling and marketing expenses include wages and commissions for sales,
marketing and technical support personnel, our direct mail catalog, co-operative
advertising with our software distributors, print advertising and various
promotional expenses for both our products and services. Timing of these costs
may vary greatly depending on introduction of new products and services or
entrance into new markets.

                              2001 compared to 2000

Selling and marketing expenses decreased by $7,268, or 39%, to $11,554 in 2001
from $18,822 in 2000. This decrease can be attributed to the following items; 1)
significant staff reductions in Q1-2001; 2) a greater percentage of revenues
coming from the media services division, which requires less expensive, more
targeted forms of marketing; which coincides with 3) a lesser focus on more
costly brand marketing such as tradeshows and media advertising.

Going forward we anticipate sales and marketing spending to increase slightly
from Q4 levels due to the acquisition of MediaSite sales personnel and the
marketing efforts necessary to promote our new systems offerings, however, as
the system business is closer to services with regard to advertising methods, we
anticipate that sales and marketing as a percentage of revenue will continue to
decline.

                                       28

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                              2000 compared to 1999

Selling and marketing expenses increased by $9,486 or 102%, to $18,822 in 2000
from $9,336 in 1999. The increase from 1999 to 2000 is primarily attributable to
the following items: 1) the development and distribution of Sonic Foundry
product catalogs to over 3 million consumers; 2) tradeshow participation, media
advertising, sales promotions and rebate programs to launch two new major
software products as well as the media services division; and 3) the addition of
personnel to facilitate these many initiatives.

General and Administrative Expenses ("G&A expenses")

G&A expenses consist primarily of personnel and related costs associated with
the facilities, finance, executive, legal and information technology
departments, as well as other expenses not fully allocated to functional areas.

                              2001 compared to 2000

G&A expenses increased slightly by $171, or 2%, to $10,153 in 2001 from $9,982
in 2000. The elimination of non-recurring, acquisition related expenses and
elements of the December 2000 restructuring plan, including removal of duplicate
functions through staff reductions and consolidation of facilities greatly
improved our efficiencies in 2001. The impact resulted in a decrease in Q1 G&A
from 3.9 million to 2.2 million in Q4 or 39%. These improvements partially
offset a $995 increase in bad debt expense. $780 of the increase is attributable
to the software division with 52% relating to the termination of a relationship
with one of our distributors. Bad debt expense from the media services division
comprised the remaining $213 with three customers contributing 51% of the
increase. Going forward we anticipate bad debt expense to decrease from the 2001
levels due to the continuing shift in software revenues from the retail channel
to the direct channel in which payment is generally collected within three days
of purchase.

Other than the addition of MediaSite's Pittsburgh facility, we do not anticipate
growth in G&A and feel we are adequately staffed and sized for future growth.

                              2000 compared to 1999

General and administrative expenses increased by $5,729 or 135%, to $9,982 in
2000 from $4,253 in 1999. The increase from 1999 to 2000 is primarily
attributable to expenses such as legal, accounting, personnel, consulting and
travel associated with the acquisition of STV and II. Increased facility and
other miscellaneous costs to support the growing headcount levels, including
expenses associated with setting up temporary office space while our current
corporate headquarters was under renovation also contributed to the increase.

                                       29

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Product Development Expenses ("R&D expenses")

R&D expenses include salaries and wages of the software research and development
staff and an allocation of benefits, facility and administrative expenses, net
of product development expenses capitalized pursuant to SFAS No. 86, "Accounting
for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed."

                              2001 compared to 2000

R&D expenses remained relatively unchanged, increasing $118, or 1%, from $7,868
in 2000 to $7,986 in 2001. As a percentage of total revenue, R&D expenses also
remained unchanged at 30% for both 2000 and 2001.

In accordance with SFAS Number 86, the Company capitalizes the cost of
development of software products that have reached technological feasibility. No
development costs for our core product line were capitalized during 2000 or
2001, however, the majority of the purchase price for the acquisition of Jedor,
Inc., which was completed in February 2000, was allocated to the capitalized
software development of Viscosity and is being amortized over two years.

Going forward we believe software development costs qualifying for
capitalization will continue to be insignificant, and, as such, we expect that
we will expense most or all research and development costs as incurred. We
anticipate that R&D spending will decrease in 2002 despite the recent
acquisition of MediaSite software developers.

                              2000 compared to 1999

Product development expenses increased by $4,993, or 174%, to $7,868 in 2000
from $2,875 in 1999. The addition of software engineers to accelerate
development of the Company's expanding line of software products, as well as
efforts expended to establish our media services division and add to a host of
internally used filtering algorithms, caused the increase in product development
costs between the two periods.

Restructuring and Other Charges

As outlined in footnote 15 to the audited financial statements included in this
report, restructuring charges of $4,973 and an impairment charge of $1,000 were
incurred in 2001. Consistent with management's plan to reduce costs in response
to weak market conditions, the restructuring charge primarily consisted of: 1)
an accrual for 60 days of severance and benefits for domestic employees
terminated on December 20, 2000 as well as severance and other expenses
associated with closing our office in the Netherlands; 2) an asset impairment
charge related to the sale, disposal or write-down of PCs, office equipment and
other assets no longer required; 3) operating and lease termination costs
related to the consolidation of facilities; and 4) miscellaneous charges such as
forfeited tradeshow deposits. The restructuring has significantly reduced
certain expenses as evidenced in the chart below, which compares Q1-2001
expenses to those same expenses in Q4-2001:

                                       30

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001


(In thousands)                        Q4-2001    Q1-2001    Variance   % Decline
                                      ------------------------------------------
Cost of media services                $ 1,651    $ 2,333    $  (682)       29%
Selling and marketing expenses          1,413      5,228     (3,815)       73
General and administrative expenses     2,231      3,684     (1,453)       39
Product development expenses            1,674      2,834     (1,160)       41

Both the $1,000 impairment charge recognized in 2001 as well as the $1,000
impairment charge recognized in 2000 relate to non-cash write-offs of Internet
advertising credits received in connection with the issuance of common stock to
Warner Brothers and Sony (See footnote 1, Advertising Costs).

Amortization of Goodwill and Other Purchase Intangibles

The 2001 and 2000 amortization of goodwill and other purchase intangibles
consists of expense associated with the purchases of STV and II. Total purchased
intangibles consist of assembled workforce of $3,200, which is being amortized
over one to five-years and goodwill of $82,900, which is being amortized over a
three to seven year period. In the quarter ended December 31, 2000 we received a
final appraisal of II's fixed assets and, as a result, reclassified $1,200 of
the purchase price from goodwill to fixed assets. In April 2001, we paid $500 in
full settlement of a $700 note due the minority shareholders of II, which
resulted in a reduction of goodwill.

In June 2001, the Financial Accounting Standards Board issued two Statements of
Financial Accounting Standards (SFAS) that will impact amortization expense in
fiscal 2002; 1.) SFAS No. 141, "Business Combinations," which requires that the
purchase method of accounting be used for all business combinations initiated
after June 30, 2001; and 2.) SFAS No. 142, "Goodwill and Other Intangible
Assets," which no longer permits the amortization of goodwill and
indefinite-lived intangible assets. Instead, these assets must be reviewed
annually (or more frequently under certain conditions) for impairment in
accordance with this statement. The acquisition of MediaSite will be accounted
for as a purchase in accordance with the new rules. The amortization of goodwill
associated with the acquisitions of STV and II will no longer be recorded upon
adoption of the new rules on October 1, 2001. We have recently retained an
outside valuation firm to assist us in evaluating our intangible assets in
relation to the provisions of SFAS No. 142 and this valuation may result in an
adjustment to the carrying value of intangible assets.

LIQUIDITY AND CAPITAL RESOURCES

We have funded our operations to date primarily from public and private
placement offerings of equity securities and cash flows from operations. For the
years ended September 30, 2001, 2000 and 1999, we had cash and cash equivalents
of $7,809, $21,948 and $5,889. The higher cash balance in 2000 was due to
proceeds of $53,995 raised from the exercise of common stock warrants and the
issuance of common stock through private placements.

                                       31

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                              2001 compared to 2000

Cash used in operating activities totaled $10,197 in 2001 compared to $19,008 in
2000. Decreased use of operating cash of $8,811 from 2000 to 2001 consisted
primarily of operating cost reductions identified in the Q1-2001 restructuring.
The following items contributed to the decrease:

     .    Selling and marketing expenses declined $7,268 from 2000 to 2001. This
          decline is attributable to a reduction in personnel and a
          significantly lesser focus on expensive brand marketing such as
          tradeshows and media advertising. This reduction also helped drive the
          $2,860 reduction in accounts payable and accrued liabilities.

     .    Trade receivables declined $5,010 from 2000 to 2001. The entire
          decline is related to the software division and reflects the continued
          switch in channel mix away from retail, in which customers are granted
          terms, to the direct channel, in which credit card payments are
          processed within three days.

     .    Inventory balances declined $788 from 2000 to 2001. This decline is
          directly related to the increase in electronic delivery of our
          software products and the reduction in retail business.

Cash used in investing activities totaled $2,023 in 2001 compared to $18,125 in
2000. Investing activities in both years related to the acquisition of STV and
II, fixed asset purchases primarily for our media services division, and the
sale of underutilized assets. Also in 2000, we recognized a $600 gain on shares
we sold from an investment in a high speed networking company (See footnote 3).
The acquisition activities in the current year relate to legal, accounting and
other professional fees accrued in 2000 for the II acquisition and paid in 2001.

In 2001, cash used in financing activities was $2,025 compared to $53,192
provided by financing activities in 2000. The most significant change between
the two years was the $53,995 raised in 2000 from equity compared to only $317
in 2001. The majority of the $2,546 increase in debt and capital lease payments
from 2000 to 2001 relates to lease financing for media services equipment
obtained in the STV transaction. Also impacting 2001 was $436 in proceeds
received from a term loan from a bank in Toronto and a draw of $571 on our line
of credit from the same bank (See footnote 4), which was subsequently paid back
in October 2001.

                              2000 compared to 1999

Cash used in operating activities increased by $12,954 from 1999 to 2000. This
change was driven by a $20,208 increase in sales and marketing, G&A and R&D
expenses, which resulted from the entrance into media services and acquisitions
of STV and II.

Cash used in investing activities increased $18,713 from 1999 to 2000. The
primary driver was the 2000 acquisition of STV and II. Fixed asset purchases
increased $5,840 and were primarily

                                       32

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

due to the addition of media services fixed assets and, to a lesser extent,
investing in equipment and infrastructure necessary to support our rapidly
growing staff. In a growing effort to consolidate our facilities and equipment,
we sold underutilized assets in 2000, which provided cash of $426. In that same
year, we recognized a $600 gain on shares we sold from an investment in a high
speed networking company. These shares had a zero basis and were given in
exchange for a guarantee to a lease. In 1999 we invested $514 in the common
stock of this same company and still hold those shares. The primary generator of
cash provided by investing activities in 1999 was $3,000 in proceeds from the
sale of marketable securities.

Cash provided by financing activities increased by $48,777 from 1999 to 2000. In
2000, we raised $53,995 from the issuance of common stock compared to only $1 in
1999. In 1999, we received $5,257 from proceeds of debt, including $4,625 from
the issuance of redeemable convertible subordinated debt. In both years proceeds
were impacted by payments on long-term debt and capital leases.

                     Recent Developments Impacting Liquidity

In October 2001, we assumed the assets and certain liabilities of MediaSite (See
footnote 16). The assumed liabilities totaled approximately $2.2 million. Due to
the increase in liabilities and expenses associated with additional personnel
and closing costs, we anticipate being cash flow negative in Q1-2002. We are
working diligently to negotiate payment plans and discounts for the liabilities
assumed, as well as quickly eliminating any unnecessary and duplicate efforts
and expenditures.

In October 2001, the Company deposited $1,000,000 with the Ontario Superior
Court of Justice to be held in trust until settlement of a lawsuit with the
former shareholders of II (See Item 3 - Legal Proceedings). In future filings of
the Company, the $1,000,000 will be reported as restricted cash on the balance
sheet.

Although we plan to raise additional capital to grow our systems business and
pursue additional technology, the Company believes it has access to sufficient
resources and operating flexibility to fund operations for at least the next
twelve months. The structure of such capital is likely to come in the form of
senior and subordinated debt but may contain equity features such as common
stock purchase warrants or fixed rate convertibility. There can be no assurance
that we will obtain additional capital or that it will be raised on satisfactory
terms.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other
financial instruments for which the fair value disclosure would be required
under SFAS No. 107, "Derivative Financial Instruments, Other Financial
Instruments and Derivative Commodity Instruments." The Company's cash
equivalents consist of overnight investments in money market funds that are

                                       33

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

carried at fair value. Accordingly, we believe that the market risk of such
investments is minimal.

Interest Rate Risk

The Company's cash equivalents are subject to interest rate fluctuations,
however, we believe this risk is immaterial due to the short-term nature of
these investments.

Foreign Currency Exchange Rate Risk

All international sales of our software products are denominated in US dollars.
However, the majority of transactions for our media services division in Toronto
are denominated in Canadian dollars. Although these transactions are not
generally subject to significant foreign exchange rate gains and losses, they
are translated into US dollars as part of our consolidated financial statements
and therefore fluctuations in the exchange rate will affect our consolidated
financial statements. The Canadian dollar has been stable relative to the US
dollar and we have not engaged in any foreign currency hedging activities.

                                       34

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders
Sonic Foundry, Inc.

We have audited the accompanying consolidated balance sheets of Sonic Foundry,
Inc. (the Company) as of September 30, 2001 and 2000, and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years ended September 30, 2001, 2000, and 1999. Our audits also included the
financial statement schedule listed in the index at Item 14(a). The financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of the Company at
September 30, 2001 and 2000 and the consolidated results of its operations and
its cash flows for the years ended September 30, 2001, 2000, and 1999, in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

                                   ERNST & YOUNG LLP


Milwaukee, Wisconsin
November 9, 2001

                                       35

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                      (in thousands except for share data)

<TABLE>
<CAPTION>

                                                                            September 30,
                                                                        2001             2000
                                                                    ------------------------------
<S>                                                                 <C>              <C>
Assets
Current Assets:
  Cash and cash equivalents                                           $  7,809         $ 21,948
    Accounts receivable, net of allowances of $1,075 and $1,209          4,065            9,075
  Accounts receivable, other                                                26              355
  Revenues in excess of billings for software license fees                  --              105
  Inventories                                                            1,118            1,906
  Prepaid expenses and other current assets                              1,085            1,591
  Prepaid advertising                                                       --            1,000
                                                                    ------------------------------
Total current assets                                                    14,103           35,980
Property and equipment:
  Land                                                                      --               95
  Buildings and improvements                                             2,409            3,186
  Equipment                                                             13,823           15,370
  Furniture and fixtures                                                   542              504
  Assets held for sale                                                      40               --
                                                                    ------------------------------
    Total property and equipment                                        16,814           19,155
    Less accumulated depreciation                                        5,010            3,071
                                                                    ------------------------------
      Net property and equipment                                        11,804           16,084
Other assets:
  Goodwill and other intangibles, net                                   44,732           73,632
  Capitalized software development costs, net                               73              518
  Long term investment                                                     514              514
  Other assets                                                             457               97
                                                                    ------------------------------
    Total other assets                                                  45,776           74,761
                                                                    ------------------------------
Total assets                                                          $ 71,683         $126,825
                                                                    ==============================
</TABLE>

See accompanying notes

                                       36

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                      (in thousands except for share data)
<TABLE>
                                                                         September 30,
                                                                       2001        2000
                                                                    ---------------------
<S>                                                                 <C>          <C>
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable                                                  $  2,316     $  5,231
  Unearned revenue                                                        83           --
  Accrued liabilities                                                  1,719        2,819
  Accrued restructuring charges                                          345           --
  Current portion of long-term debt                                    4,003        4,300
  Current portion of capital lease obligations                         1,216        1,477
                                                                    ---------------------
Total current liabilities                                              9,682       13,827

  Long-term obligations, net of current portion                          217          923
  Capital lease obligations, net of current portion                      525        1,703
  Other liabilities                                                       28            6
Stockholders' equity:
  Preferred stock, $.01 par value, authorized 5,000,000
    shares; none issued and outstanding                                   --           --
  5% preferred stock, Series B, voting, cumulative,
    convertible, $.01 par value (liquidation preference at
    par), authorized 10,000,000 shares, none issued and
    outstanding                                                           --           --
  Common stock, $.01 par value, authorized 100,000,000
    shares; 22,345,503 and 21,904,574 issued and 22,317,753
    and 21,876,824 outstanding at September 30, 2001 and 2000            223          219
  Common stock to be issued                                            5,375        5,579
  Additional paid-in capital                                         148,188      148,290
  Accumulated deficit                                                (92,248)     (42,388)
  Receivable for common stock issued                                     (34)         (72)
  Cumulative foreign currency translations                                 7          137
  Unearned compensation                                                 (130)      (1,249)
  Treasury stock, at cost, 27,750 shares                                (150)        (150)
                                                                    ---------------------
Total stockholders' equity                                            61,231      110,366
                                                                    ---------------------
Total liabilities and stockholders' equity                          $ 71,683     $126,825
                                                                    =====================
</TABLE>

See accompanying notes

                                       37

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Operations
                    (in thousands except for per share data)

<TABLE>
<CAPTION>
                                             Years Ended September 30,
                                       -------------------------------------
                                         2001           2000          1999
                                       -------------------------------------
<S>                                    <C>            <C>            <C>
Revenue:
Software license fees                  $ 15,550       $ 21,455       $13,682
Media services                           10,734          4,852            --
                                       -------------------------------------
    Total revenue                        26,284         26,307        13,682

Cost of revenue:
Cost of software license fees             5,187          5,493         3,390
Cost of media services                    7,733          5,177            --
                                       -------------------------------------
    Total cost of revenue                12,920         10,670         3,390
                                       -------------------------------------
Gross margin                             13,364         15,637        10,292

Operating expenses:
Selling and marketing expenses           11,554         18,822         9,336
General and administrative expenses      10,153          9,982         4,253
Product development expenses              7,986          7,868         2,875
Restructuring and other charges           5,973          1,000            --
Amortization of goodwill and
  other intangibles                      27,478         14,300            --
                                       -------------------------------------
    Total operating expense              63,144         51,972        16,464
                                       -------------------------------------
Loss from operations                    (49,780)       (36,335)       (6,172)

Other income (expense):
Interest expense                           (515)          (618)          (54)
Interest and other income                   435          2,031           229
                                       -------------------------------------
    Total other income (expense)            (80)         1,413           175
                                       -------------------------------------
Net loss                               $(49,860)      $(34,922)      $(5,997)
                                       =====================================

Per common share:
Net loss per common share -            -------------------------------------
  basic and diluted                    $  (2.25)      $  (1.89)      $ (1.06)
                                       =====================================
</TABLE>


See accompanying notes

                                       38


<PAGE>

                               Sonic Foundry, Inc.
                 Consolidated Statements of Stockholders' Equity
              For the Years Ended September 30, 2001, 2000 and 1999
                                 (in thousands)

<TABLE>
<CAPTION>

                                                                                                     Receiv-
                                                                                                      ables
                                           Common                 Addi-                               for
                    Preferred              stock                 tional      Accumu-     Currency    common    Unearned
                    series B     Common    to be     Treasury    Paid-in      lated      transla-    stock      compen-
                      Stock      stock     issued     stock      capital     deficit      tions      issued     sation      Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                 <C>          <C>       <C>       <C>         <C>         <C>         <C>         <C>        <C>        <C>

Balance,
September 30, 1998    $ 72        $ 53     $    -     $   -      $ 15,430    $ (1,464)    $   -       $  -      $     -    $ 14,091
Issuance of common
 stock warrants and
 options                 -           -          -         -           852           -         -          -            -         852
Exercise of common
 stock warrants and
 options                 -           -          -         -             1           -         -          -            -           1
Preferred stock
 dividend                5           -          -         -             -          (5)        -          -            -           -
Conversion of
 preferred stock to
 common stock          (77)         77          -         -             -           -         -          -            -           -
Purchase and
 subsequent
 issuance of stock
 under restricted
 stock awards            -           -          -         -             -           -         -          -         (200)       (200)
Net loss                 -           -          -         -             -      (5,997)        -          -            -      (5,997)
-----------------------------------------------------------------------------------------------------------------------------------
Balance,
September 30, 1999       -         130          -         -        16,283      (7,466)        -          -         (200)      8,747
Issuance of common
 stock                   -          18          -         -        41,164           -         -          -            -      41,182
Issuance of common
 stock warrants and
 options                 -           -          -         -           830           -         -          -            -         830
Issuance of stock
 and stock options
 for acquisitions        -          22      5,579         -        74,079           -         -          -       (5,307)     74,373
Exercise of common
 stock warrants and
 options                 -          39          -         -        15,374           -         -        (72)           -      15,341
Conversion of
 subordinated debt
 to common stock         -          10          -         -         4,208           -         -          -            -       4,218
Amortization of
 unearned
 compensation and
 adjustments
 related to
 employee
 terminations            -           -          -      (150)      (3,648)           -         -          -        4,258         460
Comprehensive Loss:
  Net loss               -           -          -         -             -     (34,922)        -          -            -     (34,922)
  Foreign currency
   translation
   adjustments           -           -          -         -             -           -       137          -            -         137
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss       -           -          -         -             -     (34,922)      137          -            -     (34,785)
-----------------------------------------------------------------------------------------------------------------------------------
Balance,
September 30, 2000       -         219      5,579      (150)      148,290     (42,388)      137        (72)      (1,249)    110,366
Issuance of common
 stock                   -           2          -         -           214           -         -          -            -         216
Issuance of common
 stock warrants and
 options                 -           -          -         -           635           -         -          -         (616)         19
Exercise of common
 stock warrants and
 options                 -           2          -         -            99           -         -          4            -         105
Conversion of
 exchangeable stock
 to common stock         -           -      (204)         -           204           -         -          -            -           -
Amortization of
 unearned
 compensation and
 adjustments
 related to
 employee
 terminations            -           -          -         -       (1,249)           -         -          -        1,735         486
Rescission of
 option exercise
 and subsequent
 reissuance              -           -          -         -           (5)           -         -         34            -          29
Comprehensive Loss:
  Net loss               -           -          -         -             -     (49,860)        -          -            -     (49,860)
  Foreign currency
   translation
   adjustments           -           -          -         -             -           -      (130)         -            -        (130)
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss       -           -          -         -             -     (49,860)     (130)         -            -     (49,990)
-----------------------------------------------------------------------------------------------------------------------------------
Balance,
September 30, 2001    $  -        $223     $5,375     $(150)     $148,188    $(92,248)    $   7       $(34)     $  (130)   $ 61,231
===================================================================================================================================
</TABLE>

     See accompanying notes

                                       39

<PAGE>


                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                          Years Ended September 30,
                                                                                 ------------------------------------------
                                                                                     2001             2000          1999
                                                                                 ------------------------------------------
<S>                                                                               <C>              <C>            <C>
Operating activities

Net loss                                                                          $(49,860)        $(34,922)      $(5,997)
Adjustments to reconcile net loss to net cash used in operating activities:
  Amortization of goodwill and other intangibles                                    27,478           13,504             -
  Depreciation and amortization of property and equipment                            3,726            2,684           546
  Amortization of capitalized software development costs                               445              564           298
  Amortization of debt discount and debt issuance costs                                  -              164            13
  Non-cash compensation charges                                                        635            1,260           239
  Non-cash advertising impairment charge                                             1,000            1,500             -
  Non-cash imputed interest charge for acquisition                                       -              191             -
  (Gain) loss on sale of assets                                                      2,576             (545)            5
  Changes in operating assets and liabilities:
    Accounts receivable and revenues in excess of billings                           5,444           (3,459)       (1,365)
    Inventories                                                                        788           (1,342)         (725)
    Prepaid expenses and other assets                                                  431             (392)         (602)
    Accounts payable and accrued liabilities                                        (2,860)           1,785         1,534
                                                                                 ------------------------------------------
Total adjustments                                                                   39,663           15,914           (57)
                                                                                 ------------------------------------------
Net cash used in operating activities                                              (10,197)         (19,008)       (6,054)

Investing activities

Acquisitions, net of cash acquired                                                  (1,255)         (11,949)            -
Proceeds from marketable securities                                                      -                -         3,000
Purchases of property and equipment                                                 (1,984)          (7,202)       (1,362)
Proceeds from disposals of assets                                                    1,216            1,026             4
Capitalized software development costs                                                   -                -          (540)
Purchases of long-term investments                                                       -                -          (514)
                                                                                 ------------------------------------------
Net cash provided by (used in) investing activities                                 (2,023)         (18,125)          588

Financing activities

Proceeds from issuance of common stock, net of issuance costs                          317           53,995             1
Proceeds from debt issuance                                                            436                -         5,257
Payments on long-term debt and capital leases                                       (3,349)            (803)         (643)
Borrowings on line of credit, net                                                      571                -             -
Purchase of common stock for restricted stock awards                                     -                -          (200)
                                                                                 ------------------------------------------
Net cash provided by (used in) financing activities                                 (2,025)          53,192         4,415
Effect of exchange rate changes on cash                                                106                -             -
                                                                                 ------------------------------------------
Net increase (decrease) in cash                                                    (14,139)          16,059        (1,051)
Cash and cash equivalents at beginning of period                                    21,948            5,889         6,940
                                                                                 ------------------------------------------
Cash and cash equivalents at end of period                                        $  7,809         $ 21,948  $    $ 5,889
                                                                                 ==========================================
</TABLE>

                                       40

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                                 (in thousands)

<TABLE>
<CAPTION>
<S>                                                                                              <C>        <C>          <C>
Supplemental cash flow information:
  Interest paid                                                                                  $  321     $   233      $ 33
Noncash transactions:
  Capital lease acquisitions                                                                        100       2,614         -
  Issuance of common stock in exchange for advertising                                                -       2,500         -
  Issuance of common stock for Jedor                                                                  -         300         -
  Issuance of common stock and stock options for STV                                                  -      72,480         -
  Common stock issued and issuable for International Image                                            -       6,900         -
  Note payable for acquisition of International Image                                                 -       4,000         -
  Reclassification of goodwill to fixed assets upon final appraisal of International Image        1,281           -         -
  Reduction of goodwill upon settlement of notes due certain International Image
    shareholders                                                                                    200           -         -
  Cancellation of unvested stock options classified as unearned compensation upon
    acquisition of STV                                                                            1,249           -         -
  Preferred stock dividend                                                                            -           -         4
  Issuance of warrants for consulting services                                                       19         830       285
  Issuance of restricted stock to employee                                                            -           -       200
  Receivables from employees for option exercises                                                     -          72         -
  Conversion of debt into common stock, net                                                           -       4,218         -
  Conversion of exchangeable stock into common stock                                                204           -         -
</TABLE>

See accompanying notes

                                       41

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

1. Basis of Presentation and Significant Accounting Policies

Business and Concentration of Credit Risk

Sonic Foundry, Inc. (the Company) is a media solutions provider developing and
offering 1.) Windows-based software tools for the creation, editing and
publishing of digital multimedia and 2.) Media services for the conversion,
reformatting and encoding of television, film and audio content into multiple
delivery platforms. The Company sells its software to music, video, broadcast
and Internet markets worldwide. The Company sells its services to primarily the
entertainment industry. All domestic and international sales are denominated in
either U.S. or Canadian dollars. The Company performs periodic credit
evaluations of its customers' financial condition and generally does not require
collateral.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries, STV Communications, Inc. ("STV") and International
Image, Inc. ("II"), (See Note 13). All significant intercompany transactions and
balances have been eliminated. The functional currency of foreign owned
subsidiaries is the local currency; accordingly, assets and liabilities are
translated into United States dollars at the rate of exchange existing at the
end of the period. Income and expense amounts are translated at the average
exchange rates during the period. Adjustments resulting from translation are
classified as a separate component of comprehensive income within stockholders'
equity.

Cash and Cash Equivalents

For purposes of the statement of cash flows, the Company considers all highly
liquid investments purchased with a maturity of three months or less to be cash
equivalents.

Use of Estimates

The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

Revenue Recognition
Software License Fees

Revenues from software license fees consist of fees charged for the licensing of
Windows-based software products. Software license fees are recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered and no significant obligations of the Company remain, the fee to the
Company is fixed and determinable, and collection of the resulting receivable is
deemed probable. Delivery occurs through the following methods:

                                       42

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     .    Direct Distribution: Direct revenues are recognized upon delivery to
          the end-user either via shipment of a boxed product from the Company's
          warehouse or electronic download. No returns are accepted.

     .    Retail Distribution: Retail revenues are recognized upon delivery to a
          third-party distributor, net of allowances for estimated returns.

     .    OEM: OEM revenues are generated through partnerships with hardware and
          software vendors who license the right to bundle one of the Company's
          products with the partner's products. Typically, this type of revenue
          is recognized as the partner sells through to the end-user.

     .    Consulting: Consulting revenues include fees recorded pursuant to
          long-term contracts, using the percentage of completion method of
          accounting, when significant customization or modification of a
          product is required.

     .    Consignment: Consignment revenues are recognized when a third-party
          reseller delivers the boxed product to their customer.

Media Services

Revenues from media services are recognized when persuasive evidence of a
contract exists, the service has been completed and no significant obligations
of the Company remain, the fee is fixed and determinable and collection of the
resulting receivable is deemed probable.

Inventory Valuation

Inventories are carried at the lower of cost or market with cost determined on a
first-in, first-out (FIFO) basis.

Software Development Costs

The Company capitalizes the cost of development of software products that have
reached technological feasibility. Costs incurred prior to the establishment of
technological feasibility are charged to product development expense. When the
product is available for general release to customers, capitalization ceases and
such costs are amortized on a product-by-product basis computed as the greater
of (a) the ratio that current gross revenues for the product bear to the total
of current and anticipated future gross revenues or (b) the straight-line
amortization over the remaining estimated economic useful life (generally two
years) of the product. Capitalized software development costs are reported at
the lower of unamortized cost or net realizable value. No additional development
costs for the Company's core product line were capitalized during the year.

Capitalized software development costs at September 30, 2001 and 2000 are net of
accumulated amortization of $1,660,000 and $1,215,000.

                                       43

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Advertising Costs

Advertising costs are expensed at the time the advertising takes place.
Advertising costs were $4,161,000, $6,657,000, and $1,039,000 for the years
ended September 30, 2001, 2000, and 1999.

In March 2000, $1,500,000 of advertising credits were received from Warner
Brothers and $1,000,000 from Sony in exchange for common stock. The $1,500,000
received from Warner Brothers was allocated to its Entertaindom website and the
$1,000,000 from Sony was allocated to its Screenblast web site. During fiscal
2000, $500,000 relating to Warner Brothers was charged to advertising expense.
In September 2000, the remaining Warner Brother's credits were written off as an
impairment charge after the determination that the Entertaindom website had not
generated the click-throughs originally anticipated and failed to generate much
marketing value. Following Sony's launch of the Screenblast web site in
September 2001, the Company concluded that the weak overall market for on-line
advertising and marketing services and changes in business strategies
necessitated an impairment of the full value of the Sony advertisement credits.

Property and Equipment

Property and equipment are recorded at cost and are depreciated using the
straight-line method for financial reporting purposes. The estimated useful
lives used to calculate depreciation are as follows:

                                                           Years
                                                           -----
Building and improvements                              5 to 40 years
Equipment and capital lease assets                     3 to 5 years
Furniture and fixtures                                 7 years

Impairment of Long-Lived Assets
Property and equipment, capitalized software development costs and goodwill and
other intangibles are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. If the
sum of the expected undiscounted cash flows is less than the carrying value of
the related asset or group of assets, a loss is recognized for the difference
between the fair value and carrying value of the asset or group of assets.

Income Taxes
Deferred income taxes are provided for temporary differences between financial
reporting and income tax basis of assets and liabilities, and are measured using
currently enacted tax rates and laws. Deferred income taxes also arise from the
future benefits of net operating loss carryforwards. A valuation allowance equal
to 100% of the net deferred tax assets has been recognized due to uncertainty
regarding future realization.

Fair Value of Financial Instruments
The Company's financial instruments consist primarily of cash and cash
equivalents, trade receivables, trade payables and debt instruments. The book
values of cash and cash equivalents,

                                       44

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

trade receivables, and trade payables are considered to be representative of
their respective fair values. None of the Company's debt instruments that are
outstanding at September 30, 2001, have readily ascertainable market values;
however, the carrying values are considered to approximate their respective fair
values. See Note 4 for the terms and carrying values of the Company's various
debt instruments.

Per Share Computation

The following table sets forth the computation of basic and diluted loss per
share:

<TABLE>
<CAPTION>

(in thousands except share and per share data)               Years Ended September 30,
                                                          2001          2000          1999
                                                       -------------------------------------
<S>                                                    <C>           <C>           <C>
Numerator
Net loss                                                 $(49,860)     $(34,922)     $(5,997)
Preferred stock dividends declared                             --            --           (4)
                                                       -------------------------------------
Net loss used in computing basic and diluted loss
   per share                                             $(49,860)     $(34,922)     $(6,001)
                                                       =====================================
Denominator

Denominator  for basic and dilutive  loss per share
   - weighted average common shares                    22,129,000    18,503,000    5,687,000
                                                       =====================================
Securities that could potentially dilute
   earnings per share in the future that are not
   included in the computation of diluted loss
   per share as their impact is antidilutive
   (treasury stock method)
   Options and warrants                                   914,000     2,654,000    1,046,000
   Convertible debt                                            --            --          972
   Common stock to be issued                              467,380       161,700           --
</TABLE>

Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended by SFAS No. 138, which
establishes accounting and reporting standards for derivative instruments and
hedging activities. SFAS No. 133 establishes a new model for accounting
standards and was effective for fiscal years beginning after June 15, 2000.
Adoption of SFAS 133 did not have any impact on the Company's consolidated
financial statements.

In December 1999, the Securities and Exchange Commission (SEC) released Staff
Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial
Statements". Adoption of SAB 101 had no material impact on the Company's
financial position and results of operations.

                                       45

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

In May 2000, the Emerging Issues Task Force (EITF) reached a consensus on Issue
No. 00-14, "Accounting for Certain Sales Incentives." EITF No. 00-14 was
effective for the Company beginning July 1, 2001. EITF No. 00-14 requires cash
rebates to be classified as a reduction of revenue and prior periods presented
for comparative purposes to be reclassified to comply with the new presentation
requirements. Historically, the Company has recognized revenue for products with
cash rebates on a gross basis at the time of the sale and cash rebates expected
to be claimed were charged to marketing expense. Total rebates claimed by
customers during 2001, 2000 and 1999 were approximately $1,924,000, $1,071,000
and $1,148,000, respectively.

Adoption of EITF No. 00-14 for all periods presented has affected the
presentation of cash rebates in the statement of operations but has not affected
the loss from operations reported. Please see footnote 17 regarding the
presentation of quarterly financial data for further clarification.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,
"Business Combinations," and No. 142, "Goodwill and Other Intangible Assets."

SFAS No. 141 requires that the purchase method of accounting be used for all
business combinations initiated after June 30, 2001. Use of the
pooling-of-interests method is no longer permitted. SFAS No. 141 also includes
guidance on the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination that is completed after
June 30, 2001.

SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived
intangible assets. Instead, these assets must be reviewed annually (or more
frequently under certain conditions) for impairment in accordance with this
Statement. This impairment test uses a fair value approach rather than the
undiscounted cash flows approach previously required by SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of." The amortization of goodwill associated with the acquisitions
of STV and II will no longer be recorded upon adoption of the new rules.
Intangible assets that do not have indefinite lives will continue to be
amortized over their useful lives and reviewed for impairment. The Company will
apply SFAS No. 142 beginning October 1, 2001. The Company has retained an
outside valuation firm to assist in evaluating intangible assets under the
provisions of SFAS No. 142 to determine the impact SFAS No. 142 will have on
results of operations and financial position and whether an impairment charge
will be necessary.

                                       46

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

2.  Inventories

Inventory consists of the following (in thousands):

                                                       September 30,
                                          --------------------------------------
                                                2001                2000
                                          ------------------ -------------------
        Raw materials and supplies             $   390            $   1,121
        Work-in-process                            112                  213
        Finished goods                             616                  572
                                          ------------------ -------------------
                                               $ 1,118            $   1,906
                                          ================== ===================

3.  Long-Term Investment and Other Assets

Early in 1999, the Company guaranteed the operating lease of a company (the
entity) that develops high speed networking products for broadband access to and
delivery of on-line media. The Company received common stock of the entity, in
exchange for the guarantee and also invested $514,000 in common stock of the
entity. The operating lease has a five-year term with aggregate base lease
payments of approximately $500,000 at September 30, 2001. The Company owns less
than 20% of the entity; accordingly, the investment is accounted for using the
cost method. In December 1999, the Company sold a portion of shares and
recognized a $600,000 gain on the sale. Certain directors of the Company have
personal investments in the entity.

In September 2001, the Company advanced $419,000 to MediaSite, Inc. (see
footnote 16), which was recorded as a non-current asset. This balance will be
accounted for as part of the purchase price in the first quarter of 2002.

                                       47

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

4.  Long-Term Debt and Notes Payable

Long-term obligations consist of the following:
<TABLE>
<CAPTION>
(in thousands)                                                               Years Ended September 30,
                                                                              2001               2000
                                                                             -------------------------
<S>                                                                          <C>                <C>
Subordinated note payable due to former owners of International
   Image due January 2001, interest rate of 9% per annum (a)                 $3,300             $4,000
Mortgage note paid in full in March 2001.                                        --                590
Term loan to a bank, due May 2004, monthly payments of
   $16 Canadian dollars including interest at Canadian Prime plus 1.5%
   and secured by substantially all Canadian assets.                            340                 --
Note payable to the Madison Development Corporation, due
   February 2002, monthly payments of $3 including interest at
   7.70% per annum, secured by substantially all assets.                          9                 64
Other bank loans due on demand                                                  571                569
                                                                             -------------------------
Total                                                                         4,220              5,223
Less amounts due within one year                                              4,003              4,300
                                                                             -------------------------
Long-term debt                                                               $  217             $  923
                                                                             =========================
</TABLE>

Maturities of long-term debt at September 30, 2001 are as follows:

                   Fiscal          (in thousands)
                   ------
                   2002                $4,003
                   2003                   125
                   2004                    92
                                       ------
                   Total               $4,220
                                       ======

     (a)  In early January 2001, the Company withheld paying a $4 million note
          due to the former shareholders of International Image pending the
          resolution of certain disputed representations made during the
          acquisition. In January 2001 the note holders initiated litigation
          against the Company in Toronto for payment of the note and in March
          2001 the Company initiated a counter action for damages incurred. In
          April 2001, the Company paid certain shareholders $500,000 in full
          settlement of $700,000 of the note plus accrued interest originally
          owed. Litigation with the remaining shareholders is still pending. In
          October 2001, pursuant to an agreement with the plaintiffs, the
          Company deposited $1,000,000 with the Ontario Superior Court of
          Justice to be held in trust until settlement of the suit. The
          $1,000,000 will be classified as restricted cash in balance sheets
          subsequent to September 30, 2001.

                                       48

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

5. Commitments

At September 30, 2001 the gross amount of capital leases and related accumulated
amortization was approximately $2,839,000 and $834,000, respectively. The
Company has a letter of credit in the amount of $100,000 which secures a
building lease. The Company leases certain facilities and equipment under
operating lease agreements expiring through May 31, 2010. Total rent expense on
all operating leases was approximately $2,158,000, $1,369,000 and $390,000 for
the years ended September 30, 2001, 2000 and 1999. The following is a schedule
by year of future minimum lease payments under capital and operating leases,
excluding the anticipated receipt of sublease income of $398,000 and of
$181,000 in 2002 and 2003, respectively.

<TABLE>
<CAPTION>

Fiscal                               Capital    Operating
----------                           -------    ---------
<S>                                  <C>        <C>
2002                                 $ 1,337     $ 1,512
2003                                     534       1,115
2004                                      13         844
2005                                       -         836
2006                                       -         653
Thereafter                                 -       2,793
                                     -------     -------
Total                                  1,884     $ 7,753
                                                 =======
Less amount representing interest        143
                                     -------
Capital lease obligations            $ 1,741
                                     =======
</TABLE>

6. Preferred Stock

In September 1999, all previously outstanding preferred stock, plus an
additional 77,579 shares representing dividends in arrears, was converted into
common stock at the rate of one common share for two preferred shares. The
Series B preferred stock accrued cumulative dividends at a 5% rate per annum
(using a liquidation value of $.01 per share). Dividends could be paid in cash
or with additional shares of preferred stock at the holder's option.

7. Common Stock Warrants

The Company has issued restricted common stock purchase warrants to various
consultants, underwriters, and debtors. Each warrant represents the right to
purchase one share of common stock. All warrants are currently exercisable.

<TABLE>
<CAPTION>
                   Warrants Outstanding at
Exercise Prices       September 30, 2001      Expiration Date
---------------    -----------------------    ---------------
<S>                <C>                        <C>
$ 0.09                       4,426                      2005
  1.09                      20,000                      2005
  2.50 to 5.00             480,000              2003 to 2004
  5.00 to 11.50            340,800              2004 to 2010
 28.12 to 37.44            200,000                      2005
                         ---------
                         1,045,226
                         =========
</TABLE>

                                       49

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001


8. Stock Options and Employee Stock Purchase Plan

The Company maintains an employee stock option plan under which the Company may
grant options to acquire up to 4,000,000 shares of common stock.

In 1999, the Company established an additional non-qualified plan under which
400,000 shares of common stock could be issued. The shares under this plan were
increased to 800,000 in fiscal 2001 and to 3,400,000 in December of 2001.

The Company also has a directors' stock option plan under which the Company may
grant options to acquire up to 600,000 shares of common stock to non-employee
directors. Each non-employee director, who is re-elected or who is continuing as
a member of the board of directors on the 2001 annual meeting date and on each
subsequent meeting of stockholders, is granted options to purchase 20,000 shares
of common stock.

Each option entitles the holder to purchase one share of common stock at the
specified option price. The exercise price of each option granted under the
plans was set at the market price of the Company's common stock at the
respective grant date. The exercise price of options assumed in the STV
acquisition was calculated using the exchange ratio. Options vest at various
intervals, as determined by the Board of Directors at the date of grant, and
expire at the earlier of termination of employment, discontinuance of service on
the board of directors, ten years from the grant date or at such times as are
set by the Company at the date of grant.

The number of shares available for grant under these plans at September 30, 2001
is as follows:

<TABLE>
<CAPTION>
                                                                 Employee       Non-qualified     Director
                                                                Stock Option     Stock Option    Stock Option
                                                                    Plan             Plan            Plan
                                                                ------------    -------------    ------------
<S>                                                             <C>             <C>              <C>
Shares available for grant at September 30, 1999                   183,550                -           60,000
Amendment to increase shares available in plan                   2,000,000                -          420,000
Adoption of plan                                                         -          400,000                -
Options granted                                                   (397,132)        (365,159)         (60,000)
Options assumed in STV acquisition                                (359,850)               -                -
Options forfeited                                                  206,541           43,000                -
                                                                --------------------------------------------

Shares available for grant at September 30, 2000                 1,633,109           77,841          420,000
Amendment to increase shares available in plan                           -          400,000                -
Options granted                                                 (2,032,900)        (210,000)         (60,000)
Options forfeited                                                  693,451          111,000                -
                                                                --------------------------------------------
Shares available for grant at September 30, 2001                   293,660          378,841          360,000
                                                                ============================================
</TABLE>

                                       50

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

The following table summarizes information with respect to the stock option
plans.

<TABLE>
<CAPTION>
                                                                   Years Ended September 30,
                                       ------------------------------------------------------------------------------------
                                                2001                          2000                           1999
                                       -----------------------       -----------------------        -----------------------
                                                     Weighted                       Weighted                      Weighted
                                                     Average                        Average                        Average
                                                     Exercise                       Exercise                      Exercise
                                        Options        Price          Options         Price          Options        Price
                                       ------------------------------------------------------------------------------------
<S>                                    <C>           <C>             <C>            <C>             <C>           <C>
Outstanding at beginning of
  year                                 1,720,469      $ 9.25         1,536,450       $ 1.69         1,067,400      $ 0.74
Granted                                2,302,900        1.27           822,291        18.53           480,050        3.81
Assumed in acquisition                         -           -           359,850         7.42                 -           -
Exercised                               (244,604)       0.41          (748,581)        0.92                 -           -
Forfeited                               (804,451)       8.95          (249,541)       15.05           (11,000)       1.10
                                       ------------------------------------------------------------------------------------
Outstanding at end of year             2,974,314      $ 3.88         1,720,469       $ 9.25         1,536,450      $ 1.69
                                       ====================================================================================
Exercisable at end of year             1,021,785                       605,907                      1,016,334
                                       =========                     =========                      =========
Weighted average fair value of
options granted during period              $1.04                        $16.61                          $1.89
                                       =========                     =========                      =========
</TABLE>

The options outstanding at September 30, 2001 have been segregated into four
ranges for additional disclosure as follows:

<TABLE>
<CAPTION>

                                           Options Outstanding                                     Options Exercisable
                        ----------------------------------------------------------    ----------------------------------------
                             Options             Weighted
                         Outstanding at          Average             Weighted              Options                Weighted
                          September 30,         Remaining             Average           Exercisable at        Average Exercise
 Exercise Prices              2001           Contractual Life     Exercise Price      September 30, 2001            Price
-----------------       -----------------    -----------------    ----------------    ------------------      ----------------
<S>                     <C>                  <C>                  <C>                 <C>                     <C>
$0.47 to $0.57                41,968               7.51              $ 0.54                 36,496                $ 0.54
$1.09 to $2.00             1,939,263               9.35                1.23                477,388                  1.10
$2.50 to $5.91               795,842               7.28                3.98                417,012                  3.31
$6.00 to $59.88              197,241               8.06               30.24                 90,889                 46.00
</TABLE>

In August 1999, the Company entered into a separation agreement with a former
employee. The agreement allowed a change in certain vesting and termination
provisions on previously granted employee stock options. Accordingly, the
Company recorded $142,000 of compensation expense associated with changes in the
measurement dates of these options.

                                       51

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," the
Company follows Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," in accounting for its stock option plans. Had the
Company accounted for its stock option plans based upon the fair value at the
grant date for options granted under the plan, based on the provisions of SFAS
123, the Company's pro forma net loss and pro forma net loss per share would
have been as follows (for purposes of pro forma disclosures, the estimated fair
value of the options is amortized to expense over the options' vesting period):

<TABLE>
<CAPTION>
                                                Years Ended September 30,
                                             -------------------------------
                                               2001        2000        1999
                                             --------    --------    -------
<S>                                          <C>         <C>         <C>
Pro forma net loss (in thousands)            $(52,567)   $(39,313)   $(6,851)
Pro forma net loss per share                    (2.37)      (2.12)     (1.05)
</TABLE>

Pro forma information regarding net loss and net loss per share is required by
SFAS No. 123, and has been determined as if the Company had accounted for its
employee stock options under the minimum value method of that Statement for
option grants made prior to the Company's initial public offering and the
Black-Scholes method for grants made subsequent to such offering. With the
exception of volatility (which is ignored in the case of the minimum value
method), the following weighted-average assumptions were used for all periods
presented: risk-free interest rates of 5% to 6%, dividend yields of 0%; expected
common stock market price volatility factors ranging from .50 to 1.3 and a
weighted-average expected life of the option of three to five years.

In July of 2000, the Company began an Employee Stock Purchase Plan (Stock
Purchase Plan), which allows for the issuance of 1,000,000 shares of common
stock. There were no shares issued under the plan for the year ended September
30, 2000. There were 181,005 shares issued under the plan for the year ended
September 30, 2001. All employees of the Company who have completed three months
of employment are eligible to participate in the Stock Purchase Plan, provided
the employee would not hold 5% or more of the total combined voting power of the
Company. Shares may be purchased at the end of a specified period at the lower
of 85% of the market value at the beginning or the end of the specified period
through accumulation of payroll deductions.

9. Income Taxes

Income tax benefit in the statement of operations consists of the following (in
thousands):

<TABLE>
<CAPTION>
                                                Years Ended September 30,
                                             -------------------------------
                                               2001        2000       1999
                                             -------     -------    -------
<S>                                          <C>         <C>        <C>
Deferred income tax benefit                  $(8,503)    $(8,901)   $(2,448)

Change in valuation allowance                  8,503       8,901      2,448
                                             ------------------------------
                                             $    --     $    --    $    --
                                             ==============================
</TABLE>

                                       52

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

The reconciliation of income tax expense computed at the U.S. federal statutory
rate to income tax expense is (in thousands):

<TABLE>
<CAPTION>
                                                   Years Ended September 30,
                                             -------------------------------------
                                               2001           2000          1999
                                             --------       --------       -------
<S>                                          <C>            <C>            <C>
     Tax benefit at U.S. statutory rate
        of 34%                               $(16,952)      $(11,873)      $(2,039)
     State income tax benefit, net of
        federal benefit                        (2,493)        (1,907)         (308)
     Permanent differences, net                11,070          5,279            25
     Other                                       (128)          (400)         (126)
     Change in valuation allowance              8,503          8,901         2,448
                                             --------       --------       -------
                                             $     --       $     --       $    --
                                             ========       ========       =======
</TABLE>

The significant components of the deferred tax accounts recognized for financial
reporting purposes were as follows (in thousands):

<TABLE>
<CAPTION>
                                                            September 30,
                                                      -------------------------
                                                        2001             2000
                                                      --------         --------
<S>                                                   <C>              <C>
     Deferred tax assets:
     Net operating loss and other carryforwards       $ 18,351         $ 10,510
     Common stock warrants                                 649              649
     Allowance for doubtful accounts                       419              472
     Other                                               1,030              315
                                                      --------         --------
     Total deferred tax assets                          20,449           11,946
     Valuation allowance                               (20,449)         (11,946)
                                                      --------         --------
     Net deferred tax assets                          $     --         $     --
                                                      ========         ========
</TABLE>


At September 30, 2001, the Company had net operating loss carry forwards of
approximately $45 million for U.S. Federal and state tax purposes, which expire
beginning in 2011. In the event of a change in ownership greater than 50% in a
three-year period, utilization of the net operating losses may be subject to a
substantial annual limitation due to the ownership change limitations provided
by the Internal Revenue Code of 1986 and similar state provisions.

10. Savings Plan

The Company's defined contribution 401(k) savings plan covers substantially all
employees meeting certain minimum eligibility requirements. Participating
employees can elect to defer a portion of their compensation and contribute it
to the plan on a pretax basis. The Company may also match certain amounts and/or
provide additional discretionary contributions, as defined. The Company made
discretionary contributions of $286,000, $268,000, and $88,000 during the years
ended September 30, 2001, 2000 and 1999.

                                       53

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

11.   Related-Party Transactions

The Company paid fees of $180,000 $500,000 and $135,000 during the years ended
September 30, 2001, 2000 and 1999 to a law firm whose partner is a director and
stockholder of the Company.

For the years ended September 30, 2001 and 2000, the Company had loans
outstanding to certain officers for $25,000 and $61,000 to exercise employee
stock options. In addition, the Company loaned an officer $175,000, in
connection with the sale of his former residence and his relocation to Madison,
Wisconsin. This loan was repaid in June 2001.

In August 1999, a partnership, of which a director is a 50% principal, was
granted warrants to purchase 60,000 shares of common stock at an exercise price
of $4.00 per share, in exchange for a stand by capital commitment of $2,000,000.
The commitment expired in December 1999.

In June 1998 the Board of Directors approved the issuance of guarantees of
certain obligations of certain officers of the Company. The guarantees were
executed in June and July of 1998 to a bank in order to facilitate the issuance
of loans to the officers. As of September 30, 2001 the loans were paid in full.

12.   Segment Disclosure

Accounting principles generally accepted in the United States require the
Company to present financial information in a format that is used by the
Company's management to make decisions. Management views the Company in its
entirety as a digital media solutions provider with two primary revenue centers:
(i) a software product division, and (ii) a media services division. The Company
analyzes these two revenue centers, along with their respective production
costs, independently from each other. However, because the majority of our
operating expenses support both revenue centers, the Company analyzes all items
below gross margin on a combined basis.

                                       54

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Summarized financial information of the Company's continuing operations by
business segment for the fiscal years ended September 30, 2001, 2000 and 1999 is
as follows (in thousands):

<TABLE>
<CAPTION>
                                                     Years Ended September 30,
                                           ---------------------------------------------
                                              2001              2000             1999
                                           ---------        -----------       ----------
<S>                                        <C>              <C>               <C>
Revenues:
  Software                                 $  15,550        $   21,455        $  13,682
  Media services                              10,734             4,852                -
                                           ---------       ------------       ----------
                                           $  26,284        $   26,307        $  13,682

Gross margin:
  Software                                 $  10,363        $   15,962        $  10,292
  Media services                               3,001              (325)               -
                                           ---------       ------------       ----------
                                           $  13,364        $   15,637        $  10,292

Total assets:
  Software                                 $   2,722        $    9,493        $  16,709
  Media services                              10,187            11,371                -
  Unallocated and intangibles                 58,774           105,961                -
                                           ---------       ------------       ----------
                                           $  71,683        $  126,825        $  16,709
</TABLE>


Of the $71.7 million in total assets held by the Company, $3.4 million are held
in Canada.

Major Customers

Software revenues to the largest software customer were 18% of total software
revenues in 2001. Software revenues to the largest two software customers were
16% and 15% in 2000. Software revenues to the largest software customer were 22%
in 1999.

Media services revenues to the two largest media services customers were 13% and
10% of total media services revenues in 2001. There were no individual media
services customers that exceeded 10% of media services revenues in 2000.

Percentage of revenues by continent were as follows:

<TABLE>
<CAPTION>
                                       Year ended September 30,
                            -------------------------------------------
                               2001             2000             1999
                            ---------       ---------        ----------
<S>                         <C>             <C>              <C>
North America                   82%             87%               83%
Europe                           7               6                10
Asia                             9               6                 5
Other                            2               1                 2
                            ---------       ---------        ----------
Total                          100%            100%              100%
                            =========       =========        ==========
</TABLE>

                                       55

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

13.  Acquisitions

On April 3, 2000, the Company completed its acquisition of STV, a media
convergence company offering webcasting, syndication and production, and
post-production services. Pursuant to the Merger Agreement, an aggregate of
$1.22 million in cash was paid and 2,107,096 shares of the Company's common
stock valued at $30.75 per share were issued in exchange for all of the issued
and outstanding capital stock of STV. In addition 485,584 options to purchase
shares of Sonic Foundry common stock were issued to replace existing STV options
and warrants. As part of the acquisition, the Company incurred $1.63 million of
direct transaction costs. The acquisition was accounted for as a purchase and,
accordingly, the results of operations have been included in the consolidated
financial statements from April 3, 2000, the effective date of the acquisition.
The purchase price has been allocated to the acquired assets and assumed
liabilities on the basis of their estimated fair values as of the date of the
acquisition, with intangible assets determined by an independent appraisal.
Intangible assets have been classified as assembled workforce ($1 million with 1
year amortization period) and goodwill ($70 million with 3 year amortization
period). Unearned compensation of $5.3 million resulted from the valuation of
the assumed options and was being amortized over the average remaining vesting
period of 3.5 years. However, this figure was reduced to account for adjustments
for forfeited, unvested options of employees terminated since the acquisition
date and became fully amortized in fiscal 2001.

Effective June 1, 2000, the Company acquired all of the capital stock of
International Image, a leading developer and marketer of Internet software
tools, services, and systems. The purchase consideration consisted of 600,000
shares of the Company's common stock valued at $11.50 per share, $4 million of
short-term notes payable and approximately $8 million in cash and debt assumed.
Approximately 485,000 of the 600,000 common shares will be issued in the future
pursuant to an Exchange Agreement whereby holders of the "Exchangeable Shares"
may exchange such shares at their option into the Company's common shares. At
September 30, 2001, 17,720 of the shares had been exchanged. The acquisition was
accounted for as a purchase and, accordingly, the results of operations have
been included in the consolidated financial statements from June 1, 2000, the
effective date of the acquisition. The close of the acquisition occurred in
August of 2000, following approval of the transaction from Canadian securities
authorities. The purchase price was allocated to the acquired assets and assumed
liabilities on the basis of their estimated fair values as of the date of the
acquisition, with intangible assets determined by an independent appraisal.
Intangible assets have been classified as assembled workforce ($2.2 million with
5 year amortization) and goodwill ($14.1 million). Goodwill related to the video
tape business operations of the Company ($4.7 million) is being amortized over 7
years. Goodwill related to the remaining business operations ($9.4 million) is
being amortized over 3 years.

                                       56

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

Based on unaudited data, the following table presents selected financial
information for the Company on a pro forma basis, assuming International Image
and STV had been consolidated since October 1, 1998:

(in thousands except per share data)                Years ended September 30,
                                                       2000            1999
                                                  ---------------- -------------
Net Revenues                                        $  35,558       $  23,523
Net loss                                              (53,555)        (37,532)
Net loss per share                                  $   (2.66)      $   (4.46)

The pro forma net loss includes the additional amortization of goodwill that
would have been expensed had the transaction taken place at the beginning of the
period being reported.

The pro forma results are not necessarily indicative of future operations or the
actual results that would have occurred had the acquisition been made as of the
beginning of the period being reported.

14.      Contingencies

The Company is involved in various claims brought about by certain parties that
are incidental to its operations. In the opinion of management, the outcome of
these matters will not have a material adverse impact on the Company's financial
position or results of operations.

                                       57

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

15. Restructuring and Other Charges

As a result of rapidly changing market conditions, in December 2000 the
Company's Board of Directors authorized management to make a 40% workforce
reduction in order to improve cash flow. The restructuring charges were
determined based on plans submitted by the Company's management and approved by
the Board of Directors using information available at the time. As a result of
this reduction, the Company recorded restructuring charges of $3,782,000 during
the first quarter of fiscal 2001 and recorded a restructuring accrual of
$2,557,000. In the fourth quarter, the Company posted a non-cash charge of
$1,000,000 to record an impairment in value of Internet advertising credits (see
Note 1, Advertising Costs). Also, the Company refined the estimated value of
equipment no longer necessary in operations that was identified in the December
2000 restructuring plan, which resulted in an additional charge of $1,191,000.
The remaining accrual of $345,000 will continue to decrease as lease obligations
are fulfilled.

<TABLE>
<CAPTION>
(in thousands)                                   Severance and       Lease       Fixed asset      Prepaid
                                                Related Charges  Terminations     Disposals     Advertising     Other       Total
                                                ---------------  ------------    -----------    -----------     -----       -----
<S>                                             <C>              <C>             <C>            <C>             <C>       <C>
Charge in December 2000                            $   1,470       $  1,555       $    594       $      -      $   163    $  3,782
Charge in September 2001                                   -              -          1,191          1,000            -       2,191
                                                -----------------------------------------------------------------------------------
  Total charges                                        1,470          1,555          1,785          1,000          163       5,973
Adjustments to December 2000 charge                        -           (503)           503              -            -           -
Amount paid                                           (1,470)          (707)             -              -           (2)      2,179)
Non-cash charges                                           -              -         (2,288)        (1,000)        (161)      3,449)
                                                -----------------------------------------------------------------------------------
  Accrued  liabilities  at September 30, 2001      $       -       $    345       $      -       $      -      $     -    $    345
                                                ===================================================================================
</TABLE>

16. Subsequent Events

In October 2001, the Company purchased substantially all of the assets and
assumed certain liabilities of MediaSite, Inc., a global pioneer in providing
automated rich media publishing, management and access solutions. Pursuant to an
Asset Purchase Agreement, the following consideration was paid: (a) 3,780,000
shares of the Company's common stock; and (b) assumption of certain scheduled
liabilities of MediaSite. The total approximate amount of trade accounts payable
that the Company is assuming under the Purchase Agreement is approximately
$1,550,000, as well as approximately $696,000 of amounts owed certain of the
former shareholders of MediaSite. The Acquisition has been accounted for as a
purchase. Results of operations for MediaSite will be included in the Company's
consolidated operating results subsequent to the date of purchase.

                                       58

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2001

17. Quarterly Financial Data (unaudited)

The following table sets forth selected quarterly financial and stock price
information for the years ended September 30, 2001 and 2000. The operating
results are not necessarily indicative of results for any future period. Any
variances from originally reported results in Form 10-Q have been reconciled in
the second table.

                     Quarterly Financial Data (in thousands)

<TABLE>
<CAPTION>

                        Q4-2001    Q3-2001      Q2-2001     Q1-2001      Q4-2000       Q3-2000      Q2-2000      Q1-2000
                      ----------------------------------------------------------------------------------------------------
<S>                   <C>         <C>          <C>         <C>          <C>          <C>           <C>          <C>
Net Revenues          $   5,408   $  7,094     $   7,264   $   6,518    $   8,477    $   6,742     $  6,002     $  5,086
Gross Margin              2,936      4,130         3,517       2,781        3,890        3,337        4,473        3,937
Net Loss                (11,374)    (8,536)      (10,277)    (19,673)     (15,947)     (14,301)      (2,471)      (2,203)

Net loss per share    $    (.51)  $   (.39)    $    (.46)  $    (.90)   $    (.79)   $    (.66)    $   (.15)    $   (.16)
</TABLE>


Reconciliation of Quarterly Financial Data to Reported Results in Form 10-Q

<TABLE>
<CAPTION>
                                                                       Q4-2000    Q3-2000     Q2-2000    Q1-2000
                                                                      --------------------------------------------
<S>                                                                    <C>        <C>         <C>        <C>
Revenue reported in Form 10-Q                                          $ 9,372    $ 6,874     $ 6,028    $ 5,104
Rebate adjustment under EITF No. 00-14                                    (895)      (132)        (26)       (18)
                                                                      --------------------------------------------
  Adjusted gross revenue for comparative purposes                      $ 8,477    $ 6,742     $ 6,002    $ 5,086
                                                                      ============================================

Gross margin reported in Form 10-Q                                     $ 4,785    $ 3,881     $ 4,492    $ 3,946
Rebate adjustment                                                         (895)      (132)        (26)       (18)
Reclassification of depreciation for Media Services production
  equipment                                                                  -       (412)          7          9
                                                                      --------------------------------------------
  Adjusted gross margin for comparative purposes                       $ 3,890    $ 3,337     $ 4,473    $ 3,937
                                                                      ============================================
</TABLE>

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

Not applicable.

                                    PART III

ITEMS 10 - 13

A definitive proxy statement pursuant to Regulation 14A will be filed with the
Commission not later than January 28, 2002, which is 120 days after the close of
the Registrant's fiscal year. The proxy statement will be incorporated by
reference into Part III (Items 10 through 13) of Form 10-K.

                                       59

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

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

     (a)  The following financial statements are filed as part of this report:

          1.   Financial Statements and Supplementary Data. Listed in the Table
               of Contents provided in response to Item 14 hereof.

          2.   Financial Statement Schedule. Financial Statement Schedule II of
               the Company is included in this Report. All other Financial
               Statement Schedules have been omitted since they are either not
               required, not applicable or the information is otherwise
               included.

          3.   Exhibits.



     3.1   Amended and Restated Articles of Incorporation of the Registrant,
           filed as Exhibit No. 3.1 to the registration statement on amendment
           No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the
           "Registration Statement"), and hereby incorporated by reference.

     3.2   Amended and Restated By-Laws of the Registrant, filed as Exhibit No.
           3.2 to the Registration Statement, and hereby incorporated by
           reference.

     10.1  Registrant's 1995 Stock Option Plan, as amended, filed as Exhibit No.
           4.1 to the Registration Statement on Form S-8 on September 8, 2000,
           and hereby incorporated by reference.

     10.2  Registrant's Non-Employee Directors' Stock Option Plan, filed as
           Exhibit No. 10.2 to the Registration Statement, and hereby
           incorporated by reference.

     10.3  Commercial Lease between Registrant and The Williamson Center, LLC
           regarding 740 and 744 Williamson Street, Madison, Wisconsin dated
           January 20, 1998, filed as Exhibit No. 10.3 to the Registration
           Statement, and hereby incorporated by reference.

     10.4  Employment Agreement between Registrant and Rimas Buinevicius dated
           as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report
           on Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

     10.5  Employment Agreement between Registrant and Monty R. Schmidt dated as
           of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on
           Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

                                       60

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     10.6  Employment Agreement between Registrant and Curtis J. Palmer dated as
           of January 1, 2001, filed as Exhibit 10.6 to the Quarterly Report on
           Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

     10.7  Digital Audio System License Agreement between Registrant and Dolby
           Laboratories Licensing Corporation dated July 28, 1997, filed as
           Exhibit No. 10.7 to the Registration Statement, and hereby
           incorporated by reference.

     10.8  Digital Audio System License Agreement between Registrant and Dolby
           Laboratories Licensing Corporation dated July 28, 1997, filed as
           Exhibit No. 10.8 to the Registration Statement, and hereby
           incorporated by reference.

     10.9  Software License Agreement, effective as of September 29, 1998,
           between Registrant and Hewlett-Packard Company - CONFIDENTIAL
           MATERIAL FILED SEPARATELY, and hereby incorporated by reference.

     10.10 Convertible Debenture Purchase Agreement dated September 13, 1999
           between Purchasers and the Registrant filed as Exhibit No. 10.17 to
           the Current Report on form 8-K filed on September 24, 1999, and
           hereby incorporated by reference.

     10.11 Commercial Lease between Registrant and Tenney Place Development, LLC
           regarding 1617 Sherman Ave., Madison, Wisconsin dated October 1,
           1999, filed as Exhibit No. 10.18 to the Annual Report on form 10-K
           for the period ended September 30, 1999, and hereby incorporated by
           reference.

     10.12 Registrant's 1999 Non-Qualified Stock Option Plan, filed on Form S-8
           on September 8, 2000, and hereby incorporated by reference.

     10.13 Commercial Lease between Registrant and Hargol Management Limited
           regarding 23 Prince Andrew Place, Don Mills, Ontario, Canada dated
           January 15, 1990, filed as Exhibit No. 10.20 to the Amended Annual
           Report on Form 10-K/A for the year ended September 30, 2000, and
           hereby incorporated by reference.

     10.14 Commercial Lease between Registrant and the Richlar Partnership
           regarding 1703 Stewart St., Santa Monica, CA, dated August 10, 1995,
           filed as Exhibit No. 10.21 to the Amended Annual Report on Form
           10-K/A for the year ended September 30, 2000, and hereby incorporated
           by reference.

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     10.15 Commercial Lease between Registrant and Thomas Seaman regarding 12233
           Olympic Blvd., Santa Monica, CA, dated January 23, 2000 filed as
           Exhibit No. 10.22 to the Amended Annual Report on Form 10-K/A for the
           year ended September 30, 2000, and hereby incorporated by reference.

     10.16 Agreement and Plan of Merger, dated as of March 15, 2000, by and
           among the Registrant, New Sonic, Inc., and STV Communications, Inc.,
           filed as Exhibit 2.1 to a Current Report on Form 8-K dated April 18,
           2000 and hereby incorporated by reference.

     10.17 Stock Purchase Agreement, dated January 18, 2000, by and among the
           Registrant, Jedor, Inc., and certain principals of Jedor, Inc., filed
           as Exhibit 2.2 to the registration statement filed on Form S-3 on May
           12, 2000 and hereby incorporated by reference.

     10.18 Share Purchase Agreement dated as of June 1, 2000, by and among the
           Registrant, Sonic Foundry (Nova Scotia) Inc., Charles Ferkranus,
           Michael Ferkranus, 1096159 Ontario Limited, 1402083 Ontario Limited,
           Dan McLellan, Curtis Staples, Bank of Montreal Capital Corp., Roynat
           Inc. and DGC Entertainment Ventures Corp., filed as Exhibit 2 to the
           Current Report filed on Form 8-K on September 12, 2000, and hereby
           incorporated by reference.

     10.19 Stock Restriction and Registration Agreement, dated as of March 15,
           2000, among the Company, Jan Brzeski, Jeffrey Gerst, David Fife, and
           Fife Capital, L.L.C., filed as Exhibit 4.2 to the Registration
           Statement filed on Form S-3 on May 12, 2000, and hereby incorporated
           by reference.

     10.20 Voting and Option Agreement, dated March 15, 2000, among the Company,
           certain of its stockholders, and Jan Brzeski, David Fife, Jeffrey
           Gerst, and Fife Waterfield, filed as Exhibit 4.3 to the Registration
           Statement filed on Form S-3 on May 12, 2000, and hereby incorporated
           by reference.

     10.21 Subscription Agreement dated February 8, 2000 between Subscribers and
           the Company, filed as Exhibit 10.19 of a Current Report on Form 8-K
           dated February 14, 2000, and hereby incorporated by reference.

     10.22 Registration Rights Agreement, dated February 8, 2000, by and among
           the Company and certain investors, filed as Exhibit 4.5 to the
           Registration Statement filed on Form S-3 on May 12, 2000, and hereby
           incorporated by reference.

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

     10.23 Registration Rights Agreement, dated March 31, 2000, among the
           Company and Sony Pictures Entertainment Inc., filed as Exhibit 4.6 to
           the Registration Statement filed on Form S-3 on May 12, 2000, and
           hereby incorporated by reference.

     10.24 Buyer Non-Voting Exchangeable Share Option Agreement, dated August
           24, 2000, among the Registrant, Dan McLellan, Curtis Staples, and
           Sonic Foundry (Nova Scotia), Inc., filed as Exhibit 4.3 to the
           Registration Statement filed on Form S-3 on November 7, 2000, and
           hereby incorporated by reference.

     10.25 Support Agreement, dated August 24, 2000, between the Company and
           Sonic Foundry (Nova Scotia), Inc. filed as Exhibit 4.4 to the
           Registration Statement filed on Form S-3 on November 7, 2000 and
           hereby incorporated by reference.

     23    Consent of Ernst & Young LLP, Independent Auditors.

     (b)   REPORTS ON FORM 8-K

On October 30, 2001 the Company filed a current report on Form 8-K. The report
provided certain information in Item 2 regarding the acquisition of assets and
assumption of liabilities for MediaSite, Inc.

                                       63

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

SIGNATURES

Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized in the City of Madison,
State of Wisconsin, on December 20 , 2001.

                               Sonic Foundry, Inc.
                               -------------------
                                  (Registrant)

By:      /s/ Rimas P. Buinevicius
         -------------------------------------
         Rimas P. Buinevicius
         Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons in the capacities and on the dates
indicated.

<TABLE>
<CAPTION>
Signature                      Title                                     Date
---------                      -----                                     ----
<S>                            <C>                                       <C>


/s/ Rimas P. Buinevicius       Chief Executive Officer and Chairman      December  20, 2001
---------------------------                                                        ---

/s/ Monty R. Schmidt           President and Director                    December  20, 2001
---------------------------                                                        ---

/s/ Curtis J. Palmer           Chief Technology Officer and Director     December  20, 2001
---------------------------                                                        ---

/s/ Kenneth A. Minor           Chief Financial Officer                   December  20, 2001
---------------------------                                                        ---

/s/ Frederick H. Kopko, Jr.    Secretary and Director                    December  20, 2001
---------------------------                                                        ---

/s/ Arnold Pollard             Director                                  December  20, 2001
---------------------------                                                        ---

/s/ David C. Kleinman          Director                                  December  20, 2001
---------------------------                                                        ---
</TABLE>

                                       64

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2001

                               SONIC FOUNDRY, INC

                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)

<TABLE>
<CAPTION>

                                                                      Additions
                                                        ---------------------------------------
                                                                               Charged to Other
                                    Balance at              Charged to             Accounts          Deductions      Balance at
                                Beginning of Period     Costs and Expenses       Describe (1)       Describe (2)   End of Period
                                ------------------------------------------------------------------------------------------------
<S>                             <C>                     <C>                    <C>                  <C>            <C>
Year ended September 30, 2001
-----------------------------
  Accounts receivable reserve   $             1,209     $            2,929     $              -     $      3,063   $       1,075
                                ================================================================================================

  Inventory reserve             $               225     $                -     $              -     $         48   $         177
                                ================================================================================================

Year ended September 30, 2000
-----------------------------
  Accounts receivable reserve   $             1,315     $            1,763     $            171     $      2,040   $       1,209
                                ================================================================================================

  Inventory reserve             $                 -     $              225     $              -     $          -   $         225
                                ================================================================================================

Year ended September 30, 1999
-----------------------------
  Accounts receivable reserve   $                73     $            2,094     $              -     $        853   $       1,315
                                ================================================================================================
</TABLE>

1.   Allowance upon acquisition of receivables of STV and II.

2.   The deduction for the accounts receivable reserve includes uncollectible
     accounts written off of $1,139 and actual rebates taken of $1,924. The
     deduction for the inventory reserve includes inventory written off.

                                       65