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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-Q

(Mark one)

For the quarterly period ended December 31, 2003

or

For the transition period from                      to                     

Commission File Number: 72870

SONIC SOLUTIONS

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (415) 893-8000

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No ¨

The number of outstanding shares of the registrant’s Common Stock on February 9, 2003, was 21,658,135.

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SONIC SOLUTIONS

FORM 10-Q

For the quarterly period ended December 31, 2003

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PART I – FINANCIAL INFORMATION

Sonic Solutions

Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts — unaudited)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Condensed Consolidated Statements of Cash Flows

(in thousands — unaudited)

See accompanying notes to condensed consolidated financial statements.

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Sonic Solutions

Notes to Condensed Consolidated Financial Statements

(unaudited)

The accompanying unaudited condensed financial statements of Sonic Solutions, referred to as “we,” “Sonic,” “our” or “the Company,” have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, the condensed financial statements include all adjustments, consisting of only normal, recurring adjustments, necessary for a fair statement of the results for the interim periods presented. The interim results are not necessarily indicative of results expected for a full year. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and related notes included in the Company’s Form 10-K for the year ended March 31, 2003, filed with the Securities and Exchange Commission.

Use of Estimates and Certain Concentrations

We prepare our financial statements in conformity with U.S. generally accepted accounting principles. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. 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 are dependent on sole-source suppliers for certain key components used in our products. We purchase these sole-source components pursuant to purchase orders placed from time to time. We do not carry significant inventories of these components, and have no guaranteed supply agreements. Any extended future interruption or limitation in the supply of any of the components obtained from a single source could have a material adverse effect on our results of operations.

Revenue Recognition

We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition, with Respect to Certain Arrangements” and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence.

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We derive our software revenue primarily from licenses of our software products, including any related hardware components, development agreements and maintenance and support. Revenue recognized from multiple-element software arrangements is allocated to each element of the arrangement based on the fair values of elements, for example, the license to use software products versus maintenance and support for the software product. The determination of fair value is based on objective evidence specific to us. Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately. Objective evidence of support services is measured by annual renewal rates. SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement. Under the “residual method,” the total fair value of the undelivered element is deferred and subsequently 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. We record revenue on a net basis for those sales in which we have in substance acted as an agent or broker in the transaction.

Revenue from license fees is recognized when persuasive evidence of an arrangement exists (such as receipt of a signed agreement, purchase order or a royalty report), delivery of the product (including hardware) has occurred (generally F.O.B. shipping point), no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectibility is probable. In addition, royalty revenue from certain distributors that do not meet our credit standards and revenues from our distributor agreement with Daikin Industries, Ltd. 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 performance 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 to technology customers for license and development agreements in advance of recognizing the related revenue; and (4) amounts billed to certain original equipment manufacturers (OEMs) for products which contain one or more undelivered elements.

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The following table sets forth the computations of shares and net income per share, applicable to common shareholders used in the calculation of basic and diluted net income per share for the third quarter and nine months ended December 31, 2002 and 2003 (in thousands, except per share data), respectively:

Potential dilutive common shares consist of shares issuable upon exercise of stock options. The impact of our stock options on the shares used for the diluted earnings per share computation is calculated based on the average share price of our common stock for each year using the treasury stock method.

We exclude all potentially dilutive securities from our diluted net income per share computation when their effect would be anti-dilutive. The computation of diluted net income per share excludes stock options to purchase 2,237,737 and 1,605,524 shares of common stock as of December 31, 2002 and 2003, respectively. The shares were excluded due to the exercise price

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exceeding the average fair value of the common stock, and their inclusion would have been anti-dilutive.

Had compensation cost for stock options issued pursuant to our stock option plan been determined in accordance with the fair value approach enumerated in Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” our net income and net income per share for the third quarter and nine months ended December 31, 2002 and 2003 would have been adjusted as indicated below (in thousands, except per share data):

The weighted-average fair value of options granted in the three and nine months ended December 31, 2003 was $11.78 and $7.02, respectively, and in the three and nine months ended December 31, 2002 was $3.96 and $4.45, respectively. The fair value of options granted was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the three and nine months ended December 31, 2002 and 2003: risk-free interest rate of 3.0% and 2.3% for the three and nine months ended December 31, 2003, respectively, and of 2.5% and 2.6% for the three and nine months ended December 31, 2002, respectively; expected life of 4.0 and 3.4 years for the three and nine months ended December 31, 2003, respectively, and of 4.0 and 3.3 years for the three and nine months ended December 31, 2002, respectively; expected volatility of 114% and 106% for the three and nine

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months ended December 31, 2003, respectively, and of 113% and 112% for the three and nine months ended December 31, 2002, respectively; and no dividends.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our stock options have characteristics significantly different from those of traded options, and because changes with respect to the subjective assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our stock options.

The effect of applying SFAS No. 123 for disclosing compensation costs may not be representative of the effects on reported net income for future periods because pro forma net income reflects compensation costs only for stock options granted in fiscal 1996 through 2003 and does not consider compensation costs for stock options granted prior to April 1, 1995.

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

Ravisent License Agreement

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 $2,000,000 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.

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

DMD Acquisition

On November 13, 2002, we entered into an asset purchase agreement with VERITAS Operating Corporation and its affiliates (“VERITAS”) to acquire the Desktop and Mobile Division (“DMD”) of VERITAS, 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. The results of DMD’s operations have been included in our financial statements since 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 the 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, approximately 40 of the employees of the DMD business joined Sonic. Pursuant to this agreement we also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.

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, subject to adjustment for stock splits and the like. Pursuant to the agreement, we entered into an amended and restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they are converted into shares of our common stock. The shares were convertible at Sonic’s option three months following the effective registration of the shares. All of the preferred stock was converted into our common stock in March 2003. As we determined that the preferences associated with the preferred stock did not have significant value, the value of the 1,290,948 shares of preferred stock was determined based on the average market price of our common stock over the two-day period before and after the terms of the acquisition were agreed to and announced. The total purchase price of the DMD business was approximately $9,433,000.

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

The acquired technology and customer relationships are being amortized on a straight-line basis over a period of three years.

On May 4, 2000, we entered into a private equity line agreement with Kingsbridge Capital. During the quarter ended June 30, 2002, we drew $2,000,000 from the equity line for which we issued 269,360 shares of common stock. These proceeds were recorded net of fees of $16,000. The agreement ceased by its terms on November 13, 2002.

On June 27, 2003, we announced a public offering of 1,000,000 shares of our common stock to institutional investors at a price of $8.50 per share for gross proceeds of $8,500,000. The transaction was completed and the stock was issued to investors on July 2, 2003. We received net proceeds of approximately $8,000,000 after deducting placement agent fees and costs associated with the offering.

On September 2, 2003, at our annual shareholder’s meeting, the amendment to the Company’s Restated Articles of Incorporation to increase the authorized number of shares of common stock by 70,000,000 shares, from 30,000,000 shares to 100,000,000 shares was approved.

On September 17, 2003, we announced an underwritten public offering of 920,000 shares of our common stock to institutional investors at a price of $15.00 per share for gross proceeds of $13,800,000. The transaction was completed and the stock was issued to investors on September 22, 2003. We received net proceeds of approximately $13,011,000 after deducting underwriting discounts and costs associated with the offering.

Convertible Preferred Stock – Series D

In February 2001, we issued 700,000 shares of Series D convertible preferred stock to Daikin Industries in conjunction with our purchase of the DVD-Video authoring tools business of Daikin valued at $1,750,000 or $2.50 per share. During the quarter ended September 30, 2002, Daikin converted 350,000 shares of their Series D convertible preferred stock into 350,000 shares of our common stock and during the quarter ended December 31, 2002, Daikin converted all of their

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remaining shares of their Series D convertible preferred stock into an equivalent number of shares of common stock.

Convertible Preferred Stock – Series E

In December 2001, we sold 250,000 shares of Series E preferred stock to Sanshin Electronic Co., Ltd. for $1,000,000. During the quarter ended September 30, 2002, Sanshin converted all of their Series E preferred stock into 250,000 shares of our common stock.

Convertible Preferred Stock – Series F

On December 18, 2002, we issued 1,290,948 shares of Series F preferred stock to VERITAS in connection with our acquisition of the Desktop and Mobile Division of VERITAS. The shares were issued pursuant to the exemption provided by Section 4(2) of the Securities Act of 1933. Each share of Series F preferred stock was convertible at the option of the holder into one share of common stock subject to adjustment for certain dilutive events, such as stock splits. In March 2003, VERITAS converted all of their Series F preferred stock into 1,290,948 shares of our common stock.

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

Our President and Chief Executive Officer (the “CEO”) is considered our chief operating decision maker. The CEO reviews financial information presented on a consolidated basis accompanied by desegregated information about revenue by product line and revenue by geographic region for purposes of making operating decisions and assessing financial performance. Prior to March 31, 2003, consolidated financial information reviewed by the CEO was identical to the information presented in the accompanying statements of operations. Beginning in the first fiscal quarter ended June 30, 2003, financial information reviewed by management includes not only revenue by product line, but also gross margin analysis and operating income for the related operating segments. This information was not tracked previously and is not available for presentation. Beginning with the fiscal quarter ended June 30, 2003, we have presented, and we continue to present for the current fiscal quarter, information required for our new operating segments. The consumer segment includes software-only DVD-Video creation tools and DVD-Video playback software products intended for use by lower end professionals, enthusiasts or “prosumers,” and consumers, and software-only CD-Audio, CD-ROM and DVD-ROM making tools, as well as data backup software. Our consumer products also include software that we license to other companies for inclusion in their products. Our professional audio and video segment includes advanced DVD-Video creation tools which are intended for use by high-end professional customers. The following table shows the revenue by product line, operating results by segment, revenue by geographic and significant customer information:

Net Revenue by Segment (in thousands):

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Net Revenue and Operating Income by Segment (in thousands for the quarter ended December 31, 2003):

Net Revenue and Operating Income by Segment (in thousands for the nine months ended December 31, 2003):

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Net Revenue by Geographic Location (in thousands):

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

Significant Customer Information (in thousands):

Revenue recognized from Customers A,B and C was pursuant to development and licensing agreements.

Revenue recognized from Customers D and E was pursuant to development and licensing agreements for which most amounts had been prepaid and previously included in deferred revenue.

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

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

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

In November 2002, the Financial Accounting Standards Board issued a Consensus, which clarified certain issues within EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” The Consensus addresses how to allocate the revenue in an arrangement involving multiple deliverables into separate units of accounting consistent with the identified separate earnings processes of each deliverable for revenue recognition purposes. The Consensus also addresses how each element in a bundled sales arrangement should be measured and allocated to the separate units of accounting in the arrangement. The Consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this Statement did not have a significant impact on our financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This Statement also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We adopted the annual disclosure requirements of SFAS No. 148 for the year ended March 31, 2003. We adopted the interim disclosure requirements during the quarter ending June 30, 2003. The adoption of SFAS No. 148 did not have a material effect on our financial position or results of operations.

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In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN No. 46”), “Consolidation of Variable Interest Entities.” FIN No. 46 expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN No. 46 apply to variable interest entities created after January 31, 2003. In December 2003, the FASB issued FIN 46R, which made certain amendments to FIN No. 46. The revision clarifies the definition of a business by providing a scope exemption that eliminates the overly broad definition in the original release that potentially could have classified any business as a variable interest entity. The revision also delays the effective date of the Interpretation from the first reporting period following December 15, 2003 to the first reporting period ending after March 15, 2004. The adoption of this Statement is not anticipated to have a significant impact on our financial position and results of operations.

In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement did not have a significant impact on our financial position or results of operations.

In December 2003, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bullentin No. 104, “Revenue Recognition” (SAB 104), which codifies, revises and rescinds certain sections of SAB 101, “Revenue Recognition in Financial Statements’ in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The adoption of SAB 104 did not have a material impact on our financial position or results of operations.

InterActual Acquisition

On January 31, 2004, we entered into a definitive agreement to acquire all the stock of InterActual Technologies for $8.8 million in cash. We closed this transaction on February 13, 2004. As a result of the acquisition, we acquired all of InterActual’s assets and liabilities, including their portfolio of patents and patent applications, the InterActual Player, and all engineering and service operations. Most of the employees of InterActual, approximately 23 people, accepted offers to join our company. The majority of these employees are located in San Jose, California. The accounting for this acquisition is pursuant to the purchase accounting method.

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

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As a result of InterActual becoming our wholly-owned subsidiary, third parties may bring a claim or otherwise seek recourse against InterActual or us for known and unknown liabilities of the InterActual business that arose before the acquisition, including claims related to intellectual property ownership and infringement. While we do not currently anticipate that these liabilities will be significant, any such claim, with or without merit, could be time consuming to defend, result in costly litigation and divert management’s attention.

InterActual had been a defendant in a lawsuit entitled Trust Licensing, LLC and Leigh Rothschild v. InterActual Technologies, Inc. in the United States District Court for the Southern District of Florida (Civil Action No. 03-20672) in which InterActual had been charged with patent infringement and other wrongdoing. As a result of court-sponsored mediation, InterActual and the plaintiffs executed an agreement settling the matter on January 28, 2004. We understand that, after learning of our agreement to acquire InterActual, the plaintiffs in this matter intend to ask the court to set aside the settlement. We do not believe the plaintiffs have any reasonable basis for setting aside the settlement agreement. In the event that the settlement is set aside, the lawsuit could be reinstated. If that were to occur, the lawsuit could be time consuming and expensive to defend, divert management’s attention, and potentially result in an adverse judgment.

“Shelf” Registration

On February 5, 2004, we filed a Form S-3 Registration Statement with the Securities and Exchange Commission to register our common stock, preferred stock and warrants to purchase common stock and preferred stock with an aggregate maximum offering price not to exceed $80.0 million.

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FORWARD LOOKING STATEMENTS

This report contains forward-looking statements within the meaning of federal securities laws that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “can,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Risks and uncertainties and the occurrence of other events could cause actual results to differ materially from these predictions. Factors that could cause or contribute to such differences include those discussed below as well as those discussed in our Annual Report on Form 10-K for the year ended March 31, 2003 and our other filings with the Securities and Exchange Commission.

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

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 original equipment manufacturer (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 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.

OVERVIEW

The financial section of this Quarterly Report consists of management’s discussion of our financial condition and results of operations, and accompanying condensed consolidated financial statements for the quarter and the nine months period ended December 31, 2003 and related notes.

We develop and market computer based tools:

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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 various other companies to incorporate in products they develop.

Our business is divided into two reporting segments, our consumer segment and our professional audio and video segment. At the same time, we divide our products into three categories: professional audio and video products, desktop products and technology products.

During the first three quarters of fiscal year 2004, we experienced a continued growth in our net revenue as well as a growth in our profitability and net income. Our revenue growth for the third quarter of fiscal year 2004, which amounted to an increase of 77% from the same period in the prior year, was driven mainly by an increase in sales of our consumer products primarily through new and existing OEM licensing agreements, including OEM licensing agreements assumed in connection with our acquisition of the VERITAS DMD business. International sales increased to 43% of our net revenue for the third quarter of fiscal year 2004 up from 39% of our net revenue for the second quarter of fiscal 2004. Approximately 41% of our net revenue for the quarter ended December 31, 2003 resulted from two customers and 45% of our net revenue for the nine months ended December 31, 2003 resulted from three customers. The loss of any of these customers would have a material adverse effect on our financial results.

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 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.

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We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support. Revenue recognized from multiple-element software arrangements 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. We record revenue on a net basis for those sales in which we have in substance acted as an agent or broker in the transaction.

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 Industries 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 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.

We maintain an allowance for returns and 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 may be required.

We capitalize a portion of our software development costs in accordance with SFAS 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

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associated with certain products, and the future cost of sales. If these estimates change, write-offs of capitalized software costs could result.

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.

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 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 No. 142 at least annually and more frequently upon the occurrence of certain events, as defined in SFAS No. 142. As required by SFAS 142, we have determined that our reporting units are the same as our reportable segments. Goodwill within our reporting units 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 No. 142, to its carrying amount to determine the impairment loss, if any. Goodwill resulted from our Ravisent product business acquisition during the quarter ended June 30, 2002, which was accounted for as a purchase, and from our acquisition of the Desktop and Mobile Division or DMD business from VERITAS during the quarter ended December 31, 2002, which was also accounted for as a purchase. As of December 31, 2003, no events had occurred that led us to believe that there was any impairment.

We follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” to determine stock-based compensation expense in connection with stock option grants under our stock option plan. See Note (2) in our Notes to Condensed Consolidated Financial Statements included in Part 1, Item I of this quarterly report for further discussion of the effect on net income and earnings per share of our stock option grants, including if we had applied the fair value recognition provisions of SFAS No. 123 “Accounting for Stock-Based Compensation.”

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. Under the terms of the agreement, we transferred our SonicStudio workstation business to SonicStudio LLC and licensed this company to utilize the technology underlying SonicStudio in the professional audio workstation market. The book value of net assets and liabilities transferred to SonicStudio LLC, totaled $235,661. We accounted for this investment in SonicStudio LLC using the modified equity method. As of December 31, 2003, our investment in SonicStudio LLC was recorded at zero.

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

During the quarter ended June 30, 2003 we established a wholly owned subsidiary in Japan, called “Sonic Japan KK.” We transferred a total of 6 employees into this new subsidiary.

The new subsidiary was established because of the increased level of business we have encountered in Japan, to potentially lower our overall tax rate, and to increase our level of direct contact with important Japanese customers, particularly those OEM customers utilizing our consumer software products. As part of this reorganization, we began reorganizing the distribution of our software products in Japan. In July 2003, we notified Easy Systems Japan (ESJ) of our intention to terminate its distributorship of some of our software products, and we began the process of transitioning our business and customers from ESJ. While we believe that we have taken the necessary steps to ensure a smooth transition for ESJ’s customers, we may not be able to maintain our relationship with these customers in the future or ESJ may not live up to its contractual obligations during the transition.

During the quarter ended September 30, 2003, we established a wholly owned subsidiary in China, called “Sonic Solutions Shanghai China,” and hired a number of engineers to work for this new subsidiary. We established this subsidiary in response to the growing demand for our CD/DVD creation technology worldwide. This new subsidiary allows us to tap into the large pool of engineering talent in China, speeding the development and deployment of our products and technologies to our customers. The subsidiary also brings additional reach to our operations which include development and sales offices in North America, Europe, Japan and Taiwan.

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

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Results of Operations

The following table sets forth certain items from Sonic’s statements of operations as a percentage of net revenue for the quarters and nine months ended December 31, 2002 and 2003, respectively (in thousands):

Comparison of Quarter and Nine Months Ended December 31, 2002 and 2003

NET REVENUE. Our net revenue increased from $8,379,000 for the third quarter ended December 31, 2002 to $14,834,000 for the third quarter ended December 31, 2003, representing an increase of 77%. For the nine months ended December 31, 2003, net revenue increased from $23,251,000 to $39,551,000 compared to the same period in the prior fiscal year, representing an increase of 70%. The increase in net revenue for the quarter and nine months ended December 31, 2003 was primarily due to the increase in sales of our consumer products which increased approximately 106% and 108%, for the third quarter and nine months ended December 31, 2003, respectively. The increase in sales was due to new OEM licensing agreements entered into during the quarter ended December 31, 2003 and in prior quarters and the increase in volume of sales reported by these and existing OEM partners. The increase in sales was also due to inclusion of the results of OEM licensing agreements that we assumed as part of our acquisition of the DMD business of VERITAS in December 2002. Since the DMD business has now been integrated into our other operations, we are not able to specifically track results of its operations separately from our other consumer software business. The increase in sales of our consumer products was offset in part by decreases in our professional audio and video sales of approximately 1% and 15% for the third quarter and nine months ended December 31, 2003, respectively.

International sales accounted for 33% and 43% of our net revenue for the third quarter ended December 31, 2002 and 2003, respectively. International sales accounted for 27% and 40% of our net revenue for the nine months ended December 31, 2002 and 2003, respectively. International sales have historically represented slightly less than 50% of our total revenue, and we expect that they will continue to represent a significant percentage of future revenue. The following table

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shows the breakdown of net revenue for the periods indicated by geographic location (in thousands).

COST OF REVENUE. Our cost of revenue, as a percentage of net revenue decreased from 21.2% for the third quarter ended December 31, 2002 to 11.7% for the third quarter ended December 31, 2003. Cost of revenue, as a percentage of net revenue decreased from 23.5% for the nine months ended December 31, 2002 to 13.0% for the nine months ended December 31, 2003. The decrease in cost of revenue as a percentage of revenue was 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.Cost of revenue mainly consists of third party licensing OEM arrangments, employee salaries and benefits for personnel directly involved in the production of revenue-generating products and amortization of acquired and internally-developed software.

We capitalize a portion of our software development costs in accordance with SFAS No. 86. This means that a portion of the costs we incur for software development are not recorded as an expense in the period in which they are actually incurred. Instead, they are recorded as an asset on our balance sheet. The amount recorded on our balance sheet is then amortized to cost of revenue over the estimated life of the products in which the software is included. During the third quarter ended December 31, 2003, we capitalized approximately $89,000 and amortized approximately $86,000. During the third quarter ended December 31, 2002 we capitalized approximately $116,000 and amortized approximately $140,000, excluding amounts capitalized and amortized relating to Daikin Industries, Ltd., Ravisent and the DMD business acquisitions. During the nine months ended December 31, 2003 we capitalized approximately $313,000 and amortized approximately $272,000. During the nine months ended December 31, 2002 we capitalized approximately $359,000 and amortized $428,000, excluding amounts capitalized and amortized relating to Daikin Industries, Ltd., Ravisent and the DMD business acquisitions.

SIGNIFICANT CUSTOMERS. Revenue from two customers accounted for 27% and 14%, respectively, of our total net revenue for the quarter ended December 31, 2003. Additionally, three customers accounted for 19%, 16% and 10%, respectively, of our total net revenue for the nine months ended December 31, 2003. Revenue recognized from these customers was pursuant to development and licensing agreements we have with them. The loss of any one of these customers and our inability to obtain new customers to replace the lost revenue in a timely manner could harm our sales and results of operations.

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GROSS PROFIT. Our gross profit as a percentage of total net revenues increased to 88.3% for the quarter ended December 31, 2003 from 78.8% for the same period in 2002. Gross profit as a percentage of total net revenues increased to 87.0% for the nine months ended December 31, 2003 from 76.5% for the same period in 2002. The increase in our gross profit in 2003 as compared to 2002 was primarily due to a shift in sales product mix towards higher margin consumer products 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 increased from $2,067,000 for the third quarter ended December 31, 2002 to $3,304,000 for the third quarter ended December 31, 2003. Marketing and sales expenses increased from $6,214,000 for the nine months ended December 31, 2002 to $9,286,000 for the nine months ended December 31, 2003. Marketing and sales represented 24.7%, 22.3%, 26.7% and 23.5% of net revenue for the third quarter ended December 31, 2002 and 2003 and the nine months ended December 31, 2002 and 2003, respectively. Our marketing and sales expenses increased primarily due to an increase in sales commissions expense, and increase in marketing and advertising expenses as a result of the increase in the number of products we sell. Sales commissions expense increased as a percentage of net revenue to 7% for the quarter ended December 31, 2003 up from 4% of net revenue for the quarter ended December 31, 2002. Marketing and advertising expense, including trade show expenses, increased in dollar terms by approximately 49% and 15% for the quarter and nine months ended December 31, 2003. Headcount increased from 53 at December 31, 2002 to 60 at December 31, 2003. Marketing and sales expenses mainly consist of employee salaries and benefits, travel, advertising and other promotional expenses and dealer and employee sales commissions.

RESEARCH AND DEVELOPMENT. Our research and development expenses increased from $2,658,000 for the third quarter ended December 31, 2002 to $4,986,000 for the third quarter ended December 31, 2003 and increased from $6,800,000 for the nine months ended December 31, 2002 to $14,007,000 for the nine months ended December 31, 2003. Our research and development expenses represented 31.7%. 33.6%, 29.2% and 35.4% of net revenue for the third quarter ended December 31, 2002 and 2003 and for the nine months ended December 31, 2002 and 2003, respectively. Our research and development expenses increased primarily due to higher salary expense associated with the increase in headcount from 118 at December 31, 2002 to 171 at December 31, 2003. Included in this headcount increase were approximately 59 engineers and other development personnel hired by us as a result of our acquisition of the DMD business of VERITAS and the transfer of personnel as part of the license agreement we executed with Axeda. Research and development expenses mainly consist of employee salaries and benefits, travel and consulting expenses incurred in the development of new products. We anticipate that research and development expenditures in future periods, as a percentage of revenue, will be relatively consistent with fiscal 2004 levels, excluding the impact of any future acquisitions.

GENERAL AND ADMINISTRATIVE. Our general and administrative expenses increased from $730,000 for the third quarter ended December 31, 2002 to $1,174,000 for the third quarter ended December 31, 2003 and increased from $2,309,000 for the nine months ended December 31, 2002 to $3,203,000 for the nine months ended December 31, 2003. Our general and administrative expenses represented 8.7%, 7.9%, 9.9% and 8.1% of net revenue for the third quarter ended December 31, 2002 and 2003 and for the nine months ended December 31, 2002 and 2003, respectively. The dollar increase was primarily due to increased rent, insurance, professional and other general expenses related to the overall increase in our headcount from 188 at December 31, 2002 to 253 at December 31, 2003. We anticipate that general and administrative expenses will increase in the future as our operations expand. General and administrative expenses mainly consist of employee salaries and benefits, travel, overhead, corporate facilities expense, legal, accounting and other professional services expenses.

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OTHER INCOME AND EXPENSE, NET. Other income on our condensed consolidated statements of operations includes the interest we earned on cash balances and short term investments and realized foreign currency fluctuations. Interest income was approximately $29,000 and $76,000 for the third quarter ended December 31, 2002 and 2003, respectively and approximately $85,000 and $122,000 for the nine months ended December 31, 2002 and 2003, respectively . Other expense includes primarily the interest and realized foreign currency fluctuations. During the nine months ended December 31, 2002 and 2003, approximately $ 71,000 and $69,000, respectively, was recorded as other expense relating to the write-down of our investment in SonicStudio LLC.

PROVISION FOR INCOME TAXES. In accordance with SFAS No. 109, we made no provision for U.S. income taxes for the third quarter and the nine months ended December 31, 2002 and 2003 due to net operating loss carryforwards and other credits. However, for the third quarter and the nine months ended December 31, 2002 and 2003, foreign tax expense was recorded to reflect the taxes withheld by various foreign customers and paid to the foreign taxing authorities.

ACQUISITIONS. 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 asset purchase agreement with VERITAS to acquire the DMD business of VERITAS, which sold personal computer based CD–ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software. The transactions contemplated by this 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 the outstanding customers and other contracts of the DMD business. Under this agreement, approximately 40 individuals of the DMD business joined Sonic.

Under the 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 transaction was applied pursuant to the purchase accounting method.

LIQUIDITY AND CAPITAL RESOURCES. Our operating activities used cash of $2,452,000 for the nine months ended December 31, 2002 and generated cash of $7,406,000 for the nine months ended December 31, 2003.

During the nine months ended December 31, 2002, cash used in operations was primarily the result of the decrease in deferred revenue of $6,481,000 as a result of revenue recognized on various OEM and development contracts for which cash had been previously collected and the increase in accounts receivables of $1,566,000 primarily due to increased sales. These amounts were offset in part by our net income of $2,392,000, including depreciation and amortization of $1,873,000, and by our increase in accounts payable and accrued liabilities of $2,006,000.

During the nine months ended December 31, 2003, cash generated by operations included net income of $6,748,000 including depreciation and amortization of $1,521,000. Cash generated by

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operations was also the result of the increase in deferred revenue and deposits of $2,653,000, offset in part by the increase in accounts receivables of $2,961,000 due to increased sales and an increase in other assets of $735,000.

In addition to our operations, we utilized cash during the nine months ended December 31, 2002 and 2003 to purchase new fixed assets and to develop and purchase software that was added to capitalized software. Additionally, during the nine months ended December 31, 2002, $2,275,000 was used to complete the acquisition of the Ravisent product line from Axeda.

On June 27, 2003, we announced a public offering of 1,000,000 shares of our common stock to institutional investors at a price of $8.50 per share for gross proceeds of $8,500,000. The transaction was completed and the stock was issued to investors on July 2, 2003. We received net proceeds of approximately $8,000,000 after deducting placement agent fees and costs associated with the offering.

On September 17, 2003, we announced an underwritten public offering of 920,000 shares of our common stock to investors at a price of $15.00 per share for gross proceeds of $13,800,000. The transaction was completed and the stock was issued to investors on September 22, 2003. We received net proceeds of approximately $13,011,000 after deducting underwriting discounts and costs associated with the offering.

We lease certain facilities and equipment under noncancelable operating leases. Rent expense under operating leases was approximately $393,000 and $524,000 for the third quarter ended December 31, 2002 and 2003, respectively and was approximately $1,113,000 and $1,529,000 for the nine months ended December 31, 2002 and 2003, respectively. Future payments under these 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, coupled with the proceeds from our two common stock offerings, will be sufficient to meet our cash requirements at least through the middle of fiscal year 2005.

As of December 31, 2003, we had cash and cash equivalents of $38,930,000 and working capital of $37,354,000. As discussed below in the section captioned “Subsequent Events,” after the quarter end, we completed the acquisition of InterActual for $8.8 million in cash.

In addition, as part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies. Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses. Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our current operations, or expand into new markets. Furthermore, we cannot assure you that additional financing will be available to us in any required time frame and on commercially reasonable terms, if at all. See “Risk Factors —We may engage in future acquisitions that could dilute our

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shareholders’ equity and harm our business, results of operations and financial condition” for more detailed information.

Off-Balance Sheet Arrangements. We do not have any off-balance sheet arrangements, as such term is defined in recently enacted Securities and Exchange Commission 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.

Subsequent Events. On January 31, 2004, we entered into a definitive agreement to acquire all the stock of InterActual Technologies for $8.8 million in cash. This transaction closed on February 13, 2004. As a result of the acquisition, we acquired all of InterActual’s assets and liabilities, including their portfolio of patents and patent applications, the InterActual Player, and all engineering and service operations. Most of the employees, approximately 23, joined our company. The majority of the employees are located in San Jose, California. The accounting for this acquisition is pursuant to the purchase accounting method.

On February 5, 2004, we filed a Form S-3 Registration Statement with the Securities and Exchange Commission to register our common stock, preferred stock and warrants to purchase common stock and preferred stock with an aggregate maximum offering price not to exceed $80.0 million.

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Risk Factors

You should consider carefully the risk factors set forth below as well as those in other documents we file with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing Sonic. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair business operations. The risks identified below could harm our business and 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 experienced 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 and the first three quarters of the 2004 fiscal year, we may not maintain profitability and as a result our share price may decline. Although we have provided revenue and earnings “guidance” for full fiscal year 2004 that anticipates profitability, 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. During the nine months ended December 31, 2003, we had a positive operating cash flow of $7,406,000. We may 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 through to the middle of fiscal year 2005. 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 and faster than anticipated. Currently we 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 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.

Failure to successfully integrate InterActual Technologies into our existing business could have a negative impact on us.

On January 31, 2004, we entered into a definitive agreement to acquire all the stock of InterActual Technologies for $8.8 million in cash. We closed this transaction on February 13, 2004. As a result of the acquisition, we acquired all of InterActual’s assets and liabilities, including their portfolio of patents and patent applications, the InterActual Player, and all engineering and service operations. InterActual Technologies will become our wholly-owned subsidiary. Most InterActual employees, approximately 23, joined our company. The majority of the employees are located in San Jose, California.

The acquisition InterActual involves risks related to the integration and management of this business, which may be a complex, time-consuming and an expensive process, and which may disrupt our businesses if not completed in a timely and efficient manner. We may encounter

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substantial difficulties, costs and delays in integrating the InterActual operations including the following:

As a result of InterActual becoming our wholly-owned subsidiary, third parties may bring a claim or otherwise seek recourse against InterActual or us for known or unknown liabilities of the InterActual business that arose before the acquisition, including claims related to intellectual property ownership and infringement. While we do not currently anticipate that these liabilities will be significant, any such claim, with or without merit, could be time consuming to defend, result in costly litigation and divert management’s attention.

InterActual had been a defendant in a lawsuit entitled Trust Licensing, LLC and Leigh Rothschild v. InterActual Technologies, Inc. in the United States District Court for the Southern District of Florida (Civil Action No. 03-20672) in which InterActual had been charged with patent infringement and other wrongdoing. As a result of court-sponsored mediation, InterActual and the plaintiffs executed an agreement settling the matter on January 28, 2004. We understand that, after learning of our agreement to acquire InterActual, the plaintiffs in this matter intend to ask the court to set aside the settlement. We do not believe the plaintiffs have any reasonable basis for setting aside the settlement agreement. In the event that the settlement is set aside, the lawsuit could be reinstated. If that were to occur, the lawsuit could be time consuming and expensive to defend, divert management’s attention, and potentially result in an adverse judgment.

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.

In addition, our acquisition of the DMD business included the retention of approximately 40 employees of VERITAS, representing approximately a 25% increase in our total number of employees at that time. Consequently, we may face management and organizational issues as we continue to integrate the DMD business employees into our other operations. Our general and administrative expenses increased in the third quarter ended December 31, 2003 and the nine months ended December 31, 2003, as compared to the comparable periods in 2002. The

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increase in expenses was primarily due to increased rent, insurance, professional and other general expenses related to the overall increase in headcount, partly as a result of new hires from VERITAS.

The process of integrating the DMD operations could cause an interruption or loss in momentum in our business and operating activities and, if material, could harm our business.

If we fail to integrate the DMD business into our existing operations, we may not achieve the desired synergies and benefits originally anticipated by the DMD acquisition and, as a result, we may not achieve a positive, long-term benefit to our operating results.

Our acquisition of the Ravisent business line may not positively contribute to our operations.

The Ravisent business line was not profitable when owned by Axeda prior to May 2002. While we have operated the Ravisent business line for more than a year, it remains possible, given the amount that we paid to obtain exclusive rights to deploy the Ravisent technologies in the personal computer market coupled with the on-going costs associated the maintaining the business line, that the Ravisent technology and employees will not be a positive contributor to our operations and instead may constitute a drain on our resources.

Because we have significant international operations and a significant portion of our revenue derives from sales made to foreign customers located primarily in Europe and Japan, we may be subject to political, economic and other conditions relating to our international operations that could increase our operating expenses and disrupt our business.

We are dependent on sales to customers outside the United States, in particular Europe and Japan. Revenue derived from these customers accounted for approximately 43% of our revenues for the third quarter ended December 31, 2003. Revenue derived from these customers accounted for approximately 47%, 39% and 30% of our revenues in fiscal years 2001, 2002 and 2003, respectively. Although most of our revenue and expenses are transacted in U.S. dollars, we may be exposed to currency exchange fluctuations in the future as business practices evolve and are forced to transact business in local currencies. This may expose us to foreign currency fluctuation risks. These foreign customers expose us to the following additional risks, among others:

International sales have historically represented slightly less than 50% of our total sales. We expect that revenue from international sales will continue to account for a significant portion of our net revenue for the foreseeable future. As a result, the occurrence of any negative international political, economic or geographic events could result in significant revenue shortfalls. These shortfalls could cause our business, financial condition and results of operations to be harmed.

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We may engage in future acquisitions that could dilute our shareholders’ equity and harm our business, results of operations and financial condition.

As part of our effort to enhance our existing products and introduce new products, we have pursued, and we may pursue in the future, acquisitions of complementary companies, products and technologies. We are unable to predict whether or when any other prospective acquisition will be completed. We have limited experience in acquiring and integrating outside businesses. The process of integrating an acquired business may produce operating difficulties, may be prolonged due to unforeseen difficulties, may require a disproportionate amount of our resources and expenditures and may require significant attention of our management that otherwise would be available for the ongoing development of our business. We cannot assure you that we will be able to successfully identify suitable acquisition candidates, complete acquisitions, integrate acquired businesses into our current operations, or expand into new markets. Further, once integrated, acquisitions may not achieve anticipated levels of revenues, profitability or productivity or otherwise perform as expected. The occurrence of any of these events could harm our business, financial condition or results of operations. Future acquisitions may require substantial capital resources, which may require us to seek additional debt or equity financing.

Future acquisitions by us could result in the following, any of which could seriously harm our results of operations or the price of our stock:

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 any of the following reasons:

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In addition, stock markets in general, and the market for 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 single supplier for our manufacturing makes us vulnerable to supplier operational problems.

Our hardware outsourcing manufacturing program commits responsibility for almost all of our manufacturing activities to a single supplier – Arrow Bell Electronics. As a result of our dependence on this one manufacturer, we do not directly control hardware product delivery schedules or hardware product quality. Any product shortages or quality assurance problems could increase the costs of manufacturing and distributing our products.

We are dependent on third-party single-source suppliers for components of some of our products and any failure by them to deliver these components could limit our ability to satisfy customer demand.

We often use components in our products that are available from only a single source. These components include, for example, Phillip’s Video Scaler and various Xilinx devices. 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.

Any interruption in the operations of our vendors of sole source components could adversely affect our ability to meet our scheduled product deliveries to customers. If we are unable to obtain a sufficient supply of components from our current sources, we could experience difficulties in obtaining alternative sources or in altering product designs to use alternative components. Resulting delays or reductions in product shipments could damage customer relationships and expose us to potential damages that may arise from our inability to supply our

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customers with products. Further, a significant increase in the price of one or more of these components could harm our gross margin or operating results.

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

Unlicensed copying and use of our intellectual property or illegal infringements of our intellectual property rights represent losses of revenue to our company. Our products are based in large part on proprietary technology which we have sought to protect with patents, trademarks, copyrights and trade secrets. For example, we have many 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 SDK among others. In addition, we make extensive use of trade secrets that we may not be able to protect. Effective patent, trademark, copyright and trade secret protection may not be available in every country in which our products may be manufactured, marketed or sold. Moreover, despite our efforts, these measures can only provide limited protection. Unauthorized third parties may try to copy or reverse engineer portions of our products or otherwise obtain and use our intellectual property.

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. Patent protection throughout the world is generally established on a country-by-country basis. Failure to obtain patents or failure to enforce those patents that are obtained may result in a loss of revenue to us. We cannot assure you that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar technology, duplicate our products or design around any of our patents or other intellectual property rights we hold.

If we fail to protect our intellectual property rights and proprietary technology adequately, if there are changes in applicable laws that are adverse to our interests, or if we become involved in litigation relating to our intellectual property rights and proprietary technology or relating to the intellectual property rights of others, our business could be seriously harmed because the value ascribed to our intellectual property could diminish and result in a lower stock price. To the extent we are unable to protect our proprietary rights, competitors also may enter the market offering products identical to ours, with a negative impact on sales of our products.

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

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

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

Our products are designed to adhere to industry standards, such as DVD-ROM, DVD-Video, DVD-Audio and MPEG video. A number of companies and organizations hold various patents that claim to cover various aspects of DVD and MPEG technology. We have entered into license agreements with certain companies and organizations relative to some of these technologies. For instance, we have entered into license agreements with Dolby Licensing Corporation covering Dolby Digital Audio, with Meridian Audio Limited covering Meridian Lossless Packing, with MPEG-LA (see below) covering various aspects of MPEG-2 video compression technology, and with Thomson/Fraunhofer covering various aspects of MPEG-2 and layer 3 audio compression

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technology, among others. 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.

We face risks associated with our patent position, including the potential need to engage in significant legal proceedings to enforce our patents, the possibility that the validity or enforceability of our patents may be denied, the possibility that third parties will be able to compete against us without infringing our patents and the possibility that our products may infringe patent rights of third parties. Budgetary concerns may cause us not to file, or continue, litigation against known infringers of our patent rights. Failure to reliably enforce our patent rights against infringers may make licensing more difficult.

Third parties could pursue us claiming that our products infringe various patents. 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 not represented by MPEG-LA from asserting that we infringe a patent covering some aspects of MPEG-2 technology.

Patent infringement litigation can be time consuming and costly, may divert management resources and may result in the invalidation of our intellectual property rights. If such litigation resulted in an unfavorable outcome for us, we could be subject to substantial damage claims and requirements to cease production of infringing products, terminate our use of infringing technology or develop non-infringing technology and obtain a royalty or license agreement to continue using the technology at 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. Our use of protected technology may result in liability that threatens our continuing operation.

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 through OEM customers, including for example Dell, Hewlett-Packard, Sony, Matrox and Avid. The revenue from many of these customers is recognized on a sell-through basis. Temporary fluctuations in the pricing and availability of the OEM customers’ products could negatively impact sales of our products, which could in turn harm our business, financial condition and results of operations. In addition, some of the materials, components and/or software included in the end products sold by our OEM customers, who also incorporate our products, are obtained from a limited group of suppliers. Supply disruptions, shortages or termination of any of these sources could have an adverse effect on our business and results of operations due to the delay or discontinuance of orders

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for our products by our OEM customers until those necessary materials, components or software are available for their end products. Moreover, if OEM customers do not ship as many units as forecasted or if there is a general decrease in their unit sales, our net revenue will be adversely impacted and we may be less profitable than forecasted or unprofitable. Finally, we are dependent on reports prepared by the OEM customers to determine the results of our sales of products through these OEM customers. If the OEM customers prepare inaccurate or substandard sales reports, we may be required to take corrective actions, including auditing current and prior reports. Such corrective action may result in negative effects on us, including that our prior reported net revenue and related results may be inaccurate, in particular less than previously reported.

Changes in requirements or business models of our OEM customers may negatively affect our financial results.

OEM customers can be quite demanding, in terms of the features they demand in software products they bundle, in terms of their quality and testing requirements, and in terms of their economic demands. Because there is a relatively small number of significant OEM customers, if they demand reduced prices for our products, we may not be in a position to refuse such demands, in which case our revenues and our results of operations will be negatively affected. If particular OEMs demand certain product or product features that we are unable to deliver, or if they impose higher quality requirements than we are in a position to satisfy, our revenues and our results of operations could be negatively affected.

We have embarked on a new program with one of our major OEMs, Dell, in which we are developing a number of versions of our products specifically for that OEM’s customers. The versions include a base version to be included with the OEM’s products, and enhanced versions. The enhanced versions will be marketed by the OEM’s sales force and by us to obtain favorable end user upgrade decisions at the “point of sale,” that is the time and place at which end user customers purchase a PC or other device, as well as after the point of sale. If the OEM offers an upgrade, then the base version can be sold by them to their customers without royalty to us. We will be contributing significant resources to this effort including (i) extra development resources to develop the various product versions required by the program, (ii) enhanced first line customer support activities, and (iii) enhanced marketing obligations, among others. While we believe that upgrade rates and resulting revenues, which will be split between the OEM and ourselves, will more than compensate for the lack of royalty revenues deriving from shipments of the base versions of our products and for our increased resource commitment, thereby increasing our overall revenues and contribution deriving from this OEM, the new business model is untested at this time, and actual results may be disappointing. In that case, our revenues and our results of operations could be negatively affected. During the quarter ending December 31, 2003 Dell began this transition and during the quarter ended March 31, 2004, we anticipate that they will continue to transition our products into this new model, and that the model will be significantly adjusted by our OEM partner in consultation with us. If the transition and adjustment process takes a significant length of time, or encounters difficulties, the results of our operations in those quarters could be negatively affected.

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 Software, Apple Computer, CyberLink, Intervideo, Inc., MedioStream, Pinnacle, Roxio and Ulead. Most of these companies have greater financial and technological resources than we do.

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For example, in April 2000, Apple Computer announced the acquisition of the DVD authoring business of Astarte Gmbh. Prior to the acquisition, Astarte sold a DVD authoring system that competed primarily with our DVD Fusion product. In January 2001, Apple announced two new DVD authoring products, which we presume are based on Astarte’s technology. The first product, iDVD, is intended for consumer users and competes 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.