3do Company (the) (THDOQ) - Description of business

Symbol:	THDOQ
SIC:	7372 - Services-Prepackaged Software
Type:	PINK-SHEET
State location:	CA
State of Inc:	DE
Business Address:	200 CARDINAL WAY REDWOOD CITY CA 94063 6502613000
Mailing Address:	200 CARDINAL WAY REDWOOD CITY CA 94063

OVERVIEW

The 3DO Company is a developer and publisher of branded interactive entertainment software. We have developed products for several multimedia platforms including personal computers, the PlayStation game console, the PlayStation 2 computer entertainment system, the Nintendo 64 game system, the Nintendo Game Boy Color hand-held game system, and the Nintendo Game Boy Advance hand-held game system. We are also developing software, but have not shipped, for other next generation video game consoles including the Nintendo Game Cube and the Microsoft Xbox. We will continue to develop products for our existing brands across multiple categories, or “genres,” and platforms while we develop new products and brands to expand our current variety of products. Our existing brands include Army Men, Cubix, Heroes of Might and Magic, High Heat Baseball and Might and Magic. Our software products cover a variety of genres, including action, strategy, adventure/role playing, sports and family entertainment.

We distribute our products through a broad variety of retail outlets, including mass merchants, warehouse club stores, computer and software retail chains other specialty retailers and Internet retailers. We sold our products to over 20,000 retail outlets in fiscal 2002. Our largest retail customers in fiscal 2002 were Best Buy, Blockbuster Entertainment, Electronics Boutique, Game Stop, Jack of All Games, KayBee Toys, Target, Toys “R” Us and Wal-Mart.

Our software publishing revenues decreased to $53.7 million in fiscal 2002 from $80.0 million in fiscal 2001 and $118.5 million in fiscal 2000. Our net loss was $47.3 million in fiscal 2002 compared to a net loss of $77.0 million in fiscal 2001 and net income of $0.2 million in fiscal 2000. Research and development costs decreased to $29.5 million in fiscal 2002 from $48.9 million in fiscal 2001 and from $34.3 million in fiscal 2000. The change in net income during fiscal 2002 is the result of an emphasis on reducing operating expenses. Our total assets were $44.9 million as of the end of fiscal 2002 compared with $66.6 million for fiscal 2001 and $97.8 million as of the end of fiscal 2000. At March 31, 2002, we had an accumulated deficit of $251.9 million. These circumstances raise substantial doubt about our ability to continue as a going concern. Our continued existence is dependent on our ability to obtain adequate funding and eventually establish profitable operations through increasing revenues and controlling costs. We began this process during the third quarter of fiscal 2002 by implementing a restructuring program to align our cost structure with our projected sales resulting from the current unfavorable economic conditions and to reduce future operating expenses. Also, we have recently signed a new line of credit agreement with a financial institution, which will provide us with additional liquidity. As part of the line of credit agreement, we have agreed to complete a new equity or subordinated debt financing of $4.6 million by October 1, 2002. Additionally, we have recently amended our headquarters office lease and its furniture lease agreements. The amended lease agreements allow us to reduce future lease payments and enable us to utilize our restricted cash balances for some of the future lease payments. In fiscal 2002, we released 26 new products compared to 35 new products in fiscal 2001 and 31 new products in fiscal 2000. New products consist of new brands, sequels and line extensions released on one or more platforms. We are currently developing over 30 new products that we expect to release during fiscal 2003 or the first half of fiscal 2004.

INDUSTRY BACKGROUND

The home interactive game market consists of software distributed on disc and cartridge media for use solely on dedicated hardware systems, and software distributed on CD-ROMS for use on PCs. Disc media includes DVD-ROM discs for use on the Sony PlayStation 2 and Microsoft Xbox, proprietary discs for use on the Nintendo Game Cube and CD-ROM discs for use on the Sony PlayStation. The Nintendo Game Boy Advance is the only current platform that uses cartridges. Until 1996, most software for dedicated platforms was sold in cartridge form. Since then, disc-based products have become increasingly popular because they have

substantially greater data storage capacity and lower costs than cartridges. As the technology of the hardware has advanced, the software has similarly advanced, with faster and more complex images, more lifelike animation and sound effects and more intricate scenarios. The larger data storage capacity of disc-based media for systems such as the Sony PlayStation 2, Microsoft Xbox and the Nintendo Game Cube enables them to provide richer content and longer play. This new generation of systems is based primarily on 128-bit technology. The latest hand-held platform, Game Boy Advance, uses 32-bit technology.

The introduction of new generation of game consoles has spurred progressively stronger sales than the previous generation. Each new generation of game consoles have a cycle of approximately four to six years before it is replaced with the next generation. At the end of each cycle, when the introduction of a new generation of home game consoles is announced, sales of the current generation of platforms and games generally diminish, as consumers defer purchases in anticipation of the new platforms and games. The next-generation consoles include Sony’s PlayStation 2, released in 2000, the Nintendo Game Cube and Microsoft Xbox, each released in 2001. We believe that the poor performance of our industry in 2000 and 2001 was impacted by the transition to the new generation of platforms and that these next-generation home game consoles will quickly dominate the videogame market, creating strong demand for games played on these platforms. Videogame software is created by the platform manufacturers and by many independent developers. Platform manufacturers license publishers to publish games for their platforms and retain a significant degree of control over the content, quality and manufacturing of these games. The developers, subject to the approval of the platform manufacturers, determine the types of games they will create. Software publishers either create their games in-house, through their own development teams, or outsource this function to independent developers.

The interactive entertainment software market can generally be divided into several game categories or genres. The most popular genres include action, puzzle/board/card, sports, and adventure/role playing. The hit-driven nature of the market has often led to higher production budgets for titles as well as more complex development and production processes and longer development cycles. Publishers with a history of producing hit titles have generally enjoyed a significant marketing advantage because of their heightened brand recognition and customer loyalty. To capitalize on this heightened brand recognition and customer loyalty, some publishers have introduced sequels or line extensions of their hit titles. Sequels are typically new releases of games based upon the original game concept that also include new characters, settings, and game-play attributes. Line extensions are typically new releases of games based upon the same successful brands and offering the brand in a different genre and/or on additional platforms.

The importance of the timely release of hit titles, as well as the increased scope, complexity and expense of the product development and production process, have increased the publisher’s need for disciplined product development processes that limit cost and schedule overruns and reduce development time. Further, this need has increased the importance of leveraging the technologies, characters and story lines of past or existing hit titles into additional interactive entertainment software products in order to spread development costs among multiple products.

INTERACTIVE ENTERTAINMENT SOFTWARE DEVELOPMENT

With 288 studio employees as of March 31, 2002, the majority of our development occurs internally. Our internal development studios are 3DO Redwood City (Redwood City, California) and New World Computing (Agoura Hills, California).

Historically we have developed products for several multimedia platforms including personal computers, the PlayStation 2 computer entertainment system, the PlayStation game console, the Nintendo Game Boy Color hand-held game system, the Nintendo Game Boy Advance hand-held game system, the Nintendo 64 game system, and the Internet. We are also developing software for other next generation video game consoles, such at the Nintendo Game Cube and the Microsoft Xbox. We will continue to develop products for our existing brands across multiple categories, or “genres,” and platforms while we develop new products and brands to expand our

current variety of products. Our existing brands include Army Men, Heroes of Might and Magic, Cubix, High Heat Baseball and Might and Magic. Our software products cover a variety of genres, including action, strategy, adventure/role playing, sports and family entertainment. Software for new platforms requires different standards of design and technology to fully exploit their capabilities. The introduction of new platforms also requires that game developers devote substantial additional resources to product design and development.

The Company’s current release schedule is primarily developed around the PC, PlayStation 2, Xbox, Game Boy Advance and Game Cube. The Company will continue to support legacy systems, such as PlayStation, on a limited basis. The Company anticipates that the eventual installed base next-generation consoles will provide a market for its software large enough to substantiate software sales at levels greater than those achieved in 2000 and 2001.

We believe our internal studios allow us to maintain better control over product quality, development costs and development schedules in comparison to companies that outsource product development to external development studios. By developing more of our interactive entertainment software internally, we retain ownership of the technology we develop and spread our investment in research and development across brands, platforms and genres by utilizing the existing code written for previous games.

Our internal studios consist of several development teams, all of which report to our Senior Vice President of Product Development. Each team is dedicated to the development of a particular product for the duration of a specific project. A team generally consists of producers, engineers, designers, programmers and artists. We allocate personnel to brands and platforms to maintain brand continuity and creativity in development while seeking to maximize productivity from experts in the technology for each hardware platform.

Employees from our internal studios, as well as from our sales, marketing and executive teams, generate interactive entertainment software game concepts. Concept or theme proposals are reviewed and approved by our executive team. We also conduct product and marketing focus groups to determine the potential market for a new product or brand. Once a game is approved, we assign an executive producer and a product-marketing manager to oversee its development and marketing. This team develops a design document and script for the game, as well as a timeline. During development, our development management reviews each product’s development progress against predetermined milestones, as well as market conditions and the title’s potential financial performance. If market conditions or development milestones indicate that the product will not achieve the approved strategic or financial plan, we either take corrective actions or terminate the product and reallocate current resources to other projects. Prior to release for shipment to our customers, our development management team and our internal testing group complete extensive tests on each product.

We complement our internal development with external resources. External development firms are used to develop games:

• on platforms that are not supported by internal capabilities (e.g., Game Boy Color and Game Boy Advance),

• that utilize unique technologies developed and owned by the external developer,

• when the nature or timing of the desired development could be more efficiently performed externally,

• in order to provide unique capabilities (e.g., localization).

SALES, MARKETING AND DISTRIBUTION

We target the retail channel and consumers through a variety of sales, advertising and marketing campaigns including print media, public relations, Internet marketing and television. The selling and marketing strategies associated with a particular product may vary depending upon the product platform. Advertising and marketing campaigns for interactive entertainment software for the personal computer usually require expenditures in print

media such as trade magazines, newspapers and consumer magazines. These expenditures may be supplemented by partnering with third parties who wish to advertise their products within our video games. Historically, products for the video game console platform generally required a more significant investment in the production of a television campaign. During fiscal 2002, we have reduced spending on television advertising and plan to further reduce our television spending in fiscal 2003. Consumers for the next generation video game console appear to be best reached by expenditures in print media, including online marketing.

Retailers of our products typically have a limited amount of shelf space and promotional resources, and there is intense competition among consumer software publishers, and in particular interactive entertainment software publishers, for high quality retail shelf space and promotional support from retailers. To the extent that the number of consumer software products and computer platforms increases, competition for shelf space may intensify and may require us to increase our marketing expenditures. Due to increased competition for limited shelf space, retailers and distributors are in an increasingly better position to negotiate favorable terms of sale, including price discounts, price protection, marketing and display fees and product return privileges and other concessions. Retailers and distributors also consider, as important competitive factors, marketing support, quality of customer service and historical performance. Our products constitute a relatively small percentage of any retailer’s sales volume.

North America. We distribute and sell our interactive entertainment software in North America through direct relationships with major retail customers, as well as through third party distributors. Our distributors primarily sell products for the personal computer platform. In addition to our internal sales and marketing organization focused on sales to major North American retailers and distributors, we also utilize independent sales representative firms that specialize in the sales and marketing of products for video game console platforms. Our largest customers in fiscal 2002 were:

Best Buy		Jack of all Games
Blockbuster Entertainment		K-mart
Cokem International, Ltd.		Navarre Corporation
Electronics Boutique		Toys “R” Us
Game Stop		Wal-Mart
Ingram Entertainment

In fiscal 2002, sales to Cokem International, Ltd. represented 12% and Toys “R” Us represented 10% of our total software publishing revenues. Accounts receivable for these customers at March 31, 2002, represented 1% of total accounts receivable for Cokem International, Ltd. and 3% of total accounts receivable for Toys “R” Us. In fiscal 2001, sales to Wal-Mart represented 15% of our total software publishing revenues. Accounts receivable at March 31, 2001, represented 24% of total accounts receivable for Wal-Mart. In fiscal 2000, sales to Wal-Mart represented 14% of our total software publishing revenues. In addition, sales to our largest five customers accounted for approximately 44% of our software publishing revenues in fiscal 2002, 49% of our software publishing revenues in fiscal 2001, and 40% of our software publishing revenues in fiscal 2000.

International. At the end of March 2002, 3DO Europe Ltd began a change in distribution shifting from direct distribution of its products for the United Kingdom and distribution agreements throughout Europe, to a series of licensing agreements covering all European countries. Under these new licensing agreements, the licensee receive master copies of the software code and packaging, which they can manufacture, market and sell to distributors or retailers in exchange for royalty payments. Our European sales and marketing staff previously focused on product distribution has been cut back and now works with these licensors to continue the successes that we have enjoyed in these countries. We also have licensing agreements in Asia and Latin America. We also have product distribution agreements for New Zealand and Australia under which our distributors purchase full packaged products from us for resale to retailers. Sales from our European entity for fiscal 2002 were $12.2 million and were $14.0 million in fiscal 2001. Costs and expenses for fiscal 2002 were $9.1 million and were $15.4 million in fiscal 2001. Assets for this entity were $5.6 million at March 31, 2002 and $8.9 million at

March 31, 2001. Because of the change in direction discussed above, we anticipate that both sales and expenses will decline for our European entity in fiscal 2003.

Internet. We currently maintain a web site that contains a detailed description of products and game play. The site offers consumers the ability to purchase packaged versions of our products online, directly from us, for conventional delivery to their homes.

MANUFACTURING

We believe that our principal strengths are designing and developing strong, high quality interactive entertainment software brands. In order to concentrate our efforts on brand and title development, we have established relationships with JVC, Sony and Nintendo to outsource manufacturing and physical distribution of our titles. We also outsource these functions to take advantage of the manufacturing economies of scale, which these major companies can offer, and to avoid the capital investment and overhead costs inherent in establishing and maintaining internal manufacturing operations.

Sony Computer Entertainment America (“SCEA”) has granted us a non-exclusive license to develop and distribute entertainment software products for the PlayStation 2 computer entertainment system and PlayStation video game console in the United States, Canada and Europe. The agreements grant us licenses to use proprietary Sony software and hardware to develop titles for the PlayStation and PlayStation 2 and to use Sony trademarks to market, distribute and sell titles for these platforms. Development of new games under this agreement is subject to approval by Sony and testing and approval of the completed game by Sony is required prior to market introduction. We pay Sony a per unit royalty for each unit manufactured. Sony is the exclusive manufacturer of products licensed under these agreements.

Nintendo has granted us a non-exclusive license to utilize proprietary programming specifications, development tools, trademarks, and other intellectual property rights solely in order to develop and distribute video game software for play on the Game Cube system throughout the Western Hemisphere. Development of new games for use under this agreement is subject to approval by Nintendo and testing and approval of the completed game by Nintendo is required prior to market introduction. We also have similar licenses for the Game Boy Color in the United States and Europe, Game Boy Advance in the Western Hemisphere and Nintendo 64 system throughout the Western Hemisphere and Western Europe, Australia, New Zealand, South Africa and certain countries of Eastern Europe. Additionally, Nintendo has exclusive responsibilities for establishing and fulfilling all aspects of the manufacturing process. Under these agreements, after licensing a product, we buy discrete quantities of licensed game software units from Nintendo for sale. We pay Nintendo a per unit royalty for each unit manufactured.

JVC manufactures our personal computer CD-ROMs. We have granted JVC a non-exclusive license to replicate compact discs of our executable game software code and assemble and package materials to create a finished product. Prices for replication are pursuant to prices submitted by written quotation or contract and are subject to change annually by JVC based on changes in material and labor costs and market conditions. Additionally JVC provides warehousing services and takes orders from us for finished products and packages and prepares them for shipping. At no time does JVC acquire any ownership rights to items we supply to it. Either party with 60 days’ prior written notice may terminate the contract.

Before we start shipping a product, we provide our manufacturers with a title’s software code and related artwork, user instructions, warranty information, brochures and packaging designs. JVC, Nintendo and Sony manufacture based on purchase orders we submit in the ordinary course of business. JVC, Nintendo and Sony generally ship our titles within two weeks after receiving our order. Nintendo generally ships game cartridges titles within four to six weeks after receiving our order primarily due to the additional time required to manufacture overseas. Although we depend on a limited number of manufacturers, we have not experienced any material difficulties or delays in the manufacture of our titles, nor have we experienced any material delays due

to title defects or due to the unavailability of components or raw materials. Our software titles carry a 90-day limited warranty.

INTELLECTUAL PROPERTY

We hold copyrights on our products, product literature, advertising and marketing materials, and other published materials. We also hold a patent in Internet gaming. We also hold trademark rights in our corporate name and logo, as well as in certain of our product names and publishing labels. We have licensed certain products to third party for manufacture and distribution in particular geographic markets, principally outside of North America and Europe, and we receive royalties in connection with such licenses. We currently outsource some of our product development to third-party developers, and have a policy of endeavoring contractually to retain all intellectual property rights relating to such externally developed projects.

We regard our software as proprietary and rely primarily on a combination of copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements, and other such methods to protect our proprietary rights. We own or license various copyrights and trademarks. While we provide end-user license agreements or other limitations on the use of our software, the enforceability of such agreements or limitations is uncertain. While we copy-protect our products, we are aware that unauthorized copying occurs within the computer software industry, and if a significantly greater amount of unauthorized copying of our software products were to occur, our operating results could be materially adversely affected.

We rely on existing copyright laws to prevent the unauthorized reproduction and distribution of our software. However, existing copyright laws afford only limited protection. Policing unauthorized use of our products is difficult, and software piracy can be expected to be a persistent problem, especially in certain international markets. Further, the laws of certain countries in which our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of the United States or are weakly enforced, and consequently legal protection of our rights may be ineffective in such countries. Additionally, if we seek to leverage our software products using technologies, such as the Internet and on-line services, it may become more difficult to protect our intellectual property rights and to avoid infringing the intellectual property rights of others. Furthermore, the intellectual property laws are less clear with respect to such technologies. We cannot be certain that existing intellectual property laws will provide adequate protection for our products and services in connection with such technologies.

As the number of interactive entertainment software products in the industry increases and the features and content of these products further overlap, software developers may increasingly become subject to infringement claims. Although we believe that we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, we cannot be certain that claims of infringement will not be made. Any such claims, with or without merit, can be time consuming and expensive to defend. From time to time, we have received communications from third parties asserting that features or content of certain of our products may infringe upon the intellectual property rights of such parties. We cannot be certain that existing or future infringement claims against us will not result in costly litigation or require us to seek to license the intellectual property rights of third parties, which licenses may not be available on acceptable terms, if at all.

We license certain copyrights and trademarks for use in our High Heat Baseball brand and pay applicable royalties to Major League Baseball Properties, Inc. and the Major League Baseball Players Association. We also license certain copyrights and trademarks for use in our Johnny Moseley and Cubix brands. If we should be unable to maintain or renew those licenses for use in High Heat Baseball, Johnny Moseley and Cubix, we would be unable to release additional sequels and line extensions for those brands and our operating results could be materially adversely affected.

COMPETITION

The interactive entertainment software industry is intensely competitive and is characterized by the frequent introduction of new hardware systems and software products. Our competitors vary in size from small companies to very large corporations with significantly greater financial, marketing and product development resources than us. Due to these greater resources, some of our competitors are better able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, and pay higher fees to licensors of desirable properties and to third party software developers. Our competitors may spend more time and money developing games, which could result in their games being perceived as having more depth, better graphics or more sophisticated content. We believe that the principal competitive factors in the interactive entertainment software industry include brand name recognition, entertainment value of specific titles, product features, quality, ease of use, price and product support.

We compete primarily with other publishers of interactive entertainment software for personal computers and video game consoles. Significant competitors include Acclaim Entertainment, Activision, BAM Entertainment, Eidos, Electronic Arts, Infogrames, Interplay, Lucas Arts, Midway, Sega, Take-Two Interactive, THQ, Ubi Soft International and Vivendi Universal. In addition, integrated video game console hardware/software companies such as Sony, Microsoft and Nintendo compete directly by developing their own software titles for their respective platforms. Large diversified entertainment or software companies, such as The Walt Disney Company, own substantial libraries of available content and have substantially greater financial resources than us, may decide to compete directly with us or to enter into exclusive relationships with our competitors.

GOVERNMENT REGULATION

The home video game industry requires interactive entertainment software publishers to provide consumers with information about graphic violence and sexually explicit material contained in their interactive entertainment software products. This system requires publishers to identify particular products within defined rating categories and communicate such ratings to consumers through appropriate package labeling and through advertising and marketing presentations consistent with each product’s rating.

Mandatory government-imposed interactive entertainment software products rating systems eventually may be adopted in many countries, including the United States. Due to the uncertainties inherent in the implementation of rating systems, confusion in the marketplace may occur, and publishers may be required to modify or remove products from the market. However, we are unable to predict what effect, if any, such rating systems would have on our business.

Many foreign countries have laws that permit governmental entities to censor the content of certain works, including interactive entertainment software. As a result, we may be required to modify our products to comply with these requirements, or withdraw them from the market that could result in additional expense and loss of revenues.

Certain retailers have in the past declined to stock some software products because they believed that the content of the packaging artwork or the products would be offensive to their customer base. Although such actions have not yet affected us, we cannot be certain that our distributors or retailers will not take such actions in the future.

EMPLOYEES

As of March 31, 2002, we employed 362 full-time employees and 25 independent contractors to supplement our permanent work force. These employees provided services in the following areas: 288 in product development, 30 in sales and marketing, and 44 in finance, administration, distribution and legal services. We believe that our relations with employees are good. None of our employees are subject to collective bargaining agreements.

RISK FACTORS

You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Our business, future operating results and financial condition are dependent upon many factors that are subject to a number of risks and uncertainties. The material risks and uncertainties that are known to us and that may cause our future operating results to be different than our planned or projected results, and that may negatively affect our operating results and profitability are summarized below. However, the risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that are not presently known to us or that we currently believe are immaterial may also impair our business operations or profitability.

Risks and uncertainties relating to our business and operations

Our ability to meet cash requirements and preserve liquidity is dependent on timely product releases, attainment of our sales and licensing objectives and maintaining tight controls over spending. If our cash requirements cannot be satisfied from operational cash flows, we may be forced to sell assets, refinance existing indebtedness, or further reduce our business, operations and related activities. Due to these factors, we may need to combine with another company in order to obtain additional resources to remain competitive.

We recorded a net loss attributable to common stockholders of $50.5 million on revenues of $53.7 million for fiscal year 2002 and also sustained significant losses for the fiscal year ended 2001. At March 31, 2002, we had an accumulated deficit of $251.9 million. These circumstances raise substantial doubt about our ability to continue as a going concern.

We cannot provide assurances that future cash flows from operations will be sufficient to meet operating requirements and allow us to service debt and dividend requirements and repay any underlying indebtedness at maturity. Our Loan and Security Agreement with GE Capital Commercial Services, Inc. (“GE Capital”) dictates that we raise $4.6 million through an equity or subordinated debt financing by October 2002 or we may not be able to utilize our scheduled increases in our maximum borrowing amount. If we do not achieve the cash flows that are anticipated from our plan to raise capital, our planned product release schedules and attainment of our forecast sales objectives, or if we do not maintain availability under the accounts receivable credit line from our bank, we may not be able to meet our cash requirements from operational cash flows. In such event we will require additional financing to fund on-going and planned operations and may need to implement further expense reduction measures, including, but not limited to, the sale of assets, the consolidation of operations, workforce reductions, and/or the delay, cancellation or reduction of certain product development, marketing, licensing, or other operational programs. Some of these measures will require third-party consents or approvals, including that of our bank, and we cannot provide assurances that such consents or approvals will be obtained. There can be no assurance that we will be able to make additional financing arrangements on satisfactory terms, if at all, and our operations and liquidity would be materially adversely affected and we could be forced to cease operations.

Although actions we have taken, including recent reductions of workforce, spending reductions in marketing and renegotiation of the lease of our headquarters facility, which are expected to contribute to returning our operations to profitability, we cannot assure our shareholders and investors that we will achieve profitability in fiscal 2003 and beyond, nor can we provide assurances that we will successfully complete the development of products planned for release or achieve the sales necessary to avoid further expense reductions in the future.

Our future capital needs are uncertain and there is a risk of us becoming insolvent if we cannot satisfy future capital needs in a timely manner.

On October 9, 2001, we raised $9.75 million in equity financing. Then, on December 10, 2001, we raised $15.8 million in additional equity financing. We will need to raise $4.6 million in additional financing by October 2002 in order to a meet a financial covenant with our GE Capital line of credit. We are exploring raising additional debt or equity financing although we do not have definitive plans. Our ability to maintain sufficient liquidity in the future is dependent on us successfully achieving our product release schedules, raising additional capital and attaining our forecasted sales objectives, and on the continued availability of an accounts receivable line of credit with a financial institution. If we are unable to achieve our projected sales forecasts or if we should lose the availability of an accounts receivable credit line, we will need to raise capital to meet our capital needs. Such capital may not be available on acceptable terms, if at all. We may also require additional capital to acquire or invest in complementary businesses or products or obtain the right to use complementary technologies. If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock. Debt incurred by us would be senior to equity in the ability of debt holders to make claims on our assets. The terms of any debt issued could impose restrictions on our operations. If adequate funds are not available to satisfy either short or long-term capital requirements, we may be required to curtail our operations significantly or to seek funds through arrangements with strategic partners or other parties that may require us to relinquish material rights to certain of our products, technologies or potential markets, or we may become insolvent.

If the popularity of our brands lessens, revenues could decline.

Significant portions of our historical revenues have been derived from a limited number of brands. A decline in the popularity of one or more of these brands could adversely affect revenues from operations, and require us to revise the forecasts of our future business. Our product strategy is to extend our established interactive entertainment software brands across multiple genres and platforms in order to better differentiate our products to consumers and retailers. Each of our current brands is based on a well-defined computer game environment, or “fantasy world.” We create fantasy worlds in our products that allow users to engage in activities that they otherwise may be unable to perform, in settings to which they may not otherwise have access. We develop products in the most popular genres, which include action, strategy, adventure/role playing, sports and family entertainment. We believe that consumers who have enjoyed game playing in a distinctive fantasy world are more likely to buy other products based on the same or a similar fantasy world. We offer consumers of our products both sequels and line extensions of games they already own, as well as new game experiences in different genres within a familiar fantasy world. Our brands include Army Men, Cubix, Heroes of Might and Magic, High Heat Baseball, Johnny Moseley, and Might and Magic. We employ our branding strategy to leverage our marketing efforts so longer-lived brands can yield results across multiple platforms and multiple years.

Breach of our financing arrangements could result in default and cause the termination of our existing line of credit.

If we violate the financial or other covenants contained in the Loan and Security Agreement, dated June 27, 2002 that we entered into with GE Capital, and such default is not timely cured or waived, GE Capital could pursue its contractual remedies against us. These could include: (1) decreasing advance rates (2) restricting advances (3) penalty rates of interest, (4) restricting the seasonal line limits necessary to achieve our plan, (5) penalty fees associated with our line of credit, (6) acceleration of our financial obligations to the bank, and/or (7) the foreclosure on any assets securing our indebtedness to GE Capital. In accordance with the Loan and Security Agreement, we are obliged to meet certain specified levels for current ratio, debt to equity ratio, net sales, net income, net worth, and not exceed specified spending levels. We are also required to raise an additional $4.6 million of equity during fiscal 2003 as well as maintain the effectiveness of other covenants relating to our operations. We cannot provide assurances that we will be able to remain in compliance in the future with the financial covenants and other contractual obligations set forth in the Loan and Security Agreement. Additionally,

should we be in default of the agreement in the future, we cannot provide assurances that the bank will agree to waive such non-compliance or amend the Loan and Security Agreement in a manner that would permit us to be in compliance with the financial covenants and other obligations under the Loan and Security Agreement. Further restrictions on spending may be breached in order to offer greater discounts on products or additional marketing spending to meet competitive pressures.

If we do not introduce products on a timely basis, revenue, profit and cash flow could be negatively impacted.

Since video games and computer software products have relatively short life cycles, with many products having a sales life cycle of less than six months, we are continuously developing new products in order to generate revenues that can sustain our operations and allow us to achieve our business plans. The timely development and commercial release of a new video game or computer game depends on a variety of factors, including the creative design and development process, testing and debugging, obtaining the approvals of third-party content licensors, obtaining the approvals of hardware platform licensors (such as Sony and Nintendo), and manufacturing and assembly of production units of such products. The development of games for technically sophisticated next-generation interactive platforms is a relatively complex, expensive and time-intensive undertaking that requires the coordinated services of numerous employees and contractors working for us. Delays incurred in the development, approval or manufacturing processes may result in delays in the introduction of our products. Delay in the commercial release of a new product that results in that product’s introduction slipping from one fiscal quarter to the next is likely to have an adverse effect on our resulting revenues for the affected quarter since initial shipments of a new product typically account for a high percentage of the product’s total net revenues over its life.

We have experienced significant delays in introducing some of our prior titles and these delays have adversely affected our results of operations. We cannot provide assurances that we will be able to complete the timely development and commercial release of new products in accordance with originally planned release schedules. In the event that we are unable to commercially release new products in accordance with operating plans for a particular quarter or longer period, these product delays would likely have an adverse effect on our revenues and results of operations during the affected quarter and cash flow during subsequent quarters.

Our stock could be delisted from the Nasdaq National Market.

Our common stock trades on the Nasdaq National Market, which specifies certain requirements for the continued listing of common stock. One of these requirements is that the minimum closing bid price per share not fall below a specified level for an extended period of time. On March 22, 2002, the NASDAQ Staff notified us that the bid price of our common stock had closed at less than $1.00 per share over the previous 30 consecutive trading days, and as a result, did not comply with Marketplace Rule 4450(a)(5). Therefore, in accordance with the Marketplace Rule 4450(e)(2), we were provided 90 calendar days, or until June 20, 2002, to regain compliance with the Rule. On June 21, 2002, NASDAQ notified us that we had not regained compliance with marketplace Rule 4450(e)(2) and as a result our securities will be delisted from The Nasdaq National Market at the opening of business on July 1, 2002. We, however, intend to request a hearing regarding the Nasdaq staff determination and will present its plan of action, which may include a reverse stock split, to maintain compliance with the Nasdaq National Market continued listing standards. The request for a hearing will suspend the delisting action until the Nasdaq Listing Qualifications Panel reaches a final decision on the Company’s appeal, but there can be no assurance that the Panel will decide in the Company’s favor.

There can be no assurance that Nasdaq’s Listing Qualifications Panel will decide to allow us to remain listed or that our actions will prevent the delisting of our common stock. We will not be notified until the Panel makes a formal decision. Until then, our common stock will continue to trade on the Nasdaq National Market. In the event our shares are delisted from the Nasdaq National Market, we will attempt to have our common stock traded on the NASDAQ SmallCap Market. Moving to the Nasdaq SmallCap Market could allow holders of our Series A Convertible Preferred Stock to force the redemption of their shares at 125% of the original issue price plus

dividends. If our common stock was delisted, it would seriously limit the liquidity of our common stock and impair our ability to raise future capital through the sale of our common stock, which could have a material adverse effect on our business. Delisting could reduce the ability of holders of our common stock to purchase or sell shares as quickly and as inexpensively as they have done historically, and may have an adverse effect on the trading price of our common stock. Delisting could also adversely affect our relationships with vendors and customers.

The concentration of our sales and accounts receivable in a limited number of customers increases our reliance on that limited number of customers.

In fiscal 2002, sales to Cokem International, Ltd. represented 12% and Toys “R” Us represented 10% of our total software publishing revenues. In fiscal 2001, sales to Wal-Mart represented 15% of our total software publishing revenues. In fiscal 2000, sales to Wal-Mart represented 14% of our total software publishing revenues. In addition, sales to our largest five customers accounted for approximately 44% of our software publishing revenues in fiscal 2002, 49% of our software publishing revenues in fiscal 2001, and 40% of our software publishing revenues in fiscal 2000.

Our sales are typically made on credit, with terms that vary depending upon the customer and the demand for the particular title being sold. We do not hold any collateral to secure payment by our customers. As a result, we are subject to credit risks, which are increased when our receivables represent sales to a limited number of retailers or distributors or are concentrated in foreign markets. Distributors and retailers in the computer industry have from time to time experienced significant fluctuations in their businesses, and there have been a number of business failures among these entities. The insolvency or business failure of any significant distributor or retailer of our products could result in reduced revenues and write-offs of accounts receivable. If we are unable to collect on accounts receivable as they become due, it could adversely affect our business, operating results and financial condition.

An inability to obtain or retain valuable intellectual property licenses may prevent product releases or result in a decline in sales of our products.

A number of our existing products and planned products are based on trade names, trademarks, logos, or copyrighted materials that are licensed from third parties (e.g., Major League Baseball, Major League Baseball Players Association, Johnny Moseley, and Cubix). License agreements for these third-party rights typically remain in effect for two to five years. In general, license agreements may be terminated by the licensors upon the occurrence of any of a number of events or circumstances, such as the failure to timely pay the sums that are owed to the licensor, material breach of other provisions of such agreements, or as a result of bankruptcy or insolvency. We cannot provide assurance that we will be able to obtain or will be able to extend the term of any third-party intellectual property licenses. An inability to obtain a desired license or the loss of existing license rights would prevent us from publishing particular products or could limit our sales of unlicensed versions of comparable products which would not feature the trademarks or other intellectual property rights of third-party licensors.

Platform licensors can influence the number of video games that we publish on their respective platforms, as well as our product release schedules, and resulting revenues and gross margins.

We depend heavily on non-exclusive licenses with Sony and Nintendo for the right to publish titles for their platforms and for the manufacture of our software products designed for use on their platforms. Our licenses with Sony and Nintendo require that we obtain their concept approval for each of the products that we would like to publish, as well as their approval of the completed games and associated manuals, packaging artwork and marketing materials. This approval process could cause a delay in our ability to release a new title and could cause us to incur additional expenses to modify our products in order to obtain such approvals. As a result, the number of titles that we are able to publish for these licensors’ platforms may be limited or may be delayed from our originally planned product release schedules.

Our licenses with Sony Computer Entertainment America, Sony Computer Entertainment Europe and Nintendo are limited in term. If any of these licenses should be terminated or not be renewed on acceptable terms, we would be unable to develop and publish software titles for these platforms and our business would be significantly harmed. While we cannot guarantee that these platform licensors will agree to extend the term of their license agreements (some of which are scheduled to expire in the second half of 2002), we have previously been successful in negotiating comparable license extensions with platform licensors.

Both Sony and Nintendo are the sole manufacturers of the titles that we publish under licenses from them. These license agreements provide that the manufacturer may raise the costs that it charges for the units that it manufactures at any time and allows the manufacturer substantial control over whether and when we can release new titles. Additionally, the two to six week manufacturing and delivery cycle for software products for the Game Cube, the Game Boy Color and Game Boy Advance handheld game systems, and the Nintendo 64 game console requires us to accurately forecast retailer and consumer demand for our titles far in advance of planned product releases and expected sales of such software products. Nintendo cartridges are also more expensive to manufacture than CD-ROMs and DVDs, resulting in greater inventory risks for those titles.

The manufacturers of the software products may not have sufficient production capacity to satisfy our requirements.

Both Sony and Nintendo publish software products that are designed for use with their own hardware platforms, as well as manufacture software products for their other licensees. If Sony or Nintendo experience an interruption in their manufacturing capabilities or if their manufacturing capacity is adversely impacted as a result of increased demand for third-party software products that compete with our products, these hardware licensors may choose to give priority to the manufacture of their own titles or to the manufacture of other third-party titles. These manufacturers may not have sufficient production capacity to satisfy our scheduling requirements during any period of sustained demand. If Sony and Nintendo are unable to supply us with production software units on acceptable terms and without unexpected delays, our business operations could be materially interrupted and our potential revenues from planned product releases could be significantly and adversely affected.

If we do not create titles for popular hardware platforms, our sales of products and resulting revenues from operations could decline.

The interactive entertainment software market and the personal computer and video game console industries in general have been affected by rapidly changing technology, which has led to the early obsolescence of particular platforms and compatible software titles. Our titles have historically been developed and published primarily for multimedia personal computers and video game systems, including the Nintendo 64 and PlayStation game consoles, the PlayStation 2 computer entertainment system, and the Game Boy Color and Game Boy Advance handheld game systems. We have not as yet obtained the license required in order to publish titles that would be compatible with Microsoft’s Xbox entertainment system. No assurance can be given that we will be able to conclude agreements with Microsoft for the publishing of titles compatible with the Xbox entertainment system. If we should be unable to obtain licenses for new interactive entertainment platforms, we would not be able to publish software titles compatible with the affected systems, which could have an adverse effect on our business. While we cannot provide assurances that we will be successful in our efforts to conclude appropriate licensing agreements with the licensors of new interactive platforms, we have previously been successful in negotiating new agreements with platform licensors.

Additionally, our software titles that are designed and intended for use with personal computers must maintain compatibility with new computer models, operating system software, and various hardware peripherals and accessories compatible with such personal computers. If we should be unable to successfully develop software products that are compatible with any particular interactive platforms, the opportunities to publish new products could be limited and our resulting revenues from operations could be adversely affected.

If product returns and pricing concessions exceed allowances, we may incur additional costs and potential losses.

Our arrangements with retailers and distributors require us to accept returns for defective product units. We also provide pricing concessions and allowances to key retail customers whenever wholesale price adjustments are deemed necessary to support our relationship with retailers and maintain access to their retail channel customers. If consumer demand for a particular title does not fulfill expectations, or if consumer demand declines from a prior period, then a subsequent price concession may be provided in an effort to stimulate further sales of the affected titles.

We establish an allowance for estimated future product returns and price concessions at the time of shipment, based on our historical sell through and return data, our specific minimum low price used for price protection, the level of channel inventory and units for the product previously shipped, and we recognize revenues net of these allowances. Management monitors and adjusts our product returns and pricing allowances throughout the year in order to reflect market acceptance of our products, retail and distributor inventory levels of our products, and results of our prior returns programs and pricing allowances. Our reserve allowance for product returns and pricing allowances was $5.7 million as of March 31, 2002. If we experience product return rates or provide pricing allowances that exceed our estimates based on historical experience, our operating results could be significantly and adversely affected. In addition, if future products should prove to be defective, we would lose potential revenues from sales of the affected product units and may incur an unplanned increase in expenses in connection with efforts to remedy the situation.

Delays in new product development could result in loss of significant potential revenues.

Most of our video game and computer software products have a relatively short life cycle and sell for a limited period of time after their initial release. We depend on the timely introduction of successful new products, including enhancements of or sequels to existing products and conversions of previously released products to additional platforms, to offset and replace declining net revenues from older products. Delays incurred during the development process may result in delays in the commercial release of the affected title. Delays in the release of any new product are likely to have an adverse effect on our revenues for the affected quarter.

If external developers fail to perform satisfactorily, our operating results could be negatively affected.

While we develop the majority of our titles internally, third-party developers develop many products. A delay in the work performed by a third-party developer may result in delay of our release of the affected product. As importantly, the work performed by third-party developers may not meet our quality standards, and, as a result, we may terminate the development contracts with some developers. Our hardware licensors (e.g., Sony and Nintendo) require that third-party developers obtain and maintain licensor authorization to develop games on our behalf that are compatible with the licensor’s hardware platform. Through no fault of ours, a third-party developer’s authorization to create a particular product for us may be terminated by the hardware platform licensor, at its sole discretion.

If we need to write down prepaid royalties or capitalized development costs below their current recorded value, our results of operations could be adversely affected.

We typically enter into agreements with content licensors and external developers that require advance payments of royalties and/or guaranteed minimum royalty payments. We cannot provide assurance that the sales of products for which such royalties are paid or guaranteed payments are made will be sufficient to offset and effectively recoup the amount of these required advance payments. We capitalize our advances to licensors as a part of prepaid assets and advances to external developers as part of capitalized software costs. We also capitalize internally developed software once technological feasibility is established as part of capitalized software costs.

We analyze these accounts quarterly, and take write-offs when, based on estimates, future individual product contribution will not be sufficient to recover our investment.

If we do not post strong sales during the holiday season and subsequent quarter, our operating results could be negatively affected.

Our sales of video game and computer software products are highly seasonal. Our peak shipments typically occur in the fourth and first calendar quarters as a result of increased demand for video games and computer software during the year-end holiday season and the after-holiday period. If we do not achieve strong sales in the second half of each fiscal year (which ends on March 31) our fiscal year results could be significantly and adversely affected and our ability to achieve profitability in the fiscal year could be negatively impacted.

Our changes to international operations could adversely affect our business.

Our video game and computer software products are now sold in international markets both principally through licensees, primarily in, the United Kingdom and other European countries, and, to a lesser extent, in Asia and Latin America. The percentage of our total revenues derived from international software publishing activities increased to 23% in the fiscal year ending March 31, 2002. There can be no assurance that the recent move to a licensing model will generate similar levels of profitability operations. These risks include the following:

• rely almost exclusively on third parties for sales and distribution of our products

• increased credit risks and collection difficulties;

• increased risk of piracy and disputes between licensees on distribution;

• shipping delays;

• tariffs and duties;

• fluctuations in foreign currency exchange rates; and

• international political, regulatory and economic developments and conditions.

Our quarterly operating results fluctuate significantly causing unpredictability regarding our revenues and income.

We have experienced and expect to continue to experience wide fluctuations in quarterly operating results. We are unable to effectively control many of these factors, which include the following:

• market acceptance of our titles;

• the timing and number of new video game consoles;

• delays in product acceptances by Sony, Nintendo or Microsoft

• the timing and number of new title introductions by our competitors;

• increased marketing spending by our competitors relating to the introduction of new titles;

• changes in pricing policies by our competitors and our actions to meet retailer requests;

• product returns;

• the timing of orders from distributors and major retail customers;

• delays in production and shipment; and

• the mix of sales of higher and lower margin product in a quarter.

We typically earn a higher gross margin on sales of games that are designed for use with personal computers. Gross margins on sales of products for next generation game console platforms are generally lower because of license fees payable to platform licensors such as Sony, Nintendo and Microsoft, and higher manufacturing costs for game cartridge products for the Game Boy Color and Game Boy Advance handheld game systems. As a consequence, the mix of products sold during each fiscal quarter can significantly affect our gross margins.

The timing of new title introductions can cause quarterly revenues and earnings to fluctuate substantially from quarter to quarter. A significant portion of our revenues in any fiscal quarter is typically achieved as a result of sales of new titles first introduced in the quarter. Our revenues and earnings will be negatively affected in a given fiscal quarter if we should be unable to complete the development of any particular title or titles in time to commercially release such product(s) during that quarter.

You should not rely on period-to-period comparisons of our financial results as indications of future results. Our future product releases, operating results, revenues, or profitability could fall below expectations of security industry analysts and investors. Any such shortfall in expectations could cause a decline in the market price of our common stock. Fluctuations in operating results are likely to increase the volatility of our common stock’s price. The market price of our common stock has been volatile and is likely to continue to be highly volatile, and stockholders may not be able to recoup their investment.

If we lose key personnel and are unable to replace them, our operating results could be negatively affected.

Our business operations and prospects for commercial success are largely dependent on the personal efforts of key personnel, particularly Trip Hawkins, our Chairman and Chief Executive Officer. We rely heavily on our internal development studio to design and develop the majority of our products. The loss of any key developers or groups of developers may delay the release of our products. Our success is also dependent upon the ability to hire and retain additional qualified operating, marketing, technical, legal and financial personnel. Competition for personnel is intense, especially in the San Francisco Bay area where we maintain our headquarters. The decline in stock price combined with salary reduction programs and related cost reductions could impact our ability to retain key personnel. Further, we cannot provide assurance that we will be able to successfully attract qualified replacement personnel.

Risks and uncertainties that affect our industry in general, including 3DO

Industry competition is intensive and can impact our ability to attain retail shelf space.

The interactive entertainment software industry is intensely competitive and is characterized by the frequent introduction of new hardware systems and software products. Our competitors vary in size from small companies to very large corporations, which have significantly greater financial, marketing and product development resources than us. Due to these greater resources, some of our competitors are better able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, pay higher licensing fees to third-party content licensors which control desirable properties, and pay higher advances and development fees to third-party software developers.

Our competitors include the following:

• Other publishers of interactive entertainment software for personal computers and video game consoles, including Acclaim Entertainment, Activision, BAM Entertainment, Eidos, Electronic Arts, Infogrames, Interplay, Lucas Arts, Midway, Sega, Take-Two Interactive, THQ, Ubi Soft International and Vivendi Universal. Integrated video game console hardware/software companies such as Sony, Microsoft and Nintendo, who compete directly with us in the development of software titles for their respective platforms.

• Large diversified entertainment or software companies, such as The Walt Disney Company, many of which own substantial libraries of available content and have substantially greater financial resources than us, who may decide to compete directly with us or to enter into exclusive relationships with our competitors.

Retailers of our products typically have a limited amount of shelf space and promotional resources. Publishers of interactive entertainment software products compete intensely for high quality retail shelf space and promotional support from mass merchant resellers and other retailers. To the extent that the number of consumer software products increases, competition for shelf space may intensify and may require us to increase our marketing expenditures.

If more mass merchants establish exclusive buying arrangements, or if retailers terminate their relationship with us, our sales and gross margins would be adversely impacted.

Mass merchants have become the most important distribution channels for retail sales of interactive entertainment software. Our revenues and operating results may be significantly and adversely affected if any of the mass merchants with whom we conduct business elect to terminate their relationship with us or significantly reduce the amount of business they do with us. A number of these mass merchants, including Wal-Mart, have entered into exclusive buying arrangements with other software developers or distributors, which prevent us from selling our PC products directly to that mass merchant. If the number of mass merchants entering into exclusive buying arrangements with software distributors were to increase, our ability to sell to those merchants would be restricted to selling through the exclusive distributor. Because we typically earn a lower gross margin on sales to distributors than on direct sales to retailers, this would have the effect of lowering our gross margins.

Our business depends on “hit” products, so if we fail to anticipate changing consumer preferences and produce “hits”, we could suffer declining revenues.

The market for interactive entertainment software is largely “hits” driven. Few such entertainment software products achieve sustained market acceptance and are regarded as “hits”, and yet the products that are “hits” account for a substantial portion of revenues in the video game and computer software industry. Our future results from operations, profitability and financial condition could be negatively impacted if we fail to publish or distribute “hit” titles for popular interactive platforms. We cannot provide assurance that we will be able to publish “hit” titles in the future. Our ability to develop a “hit” title or titles is dependent on a variety of factors, many of which are beyond our control, including:

• public tastes and preferences change rapidly and are hard to predict;

• the timing and pricing of new interactive entertainment products published by us;

• the brands, timing and pricing of new interactive entertainment products published by our competitors;

• critical previews and reviews of our products; and

• the availability, appeal and pricing of other forms of entertainment.

If we fail to accurately predict or promptly respond to these factors, our sales could decline. Additionally, in the event that we do not achieve adequate market acceptance of a particular product, we could be forced to accept substantial product returns or grant significant markdown allowances in order to maintain a good working relationship with retailers to ensure access to their distribution channels.

Introduction of next-generation platforms leads to a decline in sales of software products for prior platforms.

Historically, the anticipation or introduction of next-generation video game platforms has resulted in decreased sales of interactive entertainment software for prior platforms. Sony introduced its PlayStation 2 computer entertainment system in October 2000. More recently, in November 2001, Microsoft introduced its new

Xbox entertainment system and Nintendo introduced its new Game Cube console. On-going sales of our software products for Sony’s original PlayStation game console or for Nintendo’s N64 game console have been adversely affected as a result of consumer preferences shifting to newer video game systems. We expect this trend to continue until one or more new platforms achieve a widely installed base of consumers. Obsolescence of software for prior interactive platforms could leave us with increased inventories of unsold titles and limited amounts of new titles to sell to consumers.

Delays in the introduction of new platforms adversely affect potential revenue.

Our ability to effectively sell our products depends in large part on platform licensors’ timely introduction of their next-generation interactive systems and the licensors’ achievement of market acceptance for their platforms. Our ability to continue to sell software products that are compatible with older target platforms are dependent upon the platform licensors’ efforts to continue to encourage resellers’ and end users’ ongoing interest in such older platforms. Limited availability of older platforms as part of a manufacturer’s efforts to prepare for the commercial introduction of a new platform (e.g., the limited availability of PlayStation consoles in the United States during the first half of 2000 in preparation for Sony’s launch of the PlayStation 2 in the Fall of 2000) adversely affects our sales of software products for such older interactive platforms and resulting revenues from operations. Similarly, delays in the introduction of new interactive platforms or the limited availability of hardware following the introduction of a new interactive platform (as occurred, for example, following the commercial release of the PlayStation 2 computer entertainment system in the United States) also adversely affect our revenues, and result in significant uncertainty about our quarterly and fiscal year results.

Our business could be adversely affected by the illegal copying of our software or by infringement claims brought by or against us.

Although we use copy-protection devices, unscrupulous individuals or entities may be able to make unauthorized copies of our products or otherwise obtain and use our proprietary information and related intellectual property rights. In the event of the occurrence of a significant amount of illegal copying of the software products published or distributed by us, our resulting revenues from operations could be significantly and adversely affected.

Although we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, we cannot provide assurances that claims of infringement will not be made against us. Any such claims, with or without merit, can be time consuming and expensive to defend.

If Internet-based game play becomes popular, we may need to quickly develop products and establish a viable Internet business model to remain competitive.

A number of software publishers have developed or are currently developing server-based Internet games for consumers to access and enjoy over the Internet. If the Internet becomes a more popular venue for interactive video games and computer software, in order to remain competitive, we may need to rapidly develop and release additional games for the Internet, and continue to refine our business models for Internet-based games.

In December 1999, we were issued a U.S. patent that could allow us to create a new genre of Internet-based games and related business models for such entertainment products. However, in order to fully develop the patents potential, investment would be required in research and development or to obtain rights to complementary Internet-related technologies. Without the required investment in research and development or without obtaining rights to technologies that would allow us to exploit our Internet-related patent, we cannot be certain that we will be able to fully utilize the patent in a commercially successful manner. In addition, even if we are able to use the patent in connection with the development of new Internet games or other forms of interactive entertainment that are intended to be experienced through the Internet, the development of such products will require additional investments by us. We cannot be certain that such products will be commercially successful,

nor can we even be certain that our investments in developing and marketing such products will be recouped by our sales or licenses of such potential future products.

Rating systems for interactive entertainment software, government censorship, or retailer resistance to violent games could inhibit our sales or increase our costs.

The home video game industry requires interactive entertainment software publishers to identify products within defined rating categories and communicate these ratings to consumers through appropriate package labeling and through advertising and marketing presentations consistent with each product’s rating. If we do not comply with these requirements, it could delay our product introductions and require us to remove products from the market.

Legislation is currently pending at both the federal and state level in the United States and in certain foreign jurisdictions to establish mandatory video game rating systems. Mandatory government-imposed ratings systems for interactive entertainment software products may eventually be adopted in many countries. Due to the uncertainties inherent in the implementation of such rating systems, confusion in the marketplace may occur and publishers may be required to modify or remove products from the market. However, we are unable to predict what effect, if any, such rating systems would have on our business.

Many foreign countries have laws that permit governmental entities to censor the content of certain works, including interactive entertainment software. As a result, we may be required to modify some of our products or remove them from the market that could result in loss of revenues and additional costs to remedy such situation.

Certain retailers have in the past declined to stock some software products because they believed that the content of the packaging artwork or the underlying products themselves would be offensive to these retailers’ customer bases. Although such actions have not yet affected us, we cannot be certain that our distributors or retailers will not take such actions in the future.

If the U.S. economy continues to weaken or enters a recession, our business and results from operations could be adversely affected.

We are subject to risks arising from adverse changes in consumer spending patterns. Because of the recent economic slowdown in the United States, many consumers may delay or reduce purchases of non-essential products and services. If the economic slowdown in the United States leads to decreased consumer spending on entertainment products, sales of our products would likely decline and revenues and results from operations could be significantly and adversely affected.

Risks Related to our Securities

Anti-takeover provisions may prevent an acquisition.

Provisions of our Amended and Restated Certificate of Incorporation (including the Certificate of Designations, Preferences and Rights of the Series A convertible preferred stock), Bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.

Our Chairman and Chief Executive Officer may be able to influence stockholder actions.

Trip Hawkins, our Chairman and Chief Executive Officer, beneficially owns approximately 38% of our outstanding common stock. Mr. Hawkins is able to significantly influence all matters that require approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions.

Shares eligible for future sale may negatively affect our stock price.

If our stockholders sell substantial amounts of common stock (including shares issued upon the exercise of options or issued upon conversion of our Series A redeemable convertible preferred stock) in the public market following this offering, the market price of our common stock could fall. The perception that such sales may occur could cause the market price of our common stock to fall on or before the date those shares are first sold. Such sales also might make it more difficult for us to sell securities in the future at a time and price that we deem appropriate.

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