Brilliant Digital - Rapport annuel des comptes

LIQUIDITY, CAPITAL RESOURCES AND RELATED PARTY TRANSACTIONS
As of December 31, 2001, our cash and cash equivalents totaled approximately $185,000. This is a decrease of $3,216,000 as compared to December 31, 2000, resulting primarily from a net loss of $6,328,000.

We primarily satisfied our cash needs in 2001 through the sale of Secured Convertible Promissory Notes and related Common Stock Purchase Warrants in the aggregate principal amounts of $2,264,000 in May 2001, and $350,000 in December 2001 with subsequent funding in 2002, of $400,000 tied to the December financing agreement. A detailed description of these notes is provided below. Also, see Notes 5, 7 and 14 to the Financial Statements.

Cash flows from operating, financing and investing activities for the years ended December 31, 2001 and 2000 are summarized in the following table (dollars in thousands):

ACTIVITY: 2001 2000

------------------------- ----------- ----------

Continuing Operations $ ( 5,000) $ (16,000)
Discontinuing Operations $ ( 1,000) $ 5,000
Investing $ -- $ (1,000)
Financing $ 3,000 $ 12,000

Net cash of $5,397,000 used in operating activities during the year ended December 31, 2001 was primarily attributable to a net loss from continuing operations of $6,635,000 partially offset by the sale of substantially all of the assets of The Auction Channel and subsequent closure of the London and New York offices. This is compared to a net use of cash in 2000 of $10,590,000 attributable primarily to a net loss of $21,916,000.

Net cash used to purchase computer equipment amounted to $23,000 in 2001 as compared to $760,000 in 2000. In 2001, cash of $73,000 was used in financing activities for the repayment of notes for the financing of office furniture and computer equipment, and financing costs related to our Director's and Officer's insurance. In 2000 we paid $76,000 on the repayment of notes for the financing of office furniture and computer equipment.

We have an obligation under our agreement with Morgan Creek to fund entirely the development of two MultipathTM Movies, the first of which, ACE VENTURA CD-ROM, was developed and shipped in the fourth quarter of 1998. The second project has not been identified yet. We have an obligation under our joint venture agreement with KISS Digital, LLC to fund 75% of the development of a MultipathTM Movie up to $900,000. As of December 31, 2000 we had contributed $917,000 to the project. We do not expect to contribute additional funds to this project. We also are required as of December 31, 2001 to make minimum payments of $37,000 under various licensing agreements.

At December 31, 2001, we had rental commitments for our office facility of $90,000 and two promissory notes for the financing of office furniture and computer equipment in the amount of $54,000 and $31,000 payable over the next 2 years. Our contractual obligations are as follows:

CONTRACTUAL TOTAL LESS THAN 1-3
OBLIGATIONS 1 YEAR YEARS
Capital Leases $85,000 $54,000 $31,000
Operating Lease $90,000 $83,000 $ 7,000

---------- ----------- --------

Total Cash Obligations $175,000 $137,000 $38,000
========== =========== ========

As reported in our Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on August 14, 2001, in May 2001, we sold to Harris Toibb, Europlay 1, LLC (an entity in which our Chairman has an ownership interest) and Preston Ford, Inc. secured convertible promissory notes (the "Original Notes") in the aggregate principal amount of $2,264,150 and three-year warrants (the "Original Warrants") to purchase up to an aggregate of 2,850,393 shares of our common stock at exercise prices of $0.793 per share (with respect to 2,792,118 shares) and $0.858 per share (with respect to 58,275 shares). We sold these securities for an aggregate purchase price of $2,264,150. The Original Notes have a term of eighteen months from the date of issuance and an interest rate of 10% per annum, payable at maturity. The principal amount of the Original Notes and, at the option of the holder, all accrued interest, may be converted by the holder into shares of our common stock at a conversion price of $0.706 per share. The Original Notes are secured by all of our assets and the assets of our subsidiaries, B3D, Inc. and Brilliant Studios, Inc., and guaranteed by B3D, Inc. and Brilliant Studios, Inc. The Original Notes and the Original Warrants were amended in our recent financing transaction, as described below.

On December 19, 2001, we entered into a financing transaction that was structured similar to the financing we conducted in May 2001 and involved one of the same investors. In the December financing transaction, we sold to Harris Toibb and Capel Capital Ltd. secured convertible promissory notes (the "New Notes") in the aggregate principal amount of $750,000 (the "Principal Amount") and warrants (the "New Warrants") to purchase up to that number of shares of our common stock obtained by dividing 200% of the Principal Amount by the lesser of (i) $0.20, or (ii) the volume weighted average price of a share of our Common Stock on the American Stock Exchange, or any exchange on which the Common Stock is then traded, over any five (5) consecutive trading days commencing on December 14, 2001 and terminating at 5:00 p.m. (Pacific Standard Time) on November 10, 2002 (we refer to items (i) and (ii) collectively as the "Conversion Price"). The New Warrants are exercisable at a price per share equal to 1.125 times the Conversion Price. The New Notes mature simultaneous with the Original Notes on November 10, 2002 and bear interest at the rate of 10% per annum. The principal amount of the New Notes and, at the option of the holder, all accrued interest, may be converted by the holder into shares of our Common Stock at the Conversion Price. As with the May 2001 financing, the New Notes are secured by all of our assets and the assets of our two subsidiaries, B3D, Inc. and Brilliant Studios, Inc., and guaranteed by B3D, Inc. and Brilliant Studios, Inc.

As a condition to the December 2001 financing transaction, the Original Notes and the Original Warrants were amended to correspond to all the terms of the New Notes and New Warrants. As a consequence, Harris Toibb, Europlay 1, LLC and Preston Ford, Inc. are able to convert the aggregate purchase price of the Original Notes and all accrued interest into shares of our common stock at the much lower Conversion Price for the New Notes. In addition, these original investors are able to exercise the Original Warrants at a price per share equal to 1.125 times the much lower Conversion Price from the December 2001 financing.

In support of the December 2001 financing transaction, our Board of Directors sought and received an opinion from a reputable financial advisory firm that the financing transaction is fair to us and our stockholders from a financial point of view.

The issuance of the additional shares of Common Stock pursuant to the terms of the 2001 financing transactions, if so issued, could result in a change in control of the Company. As of December 19, 2001, upon conversion and exercise of his notes and warrants, Harris Toibb would own approximately 68% of our issued and outstanding common stock, assuming a Conversion Price of $0.20. As a consequence, following the conversion and exercise by him of the promissory notes and warrants, Mr. Toibb would own a majority of our voting securities and would be able to approve any matter presented to the stockholders for approval at a meeting, including the ability to elect all of the nominees for director presented to the stockholders for election at each annual meeting. The Board of Directors of the Company is divided into three classes, with each class to serve a staggered term of three years. One class of the Board of Directors is elected at each annual meeting of the stockholders. Accordingly, upon Mr. Toibb's conversion and exercise of his promissory notes and warrants, he would have the ability, within two annual meetings of stockholders, to elect a majority of the Company's Board of Directors.

On March 7, 2002, we entered into a Common Stock and Warrant Purchase Agreement among us, Harris Toibb, a current investor, and MarKev Services, LLC, an entity co-owned by our Chairman and our Chief Executive Officer and President (collectively, the "Purchasers"), whereby we sold (i) 5,673,222 shares of our common stock at $0.1322 per share (the "Purchase Price"), a price per share of our common stock based on the volume weighted average price of a share of our common stock on the American Stock Exchange over the five (5) consecutive trading days immediately preceding March 7, 2002, for an aggregate investment amount of $750,000, and (ii) warrants (the "Warrants") to purchase in the aggregate up to 10,085,728 shares of our common stock at an exercise price per share of $0.148725, which represents a price paid per share equal to 1.125 times the Purchase Price. Each of the Purchasers received "piggyback" registration rights with respect to the common stock they purchased and with respect to the common stock issuable upon exercise of the Warrants.

In support of the March 2002 financing transaction, our Board of Directors sought and received an opinion from a reputable financial advisory firm that the financing transaction is fair to us and our stockholders from a financial point of view.

The March 2002 financing transaction, was unanimously approved by an independent committee of the Board, as well as by the Board of Directors, with only our Chairman and our Chief Executive Officer and President, who are also Directors, abstaining because of their interest in the transaction. The Board approved the sale of up to $1,250,000 worth of common stock.

On March 20, 2002, we entered into a Common Stock and Warrant Purchase Agreement between us and David Wilson, a current investor who controls Preston Ford, Inc. and participated in the May 2001 financing, whereby we sold (i) 378,215 shares of our common stock at $0.1322 per share (the "Purchase Price"), a price per share of our common stock based on the volume weighted average price of a share of our common stock on the American Stock Exchange over the five (5) consecutive trading days immediately preceding March 7, 2002, for an aggregate investment amount of $50,000, and (ii) warrants (the "Wilson Warrants") to purchase in the aggregate up to 672,382 shares of our common stock at an exercise price per share of $0.148725, which represents a price paid per share equal to 1.125 times the Purchase Price. Mr. Wilson received "piggyback" registration rights with respect to the common stock he purchased and with respect to the common stock issuable upon exercise of the Wilson Warrants.

Our operations generated negative cash flow during the years ended December 31, 2000 and 2001, and we expect a significant use of cash during the upcoming 2002 fiscal year as we initiate the business opportunity for Altnet, Inc., as well as continue to develop our software tools and continue our marketing efforts for our tools and 3D rich media banners ads. We anticipate our current cash reserves, plus our expected generation of cash from existing operations, to fund our anticipated expenditures into the third quarter of 2002. As such, we will require additional equity or debt financing during 2002, the amount and timing depending in large part on our spending program. If additional funds are raised through the issuance of equity securities, our stockholders may experience significant dilution. Furthermore, there can be no assurance that additional financing will be available when needed or that if available, such financing will include terms favorable to our stockholders or us. If such financing is not available when required or is not available on acceptable terms, we may be unable to develop or enhance our products and services, take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition and results of operations, and would most likely result in our having to file for bankruptcy protection under the Internal Revenue Code. Please see "Cautionary Statements and Risk Factors - IF WE ARE UNABLE TO RAISE ADDITIONAL

FUNDS, WE MAY BE REQUIRED TO DELAY IMPLEMENTATION OF OUR BUSINESS PLAN, REDUCE OVERHEAD SIGNIFICANTLY OR SUSPEND OPERATIONS."
The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The carrying amounts of assets and liabilities presented in the financial statements do not purport to represent realizable or settlement values. The report of our Independent Certified Public Accountants for the December 31, 2001 financial statements included an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.

We are seeking additional funding and believe that, if we are successful in raising additional capital, this may result in improved operating results. There can be no assurance, however, that with any additional financing, higher cash flows will be generated by operations.

ACCOUNTING TREATMENT FOR DEVELOPMENT COSTS AND RESEARCH EXPENDITURES
Our accounting policy follows Statement of Financial Accounting Standards No. 86 ("SFAS No. 86"), which provides for the capitalization of software development costs once technological feasibility is established. The capitalized costs are then amortized beginning on the date the product is made available for sale either on a straight-line basis over the estimated product life or on a ratio of current revenues to total projected product revenues, whichever results in the greater amortization amount. Prior to reaching technological feasibility, we expense all costs related to the development of both our software tools and MultipathTM Movie titles. The Company achieved technological feasibility of its original Digital Projector during the third quarter of 1997. Since the date of achieving technological feasibility, the costs of developing MultipathTM Movies intended to be viewed on the original projector have been capitalized in accordance with SFAS No. 86. We continue to develop new Digital Projectors with enhanced functionality such as improved compression technology. Costs incurred in the development of new Digital Projectors are expensed until technological feasibility is reached. MultipathTM Movies that are developed for new Digital Projectors that have not yet reached technological feasibility are capitalized in accordance with SFAS No. 86 to the extent that they are compatible with an existing Digital Projector. Amounts incurred for MultipathTM Movies that are developed for new Digital Projectors that are not compatible with an existing projector and would require substantial revision in order to achieve compatibility are expensed as incurred.

ACCOUNTING GUIDANCE FOR REVENUE RECOGNITION FOR SOFTWARE TRANSACTIONS
Software sales entered into prior to December 15, 1997 were accounted for in accordance with AICPA Statement of Position ("SOP") 91-1, "Software Revenue Recognition." For transactions entered into after December 15, 1997 the Company recognizes revenue from the sale of software in accordance with SOP 97-2, "Software Revenue Recognition". SOP 97-2 provides guidance on when revenue should be recognized and in what amounts for licensing, selling, leasing, or otherwise marketing computer software.

NEW ACCOUNTING PRONOUNCEMENTS
In December 1999, the Securities and Exchange Commission ("SEC") released Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements," which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. Subsequently, the SEC released SAB 101B, which delayed the implementation date of SAB 101 for registrants with fiscal years that begin between December 16, 1999 and March 15, 2000. We were required to be in conformity with the provisions of SAB 101, as amended by SAB 101B, no later than October 1, 2000. The adoption of SAB 101, as amended by SAB 101B, has not had a material adverse effect on our financial position, results of operations or cash flows.

In October 2000, we adopted the Financial Accounting Standards Board SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards requiring that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability, measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized in earnings unless specific hedge accounting criteria are met. The adoption of SFAS No. 133 has not had a material effect on our financial statements.

In March 2000, the FASB issued Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation, and Interpretation of APB Opinion No. 25" (FIN. 44). The Interpretation is intended to clarify certain problems that have arisen in practice since the issuance of APB No. 25, "Accounting for Stock Issued to Employees." The effective date of the interpretation was July 1, 2000. The provisions of the interpretation apply prospectively, but they will also cover certain events occurring after December 15, 1998 and after January 12, 2000. The adoption of FIN. 44 has not had a material adverse effect on our current or historical consolidated financial statements, but may affect future accounting regarding stock option transactions.

In March 2000, EITF 00-2 "Accounting for Web Site Development Costs" was released. EITF 00-2 provides guidance on how an entity should account for costs involved in such areas as planning, developing software to operate the web site, graphics, content, and operating expenses. EITF 00-2 is effective for web site development costs incurred for fiscal quarters beginning after June 30, 2000. We adopted EITF 00-2 during the year ending December 31, 2000, and all amounts associated with our web sites were expensed in accordance with EITF 00-2.

In June 2001, the Financial Accounting Standards Board finalized FASB Statements No. 141, Business Combinations (SFAS 141), and No. 142, Goodwill and Other Intangible Assets (SFAS 142). SFAS 141 requires the use of the purchase method of accounting and prohibits the use of the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. SFAS 141 also requires that we recognize acquired intangible assets apart from goodwill if the acquired intangible assets meet certain criteria. SFAS 141 applies to all business combinations initiated after June 30, 2001 and for purchase business combinations completed on or after July 1, 2001. It also requires that, upon adoption of SFAS 142, we reclassify the carrying amounts of intangible assets and goodwill based on the criteria in SFAS 141.

SFAS 142 requires, among other things, that companies no longer amortize goodwill, but instead test goodwill for impairment at least annually. In addition, SFAS 142 requires that we identify reporting units for the purposes of assessing potential future impairments of goodwill, reassess the useful lives of other existing recognized intangible assets, and cease amortization of intangible assets with an indefinite useful life. An intangible asset with an indefinite useful life should be tested for impairment in accordance with the guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized at that date, regardless of when those assets were initially recognized. SFAS 142 requires us to complete a transitional goodwill impairment test nine months from the date of adoption. We are also required to reassess the useful lives of other intangible assets within the first interim quarter after adoption of SFAS 142.

In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 requires the fair value of a liability for an asset retirement obligation to be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We believe the adoption of this Statement will have no material impact on our financial statements.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFASB 144 requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations will no longer be measured at net realizable value or include amounts for operating losses that have not yet occurred. SFASB 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, are to be applied prospectively. We believe the adoption of this Statement will have no material impact on our financial statements.

CAUTIONARY STATEMENTS AND RISK FACTORS
Several of the matters discussed in this document contain forward-looking statements that involve risks and uncertainties. Factors associated with the forward-looking statements that could cause actual results to differ materially from those projected or forecast are included in the statements below. In addition to other information contained in this report, readers should carefully consider the following cautionary statements.

IF WE ARE UNABLE TO RAISE ADDITIONAL FUNDS, WE MAY BE REQUIRED TO DELAY IMPLEMENTATION OF OUR BUSINESS PLAN, REDUCE OVERHEAD SIGNIFICANTLY OR SUSPEND OPERATIONS.
We currently have a number of obligations that we are unable to meet without generating additional revenues or raising additional capital. If we cannot generate additional revenues or raise additional capital in the near future, we may become insolvent. As of December 31, 2001, our cash balance was approximately $185,000 and our outstanding accounts payable, accrued expenses and current debt totaled approximately $1,814,000. Historically, we have funded our capital requirements with debt and equity financing. Our ability to obtain additional equity or debt financing depends on a number of factors including our financial performance and the overall conditions in our industry. If we are not able to raise additional financing or if such financing is not available on acceptable terms, we may liquidate assets, seek or be forced into bankruptcy, and/or continue operations but suffer material harm to our operations and financial condition. These measures could have a material adverse affect on our ability to continue as a going concern.

WE HAVE A HISTORY OF LOSSES, A NEGATIVE NET WORTH AND MAY NEVER ATTAIN PROFITABILITY.
We have a limited operating history and have not attained profitability. Since inception, we have incurred significant losses and negative cash flow, and as of December 31, 2001 we had an accumulated deficit of $54.6 million. Additionally, as of the date of this report, our current liabilities exceed our current assets. We have not achieved profitability and expect to continue to incur operating losses for the foreseeable future as we fund operating and capital expenditures in the areas of software tools development, brand promotion, sales and marketing, administration, deployment of our Altnet peer-to-peer network and operating infrastructure. Our business model assumes that consumers and advertisers will be attracted to our rich media advertising formats (Brilliant Banners), and that animators and those who produce banner advertisements will use our b3d tools and technology in the development of other b3d-produced content. Our business model also assumes that a significant portion of our future revenues will be derived from our Altnet peer-to-peer business, which is not operational. This business model is not yet proven and we cannot assure you that we will ever achieve or sustain profitability or that our operating losses will not increase in the future or be inconsistent with the expectations of the public market. Primarily as a result of our continued losses, our independent public accountants modified the opinion on our December 31, 2001 financial statements to include an explanatory paragraph wherein they expressed substantial doubt about our ability to continue as a going concern.

IF WE BECOME INSOLVENT, WE WILL BE IN DEFAULT UNDER OUR SECURED CONVERTIBLE PROMISSORY NOTES, WHICH COULD RESULT IN OUR OBLIGATION TO PAY IMMEDIATELY ALL AMOUNTS THEN OUTSTANDING UNDER THE NOTES.
If we generally do not pay, or become unable to pay, our debts as such debts become due, we will default under our outstanding Secured Convertible Promissory Notes, in the aggregate principal amount of $3.0 million. If a default occurs, all amounts owed to the holders of the notes would immediately become due and payable. If the debt becomes due before its stated maturity in November 2002, we likely will not have sufficient funds to repay the indebtedness, which will entitle the holders of the notes to exercise all of their rights and remedies, including foreclosure on all of our assets which we pledged as collateral to secure repayment of the debt.

ALTNET IS AN UNPROVEN BUSINESS VENTURE AND MAY REQUIRE SIGNIFICANT CAPITAL TO BE SUCCESSFULLY IMPLEMENTED.
Our Altnet peer-to-peer business is unproven and we cannot guaranty that it will be successful. The success of the business will depend, in part, on our ability to enter into end user agreements with a sufficient number of qualified personal computer owners to allow the network to work efficiently and effectively, acceptance by corporate customers of our services, the technical viability of the commercially available DRM software we employ to protect the proprietary content that will pass through the Altnet network and reside on network computers, and our underlying peer-to-peer technology. Additionally, we do not have sufficient capital to internally fund Altnet's development and operations. Consequently, the capital necessary to launch and fund Altnet will need to come from outside sources. We cannot make assurances that sufficient capital will be available at all or on terms acceptable to us to fund Altnet's development and operations.

OUR BUSINESS MODEL CONTEMPLATES RECEIVING A SIGNIFICANT PORTION OF OUR FUTURE REVENUES FROM RICH MEDIA INTERNET ADVERTISEMENTS DEVELOPED AND SERVED USING OUR SOFTWARE TOOLS AND FROM INTERNET ADVERTISING SERVICES. INTERNET ADVERTISING IS DEPENDENT ON THE ECONOMIC PROSPECTS OF ADVERTISERS AND THE ECONOMY IN GENERAL AND RECENTLY HAS EXPERIENCED A SIGNIFICANT DECLINE. A CONTINUED DECREASE IN EXPENDITURES BY ADVERTISERS OR A PROLONGED DOWNTURN IN THE ECONOMY COULD CAUSE US TO FAIL TO ACHIEVE OUR REVENUE PROJECTIONS.

We are increasing our emphasis on generating revenues from the sale of our b3d tools for the creation of rich media Internet advertisements and from the sale of technologies and services to Web publishers, third party advertising representation firms, advertisers and agencies. In recent quarters, the market for Internet advertising has experienced lower demand, lower prices for advertisements and the reduction of marketing and advertising budgets. As a consequence, expenditures for Internet advertisements have decreased. We cannot be certain that future decreases will not occur and that spending on Internet advertisement will return to historical levels. A continued decline in the economic prospects of advertisers or the economy in general could cause us to fail to achieve our advertising-related revenue projections.

WE WILL NOT BE ABLE TO GENERATE REVENUES FROM OUR BRILLIANT BANNERS IF THEY DO NOT ACHIEVE MARKET ACCEPTANCE.
The success of our Brilliant Banner rich media ad format and our ability to generate revenues through sale and serving of these advertisements will be determined by consumer reaction and acceptance. To generate revenues, we must develop advertisements that appeal to the advertising community and the consumer, which is unpredictable. Additionally, our Brilliant Banner advertisements face competition from other online advertising companies like Unicast and Viewpoint. Other factors that influence our ability to generate revenues from our Brilliant Banners include:

• Acceptance of the Brilliant Banner advertising format by websites;
• Performance of the Brilliant Banner versus other rich media advertising formats and traditional 2D advertisements; and
• Our ability to broadly disseminate our Digital Projector, which is necessary to view our Brilliant Banners.

We distribute our Digital Projector and the software necessary to create and run our Altnet peer-to-peer business primarily by bundling it with Sharman Networks' KaZaA Media Desktop. We rely on computer users' demand for the KaZaA Media Desktop to increase the installed base of our (1) Digital Projector, which is necessary to view b3d-produced content such as our Brilliant Banners, and (2) Altnet software, which is necessary to connect users to our private peer-to-peer network. Our business, results of operations and financial condition could be materially adversely affected if we do not maintain our distribution relationship with Sharman Networks on acceptable terms or if this relationship does not achieve the projected distribution of our Digital Projector and Altnet software. Additionally, a disruption in the distribution of the KaZaA Media Desktop or a decrease in demand for the product by users would necessarily impact the future distribution of our technology. The KaZaA Media Desktop, as well as other peer-to-peer software products, is currently the subject of a lawsuit; Metro-Goldwyn-Mayer Studios, Inc. et. al. v. Grokster, Ltd. et. al., filed in the United States District Court for the Central District of California (Western Division) by twenty-eight entertainment companies claiming that, among other things, the KaZaA Media Desktop facilitates, contributes to and encourages copyright infringement. On November 18, 2001, there was an additional complaint filed, Lieber et. al v. Consumer Empowerment B.V., et. al. To the extent that Sharman Networks is precluded from distributing the KaZaA Media Desktop as a result of this litigation, it would prevent the further distribution of the Digital Projector and Altnet peer-to-peer software with the KaZaA product which could have a material adverse affect on our business and financial condition.

OUR STOCK PRICE MAY DECLINE SIGNIFICANTLY IF WE ARE DELISTED FROM THE AMERICAN STOCK EXCHANGE.
Our common stock currently is quoted on the American Stock Exchange. For continued inclusion on the American Stock Exchange, we must meet certain tests, including maintaining a sales price for our common stock above $1.00 per share, and net tangible assets of at least $4 million. We currently are not in compliance with both the bid price and net tangible assets requirements.

If we continue to fail to satisfy the listing standards on a continuous basis, the American Stock Exchange may, at its sole discretion, delist our common stock from the exchange. If this occurs, trading of our common stock may be conducted on (i) the NASDAQ SmallCap Market, if we qualify for listing at that time, which we currently do not, (ii) in the over-the-counter market on the "pink sheets", or (iii) if available, the NASD's "Electronic Bulletin Board." In any of those cases, investors could find it more difficult to buy or sell, or to obtain accurate quotations as to the value of our common stock. The trading price per share of our common stock likely would be reduced as a result.

WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY WITH OTHER COMPANIES THAT OFFER SOFTWARE TOOLS AND SERVICES SIMILAR TO OURS.
The markets for our software tools are highly competitive and characterized by pressure to incorporate new features and accelerate the release of new and enhanced products. A number of companies currently offer content development products and services that compete directly or indirectly with one or more of our tools sets. These competitors include, among others, Macromedia, Inc., Adobe Systems, Inc. as well as Pulse Entertainment, Inc. and Viewpoint Corporation. As we compete with larger competitors such as Macromedia across a broader range of product lines and different platforms, we may face increasing competition from such companies.

WE MAY BE UNABLE TO SUCCESSFULLY COMPETE WITH MICROSOFT, REAL NETWORKS AND OTHER COMPANIES IN THE MEDIA DELIVERY MARKET.
The market for software and services for the delivery of media over the Internet is constantly changing and highly competitive. Companies such as Microsoft Corporation and Real Networks, Inc. have substantial penetration in the media delivery market, and significantly greater resources than we do. More companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify. Because our b3d content, such as our Brilliant Banners, can only be viewed using our Digital Projector, if we do not achieve a widespread distribution of our media player, there will not be substantial demand for b3d-produced content or our software tools.

IF WE DO NOT IMPROVE OUR SOFTWARE TOOLS TO PRODUCE NEW, MORE ENHANCED 3D ANIMATED CONTENT, OUR REVENUES WILL BE ADVERSELY AFFECTED.
The software tools that enable us to create 3D content, such as our Brilliant Banners, have been developed over the past five years. Additional refinement of these tools is necessary to continue to enhance the b3d format. If we cannot develop improvements to these software tools, our Brilliant Banners and all other b3d-produced content may not obtain or maintain market acceptance and our revenues will be adversely affected.

ERRORS OR DEFECTS IN OUR SOFTWARE TOOLS AND PRODUCTS MAY CAUSE A LOSS OF MARKET ACCEPTANCE AND RESULT IN FEWER SALES OF OUR PRODUCTS.
Our products are complex and may contain undetected errors or defects when first introduced or as new versions are released. In the past, we have discovered software errors in some of our new products and enhancements after their introduction into the market. Because our products are complex, we anticipate that software errors and defects will be present in new products or releases in the future. While to date these errors have not been material, future errors and defects could result in adverse product reviews and a loss of, or delay in, market acceptance of our products.

TO DEVELOP PRODUCTS THAT CONSUMERS DESIRE, WE MUST MAKE SUBSTANTIAL INVESTMENTS IN RESEARCH AND DEVELOPMENT TO KEEP UP WITH THE RAPID TECHNOLOGICAL DEVELOPMENTS THAT ARE TYPICAL IN OUR INDUSTRY.
The software market and the PC industry are subject to rapid technological developments. To develop products that consumers desire, we must continually improve and enhance our existing products and technologies and develop new products and technologies that incorporate these technological developments. We cannot be certain that we will have the financial and technical resources available to make these improvements. For instance, for the twelve months ended December 31, 2001, we reduced our expenditures on research and development by $1.96 million as compared to the same period in 2000, due primarily to our capital constraints. We must make improvements to our technology while remaining competitive in terms of performance and price. This will require us to make investments in research and development, often times well in advance of the widespread release of the products in the market and any revenues these products may generate.

OUR STOCK PRICE AND TRADING VOLUME FLUCTUATE WIDELY AND MAY CONTINUE TO DO SO IN THE FUTURE. AS A RESULT, WE MAY EXPERIENCE SIGNIFICANT DECLINES IN OUR STOCK PRICE.
The market price and trading volume of our common stock, which trades on the American Stock Exchange, has been subject to substantial volatility, which is likely to continue. This volatility may result in significant declines in the price of our common stock. Factors that may cause these fluctuations include:

• variations in quarterly operating results
• the gain or loss of significant contracts
• changes in management
• announcements of technological innovations or new products by us or our competitors
• recommendations by securities industry analysts
• dilution to existing stockholders resulting from the issuance of additional shares of common stock
• short sales and hedging of our common stock

Additionally, the stock market has experienced extreme price and trading volume fluctuations that have affected the market price of securities of many technology companies. These fluctuations have, at times, been unrelated to the operating performances of the specific companies whose stock is affected. The market price and trading volume of our stock may be subject to these fluctuations.

IF OUR STOCK DOES NOT SUSTAIN A SIGNIFICANT TRADING VOLUME, STOCKHOLDERS MAY BE UNABLE TO SELL LARGE POSITIONS IN OUR COMMON STOCK.
In the past, our common stock has not experienced significant trading volume on a consistent basis and has not been actively followed by stock market analysts. The average trading volume in our common stock may not increase or sustain its current levels. As a result, we cannot be certain that an adequate trading market will exist to permit stockholders to sell large positions in our common stock.

FLUCTUATIONS IN OPERATING RESULTS MAY RESULT IN UNEXPECTED REDUCTIONS IN REVENUE AND STOCK PRICE VOLATILITY.
We operate in an industry that is subject to significant fluctuations in operating results from quarter to quarter, which may lead to unexpected reductions in revenues and stock price volatility. Factors that may influence our quarterly operating results include:

• the introduction or enhancement of software products and technology by us and our competitors
• the use by animators of our toolsets to create b3d-produced content
• the market's acceptance of our 3D Brilliant Banner advertising format
• our ability to launch and operate our Altnet peer-to-peer business

Additionally, a majority of the unit sales for a product typically occurs in the quarter in which the product is introduced. As a result, our revenues may increase significantly in a quarter in which a major product introduction occurs and may decline in following quarters.

DECREASES IN THE PRICE OF OUR COMMON STOCK COULD INCREASE SHORT SALES OF OUR COMMON STOCK BY THIRD PARTIES, WHICH COULD RESULT IN FURTHER REDUCTIONS IN THE PRICE OF OUR COMMON STOCK.
Our sales of common stock at a discount to the market price of our common stock, which may be necessary to raise additional capital to fund operations, could result in reductions in the market price of our common stock. Downward pressure on the price of our common stock could encourage short sales of the stock by third parties. Material amounts of short selling could place further downward pressure on the market price of the common stock. A short sale is a sale of stock that is not owned by the seller. The seller borrows the stock for delivery at the time of the short sale, and buys back the stock when it is necessary to return the borrowed shares. If the price of the common stock declines between the time the seller sells the stock and the time the seller subsequently repurchases the common stock, then the seller sold the shares for a higher price than he purchased the shares and may realize a profit.

WE WILL NOT BE ABLE TO GENERATE SIGNIFICANT REVENUES FROM OUR TECHNOLOGY BUSINESS IF OUR B3D TOOLSET DOES NOT ACHIEVE MARKET ACCEPTANCE.
Our b3d toolset may have programming errors, may be incompatible with other software or hardware products in the market, may face slow adoption in the marketplace and may face competition from other toolmakers. Other factors that influence our ability to generate revenues from our b3d toolset include:

• our marketing strategies
• the quality of our products and competing products
• critical reviews
• the availability of alternative forms of entertainment and leisure time activities
• our ability to sell advertising and sponsorships for the content
• our ability to increase the installed base of our Digital Projector, which is necessary to view b3d-produced content
• our b3d toolset may contain features, functionality or workflow conventions that may not be widely accepted by our target audience
• our ability to continue to develop, enhance and deliver the toolset in accordance with established milestones
• the marketplace's reluctance to adopt a new toolset

WE MAY NOT BE ABLE TO GENERATE SIGNIFICANT DEMAND FOR OUR PRODUCTS VIEWED ON THE INTERNET UNLESS THERE IS A REDUCTION IN THE TIME IT TAKES TO DOWNLOAD THE LARGE AMOUNTS OF DATA NECESSARY TO VIEW OUR PRODUCTS ON THE INTERNET.
Our revenue growth depends in part on our ability to distribute our products for viewing on the Internet. We believe that without reductions in the time to download animated content over the Internet, b3d-produced content may be unable to gain wide consumer acceptance. This reduction in download time depends in part upon advances in compression technology. We have previously experienced delays in the development of compression technologies, which, we believe, materially and adversely affected our online sales and results of operations. We believe that large, time-consuming downloads for both our Digital Projector and b3d content have previously deterred potential users of our products and have reduced the effectiveness of our marketing campaigns. The development of these technologies continues to be a significant component of our business strategy and a primary focus of our research and development efforts.

OUR PROPRIETARY TECHNOLOGY MAY NOT BE ADEQUATELY PROTECTED FROM UNAUTHORIZED USE BY OTHERS, WHICH COULD INCREASE OUR LITIGATION COSTS AND ADVERSELY AFFECT OUR SALES.
Our ability to compete with other entertainment software companies depends in part upon our proprietary technology. Unauthorized use by others of our proprietary technology could result in an increase in competing products and a reduction in our sales. We rely on trademark, patent, trade secret and copyright laws to protect our technology, and require all employees and third-party developers to sign nondisclosure agreements. We cannot be certain, however, that these precautions will provide meaningful protection from unauthorized use by others. We do not copy-protect our software, so it may be possible for unauthorized third parties to copy our products or to reverse engineer or otherwise obtain and use information that we regard as proprietary. Our customers may take inadequate precautions to protect our proprietary information. If we must pursue litigation in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others, we may not prevail and will likely make substantial expenditures and divert valuable resources. In addition, many foreign countries' laws may not protect us from improper use of our proprietary technologies overseas. We may not have adequate remedies if our proprietary rights are breached or our trade secrets are disclosed.

IF OUR PRODUCTS INFRINGE ANY PROPRIETARY RIGHTS OF OTHERS, A LAWSUIT MAY BE BROUGHT AGAINST US THAT COULD REQUIRE US TO PAY LARGE LEGAL EXPENSES AND JUDGMENTS AND REDESIGN OR DISCONTINUE SELLING OUR PRODUCT.
We believe that our products, including our software tools, do not infringe any valid existing proprietary rights of third parties. Any infringement claims, however, whether or not meritorious, could result in costly litigation or require us to enter into royalty or licensing agreements. If we are found to have infringed the proprietary rights of others, we could be required to pay damages, redesign the products or discontinue their sale. Any of these outcomes, individually or collectively, could have a material adverse effect on our business and financial condition.

WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF OUR COMMON STOCK.
Our adoption of a stockholders' rights plan, our ability to issue up to 700,000 shares of preferred stock and some provisions of our certificate of incorporation and bylaws and of Delaware law could make it more difficult for a third party to make an unsolicited takeover attempt of us. These anti-takeover measures may depress the price of our common stock by making third parties less able to acquire us by offering to purchase shares of our stock at a premium to its market price. Our Board of Directors can issue up to 700,000 shares of preferred stock and determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. Our Board of Directors could issue the preferred stock with voting, liquidation, dividend and other rights superior to the rights of our common stock. The rights of holders of our common stock will be subject to, and may be adversely affected by, the rights of holders of the share purchase rights and of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connexion with possible acquisitions and other corporate purposes, could make it more difficult for a third party to acquire a majority of our outstanding voting stock.

OUR RECENT CAPITAL RAISING EFFORTS HAVE RESULTED IN SUBSTANTIAL DILUTION TO OUR STOCKHOLDERS AND OUR FUTURE CAPITAL NEEDS WOULD INCREASE THIS DILUTION.
During 2001, we raised $3.0 million through the sale of convertible promissory notes and common stock purchase warrants. The promissory notes, which mature on November 10, 2002, and accrued interest may be converted by the holders at any time into a number of shares of our common stock determined by dividing the amount due under the notes, including interest, by a price equal to the lesser of $.20 and the lowest 5 day volume weighted average price of our common stock as reported by the American Stock Exchange at any time during the term of the notes. At March 22, 2002, the principal and interest outstanding under the Notes could be converted by the holders into 26,624,194 shares of common stock, which would represent 54.1% of our outstanding common stock immediately following the conversion. The warrants have an expiration date of May 23, 2004 and entitle the holders to purchase up to an aggregate of 200% of their invested capital in shares of our Common Stock at a per share exercise price equal to 112.5% of the conversion price. The exercise of the warrants would increase the number of shares outstanding and result in further dilution to our other stockholders. Additionally, during the first quarter of 2002, we raised an additional $800,000 through the sale of 6,051,437 shares of common stock and common stock purchase warrants. These warrants have an expiration date of May 23, 2004 and entitle the holders to purchase up to an aggregate of 10,758,110 shares of our Common Stock at a per share exercise price of $0.148725. We anticipate that during remainder of 2002, we will need to raise additional capital, as our current operations do not generate positive cash flow. As such, any additional capital raising efforts would cause further dilution to stockholders.