<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 year ended       September 30, 2000

                                      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 $25,663,000 based on the last sale price on December
26, 2000.

The number of shares outstanding of the issuer's common equity was 21,904,574 as
of December 26, 2000.

The information required to be disclosed in Part III will be disclosed in the
registrant's 10-K/A. The form 10-K/A will be filed with the Commission no later
than January 28, 2001.

                      DOCUMENTS INCORPORATED BY REFERENCE

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_____       No  X
                                              -----

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                              Sonic Foundry, Inc.
                          Annual Report on Form 10-K
                     For the Year Ended September 30, 2000

                               TABLE OF CONTENTS
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                                                                                PAGE NO.
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                                    PART I
<S>                                                                             <C>
Item 1.        Business..........................................................   3
Item 2.        Properties........................................................  14
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........  34
Item 8.        Financial Statements and Supplementary Data:
               Report of Ernst & Young LLP, Independent Auditors.................  35
               Consolidated Balance Sheets.......................................  36
               Consolidated Statements of Operations.............................  38
               Consolidated Statements of Stockholders' Equity...................  39
               Consolidated Statements of Cash Flows.............................  40
               Notes to Consolidated Financial Statements........................  42
Item 9.        Changes in and Disagreements with Accountants on
               Accounting and Financial Disclosure...............................  55


                                    PART III

Item 10.       Directors and Executive Officers of the Registrant................  56
Item 11.       Executive Compensation............................................  56
Item 12.       Security Ownership of Certain Beneficial Owners and
               Management........................................................  56
Item 13.       Certain Relationships and Related Transactions....................  56
Item 14.       Exhibits, Financial Statement Schedules and Reports
               on Form 8-K.......................................................  56
               Signatures........................................................  60
</TABLE>

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                                    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 Overview

Sonic Foundry(R) , Inc. is a leading developer and marketer of digital media and
Internet software tools, services, and systems. Sonic Foundry's award-winning
products and services are used worldwide for multimedia and Internet
applications, music, video, and broadcast solutions, and digital content
creation.

Sonic Foundry's digital audio and video software tools include the award-winning
ACID(TM), Sound Forge(R), Vegas(R) Audio, Vegas(R) Video, VideoFactory(TM),
Stream Anywhere(TM), SIREN(TM) Jukebox, Viscosity(TM), and a variety of
compatible music loop libraries and DirectX Audio Plug-Ins.

Sonic Foundry's Media Services supplies digitization, management, and delivery
solutions for audio and video content owners. Serving as the link between
content and customers, the Company provides proven, comprehensive processes that
enable content delivery to traditional and emerging distribution channels. The
five key components that make up these solutions include: Media Distribution
Fulfillment, Enterprise Content Management, Turnkey Systems, Consulting
Services, and Encoding.

Our proprietary digital technologies and worldwide relationships/reputation
position us as a leading Digital Media Asset Management (DMAM) solutions
provider to major motion picture studios, television networks, music labels, and
other broadcasters and producers. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for financial information
regarding segment reporting.

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. Our
executive offices are located at 1617 Sherman Avenue, Madison, Wisconsin, 53704
and our telephone number is

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(608) 256-3133. Our corporate website is http://www.sonicfoundry.com. The
information on our website is not a part of this annual report on Form 10-K.

Industry Overview
-----------------

The Entertainment Industry is Moving to Digital Media

Digital and broadband technologies are changing the distribution model for the
entertainment industry. Twenty years ago, consumers experienced media through
analog delivery methods such as cassette tapes, beta cassettes, and rabbit ear
antennas. Today, CDs, DVDs, digital cable, digital subscriber lines (DSL) and
direct broadcast satellite (DBS), offer digital content with greatly improved
clarity, variety, and quality. With the abundance of streaming media and
compression techniques available, such as MPEG, RealNetworks RealMedia,
Microsoft Windows Media, and Apple Quicktime, the Internet now offers consumers
convenience and selection unmatched by any previous distribution channel.

This evolution greatly changes the revenue and cost models for entertainment
companies. Potential new opportunities resulting from the digital media content
and distribution opportunity include:

     .  Leverage vast media vaults - For years, the entertainment companies have
        leveraged older assets through the release of commemorative or special
        edition VHS tapes. Now, they generate sales from re-releasing those same
        classics on DVD. In some major markets, cable operators currently offer
        video-on-demand for recent major releases; soon, those same operators,
        and certain Internet sites, will offer video-on-demand services which
        allow consumers to view individual episodes of their favorite 70's
        sitcom, a memorable movie from the summer of 1981, or a classic sporting
        event from 1955.

     .  Reduce cost of distribution - The current costs of distributing media
        include raw materials, packaging, shipping, and marketing funds for
        favorable shelf placement. The digital distribution model eliminates
        material and shipping costs and allows more focused marketing.

     .  Reduce concerns and costs of maintaining physical media vaults - We
        believe major production studios spend $5 million to $10 million per
        studio per year to maintain and distribute vaults of analog content.
        Digital archiving alleviates deterioration concerns, cuts the cost of
        maintaining secure, climate controlled vaults, and reduces costs of
        utilizing stored media. In a digital world, files stored on a central
        server can be accessed and shared, while analog copies require couriers
        to enter vaults, peck through shelves for a master, remove the tape
        master, copy the tape master, and pay UPS to deliver the package.

     .  Reduce cost and time to create and edit content - Novelists no longer
        use typewriters, most graphic designers no longer use markers, and many
        photographers no longer use film. Similarly, movies and music producers
        benefit from the ability to create and edit content in a digital
        environment. Recently, several technological trends have converged to
        make digital audio and video production systems increasingly practical
        and cost effective. Storage, memory, and processing power have become
        more affordable and inexpensive software has replaced capital-intensive
        hardware.

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The Corporate and Science/Professional Industries Will Follow

The benefits of digital media are not restricted to the major entertainment
companies. Fortune 500 companies store thousands of hours of media content such
as training seminars, commercials and other corporate communications. The move
to digital media can decrease storage expense, save on time and travel of
training departments/participants, make training and research more convenient
and accessible, and allow sales staff to collaborate on and share effective
marketing pieces. Given the power and ease of use of current digital media
software, commercial quality videos created by a sales person with a laptop and
a connection to the home office's network may soon replace static powerpoint
presentations.

Sonic Foundry's Evolution
-------------------------

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. 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
webcasting, production, hosting and encoding of media into various streaming
formats.

Our August 2000 acquisition of International Image, Inc. (II) has 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

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such as "Ally McBeal" and "Friends" has established a brand and reputation that
has attracted major studios such as Warner, MGM, 20/th/ Century Fox, Paramount,
and DreamWorks as well as leading independent production companies including
Alliance Atlantis, Carsey-Warner, Hallmark, Endemol, HBO, and MTV.

We believe that the technology, expertise, and reputation of the combined
company positions us as a leading DMAM solutions provider to major motion
picture studios, television networks, and other broadcasters and producers.

Sonic Foundry's Media Services Solution and Market Opportunity
--------------------------------------------------------------

We believe that the entertainment and corporate community ultimately will adopt
a DMAM program in order to fully realize and leverage the benefits of digital
media. These programs may be installed systems or outsourced services. In either
case, we believe our solutions will be the highest quality, most complete answer
to their needs. The key components of a DMAM program and our solutions for each
are outlined below:

Capturing, Restoring, Digitizing, and Encoding existing content

By definition, the content must be in a digital format. Old tapes must be
cleaned up in order to provide the highest quality master for digital
conversion. Once digitized, content must be formatted or compressed into various
formats to enable delivery or storage. Such formats include MPEG, MP3,
RealNetworks RealMedia, and Microsoft Windows Media.

Many entertainment companies 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. We have developed certain
automation and processing technology, including batching, which is unreleased
and used only in our services operations. Because many content companies need to
ingest large volumes of existing data in order to implement the digital model,
we believe they will pay a premium for our automation tools either in the form
of systems or services

Managing and Indexing content

Once digitized, content must be stored and retrieved in an efficient manner.
Users will need to find and review specific episodes on the server, quickly copy
or edit those clips, and burn the results to a DVD to be used at a production
meeting.

The underlying code for our successful jukebox product Siren(TM), includes key
technology for management of content. Siren allows users to play, capture, burn,
sort, group and manage both audio and video digital files. In addition, we are
pursuing relationships with companies providing video indexing and searching
tools in order to include such features in our systems offering.

Distributing content

The final function of the DMAM program is to efficiently distribute the content
to users and consumers. This task will be accomplished by allowing downloads or
streams from websites or

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cable operators and, in the near term by taking digital content and re-purposing
it to traditional formats.

II has been hosting and distributing physical content of major studios for a
number of years and currently holds over 60,000 active program elements in its
vaults. We believe we can leverage the trust developed from those relationships
to continue to service the distribution needs of the entertainment companies.

Sonic Foundry's Software Strategy
---------------------------------

Extend Technology Leadership

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 continuing to expand 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 have further
demonstrated our commitment to extending our technology leadership by using our
digital content creation technology to develop a jukebox software product,
called Siren, which performs CD recording, transfer support for popular handheld
playback devices, and music and video database management. We incorporated our
expertise in audio and digital editing into our first professional video-editing
product, Vegas Video, in fiscal 2000. Leveraging the Vegas Video technology and
early professional acclaim, we introduced a scaled down consumer version,
VideoFactory, 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.

Maintain Standards Neutrality

We believe that maintaining a neutral position on various industry file and
compression formats allows us to offer a key market advantage. By offering the
broadest range of file formats and compression schemes within our product and
service offering, we believe we maintain a marketing advantage over companies
that attempt to impose exclusive use of their format. For example, in the
streaming media marketplace, we believe we have managed to gain broad adoption
and use of our Stream Anywhere, Sound Forge, ACID, and Vegas products. These
products support both RealNetworks G2 and Microsoft WMT formats, offering a true
cross-format advantage to the content developer who now needs to purchase only a
single media authoring package. Our Vegas and VideoFactory products also support
Apple's Quicktime format.

Maximize Market Penetration and Brand Recognition

We believe that our Sonic Foundry brand is one of the most widely recognized
brands in the audio software industry. We pursue our brand development strategy
through various means, such as initially targeting the professional user market
to generate credible product references for expansion into consumer markets. Our
strategy incorporates consumer rebate programs, in-store demos, direct mail and
Internet campaigns, licensing products for distribution with third party
hardware and software and distribution through multiple channels. We use major
distributors such as Ingram Micro and Navarre to reach consumer electronics and
office superstores, such as

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Best Buy and CompUSA. We also utilize free beta product downloads and third
party distribution through OEM partnerships for the purpose of distributing our
software with partner hardware and software.

Offer Products That Meet The Needs of The Consumer Market

After establishing brand recognition and meeting the needs of the professional
market, we should be able to define the features and functions that will appeal
to the general consumer. Our consumer effort offers the same functionality
offered in the professional product line, but with a simplified function/feature
set.

Customers and Strategic Relationships
-------------------------------------

The DMAM opportunity hinges on relationships with media companies and
corporations who create and manage large vaults of content. Currently, a
significant number of such entities employ the services of II - now a part of
Sonic Foundry Media Services. In addition, we believe a number of digital media
savvy employees of such entities use Sonic Foundry's software offerings
purchased through commercial and direct channels.

Recently, we have entered into strategic relationships with Sony Pictures
Digital Entertainment (Sony), Net-36 and others. In the case of Sony, the
transaction involved joint advertising initiatives and an investment by Sony in
our common stock. We announced a partnership with Net-36, a PanAmSat company, in
October 2000 whereby we will offer expertise in building custom encoding
applications, hardware, and consulting services in connection with Net-36's
satellite-based Internet broadcasting services.

Our relationship with Sony has continued to develop throughout fiscal 2000 and
resulted in total Sony revenues exceeding 6% of total FY 2000 revenue. In
addition to the issuance of common stock and advertising consideration discussed
above, the agreement includes:

     .   Licenses for our core software products
     .   A consulting agreement pursuant to which we are currently developing
         customized software publishing tools
     .   A commitment to use our services for encoding and live event
         webcasting.

Top customers for media distribution fulfillment, via II, include major North
American studios and production companies such as MGM, Hallmark Entertainment,
20/th/ Century Fox, and Alliance Atlantis. These relationships have developed
over several years and have solidified II as a trusted services provider. The
MGM relationship has matured into a pilot DMAM project that is expected to
generate our initial revenues in that promising line of business.

We license software products to a wide variety of customers in various market
segments. Distributors such as Ingram Micro, Navarre, Kaysound and Infogrames
distribute our software to major retailers such as Best Buy, Comp USA, Staples,
Guitar Center, MARS Music and K-Mart. Hook Up, Inc. of Japan is also a major
distributor of our products. OEM's such as Hewlett Packard, Pinnacle, Phillips
and Macromedia bundle certain software with their retail product offerings.
Sales to Navarre and Ingram Micro both exceeded 10% of FY 2000 revenues, while

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Hewlett Packard was over 7%. International software revenues accounted for 22%,
20% and 17% of total revenues for years ended September 30, 2000, 1999 and 1998.

Under the distribution agreements, we have granted some distributors the right
to return unsold inventories of outdated products in exchange for credit against
open invoices. Likewise, price protection support is offered in certain
circumstances, whereby the distributor is protected from price reductions.

Current Software Products
-------------------------

Creation Products

The ACID Family of Products 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,
tunes, cymbals, piano, or any other audio information into another audio file or
into itself and thereby create music, all on a royalty free basis. ACID also
allows the user to change the tempo, add new rhythms, and add vocals by
embedding samples wherever desired, all in real-time. ACID allows the user to
record finished songs to a CD or encode into various compression formats for
Internet delivery or transfer to a portable MP3 device. Musicians who wish to
edit and record music loops for output in a different format use this product on
a stand-alone basis or in conjunction with Sound Forge. ACID is used in consumer
music markets such as the rap market and the techno market, and by anyone who
wishes to create quality music quickly and easily. We sell ACID with a library
of audio loops, but sell additional audio loop libraries to be used in
conjunction with our ACID product. ACID is available in several consumer style
versions. These products include loops specifically designed to appeal to
consumers desiring a certain genre of music such as rock. The style versions of
ACID also include simplified user interfaces and features established especially
for the consumer. Revenues from creation products represented 48%, 51% and 26%
of total software revenues during the fiscal years ended September 30, 2000,
1999 and 1998, respectively.

Editing Products

Vegas, VideoFactory, 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 tape recorders. The advantages of
manipulating data digitally are as follows:

     .  digital files can be edited non-linearly, whereas in order to edit an
        analog recording, a user would have to rewind the tape to find the spot
        that needs editing

     .  editing on a digital file can be non-destructive, whereas analog editing
        destroys a portion of the tape

     .  digital files do not deteriorate over time, as opposed to the serious
        problem of degradation of tapes

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     .  digital files can be transferred electronically, whereas tapes must be
        mailed or shipped

     .  multiple users can work on digital files on a shared basis, which is
        impossible with analog tapes

     .  digital files can be manipulated in ways that analog tapes cannot

Revenues from editing products represented 35%, 27% and 43% of total software
revenues during the fiscal years ended September 30, 2000, 1999 and 1998,
respectively.

Delivery Products

Siren, a complete digital media management system, allows PC users to locate and
download digital music from the Internet, record music from their personal CD
collection to their PC hard drive or to blank CDs, and manage and play music and
video in multiple play-list arrangements on their PCs. Siren utilizes MP3 and
other popular compression technologies allowing Internet delivery, hard drive
storage or transfer to portable music players. Siren features fully integrated
audio CD and data recording and label creation, allowing users to create and
record custom compilations of their favorite hits and record them to CDs from
within the jukebox application.

Stream Anywhere provides users with the ability to encode multimedia content in
either the Microsoft Windows Media Technologies or the RealNetworks RealSystem
G2 format in a single operation. Media content can either be captured directly
from camera, tape or imported in several popular file formats such as AVI, Apple
QuickTime, MPEG-1, and MP3.

Revenues from delivery products represented 17%, 22% and 31% of total software
revenues during the fiscal years ended September 30, 2000, 1999 and 1998,
respectively.

Marketing
---------

Our marketing efforts have generally been focused in the following areas:

     .  Targeted mailings, special events and tradeshows for key personnel of
        entertainment companies which promote brand recognition and reinforce
        current relationships

     .  Print, radio, TV and Internet ads and tradeshows focused on digital
        media professionals and hobbyists which drive retail software revenues
        and promote brand recognition

     .  Mass catalog mailings to digital media professionals and hobbyists which
        drive direct software revenue and promote brand recognition

     .  Endcap displays, advertising circulars, rebates and other marketing
        efforts focused directly at key retail accounts.

In addition, the marketing department - in order to form and maintain a cohesive
corporate message and appearance - manages such functions as graphic design, web
design, literature preparation, product launch planning, advertising
preparation, advertising placement and news media relations.

We have focused our sales efforts by product line, regions, and distribution
channels. The primary segments of our sales force are:

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     .  Sales staff and product managers for media services based both in Santa
        Monica and Toronto. These staff members call on the major entertainment
        companies and service existing relationships and orders.

     .  Sales staff with individual assignments in the professional, consumer,
        OEM, Education, and Video software products and/or channels. Functions
        include one-on-one meetings with major retailers, distributors and
        manufacturers and development of in-store promotions.

     .  Customer support (including order processing), technical support and
        training for software products. Some after hours and foreign customer
        service is also outsourced.

In addition to sales generated through the efforts of the above staff, we
utilize the catalogs mentioned in the marketing section to actively seek direct
orders through www.sonicfoundry.com. We also encourage that the website be used
               --------------------
for customer and technical support and intend to enhance the breadth of those
alternatives.

Operations and Fulfillment
--------------------------

Distribution fulfillment and encoding services occur over time periods ranging
from days to months. Our traditional fulfillment services often encompass entire
TV seasons, so we are continually receiving, duplicating, converting, and
delivering master tapes. Encoding jobs often include thousands of CD's that are
received in batches from the customers. In the past year, we have made
significant investments in equipment used in both the distribution and encoding
business.

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. Many of the production tasks are provided by a
variety of third-party manufacturers. Third parties produce, assemble, and
fulfill most 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.

Over the past several quarters, many of our products have been made available
via Internet download. Material costs associated with downloads are virtually
zero, but in a few cases, include the cost of mailing a CD or manual. We expect
downloads to grow as a percentage of revenue as we continue to promote our
online store and as more consumers become comfortable with the concept.
Downloads accounted for just over 5% of FY 2000 revenues.

Research and Development
------------------------

We believe our proprietary digital media technology and engineering staff is our
greatest competitive advantage. Several man-years have been spent developing the
underlying code for our software products. These efforts, along with automation
solutions never made available to

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the public, can now be scaled into our services and DMAM systems business. Our
research and development activities are currently focused on:

    .  The pilot DMAM project with MGM. We have successfully completed the first
       phase of this project, demonstrating competence in providing: 1) high-
       quality encoding solutions; 2) digital archiving and retrieval
       capability; 3) solutions attendant to the desk-top screening of dailies
       footage and archive elements; and 4) data content delivery to MGM
       business partners.

    .  Creating efficiencies and developing extended proprietary services. II
       had developed a number of proprietary processes but continued to rely
       heavily on third party offerings to complete its services offering. Now
       joined with Sonic Foundry, II will have access to additional engineering
       resources in the areas of audio and video editing, processing and
       manipulation. Engineering efforts will focus on reducing reliance on
       third party solutions and enabling a more extensive proprietary service
       with greater efficiencies.

    .  Developing customized media publishing tools pursuant to the previously
       mentioned contract with Sony. Sony expects to market and distribute these
       tools as part of their media and entertainment strategy. We also expect
       to market these tools separately as part of our own efforts to expand our
       media publishing products.

    .  Enhancing and upgrading our major platforms (ACID, Sound Forge, Vegas
       Audio, Vegas Video, Stream Anywhere, and Siren). Future upgrades will
       include support for transfer and publishing of media, new compression
       format support, and new product lines designed to capitalize on the
       explosion of media delivery over the Internet. We attempt to offer
       significant improvements to our products in the form of upgrades every
       one to two years.

During fiscal years 2000, 1999 and 1998, the Company spent $7.9, $2.9, and $1.0
million, respectively, on product research and development activities. Those
amounts represented 28.7%, 19.4%, and 14.0%, respectively, of revenue in each of
those years.

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 the competitors provide the unique
combination of technology, expertise, and experience as they relate to the DMAM
opportunity.

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, VDI Multimedia and Loudeye Technologies. Our software offerings
compete against products from Adaptec, Adobe, Apple, Avid Technology, Media 100,
MusicMatch, 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

                                       12
<PAGE>

companies such as Informix, Oracle, Corel or Macromedia. Each of these potential
competitors has substantially greater resources than we do and could become a
significant competitor.

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 success depends in part on our ability to protect our proprietary products
and other technology. We rely on a combination of trade secret, contract,
copyright and trademark law to establish and protect our proprietary rights in
our products and technology. We do not currently have any patent protection for
our products. Our software products are sold under "shrink wrap" licenses which
set forth the terms and conditions under which the purchaser can use the product
and which bind the purchaser by its acceptance and purchase of the products to
such terms and conditions. Such shrink-wrap licenses are not signed by licensees
and may be unenforceable under the laws of certain jurisdictions. We also
license certain of our proprietary rights to third parties. We are currently in
the process of obtaining federal copyright registrations for all of our software
products.

Although we rely to a great extent on trade secret protection for much of our
technology and have obtained confidentiality agreements from most of our key
employees, there can be no assurance that third parties will not independently
develop the same or similar technology, obtain unauthorized access to our
proprietary technology or misuse technology to which we have granted access. We
believe that the rapid pace of innovation in the industry renders the
innovation, skill and creativity of our development staff more influential to
our competitive success than the various legal protections of our technology.

We attempt to avoid infringing known proprietary rights of third parties in our
product development efforts. However, we have not conducted and do not conduct
comprehensive patent or trademark searches to determine whether we infringe
patents or proprietary rights held by third parties. In addition, it is
difficult to proceed with certainty in a rapidly evolving technological
environment in which there may be numerous patent applications pending, many of
which are confidential when filed, with regard to similar technologies. If we
were to discover that our products violate third-party proprietary rights, there
can be no assurance that we would be able to obtain licenses to continue
offering such products without substantial reengineering or that any effort to
undertake such reengineering would be successful, that any such licenses would
be available on commercially reasonable terms, if at all, or that litigation
regarding alleged infringement could be avoided or settled without substantial
expense and damage awards.

We also rely on certain technology that we license from third parties, including
software that is integrated with our internally developed software and used in
our products, to perform key functions. There can be no assurance that such
third-party technology licenses will continue to be available to us on
commercially reasonable terms. The loss of any of these technologies could have
a material adverse effect on us. In addition, we have agreed to indemnify
certain

                                       13
<PAGE>

distributors and OEMs from claims that our technology infringes the proprietary
rights of others. There can be no assurance that infringement or invalidity
claims arising from the incorporation of third-party technology, and claims for
indemnification from distributors and OEMs resulting from such claims, will not
be asserted or prosecuted against us.

Employees
---------

As of September 30, 2000, 1999 and 1998, we had 445, 160 and 83 full-time
employees, respectively. The growth in employees during fiscal 2000 was related
to the acquisitions of STV and II as well as growth in functional support areas.
The continuing integration efforts of these acquired companies identified a
number of duplicative positions as well as efforts not core to our strategy,
resulting in a staff reduction of approximately 40 employees in November of
2000. Slow sales in the personal computer and software markets and narrowing of
our strategy further necessitated an additional reduction of 160 employees in
December of 2000. The majority of employees affected by the December layoff will
receive 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

We own one property and have leases on several others in downtown Madison,
Wisconsin. Recently, we consolidated most of Madison's operations in a leased
45,000 sq ft facility. Encoding production is performed at the owned Madison
facility (10,000 sq ft). We lease a 6,000 square foot facility that we use as a
shipping, assembly and warehouse facility. We are in the process of sub-leasing
or selling space no longer required for our Madison operations.

In addition, we lease space in three locations in Santa Monica, California
(19,000 sq ft) and one location in Toronto, Canada (20,000 sq ft). These
facilities house the production facilities, encoding stations, and content
vaults. We plan to consolidate both of the former STV facilities located in
Santa Monica into space reserved for expansion adjacent to the former II
operations. We will attempt to sublease space previously occupied by STV.

We also lease small sales and engineering offices totaling 4,000 sq ft in Los
Angeles, Waterloo, Canada and Delft, Netherlands. We intend to exit the offices
in Los Angeles and Delft when leases expire in the current year.

ITEM 3.  LEGAL PROCEEDINGS

We are not involved in any material legal proceedings.

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

There were no stockholder actions during the fourth quarter ended September 30,
2000.

                                       14
<PAGE>

PART II

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

Our common stock was traded on the American Stock Exchange under the symbol
"SFO" since our initial public offering in April of 1998 until April 21, 2000.
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 American Stock Exchange or the NASDAQ National Market. Price per
share data and share data set forth below and otherwise 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, 1998:
          Third Quarter (commencing April 22, 1998)        $  5.07    $   3.07
          Fourth Quarter                                      4.47        2.88

          Year Ended September 30, 1999:
          First Quarter                                       7.44        2.69
          Second Quarter                                      5.44        3.35
          Third Quarter                                      10.38        5.07
          Fourth Quarter                                      6.13        3.94

          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

          Year Ended September 30, 2001:
          First Quarter (through December 26, 2000)           8.94        0.91

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

At December 27, 2000 there were 303 common stockholders of record. Many shares
are held by brokers and other institutions on behalf of shareholders.

RECENT SALES OF UNREGISTERED SECURITIES

Between July 1, 2000 and September 30, 2000, the Company issued unregistered
securities as follows:

(1) In connection with the acquisition of the stock of International Image
Services Inc. and its parent holding company, the Company issued 114,900 shares
of its common stock, and an affiliated company, Sonic Foundry (Nova Scotia),
Inc. issued a total of 485,100 shares or options to acquire shares of its common
stock which are exchangeable for 485,100 shares of the

                                       15
<PAGE>

Company's common stock. 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 was filed with the Securities and Exchange
Commission on November 7, 2000.

(2) The issuance of 72,000 options granted to employees. These issuances of
options 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
public offering. Based on a close working relationship with such optionees,
along with various discussions with such optionees, the Registrant reasonably
believes that such optionees were accredited and/or sophisticated investors. By
virtue of their relation to the Registrant, these employees had access to
information on the Registrant necessary to make an informed decision.

ITEM 6.   SELECTED FINANCIAL DATA

The selected financial and operating data as of and for the years ended
September 30, 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 and operating data as of
and for the year ended December 31, 1996 was derived from our financial
statements that have been audited by Williams, Young & Associates LLC,
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
                                                                                  Ended         Ended       Year Ended
                                              Years Ended September 30,      September 30,  September 30,   December 31,
                                        ------------------------------------
(in thousands except per share data)       2000         1999         1998         1997          1997            1996
                                        ----------   ----------   ----------   ----------    ----------      ----------
<S>                                     <C>          <C>          <C>        <C>            <C>             <C>
         Statement of Operations Data:                                       (Unaudited)
 Total net revenues                     $  27,378    $  14,830    $   7,470    $   3,061     $   2,242       $   2,442
 Total cost of revenues                    10,670        3,390        2,028          580           407             372
                                        ----------   ----------   ----------   ----------    ----------      ----------
                                           16,708       11,440        5,442        2,481         1,835           2,070
 Selling and marketing expenses            19,893       10,484        3,231        1,772         1,445             954
 General and administrative expenses        9,982        4,253        1,878        1,084           835             718
 Product development expenses               7,868        2,875        1,046          461           374             184
 Impairment charge                          1,000            -            -            -             -               -
 Amortization of goodwill                  14,300            -            -            -             -               -
                                        ----------   ----------   ----------   ----------    ----------      ----------
 Income (loss) from operations            (36,335)      (6,172)        (713)        (836)         (819)            214
 Other income (expense)                     1,413          175          130          (45)          (20)            (35)
                                        ----------   ----------   ----------   ----------    ----------      ----------
 Income (loss) before extraordinary
   item                                   (34,922)      (5,997)        (583)        (881)         (839)            179
 Extraordinary item - early
   extinguishment of debt                       -            -          (49)           -             -               -
                                        ----------   ----------   ----------   ----------    ----------      ----------
 Net income (loss)                      $ (34,922)   $  (5,997)   $    (632)   $    (881)    $    (839)      $     179
                                        ==========   ==========   ==========   ==========    ==========      ==========

 Pro forma net income (loss) per
   common share:
     Basic                              $   (1.89)   $   (1.06)   $    (.22)   $   (3.07)    $   (2.58)      $    2.91
                                        ==========   ==========   ==========   ==========    ==========      ==========
    Diluted                             $   (1.89)   $   (1.06)   $    (.22)   $   (3.07)    $   (2.58)      $     .05
</TABLE>

                                      16
<PAGE>

<TABLE>
<S>                                     <C>          <C>          <C>          <C>           <C>             <C>
                                        ==========   ==========   ==========   ==========    ==========      ==========

Weighted average common shares             18,503        5,687        2,713          288           326              44
                                        ==========   ==========   ==========   ==========    ==========      ==========
Weighted average adjusted common
         shares                            18,503        5,687        2,713          288           326           2,866
                                        ==========   ==========   ==========   ==========    ==========      ==========
</TABLE>

<TABLE>
<CAPTION>
                                                          September 30,                   December 31,
                                        ----------------------------------------------
                                           2000        1999        1998        1997           1996
                                        ----------  ----------  ----------  ----------     ----------
          <S>                           <C>         <C>         <C>         <C>           <C>
          Balance Sheet Data:
          Cash and Cash Equivalents     $  21,948   $   5,889   $   9,940   $     115      $     454
          Working capital                  22,153       8,843      11,156        (265)           516
          Total assets                    126,825      16,709      15,950       2,333          1,627
          Total indebtedness                8,409       5,283         714         993            200
          Stockholders' equity            110,366       8,747      14,091         684          1,077
</TABLE>

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

The financial and business analysis below provides information, which 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,
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.

Overview

In accordance with FAS 131 disclosure 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. We view the Company as a digital media
solutions provider with two primary revenue centers: a software product
division, with a full suite of software products utilized by both producers and
consumers of digital media; and a media services division, which provides
broadcast conversion, tape duplication, audio and video encoding, webcasting,
streaming, hosting and consulting services. 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.

                                       17
<PAGE>

Results Of Operations

The following chart has been presented to add clarification only and should be
read in conjunction with the audited financial statements.

<TABLE>
<CAPTION>

                                                                  Years Ended September 30,
                                                 -------------------------------------------------------------
                                                         2000                 1999               1998
                                                 ------------------------------------------------------------
<S>                                               <C>          <C>     <C>        <C>      <C>       <C>
Software license fees                             $  22,526    100.0%  $ 14,830   100.0%   $ 7,470   100.0%
Cost of software license fees                         5,493     24.4      3,390    22.9      2,028    27.1
                                                 ------------------------------------------------------------
  Gross margin - software license fees               17,033     75.6     11,440    77.1      5,442    72.9


Media services                                        4,852    100.0          -       -          -       -
Cost of media services                                5,177    106.7          -       -          -       -
                                                 ------------------------------------------------------------
  Gross margin - media services                        (325)    (6.7)         -       -          -       -
</TABLE>

Total Net Revenue

Total net revenues increased $12,548, or 85% to $27,378 for the year ended
September 30, 2000 from $14,830 in the comparable period of 1999. 61% of this
increase was due to the continued growth of the software division, while the
remaining 39% came from the introduction of the media services division. For the
comparable period from 1998 to 1999, total net revenues increased 98% and
consisted entirely of revenues from software license fees.

Revenue from Software License Fees

Revenues from software license fees consist of fees charged for the licensing of
Windows based software products that are built on the principle of "Create"
(ACID, Loop Libraries, Audio Anywhere), "Edit" (Sound Forge, Sound Forge XP,
Vegas Audio, Viscosity, Vegas Video, VideoFactory) and "Deliver" (CD Architect,
Siren, Stream Anywhere, Soft Encode). These software products are marketed to
all levels of both consumers and producers of digital media. We reach both our
domestic and international markets through traditional retail distribution
channels, our direct sales effort and OEM partnerships. For more detailed
information on revenue recognition principles, please see Note 1 to the audited
financial statements filed as part of this document.

Year ended September 30, 2000 ("2000") compared with year ended September 30,
1999 ("1999")

Revenue from software license fees increased $7,696, or 52%, from 1999 to 2000.
This net change resulted from the following items:

    .   Strong sales of our ACID products. The ACID family now contains ACID
        Pro, ACID Styles (i.e. ACID Hip-Hop, ACID DJ, etc.), and a catalog of
        over 40 various loop libraries. Sales of these combined items grew 85%
        from 1999 to 2000 and contributed 65% of the total increase in software
        license fees.
    .   New product introduction. Fiscal 2000 marked the addition of two new
        products to our editing line; Vegas Video, a professional audio and
        video editor complete with streaming

                                       18
<PAGE>

        capabilities, released in the third quarter, and VideoFactory, an entry-
        level digital editor aimed at the home-user, released in the 4th
        quarter. Sales from these products accounted for 22% of the increase in
        software license fees from 1999 to 2000.
     .  Strong sales from Siren. In its first full year on the market, Siren
        accounted for 15% of the increase in software license fees.
     .  Discontinuance of Audio Anywhere and CD Architect. Combined sales for
        these products equaled 23% in 1999 compared to 1% in 2000. While both
        products had a strong showing in 1999, demand fell in 2000 and
        production was discontinued.
     .  Sales from our direct marketing efforts increased as a percentage of
        software license fees from 10% in 1999 to 15% in 2000. Sales from the
        OEM channel, driven mainly by existing relationships, increased slightly
        in dollars, but decreased as a percentage due to a change in strategy.
        Our OEM strategy shifted toward transactions involving larger volumes of
        free product in return for opportunities to market special upgrades and
        other offers. Due to the emergence of a direct catalog effort, sales
        through our retail distribution channel declined as a percentage of
        software license fees.
     .  Pricing on all products remained relatively stable throughout 2000.

Going forward, we anticipate future sales growth to be driven by our consumer
line of products, particularly Siren and VideoFactory. In conjunction with this,
we expect to see an increase in our direct and retail channels and, consistent
with our change in strategy, a decline in our OEM channel.

           1999 compared with year ended September 30, 1998 ("1998")

Revenue from software license fees increased $7,360, or 99%, from 1998 to 1999.
This net increase was related to the following items:

     .  Retail sales of the ACID consumer products released in October 1998.
     .  The introduction of Audio Anywhere into the office superstore market in
        the June quarter of 1999.
     .  OEM agreements for Siren in June and September of 1999.

Cost of Software License Fees

Costs of software license fees include product material costs, contracted and
internal assembly labor, freight, royalties on third party technology or
intellectual content, and amortization of previously capitalized product
development costs.

                             2000 compared to 1999

Cost of software license fees increased by $2,103, or 62%, from 1999 to 2000.
Cost as a percentage of software license fees was 24% and 23% of 2000 and 1999
software license fees, respectively. The increase as a percentage of software
license fees was driven primarily by a greater revenue mix of lower margin
consumer products, such as Siren, ACID, and

                                       19
<PAGE>

VideoFactory, and an increase in the number of products requiring payment of
third-party royalty fees.

We expect that future margins will be negatively impacted by further market
penetration of our lower margin products as well as declines in OEM revenues,
partially offset by an increase in product delivered electronically from our
website.

                             1999 compared to 1998

Cost of software license fees increased by $1,362, or 67%, from 1998 to 1999.
Cost as a percentage of software license fees was 23% and 27% of 1999 and 1998
software license fees, respectively. The majority of the decrease as a
percentage of net software license fees resulted from a shift in mix toward
higher margin, stand-alone software sales versus products bundled with purchased
third-party CD recordable disk drives. Initial order quantities of Audio
Anywhere exceeded our available assembly capacity and necessitated outside
fulfillment. Such costs partially offset reduced material costs both in absolute
dollars and as a percentage of revenues. The remainder of the increase in
absolute dollars related to the increased volume of software products sold
during the period.

Revenue from Media Services

Revenues from media services include tape duplication for broadcast
distribution, broadcast standard conversions, audio and video encoding,
webcasting, production, hosting and streaming as well as fees for consulting
services. All are recognized upon completion of the service, provided that no
significant obligations of the Company remain and collection of the resulting
receivable is deemed probable. In the case of long-term contracts, which are
defined as those projects extending longer than one month, revenues are
recognized using the percentage of completion method.

In October 1999, we announced the formation of our Media Services division,
which uses our existing technology to provide format conversion and digital
encoding to music, film, broadcast, and corporate content owners interested in
digital distribution of their media. We began this division by offering audio
and video encoding services from our Madison location, as well as offering
consulting services. In April 2000, we acquired STV Communications, Inc. (STV),
which helped us further our goal of being a single source, Internet media
solutions company by adding hosting, streaming, syndication, webcasting and a
Los Angeles-based audio and video encoding facility to our list of digital
offerings. In August 2000 we finalized the acquisition of International Image
(II), which added tape duplication and broadcast conversion services to our
media services division. This acquisition had an effective date of June 2000 and
contributed 59% to total revenue from media services for fiscal 2000.

Costs of Media Services

Costs of media services include compensation and benefits for direct labor,
depreciation on production equipment, and other general expenses associated with
production personnel.

                                       20
<PAGE>

Going forward, the inclusion of a full year of II's higher-margin, established
broadcast conversion and tape duplication services, is expected to improve
margins in fiscal 2001. Additionally, in an effort to reduce fixed costs and
better match production expenses with revenues, we switched to a temporary labor
force for audio encoding services in mid-November. This staff reduction is
expected to result in significant cost savings while not decreasing the quality
of service provided to our encoding clients.

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>
                                                          Years Ended September 30,
                                                      -------------------------------
                                                          2000       1999       1998
                                                      -------------------------------
<S>                                                   <C>           <C>        <C>
     Total revenues                                      100.0%     100.0%     100.0%
     Cost of revenues                                     39.0%      22.9%      27.1%
                                                      ------------------------------
        Gross margin                                      61.0%      77.1%      72.9%

     Operating expenses

        Selling and marketing expenses                    72.6%      70.7%      43.2%
        General and administrative expenses               36.5%      28.7%      25.1%
        Product development expenses                      28.7%      19.4%      14.0%
       Impairment charge                                   3.7%       0.0%       0.0%
       Amortization of goodwill and other purchase
        intangibles                                       52.2%       0.0%       0.0%
                                                      ------------------------------
          Total operating expenses                       193.7%     118.8%      82.3%
                                                      ------------------------------
          (Loss) from operations                        (132.7)%    (41.7)%     (9.4)%
                                                      ------------------------------
</TABLE>

Selling and Marketing Expenses

Selling and marketing expenses include wages and commissions for sales,
marketing and technical support personnel, as well as print, radio and TV
advertising, our direct mail catalog, trade shows, rebate programs 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.

                             2000 compared to 1999

Selling and marketing expenses increased by $9,409, or 90%, to $19,893 in 2000
from $10,484 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

                                       21
<PAGE>

new major software products as well as the media services division; and 3) the
addition of personnel necessary to facilitate these initiatives.

Looking forward, we anticipate sales and marketing expenses as a percentage of
total revenue to decline. We believe this decline may be impacted by the
following items; 1) a tapering off of new software introductions into the
market, which historically have been quite costly in regards to media
advertising and various sales promotions; 2) the new accounting treatment for
rebates, which is referred to in greater detail in footnote 1 of the financial
statements; 3) a greater attention placed on the media services division, which
requires less expensive, more targeted forms of marketing; and 4) staff
reduction, to coincide with more streamlined and focused efforts.

                             1999 compared to 1998

Selling and marketing expenses increased by $7,254, or 225%, to $10,484 in 1999
from $3,230 in 1998. The increase in selling and marketing costs in absolute
dollars, and as a percentage of revenues, resulted from marketing and
promotional expenses incurred to introduce our ACID products to the consumer
markets and Audio Anywhere product to the electronics and office retail markets.
We began investing heavily in promoting our ACID consumer products upon
introduction in October 1998, including trade shows, print and radio
advertisements, concert promotions, store demos and other marketing related
activities. In June 1999, we took part in the promotional campaign introducing
Microsoft's Office 2000 product. During the promotion, we offered rebates
applied against the purchase price of Audio Anywhere to office superstore
customers that bought Office 2000. In return, we received favorable shelf
placement, in-store displays, inclusion in fliers and performed in-store
demonstrations of the product. European trade show and other marketing costs
incurred by our sales and marketing office in Delft, Netherlands impacted both
absolute dollars and costs as a percentage of revenues. The remaining increase
related to personnel costs to support the growth in revenues from existing
products and for future product releases.

General and Administrative Expenses

General and administrative expenses consist of costs associated with facilities,
finance, legal, management information systems, depreciation on non-production
equipment and various employee benefits, none of which are fully allocated to
functional areas.

                             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 and integration of STV and II, increased
facility costs to support the growing headcount levels, including expenses
associated with setting up temporary office space while our current corporate
headquarters was under renovation and other miscellaneous costs associated with
building and maintaining an infrastructure to support the current level of
growth.

                                       22
<PAGE>

We believe general and administrative expenses as a percentage of total revenues
will decline. The elimination of non-recurring acquisition related expenses and
duplicate functions, as well as the consolidation of some facilities should
contribute to the decline.

                             1999 compared to 1998

General and administrative expenses increased by $2,375, or 126%, to $4,253 in
1999 from $1,878 in 1998. The increase in absolute dollars related to wages and
related recruitment and benefit costs, professional fees, facility costs, and
other expenses. These costs were required to build an infrastructure to support
existing and future products and to satisfy reporting and other requirements of
a public company. General and administrative costs in 1999 also include a charge
of $625 to record an allowance against a receivable recorded from a customer
that announced a restructuring in November 1999. The allowance was recorded due
to uncertainty regarding collection of the amount due. In September 2000, we
reached a settlement with the customer and collected $325 of the $625 initially
due.

Product Development Expenses

Product development 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."

                             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.

Looking forward, we expect to narrow our product offering to the product lines
achieving the greatest success and eliminate low volume niche products such as
CD Architect, Soft Encode, Audio Anywhere and certain others. As a result, we
reduced engineering staff positions in December of 2000.

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,
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 be less
significant, and, as such, we expect that we will expense most or all research
and development costs as incurred.

                                       23
<PAGE>

                             1999 compared to 1998

Product development expenses increased by $1,829, or 175%, to $2,875 in 1999
from $1,046 in 1998. In accordance with SFAS Number 86, we capitalized $316 of
ACID development costs during 1998. Development of our Vegas product reached the
beta stage in March 1999 resulting in capitalization of $540 in 1999. The
addition of software engineers to accelerate development of our expanding line
of software products caused the remaining increase in product development costs
between the two years.

Impairment Charge

The $1,000 impairment charge recognized in 2000 relates to a non-cash write-off
of prepaid advertising credits received in connection with the issuance of
common stock to Warner Brothers. Advertising obtained from the transaction was
allocated to Warner Brothers' Entertaindom website which hasn't generated the
click-throughs originally anticipated and failed to generate much marketing
value. We have a similar arrangement with Sony with $1,000 included in prepaid
advertising as of the end of 2000. Sony's website is still under development,
therefore, we have not had the opportunity to assess whether or not it will
generate marketing value.

Amortization of Goodwill and Other Purchase Intangibles

The 2000 amortization of goodwill and other purchase intangibles consists of
expense associated with the purchases of STV and II. STV's total purchase
intangibles consist of: 1) assembled workforce of $1 million amortized over a
one year period; 2) goodwill of $70 million amortized over a three year period;
and 3) unearned compensation of $5.3 million resulting from the valuation of the
assumed options, amortized over the average remaining vesting period of 3.5
years. The unearned compensation figure was reduced to approximately $1.25
million due to forfeited, unvested options of employees terminated since the
acquisition date. II's total goodwill consists of: 1) assembled workforce of
$2.2 million amortized over a five year period; and 2) goodwill of $14.1 million
amortized over a three to seven year period.

Liquidity and Capital Resources
-------------------------------

Cash used in operating activities amounted to $19,008 and $6,054 in 2000 and
1999, respectively. Increased use of operating cash in 2000 consisted primarily
of the $34,922 net loss offset by non-cash expenses of $19,322, the most
significant of which were acquisition-related expenses. Operating losses in 1999
and 1998 also accounted for the primary use of funds in those respective years.
Additional increases in working capital, primarily growth in receivables, of
$3,408 in 2000, $1,158 in 1999, and $1,941 in 1998 also impacted cash used in
operations.

Cash provided by (used in) investing activities was $(18,125) in 2000, $588 in
1999 and $(4,781) in 1998. The most significant use of cash in 2000 was the
acquisitions of STV and II. Fixed asset purchases impacted cash in all three
years, primarily in 2000. The increase in fixed asset additions from $1,362 in
1999 to $7,202 in 2000 was primarily due to the addition of media

                                       24
<PAGE>

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. Also in 2000, 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 issued to the Company in exchange for a
guarantee of a lease. In 1999 we invested $514 in the common stock of this same
company and still hold those shares. Investing activities in 1999 and 1998 also
included capitalized software development efforts of $540 and $316. No costs of
software development were capitalized in 2000.

Cash provided by financing activities was $53,192 in 2000, $4,415 in 1999 and
$13,678 in 1998. In 2000, we raised $53,995 from the exercise of common stock
warrants and the issuance of common stock through private placements. Financing
proceeds in 1998 included the combined issuance of $13,918 of common stock from
the June 1998 initial public offering and from an earlier private placement.
Payments on debt impacted all three years with an increase in 2000 due to
increases in capital leases. In 1999 and 1998, cash was provided by net proceeds
from debt of $5,257 and $1,022. Debt proceeds in 1999 included $4,625, net of
commissions and other expenses from the issuance of redeemable convertible
subordinated debentures.

In June 1998, we completed an initial public offering, including over-allotment
shares, of 4.2 million shares of common stock at a price of $3.75 per share and
2.3 million common stock purchase warrants at a price of $0.05 each. The net
proceeds from the offering, after deduction of underwriting discounts and other
expenses relating to the offering, were approximately $13,258. We have used the
net proceeds for development of new products, capital expenditures, sales and
marketing, expansion of internal operations, acquisition activities and/or joint
venture activities and working capital and general corporate purposes.

In response to the tightening of the market for both software and media services
and in anticipation of a $4,000 note payable due in January 2001, we have
already initiated efforts to reduce our operating expenses. In December 2000, we
further reduced headcount across all departments and eliminated certain sales
and marketing programs. None of these cuts are anticipated to impact future
revenue generation or the quality of products and services we provide. Although
we believe these efforts will allow us to generate positive cash from operations
in the near term with available resources, there can be no assurance we will be
successful. We may pursue cash in the equity market with key strategic partners
or private investors. We are also reviewing other financing activities such as
debt, sale-leaseback arrangements and the sale of underutilized assets. There
can be no assurance that we will obtain additional debt or equity on
satisfactory terms.

New Accounting Standards

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" (SFAS 133). SFAS 133 establishes a new model for
accounting for derivatives and hedging activities and supersedes and amends
existing accounting standards and is effective for fiscal years beginning after
June 15, 2000. SFAS 133 requires that all derivatives be recognized in the

                                       25
<PAGE>

balance sheet at their fair market value, and the corresponding derivative gains
or losses be either reported in the statement of operations or as a component of
other comprehensive income depending on the type of hedge relationship that
exists with respect to such derivative. The Company does not expect the adoption
of SFAS 133 to have a material impact on its consolidated financial statements.

Factors that may affect Sonic Foundry's Business, Future Operating results and
Financial Condition

In addition to the other information in this Annual Report on Form 10-K, the
following factors should be considered in evaluating our business and prospects.

Operating History Risks
-----------------------

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

We have incurred significant losses since our inception, $34,922 in 2000, $5,997
in 1999 and $632 in 1998, and we may never become profitable. As of September
30, 2000, we had an accumulated deficit of $42,388. 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. We have not yet generated revenue
from our DMAM efforts.

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

                                       26
<PAGE>

developments for software products and media services. To the extent that these
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 software, products 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. 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 software products and 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.

Our business depends, in part, upon relationships that we have with strategic
partners such as Microsoft, RealNetworks, Sony 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 brand; and

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

                                       27
<PAGE>

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 selling and marketing
our products, the international sales of our products may decrease.

We have contracts with Ingram Micro, Inc., and other U.S. companies, that
distribute our software products to various computer resellers, value-added
resellers, catalog distributors and smaller retail outlets. Our contracts with
these distributors requires 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 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.

                                       28
<PAGE>

Technology Risks
----------------

We depend upon access to Microsoft 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.

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;
 .    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

                                       29
<PAGE>

many musicians, 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,
particularly music, could significantly affect our growth and the way we do
business.

The onset of competing industry standards for the electronic delivery of music
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 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 adopting a
new enterprise resource planning system, which handles all of our accounting,
operations, sales and information systems. 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.

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.

                                       30
<PAGE>

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, copyright
and trade secret laws, confidentiality agreements with our employees and third
parties and "shrink wrap" licenses. 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 protect 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 rather than with 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.

                                       31
<PAGE>

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.

Management Risks
----------------

We may not be able to reduce our staff while successfully maintaining our
reputation for quality products and services.

During November and December 2000 we reduced our staff by approximately 200
employees. While we believe these reductions will have limited or no impact on
revenues nor harm our reputation for providing quality products and services,
our business will be significantly impaired if we are unsuccessful.

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. We maintain
$1 million "key-man" insurance policies on the lives of Mr. Buinevicius, Mr.
Schmidt, and Mr. Palmer, but do not maintain any "key-man" insurance policies on
any other 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.

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

We have made three acquisitions of complimentary businesses in fiscal 2000 and
may make acquisitions of, or investments in, businesses, products or
technologies in the future. Fiscal 2000 acquisitions were spread out
geographically and required significant management attention and resources.
Integration efforts are not yet complete and will likely continue to place a
significant strain on our business. If we identify an acquisition candidate, we
may not be able to

                                       32
<PAGE>

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. We currently have no commitments or
agreements with respect to any business acquisitions or investments.

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; and

 .    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. We cannot assure you that this moratorium will be 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.

                                       33
<PAGE>

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 40% of our 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 of our five directors
each year. Moreover, Maryland corporate law restricts certain business
combination transactions with "interested stockholders."

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Because our cash equivalents consist of overnight investments in money market
funds, we will not experience decreases in principal value associated with a
decline in interest rates. Although we license our software to customers
overseas in U.S. dollars, we have exposure to foreign currency fluctuations
associated with liabilities, bank accounts and other assets maintained by our
offices in Canada and the Netherlands. The $4 million note due in January 2001
is denominated in Canadian dollars and exposes us to changes in exchange rates
until that note is paid. We currently do not hedge our exposure to foreign
currency fluctuations, which have historically been immaterial.

ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                                       34
<PAGE>

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, 2000 and 1999, and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years ended September 30, 2000, 1999 and 1998. Our audits also included the
financial statement schedule listed in the index at Item 14(a). These 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, 2000 and 1999 and the consolidated results of its operations and
its cash flows for the years ended September 30, 2000, 1999 and 1998, 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 10, 2000

                                       35
<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                     (in thousands except for share data)
<TABLE>
<CAPTION>
                                                                  September 30,
                                                               2000          1999
                                                          ------------------------------
<S>                                                         <C>             <C>
Assets
Current assets:
  Cash and cash equivalents                                  $ 21,948         $ 5,889
  Accounts receivable, net of allowances of $1,209 and
    $1,315                                                      9,075           3,704
  Accounts receivable - other                                     355              57
  Revenues in excess of billings for software license fees        105               -
  Inventories                                                   1,906           1,041
  Prepaid expenses and other current assets                     1,591             880
  Prepaid advertising                                           1,000               -
                                                          ------------------------------
Total current assets                                           35,980          11,571


Property and equipment:
  Land                                                             95             190
  Buildings and improvements                                    3,186           1,738
  Equipment                                                    15,370           2,218
  Furniture and fixtures                                          504             202
                                                          ------------------------------
    Total property and equipment                               19,155           4,348
  Less accumulated depreciation                                 3,071             923
                                                          ------------------------------
    Net property and equipment                                 16,084           3,425


Other assets:
  Goodwill and other intangibles, net                          73,632               -
  Capitalized software development costs, net                     518             643
  Long term investment                                            514             514
  Other assets                                                     97             556
                                                          ------------------------------
    Total other assets                                         74,761           1,713
                                                          ------------------------------
Total assets                                                 $126,825         $16,709
                                                          ==============================
</TABLE>

See accompanying notes.

                                       36
<PAGE>

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

<TABLE>
<CAPTION>
                                                                    September 30,
                                                                 2000          1999
                                                          ------------------------------
<S>                                                          <C>            <C>
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable                                            $  5,231       $ 1,867
  Accrued liabilities                                            2,819           812
  Current portion of long-term debt                              4,300            49
  Current portion of capital lease obligations                   1,477             -
                                                          ------------------------------
Total current liabilities                                       13,827         2,728

  Long-term obligations, net of current portion                    923           654
  Capital lease obligations, net of current portion              1,703             -
  Subordinated debt                                                  -         4,580
  Other liabilities                                                  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; 21,905,000 and 12,994,000 shares issued and
    outstanding at September 30, 2000 and 1999                     219           130
  Common stock to be issued                                      5,579             -
  Additional paid-in capital                                   148,290        16,283
  Accumulated deficit                                          (42,388)       (7,466)
  Receivable for common stock issued                               (72)            -
  Cumulative foreign currency translations/adjustments             137             -
  Unearned compensation                                         (1,249)         (200)
  Treasury stock, at cost, 27,750 shares                          (150)            -
                                                          ------------------------------
Total stockholders' equity                                     110,366         8,747
                                                          ------------------------------
Total liabilities and stockholders' equity                    $126,825       $16,709
                                                          ==============================
</TABLE>

See accompanying notes.

                                       37
<PAGE>

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

                                              Years Ended September 30,
                                     ----------------------------------------
                                        2000           1999          1998
                                     ----------------------------------------

Revenue:
Software license fees                 $  22,526     $  14,830     $  7,470
Media services                            4,852             -            -
                                     ----------------------------------------
  Total revenue                          27,378        14,830        7,470

Cost of revenue:
Cost of software license fees             5,493         3,390        2,028
Cost of media services                    5,177             -            -
                                     ----------------------------------------
  Total cost of revenue                  10,670         3,390        2,028
                                     ----------------------------------------

Gross margin                             16,708        11,440        5,442

Operating expenses:
Selling and marketing expenses           19,893        10,484        3,231
General and administrative
    expenses                              9,982         4,253        1,878
Product development expenses              7,868         2,875        1,046
Impairment charge                         1,000             -            -
Amortization of goodwill and
    other intangibles                    14,300             -            -
                                     ----------------------------------------
  Total operating expenses               53,043        17,612        6,155
                                     ----------------------------------------
Loss from operations                    (36,335)       (6,172)        (713)

Other income (expense):
Interest expense                           (618)          (54)        (111)
Interest and other income                 2,031           229          241
                                     ----------------------------------------
  Total other income                      1,413           175          130
                                     ----------------------------------------
Loss before extraordinary item          (34,922)       (5,997)        (583)
Extraordinary item - early
    extinguishment of debt                    -             -          (49)
                                     ----------------------------------------
Net loss                              $ (34,922)    $  (5,997)     $  (632)
                                     ========================================

Per common share:
Loss before extraordinary item         $  (1.89)    $   (1.06)    $   (.22)
Extraordinary item - early
    extinguishment of debt                    -             -         (.02)
                                     ----------------------------------------
Net loss per common share - basic
    and diluted                        $  (1.89)    $   (1.06)    $   (.24)
                                     ========================================

                                       38
See accompanying notes.
<PAGE>

                              Sonic Foundry, Inc.
                Consolidated Statements of Stockholders' Equity
                 Years Ended September 30, 2000, 1999 and 1998
                                (in thousands)
<TABLE>
<CAPTION>
                                                                                                    Receivables
                      Preferred           Common                Additional                          for common
                      series B   Common  stock to   Treasury     Paid-in   Accumulated  Currency       stock      Unearned
                       stock     Stock   be issued   stock       capital     deficit  translations    issued    compensation Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                    <C>      <C>     <C>         <C>       <C>         <C>          <C>         <C>          <C>      <C>
Balance,
September 30, 1997     $  69    $  5    $      -    $  -      $  1,439    $   (829)    $  -        $   -        $     -  $     684
Issuance of common
  stock                    -      44           -       -        13,867           -        -            -              -     13,911
Exercise of common
  stock options            -       4           -       -             3           -        -            -              -          7
Conversion of
  convertible debt
  to common stock          -                   -       -            40           -        -            -              -         40
Issuance of common
  stock warrants           -       -           -       -            81           -        -            -              -         81
Preferred stock
  dividend                 3       -           -       -             -          (3)       -            -              -          -
Net loss                   -       -           -       -             -        (632)       -            -              -       (632)
----------------------------------------------------------------------------------------------------------------------------------
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
  adjustment                -       -          -         -            -           -      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
==================================================================================================================================
</TABLE>

                                       39
See accompanying notes.
<PAGE>

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

<TABLE>
<CAPTION>
                                                                                          Years Ended September 30,
                                                                              -------------------------------------------------
                                                                                     2000            1999           1998
                                                                              -------------------------------------------------
<S>                                                                           <C>                <C>            <C>
Operating activities
Net loss                                                                      $    (34,922)      $(5,997)        $    (632)
Adjustments to reconcile net loss to net cash used in operating activities:
    Amortization of goodwill and other intangibles                                  13,504             -                 -
    Amortization of unearned compensation                                              846             -                 -
    Depreciation and amortization of property and equipment                          2,684           546               205
    Amortization of capitalized software development costs                             564           298               214
    Amortization of debt discount and debt issuance costs                              164            13                16
    Non-cash charge for common stock warrants and options                              414           239                17
    Non-cash advertising and impairment charges                                      1,500             -                 -
    Non-cash imputed interest charge for acquisition                                   191             -                 -
    (Gain) loss on sale of assets                                                     (545)            5                 -
    Extraordinary item                                                                   -             -                49
    Changes in operating assets and liabilities:
      Accounts receivable and revenues in excess of billings                        (3,459)       (1,365)           (1,967)
      Inventories                                                                   (1,342)         (725)             (260)
      Prepaid expenses and other assets                                               (392)         (602)             (204)
      Accounts payable and accrued liabilities                                       1,785         1,534               490
                                                                           -------------------------------------------------
Total adjustments                                                                   15,914           (57)           (1,440)
                                                                           -------------------------------------------------
Net cash used in operating activities                                              (19,008)       (6,054)           (2,072)

Investing activities

Acquisitions, net of cash acquired                                                 (11,949)            -                 -
Proceeds from (purchases of) marketable securities                                       -         3,000            (3,000)
Purchases of property and equipment                                                 (7,202)       (1,362)           (1,465)
Proceeds from disposals of assets                                                    1,026             4                 -
Capitalized software development costs                                                   -          (540)             (316)
Purchases of long-term investments                                                       -          (514)                -
                                                                           -------------------------------------------------
Net cash provided by (used in) investing activities                                (18,125)          588            (4,781)
</TABLE>


See accompanying notes.

                                       40
<PAGE>

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

<TABLE>
<CAPTION>
                                                                      Years Ended September 30,
                                                        -----------------------------------------------------
                                                               2000             1999             1998
                                                        -----------------------------------------------------
<S>                                                        <C>              <C>               <C>
Financing activities
Proceeds from issuance of common stock, net of issuance
  costs                                                          53,995                1            13,918
Proceeds from debt issuance                                           -            5,257             1,022
Payments on long-term debt and capital leases                      (803)            (643)           (1,042)
Purchase of common stock for restricted stock awards                  -             (200)                -
Borrowings (payments) on line of credit, net                          -                -              (220)
                                                        -----------------------------------------------------
Net cash provided by financing activities                        53,192            4,415            13,678
                                                        -----------------------------------------------------
Net increase (decrease) in cash                                  16,059           (1,051)            6,825
Cash and cash equivalents at beginning of period                  5,889            6,940               115
                                                        -----------------------------------------------------
Cash and cash equivalents at end of period                     $ 21,948           $5,889            $6,940
                                                        =====================================================

Supplemental cash flow information:
  Interest paid                                                $    233           $   33            $  113
Noncash transactions:
    Capital lease acquisitions                                    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                -                 -
    Preferred stock dividend                                          -                4                 3
    Issuance of warrants for consulting services                    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                -                40
</TABLE>

See accompanying notes.

                                       41
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000



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 Windows-based software and services for creating, editing and archiving
digital media. The Company sells software, services and systems to the music,
video, broadcast and Internet markets worldwide. 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 (STV) and International Image
(See Note 14). 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 generally accepted
accounting principles 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 upon delivery, net of allowances for estimated returns,
provided that no significant obligations of the Company remain and collection of
the resulting receivable is deemed probable. Revenues from software license
agreements with OEMs are recognized when persuasive evidence of an arrangement
exists, the software product has been delivered to the OEM, the fee to the
Company is fixed and determinable, and collectibility is probable. Additionally,
revenues include fees recorded pursuant to long-term contracts, using the
percentage of completion method of accounting, when significant customization or
modification is required.

Media Services: Revenues from media services include duplication for broadcast
distribution, broadcast standard conversions, audio and video encoding,
webcasting, production, hosting and streaming as well as fees for consulting
services. Media Services' revenues are recognized upon completion of the
service, provided that no significant obligations of the Company remain and
collection of the resulting receivable is deemed probable. In the case of long-
term contracts, which are defined as

                                       42
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000




those projects extending longer than one month, revenues are recognized using
the percentage of completion method.

In December 1999, the Securities and Exchange Commission (SEC) released Staff
Accounting Bulletin No. 101 (SAB 101) "Revenue Recognition in Financial
Statements". The accounting impact of SAB 101 is required to be adopted by the
Company no later than October 1, 2000. The Company has reviewed SAB 101 and
believes the adoption of SAB 101 will have no material impact on its financial
position and results of operations. The Company believes its current revenue
recognition policies and practices are consistent with generally accepted
accounting principles.

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 internal costs in developing software products upon
determination that technological feasibility has been established for the
product. 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.

Capitalized software development costs at September 30, 2000 and 1999 are net of
accumulated amortization of $949,000 and $650,000.

Advertising Costs
Advertising costs are expensed at the time the advertising takes place.
Advertising costs were $6,657,000, $1,039,000 and $720,000 for the years ended
September 30, 2000, 1999 and 1998. In 2000, advertising costs included the
utilization of $500,000 of advertising credits received in exchange for common
stock. An additional $1,000,000 of advertising credits received in 2000 in
exchange for common stock was written off because no future benefit was
expected.

                                       43
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000



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

Stock Split
A two-for-one stock split, declared by the Company's Board of Directors, became
effective in April 2000. All share information has been adjusted to reflect this
stock split.

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, 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, 2000, 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.

                                       44
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000




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,
                                                        2000             1999              1998
                                                ----------------------------------------------------------
<S>                                             <C>                  <C>              <C>
Numerator
Net loss                                        $   (34,922)         $   (5,997)      $     (632)
Preferred stock dividends declared                        -                  (4)              (3)
                                          ----------------------------------------------------------
Net loss used in computing basic and
  diluted loss per share                        $   (34,922)         $   (6,001)      $     (635)
                                          ==========================================================

Denominator
Denominator for basic and dilutive loss
  per share - weighted average common
  shares                                         18,503,000           5,687,000        2,713,000
                                          ==========================================================

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                            2,654,000           1,046,000          534,000
  Convertible debt                                        -                 972                -
  Convertible Series B Preferred Stock                    -                   -            7,224
</TABLE>


Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued 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 is effective for fiscal years beginning after
June 15, 2000. SFAS 133 requires that an entity recognize all derivatives as
either assets or liabilities in the balance sheet and measure those instruments
at fair value. The Company does not expect the effect of adopting the provisions
of SFAS No. 133, as amended, to have a material impact on its consolidated
financial statements.

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 will be
effective for the Company beginning July 1, 2001. EITF No. 00-14 will require
cash rebates to be classified as a reduction of revenue and prior periods
presented for comparative purposes will 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 2000 and 1999 were approximately $1,000,000 and
$1,148,000, respectively. Adoption of EITF No. 00-14 will affect the
presentation of cash rebates in the statement of operations but will not affect
the loss from operations reported.

                                       45
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000


2.   Inventories

Inventory consists of the following (in thousands):

                                                       September 30,
                                               -------------------------------
                                                    2000             1999
                                               -------------- ----------------
Raw materials and supplies                         $ 1,121          $   437
Work-in-process                                        213              578
Finished goods                                         572               26
                                               -------------- ----------------
                                                   $ 1,906          $ 1,041
                                               ============== ================

3.   Long-Term Investment

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,
which had a zero basis, 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. 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 with zero
basis (using the specific identification method) and recognized a $600,000 gain
on the sale. Certain directors of the Company have personal investments in the
entity.

4.   Long-Term Debt and Notes Payable

Long-term obligations consist of the following:

<TABLE>
<CAPTION>


(in thousands)                                                                Years Ended September 30,
                                                                           ---------------------------------
                                                                                 2000             1999
                                                                           ---------------- ----------------
<S>                                                                        <C>              <C>
Convertible subordinated debentures due
   September 2002, with stated interest of 7.5% per annum,
   net of unamortized discount of $419.  All debt was
   converted to common stock during fiscal 2000.                               $       -      $    4,581
Subordinated note payable due to former owners of
   International Image due January 2001, interest rate of
   9% per annum                                                                    4,000               -
Mortgage note payable to a bank, due March 2002, monthly
   payments of $5 including interest at 7.375% per annum,                            590             625
   secured by building and land
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                                                                         64              77
Other bank loans due on demand                                                       569               -
                                                                        ----------------  --------------

                                                                                   5,223           5,283
Total

Less amounts due within one year                                                   4,300              49
                                                                        ---------------- ---------------
Long-term debt                                                                 $     923       $   5,234
                                                                        ================ ===============
</TABLE>

                                       46
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

The convertible subordinated debentures, issued in September 1999, and a portion
of the accrued interest thereon were converted into common stock at a rate of
$5.14 per share. Concurrent with the issuance of the debentures, the Company
issued the investors warrants to purchase 194,552 shares of common stock at
$5.14 per share expiring September 2004. The warrants were valued at $425,000,
which reduced the carrying amount of the debt.

In February 1998, the Company issued unsecured notes payable in the aggregate
amount of $1,000,000. The notes were to mature in February 1999 and bore
interest at a rate of 12% per annum. In connection with the issuance of the
notes, the Company issued warrants to purchase 100,000 shares of common stock at
$2.50 per share (see Note 7). The warrants were valued at $65,000, which reduced
the carrying amount of the debt. In May 1998, the Company paid the face amount
of the notes and recorded an extraordinary loss equal to the remaining
unamortized debt discount of $49,000.

Maturities of long-term debt, at September 30, 2000 are as follows:

                       Fiscal                 (in thousands)
                       ------
                       2001                        $   4,300
                       2002                              850
                       2003                               58
                       2004                               15
                                                   ----------
                       Total                       $   5,223
                                                   ==========

5.  Commitments

At September 30, 2000, the gross amount of capital leases and related
accumulated amortization was approximately $3,857,000 and $502,000,
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 $1,369,000, $390,000, and
$84,000 for the years ended September 30, 2000, 1999 and 1998 respectively. The
following is a schedule by year of future minimum lease payments under capital
and operating leases. At September 30, 2000, future lease commitments under such
lease agreements are as follows:

               Fiscal                               Capital     Operating
               2001                                 $ 1,721      $ 1,757
               2002                                   1,301        1,504
               2003                                     518        1,016
               2004                                      11          717
               2005                                       -          701
               Thereafter                                 -        2,736
                                                  ------------------------
               Total                                  3,551      $ 8,431
                                                                ==========

               Less amount representing interest        371
                                                  -------------
               Capital lease obligations            $ 3,180
                                                  =============

                                       47
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

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. The Company
declared a dividend on June 30, 1999 and 1998 of 361,185 and 343,987 shares of
preferred stock.

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.

                            Warrants Outstanding at
   Exercise Prices            September 30, 2000           Expiration Date
-----------------------    --------------------------    ------------------
$0.09                                          4,426                  2005
2.50 to 5.00                                 480,000          2003 to 2004
5.00 to 11.50                                340,800          2004 to 2010
28.12                                         50,000                  2005
37.44                                        150,000                  2003
                           --------------------------
                                           1,025,226
                           ==========================

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 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 were calculated using the acquisition 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.

                                       48
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

The number of shares available for grant under these plans at September 30, 2000
is as follows:

                                                       Non-
                                      Employee       qualified       Director
                                    stock option   stock option    stock option
                                        plan           plan            plan
                                   ---------------------------------------------
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
                                   =============================================


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

<TABLE>
<CAPTION>
                                                       Years Ended September 30,
                               --------------------------------------------------------------------------
                                       2000                      1999                      1998
                               ----------------------    ----------------------   -----------------------
                                            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                         1,536,450     $ 1.69      1,067,400      $0.74     1,255,100       $0.29
Granted                          822,291      18.53        480,050       3.81       222,000        2.54
Assumed in acquisition           359,850       7.42              -          -             -           -
Exercised                       (748,581)      0.92              -          -      (400,000)       0.02
Forfeited                       (249,541)     15.05        (11,000)      1.10        (9,700)       2.50
                               --------------------------------------------------------------------------
Outstanding at end of year     1,720,469     $ 9.25      1,536,450      $1.69     1,067,400       $0.74
                               ==========================================================================

Exercisable at end of year       605,907                 1,016,334                  520,000
                               ==========                ==========               ===========
Weighted average fair value
of options granted during
period                            $16.61                    $ 1.89                    $0.65
                               ==========                ==========               ===========
</TABLE>

                                       49
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

The options outstanding at September 30, 2000 have been segregated into four
ranges for additional disclosure as follows:

<TABLE>
<CAPTION>
                                  Options Outstanding                        Options Exercisable
                     ----------------------------------------------    ---------------------------------
                                        Weighted
                       Options          Average         Weighted          Options           Weighted
                    Outstanding at     Remaining         Average        Exercisable          Average
                      September       Contractual       Exercise        at September        Exercise
Exercise Prices       30, 2000            Life            Price           30, 2000            Price
-----------------    -------------    -------------    ------------    ---------------    --------------
<S>                  <C>              <C>              <C>             <C>                <C>
           $0.03          180,000             5.42           $0.03            180,000             $0.03
    0.47 to 0.57           45,056             8.41            0.54             34,208              0.54
    2.50 to 5.00          672,758             7.04            3.39            371,604              3.21
    5.01 to 9.75          458,599             9.14            6.21             20,095              5.41
  12.00 to 15.50          149,056             9.54           15.00                  -                 -
  30.75 to 59.88          215,000             8.03           39.61                  -                 -
</TABLE>

In August 1999, the Company entered into a separation agreement with a former
employee. The agreement called for 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.

As permitted by Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" (SFAS No. 123), 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,
                                      ----------------------------------------------------------
                                            2000                1999                 1998
                                      -----------------   -----------------    -----------------
<S>                                      <C>                 <C>                     <C>
Pro forma net loss (in thousands)         $ (39,313)           $ (6,851)               $(678)
Pro forma net loss per share                  (2.12)              (1.05)                (.25)
</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 1.2 and a
weighted-average expected life of the option of five years.

During 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. Through
September 30, 2000, no shares have been issued under the Stock Purchase Plan.
All employees of the Company who have completed three months of employment are
eligible to participate in the Stock

                                       50
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000


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):

                                             Years Ended September 30,
                               -------------------------------------------------
                                     2000              1999                1998
                               -------------------------------------------------
Deferred income tax benefit         $  (8,901)       $   (2,448)      $    (260)
Change in valuation allowance           8,901             2,448             260
                               -------------------------------------------------
                                    $       -        $        -       $       -
                               =================================================

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

                                               Years Ended September 30,
                                  --------------------------------------------
                                     2000             1999             1998
                                  ---------         ---------        --------
Tax benefit at U.S.                 (11,873)        $  (2,039)       $   (215)
  statutory rate of 34%
State income tax benefit,
  net of federal benefit             (1,907)             (308)            (32)
Permanent differences, net            5,279                25             (13)
General business credits
                                       (400)             (126)              -
Change in valuation allowance         8,901             2,448             260
                                  ---------         ---------        --------
                                  $       -         $       -        $      -
                                  =========         =========        ========

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

                                                    September 30,
                                        -------------------------------------
                                            2000                   1999
                                        --------------         --------------
Deferred tax liabilities:
Capitalized computer software costs     $         (23)         $        (256)
Depreciation                                     (110)                  (153)
                                        -------------          -------------
Total deferred tax liabilities                   (133)                  (409)

Deferred tax assets:
Net operating loss and other
  carryforwards                                10,510                  2,601
Common stock warrants                             649                    155
Accruals                                          448                    185
Allowance for doubtful accounts                   472                    513
                                        -------------          -------------
Total deferred tax assets                      12,079                  3,454
                                        -------------          -------------
                                               11,946                  3,045
Valuation allowance                           (11,946)                (3,045)
                                        -------------          -------------
Net deferred tax assets                 $           -          $           -
                                        =============          =============

                                       51
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

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 $268,000, $88,000 and $29,000 during the years
ended September 30, 2000, 1999 and 1998.

11.  Related-Party Transactions

The Company paid fees of $500,000, $135,000, and $196,000 during the years ended
September 30, 2000, 1999 and 1998 to a law firm whose partner is a director and
stockholder of the Company.

During 2000, the Company loaned certain officers $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.

In August of 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.

During 1998, the Company incurred $39,000 in consulting fees from a company
whose principal stockholder is a common stockholder of the Company.

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. At September 30, 2000 there was a balance of
approximately $63,000 remaining  on the loans.

12.  Segment Disclosure

In 2000, the Company adopted SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information", which requires the reporting of segment
information using the "management approach" versus the "industry approach"
previously required. Generally accepted accounting principles 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, with a full suite of software products utilized
by both producers and consumers of digital media and (ii) a media services
division, which provides broadcast conversion, tape duplication, audio and video
encoding, webcasting, streaming, hosting and consulting services. 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.

                                       52
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

Summarized financial information of the Company's continuing operations by
business segment for the fiscal years ended September 30, 2000, 1999 and 1998 is
as follows (in thousands):

<TABLE>
<CAPTION>
                                               Years Ended September 30,
                               ----------------------------------------------------------
                                    2000                 1999                 1998
                               --------------       --------------       ---------------
<S>                            <C>                  <C>                  <C>
Revenues:
   Software                    $       22,526       $       14,830       $         7,470
   Media services                       4,852                    -                     -
                               --------------       --------------       ---------------
                               $       27,378       $       14,830       $         7,470

Gross margin:
   Software                    $       17,033       $       11,440       $         5,442
   Media services                        (325)                   -                     -
                               --------------       --------------       ---------------
                               $       16,708       $       11,440       $         5,442

Total assets:
   Software                    $        9,493       $       16,709       $        15,950
   Media services                      11,371                    -                     -
   Unallocated and
   intangibles                        105,961                    -                     -
                               --------------       --------------       ---------------
                               $      126,825       $       16,709       $        15,950
</TABLE>

Of the $126.8 million in total assets held by the Company, $4.3 million are held
in Canada.

13.  Major Customers

Included in software license fees are sales to one customer of 15%, 22% and 10%
for 2000, 1999, and 1998, respectively. The four largest service customers
combined accounted for 24% of Fiscal 2000 revenue from media services, with the
largest of the four accounting for 7% of service revenue.

Percentage of revenues by continent were as follows:

                                       Year ended September 30,
                         -----------------------------------------------------
                            2000                 1999                  1998
                         -----------          ------------          ----------
North America                     87%                   83%                 86%
Europe                             6                    10                   7
Asia                               6                     5                   5
Other                              1                     2                   2
                         -----------          ------------          ----------
Total                            100%                  100%                100%
                         ===========          ============          ==========

14.  Acquisitions

On April 3, 2000, the Company completed its acquisition of STV Communications
(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

                                       53
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

options to purchase 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 is being amortized over the average
remaining vesting period of 3.5 years. The unearned compensation figure was
reduced to approximately $1.25 million in order to account for amortization and
adjustments for forfeited, unvested options of employees terminated since the
acquisition date.

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 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. 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). $4.7 million of
goodwill is related to the video tape business operations of the Company and is
being amortized over 7 years. $9.4 million of goodwill is related to the
remaining business operations and is being amortized over 3 years.

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.

                                       54
<PAGE>

                              SONIC FOUNDRY, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                              September 30, 2000

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.

15.  Quarterly Financial Data (unaudited)

The following table sets forth selected quarterly financial and stock price
information for the years ended September 30, 2000 and 1999. The operating
results are not necessarily indicative of results for any future period.
Included below are the high and low stock prices, all prices adjusted for 2 for
1 split. The gross margins for the fiscal 2000 quarters vary slightly from
reported results due to a reclassification of depreciation for media services
production equipment.

<TABLE>
<CAPTION>
   (in thousands)             Fiscal 2000 Quarter Ended                  Fiscal 1999 Quarter Ended
                      ------------------------------------------- ----------------------------------------
                        Dec. 31   Mar. 31    June 30    Sept. 30    Dec. 31    Mar. 31  June 30   Sept. 30
                      ---------- --------- ---------- ----------- ---------- ---------- ------- -----------
<S>                   <C>        <C>       <C>        <C>         <C>        <C>        <C>     <C>
Net Revenues            $ 5,104    $ 6,028   $ 6,874   $  9,372    $  2,756   $  2,761   $ 4,223  $  5,090
Gross Margin              3,955      4,499     3,469      4,785       1,935      2,060     3,230     4,215
Net Loss                 (2,203)    (2,471)  (14,301)   (15,947)     (1,382)    (1,507)   (1,286)   (1,822)

EPS                     $  (.16)     $(.15)  $  (.66)  $   (.79)   $   (.26)  $   (.28)  $  (.24) $   (.28)
Market Price
---------------------
High                    $ 12.75    $ 64.97   $ 49.63   $  20.81    $   7.44   $   5.44   $ 10.38  $   6.13
Low                        4.25      11.34      9.38       5.75        2.69       3.35      5.07      3.94
</TABLE>

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

Not applicable.

                                       55
<PAGE>

PART III

A 10-K/A will be filed with the Commission not later than January 28, 2001,
which is 120 days after the close of the Registrant's fiscal year. The 10-K/A
will be incorporated by reference into Part III (Items 10 through 13) of Form
10-K.

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 8 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.

NUMBER                       DESCRIPTION
------      -------------------------------------------------------------------
  1           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.

  2.2         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.

  2.3         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 S-8 on
              September 12, 2000, and hereby incorporated by reference.

  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.

  4.1         Specimen Common Stock Certificate, filed as Exhibit No. 4.1 to the
              Registration Statement, and hereby incorporated by reference.

  4.2         Form of Warrant Agreement, including Warrant Certificate, filed as
              Exhibit No. 4.2 to the Registration Statement, and hereby
              incorporated by reference.

  4.3         Form of Representatives' Warrant Agreement, including Specimen
              Representatives' Warrant Certificate, filed as Exhibit No. 4.3 to
              the Registration Statement, and hereby incorporated by reference.

  4.4         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.

  4.5         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.

  4.6         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.

  4.7         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.

  4.8         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.

  4.9         Share Exchange Agreement, dated August 24, 2000 among the
              Registrant, Sonic Foundry (Nova Scotia), Inc., Charles Ferkranus,
              Michael Ferkranus, 1096159 Ontario Limited, and 10402083 Ontario
              Limited, filed as Exhibit 4.2 to the Registration Statement filed
              on Form S-3 on November 7, 2000, and hereby incorporated by
              reference.

  4.10        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.

  4.11        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.

  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.

                                       56
<PAGE>

  10.4        Employment Agreement between Registrant and Rimas Buinevicius
              dated as of November 30, 1997 and effective as of January 1, 1997,
              filed as Exhibit No. 10.4 to the Registration Statement, and
              hereby incorporated by reference.

  10.5        Employment Agreement between Registrant and Monty R. Schmidt dated
              as of November 30, 1997 and effective as of January 1, 1997, filed
              as Exhibit No. 10.5 to the Registration Statement, and hereby
              incorporated by reference.

  10.6        Employment Agreement between Registrant and Curtis J. Palmer dated
              as of November 30, 1997 and effective as of January 1, 1997, filed
              as Exhibit No. 10.6 to the Registration Statement, 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        Start-up Agreement between Registrant and Ingram Micro Inc. dated
              October 16, 1997, filed as Exhibit No. 10.9 to the Registration
              Statement, and hereby incorporated by reference.

  10.10       Form of Lock-up Agreement between Registrant and all directors,
              officers, and non-selling stockholders, filed as Exhibit No. 10.10
              to the Registration Statement, and hereby incorporated by
              reference.

  10.11       Form of Lock-up Agreement between Registrant and all selling
              stockholders, filed as Exhibit No. 10.11 to the Registration
              Statement, and hereby incorporated by reference.

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

  10.13       Commercial Lease between Registrant and Seven J's, Inc. regarding
              627 Williamson Street, Madison, Wisconsin dated March 26, 1999,
              filed as Exhibit No. 10.13 to the Quarterly Report on form 10-QSB
              for the period ended March 31, 1999, and hereby incorporated by
              reference.

  10.14       Loan Agreement, dated March 3, 1999 between Registrant and
              Associated Bank South Central, filed as Exhibit No. 10.14 to the
              Quarterly Report on form 10-QSB for the period ended March 31,
              1999, and hereby incorporated by reference.

                                       57
<PAGE>

  10.15       Business Note Agreement, dated March 3, 1999 between Registrant
              and Associated Bank South Central, filed as Exhibit No. 10.15 to
              the Quarterly Report on form 10-QSB for the period ended March 31,
              1999, and hereby incorporated by reference.

  10.16       Termination Statement between Registrant and Associated Bank South
              Central, effective June 30, 1999, filed as Exhibit No. 10.16 to
              the Quarterly Report on form 10-QSB for the period ended June 30,
              1999, and hereby incorporated by reference.

  10.17       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.

  10.18       Commercial Lease between Registrant and Tenney Place Development,
              LLC regarding 1617 Sherman Ave., Madison, Wisconsin dated October
              1, 1999, and hereby incorporated by reference.

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

  23.1        Consent of Ernst & Young LLP, Independent Auditors.

  27.1        Financial Data Schedule

  (b)     REPORTS ON FORM 8-K

On September 12, 2000 the Company filed a current report on Form 8-K. The report
provided certain information in Item 2 regarding the acquisition of
International Image, Inc.

                                       58
<PAGE>

                              SONIC FOUNDRY, INC.

                SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
                                (in thousands)

<TABLE>
<CAPTION>
                                                        Additions
                                               -----------------------------
                                   Balance at    Charged to     Charged to                    Balance at
                                  beginning of    costs and   other accounts   Deductions       end of
                                     period       expenses     Describe (1)   Describe (2)      period
                                --------------------------------------------------------------------------
<S>                             <C>            <C>            <C>            <C>            <C>
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
                                ==========================================================================

Year ended September 30, 1998
  Accounts receivable reserve       $     20     $     83        $     -        $     30       $     73
                                ==========================================================================
</TABLE>

1. Allowance upon acquisition of receivables of STV and II

2. Includes uncollectible accounts written off and actual rebates taken

                                       59
<PAGE>

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 27, 2000.

                               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 27, 2000
---------------------------

/s/ Monty R. Schmidt         President and Director                     December 27, 2000
---------------------------

/s/ Curtis J. Palmer         Chief Technology Officer and Director      December 27, 2000
---------------------------

/s/ Kenneth A. Minor         Chief Financial Officer                    December 27, 2000
---------------------------

/s/ Frederick H. Kopko, Jr.  Secretary and Director                     December 27, 2000
---------------------------

/s/ Arnold Pollard           Director                                   December 27, 2000
---------------------------

/s/ David C. Kleinman        Director                                   December 27, 2000
---------------------------
</TABLE>


                                       60