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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark one)

For the fiscal year ended March 31, 2003 or

For the transition period from                                                                               to                                                                              

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 ¨

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 127.

Yes x         No ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant on May 31, 2003, based upon the closing price of the Common Stock on the NASDAQ National Market for such date, was approximately $113,995,402.¹

The number of outstanding shares of the registrant’s Common Stock on May 31, 2003 was 18,448,818.

¹            Excludes 1,973,494 shares held by directors, officers and ten percent or greater shareholders on May 31, 2003. Exclusion of such shares should not be construed to indicate that any such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant or that such person is controlled by or under common control with the registrant.

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Forward Looking Statements

This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934, as amended. To the extent that this report discusses future financial results, information or expectations about products or markets, or otherwise makes statements about future events, such statements are forward-looking and are subject to a number of risks and uncertainties that could cause actual results to differ materially from the statements made. We have based these forward-looking statements on our current expectations and projections about future events. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” ‘intend,” “plan,” “will,” “may” and other similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Forward-looking statements include, but are not necessarily limited to, those relating to:

Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in the “Risk Factors” section under the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 below.

PART I

Item 1.     BUSINESS

Overview

We develop and market computer based tools:

Most of the products we sell consist entirely of computer software, though some of the tools we sell include “plug-in” computer hardware. We also license the software technology underlying our tools to other companies to incorporate in products they develop.

We divide our products into three categories:

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We often refer to our desktop products and our technology products collectively as our consumer products.

Quantities or results referred to as “to date” or “as of this date” mean as of or to March 31, 2003, unless otherwise specifically noted. References to “FY 2003” refer to the Company’s fiscal year ending on March 31 of the designated year. For example, “FY 2003” refers to the fiscal year ending March 31, 2003. References to years mean calendar years.

Please refer to our Company website at www.Sonic.com for the link to our Annual Report on Form 10-K.

DVD-Video and our Business

Many of our products involve the creation or playback of DVD-Video discs or related formats.

The DVD-Video optical disc format was introduced in 1996 and it offers high quality video, surround audio, and extensive interactivity on a Compact Disc-sized disc. DVD-Video is built upon the DVD-ROM standard, which specifies a disc capable of storing a significantly greater amount of digital information than the earlier Compact Disc format. A single-layer DVD-ROM disc holds 4.7 Gigabytes of data, while a CD-ROM holds approximately 650 Megabytes of data, or less than 15% of the capacity of the DVD format. DVD discs can be manufactured with two information layers on one side of the disc to store a total of 8.5 Gigabytes. They can also be manufactured with two information-carrying sides, for a maximum of 17.0 Gigabytes on a single disc (two sides, two layers on each side). The Compact Disc is limited to a single information layer on only one side of the disc. The DVD-Video format utilizes this large capacity to offer content publishers and video consumers a wide range of features and options:

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Since its introduction, DVD-Video has been very popular with consumers. In fact, DVD-Video has proven to be the most rapidly adopted consumer electronics format of all time. By the end of 2002, almost 300 million DVD players were in use world-wide, including “set-top” players, video game console based players, and personal computer based players. In the United States more than 40 million homes had DVD players by the end of 2002, and during 2002 more than 650,000 billion DVD-Video discs were sold (both to end users and to companies who rent DVDs to consumers). During 2002 in the United States more than $20 billion was spent by consumers on DVD-Video discs.

Our products are used to encode video, audio and graphics elements in the particular formats supported by the DVD-Video specification, to prescribe and specify the disc navigation, that is, the interactive behavior of the DVD title in response to user commands, and then to weave or “multiplex” together the encoded elements and navigation information in the particular manner required by the DVD-Video format. Sometimes, particularly in professional settings, this process is referred to as “DVD Authoring.” In other settings, particularly in consumer settings, it is referred to as “DVD Creation.”

There are some other optical disc audio and video formats that are related to DVD-Video and that are supported by some of our products. Video CD (“VCD”) is a CD-ROM based format utilizing relatively low resolution MPEG-1 video. Super Video CD (“SVCD”) is a kind of compromise between DVD-Video and Video CD. It utilizes a CD-ROM carrier, and low-bit-rate MPEG-2 Video. DVD-Audio is a sister format to DVD-Video, emphasizing more audio-related features. To date, DVD-Audio has had only limited success, with a relatively small compatible player population (almost all of which also play standard DVD-Video discs) and only a limited number of titles (almost all of which include a standard DVD-Video title of the same content on the same physical disc).

Professional Products

We currently offer a number of professional product lines including DVD Creator, DVD Fusion, Sonic Scenarist, DVD Producer and Reel DVD. DVD Creator and DVD Fusion are designed to run on versions of the Macintosh personal computer manufactured by Apple Computer. Sonic Scenarist, DVD Producer, and Reel DVD are designed to run on personal computers equipped with versions of the Windows operating system manufactured by Microsoft Corporation.

Professional Customers

Our professional customers are mainly facilities that process and prepare audio, video and film programming and who provide DVD authoring services as part of their offering. Most of the titles authored by our professional customers involve entertainment, educational and/or business content.

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

Professional DVD Production

Our tools enable professional customers to prepare DVD-Video titles. The tools we sell support some or all of the following processes:

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Professional Product Lines

We offer our professional products on both major PC platforms — Macintosh and Windows.

Macintosh Based Professional DVD Products: DVD Creator and DVD Fusion

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

DVD Creator

DVD Creator is a high-end professional DVD authoring system which we introduced in 1996. DVD Creator is intended for use by “Hollywood” class professionals. It offers superior audio and video encoding, a convenient and efficient workflow, and a high degree of creative control over the authoring process. It is designed to support a “mastering” model, where a piece of video content is completely finished and the main objective is to publish that content on as a DVD-Video disc. The archetypical project for DVD Creator is release of a major feature film on DVD. We also offer a number of software and some hardware options to our DVD Creator system packages.

DVD Fusion

DVD Fusion is a lower priced professional DVD authoring system. DVD Fusion is targeted at video professionals who serve corporate and multimedia applications. In most of these settings video content is sourced

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and edited specifically for inclusion on a DVD-Video disc. Thus, DVD Fusion is designed to integrate with popular professional non-linear video editing systems provided by companies such as Avid and Media 100.

To date we have shipped a combined total of more than 11,000 DVD Creator and DVD Fusion systems to customers in various locations around the world.

Windows Based Professional DVD Products: Scenarist, ReelDVD, DVD Producer, DVD-Audio Creator

Scenarist

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

In 2001, we acquired Scenarist which was the first commercially available DVD-Video authoring tool. It enjoys significant acceptance among high end authoring facilities. Because Scenarist’s formatting engine has the longest and broadest experience in the industry, the product is acknowledged by many professionals as the DVD-Video production industry’s “benchmark” for stable production of standard DVD-Video titles.

Generally speaking, Scenarist is targeted at the upper end of the same market targeted by DVD Creator. Since the introduction of Scenarist in 1996, to date, approximately 1,500 copies of Scenarist have been sold.

ReelDVD

ReelDVD is a DVD-Video authoring tool intended for video professionals who are not experts in the DVD-Video specification but who still need significant flexibility in utilizing the features of the DVD-Video specification. ReelDVD targets approximately the same video professional customer as DVDit!-PE (see below) or DVD Fusion.

ReelDVD is available as well in a system packaged with a hardware MPEG video encoder. In addition to selling ReelDVD to end users, we have marketed it through OEM agreements with other companies who include or “bundle” it with their products.

ReelDVD was introduced in 2000. Since its introduction, approximately 8,100 copies of ReelDVD have been shipped.

DVD Producer

DVD Producer is a new DVD-Video authoring tool which we introduced at the National Association of Broadcasters in April 2002. DVD Producer is intended for video professionals in the corporate and multimedia segments who wish to produce high quality professional-looking DVD-Video titles, but who need an easy-to-use system that supports a streamlined and efficient workflow. DVD Producer includes a number of Sonic technologies that make it unnecessary for customers to have deep knowledge of the DVD-Video specification, but still lets them author discs supporting advanced navigation capabilities consumers associate with Hollywood caliber titles.

DVD Producer is available also in a system packaged with a hardware MPEG video encoder.

DVD Producer began shipping in May of 2002. Approximately 350 copies of DVD Producer have been shipped to date.

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DVD-Audio Creator

DVD-Audio is a sister format to DVD-Video. The DVD-Audio specification was developed between 1996 and 1999 by an industry group called DVD Forum in consultation with the music recording industry. The DVD Forum released Version 1.0 of the new DVD-Audio specification in April 1999. The first commercially released players compatible with the new format became available in late 1999. We announced support for this new specification in the fall of 1998, and began delivery of the first software packages supporting preliminary and limited DVD-Audio authoring early in 1999. We called this product DVD Audio Creator. In April 2001 we announced an agreement with Matsushita to integrate DVD-Audio authoring developed by them into DVD Audio Creator.

Professional DVD Market and Strategy

Market Segments for Professional DVD Production Systems

We divide the professional DVD production market into three segments:

Customers in this segment tend to cluster in major film and video product centers including Hollywood/Los Angeles, New York City, Chicago, London, Paris, Tokyo, Taipei, etc. Customers in this segment demand the very highest quality in terms of processing output, strict adherence to standards, and are very concerned with the overall efficiency of production since projects are often produced on tight schedules. We estimate that there are a few thousand facilities and organizations in this segment worldwide.

Customers in this segment are typically more budget constrained than customers in the “Hollywood” segment. In certain instances, however, production values and budgets equal or even exceed those typically encountered in the Hollywood segment. They tend to be geographically more dispersed. While efficiency of production is an important requirement of such customers, compatibility with other existing recording and post-production equipment is a major concern of customers in this segment. We estimate that there are potentially more than 100,000 facilities and organizations in this segment worldwide.

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Competition

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

A number of companies produce products which compete with all or part of our professional product offerings. These companies include:

A number of these companies have financial or organizational resources significantly greater than ours and/or greater familiarity with certain technologies involved in DVD pre-mastering solutions than we do.

Strategy

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

Sales and Distribution

We sell our professional products through a field sales force in combination with a network of professional audio/video dealers. As of May 31, 2003 we employed 10 people in our field sales organization for professional products. Sales personnel are based in our headquarters office in Novato, California as well as in our offices in London (covering Europe) and in Tokyo (covering the Pacific Rim). We have other sales personnel based out of home offices in Chicago, Los Angeles, Utah, Washington and Taipei. Our field sales force includes sales managers and sales engineers. Most of our field sales personnel operate under compensation arrangements in which a substantial portion of their compensation is contingent upon performance relative to revenue targets.

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

We have dealers for our professional products in most areas of the world. As of May 31, 2003, we had 51 dealers in the Americas, 44 in Europe, Africa and the Middle East and 22 dealers in the Pacific Rim. We generally do not grant contractual exclusivity to our dealers, though as a matter of practice, depending on the dealer’s territory and competence, we may maintain only one dealer in a particular region.

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

Customer Support

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

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

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

Outlook

While we expect our professional DVD creation products to continue to account for a significant portion of our revenues in the future, we do not expect this business to experience revenue growth in the near term. Professional DVD facilities began equipping to prepare DVD titles as early as 1997, and significant expansion of DVD creation capacity occurred during 1998, 1999 and 2000. While the number of DVD discs replicated will continue to grow in future years, we do not expect that the number of titles published will expand as dramatically, hence we do not expect increases in the rate of capacity expansion by DVD production facilities. This means that we do not expect significant increases in sales of our professional DVD creation products.

Professional Audio Products — SonicStudio Spin Off

For a number of years we developed and marketed a line of professional audio workstations under the SonicStudio trade name. On March 21, 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals – Eric Jorde and

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Jeff Wilson. Under the terms of the agreement, we transferred our SonicStudio workstation business to SonicStudio LLC, and licensed them to utilize the technology underlying SonicStudio in the professional audio workstation market. The book value of net assets and liabilities transferred to the SonicStudio LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661. Certain employees transferred from Sonic to join the SonicStudio LLC.

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, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC.

As the present time, the book value of our investment in SonicStudio LLC is $68,897. We understand that the market for professional audio workstations designed for use by CD mastering engineers in the recording industry (the segment addressed by the SonicStudio product line) is currently quite depressed. If the business prospects for SonicStudio LLC deteriorates, we may find it necessary to write down the value of our investment in SonicStudio LLC, possibly to zero.

Desktop Products

Our desktop products are software tools that permit customers to combine audio, video and graphic elements to make regulation DVD-Video, DVD-ROM, CD-ROM, CD-Audio and Video CD discs. They also permit customers to play back DVD-Video discs on their computers, and to backup their PC data onto disc and tape backup devices. At the present time, we offer our desktop products under a variety of trade names, including RecordNow, Backup My PC, CinePlayer, DVDit! and MyDVD.

Recent Acquisitions

Ravisent License Agreement — CinePlayer, etc.

On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s DVD player software 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.

We market the DVD player we acquired from Ravisent under the Sonic CinePlayer tradename. CinePlayer turns a Windows PC equipped with a device capable of reading a DVD-ROM into the full-featured DVD player.

Veritas DMD Acquisition — RecordNow, Backup My PC

On December 18, 2002, we acquired the business of the VERITAS Desktop Mobile Division (“DMD”) from VERITAS. DMD sold personal computer based CD–ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software.

We acquired all the software and other intellectual property of VERITAS required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of the DMD business’s outstanding customer contracts and other contracts. Almost all the employees of the DMD business (approximately 40 individuals) joined Sonic. We also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.

We issued 1,290,948 shares of Series F preferred stock, all of which has been converted into 1,290,948 shares of our common stock. We also provided registration rights for these shares.

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The two principle end user products of the DMD business are RecordNow and Backup MyPC. RecordNow is a line of CD/DVD mastering software applications. Using RecordNow, users can transfer audio and data to recordable CDs or DVDs. Data is written in standard ISO-9660 or UDF formats, making the disc readable on virtually any computer system. Audio is written in standard CD-Audio format, making the discs produced playable on virtually every CD-Audio player in the world. We offer RecordNow in different versions, including a basic version intended for bundling with CD recorders and DVD/CD recorders, as well as an advanced version, RecordNow Max, intended for sale at retail. The enhanced version incorporates various additional features, for example, the ability to encode audio in the MP3 format for use in compatible players.

Backup MyPC is a data backup software application designed to assist computer users with preserving their valuable computer data in the event of a hardware failure or user error. Backup MyPC allows users to create backup discs or tapes, and to restore data to their PCs either selectively, or for a complete system restoration. The application incorporates a number of features to assist users in making backups an automatic process, and for making the backup process easier for users to deal with. We offer Backup MyPC in two versions: Simple Backup, which includes a limited feature set and which is oriented toward PC and drive OEMs who wish to bundle the software; and Backup MyPC, which includes a full feature set and is oriented toward retail purchasers.

DVD Creation Desktop Products

DVDit!

In April 1999 we introduced DVDit! — a simplified DVD-video creation tool.

DVDit! Positioning

DVDit! is designed to permit easy authoring of fully spec-compliant DVD titles by customers who do not have extensive knowledge of the DVD spec, and whose projects do not require the same specialized features required by “Hollywood” professional users. DVDit! is positioned to be purchased by consumers, “prosumers” and “desktop” professionals. We currently offer three different versions of DVDit!: DVDit!-LE (“Limited Edition”); DVDit!-SE (“Standard Edition”); and DVDit!-PE (“Professional Edition”).

DVDit! Customers

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

MyDVD

We introduced MyDVD in the fall of 2000. MyDVD is specifically designed as a DVD creation tool for use by consumers.

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MyDVD Positioning

MyDVD is designed to permit easy authoring of DVD titles by consumers who have virtually no knowledge of the DVD specification, but who wish to turn their videos into professional looking DVD titles. We currently offer three versions of MyDVD: a Bundle Version; MyDVD Plus and MyDVD Video Suite.

In late 2000 we first announced MyDVD and started shipping the product in November 2000. The initial version of MyDVD resembled DVDit! (but with a simplified feature set and user interface). In the summer of 2001 we introduced a new version of MyDVD with a significantly modified user interface and a feature set specifically designed for consumer use. Our belief is that as DVD recorders become widely available, consumers will begin to utilize DVD recording for a number of purposes, such as recording favorite home videos, recording favorite video broadcasts, creating highly convenient and portable copies of videos downloaded from the internet, and for copying videos published on VHS cassette or DVD. We do not advocate violation of copyright laws by our customers. None of our products contain software designed to circumvent the operation of encryption or other protection systems (for example the “CSS” encryption system commonly used by DVD-Video publishers to prevent digital copying of their published video content.)

Desktop Product Strategy

Our Desktop products are intended to take advantage of a number of trends in the PC and consumer electronics industries:

DVD readers) had been shipped worldwide. Industry observers expect that DVD players of all types will continue to be widely adopted with shipments of more than 200 million playback units expected to occur in 2003.

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Based on these trends, we believe that manipulation of digital video, along with other digital media types such as digital audio, on PCs will become an important activity for many consumers. We believe that the availability of low cost DVD recording capabilities will accelerate this trend. DVDit! and MyDVD are designed to serve the needs of general consumers who require easy-to-use DVD creation software. The Ravisent and DMD products are intended to accompany our DVD creation products to form a suite of digital media software tools enabling a satisfactory consumer experience.

Sales and Distribution for Desktop Products

As of May 31, 2003, we had 12 sales and marketing professionals responsible for our Desktop Products, located at our headquarters in Novato as well as in field and home offices in various locations around the world. These professionals plan the development “road map” for our products, develop marketing materials to position the products, and develop and conclude agreements with the various channel partners we utilize to reach end users for our products.

We distribute our Desktop Products through four main channels: “bundling” arrangements with other companies; web store sales; specialized dealers and traditional “bricks and mortar” computer and electronics retail stores.

We believe that the vast majority of consumers will first become aware of DVD creation software when they purchase a video device, for example a CD recorder, video input plug-in card, or, especially, a DVD recorder, and when they begin to use the software that comes bundled with the device. These new users will then add to their software capabilities via upgrades, in most cases through web transactions. Later, when the DVD creation software category has become established, consumers who are now used to the concept of DVD creation will shop for DVD creation software in traditional retail channels.

OEM Bundling

Our primary channel for reaching customers with our desktop applications software is “bundling” arrangements with various other companies in which copies of DVDit!, MyDVD, CinePlayer, RecordNow, and/or Backup My PC are included or “bundled” with shipments of those companies’ products. These companies (we refer to them as “Bundle Partners”) are motivated to include our software as a value-added offering for their customers and they usually pay us a royalty on each copy of our software shipped with their products. We are motivated to enter into bundling arrangements because they generate revenue for us as well as create a large installed base of customers to whom we can sell upgraded or enhanced versions of our products (through our other channels, particularly through our Web Store).

We have bundling arrangements with a variety of Bundle Partners and product types. The products with which our software is bundled include professional video editing systems, professional video capture and display cards, consumers video capture and interface cards, DVD recorders, CD recorders, PC models including DVD recorders, PC models including CD recorders, and PC models positioned as “multimedia” PCs.

Most of our bundle deals permit us to capture customer registrations or to invite the customer to click to our web site. We usually do not provide end user support as part of our bundling arrangements, but rely on our Bundle Partners to support the end user customers. We typically do provide “second line” support to our Bundle Partners to enable them to provide “first line” support of our products to their consumer-customers.

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The following are a representative list of companies with whom we have current bundling arrangements and/or with whom we bundled our software during the 2003 fiscal year:

Web Store

We have established web-based retail stores for our Desktop Products (as well as some of our Professional Products, for example, ReelDVD, that are priced in a range that is typically sold over the web). Our Web Store is intended both to meet retail demand for our Desktop Products as well as to service upgrade orders for our products, in particular, upgrade orders for software distributed by our bundle partners.

We currently have separate Web Stores for Europe, North America and Japan. We currently “outsource” operations of parts of our Web Stores through arrangements we have with Digital River, Element Five, and Sanshin Denki. Under these arrangements, our outsource partners typically provide the servers which list our products and handle purchase transactions through their secure web sites.

Specialized Channel

We have a number of professional and semi-professional Audio-Video dealers who carry MyDVD, DVDit! and other products as part of their product lines. Very often these dealers also carry professional or semi-professional products with which basic versions of our desktop software are bundled or with which our products can be used. A few of these dealers also carry some of our professional DVD products, but most do not. At the current time we have 14 such dealers in the Americas, 16 in Europe, and 9 in the Pacific Rim.

“Bricks and Mortar” Channel

At the present time we have only limited distribution of our products through traditional “bricks and mortar” retail outlets for computer and consumer electronics products. In general we have chosen to pursue this channel through the use of publishing arrangements. Under such arrangements another company packages and sells our software applications to distributors and retailers, and we receive a royalty payment on each copy of our software that is shipped. We currently have a few such arrangements, with Stomp, Inc., Adaptec, Easy Systems Japan and Softbank.

Competition for Desktop Products

The market for our Desktop Products is a very competitive one. We believe that digital media creation is perceived as a very interesting and high growth area of the PC industry and, as such, will likely attract more competition in the future. Competitors of DVDit!, MyDVD, RecordNow, and/or Backup My PC include for example: Ahead, Apple Computer, BHA, Cyberlink, Dazzle (a division of SCM Microsystems), Intervideo Inc., MedioStream, NTI, Pinnacle, Roxio, and Ulead. Some of these competitors have significant technical and financial resources exceeding our own.

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

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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. In April 2003 Apple announced its intention to release DVD Studio Pro Version 2 in the summer of 2003. We presume that DVD Studio Pro Version 2 is based, at least in part, on technology deriving from the Spruce acquisition.

Technology Products

In the past three years we have begun to market our technology to permit other companies to build software products of their own. We market our technology products under the trade name “AuthorScript.”

AuthorScript is designed to make available to software product developers our “back-end” engines for producing DVD-Video discs (and related formats such as Video CD and Super Video CD), as well as DVD- ROMs, CD-ROMs, and CD-Audio discs. We include in AuthorScript the same processing software that underlies the authoring subsystems we provide in DVD Creator, DVD Fusion, DVDit!, MyDVD, and RecordNow. We package this software with an Application Programmer’s Interface (“API”) — that is, a top level mechanism permitting other companies’ software engineers to easily access our processing technology and integrate it with their own software applications.

We believe that AuthorScript will be both a revenue source and a point of strategic leverage for our Company. Once a software product is developed using one back-end technology, it is quite difficult and possibly de-stabilizing to switch to another product. We’ve consciously packaged AuthorScript in a way which is attractive to software developers, and we license it on terms that we believe are very reasonable. We anticipate that this will create a stable and growing base of AuthorScript licensees as digital media creation technology spreads.

Customers and Licenses for AuthorScript

We have licensed AuthorScript to a number of companies including: Adobe Systems, AOL, ArcSoft, Avid Technology, Hitachi, Intervideo, Microsoft, and Sony. Because the needs and situations of AuthorScript licensees vary greatly, there is no typical AuthorScript license. Some of the licenses we have concluded resemble a software bundling arrangement in which we receive a royalty on every unit shipped of software containing AuthorScript. Some of the licenses are broad, development relationships through which the license partner receives source-level access to AuthorScript, and rights to participate with us in our ongoing development program.

Additional Markets for AuthorScript

We believe that AuthorScript or products derived from it may be applicable to other application areas outside the PC software space. We have underway an active program to market our technology to consumer electronics device manufacturers. To date, we have revealed one such license of this type — a license to Sony for use in an advanced model of the CoCoon product family, released in Japan.

COMPANY OPERATIONS

Business Units

Since the middle of the 2002 fiscal year, we have organized Sonic using a matrix form of organization. In such an organization, most managers have dual reporting relationships. They report simultaneously to a senior functional manager (e.g., head of engineering, head of marketing, etc.) as well as to a business unit general manager.

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We currently have three business units corresponding to our three product categories — professional products, desktop products and technology products. The following table shows an allocation of Sonic’s employees by major functional area and by business unit, as of March 31, 2003. Employees whose responsibilities span multiple business units are included in the “General” classification (e.g., corporate, accounting and, general services staff).

Marketing and Sales

Marketing and sales functions are handled by professional staff (50 in number as of March 31, 2003) who are dedicated to each of our business units. They are responsible for planning and monitoring the development road map of the products falling in their business unit, for preparing marketing materials to accompany the products, and for selling our products to end users or dealers, in the case of professional products, to bundle partners and channel participants in the case of desktop products, and to OEM developers in the case of technology products.

Sonic marketing and sales staff are located at our headquarters in Novato, our field offices in London, Tokyo, and Taipei, and in home offices in a number of locations around the world.

Engineering and Development

Our research and development staff includes a total of 141 hardware and software engineers and technicians and technical specialists. We tend to hire research and development personnel with backgrounds in digital audio signal processing, digital video image processing, distributed networking and computer systems design. Our development team exhibits a number of technology capabilities including the following that we believe are particularly important in light of our strategy and market position:

Our research and development staff is located principally at our headquarters in Novato and in our office in San Luis Obispo. Some of our engineers work remotely from their homes. We also have a small research and development installations in San Jose, California and in Wayne, Pennsylvania.

General and Administrative

General and administrative functions are handled by a staff of 20 people, all of whom are located at our corporate headquarters in Novato. Corporate management, accounting and financial management, information

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services, and other services including manufacturing and shipping are all included in the general and administrative group.

Employees

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

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

Revenue Concentration

During the fiscal years ended March 31, 2002 and 2003, sales to our Japanese distributor, Sanshin Electronics Company, amounted to 6% and 5%, respectively, of total revenues. Sanshin is a distributor of all of our products.

During fiscal 2003, approximately 26% of our revenue was derived from revenue recognized on development and licensing agreements from three customers as discussed in Note 10 of Notes to Financial Statements.

Apart from the revenue discussed above and in Note 10 of Notes to Financial Statements, no other single customer accounted for more than 10% of our total revenue during each of the past three fiscal years.

Backlog

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

In the case of desktop products, sales through bundle partners depend on the bundle partners’ sales activities which are, for the most part, not under our influence or control. Generally, we recognize revenue from bundling arrangements based on the receipt of royalty reports we receive from our bundle partners. While we receive some royalty reports relating to a quarter’s activities within a short time after the end of a quarter, some bundle partners are slow in their reporting, which leads to a lag in our accounting for their activities (for instance, some bundle partner reports included in our March 31, 2003 quarterly report reflected bundle partner activity from December 1, 2002 through February 28, 2003). Sales of our Desktop Products on our Web Store or to dealers are recognized as shipped. Usually, there is no significant time interval between receipt of an order and its fulfillment via web download or via physical shipment. Thus, in the case of desktop products, we have no significant backlogs.

In the case of technology products, as we discussed above, some of our licenses resemble bundling arrangements and, as such have no backlog. Certain licenses, especially those of a broad nature, involve significant up-front payments or commitments by the OEM partner. Under such licenses, we oftentimes have certain delivery obligations to the OEM (for example, for customized changes to our software) . We account for revenue under such licenses in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” whereby the revenue is recognized under the “percentage of

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completion” method of contract accounting. Since these deliveries involve in most cases some degree of development activity, the outcome of which is inherently uncertain, it is incorrect to characterize these licenses as having a significant backlog associated with them.

Manufacturing and Suppliers

We manufacture various hardware components used in some of our professional products. We also manufacture or replicate copies of our software products on CDs when our customers require physical delivery of our products.

How We Manufacture

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

We also typically contract with outside duplication and fulfillment houses for replication of our software products on CDs. Again, most of these contractors are located in the San Francisco Bay Area. Our staff performs some assembly and logistical functions associated with our software products. Our staff also replicates some of our software products in-house in the case of certain short run length shipments.

Sole-Sourced Components

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

Outsourcing

Over the past several years, we have shifted our hardware manufacturing to an “outsourcing” approach. Under outsourcing we contract with a single partner organization which takes responsibility for procuring parts, and for manufacturing them into complete, tested assemblies which are then released to us according to our instructions. Our current outsourcing arrangement is with Arrow-Bell Electronics, Inc. We believe that outsourcing provides us with increased flexibility to increase or decrease production, and allows us to operate our business with substantially reduced inventories thereby reducing financing requirements. During the 2003 fiscal year, we produced approximately 90% of our hardware via outsourcing. We plan to continue this outsourcing approach.

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

Proprietary Rights; Intellectual Property

General Approach

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

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

Patents

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

The status of patent protection in our industry is not well defined particularly as it relates to software and signal processing algorithms. In the past several years there seems to have been a trend on the part of patent authorities to grant patents in audio and video processing techniques with increasing liberality. We believe that it is quite possible that some of our present or future products may infringe issued or yet to be issued patents. It is almost certain that we will be asked by patent holders to respond to infringement claims. If such patents were held to be valid, and if they covered a portion of our technology for which there was no ready substitute, we might suffer significant market and financial losses.

Our products involve the use of certain technologies in which the overall patent situation is acknowledged by most industry observers to be very unclear. For example, patent coverage and license availability for MPEG-2 video encoding and decoding is currently somewhat uncertain. While one group of companies has attempted to create a single licensing entity for this technology (called “MPEG LA”; see “Current Infringement Issues” below), not all relevant patent holding companies have joined this entity. We plan to continue to monitor this area and to act prudently to avoid needless litigation and entanglements while continuing to offer our products. We have been able to reduce our risk to some extent by means of contractual provisions. For example, in the case of low revenue-per-copy bundling agreements with OEM customers, we typically attempt to limit any indemnity we provide to our customers against the possibility that their use of our products will ultimately be held to be infringing.

Trade Secrets

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

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

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Current Infringement Issues

In the past we have been advised of various infringements of patents and trademarks. We do not believe that in any such situation currently known to us we are at risk of material loss or serious interruption of our business. We may be incorrect in this assessment, of course. We regularly accrue certain reserves relating to shipments of products based on our assessment of what we will ultimately pay in royalties to various patent holders. Our assessment in this regard may prove to be wrong, in which case we may be exposed to additional financial losses relating to patent infringements.

In May, 2003, we entered into a license agreement with MPEG LA. MPEG LA is a company set up to afford a convenient way for companies manufacturing products based on MPEG technology to license patents purportedly essential to such products. Currently the MPEG LA patent portfolio includes more than 500 patents held by more than 20 licensors. Under the terms of the agreement we provided MPEG LA with a payment covering products we have sold prior to entering into the agreement. We expect to continue to tender reports to MPEG LA and to make payments to MPEG LA based on those reports as we ship copies of our products in the future.

As noted above, MPEG LA’s patent portfolio does not cover all aspects of MPEG technology and there are many other areas of digital media and optical recording technology to which various patents may be applicable.

Geographic Exposure

We have for many years realized a significant proportion of our revenues from sales outside the United States. In some fiscal quarters, non-U.S. revenue has constituted as much as 50% of our revenues. In the fiscal year ended March 31, 2003, approximately 30% of our revenues came from sales outside the United States. We expect that a larger percentage of our revenues will derive from sales outside the United States in fiscal year 2004.

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

Item 2.     PROPERTIES

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

We have additional research and development facilities in San Luis Obispo, CA; San Jose, CA; and Wayne PA.

We also have sales offices located in London and Tokyo.

Item 3.     LEGAL PROCEEDINGS

We are not a party to any legal proceedings.

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

During the fourth quarter of the fiscal year ended March 31, 2003, we did not submit any matters to a vote of our security holders.

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Supplemental Item.    EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers and their ages as of March 31, 2003 are as follows:

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

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

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

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

Christopher A. Kryzan.    Mr. Kryzan joined Sonic Solutions in March 1996 as Vice President of Marketing. In January, 1999, Mr. Kryzan was named Senior Vice President of Marketing and Engineering. Prior to joining Sonic, from May 1994 through February 1996, he was an independent consultant specializing in Internet business and marketing strategy development. From July 1990 to April 1994, he was Director of Marketing at SuperMac Technology, a graphics and digital video technology firm, and General Manager of E-Machines, a subsidiary of SuperMac. From January 1986 to July 1990, he was Director of Product Marketing at Wyse Technology, a manufacturer of terminals and personal computers, and National Sales Manager of Amdek, a subsidiary of Wyse. Mr. Kryzan received a B.S. in Electrical Engineering from Northwestern University and an M.B.A. from Santa Clara University. Mr. Kryzan resigned as an executive officer of Sonic Solutions effective May 31, 2003. Mr. Kryzan acts as a consultant to Sonic Solutions through July 31, 2003 pursuant to an agreement dated May 31, 2003.

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PART II

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

Our Common Stock is listed on the Nasdaq National Market. As of March 31, 2003, there were approximately 154 registered holders of our Common Stock. We believe, however, that many beneficial holders of our Common Stock have registered their shares in nominee or street name, and that there are substantially more than 154 beneficial owners. The low price and high price of our Common Stock during the last eight quarters are as follows:

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

In December 2001, we issued 250,000 shares of Series E Convertible Preferred Stock to Sanshin Electronics Co., Ltd. in conjunction with their $1 million equity investment in Sonic Solutions. In addition to the equity investment, it was agreed that the distributor agreement by and between Sanshin and Sonic Solutions would be extended. Each share of Series E Convertible Preferred Stock is convertible into one share of Common Stock. These securities were exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. These securities were sold to one investor which represented it was sophisticated and accredited. As of March 31, 2003, all shares of Series E Convertible Preferred Stock had been converted into 250,000 shares of our Common Stock.

In December 2002, we issued 1,290,948 shares of Series F Preferred Stock convertible into 1,290,948 shares of our common stock (subject to adjustment for stock splits and the like). Pursuant to the asset purchase agreement we entered into an amended and restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they were converted into shares of our Common Stock. During March 2003, all shares of Series F Preferred Stock were converted into 1,290,948 shares of our Common Stock.

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Item 6.     SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with the financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Form 10-K. The selected financial data presented below under the caption “Statement of Operations Data” and “Balance Sheet Data” for, and as of the end of, each of the years in the five-year period ended March 31, 2003, are derived from the financial statements of Sonic Solutions. The financial statements as of March 31, 2003 and 2002, and for each of the years in the three-year period ended March 31, 2003, and the report thereon, are included elsewhere in this Form 10-K.

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Summarized quarterly financial information for fiscal years 2003 and 2002 is as follows:

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

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

Our quarterly and annual 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 or any year are a poor indicator of the results to be expected in any future quarter or year.

A large portion of our quarterly and annual professional product revenue is usually generated in the last few weeks of the quarter. Since our ongoing operating expenses are relatively fixed, and we plan our expenditures based primarily on sales forecasts, if professional revenue generated in the last few weeks of a quarter or year 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 value of certain assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates.

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 recognition 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 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

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multiple-element software arrangements is 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 elements are 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 collectability 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 over the service period based on proportional performance. 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 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; (3) amounts billed in excess of services performed to technology customers for license and development agreements; and (4) amounts billed to certain OEMs for products which contain one or more undelivered elements.

—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 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.

—Business Acquisitions; Valuation of Goodwill and Other Intangible Assets

Our business acquisitions typically result in the recognition of goodwill and other intangible assets, which affect the amount of current and future period charges and amortization expense. The determination of value of these components of a business combination, as well as associated asset useful lives, requires management to make various estimates and assumptions. Estimates using different, but each reasonable, assumptions could produce significantly different results.

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On April 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. We continually review the events and circumstances related to our financial performance and economic environment for factors that would provide evidence of impairment of goodwill. We test goodwill for impairment in accordance with SFAS 142 at least annually and more frequently upon the occurrence of certain events, as defined in SFAS 142. Goodwill is tested for impairment annually in a two-step process. First, we determine if the carrying amount exceeds “fair value” based on quoted market prices of our common stock, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we will compare the “implied fair value” of the goodwill, as defined by SFAS 142, to its carrying amount to determine the impairment loss, if any. Goodwill has resulted from our Ravisent product business acquisition during the first quarter ended June 30, 2002, which was accounted for as a purchase, and from our DMD acquisition from VERITAS during the third quarter ended December 31, 2002, which was also accounted for as a purchase. As of March 31, 2003, no events have occurred that would lead us to believe that there has been any impairment.

—Stock Based Compensation

We follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” See Note 1 and 7 to our financial statements for March 31, 2001, 2002 and 2003 included elsewhere in this annual report for further discussion of our stock based compensation plans, including the illustration of the effect on net income and earnings per share as if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (SFAS 123).

—Impairment of Long-Lived Assets

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 as of March 31, 2003.

OTHER DISCLOSURES

In March 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals. The book value of net assets and liabilities transferred to SonicStudio LLC, totaled $235,661. We account for this investment in SonicStudio LLC using the modified equity method. As of March 31, 2003, our investment in SonicStudio LLC totaled $68,897.

Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year promissory note for $500,000. The promissory note, which does not carry interest, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. When the note is retired, we expect to have a 15% interest in SonicStudio LLC.

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We are subject to various claims relating to products, 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. See the discussion under the Risk Factors titled “We may become involved in costly and time-consuming patent litigation.”

RESULTS OF OPERATIONS

The following table sets forth certain items from Sonic Solutions’ statements of operations as a percentage of net revenue for fiscal years 2001 through 2003:

COMPARISON OF FISCAL YEARS ENDED MARCH 31, 2003, 2002 and 2001

Net Revenue.    Our net revenue increased from $16,519,000 in fiscal 2001 to $19,104,000 in fiscal 2002, representing an increase of 16% and increased to $32,718,000 in fiscal 2003, representing an increase of 71%. The increase in net revenue in fiscal 2002 was primarily due to the increase in sales of our consumer products which increased approximately 243% from fiscal 2001. The increase in sales was due to new OEM licensing agreements entered into during the fiscal year and the increase in volume of sales reported by the existing OEM partners. Included in consumer sales is revenue recognized on license development contracts entered into during fiscal 2002. This increase was offset in part by a decrease in our professional audio and video sales of approximately 24%. The increase in net revenue in fiscal 2003 was primarily due to the increase in sales, both from new and existing OEM partners, of our consumer products which increased approximately 174%. Included in consumer product sales is revenue recognized on new license development contracts which were entered into during the second half of fiscal 2002 and 2003. This increase was offset in part by a decrease in our professional audio and video sales of approximately 8%.

International sales accounted for 47%, of our net revenue in fiscal year 2001, 39% of our net revenue in fiscal year 2002 and 30% of our net revenue in fiscal year 2003. See Note 10 of Notes to Financial Statements. International sales have historically ranged from 30% to slightly less than 50% of our total sales, and we expect that they will continue to represent a significant percentage of future revenue. The percentage has decreased in fiscal year 2003 due to the increase in domestic OEM revenue from our consumer products.

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Cost of Revenue.    Our cost of revenue as a percentage of revenue decreased from 35.7% of net revenue in fiscal 2001 to 30.1% in fiscal 2002 to 22.8% in fiscal 2003. The decreases in cost of revenue as a percentage of revenue were primarily due to a shift in sales product mix towards higher margin consumer products (including software license and development contracts) and to the reduction of hardware as a percentage of revenue in our professional audio and video systems.

Marketing and Sales.    Our marketing and sales expenses decreased from $8,710,000 in fiscal 2001 to $8,601,000 in fiscal 2002 and increased to $8,762,000 in fiscal 2003. Marketing and sales represented 52.7%, 45.0% and 26.8% of net revenue for fiscal 2001, 2002 and 2003, respectively. Our marketing and sales expenses decreased in fiscal 2002 primarily due to lower advertising and collateral expenses, which decreased approximately $200,000, and lower salary expense which decreased approximately $140,000, as a result of our reduction in headcount. These decreases were offset in part by an increase in commission expense due to the increase in sales. Our marketing and sales expenses increased in fiscal 2003 primarily due to an increase in salary expenses of approximately $575,000 relating to the increase in headcount. This increase was partially offset with changes in other expenses, primarily the decrease in dealer and employee commission expenses, due to increased OEM and direct sales, of approximately $570,000. Our marketing and sales headcount decreased from forty-nine at March 31, 2001 to forty-four at March 31, 2002 and increased to fifty at March 31, 2003. Dealer and employee commission expenses, as a percentage of net revenue increased from 4.4% in fiscal 2001 to 6.7% in fiscal 2002 and decreased to 5.9% in fiscal 2003.

Research and Development.    Our research and development expenses increased from $5,148,000 in fiscal 2001 to $5,897,000 in fiscal 2002 to $10,625,000 in fiscal 2003. Our research and development expenses as a percentage of net revenue were 31.2% in fiscal 2001, 30.9% in fiscal 2002, and 32.5% in fiscal 2003. Our research and development expenses increased primarily due to higher salary expense associated with increases in headcount, which increased by approximately $250,000 and $3,070,000, for fiscal years ended March 31, 2002 and 2003, respectively. The increase in fiscal year 2003 was also due to an increase in consulting expense of approximately $690,000 and an increase in the allocation of occupancy expenses relating to the increase in headcount and the additional office locations. Our headcount increased from thirty-two at March 31, 2001 to forty-nine at March 31, 2002 to one hundred and forty-one at March 31, 2003. The increase in headcount during fiscal year 2003 is primarily the result of two acquisitions made during the fiscal year.

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 fiscal year 2002 we capitalized approximately $514,000 and amortized approximately $1,511,000 (excluding amounts relating to the Daikin acquisition). During fiscal year 2003, we capitalized approximately $488,000 and amortized approximately $409,000 (excluding amounts relating to Daikin, Ravisent and DMD acquisitions). The Ravisent and DMD acquisitions are discussed under the heading “Acquisitions.”

General and Administrative.    Our general and administrative expenses decreased from $2,514,000 in fiscal 2001 to $2,095,000 in fiscal 2002 and increased to $3,100,000 in fiscal 2003. These expenses represented 15.2% of net revenue in fiscal 2001, 11.0% of net revenue in fiscal 2002 and 9.4% of net revenue in fiscal 2003. General and administrative expenses decreased in fiscal 2002 primarily due to reduced legal fees and a reversal of previously recorded bad debt reserve which was no longer required due to our improvement in collections as a result of the continued shift in our customer base towards larger and more established OEM customers. General and administrative expenses increased in fiscal 2003 primarily due to increased rent, insurance, professional and other general expenses related to the overall increase in our headcount from one hundred and ten at March 31, 2002 to two hundred and eleven at March 31, 2003. We anticipate that general and administrative expenses may increase as our operations expand.

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Business Integration Expense.    In conjunction with the Daikin acquisition completed in February 2001 (fiscal year 2002), we incurred expenses to transition the business to our management. As such, these expenses did not exist during fiscal year 2003. 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. Interest income was approximately $129,000, $52,000 and $96,000 for the fiscal years ended March 31, 2001, 2002 and 2003, respectively. Other expense in fiscal year 2001 consists primarily of interest and other financing charges associated with the debt arrangements with Hambrecht & Quist. Other expense in fiscal years 2002 and 2003 primarily consist of write-downs of investments in other entities which totaled approximately $125,000 and $151,000, respectively, which was offset in part by the interest income discussed above.

Provision for Income Taxes.    In accordance with Statement of Financial Accounting Standards No. 109, we made no provision for U.S. income taxes for our 2001, 2002 and 2003 years. For the 2002 and 2003 fiscal years foreign tax expense was recorded to reflect the taxes withheld by various Japanese customers and paid to the Japanese taxing authorities.

Acquisitions.

On February 27, 2001, we entered into an Asset Purchase Agreement with Daikin Industries, Ltd., a Japanese corporation, whereby on that date we acquired Daikin DVD. In return for the assets acquired, we issued 395,000 shares of Common Stock valued at approximately $593,000 and 700,000 shares of Preferred Stock valued at approximately $1,750,000. The acquisition was recorded using the purchase method of accounting and accordingly, the operating results have been included in our results of operations from the date of acquisition.

As a result of the acquisition, we acquired all the Daikin DVD related products and intellectual property rights which is included in purchased and internally developed software costs. Additionally, we acquired tangible assets such as furniture, computers and other electronic assets, some of which will continue to be used specifically in the acquired DVD software development business while others will be used in our general DVD authoring tool business.

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 $2,000,000 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.

On November 13, 2002, we entered into an agreement with VERITAS to acquire the business of the VERITAS Desktop Mobile Division (“DMD”), which sold personal computer based CD–ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software. The transactions contemplated by the agreement were closed on December 18, 2002. We acquired the DMD business to expand our suite of CD and DVD mastering products.

Under this agreement with VERITAS we acquired all the software and other intellectual property required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of DMD businesses’ outstanding customers and other contracts. Under this agreement, almost all of the employees of the DMD business (approximately 40 individuals) joined Sonic.

Under the asset purchase agreement, we issued 1,290,948 shares of Series F preferred stock convertible into 1,290,948 shares of our common stock. The total purchase price was approximately $9,433,000 and the accounting for this transactions was applied pursuant to the purchase accounting method.

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Liquidity and Capital Resources.    Our operating activities have used cash of $848,000 in fiscal year 2001, generated cash of $5,708,000 in fiscal year 2002 and generated cash of $153,000 in fiscal year 2003. During fiscal year 2001, cash used in operations included a net loss of $5,855,000 including depreciation and amortization of $2,025,000 and interest expense amortization of $132,000. Cash used in operations was affected by changes in assets and liabilities including an increase in other assets of $177,000, and a decrease in accounts payable and accrued liabilities of $50,000, offset by decreases in accounts receivables of $2,215,000, inventory of $465,000 and an increase in deferred revenue and deposits of $219,000. In fiscal year 2001, net accounts receivables decreased 10% primarily due to lower revenues which decreased 21%. Inventory levels improved during the fiscal year, primarily due to better utilization of our outsourcing arrangement.

During fiscal year 2002, cash generated by operations included a net loss of $4,182,000 including depreciation and amortization of $1,880,000. Cash generated by operations was affected by changes in assets and liabilities including an increase in prepaid expenses and other current assets of $168,000 and an increase in other assets of $34,000, offset by decreases in accounts receivable of $1,042,000, inventory of $102,000 and increases in deferred revenue and deposits of $6,931,000 and in accounts payable and accrued liabilities of $135,000. In fiscal year 2002, net accounts receivables decreased by 25% primarily due to stronger collections and from prepayments and deposits received from OEM and licensing customers.

During fiscal year 2003, cash generated by operations included net income of $2,537,000 including depreciation and amortization of $2,396,000. Cash used in operations was affected by changes in assets and liabilities including a decrease in deferred revenue and deposits of 6,686,000 partially offset by an increase in accounts payable and accrued liabilities of $2,285,000. The decrease in accounts receivables was due to strong accounts receivable collections and the decrease in deferred revenue was the result of the revenue recognized on various OEM and development contracts.

During the fiscal years discussed above, our current ratio has fluctuated, primarily due to the increase in our deferred revenue and deposits. During fiscal year 2002, our current ratio increased over fiscal year 2001, primarily due to increase in cash from deposits and prepayments received from OEM and licensing customers which were offset in part by the increase in the deferred revenue account. During fiscal year 2003, our current ratio increased primarily due to the decrease in deferred revenue and deposits.

In addition to our operations, we utilized cash during the 2001, 2002 and 2003 fiscal years to purchase new fixed assets, and to fund the development of capitalized software. During the fiscal year 2003, cash of $2,275,000 was used to complete the acquisition of the Ravisent product line from Axeda and $962,000 was used to complete the acquisition of the DMD business from VERITAS.

We lease certain facilities and equipment under noncancelable operating leases. Rent expense under operating leases was approximately $1,011,000, $1,248,000 and $1,598,000 for the fiscal years ended March 31, 2001, 2002 and 2003, respectively. Future payments under operating leases that have initial remaining noncancelable lease terms in excess of one year are as follows (in thousands).

We believe that existing cash and cash equivalents and cash generated from operations will be sufficient to meet our cash requirements at least through the end of fiscal year 2004.

As of March 31, 2003, we had cash and cash equivalents of $9,708,000 and working capital of $8,004,000.

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Off-Balance Sheet Arrangements.    We do not have any off-balance sheet arrangements (as such term is defined in recently enacted SEC rules) that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Risk Factors.    You should carefully consider the risk factors set forth below as well as those in other documents we file with the Securities and Exchange Commission: The risks identified below could 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.

We have had losses in each of the past four fiscal years ending March 31, 2002.

We were unprofitable during each of the four fiscal years ending March 31, 2002. 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. Although we were profitable in the fourth quarter of the 2002 fiscal year and each of the four quarters of the 2003 fiscal year, we may not maintain profitability and as a result our share price may decline. Although we have provided revenue and profitable earnings guidance for fiscal 2004, there are no assurances that we will meet such guidance and our inability to meet such guidance could cause our share price to decline.

During the fiscal year ended March 31, 2001 we had negative operating cash flows.

During the fiscal year ended March 31, 2001, we had a negative operating cash flow of $848,000. During the fiscal year ended March 31, 2002, we had a positive operating cash flow of $5,708,000. During the fiscal year ended March 31, 2003, we had a positive operating cash flow of $153,000. We may continue to report a negative operating cash flow in the future, and we may 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.

If sources of financing are not available, we may not have sufficient cash to satisfy working capital requirements.

We believe that our current cash balances are sufficient to satisfy our working capital requirements for at least the next twelve months. We may need to obtain additional financing at that time or prior to that time if our plans change or if we expend cash sooner than anticipated. We currently do not have any commitments from third parties to provide additional capital. The risk to us is that at the time we will need cash, financing from other sources may not be available on satisfactory terms, if at all. Our failure to obtain financing could result in our insolvency and the loss to investors of their entire investment in our common stock.

Any failure to successfully integrate the DMD business we purchased from VERITAS could negatively impact us.

The acquisition of the DMD business involves risks related to the integration and management of the DMD business, which will be a complex, time-consuming and an expensive process and may disrupt our businesses if not completed in a timely and efficient manner. We may encounter substantial difficulties, costs and delays in integrating the DMD operations, including:

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The DMD business may not be a positive contributor to our operations but instead may constitute a drain on our resources. We may therefore not achieve the desired synergies and benefits of the DMD acquisition.

Other recent acquisitions may compromise our operations and financial results.

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.

Future acquisitions may compromise our operations and financial results.

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 future acquisitions are likely to involve similar risks associated with our financial results and the integration of technology and employees.

The issuance of stock under our registration statement will dilute the relative ownership of existing common shareholders and could result in lower market price for our stock.

As part of the acquisition of the DMD business, we issued VERITAS 1,290,948 shares of our Series F convertible preferred stock. In March, 2003, VERITAS converted all of their shares of Series F Preferred Stock into 1,290,948 shares of our Common Stock which, based upon our common stock outstanding as of March 31, 2003, resulted in approximately a 7% dilution to our shareholders.

Our stock price has been volatile, is likely to continue to be volatile, and could decline substantially.

The price of our common stock has been, and is likely to continue to be, highly volatile. The price of our common stock could fluctuate significantly for some of the following reasons:

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In addition, stock markets in general, and the market for shares of technology stocks in particular, have experienced extreme price and volume fluctuations in recent years which have frequently been unrelated to the operating performance of the affected companies. These broad market fluctuations may adversely affect the market price of our common stock. The market price of our common stock could decline below its current price and the market price of our stock may fluctuate significantly in the future. These fluctuations may be unrelated to our performance.

In the past, shareholders of various companies have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities. If a shareholder files a securities class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.

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.

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, financial and other 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, DVD Fusion, RecordNow, Backup MyPC, CinePlayer, AuthorScript, ReelDVD and Primo SKD 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.

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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.

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. Although we have entered into an agreement with MPEG-LA, that agreement may not prevent third parties from asserting that we infringe a patent covering the MPEG-2 technology.

Because a significant percentage of our professional DVD products operate only on Macintosh computers, the potential success of these products is tied to the success of this platform.

Several of our current professional DVD products, including DVD Creator and DVD Fusion, operate on Macintosh computers manufactured by Apple Computer. If the supply of Macintosh computers becomes limited, sales of these products will likely decline. If there is a decrease in the use of the Macintosh 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 on OS 9. Macintosh OS X currently offers a “compatibility mode” which supports OS 9.x compatible applications, but we believe that we will soon have to modify our DVD Creator and DVD Fusion applications for them to continue to be able to run with the latest Macintosh models. Such a modification may be difficult to accomplish or infeasible 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 Dell, Hewlett-Packard, Sony, Matrox and Avid. The revenue from many of these customers is recognized on a sell-thru basis. If these customers do not ship as many units as forecasted or if there is a decrease in their unit sales, our net revenue will be adversely impacted and we may be less profitable than forecasted or unprofitable.

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

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Ulead. See discussion entitled “Competition for Desktop Products” in the Business Section of Part I of this document. Most of these companies have greater financial and technological resources than ours.

Our reliance on outsourcing our Webstore 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). We currently “outsource” our Webstore 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.

Outsourcing means that we are dependent on a third party for smooth operation of our Webstore. Since our Webstore sales are a significant portion of our revenues, 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, especially in our professional audio and video business, 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 26% of our revenue derives from revenue recognized on development and licensing agreements from three customers for the fiscal year 2003.

During fiscal 2003, approximately 26% of our revenue was derived from revenue recognized on development and licensing agreements from three customers as discussed in Note 10 of Notes to Condensed Financial Statements. A decrease or interruption in any of the above mentioned businesses or their demand for our products or a delay in our development agreements could cause a significant decrease in our revenue.

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

Revenue derived from these customers accounted for approximately 47%, 39% and 30% of our revenues in fiscal years 2001, 2002 and 2003, respectively. These foreign customers expose us to the following risks, among others:

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Item 7A.    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. See Note 13 of Notes to Condensed Financial Statements. We do not engage in any hedging activities.

We do not use derivatives or equity investments for cash investment purposes.

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

Item 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The Report of Independent Auditors, Financial Statements and Notes to Financial Statements follow.

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors

Sonic Solutions:

We have audited the accompanying balance sheets of Sonic Solutions as of March 31, 2003 and 2002, and the related statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended March 31, 2003. In connection with our audits of the financial statements, we also have audited the financial statement schedule as listed in Item 15(a)2. These financial statements and financial statement schedule are the responsibility of Sonic Solutions’ management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Sonic Solutions as of March 31, 2003 and 2002 and the results of its operations and its cash flows for each of the years in the three-year period ended March 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/    KPMG LLP

San Francisco, California

May 1, 2003

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FINANCIAL STATEMENTS

SONIC SOLUTIONS

BALANCE SHEETS

(in thousands, except share and per share amounts)

See accompanying notes to financial statements

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SONIC SOLUTIONS

STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

See accompanying notes to financial statements

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SONIC SOLUTIONS

STATEMENTS OF SHAREHOLDERS’ EQUITY

(in thousands)