Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Commission File Number: 33-90532

SPATIALIZER AUDIO LABORATORIES, INC.
(Exact name of registrant as specified in its charter)

920 Hampshire Road, Suite A-34
Westlake Village, California 91361
(Address of principal executive offices)

900 Lafayette Street, Suite 710
Santa Clara, California 95050
(Address of principal corporate offices)

Telephone Number: (408) 296-0600
(Registrant’s telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:   Yes  [X]    No  [   ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [X]

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).   Yes  [   ]    No  [X]

     The aggregate market value of the voting stock held by non-affiliates of the registrant computed by reference to the price at which the common equity was last sold as of the last business of the registrant’s most recently completed second quarter (June 29, 2002) was approximately $3,880,000 and at March 5, 2003 was approximately $1,944,000. In addition, affiliates held non-voting preferred stock valued at $879,670, plus accrued dividends, at both June 29, 2002 and March 5, 2003.

     As of March 5, 2003, there were 47,406,939 shares of the Registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the definitive proxy statement for the 2003 Annual Meeting are incorporated by reference into Part III hereof.

Table of Contents

PART I

Item 1.  Business

Overview

     Spatializer Audio Laboratories, Inc. (“Company” or “we”) is a developer, licensor and marketer of next generation technologies for the consumer electronics, personal computing, enterprise computing and entertainment industries. Our position as a developer of next generation technologies is based on our business relationships with brand leaders, such as Apple, Toshiba and Matsushita. We conduct our audio business through our parent company and our wholly owned subsidiary, Desper Products, Inc. (“DPI”). DPI has developed a full complement of patented and proprietary 3-D or virtual audio signal processing technologies directed to the consumer electronics and multimedia PC markets. We continue to expand our product offerings to take advantage of the emerging digital audio marketplace specifically for consumer products like Digital Versatile Disc (“DVD”) players, portable mp3 players, digital televisions and digital home, portable and auto entertainment devices. As of December 31, 2002, more than 40 million licensed units had been shipped covering all of these applications. DPI’s virtual audio signal processing technologies are currently incorporated in products offered by global brand leaders including in consumer electronics, Toshiba, Panasonic, JVC, Samsung, Sanyo, and Sharp, in the PC multimedia marketplace by Apple Computer, among others, and on the Internet through our VSP-11 universal sound processor and in software plug-ins for the WinAmp and Linux-based XMMS MP3 players. We are focused on broadening recognition of the Spatializer brand name through association with these and other globally recognized consumer electronics and multimedia computer brand leaders, and on broadening our audio technology and software base to position ourselves for continued growth. We believe that with the accelerating growth in the digital audio/video marketplace, the market for virtual audio technologies, and therefore for our products, is entering a new phase of opportunity.

     Our other wholly owned subsidiary, MultiDisc Technologies, Inc., (“MDT”) formed in June 1996 when we acquired development stage optical disc storage and robotics assets and technologies from Home Theater Products International, Inc., a debtor in possession, is now inactive. In September 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies, suspend research and development at MDT and to properly position the MDT assets for sale. Therefore, MDT has been accounted for as a discontinued operation. Since 1998, we have been unsuccessful in identifying a purchaser for the MDT assets or technology. Our repositioning in 1998 recognized that the capital investment required to properly commercialize the MDT technology was beyond our capacity. We believe this strategy provides a better opportunity to further solidify our position as a provider of virtual audio solutions, based on our available capital resources.

     We were incorporated in the State of Delaware in February, 1994. Our corporate office and research center is located at 900 Lafayette Street, Suite 710, Santa Clara, California 95050, Telephone (408) 296-0600. We also maintain offices at 920 Hampshire Road, Suite A-34, Westlake Village, California 91361. We have a Website at www.spatializer.com. Copies of this Annual Report, including our financial statements, and our quarterly reports on Form 10-Q as well as other corporate information of interest to our stockholders are available on our website promptly after filing or distribution.

     Desper Products, Inc. — Virtual Audio Signal Processing Technologies

     DPI has developed a suite of proprietary advanced audio signal processing technologies for the entire spectrum of applications falling under the general category of virtual audio. The objective in each product category is to create or simulate the effect of a multi-speaker sonic environment using two ordinary speakers (or headphones) for playback. The market for virtual audio is segmented into six broad categories of technology as identified in the listing below. Each of these technologies utilizes different underlying scientific principles in accomplishing its design objectives and is targeted to a specific class of consumer electronics or multimedia computer depending on the intended product use and functional capability of the product. DPI currently has other audio signal processing technologies under development which will serve to expand its market scope and partner product capabilities.

2

Table of Contents

Licensed Products

     Our current technology product applications are directed to (1) two-speaker and headphone virtualization of multi-channel audio for DVD players and home theater applications, (2) stereo and bass enhancement in consumer electronics products and multimedia PCs, and (3) downloadable software, purchased directly by consumers, delivering audio enhancement applications for PCs.

1.

Spatializer® 3D Stereo. Based upon proprietary and patented methods of stereo signal processing, the Company’s Spatializer® 3-D Stereo technology is designed to create a vivid and expansive three- dimensional surround sound listening experience from any stereo source input using only two ordinary speakers. Along with professional audio quality and coherent stable sonic imaging, the technology includes the Company’s unique DDP™ (Double Detect and Protect™) algorithm. DDP™ continuously monitors the underlying stereo signal and dynamically optimizes spatial processing, avoiding deleterious sonic artifacts common in other systems and provides “set and forget” ease of use for consumers. First introduced in July 1994 by DPI, in the

3

Table of Contents

			form of a 20 pin analog integrated circuit (IC) from Matsushita Electronics Corporation (“MEC”), the technology is now incorporated into low-cost, standard process ICs by four chip foundries (Matsushita, ESS Technologies, Inc., OnChip Systems and Luxsonor) for easy and inexpensive implementation in any consumer electronics or computer products utilizing stereo audio. The technology is currently available in both analog and digital formats. Matsushita introduced a new Spatializer IC design in 1999, offering the Spatializer 3-D Stereo effect in a simplified, lower cost package. In early 2002, we introduced a new algorithm-based technology which provides a virtual surround sound effect from a two channel input for DSP-based environments.
	2.		Spatializer® N-2-2™Digital Virtual Surround. In September 1996, DPI introduced Spatializer N-2-2, which the Company considers a “core”, and “enabling” technology for DVD based home theater products and personal computers. In mid-2001, DPI introduced Spatializer N-2-2 Ultra as the latest generation of this core audio technology. Through outstanding performance and continuous enhancement, Spatializer N-2-2 has emerged as the “de facto standard” for branded virtual surround sound as measured by most brand adoptions, cumulative shipments and market share of such brands in the DVD player market. DVD is considered by many to be the single most important and fastest adopted consumer audio/computer technology ever introduced. The audio standards for DVD (based upon geographic region) are multi-channel audio formats (Dolby Digital® (AC-3) and MPEG-2) which carry six (or more) discrete (independent) channels of audio — the front left and right channels, a center channel (for vocal tracks), two rear surround channels and a Low Frequency Effects (LFE or “sub-woofer”) channel for sound effects. The Spatializer N-2-2 software- based algorithms permit spatially accurate reproduction of this multi-channel audio over any ordinary stereo system using two rather than the five or six speakers normally required in traditional home theater setups. Spatializer N-2-2 runs in real-time on general purpose Digital Signal Processing (“DSP”) hardware platforms like those offered by LSI, Acer Labs, Inc., Motorola, VM Labs and Zoran; may be integrated with host based software-only MPEG-2 or DVD decoders (like WinDVD and PowerDVD, offered by InterVideo and Cyberlink, respectively, for the Intel® Pentium® series of microprocessors); and can be ported to any of the principal audio codecs or media processor/accelerator platforms performing Dolby Digital (AC-3) or MPEG-2 audio decoding. Spatializer N-2-2 has been approved by Dolby Laboratories and qualifies Spatializer licensees to use the newly created Dolby Digital VIRTUAL™ trademark on products incorporating the technology. We believe our Spatializer N-2-2 process has helped to widen and accelerate the market for DVD acceptance, because it delivers the full cinematic audio experience to ordinary consumers without the additional expense and complication of multi-speaker home theater playback systems.
	3.		Spatializer® Vi.B.E™. In early 1999, DPI introduced Spatializer Vi.B.E., a virtual bass enhancement technology. Spatializer Vi.B.E. produces a dynamic bass response from even the lowest-end speakers or headphones. This is particularly important in enhancing the audio of all forms of portable digital audio devices. Spatializer Vi.B.E. uses proprietary technology to generate the perception of realistic bass frequencies that are unaffected by actual speaker system frequency response capability.
	4.		Spatializer® VSP-11™. First introduced by DPI in early 2002, Spatializer® VSP-11 (Virtual Sound Processor 11) is a stand-alone application program for Microsoft Windows 95, 98, ME, 2000 and XP platforms that utilizes Spatializer’s proprietary psychoacoustic techniques to allow consumers to enjoy the benefits of the renowned Spatializer audio enhancement technologies on all leading media players, soft DVD players and file sharing programs. This means that Spatializer VSP-11 is truly a universal audio enhancement software package that will enhance output from the Microsoft® Media Player, Real Player®, Real Jukebox®, WinAmp®, WinDVD®, PowerDVD®, among others, without any special modification. It will run in conjunction with any sound card, as well as with USB audio.
	5.		Spatializer® Natural Headphone™ Spatializer Natural Headphone, introduced by DPI in March 2001, renders spatially accurate multiple speaker positions simulating the typical home theater or stereo arrangement through a headphone. The headphone algorithm delivers a high performance simulated surround sound experience, using a reasonable amount of processing power at a reasonable cost. Thus, this solution is equally practical and effective for both low-power portable devices and home theater applications. Unlike typical virtual surround sound headphone solutions, which rely heavily on reverberation which can sound unnatural, Spatializer Natural Headphone utilizes a combination of techniques to provide an expanded, yet natural sound field.
	6.		Spatializer® PCE™ Spatializer PCE, introduced in October 2001, makes high frequencies clearer, crisper and more brilliant while low frequencies are more dramatic, tighter and have more impact. Spatializer® PCE gives the manufacturer an inexpensive way to dramatically improve the sound of low-end loudspeakers, such as the kind found in televisions, boom boxes and computers. Spatializer PCE is also ideal for improving the quality of Internet audio, which can sound rather lackluster and dull due to compression or low bit rates. It can be applied prior to encoding audio streams, and can just as easily enhance the playback of the decompressed audio. It can improve the clarity, intelligibility and impact of both dialog and music. Spatializer

4

Table of Contents

			PCE works by both modifying and smoothing non-linear phase response and by creating psycho-acoustic cues. Typical equalization techniques cause phase distortion (non-zero group delay) due to non-linear phase response. Spatializer PCE has a nearly-linear phase response, which results in a near-zero group delay. This improves the “naturalness”, or transparency of the dialog or music by not adding to phase distortion already present in many playback systems.. Spatializer PCE can be custom tailored for two or an array of speaker configurations. Indeed, the technology, without a surround sound effect, can enhance single speaker applications as well.
	7.		Spatializer® enCompass AV™ Spatializer enCompass AV, launched in late 2002, is designed to offer high quality, multi-channel audio, even from mono or stereo sources. This technology allows owners of home theater systems with five or more speakers to hear a surround sound effect, utilizing all of their speakers to deliver full system utility from CDs, cassettes or VHS tape or records.

     In addition to these technologies, we offer a series of products introduced by DPI under the Spatializer DigitalFX™ brand, first introduced in early 2000. The Spatializer DigitalFX series is a comprehensive audio enhancement software solution based on the Company’s Spatializer N-2-2 virtual surround sound technology, Spatializer Vi.B.E and Spatializer PCE, combined with additional audio effects tailored and optimized for specific product applications. This powerful combination of technologies in a single product targeted for specific product applications provides a highly efficient and cost effective solution for the television, portable digital music, PDA, AV Receiver, PC and car audio markets.

     Spatializer Digital TVFX™ is a customized application of Spatializer technology optimized for digital and analog televisions with an on board digital signal processor. Spatializer integrates its original, patented 3D Stereo and N-2-2 technologies with speaker-compensation and Vi.B.E. bass enhancement algorithms. The digital processing of the stereo signal provides a striking and immersive audio experience while the virtual bass enhancement creates apparently deeper bass response from the small speakers utilized by most televisions. Optional reverb and equalizer features further enhance the audio experience. The result is a dramatic improvement to the overall audio sound field provided by the television. Spatializer Digital TVFX is 100% digital, and applicable to any TV system with an embedded DSP.

     Spatializer Digital OntheGoFX™ is targeted specifically for portable digital music players and Personal Data Assistants (PDAs). According to industry analysts, the portable digital player market is expected to grow significantly once the music industry establishes economically feasible, secure and convenient modes of electronic music distribution. Spatializer Digital OntheGoFX shares the same core 3D stereo technology as other members of the Spatializer DigitalFX series, but includes a highly effective headphone algorithm which produces an expanded headphone audio experience. In addition, the included Vi.B.E technology is particularly effective in improving the limited bass response of inexpensive lightweight stereo headphones often incorporated into these devices. The algorithms are highly efficient, utilizing a minimal amount of MIPS any standard embedded DSP.

     Spatializer Digital PCFX™ combines the entire suite of respected Spatializer audio technologies into a single, comprehensive and cost effective software audio solution for the Wintel platform. Since the product runs on the host CPU, with minimal CPU utilization, no discrete chip is required. Spatializer Digital PCFX provides Spatializer 3-D stereo, Spatializer N-2-2 virtual surround sound for DVD playback, Vi.B.E virtual bass enhancement and enCompass™ , Spatializer’s positional audio technology for computer games utilizing the Microsoft DirectX™ API. Apple Computer began utilizing Spatializer technology across their product platforms in October 1999.

     Spatializer Digital AVFX™ is tailored for AV Receivers equipped with a Dolby Digital decoder. Spatializer Digital AVFX provides Spatializer 3-D stereo, Spatializer N-2-2 virtual surround sound for DVD audio or video playback, Vi.B.E virtual bass enhancement and in the future, extensive room modeling and customized effects.

     Spatializer Digital AutoFX™ enhances the audio performance of DSP-based car stereo systems by delivering Spatializer’s 3-D stereo, bass enhancement, equalizer and reverb technology in a single solution. Optional positional audio voice cues for on board GPS and navigation systems, virtual surround sound for on board DVD player systems and space modeling will be offered on an optional and customized basis based on specific customer need.

5

Table of Contents

Licensing Activities

     Until 2000, we licensed our technologies primarily through semiconductor manufacturing and distribution licenses (“Foundry Licenses”) with semiconductor foundries. In turn, the foundries manufacture and distribute integrated circuits ICs (integrated circuits) or DSPs (digital signal processors) incorporating Spatializer technology to consumer electronics and multimedia computer OEMs.

     In 2000, we began offering foundries the option of entering into a non-royalty bearing distribution agreement with us. Under this business model, the foundry offers Spatializer technology as an optional feature, promotes our technology in their sales materials and cooperates with the Spatializer sales force in closing license agreements for Spatializer technology with the OEM customer. This business model provides the foundry with an additional selling feature at no additional cost to the foundry. The OEM can obtain use of the technology directly from Spatializer without any additional mark-up from the foundry.

     The terms of all of our licenses are negotiated on an individual basis requiring the payment of a per unit running royalty according to sliding scales based upon cumulative volume. Some of our licenses call for the payment of an up-front license issuance fee either in lieu of, or in addition to the running royalty. Other agreements require the OEM customer, rather than the foundry, to pay the royalty. Per unit royalties are generally reportable and payable 45 days after the end of the quarter following shipment from the Foundry to the OEM or, in the case of a distribution agreement, by the OEM to its accounts.

     OEMs who desire to incorporate these DSPs or ICs into their products are required to enter into a license (“OEM Licenses”) with us before they may purchase the ICs in quantity. Foundry Licenses generally have limited the sale of DSPs or ICs with Spatializer technology to OEMs who have entered into an OEM License with us. OEM licenses generally provide for the payment of a further per unit royalty by the OEM for OEM products incorporating a Spatializer IC (“Licensed Products”) payable in the quarter following shipment by the OEM of its Licensed Products.

     In early 2001, we reached an agreement with C-Cube Semiconductor II (now LSI Logic Corporation) to unbundle the royalty on their DSPs in order to facilitate the licensing of multiple technologies to OEM manufacturers and to help ensure that their products remained highly competitive in the market. As such, effective April 1, 2001, C-Cube’s customers using Spatializer technology have entered into direct licenses with us.

     We are currently negotiating new IC/DSP Foundry and OEM licenses with potential customers for Spatializer N-2-2 Ultra, Spatializer Vi.B.E., Spatializer Natural Headphone , Spatializer PCE and combinations and optimizations of these technologies under the Spatializer DigitalFX series.

     IC/DSP Foundry Licenses

     In 2000 and early 2001, VM Labs, Inc., MIPS Technologies, New Japan Radio Corporation (“NJRC”), Tvia, Inc. and Link Up Systems entered into Foundry License or Distribution Agreements for Spatializer N-2-2 and or DigitalFX. All but the NJRC agreements were non-royalty bearing distribution agreements, with per unit royalties to be paid by the OEM customer.

     In 2001, we entered into license or distribution agreements with Texas Instruments, Cirrus Logic, Sanyo, Sharp and Kenwood, among others.

     In 2002, we entered into Distribution agreements with Mediatech, Amlogic, LSI Logic and Samsung Semiconductor for the porting and distribution of our technologies to OEM manufacturers. These Distribution agreements grant the right to port and or distribute our technology only to licensed customers of Spatializer, who then pay a royalty for the use of such technologies.

     As of December 31, 2002, we have entered into thirteen non-exclusive Foundry Licenses for our Virtual Audio Signal Processing technologies with Matsushita Electronics Corporation (“MEC”), ESS Technology, Inc. (“ESS”), OnChip Systems, Inc. (“OnChip”), C-Cube Technologies, Inc. (“C-Cube”), Acer Labs, Inc. (“Ali”), Luxsonor, VM Labs, Inc., MIPS Technologies, NJRC, Tvia, Inc., Texas Instruments, Cirrus Logic and Link Up Systems. Foundry Licenses generally require the payment of per unit running royalties based upon a sliding scale computed on the number of Spatializer ICs or DSPs sold.

     As of December 31, 2002, more than 40 million ICs and DSPs incorporating Spatializer audio signal processing technology had been manufactured and sold.

6

Table of Contents

     OEM Licensees and Customers

     As of December 31, 2002, our technology has been incorporated in products offered by more than 100 separate OEM Licensees and customers on various economic and business terms. Some of these OEM Licenses required a license issuance fee and/or a separate per unit royalty, while others were licensed under the LUA or were authorized customers under bundled royalty licenses with the IC foundries. The OEM licensees and customers offer a wide range of products, which include DVD players, car stereo systems, direct view TVs, wide screen and projection TVs, VCRs, powered speakers, portable audio systems (“Boomboxes”), HiFi stereo systems and components, computer sound cards and graphics accelerator cards, multimedia desktop personal computers, notebook computers, LCD projectors, multimedia computer monitors, and arcade pinball and video games.

     In 2002, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Inc., JVC, Samsung and Toshiba Corporation, each of whom accounted for greater than 10% of our total 2002 revenues. One OEM accounted for 33%, another accounted for 25%, another accounted for 17% and one accounted for 10% of our royalty revenues during 2002. One other account comprised 9% of total 2002 revenues. All other OEM’s accounted for less than 5% of royalty revenues individually. During 2003 we anticipate a significant reduction in the revenues from Apple as it completes its migration to its newest operating system.

     The following table is a partial list of the OEM Licensees and authorized customers as of December 31, 2002:

     As is evident from the above list we have extensive relationships with OEM licensees and customers outside the United States and, in fact, Japanese and Korean based entities accounted for 50% and 17%, respectively in 2002. The products incorporating our technology are, in turn, sold throughout the world, in market segments and amounts that are consistent with the overall general world markets for consumer electronics and software.

Hardware Products

MultiDisc Technologies, Inc. — Network Based Modular, Scaleable Compact Disc/DVD Servers

     As its first effort to broaden our technology portfolio and capitalize on our strong relationships with manufacturers of consumer electronics and personal computer peripheral products, we acquired certain developmental stage technologies and assets from Home Theatre Products (“HTP”), for approximately $1,062,000 in June 1996 and formed a subsidiary, MDT. The MDT transaction, which was implemented through a court-approved sale in the HTP bankruptcy proceeding, included an array of compact disc server robotics and software technologies in various stages of completion. The MDT transaction was intended to position us for long term growth in a significant new market. Our intention was to license this technology or enter into third party manufacturing arrangements for sale of MDT CD/DVD changer products to OEMs.

     The MDT transaction brought a combination of proprietary electromechanical designs, robotics, operating software, firmware, intellectual property, and engineering know-how and five patent applications acquired in the asset acquisition. MDT added

7

Table of Contents

an additional forty-seven patent applications filed with the United States Patent & Trademark Office (“USPTO”) to bring the total to fifty-two patent applications filed.

     On September 25, 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies and to properly position the MDT assets for sale. The repositioning strategy recognized that the capital investment required to properly commercialize the MDT technology was beyond the Company’s capacity. As a result, all operations, including research and development activities, were suspended and the Company has accounted for MDT as a discontinued operation. The Company has explored the sale of the business or the patent portfolio with interested parties, but to date, no transaction has been consummated.

     Revenues and Expenses

     We generate revenues in our audio business from royalties pursuant to our Foundry, OEM, and other licenses, and from non-recurring engineering fees to port our technologies to specific licensees’ applications. The Company’s revenues, which totaled $1,856,000 in 2002, were derived almost entirely from Foundry and OEM license fees and royalties.

     We seek to maximize return on our intellectual property base by concentrating our efforts in higher margin licensing and software products and have eliminated our hardware product operations. Licensing operations have been managed internally by our personnel and through use of an international sales rep force.

     As noted above, in 2002, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Inc., JVC, Samsung and Toshiba Corporation, each of whom accounted for greater than 10% of our total 2002 revenues. One OEM accounted for 33%, another accounted for 25%, another accounted for 17% and one accounted for 10% of our royalty revenues during 2002. One other account comprised 9% of total 2002 revenues. All other OEM’s accounted for less than 5% of royalty revenues individually.

     The Company achieved profitable operating results in 2000 and 2002 as a result of overhead reductions combined with the strong growth of DVD-related revenues. In 2001, we began expanding our headcount, primarily in the engineering area in anticipation of continued growth. At midyear, in light of a weakening in market conditions and lower than anticipated royalties from a key Asian account, expenditures were once again curtailed in order to bring overhead levels more in line with current revenues. Declining revenues were experienced from three major customers resulting from sluggish sales of their products and the cessation of use of our products by the smaller of these customers. In addition, while overhead reductions were implemented at mid-year, profitability was further impacted by either the delay or cancellation of anticipated products using our technology in light of weak market conditions. As a result, we were not profitable in 2001. With the acquisition of new accounts and to a lesser degree, growth of existing accounts, we were able to increase revenues and reduce expenses, which returned the company to profitability.

Competition

     Virtual Audio Signal Processing Marketplace

     We compete with a number of entities that produce various audio enhancement processes, technologies and products, some utilizing traditional two-speaker playback, others utilizing multiple speakers, and others restricted to headphone listening. These include the consumer versions of multiple speakers, matrix and discrete digital technologies developed for theatrical motion picture exhibition (like Dolby Digital®, Dolby ProLogic®, and DTS®), as well as other technologies designed to create an enhanced stereo image from two or more speakers.

     Our principal competitors in the field of virtual audio are SRS Labs, Inc. and Qsound Labs, Inc. In addition, some DSP foundries and OEMs have proprietary virtual audio technologies that they regularly offer to OEMs at no cost. Pressure on OEMs to reduce their costs, particularly in the DVD market is intense. The marketplace is also susceptible to undisciplined competitors who, from time to time, may offer below market prices to generate short term revenue and larger market penetrations even if it does not provide for viable margins. In the future, our products and technologies also may compete with audio technologies and product applications developed by other companies including entities that have business relationships with the Company.

     We believe that we will favorably compete in this market because we offer a single source, complete suite of patented and proprietary 3D Stereo, interactive positional, virtual surround sound, headphone and speaker virtualization technologies. By virtue of our specialized engineering and OEM support, we can offer a “turn-key” audio solution to OEMs who do not possess this expertise

8

Table of Contents

internally. We also have developed new products that address our customer’s need for a low cost solution. In addition, the strength of our IC Foundry and OEM relationships and the Spatializer brand name recognition in the industry are other key differentiators between both our branded and unbranded competition. Lastly, we continue to explore new and alternative business models that we believe serve the interests of both our customers and our stockholders.

Patents, Trademarks and Copyrights

     Our core signal processing technology is covered by U.S. patents 5,412,731, 5,896,456 and 6,307,941. On March 20, 1998, we filed a patent on our enCompass V 2.0 technology with the USPTO covering the Company’s enCompass 2.0 positional audio gaming technology. In June 2000, we filed an additional patent application for our reduced cost/higher performance 3-D Stereo circuit design. In late 2002, we filed a patent application covering our Spatializer PCE technology. Much of our intellectual property consists of trade secrets. We possess copyright protection for its principal software applications and has U.S. and foreign trademark protection for its key product names and logo marks.

     The MDT transaction brought a combination of proprietary electromechanical designs, robotics, operating software, firmware, intellectual property, and engineering know-how and five patent applications acquired in the asset acquisition. MDT added an additional forty-seven patent applications filed with the USPTO to bring the total to fifty-two patent applications filed. However, due to the absence of working capital and suspension of all operating activities of MDT, MDT cannot pursue these applications and some applications have lapsed. The core MDT data storage technology is covered by U.S. patents 5,774,431, 5,822,283, 5,886,960 and 5,886,974. MDT has either obtained or applied for U.S. trademark protection for its principal product names and logo marks.

     On September 25, 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies and to properly position the MultiDisc assets for sale. The repositioning strategy recognized that the capital investment required to properly commercialize the MDT technology was beyond our capacity. As a result, operations, including all research and development activities were suspended and we have accounted for MDT as a discontinued operation.

Employees

     We began 2002 with five full-time and nine part-time employees and sales representatives and decreased our staff to four full time and eight part-time employees, consultants and sales representatives by December 31, 2002. At year-end, there were three full-time employees and three consultants engaged in research and development. We employ the services of outside professional consultants, particularly in the engineering area, due to the tight labor market for such professionals in Silicon Valley as well as the need for specialized expertise in the course of our business. None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We consider our relations with our employees and consultants to be satisfactory.

Item 2.  Properties

     Our corporate office and research center in Santa Clara, CA, is the primary location for our audio technology division, (“DPI”). We occupy approximately 2,700 square feet with an annual rent on a full service basis of approximately $79,000. The lease expired on November 30, 2002 and is renewed on a month to month basis.

     In Westlake Village, California we occupy approximately 300 square feet with an annual rent of approximately $9,600. The lease term on this space expired in April 2002 and is renewed on a month to month basis. This space in the Los Angeles area is used to facilitate business and contacts with the entertainment community as well as with our accountants, lawyers and directors.

     We lease an apartment in Santa Clara, CA for use by the chief executive officer when away from the executive office. The annual rent on this apartment is $18,840. The lease expires on March 30, 2003 and will be renewed for another six months on the same terms.

     We lease our space at rental rates and on terms which management believes are consistent with those available for similar space in the applicable local area. Our properties are well maintained, considered adequate and are being utilized for their intended purposes.

9

Table of Contents

LEGAL PROCEEDINGS

     In connection with the downsizing of the Company in 1998, a number of employees were terminated and have filed, on various dates, employment and compensation related claims with the California State labor authorities. All but two of these claims have been settled. Two former officers and employees of MDT filed labor and employment termination related claims before the Labor Commissioner in 2000 seeking approximately $400,000 each which was allegedly due under each of their respective employment agreements, which claims, if resolved in favor of the claimants, could be material to the financial statements of the Company. The Labor Commissioner postponed those proceedings while other litigation proceeded in the Superior Court, Orange County seeking declaratory relief to bar the labor claims, as well as return of intellectual property and unspecified damages for breaches of the former officers’ and employees’ employment agreements. These employees, however, filed for personal bankruptcy and, as a result, the state court proceeding was postponed and then dismissed primarily because of the bankruptcies. The claims became inactive. While bankruptcy for one employee has been dismissed, the claims have not been reactivated. We also anticipate that, from time to time, we may be named as a party to other legal proceedings that may arise in the ordinary course of our business.

Item 4.  Submission of Matters to a Vote of Security Holders

     There were no matters submitted to a vote of the security holders of the Company either through solicitation of proxies or otherwise in the fourth quarter of the fiscal year ended December 31, 2002.

Item 5.  Market for Registrant’s Common Equity and Related Stockholder Matters

     Our Common Stock was listed and commenced trading on the NASDAQ SmallCap market on August 21, 1995 under the symbol “SPAZ”. In January 1999, the Common Stock was delisted by the NASDAQ SmallCap Market due to our inability to maintain listing requirements. Our Common Stock immediately commenced trading on the OTC Bulletin Board under the same symbol. The following table sets forth the high and low sales price of our Common Stock on its principal market for fiscal years 2000, 2001 and 2002:

     On March 5, 2003, the closing price reported by the OTC was U.S. $0.05. Stockholders are urged to obtain current market prices for our Common Stock. Beginning April 1, 1997, Computershare Investor Services, through its purchase of the transfer agent business in 2000 of Harris Trust Company of California has been our transfer agent.

Record Holders

     To our knowledge there were approximately 192 holders of record of the stock of the Company as of March 5, 2003. However, our transfer agent has indicated that beneficial ownership is in excess of 6,000 stockholders.

10

Table of Contents

Dividends

     We have not paid any cash dividends on its Common Stock and have no present intention of paying any dividends. Our current policy is to retain earnings, if any, for use in operations and in the development of its business. Our future dividend policy will be determined from time to time by the Board of Directors.

     However, holders of our Series B Preferred Stock are entitled to a cumulative dividend, payable only out of assets legally available for such payments. Holders of our Series B Preferred Stock are entitled to dividends prior to any holders of our Common Stock or any subsequent series of preferred stock which we may issue.

Item 6.  Selected Consolidated Financial Data

     The following selected consolidated financial data should be read in conjunction with the Company’s Consolidated Financial Statements and related Notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included in Item 7. The selected financial data for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 are derived from the Company’s consolidated financial statements that have been audited by Farber & Hass LLP, independent certified public accountants. The consolidated statements of operation and cash flows for the year ended December 31, 2002 and the report thereon are included elsewhere in this Report.

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are key to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

     The first critical accounting policy relates to revenue recognition. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

11

Table of Contents

     The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.

     The third critical accounting policy relates to intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the patent (which range from 3 to 20 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with definite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing.

     The fourth critical accounting policy relates to the existence of an Audit Committee of our Board of Directors.

Audit Committee

     This committee is directed to review the scope, cost and results of the independent audit of the Company’s books and records, the results of the annual audit with Management and the internal auditors and the adequacy of the Company’s accounting, financial, and operating controls; to recommend annually to the Board of Directors the selection of the independent auditors; to consider proposals made by the Company’s independent auditors for consulting work; and to report to the Board of Directors, when so requested, on any accounting of financial matters.

Compensation and Stock Committee

     The Compensation and Stock Option Committee of the Company (the “Compensation Committee”) currently consists of Messrs. Pace and Segel, each of whom is a non-employee director of the Company and a “disinterested person” with respect to the plans administered by such committee, as such term is defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (collectively, the “Exchange Act”). The Compensation Committee reviews and approves annual salaries, bonuses and other forms and items of compensation for senior officers and employees of the Company. Except for plans that are, in accordance with their terms or as required by law, administered by the Board of Directors or another particularly designated group, the Compensation Committee also administers and implements all of the Company’s stock option and other stock-based and equity-based benefit plans (including performance-based plans), recommends changes or additions to those plans or awards under the plans.

     The following discussion and analysis relates to the financial condition and results of operations of the Company and our subsidiaries for the year ended December 31, 2002 compared to the year ended December 31, 2001, and the year ended December 31, 2001 compared to the year ended December 31, 2000.

     Results of Operations

For the Year Ended December 31, 2002, Compared to the Year Ended December 31, 2001

Revenues

     Revenues increased to $1,856,000 for the year ended December 31, 2002 compared to $1,604,000 for the year ended December 31, 2001, an increase of 16%. Revenues are almost entirely comprised royalties pertaining to the licensing of Spatializer® audio signal processing algorithms.

     The increase in revenues is attributed primarily to the addition of two new accounts which generated in excess of 10% of total revenue each, partially offset by declining royalties on declining analog chip sales from another account.

     Gross Profit

     Gross profit increased to $1,725,000 for the year ended December 31, 2002 compared to $1,507,000 in the comparable period last year, an increase of 14%. Gross margin decreased to 93% of revenue in the year ended December 31, 2002 compared with 94% of revenue for the comparable period last year. The increase in gross profit results from higher revenues in the current year, partially offset by slightly lower gross margin. This decrease in the gross margin percentage reflects a slight change in mix to commissionable foreign royalty revenue compared to non-commissionable U.S. sourced revenue. The Company maintains a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to the Company’s independent representatives that solicit and oversee the particular accounts.

     Operating Expenses

     Operating expenses for the year ended December 31, 2002 decreased to $1,711,000 (92% of sales) from $1,823,000 (114% of sales) for the year ended December 31, 2001, a decrease of 6%. The decrease in operating expenses results primarily from completion of various outside engineering consulting projects in 2001 for which we paid outside engineering fees. In 2002, a much greater level of applications engineering projects were either done in house or by our licensed distributors and the fees incurred for such work was significantly reduced over the prior year. However, levels of pure R&D were unchanged between the two years, as reflected by the level of new product introductions.

     General and Administrative

     General and administrative costs increased to $766,000 for the year ended December 31, 2002 from $707,000 for the year ended December 31, 2001, an increase of 9%. The increase is primarily due to increased legal expenses related to public filings and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.

12

Table of Contents

     Research and Development

     Research and Development costs decreased to $433,000 for the year ended December 31, 2002, compared to $639,000 for the year ended December 31, 2001, a decrease of 32%. The decrease in research and development expense was due completion of various outside engineering consulting projects in 2001 for which we paid outside engineering fees. In 2002, a much greater level of applications engineering projects were either done in house or by our licensed distributors and as such, the fees incurred for such work were significantly reduced over the prior year. However, levels of pure R&D were unchanged between the two years, as reflected by the level of new product introductions.

     The Company continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of encompass AV™ , development of Spatializer Audio Alchemy™, refinement of Spatializer Natural Headphone™ and applications engineering to port the Company’s technology to leading processor platforms.

     Sales and Marketing

     Sales and Marketing costs increased to $513,000 for the year ended December 31, 2002, compared to $476,000 for the year ended December 31, 2001, an increase of 8%. Spending was increase in the area of foreign travel, where the Asian customer visitation frequency was doubled in the second half of 2002.

     Net Income (Loss)

     Net Income was $18,000 for the year ended December 31, 2002, compared to net loss of $240,000 for the year ended December 31, 2001. Net Income for the current period is primarily the result of higher revenues and improved overhead management.

For the Year Ended December 31, 2001, Compared to the Year Ended December 31, 2000

Revenues

     Revenues decreased to $1,604,000 for the year ended December 31, 2001 compared to $2,202,000 for the year ended December 31, 2000, a decrease of 27%. Revenues include license issuance fees and royalties pertaining to the licensing of Spatializer® audio signal processing designs and non-recurring engineering fees.

     The decrease in revenues is attributed primarily to (i) decreased royalties from one account resulting from lower unit sales compared to the prior year, (ii) lower royalties from another account due to a timing difference between 2000 and 2001 created when royalty reporting shifted from the DSP foundry (on shipment of DSP) to OEM customer (shipment of DVD player), (iii) loss of an account in mid 2001 which had comprised less than 10% of sales in the prior year and (iv) decreases in per unit Spatializer N-2-2 royalties due to a volume-based sliding scale pricing structure with DSP foundries which did not stabilize until the beginning of the third quarter of 2000.

     Gross profit decreased to $1,507,000 for the year ended December 31, 2001 compared to $1,954,000 in the comparable period last year. Gross margin increased to 95% of revenue in the year ended December 31, 2001 compared with 89% of revenue for the comparable period last year. The decrease in gross profit results from lower revenues in the current year, partially offset by higher gross margin. This increase in the gross margin percentage reflects the realignment of our Asian sales rep network which included the implementation of lower commission rates. The Company maintains a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs.

     Operating Expenses

     Operating expenses for the year ended December 31, 2001 increased to $1,823,000 (114% of sales) from $1,595,000 (72% of sales) for the year ended December 31, 2000, a increase of 11%. The increase in operating expenses results from expansion of the Company’s research and development efforts and higher general and administrative expenses relating to legal and public company expenses. The Company undertook an expansion of headcount in early 2001. When it became clear in mid 2001 that anticipated revenue growth was not occurring, the Company began to curtail the scope of its initiatives in order to bring spending levels back in line with reported revenue streams.

13

Table of Contents

     General and Administrative

     General and administrative costs increased to $707,000 for the year ended December 31, 2001 from $599,000 for the year ended December 31, 2000, an increase of 18%. The increase is primarily due to increased legal expenses related to public filings and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.

     Research and Development

     Research and Development costs increased to $640,000 for the year ended December 31, 2001, compared to $540,000 for the year ended December 31, 2000, an increase of 19%. The increase in research and development expense was due to the additions to headcount early in the year, search fees paid for certain engineers hired by the Company and expanded use of engineering consultants for specialized projects.

     In addition, the Company continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of Spatializer N-2-2 Ultra™ , development of Spatializer PCE™, refinement of Spatializer Natural Headphone™ and applications engineering to port the Company’s technology to leading processor platforms.

     Sales and Marketing

     Sales and Marketing costs increased to $476,000 for the year ended December 31, 2001, compared to $456,000 for the year ended December 31, 2000, an increase of less than one percent. Spending was maintained at the prior year’s level in order to continue the development of markets for existing products.

     Interest Income

     Interest income on short-term investments decreased $23,499 from 2000 to 2001 due to lower cash investments combined with lower interest rates.

     Interest Expense

     Interest expense decreased $22,862 due to repayment of $225,242 of Notes Payable to Related Parties in 2001.

     Other Income (Expense), Net

     Other income (expense) includes approximately $35,000 in gains on settlements of claims relating to its discontinued operation, MDT.

     Net Income (Loss)

     Net loss was $240,000 for the year ended December 31, 2001, compared to net income of $382,000 for the year ended December 31, 2000. The net loss for the current period is primarily the result of lower revenues and higher overhead, partially offset by improved gross margin.

     Liquidity and Capital Resources

     At December 31, 2002, we had $859,000 in cash and cash equivalents as compared to $869,000 at December 31, 2001. The decrease in cash and cash equivalents is attributed to modest increases in fixed assets and patent filing expenditures. We had working capital of $1,125,000 at December 31, 2002 as compared with working capital of $1,124,000 at December 31, 2001. Our future cash flow will come primarily from the audio signal processing licensing, Original Equipment Manufacturers’ (“OEM”) royalties and from possible common stock issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which should generate additional cash flow without imposing any substantial costs on the Company. We anticipate that there will be a wind down of our licensing program in early 2003 with a large computer account as that entity completes its migration to its latest operating system. We added or expanded our relationships with JVC, Sanyo, Orion and Mediatech this past year. We believe that growth from these and other licensing arrangements including some that are pending but not announced or in negotiation, will substantially offset any revenue shortfalls from the computer account by the third quarter of fiscal 2003. Mediatech, in particular, has been successful in penetrating the DVD market and our relationship with them positions us well as the audio solutions provider of choice in these new accounts for 2003 and 2004. Further, by the second half of 2003, we expect to begin generating revenues from the Company's new products that were introduced in 2002.

     Like other operating enterprises, the events of September 11, 2001 in the United States brought a degree of uncertainty to our operations and hindered our ability to plan and meet with our contractual partners outside the United States in this dynamic environment. The operations of our business, and those of our competitors, may also be impacted by the continued trend in the

14

Table of Contents

semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. This challenges our ability to convert business opportunities to licensing agreements in those segments that allow us to maintain or rapidly increase revenue. As a result, the Company must develop and license its products and software solutions in a market that treats some audio products, including those of our competitors, on a commodity basis in those cases where the OEM product is considered a commodity product. While our software applications deliver what we and most manufacturers who listen to it believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. The Company has responded by offering additional products targeted to each price/quality segment of the market and continues to aggressively pursue new opportunities in emerging product categories and complements to our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for the Company, and its rational commercial competitors, to enhance their operating results.

     To the extent the Company maintains or exceeds its projected revenues and is not required to fund contingencies, it expects to continue to retain its current cash reserves and therefore, maintain its liquidity position at a consistent level both on a short-term and long-term basis. To the extent that the Company does not achieve current operating levels or is required to fund contingencies, it will be required to use some of its cash reserves and this could impact its longer term liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic market forces in which we operate, rather than to be affected by them. To address these objectives, we retained Neveric Capital, a San Francisco based investment banking firm, to identify and evaluate strategic opportunities and to explore alternatives to enhance stockholder value and support the Company's growth and overall strategy.

     In December 1999, we completed a set of financial transactions (the “1999 Transactions”) with certain existing holders of our equity and debt and with new institutional investors. The 1999 Transactions included the private placement of 1,884,254 additional shares of our Common Stock ($1.05 million in new capital or $0.56 per share), the issuance of warrants to acquire 2,100,000 shares of Common Stock exercisable for three years at an exercise price of $.67 per share), the cancellation of 500,000 warrants to acquire Common Stock issued in an earlier financing, the conversion of $1 million of short term debt into a new Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”) and the conversion of $225,000 of secured debt into secured convertible debt.

     In the 1999 Transactions, $895,000 in short term loan advances from officers, directors and their affiliates and certain other securities holders, and accrued interest of $134,647, were restructured into the $1,000,000 in new Series B Preferred Stock. The Series B Preferred Stock, and any dividends therefrom not converted into cash, were convertible commencing in 2001 into restricted Common Stock at a 10% discount, based on the 10 day average closing bid price prior to the conversion, but subject to a minimum conversion of $.56 per share and a maximum of $1.12 per share. The Company had an option to redeem with cash any Series B Preferred Stock not converted before the end of 2002 and to pay Series B Preferred Stock accrued and declared cumulative dividends of 10%. In November 2002, the Board of Directors and the holders of the Series B Preferred Stock, agreed to exchange the Series B Preferred Stock for a new Series B-1 Preferred Stock which had terms substantially the same as the Series B Preferred Stock, except that the conversion date was deferred to December 2005, no future dividends will accrue and dividends for prior periods on the Series B Preferred Stock were reset and recalculated to the LIBOR rate in effect on the first business day of each of 2000, 2001 and 2002, respectively and were paid through the issuance of the appropriate number of shares of Series B-1 Preferred Stock. The exchange was completed in December 2002. The 500,000 warrants issued in the 1999 Transactions expired, without exercise in December 2002. In connection with the exchange the Series B-1 Preferred Stock, we withdrew the Series A and Series B Preferred Stock and, therefore, currently the Series B-1 Preferred Stock is our only authorized or outstanding class of preferred stock.

     As noted above, in the 1999 Transactions, $225,000 of secured debt, including accrued interest, was converted into secured long term convertible debt. The long term debt was repaid with interest in 2001. We currently have a related party obligation of $112,500 which bears interest of 10% per annum, which we pay on a current basis. The debt is due on demand.

     We eliminated Net Liabilities of Discontinued Operation since the statute of limitations for claims has been exceeded. We continue to maintain an accrual for unasserted claims or settlement costs related to the discontinuation of MDT in 1999. We do not expect any final liability to be in excess of this balance.

     Funds generated by these financing activities as well as cash generated from our existing operations and customer base is expected to be sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business. The Company will also continue to consider and evaluate capital investment or business arrangements with financial or strategic participants or investors as such opportunities become available to the Company on terms that enhance shareholder value and support the Company’s business strategy.

     To the extent the Company maintains or exceeds its projected revenues and is not required to fund significant contingencies, it expects to continue to retain its current cash reserves and therefore, maintain its liquidity position at a consistent level both on a short-term and long-term basis. To the extent that the Company does not achieve current operating levels or is required to fund contingencies, it will be required to use some of its cash reserves and this could impact its longer term liquidity.

15

Table of Contents

     Net Operating Loss Carry forwards

     At December 31, 2002, the Company had net operating loss carry forwards for Federal income tax purposes of approximately $26,000,000 which are available to offset future Federal taxable income, if any, through 2013. Approximately $21,700,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000.

     Inflation

     We believe that the moderate inflation rate of the last several years has not impacted our operations.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

     In July 2001, the FASB issued SFAS No. 141, “Business Combinations,” which establishes financial accounting and reporting for business combinations and supersedes APB Opinion No. 16, “Business Combinations,” and FASB statement No. 38, “Accounting for Preacquisition Contingencies of Purchased Enterprises.” SFAS No. 141 requires that all business combinations be accounted for using one method, the purchase method. The provisions apply to all business combinations initiated after June 30, 2001.

     In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets,” which establishes financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, “Intangible Assets.” SFAS No. 142 addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition, and after they have been initially recognized in the financial statements. The provisions of SFAS no. 142 were effective for fiscal years beginning after December 15, 2001. We adopted SFAS No. 142 during the first quarter of fiscal 2002, and the adoption of SFAS No. 142 had no material impact on our financial reporting and related disclosures.

     In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which is effective for us beginning fiscal 2003. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made, with the associated asset retirement costs capitalized as part of the carrying amount of the long-lived assets. We do not expect the adoption of SFAS No. 143 to have a material impact on our financial position and results of operations.

     In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal periods. SFAS No. 144 supersedes FASB Statement No. 121 and parts 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 Relating to Extraordinary Items.” However, SFAS No. 144 retains the requirement of APB Opinion No. 30 to report discontinued operations separately from continuing operations and extends that reporting to a component of an entity that either has been disposed of (by sale, by abandonment or in a distribution to owners) or is classified as held for sale. SFAS No. 144 addresses financial accounting and reporting for the impairment of certain long-lived assets and for long-lived assets to be disposed of. We do not expect the adoption of SFAS No. 144 to have a material impact on our financial position and results of operations.

     In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities”, which nullifies EITF Issue 94-3. SFAS 146 is effective for exit and disposal activities that are initiated after December 31, 2002 and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred in contrast to the date of an entity's commitment to an exit plan, as required by EITF Issue 94-3. We do not expect the adoption of SFAS No. 146 to have a material impact on our financial position and results of operations.

     In December 2002, the FASB issued SFAS 148 “Accounting for Stock-Based Compensation” an amendment to SFAS 123. SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years ending after December 15, 2002 for transition guidance and annual disclosure provisions; for financial reports containing financial statements for interim periods beginning after December 15, 2002 for interim disclosure provisions. The adoption of SFAS No. 148 did not have a material impact on our financial position and results of operations.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at December 31, 2002. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.

16

Table of Contents

INDEPENDENT AUDITORS’ REPORT

To the Board of Directors Of Spatializer Audio Laboratories, Inc.:

     We have audited the accompanying consolidated balance sheets of Spatializer Audio Laboratories, Inc. and subsidiaries (The “Company”) as of December 31, 2002 and 2001 and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended December 31, 2002, 2001 and 2000. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spatializer Audio Laboratories, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of its operations and its cash flows for the years ended December 31, 2002, 2001 and 2000 in conformity with generally accepted accounting policies in the United States of America.

/s/   FARBER & HASS LLP

Oxnard, California
March 18, 2003

17

Table of Contents

Item 8. Financial Statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

See accompanying notes to consolidated financial statements

18

Table of Contents

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements

19

Table of Contents

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements

20

Table of Contents

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

See accompanying notes to consolidated financial statements

21

Table of Contents

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1)

Nature of Business

     Spatializer Audio Laboratories, Inc. and subsidiaries (the “Company”) is in the business of developing and licensing technology. The Company sales, research and subsidiary administration are conducted out of facilities in Santa Clara, California.

     The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), is in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary.

     The Company’s wholly-owned subsidiary, MultiDisc Technologies, Inc. (“MDT”), was in the business of developing scaleable, modular compact disc and digital versatile disc (“DVD”) server technologies associated with a network based compact disc/DVD server for internet and intranet applications. Operations of MDT were discontinued in the fourth quarter of 1998 and the assets have been marketed for sale (see Note 11).

(2)

Significant Accounting Policies

     Basis of Consolidation — The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, Desper Products, Inc. MultiDisc Technologies, Inc. has been presented as a discontinued operation (see Note 11). All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration is not allocated to subsidiaries.

     Revenue Recognition — The Company recognizes revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

     Concentration of Credit Risk — Financial instruments, which potentially subject the company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at CitiBank FSB. At December 31, 2002 substantially all cash and cash equivalents were on deposit at two financial institutions.

     At December 31, 2002, four major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: Apple Computer, Inc., JVC, Samsung and Toshiba Corporation, each of whom accounted for greater than 10% of our total 2002 accounts receivable. One OEM accounted for 28.0%, another accounted for 22.4%, another accounted for 22.0% and one accounted for 14.6% of our total accounts receivable at December 31, 2002.

     The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.

     The Company does not apply interest charges to past due accounts receivable.

     Cash and Cash Equivalents — Cash equivalents consist of highly liquid investments with original maturities of three months or less.

     Customers Outside of the U.S.- Sales to foreign customers were 67%, 59% and 60% of total sales in the years ended December 31, 2002 and 2001 and 2000, respectively.

     Major Customers — During the year ended December 31, 2002, three customers accounted for 33%, 25%, and 17%, respectively, of the Company’s net sales.

22

Table of Contents

     Research and Development Costs — The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.

     Advertising Costs — Costs incurred for producing and communicating advertising are expensed when incurred and included in selling, general and administrative expenses. Consolidated advertising expense amounted to $27,645, $20,568 and $2,968 in 2002, 2001 and 2000, respectively.

     Property and Equipment — Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.

     Intangible Assets — Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range from five to twenty years.

     Earnings Per Share — On December 31, 1997, the Company retroactively adopted the provisions of Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”) which replaces the presentation of primary and fully diluted earnings (loss) per share with a presentation of basic and diluted earnings (loss) per share. Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted earnings (loss) per share is computed similarly to fully diluted earnings (loss) per share pursuant to the Accounting Principles Board (“APB”) Opinion No. 15.

     Since the Company generated a net loss in 2001, outstanding stock options and warrants would have been anti-dilutive and are not applicable to this calculation.

     The impact of Statement 128 on the calculation of earnings per share is as follows:

     The following table presents contingently issuable shares, options and warrants to purchase shares of common stock at December 31, 2002. Those that were outstanding during 2001 were not included in the computation of diluted loss per share because the impact would have been anti-dilutive:

     Stock Option Plan — Prior to January 1, 1996 the Company accounted for its stock option plan in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based Compensation, which permits entities to recognize as expense using the fair-value-based method over the vesting period the fair value of all employee stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma

23

Table of Contents

net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 has been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123 (Note 8).

     Impairment of Long-Lived Assets and Assets to be Disposed of - The Company adopted the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, on January 1, 1996. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets (see Notes 4). Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

     Segment Reporting - The Financial Accounting Standards Board issued Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in June 1997. SFAS No. 131 establishes standards for the way public business enterprises are to report information about operating segments in annual financial statements and requires enterprises to report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. It replaces the “industry segment” concept of SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, with a “management approach” concept as to basis for identifying reportable segments. SFAS 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The Company adopted SFAS 131 in December 1997. MDT is considered a discontinued operation as of September 1998. As of December 31, 2002, the Company has only one operating segment, DPI, the Company’s Audio Signal Processing business. Approximately 67% of total revenues in 2002 were to companies located in Asia.

     Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     Recent Accounting Pronouncements - The FASB recently issued the following statements: FASB 146 - Accounting for Costs Associated with Exit or Disposal Activities, FASB 147 - Acquisitions of Certain Financial Institutions, FASB 148 - Accounting for Stock-Based Compensation. These FASB statements did not, or are not expected to, have a material impact on the Company's financial position and results of operations.

     Use of Estimates - Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

     Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2002 and 2001 approximated fair value due to their short maturity or nature.

     The fair values of notes payable to a related party at December 31, 2002 and 2001 are materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.

     Discontinued Operation - In September 1998, the Board of Directors approved a plan to refocus corporate activities on the Company’s core audio business, Desper Products, Inc. In conjunction to this strategic refocusing, the Company permanently suspended operations of MDT and placed the business and its related patent portfolio up for sale. The Company is accounting for the on-going operating and termination expenses of MDT as a discontinued operation (see Note 11).

(3)

Property and Equipment

     Property and equipment, as of December 31, 2002 and 2001, consists of the following, net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121:

24

Table of Contents