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

Form 10-Q

(Mark one)

Commission File Number:  72870

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

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

Yes   x            No               

The number of outstanding shares of the registrant’s Common Stock on July 31, 2002, was 15,635,698.

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SONIC SOLUTIONS

FORM 10-Q

For the quarterly period ended June 30, 2002

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PART I – FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

Sonic Solutions

Condensed Balance Sheets
(in thousands, except share amounts)

See accompanying notes to condensed financial statements.

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Sonic Solutions

Condensed Statements of Operations
(in thousands, except per share amounts — unaudited)

See accompanying notes to condensed financial statements.

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Sonic Solutions

Condensed Statements of Cash Flows
(in thousands — unaudited)

See accompanying notes to condensed financial statements.

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Sonic Solutions

Notes to Condensed Financial Statements
(unaudited)

(1)      Basis of Presentation

              The accompanying unaudited condensed financial statements of Sonic Solutions, referred to as “we,” “Sonic,” “our” or “the Company” have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, the condensed financial statements include all adjustments (consisting of only normal, recurring adjustments) necessary for their fair presentation. The interim results are not necessarily indicative of results expected for a full year. These unaudited condensed financial statements should be read in conjunction with the financial statements and related notes included in the Company’s Form 10-K for the year ended March 31, 2002, filed with the Securities and Exchange Commission (SEC).

Use of Estimates and Certain Concentrations
              We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. We are also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.

Revenue Recognition
              We have adopted Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition, with Respect to Certain Arrangements” and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” 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 derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements 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, for example, the license to use software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. 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

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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 (such as receipt of a signed agreement, purchase order or a royalty report), delivery of the product (including hardware) has occurred (generally F.O.B. shipping point), 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.

              Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized under the “percentage of completion” method of contract accounting. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

              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; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; and (3) amounts billed to technology customers for license and development agreements.

   (2)      Basic and diluted income (loss) per share

              The following table sets forth the computations of shares and net income (loss) per share, applicable to common shareholders used in the calculation of basic and diluted net income (loss) per share for the first quarter ended June 30, 2002 and 2001 (in thousands, except per share data, unaudited), respectively:

              As of June 30, 2001 potentially dilutive shares totaling 721,791, for convertible preferred stock and options with exercise prices less than the average market price that could dilute earnings per share in the future, were not included in diluted loss per share as their

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effect was anti-dilutive for those periods. As of June 30, 2002, dilutive shares totaling 4,018,608, for convertible preferred stock and options with exercise prices less than the market price as of June 30, 2002, were included in the diluted income per share calculation. The computation of diluted earnings per share excludes stock options to purchase 1,093,842 shares of common stock. The shares were excluded because the exercise prices for the options were greater than the respective market price of the common shares and their inclusion would be anti-dilutive.

(3)       Inventory

              The components of inventory consist of (in thousands, unaudited):

(4)       Ravisent License Agreement

            On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us. Under the agreement, we paid Axeda a one-time fee of $2 million for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market. As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees.

            The accounting for this transaction was applied pursuant to the purchase accounting method. The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):

(5)       Credit Facilities and Debt Restructuring

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              On May 4, 2000, we entered into a 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 fiscal year March 31, 2002, we drew $2,400,000 from the equity line for which we issued 1,496,546 shares of common stock. During the first quarter ended June 30, 2002, we drew $2,000,000 from the equity line for which we issued 269,360 shares of common stock. The maximum number of shares we can sell after June 30, 2002 under this agreement is approximately 420,000 shares with gross proceeds of approximately $2,940,000 (assuming a market price for our shares of $7.00 per share.)

              In October 1999, $1,500,000 of debt due to Hambrecht and Quist Guaranty Finance per various financing agreements 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 expiring on April 30, 2006. 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. These warrants were exercised with respect to 70,000 shares at various times during fiscal years 2001 and 2002. During the first quarter ended June 30, 2002, warrants with respect to the remaining 50,000 shares were exercised.

(6)        Equity Financing – Convertible Preferred Stock

Convertible Preferred Stock – Series D

              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. Certain of the rights, preferences, and privileges of the holders of the Series D Preferred Stock include the following:

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Convertible Preferred Stock – Series E

              In December, 2001, we sold 250,000 shares of Series E Preferred Stock to Sanshin Electronic Co., Ltd. for $1,000,000. The Series E Preferred Stock was sold to Sanshin pursuant to the exemption provided by Section 4(2) of the Securities Act of 1933. Sanshin, the only investor, provided representations to Sonic Solutions that enabled Sonic Solutions to rely on this exemption, including the following: Sanshin’s status as an accredited investor, its sophistication and its intention to hold the securities. Certain of the rights, preferences and privileges of the holder of the Series E Preferred Stock include the following:

(7)      Significant Customer Information and Segment Reporting

              Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” 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 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:

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         Revenues by Product Line (in thousands):

              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 (in thousands):

              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 (in thousands):

Customer A is a current distributor and a shareholder of the Company. Included in deferred revenue at June 30, 2002, was an amount of approximately $189,000, received from Customer A.

Revenue recognized from Customers B and C is pursuant to development and licensing agreements for which amounts had been prepaid and previously included in deferred revenue.       

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(8)      Recently Issued Accounting Pronouncements

              The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”), in August 2001, and Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), in October 2001. SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs a legal obligation. SFAS No. 144 serves to clarify and further define the provisions of SFAS No. 121, “Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of.” SFAS No. 144 does not apply to goodwill and other intangible assets that are not amortized. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002 and SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. We expect to adopt SFAS No. 143 effective April 1, 2003 and have adopted SFAS No. 144 effective April 1, 2002. The effect of adopting SFAS No. 143 is not expected to have a material effect on our financial position or results of operations. The adoption of SFAS 144 has not had a material impact on our financial position or results of operations.

              In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations be accounted for under the purchase method for business combinations initiated after June 30, 2001 and for which the date of acquisition is July 1, 2001 or later. Use of the pooling-of-interest method is no longer permitted. SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142, addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life; rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Also, if the benefit of an intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, an acquired intangible asset should be separately recognized. We adopted SFAS No. 142 effective April 1, 2002. The Company did not have any intangible assets on April 1, 2002. The adoption of SFAS No. 142 has not had a material impact on our financial position or results of operations.

              In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt,” and an amendment of that Statement, No. 64 “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements”, and Statement No. 44 “Accounting for Intangible Assets of Motor Carriers.” SFAS No. 145 also amends FASB Statement No. 13 “Accounting for Leases” to eliminate the required accounting for sale-leaseback transactions. We expect to adopt SFAS No. 145 effective April 1, 2003. The adoption of SFAS No. 145 is not expected to have a material effect on our financial position or results of operations.

              In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses how costs associated with an exit activity or with a disposal of long-lived assets should be accounted for. SFAS No. 146 is effective for activities initiated after December 31, 2002, therefore, we expect to adopt SFAS No. 146 effective January 1, 2003. The adoption of SFAS No. 146 is not expected to have a material effect on our financial position or results of operations.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

              This report contains forward-looking statements within the meaning of federal securities laws that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Risks and uncertainties and the occurrence of other events could cause actual results to differ materially from these predictions. Factors that could cause or contribute to such differences include those discussed below as well as those discussed in our Annual Report on Form 10-K for the year ended March 31, 2002 and our other filings with the Securities and Exchange Commission.

              Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these statements. We are under no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results.

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 our professional customer orders and on shipments of our OEM partners which are difficult to forecast. Because our professional customers generally order on an as-needed basis and we normally ship products within one week after receipt of an order, and because our OEM partners report shipments during or after the end of the period, we do not 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 professional product revenenue 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 professional revenue generated in the last few weeks of a quarter or if OEM partner shipments do not meet our forecast, operating results can be very negatively affected.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

              We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying valued of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.

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              We believe the following critical accounting policies impact the most significant judgments and estimates used in the preparation of our financial statements:

              - Revenue Recognition

              Revenue recognition rules for software companies are very complex. We follow very specific and detailed guidance in measuring revenue. Certain judgments, however, affect the application of our revenue policy.

              We have adopted Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition,” with respect to certain arrangements and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” 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 derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements 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, for example, the license to use the software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. 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.

              Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized under the “percentage of completion“ method of contract accounting. Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

              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; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; and (3) amounts billed to technology customers for license and development agreements.

              - Allowance for Doubtful Accounts

              We maintain an allowance for doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified in our portfolio of

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receivables. If the financial condition of our customers deteriorates resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, additional allowances might be required.

               - Capitalized Software

              We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standard No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or otherwise Marketed.” Such capitalized costs are amortized to cost of revenue over the estimated economic life of the product, which is generally three years. Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value. To the extent unamortized capitalized cost exceeds net realizable value based on the product’s estimated future gross revenues, reduced by the estimated cost of sales, the excess is written off. This analysis requires us to estimate future gross revenues associated with certain products, and the future cost of sales. If these estimates change, write-offs of capitalized software costs could result.

              - Impairment of Goodwill and Other Intangible Assets

              On January 1, 2002 we adopted SFAS No. 142 "Accounting for Goodwill and Other Intangible Assets." SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. In accordance with SFAS No. 142, goodwill is no longer amortized over its estimated useful life, rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Goodwill has resulted from our Ravisent product business acquisition during the first quarter ended June 30, 2002, which was accounted for as a purchase.

              On April 1, 2002, we adopted SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS No. 121 “Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of.” There was not a cumulative transition adjustment upon adoption. In accordance with SFAS 144, we evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We do not have any long-lived assets which we consider to be impaired.

               - Other Contingencies

              We are subject to various claims relating to product, technology, patent, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted.

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Results of Operations

              The following table sets forth certain items from the Company’s statements of operations as a percentage of net revenue for the first quarter ended June 30, 2001 and 2002 (in thousands):

Comparison of First Quarters Ended June 30, 2001 and 2002

              NET REVENUE. Our net revenue increased from $4,204,000 for the first quarter ended June 30, 2001 to $7,384,000 for the first quarter ended June 30, 2002, representing an increase of 76%. The increase in net revenue was primarily due to the increase in sales of our DVD creation software products which increased approximately 309%. Included in DVD creation software sales is revenue recognized on new license development contracts which were entered into during the second half of fiscal 2002. This increase was offset in part by decreases in our professional audio and DVD sales of approximately 14%.

              International sales accounted for 53.6% and 20.7% of our net revenue for the first quarter ended June 30, 2001 and 2002, respectively. See Note 7 of Notes to Condensed Financial Statements. International sales have historically represented approximately 50% of our total sales, and we expect that they will continue to represent a significant percentage of future revenue. However, the percentage may decrease due to the anticipated increase in domestic OEM revenue related to sales of our DVD creation software products.

              COST OF REVENUE. Our cost of revenue, as a percentage of net revenue decreased from 33.0% for the first quarter ended June 30, 2001 to 25.8% for the quarter ended June 30, 2002. The decrease in cost of revenue was primarily due to a shift in sales product mix towards higher margin consumer DVD products (including software license and development contracts) and to the reduction of hardware as a percentage of revenue in our professional DVD systems.

              MARKETING AND SALES. Our marketing and sales expenses decreased from $2,176,000 for the first quarter ended June 30, 2001 to $2,146,000 for the first quarter ended June 30, 2002.

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Marketing and sales represented 51.8% and 29.1% of net revenue for the first quarter ended June 30, 2001 and 2002, respectively. Our marketing and sales expenses decreased due to a decrease in headcount from fourty-four at June 30, 2001 to forty-one at June 30, 2002. This decrease was offset in part by increases in dealer and employee commission expenses, which as a percentage of net revenue increased from 4.0% for the first quarter ended June 30, 2001 to 7.0% for the first quarter ended June 30, 2002.

              RESEARCH AND DEVELOPMENT. Our research and development expenses increased from $1,448,000 for the first quarter ended June 30, 2001 to $1,892,000 for the first quarter ended June 30, 2002. Our research and development expenses represented 34.4% and 25.6% of net revenue for the first quarter ended June 30, 2001 and 2002, respectively. Our research and development expenses increased primarily due to higher salary expense associated with an increase in headcount from thirty-six at June 30, 2001 to fifty-eight at June 30, 2002 which was offset in part by a decrease in consulting and translation expenses relating to our DVD creation software products.

              We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standards 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 to cost of revenue over the estimated life of the products in which the software is included. During the first quarter ended June 30, 2002 we capitalized approximately $120,000 and amortized approximately $149,000 and during the first quarter ended June 30, 2001 we capitalized approximately $120,000 and amortized approximately $147,000 (excluding amount amortized relating to Daikin and Ravisent acquisitions.) We expect to continue to amortize more than we capitalize.

              GENERAL AND ADMINISTRATIVE. Our general and administrative expenses increased from $450,000 for the first quarter ended June 30, 2001 to $857,000 for the first quarter ended June 30, 2002. Our general and administrative expenses represented 10.7% and 11.6% of net revenue for the first quarter ended June 30, 2001 and 2002, respectively. The increase was primarily due to increased rent, insurance, professional and other general expenses primarily related to the overall increase in headcount from ninety-five to one hundred and seventeen. We anticipate that general and administrative expenses will increase in the future as costs increase and our operations expand.

              BUSINESS INTEGRATION EXPENSE. In conjunction with the Daikin acquisition completed in February 2001, for the first quarter ended June 30, 2001, we incurred expenses to transition the business to our management. As such, these expenses do not exist during the first quarter ended June 30, 2002. This transition has been completed and all expenses were incurred as of the quarter ended December 31, 2001. Business integration expenses primarily consisted of engineering consulting expenses per the consulting agreement we entered into with Daikin dated February 27, 2001.

              OTHER INCOME AND EXPENSE. Other income on our statement of operations includes the interest we earned on cash balances and short term investments. Other expense includes primarily the interest and other financing charges related to financing agreements we had with entities associated with Hambrecht & Quist.

              PROVISION FOR INCOME TAXES. In accordance with Statement of Financial Accounting Standards No. 109, we made no provision for income taxes for the first quarters ended June 30, 2001 and 2002. For the first quarter ended June 30, 2002, foreign tax expense was recorded to reflect the taxes withheld by various Japanese customers and paid to the Japanese taxing authorities. In the fiscal year ended March 31, 1997, we exhausted our ability to carryback tax losses resulting from operations.

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              LIQUIDITY AND CAPITAL RESOURCES. On May 4, 2000, we entered into a Private Equity Line Agreement (the “Agreement”) with Kingsbridge Capital. See Note 5 of "Notes to Condensed Financial Statements" for further discussion.

              Our operating activities generated cash of $7,000 for the first quarter ended June 30, 2001 and used cash of $1,508,000 for the first quarter ended June 30, 2002. During the quarter ended June 30, 2001, cash generated from operations included a net loss of $1,643,000 including depreciation and amortization of $647,000. Cash generated from operations was primarily generated by the increase in deferred revenue of $694,000 and the decrease in accounts receivables of $263,000 due to strong collections.

              During the quarter ended June 30, 2002, cash used in operations included net income of $576,000 including depreciation and amortization of $597,000. Cash used in operations was primarily the result of the decrease in deferred revenue of $2,392,000 as a result of revenue recognized on various OEM and development contracts, the increase in accounts receivables of $905,000 primarily due to increased sales, offset in part by the increase in accounts payable and accrued liabilities of $835,000. During the quarter ended June 30, 2002, cash was used in the amount of $2,275,000, to complete the acquisition of the Ravisent product line from Axeda.

              During the quarters discussed above, our current ratio increased primarily due to increase in cash from deposits and prepayments received from OEM and licensing customers which was offset in part by the increase in the deferred revenue account. In addition to our operations, we utilized cash during both quarters to purchase new fixed assets and to develop and purchase software that was added to capitalized software.

             We lease certain facilities and equipment under noncancelable operating leases. Rent expense under operating leases for the first quarters ended June 30, 2001 and 2002 was approximately $278,000 and $335,000 respectively. Future payments under these operating leases that have initial remaining noncancelable lease terms in excess of one year are approximately $4,425,000. Approximately $738,000 will be expensed during the remainder of fiscal year 2003.

              During the first quarters ended June 30, 2001 and 2002, we augmented cash on hand primarily by drawing on the equity credit line 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 line. 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.

              We believe that existing cash, cash equivalents and short term investments, cash generated from operations, plus cash available through the equity based line of credit with Kingsbridge will be sufficient to meet our cash requirements at least through the middle of fiscal year 2004.

              As of June 30, 2002, we had cash and cash equivalents of $9,642,000 and working capital of $3,079,000.

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

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

              We were unprofitable during each of the last five fiscal years. For example, in fiscal year 2002, we had a net loss of $4,182,000 and in fiscal year 2001 we had a net loss of $5,855,000. We were unprofitable during each quarter of the 2000 and 2001 fiscal years and during the first three quarters of the 2002 fiscal year. We were profitable in the fourth quarter of the 2002 fiscal year and the first quarter of the 2003 fiscal year. Although we have provided revenue and earnings guidance indicating profitability during fiscal 2003, there are no assurances that we will meet such guidance and our inability to meet such guidance 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 may decline in value or the amount by which they may decline.

              During the fiscal years ended March 31, 2000 and 2001, and the first quarter of fiscal year 2003, we had negative operating cash flows.

              During the fiscal years ended March 31, 2000 and 2001, we had a negative operating cash flow of $2,628,000 and $848,000 , respectively. This means that without access to outside capital we would have had to cease or significantly curtail operations. During the fiscal year ended March 31, 2002, we had a positive operating cash flow of $5,708,000. The positive cash flow for fiscal year ended March 31, 2002 was due primarily to the increase in sales and the increase in deferred revenue. During the first quarter ended June 30, 2002, we had a negative operating cash flow of $1,508,000, primarily due to the decrease in deferred revenue and deposits as a result of recognizing revenue on certain OEM and development agreements and the increase in accounts receivable. There are no assurances that we may continue to report positive operating cash flow in the future, and we might 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; issuance of stock under that agreement may also dilute our shareholders, adversely affect our earnings per share, and may reduce our share price.

              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 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%.

              As of March 31, 2002, we had sold under this agreement 1,707,962 shares of common stock with gross proceeds to us of approximately $2,600,000 During the first quarter ended June 30, 2002, we sold 269,360 shares of common stock with gross proceeds to us of approximately $2,000,000. Because of the limit on the number of shares we can sell to Kingsbridge, the maximum number of shares we can sell after June 30, 2002 under this agreement is approximately 420,000 shares with gross proceeds of approximately $2,940,000 (assuming a market price of our shares of $7.00 per share). Sale of the maximum number of shares would result in dilution to our shareholders of approximately 3%. Stated another way, if we sold the maximum number of shares to Kingsbridge still available under the equity line, then the ownership percentage of our existing shareholders (excluding insider common share ownership) would decline from approximately 86.3% to approximately 83.3% 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. 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. 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.

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              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, 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.

              Recent and future acquisitions may compromise our operations and financial results.

              On May 24, 2002, we entered into an agreement with Axeda in which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us. Under this agreement, we paid Axeda a one-time fee of $2 million for the license and related agreements, and in return obtained exclusive rights to deploy the RAVISENT technologies in the personal computer market. In addition, we acquired certain key engineers from Axeda. Any failure to successfully integrate the Axeda technology or employees could impact us negatively.

              This license agreement and the integration of the Ravisent’s products involves risk for us and for our shareholders. These risks include:

              The Ravisent business line was not profitable when owned by Axeda. It is possible that the Ravisent technology and employees will not be a positive contributor to our operations and instead will constitute a drain on our resources.

              As part of our efforts to enhance our existing products and introduce new products, we may pursue acquisitions of complementary companies, products and technologies. Acquisitions could adversely affect our operating results in the short term as a result of dilutive issuances of equity securities or usage of our cash and the incurrence of additional debt costs. The purchase price for an acquired company may exceed its book value, creating goodwill, possibly resulting in significant impairment write-downs charged to our operating results in future periods. We have limited experience in acquiring and integrating outside businesses and other acquisitions are likely to involve similar risks to those identified above.

              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.

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              Our products are based on integrated circuits or “chips” produced by other companies. For example, we use the IBM I960 chip manufactured by IBM and the Motorola DSP chip manufactured by Motorola. If these chip manufacturers or another chip manufacturer that we may be using discontinues or redesigns the chips we use for our products, then we will likely incursignificant 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 Scaler 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, trademarks 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: DVDit!, MyDVD, 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 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 in 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.

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              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 large percentage of our professional audio and DVD products operate only on Macintosh computers, the potential success of our products is tied to the success of this platform.

              Many of our current professional audio and DVD 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. Our Macintosh users generally demand that we maintain compatibility with the latest models of the Macintosh and the Macintosh OS. Currently our DVD Creator and DVD Fusion applications run only in OS 9. 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 for them 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.

              Because a large portion of our net revenue is from OEM customers, the potential success of our products is tied to the success of their product sales.

              Much of our consumer revenue is derived from sales to large OEM customers, which include for example Dell, Hewlett-Packard, Sony, Matrox and Avid. The revenue from many of these customers is recognized on a sell-thru basis. If there is a decrease in unit sales by these customers, our net revenue will decrease.

              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.

              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 Ahead, Apple Computer, CyberLink, Dazzle (a division of SCM Microsystems), Intervideo, Inc., MedioStream, Pinnacle, Roxio and Ulead. Most of these companies have greater financial and technological resources than ours.

              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 competes with DVDit! PE, DVD Fusion and ReelDVD. Apple also announced the availability of aggressively priced DVD recorders with certain models of their Macintosh personal computer. In mid-2001, Apple 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 their products more competitive with our products.

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              Our reliance on outsourcing our Web Store makes us vulnerable to third party’s operational problems.

              We have initiated a web-based retail store for our DVDit! and MyDVD products (as well as some of our professional products, for example, ReelDVD, that are priced in a range that is typically sold over the internet). We currently “outsource” our Web Store through an arrangement we have with Digital River. Under this arrangement, Digital River provides the servers which list our products and handle all purchase transactions through their secure web site.

              We believe that outsourcing our Web Store gives us significant benefits, in terms of security, flexibility and overall cost. However, outsourcing means that we are dependent on a third party for smooth operation of our Web Store. Our Web Store sales are a significant portion of our revenues (and, we expect, will produce an increasing revenue stream for us). Interruption of our Web Store could have a negative effect on our business.

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

              We tend to close a 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 65% of our professional sales have been procured in the last month of the quarter. Because most of our quarterly operating expenses and our inventory purchasing are committed prior to quarter end, we have little ability to reduce expenses to compensate for reduced sales.

              Approximately 35% of our revenue derives from revenue recognized on development and licensing agreements for the first quarter ended June 30, 2002.

              During the first quarter ended June 30, 2002, approximately 35% of our revenue was derived from revenue recognized on development and licensing agreements from two customers, which were entered into during the third quarter of fiscal year 2002. During the last three fiscal years, 2000, 2001, 2002, and the first quarter ended June 30, 2002, between 2% and 11% of our revenue was derived from sales of audio processing subsystems to Discreet Logic. During the fiscal years 2000, 2001, 2002, and the first quarter ended June 30, 2002 an additional 10%, 12%, 6% and 2%, respectively, of our revenue was derived from sales to our Japanese dealer, Sanshin Electronics Company who is also a shareholder in the Company. Additionally, during the fiscal year ended 2002 and the first quarter ended June 30, 2002, an additional 8% and 2% of our revenue was derived from sales to Daikin Industries, Ltd., our Japanese distributor and a shareholder in the Company. A decrease or interruption in any of the above mentioned businesses or their demand for our products or a delay in our development agreements 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 39% and 47% of our revenues in fiscal years 2002 and 2001, respectively and for approximately 53.6% and 20.7% of our revenues for the first quarters ended June 30, 2001 and 2002, respectively. These foreign customers expose us to the following risks, among others:

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

              Based upon the number of shares of common stock outstanding on June 30, 2002, conversion of 982,691 shares of preferred stock into common stock would dilute our shareholders by approximately 6%. This potential dilution could reduce the market price of our common stock.

              Our inability to recover our investment in SonicStudio LLC would require a write-down in our total assets.

              The total amount of net assets and liabilities transferred to SonicStudio LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661 and is included in other assets on our balance sheet. Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year note for $500,000. The note, which does not carry interest, is to be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid to us by them. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC. Should SonicStudio LLC not be able to repay the note or cease to do business, we would lose the value of our minority investment of $235,661, which would result in a charge to our financial statements to reflect the write-down of the value of the investment.

ITEM 3.              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

              Our exposure to market risk is limited. All of our international sales are denominated in U.S. 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. To date we have not engaged in any hedging activities.

              We do not use deriviatives 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.

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                            PART II – OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS

                            We are not party to any material legal proceedings.

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

                            No disclosure is required or applicable pursuant to Item 102 of Regulation S-K

ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant, Sonic Solutions, has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, in the City of Novato, State of California, on the 13th day of August, 2002.

   SONIC SOLUTIONS

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