Enveric Biosciences, Inc. - Annual Report: 2003 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the period ended: December 31, 2003

OR

Commission File Number: 000-26460

SPATIALIZER AUDIO LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

2625 Hampshire Road, Suite 330
Westlake Village, California 91361
(Address of principal executive offices)

1754 Technology Drive, Suite 125
San Jose, California 95110
(Address of principal corporate offices)

Telephone Number: (408) 453-4180
(Registrant’s telephone number, including area code)

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

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

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

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

     This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, reflecting management’s current expectations. Examples of such forward-looking statements include our expectations with respect to our strategy. Although we believe that our expectations are based upon reasonable assumptions, there can be no assurances that our financial goals will be realized. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Numerous factors may affect our actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of our company. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. The important factors discussed under the caption “Factors That May Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, herein, among others, would cause actual results to differ materially from those indicated by forward-looking statements made herein and represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations. We assume no obligation to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information.

PART I

Item 1. Business

Overview

     Spatializer Audio Laboratories, Inc. (“Spatializer” or “Company”) is a developer, licensor and marketer of next generation technologies for the consumer electronics, personal computing, enterprise computing and entertainment industries. Our position as a developer of next generation technologies is based on our business relationships with brand leaders, such as Toshiba, Samsung, Sanyo and Matsushita. We conduct our audio business through our parent company and our wholly owned subsidiary, Desper Products, Inc. (“DPI”). DPI has developed a full complement of patented and proprietary 3-D or virtual audio signal processing technologies directed to the consumer electronics and multimedia PC markets. We continue to expand our product offerings to take advantage of the growing digital audio marketplace specifically for consumer products like Digital Versatile Disc (“DVD”) players, portable mp3 players, digital televisions and digital home, portable and auto entertainment devices. As of December 31, 2003, more than 45 million licensed units had been shipped covering all of these applications. DPI’s virtual audio signal processing technologies are currently incorporated in products offered by global brand leaders in consumer electronics, including Toshiba, Panasonic, JVC, Samsung, Sanyo, and Sharp. We are focused on broadening recognition of the Spatializer brand name through association with these and other globally recognized consumer electronics and multimedia computer brand leaders, and on broadening our audio technology and software base to position ourselves for continued growth. We believe that with the accelerating growth in the digital audio/video marketplace, the market for virtual audio technologies, and therefore for our products, is entering a new phase of opportunity.

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

     We were incorporated in the State of Delaware in February, 1994 as the successor company in a Plan of Arrangement pursuant to which the outstanding shares of Spatializer Audio Laboratories, Inc., a publicly held Yukon, Canada corporation, were exchanged for an equal number of shares of our common stock. Our corporate office and research center is located at 1754 Technology Drive, Suite 125, San Jose, California 95110, Telephone (408) 453-4180. We also maintain offices at 2625 Hampshire Road, Suite 330, Westlake Village, California 91361. We have a Website at www.spatializer.com. Copies of this Annual Report, including our financial statements and our quarterly reports on Form 10-Q as well as other corporate information, including press releases, of interest to our

stockholders are available on our website promptly after filing or distribution. As used herein, Spatializer, the “Company,” “we” or “our” means Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiaries.

     Desper Products, Inc. — Virtual Audio Signal Processing Technologies

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

Licensed Products

     Our current technology product applications are directed to (1) speaker enhancement, (2) stereo surround sound enhancement, (3) mobile entertainment enhancement and (4) noise reduction.

In addition, we offer three whole product solutions with multiple Spatializer technologies that comprehensively address the unique audio delivery challenges inherent in each targeted platform. The Spatializer HD Class is comprised of three new products specifically targeted at home audio, cellular telephones and other mobile applications and personal computers. The Spatializer technologies in each package operate in a complementary fashion, such that the concurrent technologies deliver a more powerful and effective audio experience than that possible from a single solution. Further, each technology has been optimized and customized for the targeted application and is designed to overcome the audio challenges presented by small form factor, transducer limitations and even cost constraints.

Spatializer UltraMobile HD™ delivers higher definition digital audio to mobile audio systems through the multiple and complementary use of Spatializer Natural Headphone, Spatializer Vi.B.E. and Spatializer PCE. UltraMobile HD improves the performance of low cost headphones or ear buds, as well as from compressed audio by opening up the sound field while improving bass performance. In cellular telephone applications, Spatializer ((environ)) delivers maximum performance from micro-speakers that are mounted closely together and helps compensate for the more limited dynamic range as compared with standard size speakers.

When applied to stereophonic ring tones, Spatializer ((environ)) creates a startling and expressive sound field when such speakers are utilized in cellular handsets.

Spatializer UltraTV HD™ delivers higher definition digital audio performance to digital televisions, DVD players and DVD Recorders. HDTV signals can realistically be retrieved only in limited ways, leading to customer disappointment. The Spatializer UltraTV HD processor is designed to compensate for these shortcomings in digital home entertainment for the millions of households without home theater systems. Realistic surround sound, near-sub-woofer effects and crisp dialog is made possible through two speakers, rather than through expensive arrays of external speakers. Another unique aspect of this product is that it is designed specifically for playback through television speakers and can be custom tailored to the frequency aspects of a manufacturer’s speaker set.

Spatializer UltraPC HD™ helps ease the transition of the personal computer from business tool to a comprehensive component of the digital home entertainment experience. Spatializer UltraPC HD includes Spatializer N-2-2 Ultra that delivers surround sound through only two speakers, Spatializer Natural Headphone for personal surround sound, Spatializer VirtuaLFE™ that processes the sub-woofer channel for a low frequency effect through ordinary speakers and Spatializer PCE for dialog clarity. Each of these technologies has been optimized for small speaker or headphone playback and can be custom tuned to a manufacturer’s specific speaker set.

Licensing Activities

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

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

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

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

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

     We are currently negotiating new IC/DSP Foundry Licenses and OEM Licenses with potential customers for Spatializer N-2-2 Ultra, Spatializer Vi.B.E., Spatializer Natural Headphone , Spatializer PCE and combinations and optimizations of these technologies under the Spatializer Ultra HD series. Currently, all new licenses are negotiated by our Chief Executive Officer.

     IC/DSP Foundry Licenses

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

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

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

     As of December 31, 2003, we have entered into non-exclusive Foundry Licenses for our Virtual Audio Signal Processing technologies with Matsushita Electronics Corporation (“MEC”), ESS Technology, Inc. (“ESS”), OnChip Systems, Inc. (“OnChip”), LSI Logic, Inc. (“LSI”), Acer Labs, Inc. (“Ali”), MIPS Technologies, NJRC, Tvia, Inc., Texas Instruments, Cirrus Logic and Link Up Systems. Foundry Licenses generally require the payment of per unit running royalties based upon a sliding scale computed on the number of Spatializer ICs or DSPs sold.

     As of December 31, 2003, more than 45 million ICs and DSPs incorporating Spatializer audio signal processing technology had been manufactured and sold.

OEM Licensees and Customers

     As of December 31, 2003, our technology has been incorporated in products offered by more than 100 separate OEM Licensees and customers on various economic and business terms. Some of these OEM Licenses required a license issuance fee and/or a separate per unit royalty, while others were licensed under the Logo Usage Agreement (“LUA”) or were authorized customers under bundled royalty licenses with the IC foundries. The OEM Licensees and customers offer a wide range of products, which include DVD players, car stereo systems, direct view TVs, wide screen and projection TVs, cellular phones, powered speakers, portable audio systems (“Boomboxes”), HiFi stereo systems and components, computer sound cards and graphics accelerator cards, multimedia desktop personal computers, notebook computers, LCD projectors, multimedia computer monitors, and arcade pinball and video games.

     In 2003, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Orion, JVC and Samsung, each of whom accounted for greater than 10% of our total 2003 revenues. One OEM accounted for 34%, two accounted for 20% each and one accounted for 10% of our royalty revenues during 2003. Two other accounts comprised more than 5%, but less than 10% of revenues, each. All other OEM’s accounted for less than 5% of royalty revenues individually. During 2003 we anticipated a significant reduction in revenues from Apple as it completes its migration to its newest operating system and from Toshiba due to sourcing reallocation on some products.

     The following table is a partial list of the OEM Licensees and authorized customers as of December 31, 2003:

     We have extensive relationships with OEM licensees and customers outside the United States. Japanese and Korean based entities accounted for 71% and 20% of our total revenues, respectively in 2003, 50% and 17% of our total revenues, respectively in 2002, and 31% and 15% of our total revenues, respectively in 2001. The products incorporating our technology are, in turn, sold throughout the world, in market segments and amounts that are consistent with the overall general world markets for consumer electronics and software.

     Customers, Revenues and Expenses

     We generate revenues in our audio business from royalties pursuant to our Foundry, OEM, and other licenses, and from non-recurring engineering fees to port our technologies to specific licensees’ applications. Our revenues, which totaled $1,269,000 in 2003, were derived almost entirely from Foundry and OEM license fees and royalties.

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

     In 2003, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Inc., JVC, Samsung and Orion Corporation, each of whom accounted for greater than 10% of our total 2002 revenues. One OEM accounted for 34%, another accounted for 20%, another accounted for 20% and one accounted for 10% of our royalty revenues during 2003. Two other accounts comprised more than 5%, but less than 10% of revenues, each. All other OEM’s accounted for less than 5% of royalty revenues individually.

     We achieved improved operating results in 2002 as a result of overhead reductions combined with the strong growth of DVD-related revenues. In 2001, we began expanding our headcount, primarily in the engineering area in anticipation of continued growth. At midyear, in light of a weakening in market conditions and lower than anticipated royalties from a key Asian account, expenditures were once again curtailed in order to bring overhead levels more in line with current revenues. In 2003, declining revenues were experienced from three major customers resulting primarily from the cessation of use of our products by these customers. In most of these cases, the DVD player market, where we had a high concentration of accounts, became commoditized and resulted in a steep decline in price and margins. Manufacturers were forced to strip out features, such as those from our company, in order to compete. Another PC account migrated completely in 2003 to a new operating system and chose not to include any audio software enhancements.

Competition

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

     Our principal competitors in the field of virtual audio are SRS Labs, Inc. and Qsound Labs, Inc. In addition, some DSP foundries and OEMs have proprietary virtual audio technologies that they regularly offer to OEMs at no cost. These companies have, or may have, substantially greater resources than us to devote to further technologies and new product developments.

     Pressure on OEMs to reduce their costs, particularly in the DVD market is intense. The marketplace is also susceptible to undisciplined competitors who, from time to time, may offer below market prices to generate short term revenue and larger market penetrations even if it does not provide for viable margins. In the future, our products and technologies also may compete with audio technologies and product applications developed by other companies including entities that have business relationships with us. Factors that affect our ability to compete include product quality, performance and features, conformance to existing and new standards, price, customer support and marketing and distribution strategies.

     We believe that we will favorably compete in this market because we offer a single source, complete suite of patented and proprietary 3D Stereo, interactive positional, virtual surround sound, headphone and speaker virtualization technologies. By virtue of our specialized engineering and OEM support, we can offer a “turn-key” audio solution to OEMs who do not possess this expertise internally. We also have developed new products that address our customer’s need for a low cost solution. In addition, the strength of our IC Foundry and OEM relationships and the Spatializer brand name recognition in the industry are other key differentiators between both our branded and unbranded competition. Lastly, we continue to explore new and alternative business models that we believe serve the interests of both our customers and our stockholders.

Research and Development

     Our research and development expenditures in 2003, 2002 and 2001 were approximately 28%, 25% and 35% of total operating expenses respectively. These expenses consist of salaries and related costs of employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies

     As of December 31, 2003, we had five employees and consultants in our R&D group representing 56% of our total human resources. Our software, hardware and application engineers focus on developing intellectual property, technology solutions and consumer products.

Intellectual Property and Proprietary Information

     We rely on a variety of intellectual property protections for our products and services, including patent, copyright, trademark and trade secret laws, and contractual obligations. Our core signal processing technology is covered by U.S. patents 5,412,731, 5,896,456 and 6,307,941. On March 20, 1998, we filed a patent application on our enCompass V 2.0 technology with the United States Patent & Trademark Office (“USPTO”) covering our enCompass 2.0 positional audio gaming technology. In June 2000, we filed an additional patent application for our reduced cost/higher performance 3-D Stereo circuit design. In late 2002, we filed a patent application covering our Spatializer PCE technology. In 2003, we filed a patent application for Spatializer Audio Alchemy. Much of our intellectual property consists of trade secrets. In 2002, patent 6,307,941 was issued by the USPTO covering our Spatializer N-2-2 technology. We possess copyright protection for its principal software applications and has U.S. and foreign trademark protection for its key product names and logo marks.

     There can be no assurance that these measures will be successful, or that competitors will not be able to produce a non-infringing competitive product or service. In addition, the laws of certain countries in which our products are or may be developed, manufactured or sold, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States, or at all. There can be no assurance that third parties will not assert infringement claims against us, or that if required to obtain any third party licenses as a result of an infringement dispute, we will be able to obtain such licenses.

     In June 1996, we acquired certain developmental stage technologies and assets from Home Theatre Products (“HTP”), for approximately $1,062,000 in June 1996 and formed a subsidiary, MultiDisc Technologies, Inc. (“MDT”). The MDT transaction brought a combination of proprietary electromechanical designs, robotics, operating software, firmware, intellectual property, and engineering know-how and five patent applications acquired in the asset acquisition. MDT added an additional forty-seven patent applications filed with the USPTO to bring the total to fifty-two patent applications filed. On September 25, 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies and to properly position the MDT assets for sale. The repositioning strategy recognized that the capital investment required to properly commercialize the MDT technology was beyond our capacity. As a result, all operations, including research and development activities, were suspended and we have accounted for MDT as a discontinued operation. We have explored the sale of the business or the patent portfolio with interested parties, but to date, no transaction has been consummated.

Seasonality

     Due to our dependence on the consumer electronics market, we experience seasonal fluctuation is sales and earnings. In particular, we believe that there is seasonality relating to the Christmas season in the third and fourth quarters, as well as the first quarter, which is generally the weakest. We are moving toward diversifying our key market segments in the consumer electronics industry in an effort to even out our seasonal fluctuation. Overall, seasonality does not have a material effect on our business.

Employees

     We began 2003 with five full-time and nine part-time employees and sales representatives and decreased our staff to four full time and five part-time employees, consultants and sales representatives by December 31, 2003. At year-end, there were two full-time employees and three consultants engaged in research and development. We employ the services of outside professional consultants, particularly in the audio engineering area, due to the costly and tight labor market for such professionals in Silicon Valley as well as the need for specialized expertise in the course of our business. None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We consider our relations with our employees and consultants to be satisfactory.

Item 2. Properties

     Our corporate office and research center in San Jose, California, is the primary location for our audio technology division, (“DPI”). We occupy approximately 1,200 square feet with an annual rent on a full service basis of approximately $22,000. The lease expires on December 30, 2004 and is renewable at market rates thereafter.

     Our executive office is located in Westlake Village, California, where we occupy approximately 100 square feet with an annual rent of approximately $5,000. The lease term on this space expires on September 30, 2004 and is renewable on a month to month basis thereafter. This space in the Los Angeles area is used to facilitate business and contacts with the entertainment community as well as with our accountants, lawyers and directors.

     We lease an apartment in San Jose, California for use by the chief executive officer when away from the executive office. The annual rent on this apartment is approximately $18,000. The lease is on a month-to-month basis.

     We lease our space at rental rates and on terms which management believes are consistent with those available for similar space in the applicable local area. Our properties are well maintained and we believe they are adequate to support our current requirements.

Item 3. Legal Proceedings

     From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. As of the date of this Annual Report on Form 10-K, we are not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for the above legal proceedings could change in the future.

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

     There were no matters submitted to a vote of our security holders either through solicitation of proxies or otherwise in the fourth quarter of the fiscal year ended December 31, 2003.

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

     Our Common Stock was listed and commenced trading on the NASDAQ SmallCap market on August 21, 1995 under the symbol “SPAZ”. In January 1999, the Common Stock was delisted by the NASDAQ SmallCap Market due to our inability to maintain listing requirements. Our Common Stock immediately commenced trading on the OTC Bulletin Board under the same symbol. The following table sets forth the high and low bid price of our Common Stock as reported on the OTC Bulletin Board for fiscal years 2001 and 2002. The quotations listed below reflect interim dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions.

     On February 25, 2004, the closing price reported by the OTC Bulletin Board was U.S. $0.17. Stockholders are urged to obtain current market prices for our Common Stock. Computershare Investor Services, LLC is our transfer agent and registrar.

     There were no sales of unregistered securities by the Company during the year ended December 31, 2003.

     To our knowledge there were approximately 200 holders of record of the stock of the Company as of March 5, 2003. Our transfer agent has indicated that beneficial ownership is in excess of 4,000 stockholders.

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

Item 6. Selected Consolidated Financial Data

     The following selected consolidated financial data should be read in conjunction with our Consolidated Financial Statements and related Notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included in Item 7. The selected financial data for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 are derived from our consolidated financial statements that have been audited by Farber & Hass LLP, independent certified public accountants. The consolidated statements of operation and cash flows for the year ended December 31, 2003 and the report thereon are included elsewhere in this Report.

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

Approach to MD&A

     The purpose of MD&A is to provide our shareholders and other interested parties with information necessary to gain an understanding of our financial condition, changes in financial condition and results of operations. As such, we seek to satisfy three principal objectives:

Operating Environment

     We operate in a very competitive business environment. This environment impacts us in the following ways, further discussed in greater detail under Risk Factors:

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are critical to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

     The first critical accounting policy relates to revenue recognition. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are

recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

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

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

     Audit Committee

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

     Compensation and Stock Committee

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

Results of Operations

     The following discussion and analysis relates to our financial condition and results of operations for the year ended December 31, 2003 compared to the year ended December 31, 2002, and the year ended December 31, 2002 compared to the year ended December 31, 2001. The following discussion of the financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report.

For the Year Ended December 31, 2003, Compared to the Year Ended December 31, 2002

     Revenues

     Revenues decreased to $1,269,000 for the year ended December 31, 2003 compared to $1,856,000 for the year ended December 31, 2002, a decrease of 32%. Revenues are almost entirely comprised royalties pertaining to the licensing of Spatializer® audio signal processing algorithms.

     The decrease in revenues is attributed primarily to the loss or reduction at two key accounts which generated in excess of 20% of total revenue each, partially offset by revenue from a new account. The first lost account was in the PC market, which completed its migration to a new operating system in which it chose not to include any software audio enhancements. The second account was in the DVD player market, where it selected a lower cost solution for its low cost, high volume DVD players.

     Gross Profit

     Gross profit decreased to $1,147,000 for the year ended December 31, 2003 compared to $1,725,000 in the comparable period last year, a decrease of 34%. Gross margin decreased to 90% of revenue in the year ended December 31, 2003 compared with 93% of revenue for the comparable period last year. The decrease in gross profit results from lower revenues in the current year and from lower gross margin. The decrease in the gross margin percentage reflects a change in mix to commissionable foreign royalty revenue compared to non-commissionable U.S. sourced revenue. We maintain a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to our independent representatives that solicit and oversee the particular accounts.

     Operating Expenses

     Operating expenses for the year ended December 31, 2003 decreased to $1,631,000 (128% of sales) from $1,711,000 (92% of sales) for the year ended December 31, 2002, a decrease of 5%. The decrease in operating expenses results primarily from reductions in sales and marketing due to the elimination of a marketing and business development executive position and related travel. These responsibilities were transferred to another executive and to a new representative firm in Japan.

     In the fourth quarter of fiscal 2003, we implemented a cost reduction program that included the elimination of an executive position, relocation of the corporate offices to smaller and lower cost facilities, replacement of a stipended representative with a commissioned representative and other overhead related cost savings. The annualized reduction to be provided by these initiatives are expected to result in an overall overhead reduction of at least 20%.

     General and Administrative

     General and administrative costs increased to $811,000 for the year ended December 31, 2003 from $766,000 for the year ended December 31, 2002, an increase of 6%. The increase is primarily due to increased legal expenses related to public filings, in part in response to the additional requirements imposed on public companies by the Sarbanes-Oxley Act, and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.

     Research and Development

     Research and Development costs increased to $459,000 for the year ended December 31, 2003, compared to $433,000 for the year ended December 31, 2002, an increase of 6%. The increase in research and development expense was due strategic use of outside specialist consultants, wage increases and increased health insurance premiums for such personnel.

     We continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of Spatializer Audio Alchemy, refinement of Spatializer Natural Headphone, development of the HD Series of whole product solutions and applications engineering to port our technology to leading processor platforms.

     Sales and Marketing

     Sales and Marketing costs decreased to $361,000 for the year ended December 31, 2003, compared to $513,000 for the year ended December 31, 2002, a decrease of 30%. The reduction in such expenses resulted from the elimination of a sales consultant position, the elimination of a sales executive position in the third quarter of 2003 and fewer trade show participations.

     Net Income (Loss)

     Net loss was $495,000 for the year ended December 31, 2003, ($0.01) basic per share, compared to net income of $18,000, ($0.00) per share basic and diluted, for the year ended December 31, 2002. Net loss for the current period is primarily the result of lower gross margin, partially offset by lower overhead.

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

     Revenues

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

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

     Gross Profit

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

     Operating Expenses

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

     General and Administrative

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

     Research and Development

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

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

     Sales and Marketing

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

     Net Income (Loss)

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

Liquidity and Capital Resources

     At December 31, 2003, we had $590,000 in cash and cash equivalents as compared to $859,000 at December 31, 2002. The decrease in cash and cash equivalents is attributed to the operating loss. We had working capital of $793,000 at December 31, 2003 as compared with working capital of $1,125,000 at December 31, 2002.

     Net cash used in operating activities was $253,965 for the year ended December 31, 2003, as compared to net cash provided by operating activities of $85,138 for the year ended December 31, 2002 and net cash used in operating activities of $339,675 for the year ended December 31, 2001. The decrease in cash flows from operations for the year ended December 31, 2003 was primarily a result of decreases in net income in 2003. Accounts receivable decreased $153,612 for the year ended December 31, 2003, due to year over year decline in sales and resulting collections

     We use cash in investing activities primarily to secure patent and trademark protection for our proprietary technology and brand name, and to purchase short-term investments such as bank certificates of deposit. Cash used in investing activities totaled $20,709, $95,891 and $34,593, respectively, in the years ended December 31, 2003, 2002, and 2001. The decrease in cash used in investing activities during for the year ended December 31, 2003 is the result of curtailment of capital expenditures. All expenditures for on-going research and development are expenses and therefore included in the Net Loss.

     Net cash flows provided by financing activities totaled $5,746 for the year ended December 31, 2003 and cash used in financing activities totaled $0 and $224,242 for the years ended December 31, 2002 and 2001, respectively.

     In November 2002, the Board of Directors and the holders of our previously outstanding Series B Preferred Stock agreed to exchange the Series B Preferred Stock for a new Series B-1 Preferred Stock, which are convertible commencing in December 2005 into restricted Common Stock at a 10% discount, based on the 10 day average closing bid price prior to the conversion, but subject to a minimum conversion of $.56 per share and a maximum of $1.12 per share. The exchange was completed in December 2002. In connection with the exchange the Series B-1 Preferred Stock, we withdrew the Series A and Series B Preferred Stock and, therefore, currently the Series B-1 Preferred Stock is our only authorized or outstanding class of preferred stock.

     In the fourth quarter of 2003, we negotiated and completed the conversion of a $112,500 related party 10% demand note to a three-year 10% term note. Principal and interest of $5,191 is paid monthly, which we pay on a current basis. Installments due in more than twelve months are classified as Notes Payable to Related Parties-long-term.

     We continue to maintain an accrual for unasserted claims or settlement costs of approximately $28,000. We do not expect any final liability to be in excess of this balance.

     Future payments due under operating lease obligations as of December 31, 2003 are described below:

     Our future cash flow will come primarily from the audio signal processing licensing, OEM royalties and from possible common stock issuances including warrants and options. We are actively engaged in negotiations for additional audio signal processing licensing arrangements which we believe should generate additional cash flow without imposing any substantial costs on us. We anticipate that there may continue to be dislocations of individual licensing programs due to continuing pressure to reduce costs, particularly in the DVD player segment. We currently believe that growth from other licensing arrangements, which include new markets such as cellular phones, and other arrangements that are pending but not announced or in negotiation, will substantially offset any revenue shortfalls from market dynamics or transitioning platforms. Further, we anticipate that our cost reduction initiative implemented in the fourth quarter of 2003 will lower the revenues needed to reach the break-even point.

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

     To the extent we maintain or exceed our projected revenues and are not required to fund significant contingencies, we expect to continue to retain our current cash reserves and therefore, maintain our liquidity position at a consistent level both on a short-term and long-term basis. To the extent that we do not achieve current operating levels or are required to fund contingencies, we will be required to use some of our cash reserves and this could impact our longer term liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic market forces in which we operate, rather than to be affected by them. We believe our current cash reserves and cash generated from our existing operations and customer base are sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business for at least the next 12 months. We will also continue to consider and evaluate capital investment or business arrangements with financial or strategic participants or investors as such opportunities become available to us on terms that enhance shareholder value and support our business strategy.

Net Operating Loss Carry forwards

     At December 31, 2003, we had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2013. Approximately $21,700,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000.

Inflation

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

Recently Issued Accounting Pronouncements

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

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

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

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

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

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

In January 2003 the FASB issued Interpretation 46 “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”. This Interpretation requires a Company to consolidate the financial statements of a “Variable Interest Entity” (“VIE”), sometimes also known as a “special purpose entity”, even if the entity does not hold a majority equity interest in the VIE. The Interpretation requires that if a business enterprise has a “controlling financial interest” in a VIE, the assets, liabilities, and results of the activities of the VIE should be included in consolidated financial statements with those of the business enterprise, even if it holds a minority equity position. This Interpretation was effective immediately for all VIE’s created after January 31, 2003; for the first fiscal year or interim period beginning after June 15, 2003 for VIE’s in which a Company holds a variable interest that it acquired before February 1, 2003.

In May 2003 the FASB issued SFAS 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. This Statement establishes standards for how an issuer of debt or equity 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). Many of those instruments were previously classified as equity. This Statement 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 pronouncement is not expected to have a material effect on the Company’s financial position, results from operations or cash flows.

In December 2003, the FASB issued SFAS 132R “Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106”. This Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The Company will adopt the provisions of SFAS 132R on January 1, 2004. The adoption of this pronouncement is not expected to have a material effect on the Company’s financial position, results from operations or cash flows.

Factors That May Affect Future Results

     Certain information in this report includes forward-looking statements. Forward-looking statements include statements regarding our expectations, beliefs, intentions, plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements that are other than statements of historical fact. When used in this report the words “shall,” “should,” “forecast,” “all of,” “projected,” “believes,” “anticipates,” “expects,” and similar expressions are intended to identify these forward-looking statements. In addition, we may from time to time make oral forward-looking statements. We wish to caution readers that a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed above in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” elsewhere in this report or from time to time described in our other filings with the Securities and Exchange Commission.

Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain Profitability in the Future or Obtain Future Financing Our Business Operations May Fail

     We experienced a loss from operations in 2003 and 2001 but were profitable in 2002. We experienced small losses in the last quarter of 2002, the first quarter of 2003, a larger loss in the second quarter of 2003 and a reduced loss in the current quarter. While our objective and full effort is on managing a profitable business, due to the market conditions and factors outlined above and below and their impact on fluctuations in operating expenses and revenues , we cannot provide assurance that we will be able to generate a positive profit position in any given future period. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability, and we may have to rely on the sale of shares or on debt financings in the future, which may have a dilutive effect on our existing shareholders. Further, we cannot assure you that debt or equity financing will be available as required and if not available, we would have to further scale down operations or even cease operations.

Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure and Competition.

     We are seeking commercial acceptance of our products in highly competitive markets. Certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. We have responded by offering additional products targeted to each price and quality segment of the market and continue to aggressively pursue new opportunities in emerging product categories and complements to our existing core business. In addition, our products have been positioned as a means for manufacturers to save money while delivering an enhanced audio experience. Nevertheless, these market conditions and competitive forces make it more challenging for us, and its rational commercial competitors, to enhance their operating results. There is no assurance that our present or contemplated future

products will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors who had access to significantly greater resources or which are willing to “give away” their products.

We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities and Alliances that May Delay or Thwart our Sales Efforts to Potential Customers.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company.

If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive Products May Reach The Market Before Our Products.

     Since our inception, we have experienced delays in bringing new products to market and commercial application as a result of delays inherent in technology development, financial resource limits and industry responses and maturity. These delays have resulted in delays in the timing of revenues and product introduction. In the future, delays in new product development or technology introduction on behalf of us, our original equipment manufacturers of consumer electronics and multimedia computer products (OEMs), integrated circuit (IC) foundries or our software producers and marketers could result in further delays in revenues and could allow competitors to reach the market with products before us. In view of the emerging nature of the technology involved, and the rapidly changing character of the entire media, internet and computer markets, our expansion into other technology areas and the uncertainties concerning the ability of our current products and new products to achieve meaningful commercial acceptance, there can be no assurance of when or if we will achieve or sustain profitability.

     Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to cashflow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced.

     We expect that we will continue to be dependent upon a limited number of OEMs for a significant portion of our net sales in future periods, although no OEM is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period. Our four largest customers as of September 30, 2003 accounted for 31%, 21%, 18% and 11% of our net sales for nine months ended September 30, 2003. The loss of any one of our major customers or licensees would significantly reduce our revenues and harm our ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a similarly sized account or accounts would have a material short term impact on our operations and there is no assurance that we will not lose all or some of the revenues from one or more of these accounts. While we are working to broaden the sources of our royalty streams, there can be no assurance that we will be successful in retaining or attracting such key accounts and broadening such revenue stream sources.

     Our products are typically one of many related products used by consumer electronic users. Demand for our products is therefore subject to many risks beyond our control, including, among others:

     There can be no assurance that we will not lose sales in the future as a result of the pressure to reduce costs faced by our customers. The reduction of orders from our significant OEM customers, or the discontinuance of our products by our end users may subject us to potential adverse revenue fluctuations.

Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those Of Our Competitors.

     We operate in a technology environment which is competitive and rapidly changing. While our software applications deliver what we, and most manufacturers who listen to it, believe is a significantly superior audio experience, the competitive market forces that pressure manufacturers to reduce their costs may create some resistance to new technology adoption or use. Our future success is dependent on establishing and maintaining the technological superiority of our products over those of competitors, our ability to successfully identify and bring other compatible technologies and products to market and a recognition by the market of product value. We compete with a number of entities that produce various stereo audio enhancement processes, technologies and products in both traditional two-speaker environments such as consumer electronics and multimedia computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of 3-D or “virtual audio”, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby Laboratories or technologies and products developed by other companies, including entities that have business relationships with us. There can be no assurance that we will be able to favorably compete in this market in the future.

If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully Operate Our Business.

     Our future success primarily depends on the abilities and efforts of a small number of individuals, with particular management obligations and technical expertise. Loss of the services of any of these persons could adversely affect our business prospects. There is no assurance that we will be able to retain this group or successfully recruit other personnel, as needed. We compete with other enterprises with stronger financial resources and larger staffs that may offer employment opportunities to our staff which are more desirable than those which we are able to offer. Failure to maintain skilled personnel with the software and engineering skills critical to our business could have an adverse impact upon our business, the results of our operations and our prospects. Currently, we have an employment agreement with Henry R. Mandell with a term expiring in November 2005.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at December 31, 2003. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.

Item 8. Financial Statements and Supplementary Data

INDEPENDENT AUDITORS’ REPORT

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

     We have audited the accompanying consolidated balance sheets of Spatializer Audio Laboratories, Inc. and subsidiaries (The “Company”) as of December 31, 2003 and 2002 and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended December 31, 2003, 2002 and 2001. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spatializer Audio Laboratories, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of its operations and its cash flows for the years ended December 31, 2003, 2002 and 2001 in conformity with accounting policies generally accepted in the United States of America.

/s/ FARBER & HASS LLP

Oxnard, California
March 10, 2004

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

See accompanying notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) Nature of Business

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

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

     The Company’s wholly-owned subsidiary, MultiDisc Technologies, Inc. (“MDT”), has been dormant since the fourth quarter of 1998 and the assets have been marketed for sale (see Note 11).

(2) Significant Accounting Policies

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

     Revenue Recognition — The Company recognizes revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries. The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin 101.

     Concentration of Credit Risk — Financial instruments, which potentially subject the company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at Citibank FSB. At December 31, 2003 and 2002, substantially all cash and cash equivalents were on deposit at one financial institution.

     At December 31, 2003, three major customers, not presented in order of importance, each accounted for 10% or more of our total accounts receivable: JVC, Samsung and Orion Corporation, each of whom accounted for greater than 10% of our total 2002 accounts receivable. One customer accounted for 42.0%, another accounted for 23% and one accounted for 16% of our total accounts receivable at December 31, 2003. At December 31, 2002, one customer accounted for 28%, two customers each accounted for 20% and a fourth customer accounted for 15%.

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

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

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

     Customers Outside of the U.S.- Sales to foreign customers were 91%, 90% and 67% of total sales in the years ended December 31, 2003 and 2002 and 2001, respectively.

     Major Customers — During the year ended December 31, 2003, three customers accounted for 34%, 20%, and 20%, respectively, of the Company’s net sales. During the year ended December 31, 2002, three customers accounted for 33%, 25%, and 17%, respectively, of the Company’s net sales.

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

     Advertising Costs — Costs incurred for producing and communicating advertising are expensed when incurred and included in selling, general and administrative expenses. Consolidated advertising expense amounted to $2,960, $4,087 and $27,645 in 2003, 2002 and 2001, respectively.

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

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

     Earnings Per Share — The Company determines earnings per share in accordance with Statement of Financial Accounting Standards No. 128, Earnings Per Share (“SFAS 128”). Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.

     Since the Company generated a net loss in 2003 and 2001, outstanding stock options and warrants would have been anti-dilutive and are not applicable to this calculation.

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

     The following table presents contingently issuable shares, options and warrants to purchase shares of common stock at December 31, 2002. Those that were outstanding during 2003 and 2001 were not included in the computation of diluted loss per share because the impact would have been anti-dilutive:

     Stock Option Plan —The Company determines the effect of stock based compensation in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, which permits entities to recognize as expense using the “fair-value” method over the vesting period of all employee stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to utilize the “intrinsic value” method for equity instruments granted to employees and provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants after 1994 as if the fair-value-based method defined in SFAS No. 123 has been applied. The Company has elected to continue to utilize the “intrinsic value” method for employee stock option grants and provide the pro forma disclosure provisions of SFAS No. 123 (Note 8).

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

     Segment Reporting - The Company adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in December 1997. MDT has been considered a discontinued operation since September 1998. As of December 31, 2002, the Company has only one operating segment, DPI, the Company’s Audio Signal Processing business.

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

Recent Accounting Pronouncements - In January 2003 the FASB issued Interpretation 46 “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51”. This Interpretation requires a Company to consolidate the financial statements of a “Variable Interest Entity” (“VIE”), sometimes also known as a “special purpose entity”, even if the entity does not hold a majority equity interest in the VIE. The Interpretation requires that if a business enterprise has a “controlling financial interest” in a VIE, the assets, liabilities, and results of the activities of the VIE should be included in consolidated financial statements with those of the business enterprise, even if it holds a minority equity position. This Interpretation was effective immediately for all VIE’s created after January 31, 2003; for the first fiscal year or interim period beginning after June 15, 2003 for VIE’s in which a Company holds a variable interest that it acquired before February 1, 2003.

In May 2003 the FASB issued SFAS 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. This Statement establishes standards for how an issuer of debt or equity 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). Many of those instruments were previously classified as equity. This Statement 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.

In December 2003, the FASB issued SFAS 132R “Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106”. This Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement

plans. The Company will adopt the provisions of SFAS 132R on January 1, 2004.

     The Company believes that the adoption of these pronouncements will not have a material effect on the Company’s financial position, results from operations or cash flows.

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

     Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2003 and 2002 approximated fair value due to their short maturity or nature.

     The fair values of notes payable to a related party at December 31, 2003 and 2002 are materially consistent with the related carrying values based on current rates offered to the Company for instruments with similar maturities.

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

(3) Property and Equipment

     Property and equipment, as of December 31, 2003 and 2002, consists of the following, net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121:

(4) Intangible Assets

     Intangible assets, as of December 31, 2003 and 2002 consist of the following:

     Estimated amortization is as follows:

(5) Notes Payable to Related Parties

(6) Shareholders’ Equity

Capitalization

Series A Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Corporations Series A Preferred Stock are outstanding and that no shares of the Series A Preferred Stock will be issued.

Series B Preferred Stock: On December 26, 2002 the Company filed a Certificate of Elimination with the Delaware Secretary of State stating that no shares of the Corporations Series B Preferred Stock are outstanding and that no shares of the Series B Preferred Stock will be issued.

Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series has a par value of $0.01 and a stated value of $10.00 per share US and is designated as a liquidation preference. The stock will rank prior to the Company’s common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain formula based on an average closing share price, subject to a floor of $0.56 and a ceiling of $1.12. At December 29, 2005 certain mandatory conversion requirements exist subject to the above formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist based on date sensitive events based on the Company’s Insider Trading Policy. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock.

(7) Escrowed Performance Shares

In December 1996, the Company accepted the terms outlined by the British Columbia Securities Commissions (“BCSC”) for the release of the Company’s 5,776,700 escrowed “Performance Shares” from Canadian Escrow into a new escrow arrangement with the Company. The overall modification was approved by the Company’s stockholders in August 1996. Under the revised arrangement, the performance shares were released automatically as follows: 20% prior to June 22, 2000, 20% on June 22, 2000; 30% on June 22, 2001; and 30% on June 22, 2002. Under the revised escrow arrangement, the performance shares vested, provided the individual had not voluntarily terminated his/her relationship with the Company prior to applicable vesting dates.

Based on the revised escrow arrangement, which primarily converted the escrow shares release from performance criteria to a time-based criteria, the Company recorded as compensation expense the excess of the fair market value of the 5,776,700 performance shares on the date the Company accepted the terms of the new escrow arrangement over the purchase price of such escrow shares.

All of the performance shares are included in the issued and outstanding shares for the years ended December 31, 2003, 2002 and 2001. However, the shares were not reflected in the calculation of loss per common share until earned by and released to the holders on December 30, 1996, the date on which the Company and the BCSC accepted and entered into the terms of the current escrowed agreement as discussed above. As of December 31, 2002, all performance shares under the escrow arrangement have been released. In December 2003, the remaining 557,740 shares of former employees or participants, who lost entitlement to such shares under the terms of the BCSC, were cancelled.

(8) Stock Options

     In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan which was approved by the stockholders authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at each calendar quarter, 4,757,360 as of December 31, 2003. Stock options are granted with an exercise price equal to the stock’s fair market value at the date of grant. Stock options have five-year terms and vest and become fully exercisable up to three years from the date of grant.

     At December 31, 2003, there were 1,716,587 additional shares available for grant under the Plan. The per share weighted-average fair value of stock options granted during 2003, 2002 and 2001was $0.05, $0.11and $0.29, respectively, on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2003- expected dividend yield 0%, risk-free interest rate of 2.25%, expected volatility of 137% and an expected life of 5 years, 2002: expected dividend yield 0%, risk-free interest rate of 6%, expected volatility of 427% and expected life of 5 years; 2001 expected dividend yield 0%, risk-free interest rate of 9.0%, expected volatility of 332% and an expected life of 5 years; 2000- expected dividend yield 0%, risk-free interest rate of 9.0%, expected volatility of 654% and an expected life of 5 years.

     The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for the fair value of its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income (loss) would have been increased to the pro forma amounts indicated below:

     Stock option activity during the periods indicated is as follows:

     At December 31, 2003, the number of options exercisable was 2,540,000 and the weighted-average exercise price of those options was $0.21.

(9) Warrants

     Warrant activity for the periods indicated below is as follows:

     All of the warrants granted in 1999 were issued in connection with private placements. At December 31, 2003, all such warrants had expired, without exercise.

(10) Income Taxes

     The Company files a consolidated return for U.S. income tax purposes. Income tax expense for the years ended December 31, 2003, 2002 and 2001 consisted of the following:

     Certain revenues received from customers in foreign countries are subject to withholding taxes that are deducted from outgoing funds at the time of payment. These taxes range from approximately 10% to 16.5% and are recorded as net foreign revenue.

     Income tax expense for the years ended December 31, 2003, 2002 and 2001 differed from the amounts computed by applying the U.S. federal income tax rate of 34 percent to loss before income taxes primarily due to the generation of additional net operating loss carry forwards for which no tax benefit has been provided.

     The tax effects of temporary differences that give rise to significant portions of the deferred tax assets at December 31, 2001 is composed primarily of the net loss carry forwards. The net change in the total valuation allowance for the year ended December 31, 2001 was insignificant. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable losses, management believes it is more likely than not the Company will not realize the benefits of these deductible differences and has established a valuation allowance to fully reserve the deferred tax assets at December 31, 2003. Additionally, the ultimate realizability of net operating losses may be limited by change of control provisions under Section 382 of the Internal Revenue Code.

     At December 31, 2003, the Company had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2013. Approximately $21,700,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000.

(11) Discontinued Operation

     On September 25, 1998, the Board of Directors determined that it would be unable to raise the necessary capital required to properly commercialize the MDT technology. Therefore, the Company ceased funding the operations of MDT and actively sought to sell the assets and technology. All employees of MDT were terminated and the Company has vacated the MDT facilities.

     Based on this action, the Company treated MDT as a discontinued operation. Accordingly, the balance sheet and statement of operations of MDT are not consolidated in the continuing operations of the Company, but rather were as Net Liabilities of Discontinued Operation and Loss From Discontinued Operation, respectively. At December 31, 2002, after four years of inactivity and inability to sell the assets, the remaining liability of $71,045 was eliminated.

(12) Commitments and Contingencies

     We also anticipate that, from time to time, we may be named as a party to other legal proceedings that may arise in the ordinary course of our business.

Operating Lease Commitments

     The Company is obligated under several non-cancelable operating leases. Future minimum rental payments for all operating leases of approximately $18,469 through November 2004. Rent expense amounted to approximately $83,000, $ 78,000 and $78,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

(13) Profit Sharing Plan

     The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan. The amount charged to administrative expense for the Plan in 2003, 2002 and 2001 was approximately $2,000 per annum.

(14) Quarterly Financial Data (unaudited)

     The following is a summary of the quarterly results of operations for the years ended December 31, 2003 and 2002:

Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure

     None.

Item 9A. Controls and Procedures

     We carried out an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer had concluded that our disclosure controls and procedures as of the end of the period covered by this report were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms. There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART III

Item 10. Directors and Executive Officers of the Registrant

     Information required for this item incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders.

     Code of Ethics

     We adopted a Code of Ethics that applies to all of our directors, officers and employees, including our Chief Executive Officer, our Chief Financial Officer and other senior financial officers. Our Code of Ethics will be posted on our website, www.spatializer.com, under the heading “Code of Ethics”. We intend to disclose on our website any amendment to, or waiver of, a provision of the Code of Ethics that applies to our Chief Executive Officer, our Chief Financial Officer or any other senior financial officers.

Item 11. Executive Compensation

     Information required for this item incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders.

Item 12. Security Ownership of Certain Beneficial Owners and Management

Equity Compensation Plan Information

     The remaining information is required for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders.

Item 13. Certain Relationships and Related Transactions

     Information required for this item incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders.

Item 14. Principal Accounting Fees and Services

     Information required for this item incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders.

PART IV

Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K

     (a) Financial Statements

     See Item 8.

     (b) Reports on 8-K

     On November 12, 2003 we furnished a report on Form 8-K under Item 12 disclosing that we announced our financial results for the quarter ended September 30, 2003 and attaching the corresponding press release.

     (c) Exhibits

     The following Exhibits are filed as part of, or incorporated by reference into, this Report:

SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: March 22, 2004

     Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.