SONIC FOUNDRY INC - Annual Report: 2003 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal period ended September 30, 2003

OR

Commission File Number                                                                  1-14007

SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)

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

Securities registered pursuant to Section 12(g) of the Act:

Common stock par value $0.01 per share

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    ü        No

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

Yes    ü        No

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

        Yes                No    ü

The aggregate market value of the voting stock held by non-affiliates of the Registrant’s was approximately $48,212,000 based on the last sale price on December 19, 2003.

The number of shares outstanding of the issuer’s common equity was 29,308,201 as of December 19, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2004 Annual Meeting of Stockholders are incorporated by reference into Part III. A definitive Proxy Statement pursuant to Regulation 14A will be filed with the Commission no later than January 28, 2004.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

TABLE OF CONTENTS

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS SUCH AS STATEMENTS OF THE COMPANY’S EXPECTATIONS, PLANS, OBJECTIVES AND BELIEFS. THESE STATEMENTS USE SUCH WORDS AS “MAY,” “WILL,” “EXPECT,” “ANTICIPATE,” “BELIEVE,” “PLAN” AND OTHER SIMILAR TERMINOLOGY. ACTUAL RESULTS COULD DIFFER MATERIALLY DUE TO CHANGES IN THE MARKET ACCEPTANCE OF SONIC FOUNDRY’S PRODUCTS OR SERVICES, MARKET INTRODUCTION OR PRODUCT DEVELOPMENT DELAYS, GLOBAL AND LOCAL BUSINESS CONDITIONS, LEGISLATION AND GOVERNMENTAL REGULATIONS, COMPETITION, THE COMPANY’S ABILITY TO EFFECTIVELY MAINTAIN AND UPDATE ITS PRODUCT OR SERVICE PORTFOLIO AND SHIFTS IN TECHNOLOGY.

PART I

ITEM 1.    BUSINESS

Sonic Foundry, Inc. is in the business of developing automated rich-media application software and systems, (our “Media Systems” business). The Media Systems business was formed in October 2001, when our wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets and assumed certain liabilities of MediaSite, Inc. (“MediaSite”). Our internally developed software code, coupled with our acquired systems technology, includes advanced publishing tools and media access technologies operating across multiple digital delivery platforms to significantly enhance a host of enterprise-based media applications. Our solutions are based on unique and, in some cases, patented technologies that enhance media communications through the extensive use of rich-media, defined as a media element that combines graphics, text, video, audio and metadata in a single data file. Our technology evolved from a four-year Carnegie Mellon University research effort funded by major government (DARPA, NSF, NASA) and private organizations (CNN, Intel, Boeing, Microsoft, Motorola, Bell Atlantic). The core products include MediaSite Live (“MSL”) a web presentation and webcasting system and Publisher, a software product for creating accessible and searchable rich media presentations.

Sonic Foundry, Inc., the parent company of our Media Systems business, was founded in 1991, incorporated in Wisconsin in March 1994 and merged into a Maryland corporation of the same name in October 1996. Our executive offices are located at 222 West Washington Ave., Suite 775, Madison, Wisconsin, 53703 and our telephone number is (608) 443-1600. Our corporate website is http://www.sonicfoundry.com. Electronic access to our SEC filings is available at the “Investor Information” section of our website.

Until recently, we were engaged in three businesses – Media Services, Desktop Software and Media Systems.

Our media services operations (the “Media Services” business) was a mature business that was a result of several acquisitions we made over recent years - performed primarily through two subsidiaries of Sonic Foundry, Inc.: Sonic Foundry Media Services, Inc. and International Image Services Corporation, Inc. d/b/a Sonic Foundry Media Services. Media Services provided format conversion, tape duplication, film restoration and other services to the media, broadcast and entertainment industries. The media services included translating analog or digital tapes, CDs, films and other audio and video media into various compression and Internet streaming file formats, including multiple compression rates. Add-on services involved cleaning or filtering recordings for improved quality. On May 16, 2003, we completed the sale of the Media Services business for approximately $5.6 million, including an estimate of the value of net working capital acquired. In fiscal 2002, our Media Services business generated revenue of $9.4 million, or approximately 36% of our total revenues. All revenue and expenses included in the results of operations of the Media Services business have been presented as discontinued operations (the “Discontinued Operations”) and previously reported consolidated financial statements have been restated to reflect the discontinued operations presentation.

Our desktop software operations (the “Desktop Software” business) designed, developed, marketed and supported software products for digitizing, converting, editing and publishing of audio, video, and/or multimedia content. The Desktop Software business included a number of mature products such as Sound Forge, ACID and Vegas. In 2002, annual revenue from our Desktop Software business was $15.9 million, or approximately 61% of our total revenues. We entered into an amended and restated asset purchase agreement to sell the Desktop Software business dated June 6, 2003 and effective May 2, 2003 with a subsidiary of Sony Pictures Digital. The transaction was completed on July 30, 2003 following shareholder approval on July 29, 2003.

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Business and Industry Background

Most organizations have a need to communicate, not just internally but externally, beyond the boundaries they’ve initially set up. In the case of universities and colleges, connecting to online lectures and materials is becoming a must have. Likewise, outbound communications from corporate entities is essential to reach key partners and customers. There are ready examples of this need when investigating the workflow of product managers, customer service groups and product trainers. And yet, significant communication delivery barriers remain. The key problem has been producing communication content economically and delivering it quickly to the person who requires it.

Reinforcing this need are the economics behind communication. More and more institutions are realizing a profit potential or significant cost savings by utilizing new rich media communications systems. In the case of secondary education, more institutions are establishing distance learning programs which offer a higher margin return on tuition. In the case of corporations, they are discovering true savings in rich media communications via their day to day functional duties such as channel communications, sales training, product support and customer and dealer training.

We currently offer an easy to use, simple-to-deploy, entry-level system for delivering and archiving real-time web-based presentations and webcasts. This offering provides significant advantages related to creating and viewing the content. Our uniqueness is best understood through an appreciation of the way we’ve moved the content through the publishing workflow process, while still delivering a viewing experience that does not require proprietary software or subprograms that various web services use for deploying graphics (“Applets”) or software other than standard Windows media.

We believe this offering is powerful because it attempts to solve a very complex workflow integration problem. Specifically, all of the technologies involved in our offering, such as streaming, database integration, video and graphic capture and Internet viewing are not easily combined, much less understood. For this and other reasons, we believe MSL delivers an elegant, easy to implement solution that shows the promise of breaking through traditional barriers of content production.

In many ways, the MSL appliance has the characteristic of an Internet projector. Just as projectors first extended overhead slides and Powerpoint presentations to the screen, the Live box takes the same presentation outside the confines of a room to the rest of the world while also creating an archive. Projectors entered the market at a price of approximately $20 thousand and sold into large lecture rooms. Over time, the economies of manufacturing and distribution placed the device in many smaller rooms. Today, the LCD projector has become truly mobile and is often carried under the arm by presenters.

Some of our customers view MSL as a media event recorder. Our device is being used to capture critical communications and acts as an archiving tool. In some instances, MSL is being used as a knowledge capture device capable of archiving presentations. In general, we’re finding that our customers predominantly use MSL in this asynchronous mode (not live). They value the flexibility of capturing content and having it available for later retrieval. So while the live capability offers some feature appeal, the real utilization is tending towards on-demand, off line access.

Media Systems Products and Services

During fiscal 2003, we introduced two versions of our MSL web presentation and webcasting system to the enterprise marketplace. MSL addresses a broad variety of communications for business, government, and education ranging from executive briefings, product marketing, and sales presentations to public safety/emergency management and community outreach, to online lectures and distance learning. MSL is a unique combination of hardware and software that automatically takes multiple media feeds (video, audio and graphics) from a variety of presentation devices and combines them into an Internet “stream”. This stream can be distributed Live to remote users, as the presentation is occurring, thereby eliminating the entire authoring process. Similarly, following the creation of the presentation, the stream is made accessible on-demand from a website. Our latest engineering effort - version 3 of MSL, released on November 3, 2003 – made further enhancements to the product line including CD burning, enhanced security, Macintosh browser support, and digital video capture.

The engineering put into the product was intended to eliminate an overly complicated problem that has restricted market growth and expansion. We believe the breadth of potential users can grow quite broadly. By way of example, videoconferencing has been a technology with great promise but minimal demonstrated use. We believe this market has stalled due to the complexity of actually invoking a videoconference, the need to have IT staff involved and the uncertainty of quality remote connections. Even with these handicaps, the video conferencing market has become a billion dollar industry having penetrated less than 10% of the estimated 25 million conference rooms that currently exist worldwide. Our own system offering is targeted at the same conference room setting and is primarily why we chose the audio / video (“A/V”) reseller channel as our primary

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distribution partner. Because many of the technology hurdles and use issues have been solved through an IP approach, we believe the web presentation and webcasting markets will expand far beyond the established video conferencing market.

We are also involved in advanced research related to the interpretation and further enhancement of rich media. A significant portion of this research is based on patented technology defined as the integration of speech, language and image processing (ISLIP) which provides the capability of extracting and creating metadata from time-based media and includes constructing meaningful indices enabling effective and efficient search and retrieval of rich media. This technology was recognized in 2001 by MIT Technology Review as one of the “Ten Emerging Technologies That Will Change the World”. Another patented technology “video skimming” provides users the capability of reviewing rich media faster than real-time. With continued funding being received from government entities, we are actively researching and developing further commercialization efforts of these technologies and applying the resulting products to broader market opportunities. On October 20, 2003, we announced the receipt of a grant from the United States Department of Justice for a 18-month project to examine how state and local law enforcement agencies can better process and manage audio and video media. We will then develop a set of media analysis software components that will form the foundation for addressing multiple law enforcement applications related to media, such as the indexing and cataloging of media, data mining and electronic surveillance. We believe the outcome of our research and commercialization efforts will advance the art of “meta-tagging” (identification and extraction of audio, visual and textual cues) as well as “video mining” technology. This will allow us to offer technologies that both produce and consume rich-media content at a more personalized and more interactive level.

MediaSite Publisher is a product for creating accessible and searchable rich media presentations by using meta-tagging tools to identify and extract audio, video, and other textual cues. Publisher then allows the user to quickly and accurately locate media files by keyword or topic. Users can view scores and descriptive information to determine relevancy of their search results, and watch the returned clips with Publisher’s Highlights Indexing Module.

Product line expansion—Software engineering on the product line continues to expand the scale and scope of our offerings. Development efforts are targeted towards enhancing content access and viewing choices. Similarly, some of our advanced technologies are expected to be incorporated in making our content much more navigable and searchable, versus non-indexed media content. Fundamentally, without accurate and full indexes available, viewing media would be analogous to reading a text book with no chapters, no indexes and no cross references, making it very time-consuming.

Service contracts—We offer our customers support for our Live product through annual maintenance contracts. The contracts are purchased by the majority of our customers at the time the Live product is purchased at a price of 18% of the Live list price and includes an extension of the hardware warranty from the standard 90-days to one year, prioritized unlimited technical support via phone or email, access to the support website, access to product hot fixes and maintenance releases and documentation.

Selling and Marketing

We sell and market our offerings through a sales force that manages a reseller channel of Value-added resellers, system integrators and distributors. These third party representatives have a unique specialization and understanding of both audio/video systems and IT networking. For this reason, we have chosen to be highly selective and targeted by bringing on only the most qualified resellers that understand the nuances of media and IT network issues. To date, we have brought on roughly 40 resellers who have demonstrated these qualifications. This group is based almost entirely in the United States and sells primarily to customers we’ve identified as having the greatest potential: presenters, trainers, lecturers, marketers and leaders who have a routine need to communicate to many people in the higher education, government, health and certain corporate markets. As the product line begins to show growth trends in the U.S. market, we expect to expand our reseller network to the worldwide market. Revenue from our largest customer was just under 10% in 2003 and from our two largest customers were 29% and 25%, respectively, in 2002.

Vertical market expansion—Currently, we realize the majority of our revenues from the education and distance learning markets. Corporations currently lag these users in adoption, but are expected to grow significantly as market awareness of web presentation and conferencing solutions expand. Similarly, we are seeing expanded interest from government, professional membership, legal, medical, engineering and marketing organizations. Targeting each group specifically offers an opportunity to build new markets as others become more established.

Repeat orders—Most customers will buy a single system to test the full capability of the system. Larger enterprises and facilities have followed up with multiple unit orders following a test of the capabilities of the system. For this reason, we have

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For the Year Ended September 30, 2003

specifically targeted larger entities that have more than 500 employees and multiple offices and that have found service provider solutions in conferencing far too cost prohibitive.

Renewals—As is typical in the industry, we expect to offer services contract extensions, for a fee to our customer base.

Marketing efforts span the spectrum of reseller sales demonstrations, tradeshows, web page information, webinars, brochures, direct mail, print advertisement and white papers. We are in the early stages of building out our database of potential customers in the government, education and corporate marketplaces. We have established a selected process of targeting specific verticals that have a direct and demonstrated need for our offerings.

Operations

We contract with a third party to build the hardware of our Live product and typically purchase quantities for specific customer orders. Product is shipped to us, where we load our proprietary software, test the unit and ship it either direct to the customer or to a reseller. The hardware manufacturer provides a limited one-year warranty on the hardware, which we pass on to our customers who purchase our support plan. We believe there are numerous sources and alternatives to the existing production process. To date, we have not experienced any material difficulties or delays in the manufacture and assembly of our system products, or material returns due to product defects.

OTHER INFORMATION

Competition

The digital media marketplace is new, rapidly evolving and intensely competitive. As more companies begin to leverage streaming video technologies, we expect competition to intensify. We currently compete directly with other providers in the market for web-based video solutions including Convera Corporation, Autonomy and Yahoo! Broadcast Solutions. We may also compete indirectly with larger system integrators who embed or integrate these directly competing technologies into their product offerings. It is possible that we may work with these same larger companies on one customer bid and compete with them on another. In the future, we may compete with other video services vendors as well as web conferencing vendors. In addition, we may compete with our current and potential customers who may develop software or perform application services internally.

We believe we compete favorably with our competitors. However, the market for our products is relatively small today, and therefore even continued success against competitors does not guarantee that we can grow our business to profitable levels. Our ability to become a profitable and sustainable business is highly dependent on the growth of the Internet and intranet streaming video business.

Intellectual Property

We depend on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of patent, trademark and copyright laws, as well as confidentiality and license agreements with our employees and others. We actively seek patent protection for our intellectual property. We have filed four U.S. patent applications on our proprietary technology. None of these patents have been issued by the Patent and Trademark Office.

We have filed for four U.S. and four foreign country trademarks, of which two U.S. and three foreign country trademarks are registered. We seek to avoid disclosure of our trade secrets by limiting access to our proprietary technology and restricting access to our source code. Despite these precautions, it may be possible for unauthorized third parties to copy particular portions of our technology or reverse engineer or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States. Our means of protecting our proprietary rights in the United States or abroad may not be adequate and competing companies may independently develop similar technology.

Research and Development

We believe that our future success will depend in part on our ability to continue to develop new, and to enhance our existing Systems business. Accordingly, we invest a significant amount of our resources in research and development activities. During the fiscal years ended September 30, 2003 and 2002, we spent $1.7 million and $3.1 million on internal research and development

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activities for our systems business. These amounts represent 138% and 358% of total Media Systems revenues in each of those years. Internal research and development activities associated with our discontinued Media Services and Desktop Software operations are reflected in the discontinued operations line items of such businesses in the statement of operations.

In October 2001, we acquired the assets of MediaSite which includes the underlying technology of our current MediaSite Publisher and MSL products for a total of $9.1 million. MediaSite derived its core technology from a Carnegie Mellon University (“CMU”) research effort funded by leading government agencies and private corporations for which it obtained a license. Simultaneously with the acquisition, we entered into a license agreement with CMU for the core technology.

Employees

As of September 30, 2003, 2002 and 2001, we had 32, 246 and 239 full-time employees, respectively. All of these employees were employed in our Systems business in 2003, while 46 were employed in the Systems business as of September 30, 2002 and none of these employees were employed in our systems business in 2001. Full time employees of our Media Services and Desktop Software businesses were terminated upon completion of the sales in May and July, 2003, respectively. The majority of employees associated with both businesses were hired by the buyers. Our employees are not represented by a labor union, nor are they subject to a collective bargaining agreement. We have never experienced a work stoppage and believe that our employee relations are satisfactory.

ITEM 2.    PROPERTIES

Our principal office is located in Madison, WI in a leased facility of approximately 6,000 square feet. The building serves as our corporate headquarters, accommodating our G&A, R&D and Sales and Marketing departments. We believe this facility is adequate and suitable for our needs.

In addition, we lease 9,000 square feet in a facility in Wexford Pennsylvania and 7,000 square feet in a building in downtown Pittsburgh, Pennsylvania. The Wexford lease ends in January 2003. We are attempting to sublet or negotiate a settlement for the space in downtown Pittsburgh.

ITEM 3.    LEGAL PROCEEDINGS

None

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

The Annual Meeting of Stockholders was held on July 29, 2003. A quorum consisting of approximately 90% of our common stock issued and outstanding was represented either in person or by proxy. At the meeting the following proposals were approved by the stockholders:

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Annual Report on Form 10-K

For the Year Ended September 30, 2003

The results of the proposals are as follows:

PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock was initially traded on the American Stock Exchange under the symbol “SFO,” beginning with our initial public offering in April of 1998. On April 24, 2000, our common stock began trading on the Nasdaq National Market under the symbol “SOFO.” The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as reported on the Nasdaq National Market.

In October 2001, our common stock failed to maintain a minimum bid price of $1.00 per share for at least 10 consecutive days, which caused our stock price to fail to meet one of the minimum standards required by the Nasdaq Stock Market for continued listing as a Nasdaq National Market Security. We requested a hearing before a Nasdaq Listing Qualifications Panel to review the Staff Determination and made a presentation on February 27, 2003. At the hearing, we asked for and later received continued listing while pursuing the sale of the Desktop Software and Media Service business transactions. On June 27, 2003 we received a letter from a Nasdaq listing qualifications official indicating that we now demonstrated compliance with the minimum closing bid price requirement and that the hearing file was closed.

The Company has not paid any cash dividends and does not intend to pay any cash dividends in the foreseeable future.

At December 10, 2003 there were 484 common stockholders of record. Many shares are held by brokers and other institutions on behalf of shareholders.

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For the Year Ended September 30, 2003

Equity Compensation Plan Information

RECENT SALES OF UNREGISTERED SECURITIES

None.

ITEM 6.    SELECTED FINANCIAL DATA

The selected financial and operating data as of and for the years ended September 30, 2003, 2002, 2001, 2000 and 1999 were derived from our financial statements that have been audited by Ernst & Young LLP, independent auditors. The selected financial data set forth below is qualified in its entirety by, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and notes thereto appearing elsewhere in this annual report on Form 10-K (in thousands except per share data).

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Annual Report on Form 10-K

For the Year Ended September 30, 2003

RISK FACTORS

The occurrences or any of the following risks could materially and adversely affect our business, financial condition and operating results.

WE HAVE NO MEANINGFUL OPERATING HISTORY IN OUR MEDIA SYSTEMS BUSINESS ON WHICH TO EVALUATE OUR OPERATIONS OR PROSPECTS.

We have only been engaged in our Media Systems business since October 2001. Accordingly, there is no significant business history on which you can base an evaluation of our Media Systems business and its prospects. Our Media Systems business must therefore be evaluated in light of the risks, uncertainties, expenses and difficulties frequently encountered by companies in their early stages of development, particularly companies in new and evolving markets. These risks include the following with respect to our Media Systems business:

WE ANTICIPATE INCURRING LOSSES FOR THE FORESEEABLE FUTURE.

For the year ended September 30, 2003, the Media Systems business had a gross margin of $376 thousand on revenues of $1.3 million with which to cover sales, marketing, research, development and general administrative costs. Our sales, marketing, research, development and general administration costs are a large multiple of the revenues from our orders, due partly to the expense of developing leads and relatively long sales cycles involved in selling products that are not yet considered “mainstream” technology investments. For the year ended September 30, 2003, these expenses were over 6 times our total revenues. Although we expect our operating losses as a percentage of revenues to decline significantly in the near future, we expect them to continue to exceed our gross margin for the foreseeable future and we may never achieve profitability.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

WE MAY NOT EARN REVENUES SUFFICIENT TO REMAIN IN BUSINESS.

Our ability to generate revenue has been significantly reduced following the sale of our Desktop Software business that previously comprised approximately 65 percent of our revenues and the sale of our Media Services business which comprised approximately 32 percent of our revenues. Our ability to become profitable depends on whether we can sell our systems for more than it costs to produce and support them. Our future sales also need to provide sufficient margin to support our ongoing operating activities. The success of our revenue model will depend upon many factors including:

Because of the recession in the technology market, the early stage of our Media Systems business, and the evolving nature of our business, we cannot predict whether our revenue model will prove to be viable, whether demand for our systems will materialize at the prices we expect to charge, or whether current or future pricing levels will be sustainable. Our stock price and business viability is dependent upon our ability to grow our revenues and manage our costs.

WE MAY NEED TO RAISE ADDITIONAL CAPITAL IF WE DO NOT QUICKLY BECOME PROFITABLE.

Our cash used in operating activities was approximately $4.1 million for the year ended September 30, 2003. Based on our cash balance at September 30, 2003 of $12.6 million, we anticipate having sufficient working capital for at least the next twelve months. However, if we do not become profitable or our losses increase, we may need additional capital. The current business environment may not be conducive to raising additional financing. If we require additional financing, the terms of such financing may heavily dilute the ownership interests of current investors, and cause our stock price to fall significantly or we may not be able to secure financing upon acceptable terms at all.

WE HAVE ALLOCATED SIGNIFICANT PRODUCT DEVELOPMENT, SALES AND MARKETING RESOURCES TOWARD THE DEPLOYMENT OF OUR MEDIA SYSTEMS PRODUCTS, WE FACE A NUMBER OF RISKS THAT MAY IMPEDE MARKET ACCEPTANCE OF THESE PRODUCTS AND SUCH RISKS MAY ULTIMATELY PROVE OUR BUSINESS MODEL INVALID, THEREBY HURTING OUR FINANCIAL RESULTS.

We have invested significant resources into developing and marketing our Media Systems products and do not know whether our business model and strategy will be successful. The market for these products is in a relatively early stage and one of our key assumptions about the market is that digital video will continue to develop as a more relevant communication medium. We cannot predict how the market for our Media Systems products will develop, and part of our strategic challenge will be to convince enterprise customers of the productivity, improved communications, cost savings and other benefits of our Media Systems products. Our future revenues and revenue growth rates will depend in large part on our success in delivering these products effectively and creating market acceptance for these products. If we fail to do so, our products will not achieve widespread market acceptance, and we may not generate significant revenues to offset our development and sales and marketing costs, which will hurt our business. Additionally, our future success will continue to depend upon our ability to develop new products or product enhancements that address future needs of our target markets and to respond to these changing standards and practices.

In addition, resources may be required to fund development of our Media Systems products’ feature-sets beyond what we have planned due to unanticipated marketplace demands. We may determine that we are unable to fund these additional feature-sets due to financial constraints and may halt the development of a product at a stage that the marketplace perceives as immature. We may also encounter that the marketplace for a Media System product is not as robust as we had expected and we may react to this by leaving the development of a product at an early stage or combining key features of one or more of our Media Systems products into a single product. Either of these product development scenarios may impede market acceptance of any of our Media Systems products and therefore hurt our financial results.

THE LENGTH OF OUR SALES AND DEPLOYMENT CYCLE IS UNCERTAIN, WHICH MAY CAUSE OUR REVENUES AND OPERATING RESULTS TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER AND YEAR TO YEAR.

During our sales cycle, we spend considerable time and expense providing information to prospective customers about the use and benefits of our products without generating corresponding revenues. Our expense levels are relatively fixed in the short-term and

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based in part on our expectations of future revenues. Therefore, any delay in our sales cycle could cause significant variations in our operating results, particularly because a relatively small number of customer orders represent a large portion of our revenues.

We anticipate that some of our largest sources of revenues will be government entities and large corporations that often require long testing and approval processes before making a decision to license our products. In general, the process of selling our systems to a potential customer may involve lengthy negotiations. As a result, we anticipate that our sales cycle will be unpredictable. Our sales cycle will also be subject to delays as a result of customer-specific factors over which we have little or no control, including budgetary constraints and internal approval procedures.

Our Media Systems products are aimed toward a broadened business user base within our key markets. These products are relatively early in their product life cycles and we are relatively inexperienced with their sales cycle. We cannot predict how the market for our Media Systems products will develop and part of our strategic challenge will be to convince targeted users of the productivity, improved communications, cost savings and other benefits. Accordingly, it is likely that delays in our sales cycles with these Media Systems products will occur and this could cause significant variations in our operating results.

OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS DO NOT IMPROVE.

Our revenues are dependent on the health of the economy (in particular, the robustness of information technology spending) and the growth of our customers and potential future customers. The economic environment has not been favorable to companies involved in information technology infrastructure for several quarters. In addition, conflicts with countries such as Iraq create a great deal of uncertainty for businesses and this uncertainty generally results in businesses delaying investments in such areas as information technology. If the economic trend continues, our customers and potential customers may continue to delay or reduce their spending on our software and service solutions. When economic conditions for information technology products weaken, sales cycles for sales of software products and related services tend to lengthen and companies’ information technology and business until budgets tend to be reduced. Although we believe that economic conditions have improved somewhat over the past few months, if the economy weakens again or the conflict with Iraq or other countries worsens, our revenues could suffer and our stock price could decline.

THERE IS A GREAT DEAL OF COMPETITION IN THE MARKET FOR SYSTEMS SOFTWARE, WHICH COULD LOWER THE DEMAND FOR OUR SYSTEMS SOFTWARE.

The market for digital media systems is relatively new, and we face competition from other companies that provide digital media applications. Companies, like Webex, Placeware (Microsoft), and Raindance offer collaboration and web conferencing applications, while Microsoft, Macromedia and Accordent provide authoring capability and other competitors such as Autonomy offer an enterprise approach to webcasting that attempts to sell a full rich media database and indexing system on top of the webcasting solution. If one of these alternative approaches are received more favorably in the marketplace, a new approach or technology is developed or an existing or new competitor markets more effectively than us or we otherwise do not compete effectively, our business will be harmed. In addition, the more successful we are in the emerging market for media systems, the more competitors are likely to emerge, including turnkey media application; streaming media platform developers; digital music infrastructure providers; and digital media applications service providers (including for digital musical subscription). Many of our competitors have far greater financial resources than we do, and could easily overtake the marketplace and severely harm our business. We may also face competition from foreign suppliers and competition from LMS or education IT companies.

The presence of these competitors could reduce the demand for our systems, and we may not have the financial resources to compete successfully.

DUE TO OUR LICENSE AGREEMENT WITH CARNEGIE MELLON UNIVERSITY, WE MAY FACE COMPETITION IN OUR PUBLISHER(TM) PRODUCT AND WE MAY LOSE THE ABILITY TO SELL THAT PRODUCT IN THE FUTURE.

Our Publisher(TM) product, is based in part on licensed technology from Carnegie Mellon. As part of our acquisition of MediaSite’s assets in October 2001, we acquired a nonexclusive license to use certain technology in that product and negotiated an exclusive license (the “License Agreement”) as to certain competitors. Because the exclusivity is limited to a defined list of competitors, a risk exists that Carnegie Mellon could license the technology to another party that is not currently a named competitor, but could become competitive with us. Moreover, if the License Agreement were to terminate before the underlying patents expired, we would lose the ability to sell the products covered by the License Agreement.

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For the Year Ended September 30, 2003

WE LACK PERSONNEL TO EFFICIENTLY GROW OUR BUSINESS.

Due to the start-up nature of our business and our need to manage cash flow, we currently do not have a sufficient number of employees to efficiently grow our business. Our engineering staff is currently attempting to respond to the many demands to add features to our systems offering. Also, our sales staff is currently attempting to identify appropriate customer targets. Our failure to respond to engineering and sales needs by either adding additional personnel or by efficiently allocating existing personnel will harm our business.

OUR DISTRIBUTION CHANNELS ARE NEW AND UNPROVEN.

Audio/visual distributors have not committed to our systems products. Because our systems products are complicated, we may have difficulty in obtaining such commitments. In addition, Tandberg and Polycom, two prominent distributors, may displace us with a competitive offering, leaving us the need to find a new distribution source. If we cannot set up an efficient distribution channel, our business could be harmed.

THE TECHNOLOGY UNDERLYING OUR PRODUCTS, SERVICES AND SYSTEMS IS COMPLEX AND MAY CONTAIN UNKNOWN DEFECTS THAT COULD HARM OUR REPUTATION, RESULT IN PRODUCT LIABILITY OR DECREASE MARKET ACCEPTANCE OF OUR SYSTEMS.

The technology underlying our systems products is complex and includes software that is internally developed, software licensed from third parties and hardware purchased from third parties. These products may contain errors or defects, particularly when first introduced or when new versions or enhancements are released. We may not discover defects that affect our current or new applications or enhancements until after they are sold. Any defects in our products, services and systems could:

Our errors and omissions coverage may not be sufficient to cover our complete liability exposure.

MANY POTENTIAL CUSTOMERS MAY NOT RESPOND TO OUR WINDOWS-BASED OPERATING SYSTEM OR OUR CONTENT VIEWING AND STREAMING FORMATS.

The streaming format and security features found in MSL are based to a large extent on Microsoft technology and Windows Media. The combination of our engineering work and the utilization of Microsoft’s technology platform allow us to deliver this end to end content creation engine and develop further technologies in as rapid a fashion as possible. However, certain customers have been requesting other streaming formats, third party browser support, or third party operating system support. Likewise, Microsoft’s server solutions are typically viewed as middle market products, but are not yet generally utilized in mission critical large enterprise deployments. Our inability to respond to customer requests for different operating systems, content viewing or streaming formats may harm our business.

IF WE ARE VIEWED ONLY AS COMMODITY SUPPLIERS, OUR MARGINS AND VALUATIONS WILL SHRINK.

We need to provide value-added services in order to become less of a commodity supplier. This entails building long-term customer relationships. If we fail to do so, our margins will shrink, and our stock may become less valued to investors.

SERIAL BUYING MAY FAIL TO MATERIALIZE.

We need to sell multiple units to educational and corporate institutions in order to become profitable. While we have addressed a strategy to accomplish this, there can be no assurances we will be successful.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

OUR SECURITY SYSTEMS MAY NOT BE ADEQUATE.

Hacking is an endemic problem in the software industry. We need to provide protection against hackers, and we may not be able to do so. Our failure to provide protection against hackers may harm our business.

IF OTHER PARTIES BRING INFRINGEMENT OR OTHER CLAIMS AGAINST US, WE MAY INCUR SIGNIFICANT COSTS OR LOSE CUSTOMERS.

Other companies may obtain patents or other proprietary rights that would limit our ability to conduct our business and could assert that our technologies infringe their proprietary rights. We could incur substantial costs to defend any litigation, even if without merit, and intellectual property litigation could force us to cease using key technology, obtain a license, or redesign our products. In the course of our business, we may sell certain systems to our customers, and in connection with such sale, we may agree to indemnify these customers from claims made against them by third parties for patent infringement related to these systems. In particular, claims are currently being made by holders of patents against learning institutions using streaming in their curriculum. We could be subject to similar claims, which could harm our business.

WE MAY NOT BE SUCCESSFUL IN PROTECTING OUR INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS.

Our inability to protect our proprietary rights, and the costs of doing so, could harm our business. Our success and ability to compete partly depends on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of trademark, patent, copyright and trade secret laws, and confidentiality agreements with our employees and third parties. Recently, we have undertaken additional efforts to identify which of our proprietary processes and algorithms may be patentable, and we currently have several patent applications pending with the U.S. Patent and Trademark Office. If patents are not issued as a result of any of these applications, or if we cannot afford to enforce them, other parties may infringe on our proprietary rights.

Despite our efforts to protect our proprietary rights, unauthorized parties may copy or infringe aspects of our technology or trademarks, or obtain and use information we regard as proprietary. In addition, others may independently develop technologies that are similar or superior to ours, which could reduce the value of our intellectual property.

Companies in the computer industry have frequently resorted to litigation regarding intellectual property rights. We may have to litigate to enforce our intellectual property rights or to determine the validity and scope of other parties’ proprietary rights.

AN INVESTMENT IN OUR COMMON STOCK IS RISKY BECAUSE THE PRICE OF OUR STOCK HAS BEEN VOLATILE AND WE COULD BE DELISTED FROM THE NASDAQ NATIONAL MARKET.

Our common stock price, like that of many companies in the Internet industry, has been and may continue to be extremely volatile, and there is a risk we could be delisted from the NASDAQ National Market. The market price of our common stock has been and may continue to be subject to significant fluctuations as a result of variations in our quarterly operating results and volatility in the financial markets. Our stock has traded below $1.00 within the last several months, and we previously received notice from the NASDAQ National Market that we need to comply with the requirements for continued listing on the NASDAQ National Market or be delisted, although we have demonstrated compliance and the hearing file was closed. If our stock trades below $1.00 for 30 consecutive business days, we may receive another notice from the NASDAQ National Market that we need to comply with the requirements for continued listing on the NASDAQ National Market within 90 calendar days from such notification or be delisted. If our stock is delisted from the NASDAQ National Market, an investor could find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock. Additionally, our stock may be subject to “penny stock” regulations. If our common stock were subject to “penny stock” regulations, which apply to certain equity securities not traded on the NASDAQ National Market which have a market price of less than $5.00 per share, subject to limited exceptions, additional disclosure would be required by broker-dealers in connection with any trades involving such penny stock.

EXERCISE OF OUTSTANDING OPTIONS AND WARRANTS WILL RESULT IN FURTHER DILUTION.

The issuance of shares of common stock upon the exercise of our outstanding options and warrants will result in dilution to the interests of our stockholders, and may reduce the trading price and market for our common stock.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

As of December 10, 2003, we had outstanding options and warrants to acquire 6,693,120 shares of common stock, 917,741 of which are subject to future vesting. Included in the foregoing are 4,226,124 options which have been granted under our 1995 Employee Stock Option Plan, our 1999 Non-Qualified Stock Option Plan and our Non-Employee Director Stock Option Plan, 3,308,383 of which are immediately exercisable.

To the extent that these stock options or warrants are exercised, the dilution to the interests of our stockholders will likely occur. Additional options and warrants may be issued in the future at prices not less than 85% of the fair market value of the underlying security on the date of grant. Exercise of these options or warrants, or even the potential of their exercise may have an adverse effect on the trading price and market for our common stock. The holders of our options or our warrants are likely to exercise them at times when the market price of the common stock exceeds the exercise price of the securities. Accordingly, the issuance of shares of common stock upon exercise of the options and warrants will likely result in dilution of the equity represented by the then outstanding shares of common stock held by other stockholders. Holders of our options and warrants can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms which are more favorable to us than the exercise terms provided by these options and warrants.

RECENTLY ENACTED AND PROPOSED CHANGES IN SECURITIES LAWS AND REGULATIONS WILL INCREASE OUR COSTS AND MAY MAKE IT MORE DIFFICULT FOR US TO ATTRACT AND RETAIN OFFICERS AND DIRECTORS.

The Sarbanes-Oxley Act (“the Act”) of 2002 that became law in July 2002 requires changes in some of our corporate governance and securities disclosure and/or compliance practices. The Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made. We believe these developments will increase our legal and accounting compliance costs. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers. We are presently evaluating and monitoring regulatory developments and cannot reliably estimate the timing or magnitude of additional costs we will incur as a result of the Act or other, related legislation.

WE MAY NEED TO MAKE ACQUISITIONS OR FORM STRATEGIC ALLIANCES OR PARTNERSHIPS IN ORDER TO REMAIN COMPETITIVE IN OUR MARKET, AND POTENTIAL FUTURE ACQUISITIONS, STRATEGIC ALLIANCES OR PARTNERSHIPS COULD BE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS AND DILUTE STOCKHOLDER VALUE.

We may acquire or form strategic alliances or partnerships with other businesses in the future in order to remain competitive or to acquire new technologies. As a result of these acquisitions, strategic alliances or partnerships, we may need to integrate products, technologies, widely dispersed operations and distinct corporate cultures. The products, services or technologies of the acquired companies may need to be altered or redesigned in order to be made compatible with our software products and services, or the software architecture of our customers. These integration efforts may not succeed or may distract our management from operating our existing business. Our failure to successfully manage future acquisitions, strategic alliances or partnerships could seriously harm our operating results. In addition, our stockholders would be diluted if we finance the acquisition, strategic alliances or partnerships by incurring convertible debt or issuing equity securities.

SUBSTANTIAL SALES OF OUR COMMON STOCK COULD LOWER OUR STOCK PRICE.

Sales of a substantial number of shares of common stock in the public market, including 3.6 million shares issued to the former stockholders of MediaSite, Inc., which we registered in 2002, or the perception that these sales may occur, could adversely affect the market price of the common stock by potentially introducing a large number of sellers of our common stock into a market in which the common stock price is already volatile, thus driving the common stock price down. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional equity securities.

PROVISIONS OF OUR CHARTER DOCUMENTS AND MARYLAND LAW COULD ALSO DISCOURAGE AN ACQUISITION OF OUR COMPANY THAT WOULD BENEFIT OUR STOCKHOLDERS.

Provisions of our articles of incorporation and by-laws may make it more difficult for a third party to acquire control of our company, even if a change in control would benefit our stockholders. Our articles of incorporation authorize our board of directors, without stockholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

adversely affect or dilute the voting power of the holders of common stock. Furthermore, our articles of incorporation provide for classified voting, which means that our stockholders may vote upon the retention of only one or two of our five directors each year. Moreover, Maryland corporate law restricts certain business combination transactions with “interested stockholders.”

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

The financial and business analysis below provides information that the Company believes is relevant to an assessment and understanding of the Company’s consolidated financial position and results of operations. This financial and business analysis should be read in conjunction with the consolidated financial statements and related notes.

Overview

Our Media Systems business develops automated rich-media applications and scalable solutions that allow media owners—including entertainment companies, educational institutions, corporations and government organizations—to deploy, manage, index and distribute video content on IP-based networks.

Critical Accounting Policies

We have identified the following as critical accounting policies to our Company and have discussed the development, selection of estimates and the disclosure regarding them with the audit committee of the board of directors:

Revenue Recognition and Allowance for Doubtful Accounts

We recognize revenue for product sales and licensing of software products upon shipment, provided that collection is determined to be probable and no significant obligations remain. The Company does not offer rights of return and typically delivers products either to value added resellers based on end-user customer orders or direct to the end user. We sell post-contract support (“PCS”) contracts on our MSL units. Revenue is recorded separately from the sale of the product and recognized over the life of the support contract using vendor specific objective evidence of the value of the support services. Please refer to Note 1 of our Notes to Consolidated Financial Statements for further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to make estimates regarding the collectability of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of long-lived assets

We assess the impairment of goodwill and capitalized software development costs on an annual basis or whenever events or changes in circumstances indicate that the fair value of these assets is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

If we determine that the fair value of goodwill is less than its carrying value, based upon the annual test or the existence of one or more of the above indicators of impairment, we would then measure impairment based on a comparison of the implied fair value of goodwill with the carrying amount of goodwill. To the extent the carrying amount of goodwill is greater than the implied fair value of goodwill, we would record an impairment charge for the difference.

We evaluate all of our long-lived assets, including intangible assets other than goodwill, for impairment in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS 144 requires that long-lived

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

assets and intangible assets other than goodwill be evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. Should events indicate that any of our long-lived assets are impaired; the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired asset and recorded in earnings during the period of such impairment.

RESULTS OF OPERATIONS

Our systems business was established in fiscal 2002 upon the acquisition of MediaSite in October 2001. Our Media Services and Desktop Software businesses were sold in fiscal 2003 and reported under the caption of discontinued operations. Therefore, our 2001 results do not include any revenues nor cost of revenues and our operating expenses reflect only general overhead expenses not allocated to our discontinued Media Services and Desktop Software businesses. The sale of our Media Services and Desktop Software businesses significantly affect the comparability of our results of operations from year to year. You should read the following discussion of our results of operations and financial condition in conjunction with our consolidated financial statements and related notes thereto included in Item 8 of this Annual Report on Form 10-K.

Revenue

Revenue from our Media Systems business include the sales of our MediaSite Live product and related customer support contracts sold separately as well as fees charged for the licensing of software products and custom software development. The primary focus is on the platforms of MediaSite Publisher^™ and MediaSite Live^™. These products are marketed to government agencies, educational institutions, and corporations who need to deploy, manage, index and distribute video content on IP-based networks. We reach both our domestic and international markets through reseller networks, a direct sales effort and partnerships with system Integrators.

2003 compared to 2002

Revenue increased $405 thousand, or 47%, from $859 thousand in 2002 to $1.3 million in 2003.

Gross Margin from Systems Software

The significant components of cost of systems include:

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

Margins are expected to increase in the near term as: total revenues increase, non-cash amortization of purchased technology costs remains constant, and as the mix of revenues reflects a greater percentage of higher margin post contract support, consulting and publisher revenues.

Operating Expenses

Selling and Marketing Expenses

Selling and marketing expenses include wages and commissions for sales, marketing, business development and technical support personnel, print advertising and various promotional expenses for our products. Timing of these costs may vary greatly depending on introduction of new products and services or entrance into new markets.

2003 compared to 2002

Selling and marketing expenses increased by $427 thousand, or 17%, to $3.0 million in 2003 from $2.5 million in 2002, primarily attributable to the following:

Selling and marketing costs are expected to increase at a lower growth rate than revenues in the future.

General and Administrative Expenses (“G&A expenses”)

General and administrative (“G&A”) expenses consist of personnel and related costs associated with the facilities, finance, legal, human resource and information technology departments, as well as other expenses not fully allocated to functional areas.

2003 compared to 2002

G&A expenses increased $461 thousand, or 17%, from $2.7 million in 2002 to $3.2 million in 2003. The increase is due to:

2002 compared to 2001

G&A expenses in 2001 reflect general corporate overhead not included in operations of our discontinued Desktop Software and Media Services businesses.

Product Development Expenses (“R&D expenses”)

Product development expenses include salaries and wages of the software research and development staff and an allocation of benefits, facility and administrative expenses. Fluctuations in product development expenses correlate directly to changes in headcount.

2003 compared to 2002

R&D expenses decreased $1.3 million, or 43%, from $3.1 million in 2002 to $1.7 million in 2003. Attrition and workforces reductions of the now closed Pittsburgh location accounted for $900 thousand of the change. The reduction in staff reflects a decision to focus on the newer MediaSite Live product and offer no near term upgrades of the MediaSite Publisher product.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

Other Income (Expense)

Other expense in 2002 was impacted by the $514 thousand write-off of long-term investment, and interest income of $88 thousand. Other income of $539 in 2001 represents interest income when interest rates were higher and the Company had higher cash balances.

Discontinued Operations

In the fall of 2002, the Company determined that operations of our Desktop Software and Media Services business would not provide sufficient cash flow along with our existing cash reserves to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets. On May 16, 2003, we completed the sale of the assets used in our Media Services business to Deluxe Media Services for gross proceeds of $5.6 million cash, including an estimate of net working capital, plus assumption of certain leases and other obligations. On July 30, 2003 we completed the sale of the assets of our Desktop Software business to SP Acquisition Company, for $19.0 million cash and assumption of certain trade payables, accrued liabilities and capital leases associated with the Desktop Software business. We have accounted for the sale of both businesses as discontinued operations in accordance with SFAS No. 144 “Accounting for the Impairment and Disposal of Long-Lived Assets.” Accordingly, the results of the Media Services business and the Desktop Software business for all periods presented are included in the consolidated financial statements and MD&A as discontinued operations.

Details of the discontinued Media Services business are as follows:

Details of discontinued Desktop Software business are as follows:

Cumulative Effect of Changes in Accounting Principle, Amortization of Goodwill and Other Purchase Intangibles

Effective October 2001, the Company adopted Financial Accounting Standards Board (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” In accordance with SFAS No. 142, the Company ceased the amortization of goodwill associated with the services reporting unit, which included the acquisitions of STV Communications and International Image. Implementation of SFAS No. 142 also required an assessment of the carrying value of goodwill using a number of criteria, including the value of the

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

overall enterprise as of October 1, 2001. The Company retained an independent appraisal firm to assist in the assessment, which resulted in a $44.7 million write off of the entire remaining value of goodwill associated with the services reporting unit. Future impairment charges, if any, associated with MediaSite or other acquisitions will be reflected as an operating expense in the statement of operations.

LIQUIDITY AND CAPITAL RESOURCES

We have funded our operations to date primarily from public and private placement offerings of equity securities, debt, and from the 2003 sales of our Desktop Software and Media Services businesses. On September 30, 2003, 2002 and 2001, we had cash and cash equivalents of $12.6, $3.7 and $7.8 million.

2003 compared to 2002

Cash used in operating activities totaled $4.1 million in 2003 compared to $4.9 million in 2002. Fiscal 2002 had greater outflows related to accounts payable assumed in the MediaSite transaction and fiscal 2003 reflected improved collections from accounts receivable.

Cash provided by investing activities totaled $20.9 million in 2003 compared to a use of cash from investing activities of $1.7 million in 2002. Investing activities for the current year included net proceeds from the sale of the Company’s Media Services and Desktop Software businesses of $4.8 and $16.3 million, respectively.

In 2003, we recorded net cash used in financing activities of $7.9 million compared to $2.6 million provided by financing activities in 2002. In early 2003, we issued a bridge note of $1.0 million to the brother of Rimas Buinevicius, Chief Executive Officer and repaid the balance in full in July 2003. In addition, we closed a line of credit with a bank in Canada and paid the $451 thousand balance. We also made monthly and balloon payments totaling $7.2 million to certain convertible subordinated note holders and paid off the note holders in full in July 2003.

2002 compared to 2001

Cash used in operating activities totaled $4.9 million in 2002 compared to $10.2 million in 2001. The change related to a $6.7 million improvement in operating expenses, excluding 2001 restructuring charges, amortization, and write-off of prepaid Internet advertising. This improvement was offset slightly by payment of liabilities assumed in the MediaSite transaction.

Cash used in investing activities totaled $1.7 million in 2002 compared to $2.0 million in 2001. Investing activities in both years relate to fixed asset and acquisition related outflows. 2001 also included $1.2 million of proceeds from the sale of underutilized assets.

In 2002, net cash provided by financing activities was $2.6 million compared to net cash used in 2001 financing activities of $2.0 million. The most significant occurrences of 2002 were $6.5 million of net proceeds from subordinated debt and $2.4 million of payments to settle the remaining $3.3 million of notes (plus accrued interest) related to the International Image acquisition. The settlement also included 500 thousand shares of stock valued at $660 thousand. The difference between the principal and accrued interest balance and the settlement cost was recorded as a gain, net of certain legal and settlement costs. In addition, in 2002, we also incurred $248 thousand of debt related to a one-time deferred compensation plan.

Recent Developments Impacting Liquidity

The Company determined in the fall of 2002 that operations of our Desktop Software and Media Services businesses, along with our existing cash reserves, would not provide sufficient cash to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets and in May 2003, completed the sale of the Media Services business for approximately $5.6 million cash, including an estimate of $1.1 million for net working capital. In July 2003, we completed the sale of the Desktop Software business for $19.0 million cash, certain other consideration and assumption of certain trade payables, accrued liabilities and capital leases. Proceeds of the transactions were used to retire all outstanding indebtedness including convertible subordinated notes and a bridge loan.

The Company expects the proceeds of the asset sale transactions noted above to provide sufficient liquidity to fund operations for at least the next twelve months.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other financial instruments for which the fair value disclosure would be required under SFAS No. 133, “Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments.” The Company’s cash equivalents consist of overnight investments in money market funds that are carried at fair value. Accordingly, we believe that the market risk of such investments is minimal.

Interest Rate Risk

The Company’s cash equivalents are subject to interest rate fluctuations, however, we believe this risk is immaterial due to the short-term nature of these investments.

Foreign Currency Exchange Rate Risk

All international sales of our products are denominated in US dollars.

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Sonic Foundry, Inc.

Annual Report on Form 10-K

For the Year Ended September 30, 2003

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders Sonic Foundry, Inc.

We have audited the accompanying consolidated balance sheets of Sonic Foundry, Inc. (the Company) as of September 30, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended September 30, 2003. Our audits also included the financial statement schedule listed in the index at Item 16(a). The financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at September 30, 2003 and 2002 and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 12 to the financial statements, effective October 1, 2001, the Company changed its method of accounting for goodwill.

ERNST & YOUNG LLP

Milwaukee, Wisconsin

November 14, 2003

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Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)

See accompanying notes

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Sonic Foundry, Inc.

Consolidated Statements of Operations

(in thousands except for per share data)

See accompanying notes

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Sonic Foundry, Inc.

Consolidated Statements of Stockholders’ Equity

For the Years Ended September 30, 2003, 2002 and 2001

(in thousands)