<PAGE>

                                 UNITED STATES

                      SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C. 20549

                            AMENDMENT NO. 1 TO


                                   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 March 31, 2001 or
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
    Exchange Act of 1934
For the transition period from _____________ to _____________

Commission File Number: 72870

                                SONIC SOLUTIONS
            (Exact name of registrant as specified in its charter)

<TABLE>
<S>                                               <C>
                   California                                   93-0925818
(State or other jurisdiction of incorporation or   (I.R.S. Employer Identification No.)
                 organization)
</TABLE>

101 Rowland Way, Suite 110,
Novato, California                                                94945
(Address of principal executive offices)                        (Zip Code)

Registrant's telephone number, including area
 code:                                                        (415) 893-8000
Securities registered pursuant to Section 12(b) of the Act:   None
Securities registered pursuant to Section 12(g) of the Act:   Common Stock, no
                                                              par value
                                                              (Title of class)

    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 [_]

    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. ___________

    The aggregate market value of the voting stock held by non-affiliates of
the registrant on May 31, 2001, based upon the closing price of the Common
Stock on the NASDAQ National Market for such date, was approximately
$ 14,302,636./1/

    The number of outstanding shares of the registrant's Common Stock on May
31, 2001 was 13,510,703.

-------
/1/  Excludes 2,068,594 shares held by directors, officers and ten percent or
greater shareholders on May 31, 2001. Exclusion of such shares should not be
construed to indicate that any such person possesses the power, direct or
indirect, to direct or cause the direction of the management or policies of
the registrant or that such person is controlled by or under common control
with the registrant.
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                               Table of Contents


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                                                                          Page
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 <C>      <S>                                                             <C>
                                      PART I

 ITEM 1.  Business......................................................    1
 ITEM 2.  Properties....................................................   18
 ITEM 3.  Legal Proceedings.............................................   18
 ITEM 4.  Submission of Matters to a Vote of Security Holders...........   19

                                      PART II

 ITEM 5.  Market for Registrant's Common Equity and Related Stockholder
          Matters.......................................................   20
 ITEM 6.  Selected Financial Data.......................................   21
 ITEM 7.  Management's Discussion and Analysis of Financial Condition
          and Results of Operations.....................................   23
 ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk....   32
 ITEM 8.  Financial Statements and Supplementary Data...................   33
 ITEM 9.  Changes in and Disagreements with Accountants on Accounting
          and Financial Disclosure......................................   51

                                     PART III

 ITEM 10. Directors and Executive Officers of the Registrant............   52
 ITEM 11. Executive Compensation........................................   55
 ITEM 12. Security Ownership of Certain Beneficial Owners and
          Management....................................................   59
 ITEM 13. Certain Relationships and Related Transactions................   59
 ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form
          8-K...........................................................   60
 Exhibits................................................................  60
 Signatures..............................................................  64
</TABLE>


                                      (i)
<PAGE>

Forward Looking Statements

     This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934To the extent that this report discusses future financial
results, information or expectations about products or markets, or otherwise
makes statements about future events, such statements are forward-looking and
are subject to a number of risks and uncertainties that could cause actual
results to differ materially from the statements made. These risks and
uncertainties include, among others, the timely introduction and acceptance of
new products, costs associated with new product introductions, the transition
of products to new hardware configurations, and other factors. In addition,
such risks and uncertainties also include the matters identified under
Management's Discussion and Analysis of Financial Condition and Results of
Operations in Item 7 below.

                                     PART I

Item 1. BUSINESS

     Overview

     We primarily develop, market and support workstations used by
professionals to edit and process digital audio and digital video information.
Our workstation products always include applications software and often include
plug-in hardware installed on a personal computer. Our customers use various
kinds of peripheral devices -- for example, disk drives, streaming tape drives,
audio and video tape recorders, and CD and DVD recorders -- along with our
products. Although we do not manufacture or sell the personal computer or
peripheral devices used with our products, we typically talk about the complete
configuration of personal computer, Sonic hardware, Sonic software, and
peripherals as a Sonic workstation.

     We currently market two professional workstation product lines: DVD
Creator(TM) for DVD-Video production and SonicStudio(TM) for digital audio
production:

   .  DVD Creator is a line of DVD-Video production workstations that
      supports the preparation and assembly of video and audio assets for
      release in the DVD-Video format. We introduced DVD Creator in the
      spring of 1996. In September 1999, we began shipments of a new line of
      DVD-Video production workstations called DVD Fusion(TM). DVD Fusion,
      which we consider to be part of the DVD Creator product line, is
      intended to provide video producers and editors a lower priced set of
      tools for preparing DVD-Video titles.

   .  SonicStudio is a line of professional audio workstations that our
      customers use to prepare audio for release on Digital Audio Compact
      Discs (CDs), for release with video and film entertainment, and for
      broadcast on radio.

     In February 2001 we acquired the professional DVD-Video authoring tools
business of Daikin Industries, Ltd. of Japan. The products acquired from Daikin
include Scenarist(TM), ReelDVD(TM) and some related products. Scenarist is a
software product intended for use by high-end video professionals in preparing
DVD-Video titles, particularly those titles intended for mass replication.
ReelDVD is a software product intended for use by corporate and "prosumer"
users in preparing DVD-Video titles for a range of applications. Roughly
speaking, Scenarist addresses the same target market as our DVD Creator
product, while ReelDVD addresses the same target market as our DVD Fusion
product.

     In the past two years, we have started supplying software products outside
our traditional professional audio/video market. In September 1999, we began
shipping DVDit!(TM) a software product which provides simplified DVD authoring
capabilities to consumer, "prosumer," and some professional users. In the fall
of 2000 we introduced a simplified DVD-Video creation product called MyDVD(TM),
which is intended for use by consumers. We believe there will be a strong
demand for this product because of the new generation of low cost DVD recording
devices that are being introduced to the personal computing market during 2001.

                                       1
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     Professional Products

        Workstation Product Lines

     We currently offer two professional workstation product lines, oriented
toward somewhat different applications within the professional audio and video
industry. DVD Creator is a line of DVD-Video/Audio production workstations.
SonicStudio is a line of professional digital audio workstations.

     SonicStudio and most of our DVD Creator workstations are designed to run
on versions of the Macintosh personal computer manufactured by Apple Computer.
Current reliance on the Macintosh computer creates risks for our Company.
Please see the discussion under "Platforms; Platform Risk" at page 5, below.

        Professional Video and Audio Industry

     Customers

     Our professional customers are mainly facilities that process and prepare
audio, video and film programming. Most of this programming is for
entertainment, though a significant portion of it is also used for educational
and business communications purposes.

     Some of our professional customers are independent organizations that
supply services to audio and video content holders and publishers. Some of our
customers are in-house facilities that are owned by particular content holders
or publishers.

     Our customers range in size from relatively small organizations with few
employees to larger facilities with hundreds of employees. Among our customers
are facilities that are independent, privately owned companies, as well as
facilities which are part of much larger public, private, or non-profit
organizations. While we have concluded corporate purchasing agreements with
certain customer organizations that have multiple facilities, even within such
organizations decisions to purchase and deploy our products are usually made at
the facility level.

     Most of the time we market our professional products as Sonic Solutions
products, and not as part of another company's products. From time to time we
have concluded agreements with other companies in which they incorporate some
product of ours into their product line (this is commonly referred to as an
"OEM" arrangement). At the present time there is one such relationship that
accounts for a significant portion of our professional audio revenues. Please
see further discussion about this below under "OEM Customers; Sales
Concentration."

     The Shift to Digital

     The professional audio and video industry has shifted significantly from
analog to digital technology over the past twenty years. Digital technology
encodes sound and video as numbers and stores them as a kind of computer data.
In contrast, analog technology records sound and video by making a physical
representation analogous to the original audio or visual signal. Long-playing
records ("LP") and Digital Audio Compact Discs ("CD-A"), are good examples of
analog (LP's) and digital (CD-A's) media. In an LP the grooves cut into the
vinyl record have a physical shape analogous to the original sound pressure
wave. In a CD-A the original sound pressure wave is encoded into numbers that
are recorded as tiny pits on the surface of an optical disc.

     The shift to digital encompasses the tools used to edit, process and
prepare audio and video prior to release, as well as audio and video release
formats -- the form in which the audio or video actually reaches the intended
consumer. Different applications and segments within the professional audio and
video industry have shifted to digital technology at different times. Complete
conversion to digital technology has not yet occurred. We expect that the shift
will continue for the next several years until some point toward the end of the
first

                                       2
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decade of the 21st century when analog technology will effectively cease being
used in the professional audio and video industries.

     There are a number of reasons why digital technology has been attractive
to audio and video professionals:

   .  Higher Quality -- Digital technology permits higher quality audio and
      video to be recorded and replayed under most circumstances. Of course,
      this assumes that the recordings involved are made at a high
      resolution.

   .  Perfect Copying -- Digitally recorded audio and video can be perfectly
      reproduced, over an unlimited number of generations. Every analog
      recording process involves some amount of signal loss with each
      successive generation of copying.

   .  Speed and Precision of Manipulation -- Digital technologies permit
      more rapid and more accurate manipulation of audio and video signals
      than is possible in analog technology.

   .  Special Capabilities -- Digital technology permits certain kinds of
      processes that are difficult or practically impossible using analog
      techniques. One of our own products, a signal processing tool called
      NoNOISE, is a good example of this. NoNOISE permits audio recording
      engineers to remove various kinds of noise from already recorded sound
      with a great degree of precision and fidelity.

   .  Declining Costs -- Digital technology is enjoying dramatic cost
      reductions, driven by the broad scale adoption and growth of computer
      technology in business, in home use, in communications and on the
      Internet. In contrast, analog technology for audio and video recording
      has reached an effective plateau in terms of cost.

     Of course, digital technologies have presented some drawbacks to adoption
over the past 20 years. A few of these are:

   .  Enormous Bandwidth -- Representing audio and video in high resolution
      consumes a large amount of storage space and computer processing
      power. Computers were historically first applied to text and
      arithmetic processing applications which require relatively limited
      digital storage and processing power. For example, a 300 page book-
      length work can easily be represented in three megaBytes of storage. A
      single CD-A requires some 600 megaBytes to store a little more than
      one hour of stereo music.

   .  Real Time Requirements -- Audio and video are real time data, meaning
      that they must be presented to the observer in strict time sequence --
      neither too fast nor too slow. For historical reasons, computer
      engineers developed much of their technology using architectures,
      called asynchronous architectures, which make it difficult to ensure
      such strict timing. This meant that it was difficult for companies
      like ours to use "off the shelf" computer technology to develop our
      products.

   .  Analog Release Formats -- In many ways release formats have been the
      slowest areas to shift to digital. Even today almost all video
      programs reaching consumers arrive via analog formats (VCR cassettes,
      conventional broadcast television, and conventional cable television).
      The Digital Audio Compact Disc, of course, now accounts for the
      majority of pre-recorded music sold to consumers in industrialized
      countries. But most broadcast radio, as well as the audio accompanying
      broadcast video, theatrical feature films, and pre-recorded video, is
      still delivered mostly using analog formats. Slow transition of
      release formats to digital technology has tended to retard adoption of
      digital technology by professionals for "upstream" processes such as
      editing.

     Our company was founded to pursue the opportunities presented by this
major transition, and to facilitate the transition by offering professionals
compelling alternatives to traditional analog production tools.

                                       3
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        Professional DVD Production: DVD Creator & DVD Fusion

     DVD-Video

     Our DVD Creator(TM) and DVD Fusion(TM) workstations support preparation of
DVD-Video discs.

     DVD-Video is a relatively new optical disc format, introduced in 1996,
which offers high quality video, surround audio, and interactivity on a Compact
Disc-sized disc. The DVD-Video format offers content publishers a wide range of
features and options:

   .  Video can be presented in the MPEG-1 or MPEG-2 compressed digital
      video format. A number of video streams may be presented in parallel
      so that, responding to user commands, the player may seamlessly jump
      from stream to stream.

   .  Audio can be presented both as compressed digital stereo and
      "surround" formats, as well as uncompressed "PCM" digital audio. Up to
      eight audio streams may be presented simultaneously (and may also be
      selected for playback based on real-time user decisions) -- to support
      different language dialog tracks, or to allow stereo and surround
      versions of the same audio program.

   .  Chapter marks may be specified for random access into the video
      program. Subpictures (images overlaid on background video or still
      images) may be included and can be used in a number of ways, for
      example, to create animated "buttons" to facilitate user interaction,
      or to display language subtitles. Still pictures may be presented with
      audio and with subpictures. Extensive navigation capabilities are
      available to permit users to select from various program branches, to
      return to previous branch points or menus, etc.

     DVD Creator and DVD Fusion Workstations

     We offer a range of professional DVD production workstations under the DVD
Creator and DVD Fusion trade names. Generally speaking DVD Creator workstations
offer more extensive capabilities to specialized professionals, at a somewhat
higher price points, while DVD Fusion workstations are designed for greater
ease of use and are targeted at less specialized video professionals at
somewhat lower price points. The two product lines share common technology and
can perform most of the same functions. We offer both lines in many
configurations so that customers can specify a workstation suited to their
particular needs and style of operation.

     In the following discussion, unless the context indicates otherwise,
please understand that when we refer to "DVD Creator" we are referring to "DVD
Fusion" as well.

     Platforms; Platform Risk

     We introduced DVD Creator for the Macintosh in 1996. In 1999 we introduced
DVD Fusion for the Macintosh. In early 2001 we introduced DVD Fusion for the
Windows platform. We may, in the future, introduce versions of DVD Creator for
the Windows platform as well.

     Because all of our DVD Creator workstations are currently Macintosh based,
and because many of our DVD Fusion systems will continue to be Macintosh based,
we are subject to certain risks. Among these are:

   .  We are dependent on Apple Computer continuing to ship and sell certain
      models of the Macintosh, particularly models that can support use of
      our plug-in PCI hardware (relevant to the higher priced models of DVD
      Creator and DVD Fusion).

   .  Our Macintosh users generally demand that we maintain compatibility
      with the latest models of the Macintosh and the Macintosh OS. In this
      regard, in March of 2001 Apple Computer announced that Macintosh OS X
      would now be available for use with its Macintosh computers. Recently,
      Apple Computer has announced that new models of the Macintosh will be
      delivering with OS X,

                                       4
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      though those machines will still be able to run the earlier 9.x
      versions of the Macintosh OS. Industry observers anticipate that at
      some point before the end of 2001 or in early 2002, new Macintosh
      computers will be able only to run with OS X. While OS X currently
      offers a "compatibility mode" which supports OS 9.x compatible
      applications, we believe that we will soon have to modify our
      Macintosh Creator and Fusion applications to OS X for Creator and
      Fusion to continue to be able to run with the latest Macintosh models.
      Such a modification may be difficult to accomplish and if it proves to
      be lengthy our revenues could be significantly reduced in the interim.

   .  Apple Computer has acquired DVD authoring technology and has
      introduced products that compete with some of our products (please see
      discussion under "Competition" at page 15, below).

     DVD Creator Functions

     DVD-Creator supports the three basic processes required to prepare audio
and video programming in the DVD-Video format. These are:

   .  MPEG-2 Video Encoding -- MPEG-2 and MPEG-1 video are the standards for
      DVD-Video discs. MPEG is a digital video format that compresses the
      original digital video stream to reduce bandwidth and storage
      requirements by 90 to 95% but with little or no loss in perceived
      quality.

   .  Audio Preparation and Encoding -- DVD-Video supports uncompressed
      ("PCM") digital audio as well as MPEG-2 and Dolby Digital compressed
      formats.

   .  Format Authoring -- To support the advanced features of DVD-Video,
      particularly menu-drive interactivity and multiple video and audio
      streams, the audio, video, graphic and text elements included in the
      disc must be organized, linked and then "woven" together.

     DVD Creator -- Subsystems & Configurations

     DVD Creator includes three principal subsystems capable together of
performing all the tasks necessary for producing a finished DVD-Video disc
image, which can then be replicated on manufactured DVD discs. These subsystems
are:

   .  Video Encoding -- The DVD-Video standard specifies MPEG-2 and MPEG-1
      compressed digital video as the video formats to be used on DVD-Video
      discs. While a number of choices within the standard are possible, the
      typically preferred format is variable bit rate MPEG-2 operating at an
      average bit rate of approximately four Megabits per second. DVD
      Creator includes an encoding system designed to support user control
      of the encoding process, and facilitate the operation of the encoding
      system with standard professional video tape recorders and other
      typical peripherals.

   .  Audio Encoding -- DVD Creator includes the ability to encode audio
      into the formats supported by DVD-Video, including MPEG-2 and Dolby
      Digital compressed audio. In some configurations of DVD Creator we
      include a SonicStudio system.

   .  Format Authoring -- The authoring subsystem takes individual
      compressed video, audio, graphics, still picture and subpicture
      elements and combines and organizes them along with instructions
      specifying interactivity (i.e., the response DVD players will make
      based on user manipulation of front panel buttons or remote control
      buttons). The output of the authoring step is an "asset list,"
      containing each of the individual elements, and a "script" describing
      how the assets are combined and accessed via user commands. Because of
      the large number of potential elements in a DVD title and the high
      level of interactivity possible, the authoring subsystem is a
      complicated software package.

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     In addition to these main subsystems, DVD Creator includes two other
subsystems:

   .  Emulation -- Because of the complexity of a DVD title, users of DVD
      Creator require the ability to preview the results of their work
      before the time consuming step of producing a final output disc. We
      offer a subsystem that permits this previewing.

   .  Formatting and Writing -- DVD Creator includes a subsystem to take the
      output of an authoring session and then to combine the navigation
      instructions together with the audio, video, text and graphic elements
      in the particular sequence required by the DVD-Video standard. This
      process, sometimes referred to as "multiplexing," produces a finished
      DVD-Video disc image that can then be recorded to a recordable DVD
      disc, or to the particular tape format that can be read by the
      mastering systems at the replication plant that actually "cut" the
      disc master using high-powered lasers.

     DVD Creator/Fusion is sold in many different configurations. Our list
prices range from entry level Fusion systems at $4,000 to $55,000 for a full
Creator configuration (again, our prices do not include host computers, disk
storage or other peripheral devices). Customers can purchase upgrade options
for any version to increase the functionality of their systems. Typically,
customers will spend (including our products, plus typical host computer,
storage and peripherals) around $50,000 for their DVD Creator system and
$20,000 for their DVD Fusion system. Please remember that revenue reported in
our financial statements is usually based on the price we receive from dealers
net of dealer commissions, and is thus lower on average than indicated by these
illustrative prices, which are based on end user list prices.

     DVD-Audio

     Version 1.0 of the DVD-Video specification was published in August of
1996, and players were introduced into various regions of the world during late
1996, 1997 and 1998. At about the same time the DVD-Video specification was
being finalized, the DVD Forum (the standards-setting industry association for
DVD) formed a working group to develop a DVD-Audio format, intended to be a
sister format to DVD-Video, but to emphasize more audio features.

     The DVD-Audio working group spent more than three years developing the new
DVD-Audio specifications in close collaboration with the major record music
companies. The DVD Forum released Version 1.0 of the new DVD-Audio
specification in April 1999. The first commercially released players compatible
with the new format became available in late 1999. We announced support for
this new specification in the fall of 1998, and began delivery of the first
software packages supporting preliminary and limited DVD-Audio authoring early
in 1999 as part of our DVD Creator product line. We introduced new releases of
DVD-Audio support on a phased release basis during the balance of 1999 working
closely with player manufacturers and early DVD-Audio content publishers.

     At this time the outlook for the DVD-Audio format is unclear. While some
amount of title production is underway, and while a limited number of DVD-Audio
compatible players are available in major market areas, the ultimate success of
the format will depend on acceptance by consumers of the format and we are
unlikely to know this for one to two more years.

        The Daikin Products

     On February 28, 2001 we announced an agreement with Daikin to acquire
their professional DVD authoring tool business. Under the terms of that
agreement we acquired a number of Daikin products including Scenarist and
ReelDVD, as well as the technology underlying those products. A number of
Daikin employees based in North America joined our company in early March.
Since the announcement, engineering for the Daikin products has been continued
by a team of Daikin engineers based in Osaka, Japan. We anticipate that support
for the Daikin products will be transferred to Sonic's development organization
in Novato by the end of the summer of 2001. We also anticipate that one or more
of the Daikin engineers will join our organization on a permanent basis. Since
the announcement of the agreement, a sales and marketing unit of Daikin,
located

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in Tokyo, Japan, has served as our exclusive distributor for the former Daikin
products in Japan. If you are interested in learning more about the other terms
of this transaction, please see our reports on Form 8K and Form 8K/A filed with
the Securities Exchange Commission, dated March 14 and May 14, 2001,
respectively.

     Scenarist

     Scenarist is a software product for DVD-Video authoring. Scenarist is
designed as a tool for "Hollywood" video professionals. Scenarist gives
authoring professionals a great degree of control over the interactivity and
feature set of DVD titles they produce. Scenarist also offers extensive
"scripting" capabilities that can be used by DVD-Video production facilities to
automate much of the work involved in producing multiple versions of the same
title. For example it can be used on a movie release on DVD-Video that will be
released in different parts of the world with different language audio and
subtitle tracks. It can also be used in producing various DVD-Video titles that
share a common "look and feel," for example, a set of class movie titles being
released as part of a series.

     First released in 1996, Scenarist was the first commercially available
DVD-Video authoring tool. It enjoys significant acceptance among high end
authoring facilities. Because Scenarist's formatting engine has the longest and
broadest experience in the industry, the product is acknowledged by many
professionals as the DVD-Video production industry's "benchmark" for stable
production of standard DVD-Video titles.

     Scenarist originally was released for use on computers manufactured by
Silicon Graphics running the Irix operating system. The current version of
Scenarist is intended for use on the Windows operating system.

     In rough terms, Scenarist is targeted at the upper end of the market
targeted by DVD Creator. Since the introduction of the product in 1996,
approximately 950 copies of Scenarist have been sold.

     We plan to continue to develop and enhance Scenarist as part of our
overall professional DVD strategy, and we plan to include the existing users of
Scenarist among our customers for future offerings.

     ReelDVD

     ReelDVD is a software product targeted at video professionals who are not
experts in the DVD-Video specification but who need significant flexibility in
utilizing the features of the DVD-Video specification. Roughly speaking,
ReelDVD targets the same video professional customer as DVDit!-PE or DVD
Fusion. ReelDVD is designed for use on the Microsoft Windows Operating System.
ReelDVD was introduced by Daikin in 2000. Since its introduction approximately
1,450 copies of ReelDVD have been shipped.

     We plan to continue to develop and enhance ReelDVD and to integrate sales
and distribution for ReelDVD with our other professional DVD sales efforts.

        Professional DVD Market and Strategy

     The Market for Professional DVD Production

     We divide the professional DVD production market into three segments:

   .  "Hollywood" Segment--This segment includes facilities that prepare
      film and video material for mass publication on DVD-Video discs. It
      includes:

      -- film and television studios,

      -- production companies and other content owners, and

      -- top flight independent video post production facilities which
         provide services to such content holders.

   Customers in this segment tend to cluster in major film and video product
   centers including Hollywood/Los Angeles, New York City, Chicago, London,
   Paris, Tokyo, Taipei, etc. Customers in this

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   segment demand the very highest quality in terms of processing output,
   strict adherence to standards, and are very concerned with the overall
   efficiency of production since projects are often produced on tight
   schedules. We estimate that there are a few thousand facilities and
   organizations in this segment worldwide.

   .  "Corporate" Segment -- Customers in this segment prepare DVD-Video
      discs for publishing a variety of kinds of information for sales,
      training, and other communications purposes. The segment includes:

      -- "in-house" departments of corporate, industrial, non-profit or
         educational organizations, and

      -- independent facilities who specialize in assisting such
         organizations in preparing such material.

   Customers in this segment are typically somewhat more budget constrained
   than customers in the "Hollywood" segment. In certain instances, however,
   production values and budgets equal or even exceed those typically
   encountered in the Hollywood segment. They tend to be geographically more
   dispersed. While efficiency of production is a key requirement of such
   customers, compatibility with other, existing recording and post-
   production equipment is a major concern of customers in this segment. This
   segment is only now beginning to adopt DVD, though given the spread of
   DVD-ROM in the personal computer industry, many industry observers predict
   rapid growth in the use of DVD in this segment. We estimate that there are
   potentially more than 100,000 facilities and organizations in this segment
   on a worldwide basis.

   .  "Multimedia" Segment -- This segment includes developers of multimedia
      entertainment and educational titles intended for a mass audience. Many
      of the organizations in this segment previously were involved in the
      production of CD-ROM, CD-I and computer based interactive entertainment
      or educational titles. Customers in this segment tend to use DVD in
      conjunction with specialized computer software and accordingly their
      needs are more varied than those in the other segments. While
      relatively few organizations in this segment have moved to DVD,
      industry observers report a high level of interest in the DVD format.
      We estimate that there are approximately 15,000 organizations that
      might ultimately become involved in DVD-based production in this
      segment.

    As of March 31, 2001 we have shipped more than 2,510 DVD Creator systems
(including DVD Fusion systems) to customers in various locations around the
world.

    Competition

    The DVD-Video format has generated significant interest among professional
system suppliers. A number of companies currently provide MPEG-2 video
encoding capabilities, audio encoding capabilities and authoring systems for
the professional user. We believe that more companies will participate in this
market in the future.

    A number of companies compete with all or part of our DVD Creator
offering. Our competitors include:

<TABLE>
             <S>                     <C>
             Apple Computer          Mitsubishi
             C-Cube Microsystems     Optibase
             Digital Vision          Philips
             Dolby Laboratories      Pinnacle
             Intec                   Pioneer
             Lucent                  Sony
             Matsushita (Panasonic)  Spruce Technologies
                                     Toshiba
</TABLE>


                                       8
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     A number of these companies have financial or organizational resources
significantly greater than ours and/or greater familiarity with certain
technologies involved in DVD premastering solutions.

     Strategy

     We expect that our professional DVD business will account for a
significant portion of our overall business in the future. Our DVD strategy
will continue to be based on the following elements:

   .  Focus on Professional Applications -- Our DVD product and service
      offerings are focused on video and audio professionals whose primary
      concern is producing the highest quality DVD discs, in complete
      compliance with worldwide standards, with a high level of efficiency.
      We will continue to evolve DVD-related premastering tools that are
      fully compatible with "industry-standard" input formats and typical
      professional video and audio equipment sets.

   .  High Performance Tools -- Our DVD tools will offer professional users
      the highest levels of performance, both in terms of power and
      sophistication of processing, and in terms of maximizing production
      efficiency.

   .  Flexible Configurations -- Because we market to a wide range of
      professional customers, we have engineered DVD Creator as a
      "workgroup" solution incorporating modular audio, video and authoring
      subsystems to make it easy for facilities to re-arrange DVD workflow
      quickly, and to comply easily with changing demands of their
      customers. We plan to continue to implement this philosophy in future
      DVD product offerings.

   .  Range of Product Offerings -- DVD has a number of potential uses,
      including applications in corporate and industrial settings, as well
      as in delivery of mass entertainment such as feature films, videos,
      and recorded music. We plan to evolve each element of our DVD
      premastering tool set -- video, audio and authoring -- to specifically
      address the specialized needs of such emerging segments.

        SonicStudio

     A SonicStudio digital audio workstation consists of:

   .  one or more of our audio signal processing cards installed on a
      Macintosh personal computer;

   .  one or more outboard interface boxes (which contain various styles of
      professional interface connections used to link the workstation to
      other audio devices in the studio); and,

   .  extensive applications software.

     Applications for SonicStudio

     Our customers use their SonicStudio systems to manipulate audio, applying
a number of processes to digital sound to prepare it for final release. Some of
these processes are quite specialized and technical. To give you a sense of the
capabilities of our workstations, here are some of the tasks typically
performed using SonicStudio workstations:

   .  Editing -- SonicStudio permits very precise editing of sound -- the
      process by which pieces of sound are combined to create a single
      resulting sound so that the existence of the original individual
      pieces is imperceptible to the listener.

   .  EQ -- SonicStudio can be used to equalize, or EQ, the sound, a process
      by which certain frequencies are emphasized or de-emphasized. EQ is
      similar in concept to manipulating the bass and treble controls on a
      consumer audio system, but with much greater precision and
      sophistication.

                                       9
<PAGE>

   .  Mixing -- SonicStudio can be used to mix or combine together two sound
      recordings into one. Mixing is often used in professional audio work
      because it is more convenient to record individual elements at
      different times and under different conditions. The individual
      elements or tracks are combined or mixed together to produce the
      resulting sound used in release.

   .  Noise Reduction -- We offer NoNOISE(R) as an option to SonicStudio.
      NoNOISE is a suite of software tools which permits users to remove
      unwanted noise from recordings. NoNOISE has been used extensively by
      audio professionals, particularly to re-issue older recordings on
      Compact Disc, and to clean up noisy location sound tracks for film and
      broadcast video work. In 1997, our company was honored with a
      technical Emmy(R) award for NoNOISE.

     Customer Segments for SonicStudio

     There are three major segments of SonicStudio customers:

   .  Mastering -- customers in this segment use our products to prepare
      music recordings for release to consumers, primarily on Digital Audio
      Compact Discs.

   .  Broadcast -- customers in this segment use our products to prepare
      audio for broadcast on radio.

   .  Sound-for-Picture -- customers in this segment use our products to
      prepare audio tracks used with film or video programming.

     SonicStudio Customers

     We have supplied SonicStudio workstations to many professional audio
facilities around the world. As of March 31, 2001, more than 4,620 SonicStudio
systems had been shipped to customers since the product was first introduced in
1990.

     SonicStudio Configurations

     We offer SonicStudio in a variety of configurations, and with various
hardware and software options. A customer could purchase a SonicStudio HD (the
current version of SonicStudio) system configured for basic two channel CD
premastering for approximately $9,000. A customer would pay approximately
$22,000 for a fully-featured SonicStudio HD system configured for NoNOISE sound
restoration. Please remember that we do not include the cost of the personal
computer or peripheral devices in our pricing. Remember also that revenue as we
report it on our financial statements is usually based on the net price we
receive from dealers, and is thus lower on average per system than indicated by
these illustrative prices, which are based on end user list prices.

     Competition

     We encounter competition from a number of companies when selling
SonicStudio. We compete with companies offering traditional analog production
tools, digital audio recording tools, digital audio processing devices, and
digital audio workstations. The key elements of competition include: product
features, cost effectiveness, product quality, customer support, and marketing
and sales.

     Many of our competitors have greater financial, technical and marketing
resources than we do. Traditional professional audio competitors, such as Japan
Victor Corporation (JVC), Otari Corp., Sony Corporation and Studer AG (a
division of Harmon Industries), sell analog as well as digital systems. A
number of competitors supply digital audio workstations including Digidesign (a
division of Avid Technology), Fairlight, Studio Audio and Design, Ltd. (Sadie),
WaveFrame, Dalet, DSP Media, Spectral Design, Augan and others. Our products
compete also with various kinds of single function digital audio processing
devices. For example, noise reduction modules from Cambridge Audio Research
compete with the NoNOISE option for SonicStudio.

                                       10
<PAGE>

     Strategy

   .  Our strategy with SonicStudio is to continue to offer products that
      enhance professional productivity while meeting the specific needs of
      each segment of our target markets.

     Consumer and Prosumer DVD Authoring Products

        DVDit!

     In April 1999 we introduced our DVDit! product line. DVDit! is a highly
simplified DVD-video authoring tool. We announced two versions of DVDit! -- a
Standard Edition ("SE") and a Limited Edition ("LE"). We began shipping DVDit!
LE in September and DVDit! SE in December, 1999. DVDit! LE carries a suggested
retail price of $199; DVDit! SE carries a suggested retail price of $499.

     In April, 2000 we introduced a new addition to the DVDit! product line --
Sonic DVDit! Professional Edition ("PE"). DVDit! PE increases DVDit!'s reach
with professional functionality previously found only on authoring systems
costing significantly more. DVDit! PE carries a suggested retail price of $999.
Shipments of DVDit! PE began in June 2000.

     DVDit! Customers

     DVDit! is intended to address the needs of a broad range of customers who
wish to author DVD-Video discs. Among DVDit!'s end user customers are:

   .  Consumers -- Individuals who use DVDit! to make DVD-Video discs from
      home videos and the like for their personal enjoyment. We believe that
      this group of customers demands software that is easy to learn, and is
      reasonably priced.

   .  "Prosumers" -- The term "prosumer" describes both video enthusiasts
      who make a significant investment of time and money in producing and
      preparing amateur videos, and professional and business people who use
      video in their work, but for whom video production is not a primary
      business activity. Compared to consumers, this customer group tends to
      be less price sensitive, and more concerned about a rich feature set,
      but is unlikely to have deep knowledge of DVD-Video.

   .  "Desktop Professionals" -- This group of customers resembles very
      closely the professional customers we described in discussing DVD
      Creator, except that they typically do not have frequent or constant
      use for DVD-Video authoring tools.

     Trends Favoring DVDit!

     We introduced DVDit! to take advantage of the following trends:

   .  Proliferation of MPEG Video -- Due to certain introductions by chip
      and software makers, relatively high quality MPEG encoding systems are
      becoming widely available at prices ranging down to a few hundred
      dollars at retail.

   .  Availability of Lower Cost DVD Recording -- Until recently, DVD
      recorders were relatively highly priced. In early 2001, the first of a
      new generation of recorders was introduced by Pioneer at "street"
      prices under $1,000. We anticipate a number of other manufacturers
      will introduce DVD recorders during the rest of 2001, and that prices
      for the recorders will decline to $500 and below, eventually becoming
      as cheap as current day CD+RW recorders (which currently are available
      for under $200).

   .  Ubiquitous Digital Video -- Relatively high quality digital video
      camera/recorders based on the DV format were introduced in the past
      three years aimed at professionals as well as consumers. Prices for
      consumer DV cameras began declining below $1,000 during 2000.
      Virtually every

                                       11
<PAGE>

      manufacturer of professional and prosumer video editing systems is
      intending to release DV compatible systems in 2001 as well.

   .  Rapid Growth in DVD Playback Units -- By the end of 1998, over ten
      million DVD-Video playback units (including both set-top players and
      DVD-equipped multimedia PCs) had been installed worldwide, according
      to industry sources. By the end of 1999, this installed base had grown
      to over 40 million and by the end of 2000 the installed base grew to
      over 80 million. By the end of 2001 it is forecast to grow to as many
      as 150 million units.

     Distribution for DVDit!

     Because DVDit! is aimed at a broader market than our traditional
professional products, we are building a distribution capability for it. There
are three elements to this effort:

   .  We are entering into "bundling" arrangements with various other
      companies in which copies of DVDit! are included or "bundled" with
      shipments of those companies' products. These companies (we refer to
      them as "OEM Partners") are motivated to include our software as a
      value-added offering for their customers. We are motivated to enter
      into bundling arrangements because they generate revenue for us as
      well as create a large installed base of customers to whom we can sell
      upgraded or enhanced versions of our products. To facilitate such
      bundling arrangements we have designed different versions of DVDit!
      offering different levels of functionality so that we can bundle the
      less functional versions. Currently we are shipping three such
      versions--DVDit! LE ("Limited Edition"); DVDit! SE ("Standard
      Edition"); and DVDit! PE ("Professional Edition").

   .  We have initiated a web-based retail store for our DVDit! products.
      Our web store is intended both to meet retail demand for our DVDit!
      products as well as to service upgrade orders for our products, in
      particular, the upgrade orders which derive from bundle shipments by
      our OEM partners.

   .  We are adding dealers and distributors for DVDit!, some of whom
      already carry some of our professional products, but many of which do
      not, targeting dealers and distributors specializing in digital video
      applications as well as those who participate in the broader personal
      computer marketplace.

     Building distribution for DVDit! will be a time-consuming and expensive
process. Since this is a new kind of product for us, there is significant risk
that our efforts, or at least some of them, will not be successful.

     DVDit! OEM Partners

     As mentioned above, we have implemented a bundling distribution strategy
for DVDit! Our current OEM partners include:

<TABLE>
             <S>                <C>
             Aplix              Matrox
             Avid Technologies  Media 100
             Canopus            NEC
             Compaq             Panasonic
             Dazzle             Pioneer
             Intervideo         Sigma Designs
             IO-Data            Sony
             Margi
</TABLE>

     Competition

     We have encountered some competition to DVDit! since its introduction. We
also believe that a number of companies have or will introduce products that
compete directly or in part with DVDit! in the future. Competitors who have
announced or are delivering products that compete with our products include
MedioStream, MGI, Pinnacle, Roxio, Spruce Technologies (now part of Apple
Computer, see below) and Ulead. In addition, other companies with greater
financial and technological resources may be interested in entering the growing
consumer business for DVD creation.


                                       12
<PAGE>


     In April 2000, Apple Computer announced the acquisition of the DVD
authoring business of Astarte Gmbh. Prior to the acquisition, Astarte sold a
DVD authoring system that competed primarily with our DVD Fusion product. In
January 2001, Apple announced two new DVD authoring products, which we presume
are based on Astarte's technology. The first product, iDVD, is intended for
consumer users and we believe will compete with MyDVD and DVDit! The second
product, DVD Studio Pro, is intended for professional users, and we believe
will compete with DVDit! PE, DVD Fusion and ReelDVD. Apple also announced the
availability of aggressively priced DVD recorders with certain models of the
Macintosh personal computer. More recently, Apple has announced the upcoming
availability of iDVD2, which adds new, attractive functionality to the iDVD
product. Also, Apple recently purchased Spruce Technologies, a long-standing
competitor of ours in the professional DVD market. While it is unclear to us
what Apple intends to do with the assets it acquired from Spruce, it is quite
likely that this acquisition will bolster Apple's DVD technology base and make
it more difficult for our products to compete with theirs.


        MyDVD

     In late 2000 we announced MyDVD, a DVD-video authoring product targeted at
consumer applications and carrying a suggested retail price of $99. Shipments
of MyDVD started in November 2000. The initial version of the product resembled
DVDit! (but with a simplified feature set and user interface).

     We plan to produce a new version of MyDVD in the summer of 2001 with a
significantly modified user interface and a feature set specifically designed
for consumer use. Our belief is that as DVD recorders become widely available
in late 2001 and 2002, consumers will begin to utilize DVD recording for a
number of purposes, such as recording favorite home videos, recording favorite
video broadcasts, creating highly convenient and portable copies of videos
downloaded from the internet, and for copying videos published on VHS cassette
or DVD./2/

     We anticipate that MyDVD will become an increasing part of our business
during the latter half of calendar 2001 and throughout 2002. We also anticipate
that competition for MyDVD will be severe and that we will confront competitors
with expertise and resources significantly greater than ours.

     Technology Licensing Products

     In the past two years we have begun to market products that permits other
companies to build software products of their own. At the current time we have
two such software offerings: "AuthorScript" and "ATL" (ATL was acquired as part
of the Daikin acquisition). In the following discussion, "AuthorScript" should
be taken to include both products.

     AuthorScript is designed to make available to software product developers
Sonic's "back-end" engines for producing DVD-Video discs (and related formats
such as Video CD and Super Video CD). In AuthorScript we include the same
processing software that underlies the authoring subsystems we provide in DVD
Creator, DVD Fusion, DVDit! and MyDVD. We package this software with an
Application Programmer's Interface ("API"), that is a top level mechanism
permitting other companies' software engineers easily to access our processing
technology.

     We believe that AuthorScript will be both a revenue source and a point of
strategic leverage for our company. Once a software product is developed using
one back-end technology, it is quite difficult and possibly de-stabilizing to
switch to another offering. We've consciously packaged AuthorScript in a way
which is attractive to software developers, and we license it to other
companies on terms that we believe are very reasonable. We anticipate that this
will create a stable and growing base of AuthorScript licensees as DVD
recordable technology spreads.
--------
     /2/We do not advocate violation of copyright laws by our customers. None
of our products contain software designed to circumvent the operation of
encryption or other protection systems (for example the "CSS" encryption system
commonly used by DVD-Video publishers to prevent digital copying of their
published video content.

                                       13
<PAGE>

     OEM Customers; Sales Concentration

     We generally market our products to end users as Sonic Solutions products.
However, from time to time we have concluded various "OEM" agreements with
other companies (in addition to those listed above for DVDit!), in which those
companies included our products as part of their product offerings. At the
present time we have one significant OEM relationship with Discreet Logic, a
division of Autodesk, in which we provide audio subsystems for use with some of
their high end video effects and editing workstations. Sales to Discreet
amounted to 11% and 7% of our total revenues in the fiscal years ended March
31, 2000, and 2001, respectively. Although we consider our relations with
Discreet to be good, we anticipate that at some point in the next two fiscal
years, Discreet may implement changes to its product line replacing or
eliminating our subsystems.

     During the fiscal years ended March 31, 2000 and 2001, sales to our
Japanese distributor, Sanshin Electronics Company, amounted to 10% and 12%,
respectively, of total revenues. Sanshin is a distributor of all of our
products.

     Apart from sales to Discreet and Sanshin, no other single customer
accounted for more than 10% of our total revenue during each of the past three
fiscal years.

                               COMPANY OPERATIONS

     Marketing, Sales and Distribution

        Marketing and Product Management

     Our marketing organization plans and manages development of our products
and manages promotion of them in the market. We currently have seven employees
in marketing, all based in our headquarters office in Novato, California,
including product marketing managers, and marketing communications and design
professionals.

        Field Sales Force

     We sell our professional workstation products through our field sales
force in combination with a network of professional audio/video dealers. We
currently employ 25 people in our field sales organization. Sales personnel are
based in our headquarters office in Novato, California as well as at our
offices in London (covering Europe) and in Tokyo (covering the Pacific Rim). We
have other sales personnel based out of home offices in Chicago, Los Angeles,
Florida, Milwaukee, Boston, Taipei and New York City. Our field sales force
includes sales managers and sales engineers. Most of our field sales personnel
operate under compensation arrangements in which a substantial portion of their
compensation is contingent upon performance relative to revenue targets.

     Although all members of our sales organization are familiar with all of
our products, some of our sales personnel focus on DVD Creator, some on DVDit!,
and some on SonicStudio.

        Dealers

     The vast majority of our workstation sales involve one of our dealers.
Dealers play an important role in our sales and support efforts. They stimulate
demand in their regions, they prospect for and qualify potential new customers,
they give product demonstrations, they close sales, and they assist in post-
sale installation, training and support. Dealers very often sell peripheral
equipment along with our products so that customers can obtain a complete
workstation configuration from one source.

     We have dealers in most areas of the world. We generally do not grant
contractual exclusivity to our dealers, though as a matter of practice,
depending on the dealer's territory and competence, we may maintain only one
dealer in a particular region.

                                       14
<PAGE>

     Recruiting and maintaining dealers can be a difficult process. Because our
products are sophisticated, our dealers need to be technically proficient and
very familiar with professional audio and video production work. Dealer
organizations sometimes have limited financial resources, and may experience
business reversals for reasons unrelated to our product lines. The attractive
dealers in a region may be carrying competing products.

     Our dealers are specialized to some extent by product line. Many
SonicStudio dealers do not carry DVD Creator products, and likewise many DVD
Creator dealers do not carry SonicStudio products. DVDit! dealers often do not
carry our professional product lines. Some dealers carry two or all three of
our product lines. The following table shows our current dealer count by
product line and region of the world:

<TABLE>
<CAPTION>
      ------------ -------------- -------------- -------------- --------------
                    SonicStudio    DVD Creator       DVDit!         Total
      ------------ -------------- -------------- -------------- --------------
      <S>          <C>            <C>            <C>            <C>
      Americas           19             37             14             42

      Europe             40             37             16             44

      Pacific Rim        17             24             9              33
      ------------ -------------- -------------- -------------- --------------
</TABLE>

In the above chart, "Total" is less than the sum of columns because one dealer
organization sometimes carries more than one of our product lines.

     Employees

     At March 31, 2001, we employed 96 full-time-equivalent employees,
including the following:

<TABLE>
<CAPTION>
            #
        Employees  Function
        --------- ------------
        <C>       <S>
           50     Marketing, Sales and Customer Support
           32     Software and Hardware Engineering
            5     Manufacturing
            9     Administration and Finance
</TABLE>

     To a very great degree our success in the future will depend on our
ability to recruit, retain and motivate engineering, technical, sales,
marketing and operations professionals. Recently the U.S. labor market has been
quite tight, and demand for technology professionals has been very strong. To
make matters worse, our company participates in what is perceived to be a "hot"
area of the "high tech" industry. We have found that recruiting high caliber
individuals is difficult and have had to expend considerable efforts in this
area.

     No labor unions represent any of our employees. We have never experienced
a work stoppage, slowdown or strike. We believe that our employee relations are
good.

     Customer Support

     Customer support is important to professional users. This is why we offer
our customers the SonicCare(TM) maintenance program. Customers purchase annual
SonicCare service contracts from us that provide for:

   .  ongoing software upgrades,

   .  telephone support,

   .  "swap" replacement hardware in case of hardware failure, and

   .  preferential access to new products and new versions of software.

                                       15
<PAGE>

     Customers typically add a SonicCare option to their initial system
purchase and a significant portion of customers renew SonicCare yearly.

     To administer SonicCare, we employ a staff of product support specialists
at our Novato headquarters and in our field offices. We provide unlimited
telephone support during scheduled support hours to all customers under
SonicCare. Customer support calls also provide us with an important means of
understanding customer requirements for future product enhancements. We also
undertake customer calling programs in which customers are contacted by a
customer support representative to assess their level of satisfaction and to
acquaint them with new product offerings.

     Research and Development

     Our research and development staff includes a total of 32 hardware and
software engineers and technicians and technical specialists. We tend to hire
research and development personnel with backgrounds in digital audio signal
processing, digital video image processing, distributed networking and computer
systems design. Since the Daikin acquisition, engineering for the Daikin
products has been continued by a team of Daikin engineers based in Osaka,
Japan. We anticipate that support for the Daikin products will be transferred
to Sonic's development organization in Novato by the end of the summer of 2001.
We also anticipate that one or more of the Daikin engineers will join our
organization on a permanent basis. Our development team exhibits a number of
technology capabilities including the following that we believe are
particularly important in light of our strategy and market position:

   .  Digital Signal Processing -- This is the term used to describe the
      sophisticated mathematical processing by which aural and visual
      signals are processed in computer-based settings. Our engineering team
      includes individuals experienced at providing sophisticated digital
      signal processing solutions to meet the quality and performance
      requirements of audio and video professionals.

   .  Real Time Architectures -- Our engineers are experienced in dealing
      with the requirements of high bandwidth, real time data in computer-
      based settings. We believe that has helped us to develop products that
      provide cost effective solutions for professional applications.

   .  Craft Familiarity -- Our engineers are experienced in the needs and
      work patterns of audio, film and video professionals. This helps us
      develop products which can be adopted more quickly by creative audio
      and video professionals.

     Backlog

     We schedule our production of products based on our projections of
customer demand, and we generally ship products within a few days of acceptance
of a customer purchase order so at any given time we have little or no order
backlog. With few exceptions, customers may cancel or delay orders with little
or no penalty. Thus, even to the extent that we have backlog, we do not think
that it is a reliable indicator of future revenue levels.

     Manufacturing and Suppliers

        How We Manufacture

     We have typically contracted with various electronics manufacturing and
assembly houses to manufacture the hardware components of our products. Most of
these contractors are located in the San Francisco Bay Area. Our staff performs
some assembly, integration and testing at our Novato, California headquarters.

                                       16
<PAGE>

        Sole-Sourced Components

     We utilize a number of components in our products that are available from
only a single source. We purchase these sole-source components from time to
time, that is, we do not carry significant inventories of these components and
we have no guaranteed supply agreements for them. We have experienced shortages
of some sole-sourced components in the past. We are likely to experience
similar shortages at some point in the future. Such shortages can have a
significant negative impact on our business.

        Outsourcing

     Over the past three years, we have shifted our hardware manufacturing to
an "outsourcing" approach. Under outsourcing we contract with a single partner
organization which takes responsibility for procuring parts, and for
manufacturing them into complete, tested assemblies which are then released to
us according to our instructions. Our current outsourcing arrangement is with
Arrow Electronics, Inc. We believe that outsourcing provides us with increased
flexibility to increase or decrease production, and allows us to operate our
business with substantially reduced inventories thereby reducing financing
requirements. During the 2001 fiscal year, we produced approximately 90% of our
hardware via outsourcing. We plan to continue this outsourcing approach.

     While we believe that outsourcing is advantageous for Sonic, it makes us
very dependent on a single production source. Financial, operational, or supply
problems encountered by our outsourcing partner or its sub-contractors could
seriously hamper or interrupt our ability to manufacture, sell and ship our
products.

     Proprietary Rights

        General Approach

     We rely on a combination of the following to protect our proprietary
rights in our products:

   .  patents,

   .  trade secrets,

   .  copyright law,

   .  trademark law,

   .  contracts, and

   .  technical measures

     We generally sell our products subject to standard purchase and license
agreements that restrict unauthorized disclosure of our proprietary software
and designs, or copying for purposes other than the use intended when the
product is sold.

        Patents

     We have applied in the United States for patents covering certain of our
technologies and will probably apply for more in the future. We will probably
also apply for foreign patents. We have been granted U.S. Patent No. 5,812,790:
"Variable encoding rate plan generation" covering certain aspects of MPEG-2
Video encoding technology; and U.S. Patent No. 6,047,356: "Method of
dynamically allocating network node memory's partitions for caching distributed
files" covering a distributed file system, and may be granted additional
patents in the future. Of course, we can't be sure that our current or future
patent applications will be granted. Nor can we be certain that we can
successfully prosecute claims against others based on our patents, or defend
our patents against the claims of others. We believe that becoming involved in
patent litigation can be quite expensive and is highly uncertain in terms of
outcome.

     The status of patent protection in our industry is not well defined
particularly as it relates to software and signal processing algorithms. In the
past several years there seems to have been a trend on the part of

                                       17
<PAGE>

patent authorities to grant patents in audio and video processing techniques
with increasing liberality. We believe that it is quite possible that some of
our present or future products may infringe issued or yet to be issued patents.
It is almost certain that we will be asked by patent holders to respond to
infringement claims. If such patents were held to be valid, and if they covered
a portion of our technology for which there was no ready substitute, we might
suffer significant market and financial losses.

     Our products involve the use of certain technologies in which the overall
patent situation is acknowledged by most industry observers to be very unclear.
For example, patent coverage and license availability for MPEG-2 video encoding
and decoding is currently quite uncertain. While one group of companies has
attempted to create a single licensing entity for this technology (called
"MPEG/LA"), not all relevant patent holding companies have joined this entity.
We plan to continue to monitor this area and to act prudently to avoid needless
litigation and entanglements while continuing to offer our products.

        Trade Secrets

     We rely to a great extent on the protection the law gives to trade secrets
to protect our proprietary technology. Our policy is to request confidentiality
agreements from all of our employees and key consultants, and we regularly
enter into confidentiality agreements with other companies with whom we discuss
any of our proprietary technology.

     Despite trade secret protection, we cannot be sure that third parties will
not independently develop the same or similar technologies. Despite contract
and procedural measures, we believe that it is practically impossible to guard
against unauthorized disclosure or misuse of technology to which we have
granted third parties access. We also have significant international
operations. Many foreign countries, in law or in practice, do not extend the
same level of protection to trade secrets as does U.S. law.

        Current Infringement Issues

     In the past we have been advised of various infringements of patents and
trademarks. We do not believe that in any such situation currently known to us
we are at risk of material loss or serious interruption of our business. We may
be incorrect in this assessment, of course.

     Geographic Exposure

     We have for many years realized a significant proportion of our revenues
from sales outside the United States. In some fiscal quarters non-U.S. revenue
has constituted as much as 52% of our revenues. In the fiscal year ended March
31, 2001, 47% of our revenues came from sales outside the United States. We
believe that it is quite likely that at some points in the future an even
higher percentage of our sales will be generated outside the United States.

     Because of our foreign sales, we are exposed to a number of factors that
would not be relevant if our sales were largely made within the United States.
Currency movements which make the U.S. dollar stronger relative to foreign
currencies can effectively raise the price of our products to foreign
customers, reducing demand for our products. Import restrictions, tariffs, and
foreign product regulations (particularly those dealing with product safety and
RF emissions) may also impede our ability to do business in foreign countries.

Item 2. PROPERTIES

     Our principal administrative, sales and marketing, research and
development and support facility is located at 101 Rowland Way in Novato,
California and consists of approximately 30,000 square feet under a lease which
expires in 2006.

     We also have sales offices located in London and Tokyo.

Item 3. LEGAL PROCEEDINGS

     We are not a party to any legal proceedings.

                                       18
<PAGE>

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

     During the fourth quarter of the fiscal year ended March 31, 2001, we did
not submit any matters to a vote of our security holders.

                                       19
<PAGE>

                                    PART II

Item 5. MARKET FOR SONIC SOLUTIONS' COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

     Our common stock is listed on the Nasdaq National Market. As of March 31,
2001 there were approximately 175 registered holders of our common stock. We
believe, however, that many beneficial holders of our common stock have
registered their shares in nominee or street name, and that there are
substantially more than 175 beneficial owners. The low price and high price of
our common stock during the last eight quarters are as follows:

<TABLE>
   -----------------------------------------------------------------------------
<CAPTION>
                                                            Low Price High Price
                                                            --------- ----------

   -----------------------------------------------------------------------------
    <S>                                                     <C>       <C>
    Quarter ended June 30, 1999............................  $3.875    $ 7.125
    Quarter ended September 30, 1999.......................  $2.000    $ 5.000
    Quarter ended December 31, 1999........................  $1.688    $ 5.313
    Quarter ended March 31, 2000...........................  $3.875    $12.500
    Quarter ended June 30, 2000............................  $3.250    $ 9.250
    Quarter ended September 30, 2000.......................  $1.688    $ 4.469
    Quarter ended December 31, 2000........................  $1.000    $ 3.063
    Quarter ended March 31, 2001...........................  $1.031    $ 2.625
   -----------------------------------------------------------------------------
</TABLE>

     We have not paid any dividends on our Common Stock during the periods set
forth above. It is presently the policy of the Board of Directors to retain
earnings for use in expanding and developing our business. Accordingly, we do
not anticipate paying any cash dividends on the Common Stock in the foreseeable
future.

     In February 2001, we issued 700,000 shares of Series D Convertible
Preferred Stock to Daikin Industries in conjunction with the acquisition of the
DVD business and assets of Daikin. Each share of Series D Convertible Preferred
Stock is convertible into one share of Common Stock. These securities were
exempt from registration pursuant to Section 4(2) of the Securities Act of
1933. These securities were sold to one investor which represented it was
sophisticated and accredited.

                                       20
<PAGE>

Item 6. SELECTED FINANCIAL DATA

     The following selected financial data should be read in conjunction with
the financial statements and related notes thereto and "Management's Discussion
and Analysis of Financial Condition and Results of Operations" appearing
elsewhere in this Form 10-K. The selected financial data presented below under
the caption "Statement of Operations Data" and "Balance Sheet Data" for, and as
of the end of, each of the years in the five-year period ended March 31, 2001
are derived from the financial statements of Sonic Solutions, which financial
statements have been audited by KPMG LLP, independent certified public
accountants. The financial statements as of March 31, 2001 and 2000, and for
each of the years in the three-year period ended March 31, 2001, and the report
thereon, are included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                              Years Ended March 31,
                                        --------------------------------------
                                         1997    1998    1999    2000    2001
                                        ------  ------  ------  ------  ------
                                            (in thousands except share
                                                     amounts)
<S>                                     <C>     <C>     <C>     <C>     <C>
STATEMENT OF OPERATIONS DATA:
Net revenue...........................  15,911  19,881  21,899  20,827  16,519
Cost of revenue.......................   7,432  10,209   9,547   8,992   5,892
                                        ------  ------  ------  ------  ------
Gross profit..........................   8,479   9,672  12,352  11,835  10,627
Operating expenses:
Marketing and sales...................   6,000   7,257   7,216   8,938   8,710
Research and development..............   5,737   6,037   5,137   6,155   5,148
General and administrative............   1,837   1,603   1,556   2,284   2,514
                                        ------  ------  ------  ------  ------
Total operating expenses..............  13,574  14,897  13,909  17,377  16,372
                                        ------  ------  ------  ------  ------
Operating loss........................  (5,095) (5,225) (1,557) (5,542) (5,745)
Other income (expense)................     (96)   (651)   (302)   (249)   (110)
Provision (benefit) for income taxes..      --      --      --     (97)      0
                                        ------  ------  ------  ------  ------
Net loss..............................  (5,191) (5,876) (1,859) (5,694) (5,855)
                                        ======  ======  ======  ======  ======
Basic loss per share..................   (0.69)  (0.76)  (0.21)  (0.56)  (0.47)
Weighted average shares used in
 computing per share amounts..........   7,542   7,761   8,896  10,460  12,402
Diluted loss per share................   (0.69)  (0.76)  (0.21)  (0.56)  (0.47)
Weighted average shares used in
 computing per share amounts..........   7,542   7,761   8,896  10,460  12,402

BALANCE SHEET DATA:
Working capital.......................   6,263   1,164   1,167   4,976     458
Total assets..........................  15,889  12,630  13,765  14,968  11,738
Shareholders' equity..................   8,430   5,418   5,932   8,750   5,455
</TABLE>

                                       21
<PAGE>

     Summarized quarterly financial information for fiscal years 2001 and 2000
is as follows:


<TABLE>
<CAPTION>
                                                  Quarter Ended
                                    ------------------------------------------
                                    June 30  September 30 December 31 March 31
                                    -------  ------------ ----------- --------
                                      (in thousands, except per share data)
<S>                                 <C>      <C>          <C>         <C>
            Fiscal Year
            -----------
2001
Total revenue......................  5,001       4,089       3,378      4,051
Gross profit.......................  3,267       2,467       2,154      2,739
Operating loss..................... (1,204)     (1,863)     (1,522)    (1,156)
Net loss........................... (1,246)     (1,895)     (1,549)    (1,165)
Basic loss per share...............  (0.10)      (0.15)      (0.13)     (0.09)
Weighted average shares used in
 computing per share amounts....... 12,201      12,351      12,351     12,704
Diluted loss per share.............  (0.10)      (0.15)      (0.13)     (0.09)
Weighted average shares used in
 computing per share amounts....... 12,201      12,351      12,351     12,704
Common Stock Price Range:
High...............................  9.250       4.469       3.063      2.625
Low................................  3.250       1.688       1.000      1.031
2000
Total revenue......................  5,591       4,811       5,156      5,269
Gross profit.......................  2,919       2,774       2,996      3,146
Operating loss..................... (1,200)     (1,474)     (1,828)    (1,040)
Net loss........................... (1,154)     (1,517)     (1,933)    (1,090)
Basic loss per share...............  (0.12)      (0.15)      (0.19)     (0.09)
Weighted average shares used in
 computing per share amounts.......  9,476       9,909      10,799     11,656
Diluted loss per share.............  (0.12)      (0.15)      (0.19)     (0.09)
Weighted average shares used in
 computing per share amounts         9,476       9,909      10,799     11,656
Common Stock Price Range:
High...............................  7.125       5.000       5.313     12.500
Low................................  3.875       2.000       1.688      3.875
</TABLE>


                                       22
<PAGE>

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

OVERVIEW; CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT;
CERTAIN ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS

     Our quarterly operating results vary significantly depending on the timing
of new product introductions and enhancements by ourselves and by our
competitors. Our results also depend on the volume and timing of orders which
are difficult to forecast. Because our customers generally order on an as-
needed basis, and we normally ship products within one week after receipt of an
order, we don't have an order backlog which can assist us in forecasting
results. For all these reasons, our results of operations for any quarter are a
poor indicator of the results to be expected in any future quarter.

     A large portion of our quarterly revenue is usually generated in the last
few weeks of the quarter. Since our ongoing operating expenses are relatively
fixed, and we plan our expenditures based primarily on sales forecasts, if
revenue generated in the last few weeks of a quarter do not meet our forecast,
operating results can be very negatively affected.

     We capitalize a portion of our software development costs in accordance
with Statement of Financial Accounting Standard No. 86. Such capitalized costs
are amortized to cost of revenue over the estimated economic life of the
product, which is generally three years. See Note 4 of Notes to Financial
Statements.

     RESULTS OF OPERATIONS

     The following table sets forth certain items from Sonic Solutions'
statements of operations as a percentage of net revenue for fiscal years 1999
through 2001:

<TABLE>
<CAPTION>
                                         Years ended
                                          March 31,
                                      ---------------------
                                      1999    2000    2001
                                      -----   -----   -----
<S>                                   <C>     <C>     <C>
Net revenue                           100.0%  100.0%  100.0%
Cost of revenue                        43.6    43.2    35.7
                                      -----   -----   -----
Gross profit                           56.4    56.8    64.3
Operating expenses:
 Marketing and sales                   33.0    42.8    52.7
 Research and development              23.5    29.6    31.2
 General and administrative             7.0    11.0    15.2
                                      -----   -----   -----
Total operating expenses               63.5    83.4    99.1
                                      -----   -----   -----
Operating loss                         (7.1)  (26.6)  (34.8)
Other expense                          (1.4)   (1.2)   (0.7)
Provision (benefit) for income taxes     --    (0.5)     --
                                      -----   -----   -----
Net loss                               (8.5)% (27.3)% (35.5)%
                                      =====   =====   =====
</TABLE>

     COMPARISON OF FISCAL YEARS ENDED MARCH 31, 2001, 2000 and 1999

     Net Revenue. Our net revenue decreased from $21,899,000 in fiscal 1999 to
$20,827,000 in fiscal 2000 to $16,519,000 in fiscal 2001, representing a
decrease of 5% from fiscal 1999 to fiscal 2000 and a decrease of 21% from
fiscal 2000 to fiscal 2001. The decreases in fiscal 2000 and fiscal 2001 were
primarily due to decreases in sales of our professional audio and DVD systems
which were partially offset by increases in sales of our consumer DVD products,
including DVDit!. Our professional audio and DVD sales decreased approximately
13% in fiscal 2000 and 26% in fiscal 2001. Decreases in our professional audio
and DVD sales were partially offset in fiscal 2001 by sales of Daikin related
products subsequent to our purchase of Daikin's DVD business in late February.
Sales of our consumer DVD products commenced during fiscal year 2000, in fiscal
year 2001 sales of these products increased 35%.


                                       23
<PAGE>


     We anticipate that we will continue to experience declines in sales of our
professional audio and DVD systems, however we anticipate significant growth in
sales of our consumer DVD products in the future.


     International sales accounted for 47%, of our net revenue in each of the
fiscal years 1999, 2000, and 2001. See Note 10 of Notes to Financial
Statements. International sales have historically represented around 50% of our
total sales, and we expect that they will continue to represent a significant
percentage of future revenue.

     Cost of Revenue. Our cost of revenue as a percentage of revenue decreased
from 43.6% of net revenue in fiscal 1999 to 43.2% in fiscal 2000 to 35.7% in
fiscal 2001. The decreases in cost of revenue in fiscal year 2000 and fiscal
year 2001 were primarily due to a shift in sales product mix towards higher
margin consumer DVD systems and to the reduction of hardware as a percentage of
revenue in our professional DVD systems. We anticipate that we will continue to
experience reductions in our cost of revenue, as a percentage of revenue in
future periods, as our shift in the sales product mix continues to the higher
margin software-only products.


     Marketing and Sales. Our marketing and sales expenses increased from
$7,216,000 in fiscal 1999 to $8,938,000 in fiscal 2000 and decreased to
$8,710,000 in fiscal 2001. Marketing and sales represented 33.0%, 42.8% and
52.7% of net revenue for fiscal 1999, 2000 and 2001, respectively. Our
marketing and sales expenses increased in fiscal 2000 primarily due to
increases in salary expenses as a result of an increase in headcount, and
increases in advertising and marketing costs related to our DVD product lines.
Our marketing and sales expenses decreased in fiscal 2001 primarily due to
lower commission expenses. Our marketing and sales headcount increased from
thirty-seven at March 31, 1999 to forty at March 31, 2000 to forty-nine at
March 31, 2001. Dealer and employee commission expenses, as a percentage of net
revenue decreased from 4.7% in fiscal 1999 and fiscal 2000 to 4.4% and fiscal
2001.

     Research and Development. Our research and development expenses increased
from $5,137,000 in fiscal 1999 to $6,155,000 in fiscal 2000 and decreased to
$5,148,000 in fiscal 2001. Our research and development expenses as a
percentage of net revenue were 23.5% in fiscal 1999, 29.6% in fiscal 2000, and
31.2% in fiscal 2001. We capitalize a portion of our software development costs
in accordance with statement of Financial Accounting Standard No. 86. (This
means that a portion of the costs we incur for software development are not
recorded as an expense in the period in which they are actually incurred.
Instead they are recorded as an asset on our balance sheet. The amount recorded
on our balance sheet is then amortized over the estimated life of the products
in which the software is included.) Our research and development expenses
increased in fiscal 2000 primarily due to increased headcount from thirty at
March 31, 1999 to thirty-two at March 31, 2000 and due to consulting expenses
associated with introductions of new products, including our DVDit! product.
Research and development expenses decreased in fiscal 2001 due to reduced
consulting expenses associated with new product development. Headcount remained
consistent at thirty-two from March 31, 2000 to March 31, 2001. Consulting
expenses can fluctuate significantly from period to period depending upon the
status of software development projects and our schedule of new product
introductions.

     General and Administrative. Our general and administrative expenses
increased from $1,556,000 in fiscal 1999 to $2,284,000 in fiscal 2000 to
$2,514,000 in fiscal 2001. These expenses represented 7.0% of net revenue in
fiscal 1999, 11.0% of net revenue in fiscal 2000 and 15.2% of net revenue in
fiscal 2001. Our general and administrative expenses increased in fiscal 2000
primarily due to a charge to bad debt expense of $600,000 which represented an
additional reserve for sales to audio professionals and distributors who are
experiencing liquidity difficulties due to a decline in their business. General
and administrative expenses increased in fiscal 2001 primarily due to an
increase in legal and professional expenses. We expect that general and
administrative expenses may increase as our operations expand.


     Other Income and Expense. Other expense on our statement of operations
includes primarily the net amount of interest or other financing charges we
have incurred due to borrowings. For our 1999, 2000 and

                                       24
<PAGE>

2001 fiscal years, we incurred interest and other financing charges related to
financing agreements we had with entities associated with Hambrecht & Quist, as
well as borrowings under our bank credit line. Other income includes the
interest we earned on cash balances and short term investments.

     Provision for Income Taxes. In accordance with Statement of Financial
Accounting Standards No. 109, we made no provision for income taxes for our
1999 and 2001 years. For the 2000 fiscal year a benefit was recorded (during
the quarter ended June 30, 1999) to reflect the refund due us following the
conclusion of an Internal Revenue Service audit. During the 2001 fiscal year we
exhausted our ability to carryback tax losses resulting from operations in the
fiscal year ended March 31, 1997.

     Liquidity and Capital Resources. In December 1996, we entered into a Loan
and Security Agreement (the "Loan Agreement") with Silicon Valley Bank. The
Loan Agreement, which we sometimes refer to as our "bank credit line," has been
modified or renewed at various times since December 1996. Our bank credit line
expired on March 17, 2001.

     In March, 1998, we renegotiated a previous financing arrangement with
Hambrecht & Quist Guaranty Finance. The agreement we reached involved the
restructuring of $3,000,000 debt into $1,500,000 of Series C Convertible
Preferred Stock (see note 7 of Notes to Financial Statements) and $1,500,000 of
debt. The interest rate on such restructured debt was 7.25% and was due in
October 1999. We filed a Form S-3 Registration Statement under the Securities
Act of 1933 to register the resale of the 461,538 shares of the Company's
Common Stock which underlie the Series C Convertible Preferred Stock issued to
Hambrecht & Quist Guaranty Finance. In connection with the agreement, the
exercise price of 90,000 of the $10.00 warrants issued with the original
arrangement reached in December 1996 was lowered to the fair value of common
stock of $3.25. We accounted for this transaction by revaluing the new
warrants, using comparable assumptions as the original warrant grant, and the
resultant value of $90,000 was amortized over the new loan period. In June,
1998, 90,000 of the $3.25 warrants were exercised on a "net exercise" basis,
and the warrant holder received 29,691 shares of common stock. During the
fiscal years ended March 31, 1999 and March 31, 2000, 167,500 and 292,000
shares of the Preferred Stock were converted into common stock pursuant to this
financing arrangement.

     In October, 1999, we renegotiated a financing arrangement with Hambrecht &
Quist Guaranty Finance. The agreement we reached involved the restructuring of
$1,500,000 debt into 153,846 shares of Series C Convertible Preferred Stock and
$1,000,000 of debt. The interest rate on the restructured debt is 7.25% and the
debt and interest were payable in monthly installments through April 30, 2001.
In connection with this agreement, we issued warrants to purchase 120,000
common shares at an exercise price of $2.50. These warrants expire on April 30,
2006. We also enhanced the conversion rate of Hambrecht and Quist's existing
Series C convertible preferred stock so that each share of Series C convertible
preferred stock is convertible into 1.625 shares of common stock. The
beneficial conversion feature, warrants and new debt were recorded at their
relative fair values. We recorded $345,000 of deferred financing costs
attributable to this finance restructuring with Hambrecht & Quist Guaranty.
This amount is being amortized using the effective interest rate method to
interest expense over the term of the financing facility (18 months). The fair
value of the warrants was estimated using the Black-Scholes option pricing
model and the following assumptions: volatility of .50, risk free interest rate
of 6% and expected life equal to the contractual terms. We filed a Form S-3
Registration Statement under the Securities Act of 1933 to register the shares
of the common stock which underlie the Series C convertible preferred stock and
the 120,000 shares of our common stock which underlie the warrants issued to
Hambrecht & Quist Guaranty Finance.

     In December, 1997, we secured a $7,000,000 equity-based line of credit.
Under this arrangement, we had the right to draw up to a total of $7,000,000 in
cash in exchange for common stock. Pricing of the common stock issued was based
on the market price of our common stock at the time of a draw subject to a 14%
discount and a 4% commission payable in common stock. The availability of the
credit line, and the amounts and timing of draws under the line were subject to
a number of conditions. In January, 1998, we filed a Form S-3 Registration
Statement under the Securities Act of 1933 to register the resale of shares
issued under

                                       25
<PAGE>

this credit line. During the fiscal year ended March 31, 1998, we drew
$1,450,000 from this credit line for which we issued 618,130 shares of common
stock. During the fiscal year ended March 31, 1999, we drew an additional
$2,358,000 from this credit line for which we issued 903,870 shares of common
stock. This facility is no longer available to us.

     On May 20, 1999, we secured a new equity-based line of credit by entering
into a new stock purchase agreement with Kingsbridge. Under this arrangement,
we were able to draw up to $12,000,000 in cash in exchange for common stock.
Pricing of the common stock issued under this arrangement was based on the
market price of our common stock at the time of a draw, discounted by 10% or
12%, depending upon the price of our common stock. The availability of the
credit line, and the amounts and timing of draws under the line were subject to
a number of conditions. On May 27, 1999, we filed a Registration Statement on
Form S-1 to register for resale the shares we may issue to Kingsbridge under
this credit line and on August 12, 1999 the Statement became effective. During
the fiscal year ended March 31, 2000, we drew $7,408,000 from the credit line
for which we issued 1,800,000 shares of common stock. Because of limitations on
the total number of shares that could be issued under this line of credit, this
facility is no longer available to us and was terminated on March 14, 2000.

     On May 4, 2000, we secured a new equity-based line of credit by entering
into a new stock purchase agreement with Kingsbridge. Under the new agreement,
we may sell up to $20,000,000 worth of our common stock, but not to exceed that
number of shares of common stock which equals 19.9% of our outstanding shares.
When we sell shares to Kingsbridge the price per share is set by a formula at a
discount from the market price of our common stock around the time of the sale
to Kingsbridge. That discount ranges from 8% to 12%. Our ability to sell stock
to Kingsbridge is contingent upon a number of terms and conditions, including
for example, continued listing on NASDAQ, effectiveness of a registration
statement, continued accuracy of representations and warranties made to
Kingsbridge and lack of material adverse changes to our business. The quantity
and timing of sales that we are able to make under the Equity Line Agreement
are also limited by the market price and trading volume of our stock. Because
of these limitations at the time we need cash in the future, the equity line
arrangement with Kingsbridge may be unavailable or insufficient to meet our
cash needs. On July 19, 2000, we filed a Registration Statement on Form S-1 to
register for resale the shares we may issue to Kingsbridge under this credit
line and on November 13, 2000 the Statement became effective. During the fiscal
year ended March 31, 2001, we drew $200,000 from the credit line for which we
issued 211,416 shares of common stock.


     Our operating activities have used cash of $124,000 in fiscal year 1999,
$2,628,000 in fiscal year 2000 and $848,000 in fiscal year 2001. During fiscal
year 1999, cash used in operations included a net loss of $1,859,000 including
depreciation and amortization of $2,621,000 and interest expense amortization
of $60,000. Cash used in operations was affected by changes in assets and
liabilities including increases in accounts receivables of 2,187,000,
inventories of $173,000, and other assets of $72,000, offset by increases in
refundable income taxes of $148,000, prepaid expenses of $30,000, accounts
payable and accrued liabilities of $1,044,000, and deferred revenue and
deposits of $282,000. Net accounts receivables increased 69% in fiscal year
1999 or to 72 days outstanding.


     During fiscal year 2000, cash used in operations included a net loss of
$5,694,000 including depreciation and amortization of $2,958,000. Cash used in
operations was affected by changes in assets and liabilities including
increases in inventory of $138,000, prepaid expenses of 138,000, and other
assets of $237,000, and by decreases in accounts payable and accrued
liabilities of $53,000 and deferred revenue and deposits of $94,000. In fiscal
year 2000, net accounts receivables decreased 14%, however days outstanding
increased to 88 days. During fiscal year 2000, we recorded a charge to bad debt
expense of $600,000 which represented a reserve for sales to audio
professionals and distributors who were experiencing liquidity difficulties due
to a decline in their business.


     During fiscal year 2001, cash used in operations included a net loss of
$5,855,000 including depreciation and amortization of $2,025,000 and interest
expense amortization of $132,000. Cash used in


                                       26
<PAGE>


operations was affected by changes in assets and liabilities including an
increase in other assets of $177,000, and a decrease in accounts payable and
accrued liabilities of $50,000, offset by decreases in accounts receivable of
$2,310,000, inventory of $465,000 and an increase in deferred revenue and
deposits of $219,000. In fiscal year 2001, net accounts receivables decreased
10% primarily due to lower revenues which decreased 21%. Inventory levels
improved during the fiscal year, primarily due to better utilization of our
outsourcing arrangement.


     During the fiscal years discussed above, our current ratio has decreased,
primarily due to the increase in our deferred revenue and deposits. In addition
to our operations, we utilized cash during the 1999, 2000 and 2001 fiscal years
primarily to purchase new fixed assets, pay down debt obligations and to
develop and purchase software that was added to capitalized software.


     During the 1999, 2000 and 2001 fiscal years we augmented cash on hand
primarily by drawing on the equity credit lines described above. We cannot
estimate the impact, if any, on the trading price of our common stock in the
event that we sell shares in the future under the equity lines. Future sales
may depress our stock price since stock is sold under the equity lines at
approximately an 8% to 12% discount from the market price. For a further
discussion of the potential effect of future sales under the equity lines, see
the Risk Factor "Our equity line agreement with Kingsbridge Capital Limited may
be unavailable or insufficient to meet our future cash needs," "Issuance of
stock may dilute our shareholders," and "The risk of dilution from sales of
stock to Kingsbridge may cause our stock price to decline."


     We believe that existing cash, cash equivalents and short term
investments, available credit and cash generated from operations, plus cash
available through the new equity based line of credit with Kingsbridge will be
sufficient to meet our cash requirements at least through the end of fiscal
year 2002.

     As of March 31, 2001, we had cash and cash equivalents of $1,616,000 and
working capital of $458,000.

     Risk Factors. You should carefully consider the risk factors set forth
below:

     We have had losses in each of the past five years.

     We were unprofitable during each of the last five fiscal years. For
example, in fiscal year 2001, we had a net loss of $5,855,000 and in fiscal
year 2000 we had a net loss of $5,791,000. We were unprofitable during the
first three quarters of the 1999 fiscal year and during each quarter of the
2000 and 2001 fiscal years. We may not be profitable at any time in the future.
Our lack of profitability could cause our share price to decline. The other
risks identified below could also cause the value of our shares to decline. We
cannot, however, estimate the likelihood that our shares will decline in value
or the amount by which they may decline.

     During the last three years we had negative operating cash flows and
expect this to continue.

     We might need additional financing in order to continue to operate. During
the last three fiscal years we had a negative operating cash flow of $124,000,
$2,628,000 and $848,000 for the fiscal years ended March 31, 1999, 2000 and
2001, respectively. This means that without access to outside capital we would
have had to cease or significantly curtail operations. We believe that we may
continue to run a negative operating cash flow for the foreseeable future, and
might continue to need to obtain additional financing to continue to operate.
If we are unable to obtain such financing, then we may have to cease or
significantly curtail operations.

     Our equity line agreement with Kingsbridge Capital Limited may be
unavailable or insufficient to meet our future cash needs.


     In May 2000, we entered into an equity line agreement with Kingsbridge
Capital Limited which allows us to sell our common stock to Kingsbridge from
time to time. Under the agreement we may sell up to $20,000,000 worth of our
common stock but only up to that number of shares of common stock which equals

                                       27
<PAGE>


19.9% of our outstanding shares. When we sell shares to Kingsbridge the price
per share is equal to the market price of our common stock around the time of
the sale to Kingsbridge minus a discount. That discount ranges from 8% to 12%.


     Issuance of stock to Kingsbridge may dilute our shareholders.


     As of August 8, 2001, we have sold under this agreement approximately
1,578,616 shares of common stock with gross proceeds to us of approximately
$1,600,000. Because of the 19.9% limit on the number of shares we may sell to
Kingsbridge, the maximum number of shares we could sell after August 8, 2001
under this agreement would be approximately 1,160,000 shares. Sale of the
maximum number of shares could result in dilution to our shareholder of
approximately 8.4%. Stated another way, if we sold the maximum number of shares
to Kingsbridge, and assuming Kingsbridge continued to hold those shares, then
our existing shareholders would own approximately 91.6% of our Company.


     Our ability to sell stock to Kingsbridge is contingent upon a number of
terms and conditions, including, for example, continued listing of our stock on
NASDAQ, continued effectiveness of a registration statement, continued accuracy
of representations and warranties made to Kingsbridge and lack of material
adverse changes to our business. Sales are also limited by the market price and
trading volume of our stock. The risk to us is that, because of these
limitations, at the time we need cash in the future, the stock sale arrangement
with Kingsbridge may be unavailable or insufficient to meet our cash needs.


     Issuances of shares under the equity line agreement with Kingsbridge will
result in a greater number of our shares outstanding. As a result, to the
extent we have net income in the future, net income per share will be lower due
to the larger number of shares outstanding.


The risk of dilution from sales of stock to Kingsbridge may cause our stock
price to decline.


     The perceived risk of dilution from sales of stock to Kingsbridge may
cause holders of our stock to sell their shares or it may encourage short-
sales. This could contribute to a decline in our share price.


     Any failure to successfully integrate the Daikin business we acquired on
February 27, 2001 could negatively impact us.



     In February 2001, we acquired the DVD business and assets of Daikin by
issuing 700,000 shares of Series D convertible preferred stock and 395,000
shares of common stock. The Daikin assets we acquired added significantly to
our balance sheet. Before acquiring the Daikin assets we had assets of
approximately $8,772,000 and after the acquisition, at fiscal year ended March
31, 2001, we have approximately $11,738,000 of assets. Approximately 25% of our
assets are therefore derived from the acquisition. The acquisition and
integration of the Daikin business involves risks for us and for our
shareholders. These risks include:


   .  Distracting management from day-to day operations of our business;

   .  Costs, delays and inefficiencies associated with integrating the
      Daikin business;



   .  The potential dilution resulting from conversion of the Preferred
      Stock issued to Daikin;

   .  Undiscovered and unknown problems, defects or other issues related to
      the Daikin products that become known to us only some time after the
      acquisition;




   .  Negative reactions from the current resellers or the current customers
      of the Daikin business to the acquisition of that business by us; and,


   .  The Daikin DVD business was not profitable when owned by Daikin and
      there was concern that the business would have been unable to operate
      as a going concern. It is possible that the Daikin DVD business will
      not be a positive contributor to our operations but instead will
      constitute a drain on our resources.


                                       28
<PAGE>

     If new digital formats are unsuccessful, it is unlikely that we will
generate sufficient revenues to recover our development cost.

     Our business involves new digital audio and video formats, such as DVD-
Video and DVD-Audio, and, more recently, the new recordable DVD formats
including DVD-RAM, DVD-R/RW and DVD+RW. If these formats prove to be
unsuccessful or are not accepted for any reason, there will be only limited
demand for our products.

     We may have to incur significant product redesign costs if chip
manufacturers discontinue or redesign their products.

     Our products are based on integrated circuits or "chips" produced by other
companies. For example, we use the IBM 1960 chip manufactured by IBM. If this
chip manufacturer or another chip manufacturer that we may be using
discontinues or redesigns the chips we use for our products, then we will
likely incur significant costs to redesign our products to handle these
changes. We cannot estimate the amount of these costs or the likelihood that we
will have to redesign our products.


     Our reliance on outsourcing and single suppliers for our manufacturing and
components makes us vulnerable to supplier operational problems.

     Our outsourcing manufacturing program commits responsibility for almost
all of our manufacturing activities to a single supplier Arrow Bell
Electronics. In addition, we often use components that are only available from
a single source. Those components include for example, Phillip's Video Sealer
and various Xilinx devices. Reliance on a single supplier for manufacturing or
for certain manufacturing components makes us vulnerable to operating or
financial problems encountered by those suppliers.


     If we fail to protect our products' intellectual property rights, such as
trade secrets, we may not be able to market our products successfully.

     Our products are based in large part on proprietary technology which we
have sought to protect with patents, trade-marks and trade-secrets. For
example, we have numerous patents and we have also filed applications for
additional patents. We also registered trademarks for the following: Sonic
Studio, DVD Creator, and DVD Fusion, among others. To the extent that we use
patents to protect our proprietary rights, we may not be able to obtain needed
patents or, if granted, the patents may be held invalid or otherwise
indefensible. In addition, we make extensive use of trade secrets that we may
not be able to protect. To the extent we are unable to protect our proprietary
rights, competitors may enter the market offering products identical to ours,
with a negative impact on sales of our products.


     Other companies' intellectual property rights may interfere with our
current or future product development and sales.


     We have never conducted a comprehensive patent search relating to the
technology we use in our products. There may be issued or pending patents owned
by third parties that relate to our products. If so, we could incur substantial
costs defending against patent infringement claims or we could even be blocked
from selling our products.

     Other companies may succeed in obtaining valid patents covering one or
more of the key techniques we utilize in our products. If so, we may be forced
to obtain required licenses or implement alternative non-infringing approaches.

     Our products are designed to adhere to industry standards, such as DVD-
ROM, DVD-Video, DVD-Audio and MPEG video. A number of companies and
organizations hold various patents that claim to cover various aspects of DVD
and MPEG technology. We have entered into license agreements with certain
companies relative to some of these technologies. For instance, we have entered
into license agreements with Dolby Licensing Corporation covering Dolby Digital
Audio and with Meridian Audio Limited covering

                                       29
<PAGE>

Meridian Lossless Packing. Such license agreements may not be sufficient to
grant all of the intellectual property rights to us necessary to market our
products.

     We may become involved with costly and time-consuming patent litigation.


     Third parties could pursue us claiming that our products infringe various
patents. Patent infringement litigation can be time consuming and costly. If
the litigation resulted in an unfavorable outcome for us, we could be subject
to substantial damage claims and a requirement that we obtain a royalty or
license agreement to continue using the technology in issue. Such royalty or
license agreements might not be available to us on acceptable terms, or at all,
resulting in serious harm to our business.


     For example a group of companies have formed an organization called MPEG-
LA to enforce the rights of holders of patents covering aspects of MPEG-2 video
technology. We have been asked by MPEG-LA to enter into a license agreement
with them. We have not entered into such an agreement with MPEG-LA, though we
are continuing to evaluate the situation. The cost to us of such a license
cannot be estimated at this time.


     Because a majority of our products operate only on Macintosh computers,
the potential success of our products is tied to the success of this platform.

     Many of our current products, including DVD Creator and DVD Fusion,
operate on Macintosh computers manufactured by Apple Computer. If Macintosh
computers become in short supply, sales of our products will likely decline. If
there is a decrease in the use of the Macintosh as a computing platform in the
professional and corporate audio and video markets, there will likely be a
decrease in demand for our products. If there are changes in the operating
system or architecture of the Macintosh, it is likely that we will incur
significant costs to adapt our products to the changes.






     Some of our competitors possess greater technological and financial
resources than we do may produce better or more cost effective products than
ours and may be more effective than we are in marketing and promoting their
products. In particular, Apple Computer may be a strong competitor of ours.


     There is a substantial risk that competing companies will produce better
or more cost-effective products, or will be better equipped than we are to
promote them in the marketplace. A number of companies have announced or are
delivering products which compete with our products. These include MedioStream,
MGI, Pinnacle, Roxio and Ulead. Most of these companies have greater financial
and technological resources than ours.


     In January 2001, Apple announced two new DVD authoring products. The first
product, iDVD, is intended for consumer users and we believe will compete with
MyDVD and DVDit!. The second product, DVD Studio Pro, is intended for
professional users, and we believe will compete with DVDit!-PE, DVD Fusion and
ReelDVD. Apple also announced the availability of aggressively priced DVD
recorders with certain models of the Macintosh personal computer. More
recently, Apple has announced the upcoming availability of iDVD2, which add
new, attractive functionality to the iDVD product. Also, Apple recently
purchased Spruce Technologies, a long-standing competitor of ours in the
professional DVD market that may bolster Apple's DVD technology base and make
it more difficult for our products to compete with theirs.


     We have little ability to reduce expenses to compensate for reduced sales.

     We tend to close the greatest number of sales in the last month or last
weeks of a quarter and we generally do not know until quite late in a quarter
whether our sales expectations for the quarter will be met. For example, in
recent quarters, as much as 75% of sales have been procured in the last month
of the quarter. Because most of our quarterly operating expenses and our
inventory purchasing is committed prior to quarter end, we have little ability
to reduce expenses to compensate for reduced sales.


     For example, in the fiscal quarter ending December 31, 2000, we
experienced a significant slowdown of demand for our professional DVD products
in the last month of that quarter, particularly in the North American

                                       30
<PAGE>


and Japanese markets. Although we attempted to control expenses in the face of
this slowdown, the changes we were able to make were quite small, leading to a
significantly greater operating loss for the quarter.


     Approximately 10% of our revenue derives from sales to a single company
and another 12% was derived from sales to a large distributor.

     During the last three fiscal years, 1999, 2000 and 2001, between 7% and
11%, of our revenue was derived from sales of audio processing subsystems to
Discreet Logic. During the fiscal years 2000 and 2001, an additional 10% and
12%, respectively, of our revenue was derived from sales to our Japanese
dealer, Sanshin Electronics Company. A decrease or interruption in either
Discreet Logic's or Sanshin's business or their demand for our products would
cause a significant decrease in our revenue.

     A significant portion of our revenue derives from sales made to foreign
customers located primarily in Europe and Japan.

     Revenue derived from these customers accounted for approximately 47% of
our revenues in fiscal year 2000 and 2001. These foreign customers expose us to
the following risks, among others:

   .  currency movements in which the U.S. dollar becomes significantly
      stronger with respect to foreign currencies, thereby reducing relative
      demand for our products outside the United States;

   .  import and export restrictions and duties;

   .  foreign regulatory restrictions, for example, safety or radio
      emissions regulations; and

   .  liquidity problems in various foreign markets.

     The issuance of stock to Daikin upon conversion of preferred stock will
dilute the relative ownership of existing common stockholders and could result
in lower market price of our stock.


     Based upon the number of shares of common stock outstanding on April 30,
2001, conversion of 850,000 shares of preferred stock into common stock would
dilute our shareholders by 6%. This potential dilution could reduce the market
price of our common stock.



                                       31
<PAGE>

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Our exposure to market risk is limited. All of our international sales are
denominated in US dollars with the exception of the payments made to us by
Daikin pursuant to the Distribution Agreement entered into on February 27, 2001
and payments made to Daikin by us pursuant to the Consulting Agreement entered
into on February 27, 2001. See Note 11 of Notes to Financial Statements. We do
not engage in any hedging activities.

     We do not use derivatives or equity investments for cash investment
purposes. Cash equivalents consist of short-term, highly-liquid investments
with original maturities of three months or less and are stated at cost which
approximates market value. Cash equivalents consist of money market funds.

                                       32
<PAGE>

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The Report of Independent Auditors, Financial Statements and Notes to Financial
Statements follow on pages 32 through 48.

                                       33
<PAGE>

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors
Sonic Solutions:

     We have audited the accompanying balance sheets of Sonic Solutions as of
March 31, 2000 and 2001, and the related statements of operations,
shareholders' equity and cash flows for each of the years in the three-year
period ended March 31, 2001 and the related financial statement schedule. These
financial statements and financial statement schedule are the responsibility of
Sonic Solutions' management. Our responsibility is to express an opinion on
these financial statements and financial statement schedule based on our
audits.

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

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Sonic Solutions as of March
31, 2000 and 2001 and the results of its operations and its cash flows for each
of the years in the three-year period ended March 31, 2001, in conformity with
accounting principles generally accepted in the United States of America. 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.

                                          /s/ KPMG LLP

San Francisco, California
May 3, 2001 except as to note 6,
  which is as of June 18, 2001

                                       34
<PAGE>

                              FINANCIAL STATEMENTS

                                SONIC SOLUTIONS

                                 BALANCE SHEETS
               (in thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                                 March 31
                                                              ----------------
                                                               2000     2001
                                                              -------  -------
<S>                                                           <C>      <C>
Assets
Current assets:
 Cash and cash equivalents................................... $ 5,179    1,616
 Accounts receivable, net of allowance for returns and
  doubtful accounts of $930 and $1,005 at March 31, 2000 and
  2001, respectively.........................................   4,635    4,185
 Inventory...................................................     945      492
 Prepaid expenses and other current assets...................     425      448
                                                              -------  -------
  Total current assets.......................................  11,184    6,741
Fixed assets, net............................................   1,515    1,333
Purchased and internally developed software costs, net.......   1,876    3,094
Other assets.................................................     393      570
                                                              -------  -------
  Total assets............................................... $14,968   11,738
                                                              =======  =======

Liabilities And Shareholders' Equity

Current liabilities:
 Accounts payable and accrued liabilities.................... $ 4,306    4,621
 Deferred revenue and deposits...............................   1,224    1,595
 Subordinated debt...........................................     600       57
 Current portion of obligations under capital leases.........      78       10
                                                              -------  -------
  Total current liabilities..................................   6,208    6,283
Obligations under capital leases, net of current portion.....      10       --
                                                              -------  -------
  Total liabilities..........................................   6,218    6,283

Commitments and contingencies

Shareholders' Equity
 Convertible preferred stock, no par value, 10,000,000 shares
  authorized: 155,544 and 700,000 shares issued and
  outstanding at March 31, 2000, and 2001, respectively......     506    1,750
 Common stock, no par value, 30,000,000 shares authorized;
  12,050,214 and 13,056,646 shares issued and outstanding at
  March 31, 2000 and 2001, respectively......................  27,083   28,399
 Accumulated deficit......................................... (18,839) (24,694)
                                                              -------  -------
  Total shareholders' equity.................................   8,750    5,455
                                                              -------  -------
  Total liabilities and shareholders' equity................. $14,968   11,738
                                                              =======  =======
</TABLE>

                 See accompanying notes to financial statements

                                       35
<PAGE>

                                SONIC SOLUTIONS

                            STATEMENTS OF OPERATIONS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                       Years Ended March 31,
                                                       -----------------------
                                                        1999     2000    2001
                                                       -------  ------  ------
<S>                                                    <C>      <C>     <C>
Net revenue........................................... $21,899  20,827  16,519
Cost of revenue.......................................   9,547   8,992   5,892
                                                       -------  ------  ------
Gross profit..........................................  12,352  11,835  10,627
                                                       -------  ------  ------
Operating expenses:
 Marketing and sales..................................   7,216   8,938   8,710
 Research and development.............................   5,137   6,155   5,148
 General and administrative...........................   1,556   2,284   2,514
                                                       -------  ------  ------
 Total operating expenses.............................  13,909  17,377  16,372
                                                       -------  ------  ------
 Operating loss.......................................  (1,557) (5,542) (5,745)
Other expense, net....................................    (302)   (249)   (110)
                                                       -------  ------  ------
 Loss before income taxes.............................  (1,859) (5,791) (5,855)
Benefit for income taxes..............................      --     (97)     --
                                                       -------  ------  ------
 Net loss............................................. $(1,859) (5,694) (5,855)
 Beneficial conversion feature given to preferred
  shareholders........................................      --     110      --
 Dividends paid to preferred shareholders.............      53      49      20
                                                       -------  ------  ------
 Net loss applicable to common shareholders........... $(1,912) (5,853) (5,875)
                                                       =======  ======  ======
 Basic and diluted loss per share applicable to common
  shareholders........................................ $ (0.21)  (0.56)  (0.47)
                                                       =======  ======  ======
 Weighted average shares used in computing per share
  amounts.............................................   8,896  10,460  12,402
                                                       =======  ======  ======
</TABLE>


                 See accompanying notes to financial statements

                                       36
<PAGE>

                                SONIC SOLUTIONS

                       STATEMENTS OF SHAREHOLDERS' EQUITY
                                 (in thousands)

<TABLE>
<CAPTION>
                           Preferred
                             stock        Common stock                    Total
                         --------------  ---------------  Accumulated Shareholders'
                         Shares Amount   Shares  Amount     deficit      Equity
                         ------ -------  ------ --------  ----------- -------------
<S>                      <C>    <C>      <C>    <C>       <C>         <C>
Balances at March 31,
 1998...................   462  $ 1,500   8,302 $ 15,204    (11,286)      5,418
 Exercise of common
  stock options.........    --       --      64      143         --         143
 Equity line of credit
  issuances, net of
  issuance costs of
  $75...................    --       --     904    2,283         --       2,283
 Conversion of preferred
  stock.................  (168)    (544)    168      544         --          --
 Preferred stock
  dividends.............    --       --      --      (53)        --         (53)
 Exercise of warrants...    --       --      30       --         --          --
 Net loss...............    --       --      --       --     (1,859)     (1,859)
                          ----  -------  ------ --------    -------      ------
Balances at March 31,
 1999                      294      956   9,468   18,121    (13,145)      5,932
 Exercise of common
  stock options.........    --       --     298      773         --         773
 Equity line of credit
  issuances, net of
  issuance costs of
  $363..................    --       --   1,800    7,053         --       7,053
 Issuance of preferred
  stock.................   154      500      --       --         --         500
 Conversion of preferred
  stock.................  (292)    (950)    464      950         --          --
 Preferred stock
  dividends.............    --       --      --      (49)        --         (49)
 Return to preferred
  stock shareholders as
  a result of beneficial
  conversion feature....    --       --      --     (110)        --        (110)
 Preferred stock
  beneficial conversion
  feature...............    --       --      --      110         --         110
 Issuance of warrants...    --       --      --      235         --         235
 Exercise of warrants...    --       --      20       --         --          --
 Net loss...............    --       --      --       --     (5,694)     (5,694)
                          ----  -------  ------ --------    -------      ------
Balances at March 31,
 2000...................   156      506  12,050   27,083    (18,839)      8,750
 Exercise of common
  stock options.........    --       --      43       73         --          73
 Equity line of credit
  issuances, net of
  issuance costs of
  $136..................    --       --     211       58         --          58
 Issuance of common
  stock.................    --       --     495      699         --         699
 Issuance of preferred
  stock.................   700    1,750      --       --         --       1,750
 Conversion of preferred
  stock.................  (156)    (506)    257      506         --          --
 Preferred stock
  dividends.............    --       --      --      (20)        --         (20)
 Net loss...............    --       --      --       --     (5,855)     (5,855)
                          ----  -------  ------ --------    -------      ------
Balances at March 31,
 2001...................   700  $ 1,750  13,056 $ 28,399    (24,694)      5,455
                          ====  =======  ====== ========    =======      ======
</TABLE>


                 See accompanying notes to financial statements

                                       37
<PAGE>

                                SONIC SOLUTIONS

                            STATEMENTS OF CASH FLOWS
                                 (in thousands)


<TABLE>
<CAPTION>
                                                       Years Ended March 31,
                                                      -------------------------
                                                       1999     2000     2001
                                                      -------  -------  -------
<S>                                                   <C>      <C>      <C>
Cash flows from operating activities:
Net loss............................................  $(1,859)  (5,694)  (5,855)
Adjustments to reconcile net loss to net cash used
 in operating activities:
Depreciation and amortization.......................    2,621    2,958    2,025
Provision for returns and doubtful accounts, net of
 write-offs.........................................      (18)     331       75
Interest expense amortization.......................       60       --      132
Changes in operating assets and liabilities, net of
 effects from purchase of Daikin DVD business:
 Accounts receivable................................   (2,187)     437    2,310
 Inventory..........................................     (173)    (138)     465
 Refundable income taxes............................      148       --       --
 Prepaid expenses and other current assets..........       30     (138)       8
 Other assets.......................................      (72)    (237)    (177)
 Accounts payable and accrued liabilities...........    1,044      (53)     (50)
 Deferred revenue and deposits......................      282      (94)     219
                                                      -------  -------  -------
 Net cash used in operating activities..............     (124)  (2,628)    (848)
                                                      -------  -------  -------
Cash flows from investing activities:
 Purchase of fixed assets...........................     (913)    (850)    (417)
 Additions to purchased and internally developed
  software..........................................     (696)    (801)  (1,656)
                                                      -------  -------  -------
 Net cash used in investing activities..............   (1,609)  (1,651)  (2,073)
                                                      -------  -------  -------
Cash flows from financing activities:
 Proceeds from exercise of common stock options.....      143      773       73
 Repayments of subordinated debt....................     (568)     (84)    (675)
 Proceeds from equity line financing................    2,283    7,053       58
 Borrowings on line of credit.......................      420      422      500
 Repayments of line of credit.......................     (420)    (922)    (500)
 Principal payments on capital leases...............     (137)    (149)     (78)
 Payment of dividends...............................      (53)     (49)     (20)
                                                      -------  -------  -------
 Net cash provided by financing activities..........    1,668    7,044     (642)
                                                      -------  -------  -------
Net increase (decrease) in cash and cash
 equivalents........................................      (65)   2,765   (3,563)
Cash and cash equivalents, beginning of year........    2,479    2,414    5,179
                                                      -------  -------  -------
Cash and cash equivalents, end of year..............  $ 2,414    5,179    1,616
                                                      =======  =======  =======
Supplemental disclosure of cash flow information:
 Interest paid during year..........................  $    71      109       44
                                                      =======  =======  =======
 Income taxes paid during year......................  $     9        4       --
                                                      =======  =======  =======
 Noncash financing and investing activities:
 Conversion of preferred stock to common stock......  $   544      956      506
                                                      =======  =======  =======
 Conversion of subordinated debt to preferred
  stock.............................................       --      500       --
                                                      =======  =======  =======
 Issuance of preferred stock to finance
  acquisition.......................................       --       --    1,750
                                                      =======  =======  =======
 Issuance of common stock to finance acquisition....       --       --      699
                                                      =======  =======  =======
 Issuance of warrants associated with conversion of
  subordinated debt                                        --      235       --
                                                      =======  =======  =======
 Beneficial conversion feature given to preferred
  shareholders......................................       --      110       --
                                                      =======  =======  =======
</TABLE>


                 See accompanying notes to financial statements


                                       38
<PAGE>

                                SONIC SOLUTIONS

                         NOTES TO FINANCIAL STATEMENTS
                         March 31, 1999, 2000 and 2001

(1) SUMMARY OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

     (a) Operations

     We primarily develop workstations used by professionals to edit and
process digital audio and digital video. Our products are computer based, and
usually include both plug-in hardware and applications software installed on a
personal computer. Our customers use various kinds of peripheral devices--for
example, disk drives, streaming tape drives, and audio and video tape
recorders--along with our products. Although we do not manufacture or sell the
personal computer or peripheral devices used with our products, we refer to the
complete configuration of personal computer, Sonic hardware, Sonic software,
and peripherals as a Sonic workstation.

     We currently market two professional workstation product lines:
SonicStudio(TM) and DVD Creator(TM). SonicStudio is a line of professional
audio workstations that our customers use to prepare audio for release on
digital audio compact discs, for release with video and film entertainment, and
for broadcast on radio. DVD Creator is a line of DVD-Video/Audio production
workstations which supports the preparation and assembly of video and audio
assets for release on the DVD-Video and DVD-Audio disc format.

     During the fiscal year ended March 31, 2000, we introduced and began
shipments of two new products: DVDit!(TM) and DVD Fusion(TM). DVDit! is an
authoring application which provides simplified DVD authoring capabilities to
consumer, "prosumer," and some professional users. DVD Fusion, which is a part
of our DVD Creator product line, provides video producers and editors a
comprehensive set of tools for encoding, authoring and proofing DVD-Video
titles derived from projects created on non-linear video editing systems.

     On February 27, 2001, we entered into an Asset Purchase Agreement with
Daikin Industries, Ltd., a Japanese corporation whereby on that date we
acquired The DVD Software Development Business of Daikin, also called "Daikin
DVD". In return for the assets acquired, we issued 395,000 shares of common
stock valued at $593,000 and 700,000 shares of preferred stock valued at
$1,750,000. The acquisition was recorded using the purchase method of
accounting.

     Our products generally include application software and specialized
hardware installed on a personal computer. Our products are designed to improve
the productivity and effectiveness of media professionals, enabling them to
process and manipulate more material in a given amount of time and to achieve
results which would have been impossible using traditional linear analog or
digital technology.

     (b) Use of Estimates and Certain Concentrations

     The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and reported amounts of revenues and expenses during the period.
Actual results could differ from those estimates.

     We are dependent on sole-source suppliers for certain key components used
in our products. We purchase these sole-source components pursuant to purchase
orders placed from time to time. We do not carry significant inventories of
these components, and have no guaranteed supply agreements. Any extended future
interruption or limitation in the supply of any of the components obtained from
a single source could have a material adverse effect on our results of
operations.

                                       39
<PAGE>

     (c) Revenue Recognition

     We have adopted Statement of Position (SOP) 97-2, Software Revenue
Recognition, as amended by SOP 98-9, Software Revenue Recognition, with Respect
to Certain Arrangements. SOP 97-2 generally requires revenue earned on software
arrangements involving multiple elements such as software products, hardware,
upgrades, enhancements, maintenance and support, installation and training to
be allocated to each element based on the relative fair values of the elements.
The fair value of an element must be based on vendor-specific objective
evidence.


     We have derived our revenue primarily from licenses of our software
products (including hardware components) and maintenance and support. Revenue
recognized from multiple-element software arrangements are allocated to each
element of the arrangement based on the fair values of elements, such as
software products and maintenance and support. The determination of fair value
is based on objective evidence specific to us. SOP 98-9 requires recognition of
revenue using the "residual method" in a multiple element arrangement when fair
value does not exist for one or more of the delivered elements in the
arrangement. Under the "residual method", the total fair value of the
undelivered element is deferred and subsequently recognized in accordance with
SOP 97-2. The difference between the total software arrangement fee and the
amount deferred for the undelivered elements is recognized as revenue related
to the delivered elements.


     Revenue from license fees is recognized when persuasive evidence of an
arrangement exists, delivery of the product (including hardware) has occurred,
no significant obligations with regard to implementation remain, the fee is
fixed and determinable and collectibility is probable. In addition, royalty
revenue from certain distributors that do not meet our credit standards and
revenues from our distributor agreement with Daikin are recognized upon sell-
through to the end-customer. We consider all arrangements with payment terms
longer than one year not to be fixed and determinable. If the fee is not fixed
or determinable, revenue is recognized as payments become due from the
customer.


     Deferred revenue includes amounts billed to customers for which revenues
have not been recognized which generally results from the following: (1)
deferred maintenance and support; and (2) amounts billed to certain
distributors for our products not yet sold through to the end-user customers.

     (d) Cash Equivalents

     Cash equivalents consist of short-term, highly-liquid investments with
original maturities of three months or less and are stated at cost which
approximates market value. Cash equivalents consist of money market funds.

     (e) Inventory

     Inventory is valued at the lower of cost, determined on a first-in, first-
out basis, or market. Our finished goods inventory is manufactured to our
specifications by a third party.

     (f) Fixed Assets

     Fixed assets consist of furniture and equipment and are recorded at cost.
Equipment under capital leases is stated at the present value of minimum lease
payments at the inception of the lease. Depreciation of furniture and equipment
is provided using the straight-line method over the estimated useful lives of
the respective assets which are generally three to five years. Equipment held
under capital leases is amortized over the shorter of the lease term or the
estimated useful life of the asset.

     (g) Purchased and Internally Developed Software Costs

     Purchased software and software product development costs are capitalized
when a product's technological feasibility has been established and then is
amortized over a future period. Amortization begins

                                       40
<PAGE>

when a product is available for general release to customers. Amortization of
capitalized software costs, for both internally developed and purchased
software products, is computed on a straight- line basis over the estimated
economic life of the product, which is generally three years, or on a basis
using the ratio of current revenue to the total of current and anticipated
future revenue, whichever is greater. All other research and development
expenditures are charged to research and development expense in the period
incurred.

     (h) Income Taxes

     We account for income taxes under the asset and liability method of
accounting. Under the asset and liability method, deferred tax assets and
liabilities are recognized based on the future tax consequences attributable to
differences between the financial statement carrying amount of existing assets
and liabilities and their respective tax bases.

     (i) Basic and diluted loss per share

     The following table sets forth the computations of shares and net loss per
share, applicable to common shareholders used in the calculation of basic and
diluted net loss per share for the years ended March 31, 1999, 2000 and 2001
(in thousands, except per share data):

<TABLE>
<CAPTION>
                                                      Years Ended March 31,
                                                      -----------------------
                                                       1999     2000    2001
                                                      -------  ------  ------
<S>                                                   <C>      <C>     <C>
Net loss............................................. $(1,859) (5,694) (5,855)
Beneficial conversion feature given to preferred
 shareholders........................................      --     110      --
Dividends paid to preferred shareholders.............      53      49      20
                                                      -------  ------  ------
Net loss applicable to common shareholders........... $(1,912) (5,853) (5,875)
                                                      =======  ======  ======
Weighted average number of common shares
 outstanding.........................................   8,896  10,460  12,402
                                                      =======  ======  ======
Basic and diluted net loss per share applicable to
 common shareholders................................. $(0.21)   (0.56)  (0.47)
                                                      =======  ======  ======
</TABLE>

     As of March 31, 1999, 2000 and 2001 potentially dilutive shares totaling
1,834,502; 1,253,947; and 1,537,493, respectively, for convertible preferred
stock and options with exercise prices less than the average market price that
could dilute basic earnings per share in the future, were not included in
earnings per share as their effect was anti-dilutive for those periods.


     (j) Concentrations of Credit Risk

     Financial instruments which potentially subject our company to
concentrations of credit risk are trade receivables. We manufacture and sell
our products to customers who are primarily audio and video and graphic arts
professionals who prepare sound, video and graphics for use in the music
recording, video, film and broadcast and printing industries or for corporate
in-house use and to dealers who support such customers. Management believes
that any risk of credit loss is significantly reduced due to the diversity of
its end users and their dispersion across many geographic sales areas. We
maintain an allowance for doubtful accounts to provide against potential credit
losses.

     (k) Liquidity

     Historically, we have incurred significant losses and negative cash flows
from operations. As of March 31, 2001, we have an accumulated deficit of
$28,399,000 and positive working capital of $458,000. We have primarily funded
operations through private equity financing with Kingsbridge (see note 6). We
intend to continue using the equity financing to fund negative cash flows. To
the extent that this equity line of credit or other sources of financing are
not available to us, we will reduce planned capital expenditures and reduce
other variable costs as necessary to maintain sufficient working capital to
operate our business through March 2002.

                                       41
<PAGE>

     (l) Stock-Based Compensation

     Our company has various stock-based compensation plans, as discussed in
Note 7. We have accounted for the effect of our stock based compensation plans
under Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock
Issued to Employees". We have elected to adopt only the disclosure based
requirements of Statement of Financial Accounting Standards (SFAS) No. 123
"Accounting for Stock-Based Compensation" and as such have disclosed the pro
forma effects on net loss and net loss per share data as if we had elected to
use the fair value approach to account for all our employee stock-based
compensation plans.

     (m) Impairment of Long-Lived Assets

     We evaluate our long-lived assets for impairment, including other
intangibles, whenever events or changes in circumstances indicate that the
carrying amount of such assets may not be recoverable. Recoverability of assets
to be held and used is measured by comparison of the carrying amount of the
asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell.

     (n) Recently Issued Accounting Pronouncements

     In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, as amended by SFAS No. 137 and SFAS No. 138, "Accounting for Derivative
instruments and hedging activities." We are required to adopt SFAS No. 133 in
the first quarter of fiscal year 2002. We do not anticipate that SFAS No. 133
will have a material impact on our financial statements.

     (o) Comprehensive Loss

     We have no significant components of other comprehensive loss and
accordingly, comprehensive loss equals net loss.

(2) INVENTORY

     The components of inventory consist of (in thousands):

<TABLE>
<CAPTION>
                       March 31,
                       ----------
                       2000  2001
                       ----- ----
      <S>              <C>   <C>
      Finished Goods   $ 387 182
      Work-in-process     75  48
      Raw materials      483 262
                       ----- ---
                       $ 945 492
                       ===== ===
</TABLE>

(3) FIXED ASSETS

     Fixed assets consist of (in thousands):

<TABLE>
<CAPTION>
                                                        March 31,
                                                      ---------------
                                                       2000     2001
                                                      -------  ------
      <S>                                             <C>      <C>
      Equipment, furniture and fixtures               $ 5,382   6,089
      Demonstration equipment                           1,888   1,909
      Parts used in service, not held for sale          1,495   1,515
                                                      -------  ------
                                                        8,765   9,513
      Less accumulated depreciation and amortization   (7,250) (8,180)
                                                      -------  ------
                                                      $ 1,515   1,333
                                                      =======  ======
</TABLE>


                                       42
<PAGE>

     As of March 31, 2001, fixed assets held under capital lease totaled
$315,000 and accumulated amortization on those assets totaled $315,000.

(4) PURCHASED AND INTERNALLY DEVELOPED SOFTWARE COSTS

     Capitalized software costs consist of (in thousands):

<TABLE>
<CAPTION>
                                        March 31,
                                     ----------------
                                      2000     2001
                                     -------  -------
      <S>                            <C>      <C>
      Purchased software             $   409      455
      Internally developed software    6,035    8,302
                                     -------  -------
                                       6,444    8,757
      Accumulated amortization        (4,568)  (5,663)
                                     -------  -------
                                     $ 1,876    3,094
                                     =======  =======
</TABLE>

     Amortization of capitalized software costs was $1,225,000, $1,310,000 and
$1,095,000 for the years ended March 31, 1999, 2000 and 2001, respectively.

(5) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

     Accounts payable and accrued liabilities consist of (in thousands):

<TABLE>
<CAPTION>
                                           March 31,
                                         -------------
                                          2000   2001
                                         ------- -----
      <S>                                <C>     <C>
      Accounts payable                   $ 1,089   872
      Commissions payable                    653   428
      Accrued compensation and benefits      903   984
      Accrued expenses                     1,470 1,495
      Accrued acquisition costs               --   356
      Accrued marketing expenses             191   486
                                         ------- -----
                                         $ 4,306 4,621
                                         ======= =====
</TABLE>

(6) CREDIT FACILITIES AND DEBT RESTRUCTURING

     On May 4, 2000, we entered into a new Private Equity Line Agreement (the
"Agreement") with Kingsbridge Capital. Under this Agreement, we may receive
("draw") cash from Kingsbridge in exchange for our common stock. The total of
all draws under the Agreement may not exceed $20,000,000 in cash nor involve
issuance of more than 19.9% of our outstanding common stock. Pricing of each
draw is based on the market price of our common stock around the time of a draw
discounted by amounts ranging from 8% to 12% of market price. Our ability to
utilize this equity line is subject to the effectiveness of a registration
statement on Form S-1 registering any shares received by Kingsbridge from us
for resale to the public. On July 19, 2000, we filed a registration statement
on Form S-1 to register for resale the shares we may issue to Kingsbridge under
the Agreement and on November 13, 2000 the Registration Statement became
effective. Utilization of the equity line by us is subject to a number of
restrictions and conditions that are described more fully in the Registration
Statement. During the fourth quarter of fiscal year March 31, 2001, we drew
$200,000 from the equity line for which we issued 211,416 shares of common
stock.

     During April, May and June 2001, we drew $700,000 from the equity line for
which we issued 683,600 shares of common stock.


                                       43
<PAGE>

     Since December 1996, we have entered into a couple of different financing
arrangements with Hambrecht & Quist Guaranty Finance, including a $5,100,000
financing facility and a $7,000,000 equity-based line of credit. In March 1998,
$3,000,000 of the $5,100,000 financing facility was restructured into
$1,500,000 of convertible preferred stock (461,538 shares) and $1,500,000 of
debt. The debt had an interest rate of 7.25% and was due in October 1999.
During the years ended March 31, 2000, and March 31, 2001, 292,000 and 156,000
shares of the convertible preferred stock were converted to common stock.

     In October 1999, the $1,500,000 of debt due to Hambrecht and Quist
Guaranty Finance was restructured into 153,846 shares of Series C Convertible
preferred stock and $1,000,000 of debt. The unpaid balance at March 31, 2000
and 2001 was $600,000 and $57,000, respectively. During the year ended March
31, 2001, all of the shares of Series C convertible preferred stock were
converted to common stock. In connection with the debt restructuring, we issued
warrants to purchase 120,000 common shares at an exercise price of $2.50. These
warrants expire on April 30, 2006 and are immediately exercisable. At March 31,
2001, 96,283 warrants remain unexercised.

(7) SHAREHOLDERS' EQUITY

     Convertible Preferred Stock

     In February, 2001, we issued 700,000 shares of Series D Convertible
Preferred Stock (the Preferred Stock) to Daikin Industries in conjunction with
our purchase of Daikin DVD valued at $1,750,000 or $2.50 per share. The rights,
preferences, and privileges of the holders of the Preferred Stock are as
follows:

   .  Dividends are cumulative and are payable only upon declaration by the
      Company's Board of Directors at an annual rate of $0.20 per share,
      until such shares have been converted into common stock. Such
      distributions shall be payable quarterly in arrears for each calendar
      quarter of each fiscal year.

   .  Holders have a liquidation preference of $5.00 per share plus all
      accrued but unpaid dividends, in the event of any liquidation,
      dissolution or winding up of the corporation, either voluntary or
      involuntary.

   .  Each share has voting rights equal to the number of shares of common
      stock into which such shares could be converted.

   .  Each share is convertible at any time into one share of common stock
      subject to certain antidilution provisions.

     Stock Options

     Under our September 1989 Stock Option Plan (the Plan), options to purchase
up to an aggregate of 2,090,000 shares of common stock may be granted to key
employees, directors and consultants. Grants of options to the directors of
Sonic Solutions may not exceed 140,000 shares. The Plan provides for issuing
both incentive stock options, which must be granted at fair market value at the
date of grant, and nonqualified stock options, which must be granted at not
less than 85% of fair market value of the stock. All options to date have been
granted as incentive stock options. Options under the Plan generally vest over
four years from the date of grant. The options generally expire ten years from
the date of grant and are canceled three months after termination of
employment. Our Board of Directors and Chief Executive Officer administer the
Plan.

     During 1995, we adopted the 1994 NonEmployee Directors Stock Option Plan
which provides for the grant of stock options to Sonic Solutions' nonemployee
directors. Under this plan, stock options are granted annually at the fair
market value of Sonic Solutions' common stock on the date of grant. The number
of

                                       44
<PAGE>

options so granted annually is fixed by the plan. Such options generally vest
over four years from the grant date. The total number of shares to be issued
under this plan may not exceed 100,000 shares. There were 22,000 options
outstanding at March 31, 2001, at prices of $2.6560, $2.5625 and $1.6880 per
share, of which 10,669 were exercisable.

     In July, 1998, the Board of Directors adopted the Sonic Solutions 1998
Stock Option Plan and the shareholder's approved the 1998 Stock Option Plan in
September, 1998. The 1998 Stock Option Plan covers 1,000,000 shares of Common
Stock, with an annual increase in the number of shares available for issuance
under the Stock Option Plan on the last day of each fiscal year; provided that
the total number of shares issuable under the plan shall not exceed 2,000,000.
The Plan provides for issuing both incentive stock options, which must be
granted at fair market value at the date of grant, and nonqualified stock
options, which must be granted at not less than 85% of fair market value of the
stock. All options to date have been granted as incentive stock options.
Options under the Plan generally vest over four years from the date of grant.
The options generally expire ten years from the date of grant and are canceled
three months after termination of employment. Our Board of Directors and Chief
Executive Officer administer the Plan.

     In July, 2000, the Board of Directors adopted the Sonic Solutions 2000
Stock Option Plan and the shareholder's approved the 2000 Stock Option Plan in
September, 2000. The 2000 Stock Option Plan covers 3,000,000 shares of Common
Stock with an annual increase in the number of shares available for issuance
under the Stock Option Plan on the last day of each fiscal year. The Plan
provides for issuing both incentive stock options, which must be granted at
fair market value at the date of grant, and nonqualified stock options, which
must be granted at not less than 85% of fair market value of the stock. All
options to date have been granted as incentive stock options. Options under the
Plan generally vest over four years from the date of grant. The options
generally expire ten years from the date of grant and are canceled three months
after termination of employment. Our Board of Directors and Chief Executive
Officer administer the Plan.

     A summary of Sonic Solutions' option plans is presented below:

<TABLE>
<CAPTION>
                                 1999                2000                2001
                          ------------------- ------------------- -------------------
                                     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                  1,660,178   $2.89   2,026,333    2.80   2,351,039    2.67
Granted                     670,250    3.08     782,300    2.73   1,029,500    1.69
Exercised                   (64,225)   2.22    (298,208)   2.58     (43,000)   1.84
Forfeited                  (239,870)   4.32    (159,386)   4.94    (224,351)   3.29
                          ---------   -----   ---------    ----   ---------    ----
Outstanding at end of
 year                     2,026,333   $2.80   2,351,039    2.67   3,113,188    2.31
                          =========           =========           =========
Options exercisable at
 year end                 1,179,191   $2.65     902,506    2.54   1,880,229    2.44
Fair value of options
 granted during the year              $2.06                1.93                1.28
</TABLE>

     Had compensation cost for our plans been determined consistent with the
fair value approach enumerated in SFAS No. 123, our net loss and net loss per
share for the years ended March 31, 1999, 2000 and 2001 would have been
increased as indicated below (in thousands, except per share data):

<TABLE>
<CAPTION>
                                              Years Ended
                                               March 31,
                                           ------------------
                                            1999  2000  2001
                                           ------ ----- -----
      <S>                                  <C>    <C>   <C>
      Net loss             As Reported     $1,859 5,694 5,855
      Pro Forma                            $3,640 7,532 7,412

      Net loss per share   As Reported     $ 0.21  0.56  0.47
      Pro Forma                            $ 0.41  0.72  0.60
</TABLE>


                                       45
<PAGE>

     The fair value of options granted was estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1999, 2000 and 2001; risk-free interest rate of
4.65%, 6.04% and 5.17%, respectively; expected life of 4 years; 91%, 97% and
110% expected volatility, respectively; and no dividends.

     The effect of applying SFAS No. 123 for disclosing compensation costs may
not be representative of the effects on reported net income (loss) for future
years because pro forma net income (loss) reflects compensation costs only for
stock options granted in fiscal 1996 through 2001 and does not consider
compensation costs for stock options granted prior to April 1, 1995.

     The following table summarizes information about stock options outstanding
at March 31, 2001.

<TABLE>
<CAPTION>
                                          Options Outstanding            Options Exercisable
                                    ------------------------------- -----------------------------
                         Number     Weighted Average    Weighted        Number        Weighted
     Range of        Outstanding at    Remaining        Average     Outstanding at    Average
  Exercise Price     March 31, 2001 Contractual Life Exercise Price March 31, 2001 Exercise Price
-------------------  -------------- ---------------- -------------- -------------- --------------
<S>                  <C>            <C>              <C>            <C>            <C>
From $1.25 to $1.75    1,127,188          9.12           $1.52          490,466        $1.60
From $2.00 to $2.91    1,632,375          7.12            2.56        1,223,083         2.57
From $3.44 to $3.94      296,375          8.71            3.37          123,315         3.42
From $4.18 to $6.00       57,250          7.16            5.31           43,365         5.41
                       ---------          ----           -----        ---------        -----
From $1.25 to $6.00    3,113,188          8.00           $2.31        1,880,229        $2.44
                       =========          ====           =====        =========        =====
</TABLE>

(8) INCOME TAXES

     The differences between income taxes computed using the statutory federal
income tax rate of 34% and that shown in the statements of operations are
summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                       Years Ended
                                                        March 31,
                                                   ----------------------
                                                    1999    2000    2001
                                                   ------  ------  ------
<S>                                                <C>     <C>     <C>
Computed tax at statutory rate                     $ (630) (1,969) (1,991)
Tax credits utilized                                  105     137     136
State taxes, net of federal benefit                     5       4       4
Tax exempt interest income                            (19)     --      --
Current year net operating losses, temporary
 differences and credits for which no benefit was
 recognized                                           520   1,804   1,834
IRS tax refund                                         --     (99)     --
Other                                                  19      26      17
                                                   ------  ------  ------
                                                   $   --     (97)     --
                                                   ======  ======  ======
</TABLE>


                                       46
<PAGE>

     The components of deferred taxes are as follows (in thousands):

<TABLE>
<CAPTION>
                                                    March 31,
                                             --------------------------
                                              1999     2000      2001
                                             -------  -------  --------
<S>                                          <C>      <C>      <C>
Deferred tax assets:
 Accounts receivable                         $   179      585       581
 Accrued salaries                                 --       --        42
 Inventories                                     123       49        82
 Tax credit carryforwards                      2,086    2,440     3,038
 Net operating losses                          4,732    6,109     7,969
 Accrued vacation pay                             55      101       120
 Commissions                                       1        1        50
 State income taxes                               52       62         1
 Warranty and other                               51       37        79
                                             -------  -------  --------
 Gross deferred tax assets                     7,279    9,384    11,962
                                             -------  -------  --------
 Valuation allowance                          (6,309)  (8,651)  (10,919)
                                             -------  -------  --------
 Total deferred tax assets, net of valuation
  allowance                                      970      733     1,043

Deferred tax liabilities:
 Fixed assets                                   (130)    (127)       65
 Internally developed software                  (840)    (606)   (1,108)
                                             -------  -------  --------
 Total deferred tax liability                   (970)    (733)   (1,043)
                                             -------  -------  --------
 Net deferred taxes                          $    --       --        --
                                             =======  =======  ========
</TABLE>

     The net change in the valuation allowance for the year ended March 31,
1999, 2000 and 2001 was an increase of approximately $966,000, $2,343,000 and
$2,268,000, respectively. Management believes that sufficient uncertainty
exists regarding the future realization of certain deferred tax assets and,
that a valuation allowance is required.

     As of March 31, 2001, we have cumulative federal and California net
operating losses of approximately $22,050,000 and $9,954,000, respectively,
which can be used to offset future income subject to taxes. The federal tax
loss carryforwards will expire beginning in the year 2012 through 2021. The
California tax loss carryforwards will expire beginning in the year 2001
through 2011.

     As of March 31, 2001, we have cumulative unused research and development
tax credits of approximately $2,160,000 and $1,126,000 which can be used to
reduce future federal and California income taxes, respectively. Federal credit
carryforwards expire from 2009 through 2021; California credits will
carryforward indefinitely.

     As of March 31, 2001, we have federal minimum tax credit carryforwards of
approximately $135,000 which will carry forward indefinitely until utilized.

(9) COMMITMENTS AND CONTINGENCIES

     (a) Leases

     In December, 1996, we entered into a leasing agreement to finance the
purchase of up to $1,000,000 in equipment, as discussed in Note 6. Lease terms
under the agreement are for 42 months and are secured by the leased equipment.
We also lease certain facilities and equipment under noncancelable operating
leases. Future

                                       47
<PAGE>

payments under capital and operating leases that have initial remaining
noncancelable lease terms in excess of one year are as follows (in thousands):

<TABLE>
<CAPTION>
                                                            Years Ended
                                                             March 31,
                                                         -----------------
                                                         Capital Operating
                                                         Leases   Leases
                                                         ------- ---------
<S>                                                      <C>     <C>
2002                                                      $ 10       983
2003                                                        --     1,073
2004                                                        --     1,116
2005                                                        --     1,161
2006                                                               1,207
Thereafter                                                  --       203
                                                          ----     -----
Total minimum lease payments                                10     5,743
                                                                   =====
Less current portion of obligations under capital lease    (10)
                                                          ----
Long-term obligations under capital lease                 $  0
                                                          ====
</TABLE>

     Rent expense under operating leases for the years ended March 31, 1999,
2000 and 2001 was approximately $954,000, $953,000 and $1,011,000,
respectively.

     (b) Benefit Plan

     We sponsor a 401(k) savings plan covering most salaried employees. To
date, no contributions have been made to this plan by us.

     (c) Inventory Purchase Commitments

     Under the terms of an agreement with an outside supplier, we have a
commitment which requires us to purchase finished goods inventory from them
subject to certain terms. At March 31, 2001 the amount was not significant.

     (d) Other

     We from time to time are subject to routine claims and litigation
incidental to our business. We believe that the results of these matters will
not have a material adverse effect on our financial condition and results of
operations.


(10) SIGNIFICANT CUSTOMER INFORMATION AND SEGMENT REPORTING

     In 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information," which
was adopted by us in 1998. SFAS No. 131 requires companies to report financial
and descriptive information about its reportable operating segments, including
segment profit or loss, certain specific revenue and expense items and segment
assets, as well as information about the revenues derived from our products and
services, the countries in which we earn revenue and hold assets, and major
customers. The method for determining what information to report is based on
the way that management organized the operating segments within our company for
making operating decisions and assessing financial performance.

     Our chief operating decision maker is considered to be our Chief Executive
Officer ("CEO"). The CEO reviews financial information presented on a
consolidated basis accompanied by desegregated information about revenue by
product line and revenue by geographic region for purposes of making operating
decisions and assessing financial performance. The consolidated financial
information reviewed by the CEO is identical to the information presented in
the accompanying statement of operations. Therefore, we operate in, and

                                       48
<PAGE>

measure our results in a single operating segment. As such, we are required to
disclose the following revenue by product line, revenue by geographic and
significant customer information:

        Revenues by Product Line:

<TABLE>
<CAPTION>
                   Years Ended March 31,
                   ---------------------
                    1999    2000   2001
                   ------- ------ ------
<S>                <C>     <C>    <C>
Revenues
 Consumer DVD      $    --  1,805  2,429
 Pro Audio/Video    21,899 19,022 14,090
                   ------- ------ ------
Total net revenue  $21,899 20,827 16,519
                   ======= ====== ======
</TABLE>

     Our accounting system does not capture meaningful gross margin and
operating income (loss) information by product line, nor is such information
used by the CEO for purposes of making operating decisions. Accordingly, such
information has not been disclosed.

        Revenues by Geographic Location:

<TABLE>
<CAPTION>
                     Years Ended March 31,
                     ---------------------
                      1999    2000   2001
                     ------- ------ ------
<S>                  <C>     <C>    <C>
North America        $11,702 11,027  8,714
Export:
Europe                 5,707  5,489  4,666
Pacific Rim            4,218  4,034  3,095
Other international      272    277     44
                     ------- ------ ------
Total net revenue    $21,899 20,827 16,519
                     ======= ====== ======
</TABLE>

     We sell our products to customers categorized geographically by each
customer's country of domicile. We do not have any material investment in long
lived assets located in foreign countries for any of the years presented.

        Significant customer information:

<TABLE>
<CAPTION>
                                        Percent of Total
                                       Accounts Receivable
             Years Ended March 31,          March 31,
            -------------------------  -------------------
             1999     2000     2001           2001
            -------  -------  -------  -------------------
<S>         <C>      <C>      <C>      <C>
Customer A      11%      11%       7%           1%
Customer B       --      10%      12%           6%
</TABLE>

(11) ACQUISITION

     On February 27, 2001, we entered into an Asset Purchase Agreement with
Daikin Industries, Ltd., a Japanese corporation whereby on that date we
acquired Daikin DVD. In return for the assets acquired, we issued 395,000
shares of common stock valued at approximately $593,000 and 700,000 shares of
preferred stock valued at approximately $1,750,000.


     The value of the common stock was determined based on the closing market
price of our common stock on February 27, 2001. The estimated value of the
preferred stock was determined based on the following considerations relative
to preferred stock: (1) the common stock conversion feature; (2) the dividend
rate; and (3) the stated liquidation preference associated with the preferred
stock. The acquisition was recorded using the purchase method of accounting and
accordingly, the operating results have been included in our results of
operations from the date of acquisition.


     A finder's fee was paid of 100,000 shares of our common stock, valued at
$150,000, in connection with the acquisition.

                                       49
<PAGE>

     As a consequence of the acquisition, we acquired all the Daikin DVD
related products and intellectual property rights which is included in
purchased and internally developed software costs. Additionally, we acquired
tangible assets such as furniture, computers and other electronic assets, some
of which will continue to be used specifically in the acquired DVD software
development business while others will be used in our general DVD authoring
tool business. The costs of the acquisition have been allocated on the bases of
the estimated fair market values of the assets and liabilities assumed.

     We estimated fair value of the individual net tangible and intangible
assets acquired exceeded the purchase price. As a result, the carrying values
of the fixed assets and purchased software costs acquired were reduced by this
excess. The amount and components of the purchase price along with the
allocation of the purchase price are as follows (in thousands):

<TABLE>
       <S>                          <C>
       Common stock issued          $  743
       Preferred stock issued        1,750
       Estimated transaction costs     365
                                    ------
         Total purchase price       $2,858
                                    ======

       Accounts receivable          $1,935
       Prepaid expenses                 31
       Inventory                        12
       Fixed assets                    330
       Purchased software costs        658
       Deferred revenue               (108)
                                    ------
         Net assets acquired        $2,858
                                    ======
</TABLE>

     In connection with the Asset Purchase Agreement, we and Daikin entered
into a fourteen month Distribution Agreement whereby we appointed Daikin as our
exclusive distributor in Japan. During the terms of the Distribution Agreement,
Daikin committed to placing minimum purchase orders of 260,000,000 yen of
Daikin acquired products. During the year ended March 31, 2001, Daikin paid us
$595,210 relating to the distribution agreement. As of March 31, 2001 and
assuming the conversion rate at March 31, 2001, Daikin has approximately
$1,583,000 to be paid to us under the Distribution Agreement.

     The following unaudited pro forma results of operations for fiscal year
2000 are as if the acquisition occurred on April 1, 1999. The pro forma
information has been presented for illustrative purposes only and are not
necessarily indicative of the combined financial position or results of
operations for future periods or the results of operations or financial
position that actually would have been realized had we been a combined company
during the specified periods.

<TABLE>
<CAPTION>
                                                       Years Ended March 31,
(in thousands, except per share amounts, unaudited)    ----------------------
                                                          2000        2001
                                                       ----------  ----------
<S>                                                    <C>         <C>
Net sales                                              $   25,147      19,413
                                                       ==========  ==========
Net loss                                               $   (8,526) $   (7,650)
                                                       ==========  ==========
Basic and diluted loss per share applicable to common
 shareholders                                          $    (0.81) $    (0.60)
                                                       ==========  ==========
</TABLE>

                                       50
<PAGE>

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

     Not applicable.

                                       51
<PAGE>

                                    PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Our directors and executive officers and their ages as of June 15, 2001
are as follows:

<TABLE>
<CAPTION>
                                                                      Director
 Name Of Nominee       Age Position With The Company                   Since
 ---------------       --- -------------------------                  --------
 <C>                   <C> <S>                                        <C>
 Robert J. Doris        48 President, Chief Executive Officer and       1986
                            Director
 Mary C. Sauer          48 Senior Vice President of Business            1986
                            Development, Secretary and Director
 Robert M. Greber       63 Director                                     1993
 Peter J. Marguglio     54 Director                                     1986
 R. Warren Langley      58 Director                                     2001
 A. Clay Leighton       44 Senior Vice President Worldwide                --
                            Operations, Finance and Chief Financial
                            Officer
 Christopher A. Kryzan  42 Senior Vice President of Engineering and       --
                           Marketing
</TABLE>

     Mr. Doris is married to Ms. Sauer. There are no other family relationships
between any director or executive officer of the Company.

     Robert J. Doris. Mr. Doris founded Sonic Solutions in 1986 and has served
as President, Chief Executive Officer and Director of the Company since that
time. Prior to 1986 he was President of The Droid Works, a subsidiary of
Lucasfilm Ltd., which produced computer-based video and digital audio systems
for the film and television post-production and music recording industries.
Prior to founding The Droid Works, Mr. Doris was a Vice President of Lucasfilm
and General Manager of the Lucasfilm Computer Division. Mr. Doris received
B.A., J.D. and M.B.A. degrees from Harvard University.

     Mary C. Sauer. Ms. Sauer founded Sonic Solutions in 1986 and has served as
a Vice President and Director of the Company since that time. Ms. Sauer became
Senior Vice President of Marketing and Sales in February 1993. Prior to 1986,
Ms. Sauer was Vice President of Marketing for The Droid Works, and prior to
joining The Droid Works, Ms. Sauer was Director of Marketing for the Lucasfilm
Computer Division. Ms. Sauer received an M.B.A. in Finance and Marketing from
the Wharton School of the University of Pennsylvania and a B.F.A. from
Washington University in St. Louis.

     Robert M. Greber. Mr. Greber has served as a director of the Company since
August 1993. Mr. Greber served as president and Chief Operating Officer of The
Pacific Stock Exchange since July 1990, until January 1996 when he was elected
Chairman and Chief Executive Officer. In December 1999, Mr. Greber retired from
The Pacific Stock Exchange. Prior to joining The Pacific Stock Exchange, he was
from 1985 to 1987 President and Chief Executive Officer of Diagnostic Networks,
Inc., a network of Magnetic Resonance Imaging Centers which was merged into NMR
America in 1987. Prior to DNI, Mr. Greber was President and Chief Executive
Officer of Lucasfilm Ltd. from 1981 to 1985 where, among other duties, he
oversaw development of digital technologies for video, film, audio, and special
effects and video games applications. Before joining Lucasfilm, Mr. Greber was
associated with the firm of Merrill Lynch where he was Vice President and
Manager of the Los Angeles Institutional Office. Mr. Greber holds a B.S. in
Finance from Temple University. Mr. Greber also serves on the Board of Bay View
Capital Corp.

     Peter J. Marguglio. Mr. Marguglio has served as a Director of the Company
since August 1986. Since January 1990, Mr. Marguglio has worked at Eatec
Corporation, a software company located in Berkeley, California where he is now
President. Prior to joining Eatec, Mr. Marguglio was President of Resource
Marketing, Inc., an equipment leasing firm he founded in 1981. Mr. Marguglio
holds a Mechanical Engineering degree from the University of Washington and an
M.B.A. degree from Stanford University.

     R. Warren Langley. Mr. Langley was appointed as a member of the Board of
Directors and as a member of the Audit Committee on June 7, 2001. Since January
2000, Mr. Langley has been a consultant and

                                       52
<PAGE>

the Managing Principal of the GuruWizard Fund, LLC. From January 2000 to May
2000, he served as interim CEO of Brush Dance, a creator of Mind-Body-Spirit
products. From September 1996 until March 1999, Mr. Langley served as President
and Chief Operating Officer of the Pacific Exchange in San Francisco. Prior to
that from August 1987 to January 1998, he was a Principal and Chief Operating
Officer of Hull Trading in Chicago, a proprietary derivatives trading firm. Mr.
Langley has also worked as Director of Operations Research and Industrial
Engineering at United Airlines and worked in several capacities in the
software, energy, and defense consulting industries after serving in the United
States Air Force for fifteen years. Mr. Langley holds degrees from the United
States Air Force Academy Massachusetts Institute of Technology, and Georgia
Institute of Technology.

     A. Clay Leighton. Mr. Leighton joined Sonic Solutions in February 1993 as
Vice President of Finance. In January, 1999, Mr. Leighton was named Senior Vice
President of Worldwide Operations and Finance and Chief Financial Officer.
Prior to joining Sonic, from January 1990 to July 1992 he was Vice President,
Finance and CFO for RESNA Industries Inc., an environmental services firm, and
from August 1988 to December 1989 he was Vice President, Finance and CFO for
Command Data Systems, a software company specializing in software for the
public safety market. Mr. Leighton has also worked as strategy consultant for
the Boston Consulting Group. Mr. Leighton received a B.A. from Wesleyan
University and an M.B.A. from the Amos Tuck School of Business Administration
at Dartmouth College.

     Christopher A. Kryzan. Mr. Kryzan joined Sonic Solutions in March 1996 as
Vice President of Marketing. In January, 1999, Mr. Kryzan was named Senior Vice
President of Marketing and Engineering. Prior to joining Sonic, from May 1994
through February 1996, he was an independent consultant specializing in
Internet business and marketing strategy development. From July 1990 to April
1994, he was Director of Marketing at SuperMac Technology, a graphics and
digital video technology firm, and General Manager of E-Machines, a subsidiary
of SuperMac. From January 1986 to July 1990, he was Director of Product
Marketing at Wyse Technology, a manufacturer of terminals and personal
computers, and National Sales Manager of Amdek, a subsidiary of Wyse. Mr.
Kryzan received a B.S. in Electrical Engineering from Northwestern University
and an M.B.A. from Santa Clara University.

     Board Meetings and Committees

     The Board held a total of four meetings during the fiscal year ended March
31, 2000. No director participated in fewer than 75% of the total number of
meetings of the Board and all meetings of the committees, if any, upon which
such director served.

     During the fiscal year ended March 31, 2001, the audit committee of the
Board consisted of Mr. Marguglio and Mr. Greber. The principal functions of the
audit committee are to recommend engagement of the Company's independent
auditors, to consult with the Company's auditors concerning the scope of the
audit and to review with them the results of their examination, to review and
approve any material accounting policy changes affecting the Company's
operating results and to review the Company's financial control procedures and
personnel. The audit committee held four meetings during the fiscal year ended
March 31, 2001.

     The Board does not have a nominating committee or a compensation
committee.

     Newly Appointed Board and Committee Member

     On June 7, 2001, Mr. R. Warren Langley was appointed as a member of the
Board of Directors and as a member of the Audit Committee.

     Compensation of Directors

     The Company does not pay fees to its directors for attendance at meetings.
The Company does reimburse its directors for their out-of-pocket expenses
incurred in the performance of their duties as directors

                                       53
<PAGE>

of the Company. Directors of the Company who are not, and have not been during
the preceding twelve months, employees, and who do not directly or indirectly
own more than 5% of the Company's Common Stock, are eligible to receive an
initial grant and thereafter annual grants of options to purchase 5,000 shares
of the Company's Common Stock in accordance with the Company's Nonemployee
Directors Stock Option Plan.

     Compliance with Section 16(a) of the Exchange Act

     Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's directors and executive officers, and persons who own more than ten
percent of a registered class of the Company's equity securities, to file
reports of ownership on Form 3 and changes in ownership on Form 4 or 5 with the
Securities and Exchange Commission and the National Association of Securities
Dealers. Such officers, directors and ten percent shareholders are also
required by Securities and Exchange Commission rules to furnish the Company
with copies of all Section 16(a) forms that they file.

     Based solely on representations from certain reporting persons, the
Company believes that, during the fiscal year ended March 31, 2001, each of the
following persons failed to file a Form 5 within the time period required by
the rules and regulations of the Securities and Exchange Commission: Robert J.
Doris, Mary C. Sauer, Peter J. Marguglio, Robert M. Greber, Christopher A.
Kryzan and A. Clay Leighton.

                 COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
                    AMONG SONIC SOLUTIONS, THE S&P 500 INDEX
                     AND THE JP MORGAN H&Q TECHNOLOGY INDEX

                           [STOCK PERFORMANCE GRAPH]

* $100 INVESTED ON 3/31/96 IN STOCK OR INDEX-
INCLUDING REINVESTMENT OF DIVIDENDS.
FISCAL YEAR ENDING MARCH 31.

                                       54
<PAGE>

     Measurement Period
<TABLE>
<CAPTION>
                                                                 JP Morgan H&Q
      (Fiscal Year Covered)    Sonic Solutions   S&P 500 Index    Technology
      ---------------------    ---------------   -------------   -------------
      <S>                      <C>               <C>             <C>
      FYE 03/96                    $100.00          $100.00         $100.00
      FYE 03/97                    $ 90.91          $119.82         $116.23
      FYE 03/98                    $ 44.55          $177.34         $173.10
      FYE 03/99                    $ 60.00          $210.07         $242.17
      FYE 03/00                    $134.55          $247.77         $560.21
      FYE 03/01                    $ 19.10          $194.06         $224.50
</TABLE>

Item 11. EXECUTIVE COMPENSATION

     The Board does not have a Compensation Committee. Accordingly, it is the
responsibility of the entire Board to determine the most effective total
executive compensation strategy, based upon our business needs and consistent
with shareholders' interests, to administer the our executive compensation
plans, programs and policies, to monitor corporate performance and its
relationship to compensation of executive officers, and to take other
appropriate actions concerning matters of executive compensation.

        Compensation Philosophy

     Sonic Solutions was formed in 1986 as a private company and initially
offered Common Stock to the public in February 1994. Four key goals form the
basis for compensation decisions for all employees of Sonic Solutions:

     1. To attract and retain the most highly qualified management and employee
team;

     2. To pay competitively compared to similar audio and video software and
hardware companies and to provide appropriate reward opportunities for
achieving high levels of performance compared to similar organizations in the
marketplace;

     3. To emphasize sustained performance by aligning rewards with shareholder
interests; and

     4. To motivate executives and employees to achieve our annual and long-
term business goals and encourage behavior toward the fulfillment of those
objectives.

     Equity participation and a strong alignment to shareholders' interests are
key elements of the Company's executive compensation philosophy. As a result of
this philosophy, the our executive compensation program consists of base
salary, cash bonuses, incentive stock options and standard benefits.

     Base Salary and Cash Bonuses. The Board recognizes the importance of
maintaining compensation practices and levels of compensation competitive with
those offered by audio and video software and hardware companies in comparable
stages of development. For external marketplace comparison purposes, a
significant group of companies operating in our industry are utilized for
determining competitive compensation levels.

     Base salary represents the fixed component of the executive compensation
program. Our philosophy regarding base salaries is conservative, maintaining
base salaries at or somewhat below the competitive industry approximate median.
Determination of base salary levels is established on an annual review of
marketplace competitiveness with similar audio and video software and hardware
companies, and on individual performance. Periodic increases in base salary
relate to individual contributions evaluated against established objectives,
relative marketplace competitiveness levels, length of service, and the
industry's annual competitive pay practice movement.

     Cash bonuses are based primarily on the financial performance for the year
and also include an assessment of individual performance.

                                       55
<PAGE>

     Equity Ownership -- Stock Options. The Board strongly believes that it is
important for key employees who have significant responsibility for the
management, growth, and future success of the company to have significant
equity ownership interest and have the potential to gain financially from our
stock price increases. The interests of shareholders, executives and employees
should thereby be closely aligned. The Board seeks to provide such ownership
interest to executives and key employees, giving them the right to purchase
shares of Common Stock in the future at a price equal to fair market value at
the date of grant. We generally grants such stock options throughout the year.

     Under our Stock Option Plans, shares of our Common Stock may be purchased
at the option price set by the Company. All grants must be exercised according
to the provisions of the Stock Option Plans. All outstanding options expire on
the earlier of ten years after the date of grant or 90 days after termination
of service.

     Other Benefits. Our philosophy is to provide adequate health- and welfare-
oriented benefits to executives and employees. We provide no other executive
benefits.

     The Chief Executive Officer, Mr. Doris, is also a founder of the Company
with a significant equity interest. The Board seeks to compensate Mr. Doris
primarily through base salary. In fiscal 2001, Mr. Doris was eligible to
receive a base salary of $225,000, which was consistent with fiscal 2000. Mr.
Doris did not receive a cash bonus in the fiscal year ended March 31, 2001. In
establishing Mr. Doris' salary the Board considered our past growth in revenue
and profitability, our experience in achieving product development goals,
domestic and international sales and our ability to develop the current
management team. The total cash compensation paid to Mr. Doris in the fiscal
year ended March 2001 is less than that paid to chief executive officers of the
competitive industry comparative group; however, the Board believes that this
compensation is appropriate in light of his equity interest.

        Summary

     The Board believes that the compensation of executives is appropriate and
competitive with the compensation programs provided by other audio and video
software and hardware companies with which we compete for executives and
employees in light of the equity interests of the Company's founders. The Board
believes its compensation strategy, principles, and practices result in a
compensation program tied to shareholder returns and linked to the achievement
of annual and longer-term financial and operational results on behalf of the
Company's shareholders.

        The Board of Directors

       --Robert J. Doris

       --Robert M. Greber

       --R. Warren Langley

       --Peter J. Marguglio

       --Mary C. Sauer

     Compensation Committee Interlocks and Insider Participation

     The Board does not have a Compensation Committee. Accordingly, the entire
Board determines executive compensation. Robert J. Doris and Mary C. Sauer are
directors and are the founders and principal executive officers.

                                       56
<PAGE>

     The following table sets forth the total compensation for the fiscal years
ended March 31, 2001, 2000 and 1999 for the Chief Executive Officer and each of
the three other most highly compensated executive officers of Sonic Solutions
who served as executive officers at fiscal year end and who received salary and
bonuses of $100,000 or more. None of the named executive officers earned any
bonuses or compensation for these fiscal years other than as set forth in the
table or received any restricted stock awards, stock appreciation rights or
long-term incentive plan payouts.

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                  FISCAL YEAR ANNUAL COMPENSATION   LONG-TERM
                                     ENDED    -------------------- COMPENSATION
  NAME AND PRINCIPAL POSITION      MARCH 31,  SALARY ($) BONUS ($) OPTIONS (#)
  ---------------------------     ----------- ---------- --------- ------------
<S>                               <C>         <C>        <C>       <C>
Robert J. Doris                      2001      $225,000   $     0     85,000
 President (Chief Executive          2000      $221,250   $     0     85,000
 Officer)                            1999      $138,750   $     0     85,000
 and Director

Mary C. Sauer                        2001      $127,875   $     0     40,000
 Senior Vice President,              2000      $112,675   $     0     40,000
 Business Development,               1999      $111,000   $     0     40,000
 Secretary and Director

Christopher A. Kryzan                2001      $187,000   $38,917     48,000
 Senior Vice President,              2000      $185,500   $45,031     25,000
 Engineering and Marketing           1999      $175,000   $32,300     40,000

A. Clay Leighton                     2001      $180,000   $15,000     50,000
 Senior Vice President Worldwide     2000      $176,250   $15,000     65,000
 Operations Finance and Chief        1999      $112,920   $15,000     25,000
 Financial Officer
</TABLE>

     The following table sets forth certain information regarding grants of
stock options made during the fiscal year ended March 31, 2001 to the executive
officers named in the Summary Compensation Table. Since inception, Sonic
Solutions has not granted any stock appreciation rights.

                       OPTION GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
                              INDIVIDUAL GRANTS
                 --------------------------------------------
                                                                  POTENTIAL
                                                                  REALIZABLE
                                                                   VALUE AT
                                                               ASSUMED ANNUAL
                 NUMBER OF                                         RATES OF
                 SECURITIES  PERCENT OF                          STOCK PRICE
                 UNDERLYING TOTAL OPTIONS EXERCISE              APPRECIATION
                  OPTIONS    GRANTED TO   OR BASE              FOR OPTION TERM
                  GRANTED   EMPLOYEES IN   PRICE   EXPIRATION ----------------
     NAME           (#)      FISCAL YEAR   ($/SH)     DATE       5%      10%
     ----        ---------- ------------- -------- ---------- -------- --------
<S>              <C>        <C>           <C>      <C>        <C>      <C>
Robert J. Doris    85,000         8%      $3.0000    9/5/10   $ 12,750 $ 25,000
Mary C. Sauer      40,000         4%      $3.0000    9/5/10   $  6,000 $ 12,000
Christopher A.
 Kryzan            48,000         5%      $1.5630    4/1/10   $  3,751  $ 7,502
A. Clay
 Leighton          50,000         5%      $1.5630    9/1/10   $  3,907  $ 7,815
</TABLE>
--------

     The exercise price of the options in the above table is equal to the fair
market value of Sonic Solutions' Common Stock on the date of grant, as
determined by reference to the closing price of Sonic Solutions' Common Stock
on the Nasdaq National Market. The options are subject to earlier expiration in
the event of the

                                       57
<PAGE>

officer's termination of employment with Sonic Solutions. Potential realizable
value is based on an assumption that the fair market value of the stock on the
date of grant appreciates at the stated rate, compounded annually, from the
date of grant until the end of the option term. These values are calculated
based on requirements promulgated by the Securities and Exchange Commission and
do not reflect Sonic Solutions' estimate of future stock price appreciation.
All of the options in the above table were granted under Sonic Solutions' Stock
Option Plan, and vest over a period of one year at a rate of 8.3333 percent per
month.

     The following table sets forth information regarding the number and value
of options exercised during the fiscal year ended March 31, 2001 and of
unexercised options held by the named executive officers on March 31, 2001.
Value is considered to be the difference between exercise price and the closing
price of $1.313 per share of the Common Stock as quoted on the Nasdaq National
Market on March 31, 2001.

                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                       AND FISCAL YEAR END OPTION VALUES

<TABLE>
<CAPTION>
                                            NUMBER OF
                                            SECURITIES
                                            UNDERLYING
                                           UNEXERCISED
                        SHARES              OPTION AT    VALUE OF IN-THE-
                       ACQUIRED AGGREGATE  FISCAL YEAR   MONEY AT FISCAL
                          ON      VALUE        END           YEAR END
                       EXERCISE REALIZED   EXERCISABLE/    EXERCISABLE/
        NAME             (#)       ($)    UNEXERCISABLE  UNEXERCISABLE(1)
        ----           -------- --------- -------------- ----------------
<S>                    <C>      <C>       <C>            <C>
Robert J. Doris              0         0  387,500/42,500       $0/0
Mary C. Sauer                0         0  197,000/35,000       $0/0
Christopher A. Kryzan        0         0  190,083/22,917       $0/0
A. Clay Leighton        33,000   $68,357  216,771/28,229       $0/0
</TABLE>
--------

(1) These values have not been, and may not be, realized, and are based on the
    positive spread between the respective exercise prices of the outstanding
    stock options and the closing price of Sonic Solutions' Common Stock at
    March 31, 2001 ($1.313).

     Sonic Solutions did not make any awards during the fiscal year ended March
31, 2001 to any of the executive officers named in the Summary Compensation
Table under any long-term incentive plan providing compensation intended to
serve as incentive for performance to occur over a period longer than one
fiscal year, excluding the stock options set forth above.

                                       58
<PAGE>

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth certain information regarding beneficial
ownership of the Common Stock as of May 31, 2001 (i) by each person who is
known by Sonic Solutions to own beneficially more than five percent of the
Common Stock, (ii) by each of Sonic Solutions' directors, (iii) by each of
Sonic Solutions' executive officers named in the Summary Compensation Table
under the caption "Executive Compensation" and (iv) by all directors and
executive officers as a group. Unless otherwise indicated, the address of each
person below is: c/o Sonic Solutions, 101 Rowland Way, Suite 110, Novato, CA
94945.

<TABLE>
<CAPTION>
                                                      NUMBER OF    PERCENTAGE
                                                        SHARES     OF SHARES
                                                     BENEFICIALLY BENEFICIALLY
               NAME AND ADDRESS (1)                    OWNED(2)     OWNED(2)
---------------------------------------------------  ------------ ------------
<S>                                                  <C>          <C>
Robert J. Doris (3)                                   1,615,389       12.0%
Mary C. Sauer(4)                                        797,329        5.9%
Peter J. Marguglio(5)                                   225,026        1.7%
Robert M. Greber(6)                                       9,000          *
Christopher A. Kryzan(7)                                204,667        1.5%
A. Clay Leighton(8)                                     303,458        2.2%
All directors and executive officers as a group
 (12 persons)                                          3,524,604       26.1%
                                                       ---------       ----
</TABLE>
--------
 *  Less than one percent.
(1) The address of the persons set forth above is the address of our Company
    appearing elsewhere in this Form 10-K.
(2) This table is based upon information supplied by directors, officers and
    principal shareholders. Applicable percentage ownership for each
    shareholder is based on 13,510,703 shares of Common Stock outstanding as of
    May 31, 2001, together with applicable options for such shareholders.
    Beneficial ownership is determined in accordance with the rules of the
    Securities and Exchange Commission and generally includes voting or
    investment power with respect to securities, subject to the community
    property laws where applicable. Shares of Common Stock subject to options
    are deemed outstanding for the purpose of computing the percentage
    ownership of the person holding such options, but are not treated as
    outstanding for computing the percentage ownership of any other person.
(3) Includes 1,227,889 shares owned by Mr. Doris, and 387,500 shares issuable
    upon exercise of options which will be exercisable within 60 days of March
    31, 2001.
(4) Includes 593,662 shares owned by Ms. Sauer, and 203,667 shares issuable
    upon exercise of options which will be exercisable within 60 days of March
    31, 2001.
(5) Includes 208,443 shares owned by Mr. Marguglio, and 16,583 shares issuable
    upon exercise of options which will be exercisable within 60 days of March
    31, 2000.
(6) Consists of shares issuable upon exercise of options which will be
    exercisable within 60 days of March 31, 2001, all of which were granted
    pursuant to the Company's Nonemployee Director Stock Option Plan.
(7) Consists of shares issuable upon exercise of options which will be
    exercisable within 60 days of March 31, 2001.
(8) Includes 38,500 shares owned by Mr. Leighton and 226,458 shares issuable
    upon exercise of options which will be exercisable within 60 days of March
    31, 2001.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Mr. Doris is married to Ms. Sauer. There are no other family relationships
between any director or executive officer of the Company.

                                       59
<PAGE>

                                    PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

    (a)1. Financial Statements.

           Included in Part II of this report:

           Report of Independent Auditors (page 32 of this Report).

           Balance Sheets as of March 31, 2000 and March 31, 2001.

           Statements of Operations for each of the three years in the
           period ended March 31, 2001.

           Statements of Shareholders' Equity for each of the three years
           in the period ended March 31, 2001.

           Statements of Cash Flows for each of the three years in the
           period ended March 31, 2001.

           Notes to Financial Statements (pages 37 through 48 of this
           Report).

    (a)2. Financial Statements Schedule.

           Included in Part IV of this report:

           Schedule II Valuation and Qualifying Accounts

           All other schedules are omitted because they are not required,
           or are not applicable, or the information is included in the
           financial statements.

    (a)3. Exhibits:

<TABLE>
         <C>  <C> <S>
          2.1 (9) Asset Purchase Agreement between Registrant and Daikin
                  Industries, Ltd., dated as of February 27, 2001

          3.1 (1) Restated Articles of Incorporation

          3.2 (1) Amended and Restated By-Laws

          3.3 (9) Certificate of Determination of Series D Preferred Stock of
                  Sonic Solutions

          4.1 (1) Specimen Common Stock Certificate

         10.1 (1) Amended and Restated Stock Option Plan (compensatory plan)

         10.2 (1) Lease Agreement dated December 16, 1991 between Phoenix
                  Leasing Incorporated and the Company

         10.3 (1) Loan Agreement dated November 28, 1993 between Bank of
                  America and the Company

         10.4 (1) Agreement dated September 28, 1993 between JL Cooper
                  Electronics and the Company

         10.5 (1) Form of Indemnity Agreement

         10.6 (2) Lease Agreement dated January 26, 1995 between Golden Gate
                  Plaza and the Company

         10.7 (3) Private Line of Credit Agreement dated December 31, 1997
                  between Kingsbridge Capital Limited and the Company
</TABLE>


                                       60
<PAGE>


<TABLE>
      <C>   <C> <S>
      10.8  (4) Private Securities Subscription Agreement dated March 31, 1998
                between Hambrecht & Quist Guaranty Finance, LLC and the Company

      10.9  (5) Stock purchase agreement dated May 20, 1999 between Sonic
                Solutions and Kingsbridge Capital Limited

      10.10 (5) Registration Rights Agreement dated May 20, 1999 between Sonic
                Solutions and Kingsbridge Capital Limited

      10.11 (6) Private Securities Subscription Agreement dated October 15,
                1999 between Hambrecht & Quist Guaranty Finance, LLC and the
                Company

      10.12 (7) 1998 Stock Option Plan (compensatory plan)

      10.13 (8) Stock purchase agreement dated May 4, 2000 between Sonic
                Solutions and Kingsbridge Capital Limited

      10.14 (8) Registration Rights Agreement dated May 4, 2000 between Sonic
                Solutions and Kingsbridge Capital Limited

      10.15  *  Amendment to Lease Agreement between Golden Gate Plaza and the
                Company

      10.16 (9) Registration Rights Agreement between Registrant and Daikin
                Industries, Ltd., dated as of February 27, 2001

      10.17 (9) Shareholder Agreement between Registrant and Daikin Industries,
                Ltd., dated as of February 27, 2001

      10.18 (9) Consulting Agreement between Registrant and Daikin Industries,
                Ltd., dated as of February 27, 2001

      10.19 (9) Distribution Agreement between Registrant and Daikin
                Industries, Ltd., dated as of February 27, 2001

      23.1      Consent of KPMG LLP

      24.1   *  Power of Attorney
</TABLE>

--------

 *  Previously filed as an exhibit to this Form 10-K.

(1) Incorporated by reference to exhibits to Registration Statement on Form S-1
    (No. 33-72870) effective February 10, 1994.
(2) Incorporated by reference to exhibits to Annual Report on Form 10-K for the
    Fiscal Year Ended March 31, 1996 (No. 33-72870).
(3) Incorporated by reference to exhibits to Registration Statement on Form S-3
    (No. 333-44347) effective January 30, 1998.
(4) Incorporated by reference to exhibits to Registration Statement on Form S-3
    (No. 333-50697) effective April 29, 1998.
(5) Incorporated by reference to exhibits to Registration Statement on Form S-1
    filed on May 27, 1999.
(6) Incorporated by reference to exhibits to Registration Statement on Form S-3
    filed on March 17, 2000.
(7) Incorporated by reference to Appendix A to the Registrant's Definitive
    Proxy Statement filed on July 21, 1998.
(8) Incorporated by reference to exhibits to Registration Statement on Form S-1
    filed with the Commission on May 21, 2001.
(9) Incorporated by reference to exhibits of Form 8-K filed with the Commission
    on March 14, 2001.

                                       61
<PAGE>

     (b) Reports on Form 8-K:

     Current Report on Form 8-K filed with the Securities and Exchange
Commission on December 13, 2000; Item 5 -- Other Events. Complaint for
Injunctive Relief and Damages; Demand for Jury Trial against Spruce
Technologies, Inc., and Kirk E. Paulsen.

     Current Report on Form 8-K filed with the Securities and Exchange
Commission on March 14, 2001; Item 2 -- Acquisition or Disposition of Assets
and Item 7 -- Financial Statements, Pro Forma Financial Information and
Exhibits related to the acquisition of the Daikin DVD Software Development
Business on February 27, 2001.

     Current Report on Form 8-K/A filed with the Securities and Exchange
Commission on May 14, 2001 as amended on August 9, 2001; Item 7 -- Amended
Financial Statements, Pro Forma Financial Information and Exhibits related to
the acquisition of the Daikin DVD Software Development Business on February 27,
2001.


     Current Report on Form 8-K filed with the Securities and Exchange
Commission on June 20, 2001; Item 5 -- Other Events. The Company's lawsuit
against Spruce Technologies, Inc., and Kirk E. Paulsen was settled.

                                       62
<PAGE>

                          FINANCIAL STATEMENT SCHEDULE

                                SONIC SOLUTIONS

                       VALUATION AND QUALIFYING ACCOUNTS

                   Years Ended March 31, 1999, 2000 and 2001
                                 (in thousands)

<TABLE>
<CAPTION>
                            Balance at Charged to Charged              Balance
                            beginning  costs and  to other             at end
                            of period   expenses  accounts Deductions of period
                            ---------- ---------- -------- ---------- ---------
<S>                         <C>        <C>        <C>      <C>        <C>
Year ended March 31, 1999
 Allowance for doubtful
  accounts.................   $ 223        50        --       (133)       140
 Allowance for returns.....     394        --        85        (20)       459
                              -----       ---       ---       ----      -----
                              $ 617        50        85       (153)       599
                              =====       ===       ===       ====      =====
Year ended March 31, 2000
 Allowance for doubtful
  accounts.................   $ 140       650        --       (319)       471
 Allowance for returns.....     459        --        --         --        459
                              -----       ---       ---       ----      -----
                                599       650        --       (319)       930
                              =====       ===       ===       ====      =====
Year ended March 31, 2001
 Allowance for doubtful
  accounts.................   $ 471       170        --        (95)       546
 Allowance for returns.....   $ 459        --        --         --        459
                              -----       ---       ---       ----      -----
                              $ 930       170        --        (95)     1,005
                              =====       ===       ===       ====      =====
</TABLE>

                                       63
<PAGE>

                                   SIGNATURES



     In accordance with Section 13 or Section 15(d) of the Securities and
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto, duly authorized on this 31st day
of August, 2001.


                                          Sonic Solutions

                                             /s/ Robert J. Doris
                                          By: _________________________________
                                             Robert J. Doris President




     Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated.


<TABLE>
 <S>                                            <C>
 August 31, 2001                                /s/ Robert J. Doris
                                                _____________________________________________
                                                President, Chief Executive Officer and
                                                Director
                                                Robert J. Doris

 August 31, 2001                                /s/ Mary C. Sauer*
                                                _____________________________________________
                                                Senior Vice President of Business Development
                                                and Director
                                                Mary C. Sauer

 August 31, 2001                                /s/ Robert M. Greber*
                                                _____________________________________________
                                                Director
                                                Robert M. Greber

 August 31, 2001                                /s/ Peter J. Marguglio*
                                                _____________________________________________
                                                Director
                                                Peter J. Marguglio

 August 31, 2001                                /s/ R. Warren Langley*
                                                _____________________________________________
                                                Director
                                                R. Warren Langley

 August 31, 2001                                /s/ A. Clay Leighton
                                                _____________________________________________
                                                Senior Vice President of Worldwide Operations
                                                and Finance and Chief Financial Officer
                                                (Principal Financial Accounting Officer)
                                                A. Clay Leighton

    /s/ Robert J. Doris
 *By: ________________________________________
    Attorney-in-fact
</TABLE>


                                       64