Form 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended December 30, 2005

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Transition Period From                      To                     

 

Commission File Number: 001-32431

 

DOLBY LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   90-0199783
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

100 Potrero Avenue

San Francisco, CA

  94103-4813
(Address of principal executive offices)   ( Zip Code)

 

(Registrant’s telephone number, including area code) (415) 558-0200

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨    No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

On February 1, 2006, the registrant had 35,070,746 shares of Class A common stock, par value $0.001 per share, and 70,098,055 shares of Class B common stock, par value $0.001 per share, outstanding.

 



Table of Contents

DOLBY LABORATORIES, INC.

FORM 10-Q

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

 

Item 1.

 

Consolidated Financial Statements

    
   

Consolidated Balance Sheets as of September 30, 2005 and December 30, 2005

   2
   

Consolidated Statements of Operations for the Fiscal Quarters Ended December 31, 2004 and December 30, 2005

   3
   

Consolidated Statements of Cash Flows for the Fiscal Quarters Ended December 31, 2004 and December 30, 2005

   4
   

Notes to Consolidated Financial Statements

   5

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   13

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

   24

Item 4.

 

Controls and Procedures

   25
PART II – OTHER INFORMATION     

Item 1.

 

Legal Proceedings

   26

Item 1A.

 

Risk Factors

   26

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

   45

Item 6.

 

Exhibits

   45

Signatures

   46

 

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Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1 – CONSOLIDATED FINANCIAL STATEMENTS

 

DOLBY LABORATORIES, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

 

     September 30,
2005


    December 30,
2005


           (unaudited)

ASSETS

              

Current assets:

              

Cash and cash equivalents

   $ 372,403     $ 404,502

Restricted cash

     205       185

Accounts receivable, net of allowances

     25,221       30,381

Inventories

     11,722       10,409

Income tax receivable

     8,021       1,244

Deferred income taxes

     31,183       33,238

Prepaid expenses and other current assets

     5,433       3,336
    


 

Total current assets

     454,188       483,295

Property, plant and equipment, net

     76,462       75,258

Intangible assets, net

     17,184       16,576

Goodwill

     23,865       23,245

Long-term deferred income taxes

     6,781       7,282

Other assets

     7,797       8,115
    


 

Total assets

   $ 586,277     $ 613,771
    


 

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Current liabilities:

              

Accounts payable and accrued liabilities

   $ 65,126     $ 65,487

Income taxes payable

     3,054       1,579

Current portion of debt

     1,346       1,352

Deferred revenues

     3,268       5,121
    


 

Total current liabilities

     72,794       73,539

Long-term debt

     12,124       11,679

Other non-current liabilities

     21,956       22,390
    


 

Total liabilities

     106,874       107,608

Controlling interest

     18,264       18,144

Stockholders’ equity:

              

Class A common stock

     33       34

Class B common stock

     71       71

Additional paid-in capital

     308,354       293,174

Deferred stock-based compensation

     (26,422 )     —  

Retained earnings

     177,369       194,638

Accumulated other comprehensive income

     1,734       102
    


 

Total stockholders’ equity

     461,139       488,019
    


 

Total liabilities and stockholders’ equity

   $ 586,277     $ 613,771
    


 

 

See accompanying notes to consolidated financial statements

 

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DOLBY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

     Fiscal Quarter Ended

 
     December 31,
2004


    December 30,
2005


 
     (unaudited)  

Revenue:

                

Licensing

   $ 62,191     $ 68,982  

Product sales

     16,487       16,004  

Production services

     5,585       6,039  
    


 


Total revenue

     84,263       91,025  
    


 


Cost of revenue:

                

Cost of licensing

     16,149       6,601  

Cost of product sales (1)

     8,812       12,681  

Cost of production services (1)

     2,015       2,889  
    


 


Total cost of revenue

     26,976       22,171  
    


 


Gross margin

     57,287       68,854  
    


 


Operating expenses:

                

Selling, general and administrative (1)

     32,857       36,537  

Research and development (1)

     8,289       7,942  

Settlements

     (2,000 )     —    
    


 


Total operating expenses

     39,146       44,479  
    


 


Operating income

     18,141       24,375  

Other income, net

     287       3,699  
    


 


Income before provision for income taxes and controlling interest

     18,428       28,074  

Provision for income taxes

     7,743       10,486  
    


 


Income before controlling interest

     10,685       17,588  

Controlling interest in net income, net of tax

     (308 )     (319 )
    


 


Net income

   $ 10,377     $ 17,269  
    


 


Basic earnings per share

   $ 0.12     $ 0.17  

Diluted earnings per share

   $ 0.11     $ 0.16  

Weighted-average shares outstanding (basic)

     86,788       104,295  

Weighted-average shares outstanding (diluted)

     97,819       110,190  

Expense for royalties payable to related party

   $ 11,053     $ —    

Expense for rent payable to related party

     873       873  

(1) Stock-based compensation included above was classified as follows:

                

Cost of product sales

   $ 54     $ 202  

Cost of production services

     26       130  

Selling, general and administrative

     2,187       4,104  

Research and development

     681       673  
    


 


Total stock-based compensation

   $ 2,948     $ 5,109  
    


 


 

See accompanying notes to consolidated financial statements

 

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DOLBY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Fiscal Quarter Ended

 
     December 31,
2004


    December 30,
2005


 
     (unaudited)  

Operating activities:

                

Net income

   $ 10,377     $ 17,269  

Adjustments to reconcile net income to net cash provided by operating activities:

                

Depreciation and amortization

     2,327       3,110  

Stock-based compensation expense

     2,948       5,109  

Excess tax benefit from exercise of stock options

     —         (3,449 )

Provision for doubtful accounts

     586       75  

Deferred income taxes

     (2,055 )     (2,698 )

Other non-cash items affecting net income

     483       (84 )

Changes in operating assets and liabilities:

                

Restricted cash

     —         20  

Accounts receivable

     7,580       (5,405 )

Inventories

     (1,082 )     1,219  

Prepaid expenses and other current assets

     (1,739 )     1,891  

Accounts payable and accrued liabilities

     (3,789 )     586  

Accounts payable and accrued royalties due to related parties

     9,308       —    

Income taxes, net

     6,022       8,852  

Deferred revenues

     (242 )     2,135  

Other non-current liabilities

     282       77  
    


 


Net cash provided by operating activities

     31,006       28,707  
    


 


Investing activities:

                

Purchases of property, plant and equipment

     (4,966 )     (1,910 )

Acquisitions, net of cash acquired

     (256 )     —    

Purchase of intangible assets

     (11,002 )     —    

Proceeds from sale of equipment

     33       —    
    


 


Net cash used in investing activities

     (16,191 )     (1,910 )
    


 


Financing activities:

                

Payments on debt

     (322 )     (329 )

Proceeds from the exercise of Class B stock options

     468       1,258  

Issuance of Class A common stock from ESPP purchase

     —         1,501  

Excess tax benefit from exercise of stock options

     —         3,449  

Repurchases of Class B common stock

     (72 )     —    
    


 


Net cash provided by financing activities

     74       5,879  
    


 


Effect of foreign exchange rate changes on cash and cash equivalents

     487       (577 )
    


 


Net increase in cash and cash equivalents

     15,376       32,099  

Cash and cash equivalents at beginning of year

     78,711       372,403  
    


 


Cash and cash equivalents at end of quarter

   $ 94,087     $ 404,502  
    


 


Supplemental disclosure:

                

Cash paid for income taxes

   $ 3,772     $ 4,320  

Cash paid for interest

     283       242  

 

See accompanying notes to consolidated financial statements

 

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Table of Contents

DOLBY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

1. Summary of Business and Significant Accounting Policies

 

Dolby Laboratories, Inc. (Dolby Laboratories, we or us), a Delaware corporation, develops and delivers innovative products and technologies that make the entertainment experience more realistic and immersive in theatres, homes, automobiles and elsewhere. Ray Dolby, our principal stockholder, founded Dolby Laboratories in 1965 to develop noise reduction technologies. Today, we deliver a broad range of sound technologies for use in both professional and consumer applications. In recent years we have expanded our focus to include other technologies that facilitate the delivery of digital entertainment. We conduct our business on a global basis.

 

Unaudited Interim Financial Statements

 

The accompanying interim consolidated balance sheet as of December 30, 2005, the consolidated statements of operations for the fiscal quarters ended December 31, 2004 and December 30, 2005 and the consolidated statements of cash flows for the fiscal quarters ended December 31, 2004 and December 30, 2005 are unaudited. These interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In our opinion, the interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements for the year ended September 30, 2005 and include all adjustments necessary for fair presentation. The results for the fiscal quarter ended December 30, 2005 are not necessarily indicative of the results to be expected for any subsequent quarterly or annual financial period, including the fiscal year ending September 29, 2006. The fiscal quarter ended December 30, 2005 consisted of 13 weeks as compared to the fiscal quarter ended December 31, 2004, which consisted of 14 weeks. Our 2006 fiscal year consists of 52 weeks and ends on September 29, 2006. Our 2005 fiscal year consisted of 53 weeks and ended on September 30, 2005.

 

The accompanying interim financial statements are prepared in accordance with Securities and Exchange Commission rules and regulations, which allow certain information and footnote disclosures, normally included in annual financial statements, to be condensed or omitted. As a result, the accompanying interim financial statements should be read in conjunction with our consolidated financial statements for the year ended September 30, 2005, included in our Annual Report on Form 10-K and filed with the Securities and Exchange Commission.

 

Use of Estimates

 

The preparation of the consolidated financial statements in accordance with U.S. GAAP requires management to make certain estimates and assumptions that affect the amounts reported and disclosed in our consolidated financial statements and accompanying notes. Significant items subject to such estimates and assumptions include valuation allowances for receivables, inventories, goodwill, intangible assets, stock-based compensation and deferred income tax assets. Actual results could differ from our estimates.

 

Per Share Data

 

Basic earnings per share is computed by dividing net income by the weighted-average number of shares of Class A common stock and Class B common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted-average number of shares of Class A common stock and Class B common stock outstanding and the potential number of shares of dilutive Class A common stock and Class B common stock equivalents outstanding during the period. The dilutive shares are comprised entirely of options to purchase shares of Class A common stock and Class B common stock.

 

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Table of Contents

The following table sets forth the computation of basic and diluted earnings per share:

 

     Fiscal Quarter Ended

    

December 31,

2004


  

December 30,

2005


    

(unaudited)

(in thousands, except per share amounts)

Numerator:

             

Net income

   $ 10,377    $ 17,269
    

  

Denominator:

             

Weighted-average shares outstanding (basic)

     86,788      104,295

Common stock equivalents from options to purchase Class A common stock and Class B common stock

     11,031      5,895
    

  

Weighted-average shares outstanding (diluted)

     97,819      110,190
    

  

Basic earnings per share

   $ 0.12    $ 0.17

Diluted earnings per share

   $ 0.11    $ 0.16

 

A total of zero and 1,765,475 options were excluded from the calculation for the first quarter of fiscal 2005 and the first quarter of fiscal 2006, respectively, because their inclusion would have been anti-dilutive.

 

Stock-Based Compensation

 

On October 1, 2005, we adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS 123R) using the modified prospective application transition method. SFAS 123R requires measurement of all employee stock-based compensation awards using a fair-value method and recording of such expense in the consolidated financial statements over the requisite service period. Previously, we had applied the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations and elected to utilize the disclosure option of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). In the first quarter of fiscal 2006, we recorded stock-based compensation expense of $5.1 million under the fair-value provisions of SFAS 123R, compared to $2.9 million in the first quarter of fiscal 2005 under the provisions of APB 25 and related interpretations. In addition, the deferred compensation balance of $26.4 million related to stock-based awards accounted for under APB 25 as of September 30, 2005 was eliminated and there was a corresponding reduction in additional paid-in capital. See Note 4 “Stock-Based Compensation” for further discussion.

 

Comprehensive Income

 

Comprehensive income includes net income and foreign currency translation adjustments, which are reflected as a component of stockholders’ equity. The components of comprehensive income, net of tax, were as follows:

 

     Fiscal Quarter Ended

 
     December 31,
2004


   December 30,
2005


 
     (unaudited)  
     (in thousands)  

Net income

   $ 10,377    $ 17,269  

Other comprehensive income (loss):

               

Foreign currency translation adjustment, net of tax

     1,036      (1,632 )
    

  


Comprehensive income

   $ 11,413    $ 15,637  
    

  


 

2. Composition of Certain Financial Statement Captions

 

Restricted Cash

 

Restricted cash includes deposits from new customers that, in accordance with certain of our licensing agreements, remain in escrow until we have rightful ownership of the funds, which occurs upon delivery of certain materials.

 

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Table of Contents

Accounts Receivable

 

Accounts receivable consists of the following:

 

     September 30,
2005


    December 30,
2005


 
           (unaudited)  
     (in thousands)  

Trade accounts receivable, licensing

   $ 4,046     $ 6,628  

Trade accounts receivable, products and services

     9,349       9,083  

Amounts receivable related to patent administration program

     12,994       16,149  

Other accounts receivable

     862       641  
    


 


       27,251       32,501  

Less: Allowance for doubtful accounts

     (2,030 )     (2,120 )
    


 


Accounts receivable, net

   $ 25,221     $ 30,381  
    


 


 

Inventories

 

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

 

     September 30,
2005


   December 30,
2005


          (unaudited)
     (in thousands)

Raw material

   $ 2,376    $ 2,735

Work in process

     1,571      1,919

Finished goods

     7,775      5,755
    

  

Total

   $ 11,722    $ 10,409
    

  

 

Goodwill and Intangible Assets

 

Following is a summary of goodwill and intangible assets:

 

     September 30,
2005


    December 30,
2005


 
           (unaudited)  
     (in thousands)  

Amortized intangible assets:

                

Patents

   $ 4,489     $ 4,436  

Acquired technology

     3,796       3,745  

Other intangibles

     11,507       11,498  
    


 


       19,792       19,679  

Less: Accumulated amortization

     (2,608 )     (3,103 )
    


 


Intangible assets, net

   $ 17,184     $ 16,576  
    


 


Non-amortized intangible assets:

                

Goodwill

   $ 23,865     $ 23,245  
    


 


 

Amortization expense associated with our intangible assets was $0.2 million and $0.5 million for the first quarter of fiscal 2005 and 2006, respectively, and is included in cost of licensing, cost of product sales and selling, general and administrative expenses in the accompanying consolidated statements of operations. The decrease in goodwill from September 30, 2005 to December 30, 2005 was due to fluctuations in foreign exchange rates.

 

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Table of Contents

Accounts Payable and Accrued Liabilities

 

Accounts payable and accrued liabilities consist of the following:

 

     September 30,
2005


   December 30,
2005


          (unaudited)
     (in thousands)

Accounts payable

   $ 6,539    $ 4,393

Accrued compensation and benefits

     18,374      17,198

Accrued royalties

     4,762      6,069

Accrued professional fees

     2,495      2,538

Current portion of litigation settlement

     2,417      2,611

Amounts payable to patent pool partners

     23,303      25,927

Other accrued liabilities

     7,236      6,751
    

  

Total accounts payable and accrued liabilities

   $ 65,126    $ 65,487
    

  

 

3. Segment Information

 

Operating Segments

 

Our chief operating decision maker is our Chief Executive Officer (CEO). While the CEO evaluates results in a number of different ways, the primary basis for which the allocation of resources and financial results is assessed is by examining our business in two operating segments: our technology licensing segment and our products and services segment. The technology licensing segment licenses technology, trademarks and know-how to consumer electronics, personal computer, broadcast, automotive and professional audio companies and administers third-party patent-only licenses. The products and services segment provides professional products to movie theatres and to the recording, broadcast, cable and video post-production industries. Additionally, this segment provides services to broadcast, film production and distribution companies.

 

Accounting policies for each of the operating segments are the same as those used on a consolidated basis. Our reportable segment information for the fiscal quarters ended December 31, 2004 and December 30, 2005 is as follows:

 

     Revenue

     Fiscal Quarter Ended

     December 31,
2004


   December 30,
2005


    

(unaudited)

(in thousands)

Technology licensing

   $ 62,191    $ 68,982

Products and services

     22,072      22,043
    

  

Total revenue

   $ 84,263    $ 91,025
    

  

 

     Gross Margin

     Fiscal Quarter Ended

     December 31,
2004


   December 30,
2005


    

(unaudited)

(in thousands)

Technology licensing

   $ 46,042    $ 62,381

Products and services

     11,245      6,473
    

  

Total gross margin

   $ 57,287    $ 68,854
    

  

 

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Table of Contents
     Reconciliation to Income before
Provision for Income Taxes and
Controlling Interest


 
     Fiscal Quarter Ended

 
     December 31,
2004


    December 30,
2005


 
     (unaudited)  
     (in thousands)  

Total segment gross margin

   $ 57,287     $ 68,854  

Operating expenses

     (39,146 )     (44,479 )

Other income, net

     287       3,699  
    


 


Total income before provision for income taxes and controlling interest

   $ 18,428     $ 28,074  
    


 


 

Geographic Data

 

     Revenue by Geographic Region

     Fiscal Quarter Ended

     December 31,
2004


   December 30,
2005


     (unaudited)
     (in thousands)

United States

   $ 20,656    $ 22,991

International

     63,607      68,034
    

  

Total revenue

   $ 84,263    $ 91,025
    

  

 

Revenue by geographic region was determined based on the location of our licensees for licensing revenue, the location of our direct customers for product sales, and the location where services were performed for production services revenue. Revenue generated from customers in Japan accounted for 25% of total revenue in the first quarter of both fiscal 2005 and 2006. Revenue generated from customers in China accounted for 11% and 9% of total revenue for the first quarter of fiscal 2005 and 2006, respectively. In the first quarter of fiscal 2005 and 2006, no single customer accounted for more than 10% of total revenue.

 

We do not track capital expenditures or assets by geographic region. Consequently, it is not practical to show assets by geographic region.

 

4. Stock-Based Compensation

 

We utilize stock-based awards as a form of compensation for employees, officers, directors and non-employee consultants. On October 1, 2005, we adopted the provisions of SFAS 123R using the modified prospective application transition method. Under the modified prospective method, previously reported amounts should not be restated to reflect the provisions of SFAS 123R. The table below shows net income and earnings per share as if the fair-value method required by SFAS 123R had been applied to periods prior to our actual date of adoption:

 

     Fiscal Quarter
Ended


 
     December 31,
2004


 
     (unaudited)  
     (in thousands,
except per share
amounts)
 

Net income as reported

   $ 10,377  

Stock-based compensation included in net income as reported, net of tax

     2,709  

Stock-based compensation under the fair-value method, net of tax

     (3,525 )
    


Pro forma net income

   $ 9,561  
    


Basic earnings per share

        

As reported

   $ 0.12  

Pro forma

   $ 0.11  

Diluted earnings per share

        

As reported

   $ 0.11  

Pro forma

   $ 0.10  

 

For the first quarter of fiscal 2006, net income included $5.1 million in stock-based compensation expense and $3.8 million in tax benefits related to stock-based compensation arrangements. For the first quarter of fiscal 2005,

 

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net income included $2.9 million in stock-based compensation expense and no tax benefits related to stock-based compensation arrangements.

 

We have issued stock-based awards in the form of stock options, stock appreciation rights, employee stock purchase plans and stock grants. Below is a summary of the different types of stock-based awards issued under our stock plans:

 

Stock Options. We have granted stock options to our employees, officers and directors under our 2005 Stock Plan and our 2000 Stock Incentive Plan. Stock options are generally granted at fair market value on the date of grant. In connection with the preparation of the financial statements for our initial public offering, we applied hindsight to reassess the fair value of our common stock during fiscal 2004 and the first quarter of fiscal 2005. This resulted in stock options with grant prices that were lower than the reassessed fair value at the time of grant. Options granted to employees and officers generally vest over 4 years, with equal annual cliff-vesting and expire after 10 years or 3 months after termination of service. Options granted to outside directors generally vest over 3 years. All options granted vest over the requisite service period and are settleable through issuance of shares of Dolby Laboratories common stock. Upon the exercise of stock options, we issue new shares of Class B common stock under the 2000 Stock Incentive Plan and new shares of Class A common stock under the 2005 Stock Plan. We utilize a Black-Scholes option pricing model to determine the fair value of employee stock options at the date of grant. The fair value of our stock-based awards was estimated using the following weighted-average assumptions for the first quarter of fiscal 2005 and fiscal 2006:

 

     Fiscal Quarter Ended

 
     December 31,
2004


    December 30,
2005


 
     (unaudited)  

Expected term (in years)

   6.00     6.25  

Risk-free interest rate

   4.2 %   4.4 %

Expected stock price volatility

   82.4 %   50.0 %

Dividend yield

   -       -    

 

To determine the expected term of our employee stock options granted in the first quarter of fiscal 2006 we utilized the simplified approach as defined by SEC Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107), which resulted in an expected term of 6.25 years. To determine the risk-free interest rate we utilized an average interest rate based on U.S. Treasury instruments whose term was consistent with the expected term of our awards. To determine the expected stock price volatility we first examined historical volatilities for our common stock and those of our peers. In addition, we considered the implied volatilities of our publicly-traded options and those publicly-traded options of our peers with similar terms to those of our employee stock options. We then utilized a weighted average of historical and implied volatility to determine our expected stock price volatility.

 

Included in stock-based compensation expense for the first quarter of fiscal 2006 was $4.3 million related to employee stock options under the provisions of SFAS 123R, net of estimated forfeitures. Total unrecorded stock-based compensation cost at December 30, 2005 associated with employee stock options was $41.4 million, which is expected to be recognized over a weighted average period of 2.7 years.

 

Non-Employee Stock Options. We have also granted stock options to employees whose status changed to non-employee consultants subsequent to the dates of grant. In the first quarter of fiscal 2006, we recognized $0.7 million of stock-based compensation expense related to stock options issued to non-employee consultants. In accordance with Emerging Issues Task Force Issue 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (EITF 96-18), compensation cost for options issued to non-employee consultants is determined based on the fair value at the end of each reporting period. We utilized a Black-Scholes option pricing model to determine the fair value of the services provided, and recognize compensation over the service period.

 

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The following table summarizes information about stock options issued to officers, directors, employees and non-employee consultants under our 2000 Stock Incentive Plan and 2005 Stock Plan:

 

     Shares

   

Weighted

Average
Exercise Price


   Weighted
Average
Remaining
Contractual Life


   Aggregate
Intrinsic
Value


     (in thousands)          (in years)    (in thousands)

Options outstanding at September 30, 2005

   11,917     $ 4.11            

Grants

   195       16.68            

Exercises

   (739 )     1.69            

Cancellations

   (41 )     5.53            
    

                 

Options outstanding at December 30, 2005

   11,332     $ 4.48    7.6    $ 145,432
    

                 

Options exercisable at December 30, 2005

   4,459     $ 1.64    7.2    $ 68,728
    

                 

 

The following table summarizes the grant-date fair values for non-vested stock options during the period:

 

     Shares

    Weighted
Average
Grant-Date Fair
Value


     (in thousands)      

Non-vested options at September 30, 2005

   6,886     $ 7.99

Grants

   195       9.00

Vested

   (202 )     9.26

Forfeited

   (41 )     8.08
    

     

Non-vested options at December 30, 2005

   6,838     $ 7.97
    

     

 

The weighted-average fair values of stock options granted during the first quarter of fiscal 2005 and the first quarter of 2006 were $10.96 and $9.00 per option, respectively. The total intrinsic value of stock options exercised was $1.3 million and $11.2 million during the first quarter of fiscal 2005 and the first quarter of fiscal 2006, respectively.

 

The following table summarizes information about stock options outstanding and exercisable at December 30, 2005:

 

     Outstanding Options

   Options Exercisable

Range of Exercise Prices


   Shares

   Weighted
Average
Remaining
Contractual Life


   Weighted
Average
Exercise
Price


   Shares

   Weighted
Average
Exercise
Price


     (in thousands)    (in years)         (in thousands)     

$1.00 - $1.50

   4,003    5.6    $ 1.26    3,106    $ 1.26

$1.51 - $6.50

   5,647    8.4      2.56    1,353      2.51

$6.51 - $15.50

   151    9.2      14.72    —        —  

$15.51 - $22.75

   1,531    9.5      18.95    —        —  
    
              
      
     11,332                4,459       
                              

 

Stock Appreciation Rights. As of December 30, 2005, a total of 45,650 stock appreciation rights were outstanding. These awards have similar terms as our employee stock options, but are settled in cash rather than in shares of common stock and are classified as liability awards. Under APB 25, compensation cost for these awards was recognized at the intrinsic value. Under the provisions of SFAS 123R, compensation cost for these awards is determined using a fair-value method and remeasured at each reporting date until the date of settlement. To determine the fair value of these awards, we utilized a Black-Scholes option pricing model. Included in stock-based compensation expense in the first quarter of fiscal 2006 was $0.1 million related to stock appreciation rights.

 

Employee Stock Purchase Plan. We have an employee stock purchase plan (ESPP). During the first quarter of fiscal 2006, the terms of our ESPP were considered compensatory under the provisions of SFAS 123R because they contained a look-back provision. Therefore, we recorded stock-based compensation expense based on the fair value of the unvested awards as of the beginning of fiscal 2006. On November 15, 2005, we issued 100,956 shares of Class A common stock under the first ESPP offering. The second offering period started on November 16, 2005. The second and all future offerings are non-compensatory under SFAS 123R and, therefore, no future stock-based compensation expense is expected to be recognized associated with our ESPP. At December 30, 2005, there were

 

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899,044 shares of Class A common stock available for issuance under the ESPP. Included in stock-based compensation expense in the first quarter of fiscal 2006 was $0.1 million related to our ESPP.

 

5. Related Party Transactions

 

Prior to our initial public offering, we had licensing and royalty agreements with Ray Dolby and his affiliates for the use of patents on which a portion of our operations is based. Under these agreements we recorded expenses for royalty obligations to Ray Dolby of $11.1 million for the fiscal quarter ended December 31, 2004. These amounts are included in cost of licensing and cost of product sales in the accompanying consolidated statements of operations, depending on the nature of the licensed technology. On February 16, 2005, Ray Dolby contributed to us all rights in the intellectual property related to our business that he and his affiliates held. In connection with the asset contribution, our previous licensing arrangements with Ray Dolby terminated, and we have no further obligation to pay royalties to Ray Dolby. Consequently, we did not record any expenses for royalty obligations to Ray Dolby subsequent to February 16, 2005.

 

6. Legal Proceedings

 

In May 2001, we filed a lawsuit against Lucent Technologies, Inc. and Lucent Technologies Guardian I, LLC together “Lucent,” contending that Lucent was wrongly asserting that our licensees using Dolby AC-3 audio compression technology required licenses to the patents at issue and seeking a declaration that the patents at issue are not infringed and/or are invalid. Lucent filed a counterclaim alleging that we have infringed the patents at issue. These patents generally involve a process and means for digitally encoding and decoding audio signals. On April 22, 2005, the U.S. District Court for the Northern District of California granted our motions for summary judgment, finding that we have not infringed, induced others to infringe, or contributed to the infringement of the patents at issue. In granting summary judgment of non-infringement, the court found that Lucent had not presented evidence from which a reasonable fact-finder could find that Dolby AC-3 technology infringes the patents at issue. In light of the Court’s finding of non-infringement, it dismissed our claims that the Lucent patents are invalid. Lucent has appealed the court’s April 22, 2005 ruling granting summary judgment of non-infringement to the United States Federal Circuit Court of Appeals.

 

In March 1997, an unrelated third party filed a lawsuit against us alleging breach of a written agreement. In April 2002, we settled the dispute and agreed to pay a total of $30.0 million, without interest, in ten equal annual installments of $3.0 million per year beginning in June 2002. We recorded this liability at its present value of $24.2 million on the consolidated balance sheet using a discount rate of 5.125%, which approximated our incremental cost of borrowing rate. Interest related to this liability is recorded quarterly and is included in interest expense on the accompanying consolidated statements of operations. Other than such payments, neither party has any material obligations as a result of the settlement. As of December 30, 2005, we had $18.0 million remaining to be paid under this settlement.

 

In addition, we are involved in various legal proceedings from time to time arising from the normal course of business activities, including claims of alleged infringement of intellectual property rights, commercial, employment and other matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could materially affect our future operating results or financial condition in a particular period.

 

7. Subsequent Events

 

On December 31, 2005, we entered into lease agreements with our Chairman and founder Ray Dolby for the premises located at 100, 130, and 140 Potrero Avenue, San Francisco, California. We have leased our principal executive offices located at 100 Potrero Avenue, San Francisco, California since 1980, and the prior lease for this property expired on December 31, 2005. These leases were negotiated with the assistance of real estate brokers based on fair market rents and lease terms of comparable properties located in the area. We believe that these leases were entered into on a reasonable fair market basis.

 

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ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes that appear elsewhere in this Form 10-Q. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology. Forward-looking statements include, but are not limited to: statements regarding demand for and future revenues from the sale of consumer electronics products incorporating our products and/or services domestically and overseas; growth opportunities in the consumer electronics market; diversification of sources of licensing revenue; demand for and profitability of our professional products and services; our critical accounting policies, including those regarding goodwill, accounting for income taxes, personal holding company matters and stock-based compensation; foreign currency exchange risk and statements regarding the sufficiency of our cash reserves for the next twelve months. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including: the rate of growth of the DVD player market domestically and overseas; the rate of adoption of next-generation DVD players; the extent to which consumers elect to purchase lower-end DVD players; the extent to which professionals using our equipment continue to demand innovative technology solutions developed by us; the rate of conversion to digital cinema; our ability to tailor our traditional model of selling to respond to market trends; the accuracy of our identification of critical accounting policies and the accuracy of the assumptions we make in implementing such policies; the accuracy of our estimates regarding our cash needs for the next twelve months; and risks set forth in the section entitled “Risk Factors” and elsewhere in this filing. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results. The periods presented herein consist of our first quarters of fiscal years 2005 and 2006. Our fiscal quarter period ended December 31, 2004 consisted of 14 weeks, compared to the fiscal quarter ended December 30, 2005, which consisted of 13 weeks. Our 2006 fiscal year consists of 52 weeks and ends on September 29, 2006.

 

Overview

 

Dolby Laboratories develops and delivers innovative products and technologies that make the entertainment experience more realistic and immersive in theatres, homes, automobiles and elsewhere. Ray Dolby founded Dolby Laboratories in 1965 to develop noise reduction technologies. Today, we deliver a broad range of sound technologies for use in both professional and consumer applications. In addition, in recent years we have expanded our focus to include other technologies that facilitate the delivery of digital entertainment.

 

We conduct our business in two segments: our technology licensing segment and our products and services segment.

 

In our technology licensing segment, we work with manufacturers of integrated circuits, or ICs, to help them incorporate our technologies into their ICs. These manufacturers then sell ICs to consumer electronics product manufacturers that license our technologies for incorporation in products such as DVD players, DVD recorders, audio/video receivers, television sets, set-top boxes, video game consoles, portable audio and video players, personal computers and in-car entertainment systems. We also license our technologies to software developers who implement our technologies for use in personal computer software DVD players. Our licensing arrangements typically entitle us to receive a specified royalty for every product shipped by our consumer electronics product manufacturer and software developer licensees that incorporates our technologies. We do not receive royalties from IC manufacturers.

 

In our products and services segment, we sell professional products and related production services to filmmakers, broadcasters, music producers, video game designers, cinema operators and DVD producers. These products are used in sound recording, distribution and playback to improve sound quality, provide surround sound and increase the efficiency of sound storage and distribution. Our production services engineers work alongside artists and content producers throughout the world to help them record and reproduce the high quality sound they envision. Our engineers also work with cinema operators to help ensure that movie soundtracks are replayed with consistent high quality sound in their theatres.

 

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We are a global organization. We have licensed our technologies to manufacturers of consumer electronics products in nearly 30 countries, including countries in North America, Europe and Asia. In fiscal 2003, 2004, 2005, and the first quarter of fiscal 2006, revenue from licensees outside the United States represented 80%, 80%, 76% and 78% of our licensing revenue, respectively. Our licensees distribute consumer electronics products incorporating our technologies throughout the world. We sell our professional products and production services in over 50 countries. In fiscal 2003, 2004, 2005, and the first quarter of fiscal 2006, revenue from sales outside the United States represented 60%, 59%, 61% and 64% of our professional products sales and production services revenue, respectively. Nearly all of our revenue is derived from transactions denominated in United States dollars.

 

Management Discussion Regarding Opportunities, Challenges and Risks

 

Our Technology Licensing Segment

 

We categorize our technology licensing segment into a variety of markets:

 

    Consumer electronics market – primarily comprised of DVD players, DVD recorders, audio/video receivers and home-theatres-in-a-box.

 

    Personal computer market – primarily comprised of software DVD players.

 

    Broadcast market – primarily comprised of digital televisions and set-top boxes.

 

    Gaming market – primarily comprised of video game consoles.

 

    Automotive market – primarily comprised of in-car entertainment products.

 

    Licensing services – revenue from patent pool administration performed by our subsidiary Via Licensing.

 

Traditionally, the consumer electronics market has been our largest market representing over 50% of our licensing revenue and has been driven primarily by revenues attributable to DVD player sales. We anticipate that revenue from this market may remain flat or decline in fiscal 2006 due to the continued maturation of the market for traditional consumer DVD players. Also, the industry has experienced a movement by discount retailers towards lower-end Chinese-made DVD players which we believe poses challenges in royalty collection and intellectual property enforcement in China. Additionally, some manufacturers are reducing the complexity of their low-end DVD players, thereby decreasing the number of processors on which we earn licensing revenue.

 

There continues to be a number of growth opportunities in the consumer electronics market, such as next generation DVD players for high-definition content and recordable DVD players. In anticipation of the introduction of the next generation DVD players, we have worked with developers to ensure that our technologies will be included as a standard audio format. Our Dolby Digital, Dolby Digital Plus and MLP Lossless technologies have been selected as a mandatory standard audio format in the High-Definition Digital Versatile Disc (HD-DVD) format. Dolby Digital has been selected as a mandatory standard audio format and Dolby Digital Plus and MLP Lossless have been selected as optional audio standards in the Blu-ray format. However, the release and consumer adoption of next generation DVD players has been delayed due in part to the competing HD-DVD and Blu-ray formats. Consequently, we expect our ability to generate royalties from incorporation of our technology in next generation DVD players will also be delayed. Currently, adoption of recordable DVD players has been slower than anticipated.

 

We are continuing to diversify our sources of licensing revenue by actively promoting the incorporation of our technologies for use in new and growing markets such as personal computers, broadcast, gaming and automotive. The personal computing market, which represents over 25% of our licensing revenue, has been primarily driven by demand for software DVD players. Revenues generated from broadcast, gaming and automotive markets have been driven by demand for Dolby Digital in set-top boxes, televisions, video game consoles and in-car entertainment systems. Although these markets have been growing, there is a risk that future growth may not fully offset a potential decline in the growth of revenues generated from our consumer electronics market. For example, in an effort to offer lower cost business PCs, PC manufacturers may exclude software DVD players in their business-oriented offerings, which may result in lower than anticipated revenues.

 

We expect that sales of products incorporating our technologies in China and India will increase in the future, as consumers in these geographical markets have more disposable income and consequently increase purchases of entertainment products with surround sound capabilities for use in homes, automobiles and elsewhere, although there can be no assurance that this will occur. We also expect that Chinese manufacturers will increase production of

 

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these products in the future to satisfy this increased demand. Associated with opportunities of doing business in China are unique risks that have and will continue to affect our operating results, such as manufacturers failing to report or underreporting product shipments.

 

Our Products and Services Segment

 

We are committed to developing technologies for use by professionals in the entertainment industry. We believe that filmmakers, broadcasters, music producers and video game designers will continue to push for technology solutions to help create, distribute and play back rich, high quality sounds and images. As a result, we believe that major advances in sound, imaging and other technologies for the recording, delivery and playback of entertainment will likely first be introduced in products designed for use by professionals.

 

Sales of our professional products and production services tend to fluctuate based on the underlying trends in the motion picture industry. In part, this is because our products have been so widely adopted in this industry. When box office receipts for the motion picture industry increase, we have typically seen sales of our professional products increase as well, as cinema owners are more likely to build new theatres and upgrade existing theatres with our more advanced cinema products when they are doing well financially. Conversely, when box office receipts are down cinema owners tend to scale back on plans to upgrade their systems or build new theatres. Our professional product sales are also subject to fluctuations based on events and conditions in the cinema industry that may or may not be tied to box office receipts in particular periods. In fiscal 2005 and in the first quarter of fiscal 2006, decreased box office receipts and changes within the cinema industry, including recent restructuring and consolidations by U.S. cinemas, appear to have delayed purchasing decisions by cinema owners. To a lesser extent, the sale of our professional products is influenced by the launch of new digital services by broadcasters. Our production services revenue, both in the United States and internationally, is also tied to the strength of the motion picture production industry and, in particular, to the number of films being made by studios and independent filmmakers. The number of films that are produced can be affected by a number of factors, including strikes and work-stoppages within the motion picture industry, as well as by the tax incentive arrangements that many foreign governments provide filmmakers to promote local filmmaking.

 

We are also committed to helping the motion picture industry develop system solutions for digital cinema; this continues to be a major initiative in our products and services segment. Digital cinema offers the motion picture industry possible means to achieve substantial cost savings in printing and distributing movies, to combat piracy, and to enable movies to be played repeatedly without degradation in image and audio quality. It also provides additional revenue opportunities for cinema operators, as concerts and sporting events already in digital format could be broadcast live via satellite to digitally-equipped theatres. The cinema industry is in the early stages of the adoption of digital cinema for the distribution and exhibition of movies. As this market evolves, we are continuing to investigate other opportunities, in addition to our traditional model of selling our products directly to our customers. Industry participants are discussing various business models to facilitate adoption of digital cinema by allocating the costs among industry participants, but no arrangements have yet emerged as definitive business models that will result in significant installations of digital cinema systems. These opportunities have inherent risks. Digital cinema may require a significant investment per screen by cinema operators. If the market for digital cinema develops more slowly than we anticipate, or if our technologies, products and services for this market are not widely adopted, our significant investment in developing digital cinema technology may not yield the returns we anticipate. In addition, a number of competitors and potential competitors are developing similar or alternative solutions for digital cinema, some of which may provide cost or technological advantages over our products, technologies and services.

 

In an effort to encourage the motion picture industry to increase the pace of conversion to digital cinema, in the third quarter of fiscal 2005, we entered into a collaboration agreement with Walt Disney Pictures and Television to deploy digital cinema systems in selected theatres throughout the U.S. in connection with the theatrical release of Chicken Little in the first quarter of fiscal 2006. We funded the majority of the equipment and installation costs related to this deployment, resulting in a total expense of $1.4 million and $6.4 million to cost of product sales and cost of production services in the fourth quarter of fiscal 2005 and the first quarter of fiscal 2006, respectively. While the primary reason for this investment was to establish us as a leader in digital cinema, we also expect to receive a fee each time a digital print is delivered, which we refer to as a virtual print fee, from participating studios that deliver digital prints for exhibition on the systems installed in this deployment.

 

In recent years, our products and services segment has grown more slowly than our technology licensing segment. In addition, the profit margin for our products and services segment has been lower than our technology licensing segment and is expected to remain so. The future deployment of digital cinema equipment associated with the collaboration with Walt Disney Pictures and Television as well as other potential arrangements may have an impact on our gross margin.

 

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Pro Forma Presentation

 

Prior to our initial public offering, Ray Dolby retained ownership of the intellectual property he created related to our business and licensed those rights to us in exchange for royalty payments. In connection with our initial public offering, Ray Dolby contributed to us all of these intellectual property rights on February 16, 2005. As a result of this contribution, all of our licensing agreements with Ray Dolby terminated and we are no longer obligated to pay royalties to Ray Dolby for the use of his intellectual property rights. The pro forma financial information included in this discussion gives effect to the asset contribution as though it had been completed prior to the first quarter of fiscal 2005. We believe the pro forma results to be meaningful as they enable comparison of pre- and post-asset contribution on our operating results. The pro forma results presented below are not necessarily indicative of financial results to be achieved in future periods. The pro forma adjustments reverse the effects of $11.1 million in royalties payable to Ray Dolby that were recorded in the first quarter of fiscal 2005. As these agreements were terminated as a result of the contribution in the second quarter of fiscal 2005, there are no pro forma adjustments made to our results for the first quarter of fiscal 2006.

 

The following table shows the pro forma effects of the asset contribution made by Ray Dolby described above on the respective line items of our consolidated statements of operations:

 

     Fiscal Quarter Ended

     December 31,
2004


    December 30,
2005


    

(unaudited)

(in thousands)

Net income

   $ 10,377     $ 17,269

Adjustments to pro forma net income by line item:

              

Cost of licensing

     10,151       —  

Cost of product sales

     902       —  

Provision for income taxes

     (4,517 )     —  
    


 

Pro forma net income

   $ 16,913     $ 17,269
    


 

 

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The following pro forma results presented below are not necessarily indicative of the results expected for any subsequent quarterly or annual financial period, including the fiscal year ending September 29, 2006:

 

     Fiscal Quarter Ended

 
     December 31,
2004


    December 30,
2005


 
     (pro forma)        
     (unaudited)  
     (in thousands, except per share amounts)  

Revenue:

                

Licensing

   $ 62,191     $ 68,982  

Product sales

     16,487       16,004  

Production services

     5,585       6,039  
    


 


Total revenue

     84,263       91,025  
    


 


Cost of revenue:

                

Cost of licensing

     5,998       6,601  

Cost of product sales (1)

     7,910       12,681  

Cost of production services (1)

     2,015       2,889  
    


 


Total cost of revenue

     15,923       22,171  
    


 


Gross margin

     68,340       68,854  
    


 


Operating expenses:

                

Selling, general and administrative (1)

     32,857       36,537  

Research and development (1)

     8,289       7,942  

Settlements

     (2,000 )     —    
    


 


Total operating expenses

     39,146       44,479  
    


 


Operating income

     29,194       24,375  

Other income, net

     287       3,699  
    


 


Income before provision for income taxes and controlling interest

     29,481       28,074  

Provision for income taxes

     12,260       10,486  
    


 


Income before controlling interest

     17,221       17,588  

Controlling interest in net income, net of tax

     (308 )     (319 )
    


 


Net income

   $ 16,913     $ 17,269  
    


 


Basic earnings per share

   $ 0.19     $ 0.17  

Diluted earnings per share

   $ 0.17     $ 0.16  

Weighted-average shares outstanding (basic)

     86,788       104,295  

Weighted-average shares outstanding (diluted)

     97,819       110,190  

(1) Stock-based compensation included above was classified as follows:

                

      Cost of product sales

   $ 54     $ 202  

      Cost of production services

     26       130  

      Selling, general and administrative

     2,187       4,104  

      Research and development

     681       673  
    


 


Total stock-based compensation

   $ 2,948     $ 5,109  
    


 


 

Critical Accounting Policies

 

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The preparation of these financial statements in accordance with U.S. GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company’s financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. We have discussed the selection and development of the critical accounting policies with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed our related disclosures in this Form 10-Q. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.

 

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The following are our critical accounting policies because we believe they are both important to the portrayal of our financial condition and results of operations and require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected. See “Risk Factors” for certain matters bearing risks on our future results of operations.

 

Revenue Recognition

 

We evaluate revenue recognition for transactions to sell products and services and to license technology, trademarks and know-how using the criteria set forth by the SEC in Staff Accounting Bulletin 104, “Revenue Recognition” (SAB 104). SAB 104 states that revenue is recognized when each of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured.

 

Licensing. Our licensing revenue is primarily derived from royalties paid to us by licensees of our intellectual property rights, including patents, trademarks and know-how. Royalties are recorded at their gross amounts and are recognized when all revenue recognition criteria have been met. We make judgments as to whether collectibility can be reasonably assured based on the licensee’s recent payment history or the existence of a standby letter-of-credit between the licensee’s financial institution and our financial institution. In the absence of a favorable collection history or a letter-of-credit, we recognize revenue upon receipt of cash, provided that all other revenue recognition criteria have been met.

 

Product Sales and Production Services. Our revenue from the sale of products is recognized when the risk of ownership has transferred to our customer as provided under the terms of the governing purchase agreement, typically the invoice we deliver to the customer, and all the other revenue recognition criteria have been met. Generally, these purchase agreements provide that the risk of ownership is transferred to the customer when the product is shipped. Production services revenue is recognized as the services related to a given project are performed and all the other revenue recognition criteria have been met.

 

Allowance for Doubtful Accounts

 

We continually monitor customer payments and maintain a reserve for estimated losses resulting from our customers’ inability to make required payments. In determining the reserve, we evaluate the collectibility of our accounts receivable based upon a variety of factors. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations, we record a specific allowance against amounts due, and thereby reduce the net recognized receivable to the amount reasonably believed to be collectible. For all other customers, we recognize allowances for doubtful accounts based on our actual historical write-off experience in conjunction with the length of time the receivables are past due, customer creditworthiness and geographic risk. Actual future losses from uncollectible accounts may differ from our estimates and may have a material effect on our consolidated statements of operations and our financial condition. Our allowance for doubtful accounts totaled $2.1 million at December 30, 2005. An incremental change of 1% in our allowance for doubtful accounts as a percentage of trade accounts receivables would have a $0.2 million increase or decrease in our operating results.

 

Goodwill

 

We account for goodwill in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 142, among other things, established new standards for goodwill acquired in a business combination, eliminated the amortization of goodwill and requires the carrying value of goodwill and certain non-amortizing intangibles to be evaluated for impairment on an annual basis. As required by SFAS 142, we perform an impairment test on recorded goodwill by comparing the estimated fair value of each of our reporting units to the carrying value of the assets and liabilities of each unit, including goodwill. This value is determined by using a discounted cash-flow model which considers a number of factors, including estimated future cash-flows, risks facing us and our current market capitalization. If the carrying value of the assets and liabilities of the reporting units, including goodwill, were to exceed our estimation of the fair value of the reporting units, we would record an impairment charge in an amount equal to the excess of the carrying value of goodwill over the implied fair value of the goodwill. Our fiscal 2005 impairment test of goodwill, which was performed in the third fiscal quarter, resulted in no impairment charge. Fluctuations in our fair value, which may result from changes in economic conditions, our results of operations and other factors, relative to the carrying value, could result in impairment charges in future periods.

 

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Accounting for Income Taxes

 

In preparing our consolidated financial statements, we are required to make estimates and judgments that affect our accounting for income taxes. This process includes estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences, including differences in the timing of recognition of stock-based compensation expense, result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. We also assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent that we believe that recovery is not likely, we have established a valuation allowance.

 

Significant judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and the valuation allowance against our deferred tax assets. Our financial position and results of operations may be materially impacted if actual results significantly differ from these estimates or the estimates are adjusted in future periods.

 

Personal Holding Company Tax Matters. For United States federal income tax purposes, a corporation is generally considered to be a “personal holding company” under the United States Internal Revenue Code if (i) at any time during the last half of its taxable year more than 50% of its stock by value is owned, directly or indirectly, by virtue of the application of certain stock ownership attribution rules set forth in the Internal Revenue Code for purposes of applying the personal holding company rules, by five or fewer individuals and (ii) at least 60% of its adjusted ordinary gross income, as defined for United States federal income tax purposes, is “personal holding company income.” Personal holding company income is generally passive income, including royalty income, subject to certain exceptions such as qualifying software royalties. A personal holding company is subject to an additional tax on its undistributed after-tax income, calculated at the statutory tax rate, which is currently 15%. Since the personal holding company tax is imposed only on undistributed income, a personal holding company can avoid or mitigate liability for the tax, but not interest or penalties, by paying a dividend to its stockholders.

 

During fiscal 2005, and the first quarter of fiscal 2006, more than 50% of the value of our stock was held by Ray Dolby and stockholders considered affiliated with him pursuant to the stock ownership attribution rules applicable to personal holding companies. We expect this will continue to be the case in the foreseeable future. In addition, a significant portion of our income is from licensing fees, which may constitute personal holding company income. Currently, however, less than 60% of Dolby Laboratories’ adjusted ordinary gross income is personal holding company income.

 

Stock-Based Compensation

 

In the first quarter of fiscal 2006, we adopted the provisions of SFAS 123R for accounting for share-based payment arrangements. SFAS 123R requires measurement of all employee stock-based compensation awards using a fair-value method and recording of such expense in the consolidated financial statements over the requisite service period. We estimate the fair value of stock options and employee stock purchase plan awards using the Black-Scholes valuation model as permitted by the provisions of SFAS 123R and SAB 107. To determine the fair value of our stock-based awards at the date of grant using the Black-Scholes model, we make assumptions about the expected stock price volatility of our common stock, employee exercise patterns, risk free interest rates, and expected dividend yield. Limitations on the effectiveness of the Black-Scholes option pricing model are that it was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable, and that the model requires the use of highly subjective assumptions including expected stock price volatility. In addition, under the provisions of SFAS 123R, we are required to make assumptions about the expected rate of forfeitures for our stock-based awards. Due to the limited amount of data available to us, particularly with respect to stock-price volatility, employee exercise patterns and forfeitures, actual results can differ from our assumptions.

 

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Results of Operations

 

Revenue

 

     Fiscal Quarter Ended

    Change

 
     December 31,
2004


    December 30,
2005


    $

    %

 
     (unaudited)                    
     ($ in thousands)  

Revenue:

                              

Licensing

   $ 62,191     $ 68,982     $ 6,791     11 %

Percentage of total revenue

     74 %     76 %              

Product sales

     16,487       16,004       (483 )   (3 %)

Percentage of total revenue

     19 %     17 %              

Production services

     5,585       6,039       454     8 %

Percentage of total revenue

     7 %     7 %              
    


 


 


 

Total revenue

   $ 84,263     $ 91,025     $ 6,762     8 %
    


 


 


 

 

Licensing. The $6.8 million, or 11%, increase in licensing revenue from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was primarily due to increased sales by our licensees of their products that incorporate our technologies. The growth was driven by increases in revenue from our personal computer (PC) and gaming markets, and to a lesser extent, by our broadcast and automotive markets, as well as from revenue generated by our Via Licensing subsidiary. The increase in the PC market was driven by growth in sales of personal computer software DVD players. The growth in the gaming, broadcast and automotive markets was driven by sales of video game consoles, set-top boxes, digital televisions and in-car entertainment systems that incorporate our technologies. These increases were offset by a decrease in revenue from our consumer electronics market, primarily due to the continued maturation of the market for traditional DVD players and movement by manufacturers to reduce the complexity of their low-end DVD players, thereby decreasing the number of processors on which we earn licensing revenue.

 

Product Sales. The $0.5 million, or 3%, decrease in our product sales revenue from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was principally attributable to a $1.2 million decrease in sales of our cinema products from the first quarter of fiscal 2005 primarily driven by continued weakness in world-wide box office receipts. This decrease was partially offset by an increase in broadcast product sales in Europe as broadcasters continued to increase their capabilities for broadcasting in Dolby Digital 5.1 surround sound.

 

Production Services. The $0.5 million, or 8%, increase in production services revenue from the first quarter of fiscal 2005 was primarily attributable to an increase related to services provided on international films, foreign language versions of those films and, to a lesser extent, services provided to encrypt films for awards group presentations.

 

Gross Margin

 

     Actual
Fiscal Quarter Ended


    Pro Forma
Fiscal Quarter Ended


 
     December 31,
2004


    December 30,
2005


    December 31,
2004


    December 30,
2005


 
     (unaudited)  

Gross margin:

                        

Licensing gross margin percentage

   74 %   90 %   90 %   90 %

Product sales margin percentage

   47 %   21 %   52 %   21 %

Production services gross margin percentage

   64 %   52 %   64 %   52 %
    

 

 

 

Total gross margin percentage

   68 %   76 %   81 %   76 %
    

 

 

 

 

Licensing Gross Margin. We license to our customers intellectual property that may be internally developed, acquired by us or licensed from other parties. Our cost of licensing consists principally of royalty obligations to third parties for the licensing of intellectual property rights that we sublicense as part of our licensing arrangements with our customers. Our cost of licensing also includes amortization expenses associated with purchased intangible assets. Prior to February 16, 2005, our cost of licensing included royalty obligations to Ray Dolby. On February 16, 2005, Ray Dolby contributed to us all rights in the intellectual property related to our business that he and his affiliates held. In connection with the asset contribution, our previous licensing arrangements with Ray Dolby terminated, and we have no further obligation to pay royalties to Ray Dolby. The increase in licensing gross margin

 

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from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was due primarily to the elimination of royalty obligations to Ray Dolby as a result of the February 2005 contribution of his intellectual property rights.

 

Pro forma licensing gross margin for the first quarter of fiscal 2005 excludes $10.2 million of expenses we recorded for sublicensing royalty obligations to Ray Dolby.

 

Product Sales Gross Margin. Cost of product sales primarily consists of material costs related to the products sold, applied labor and manufacturing overhead and, to a lesser extent, amortization of certain intangible assets. In addition, cost of product sales includes a $5.7 million charge recorded in the first quarter of fiscal 2006 in connection with our digital cinema collaboration with Walt Disney Pictures and Television discussed above in our product and services segment overview in the “Management Discussion Regarding Opportunities, Challenges and Risks” section. Prior to February 16, 2005, our cost of product sales also included royalty obligations for technologies we licensed from Ray Dolby. These royalty obligations terminated in connection with Ray Dolby’s asset contribution discussed above. In the first quarter of fiscal 2005, we recorded $0.9 million in royalty expenses to cost of product sales in connection with these obligations. The decrease in product sales gross margin for the first quarter of fiscal 2006 was primarily due to the charge recognized in connection with our digital cinema collaboration, partially offset by an increase due to the elimination of royalties due to Ray Dolby.

 

The decrease in pro forma product gross margin was due to the charge associated with the digital cinema collaboration discussed above, but was partially offset by higher than expected production levels, which reduced our actual per-unit overhead costs.

 

Production Services Gross Margin. Cost of production services consists of the payroll and benefits costs of employees performing our professional services, the cost of outside consultants and reimbursable expenses incurred on behalf of customers. In the first quarter of fiscal 2006, we recorded a charge of $0.7 million related to the digital cinema collaboration with Walt Disney Pictures and Television discussed above. Due to this charge, production services gross margin decreased from the first quarter of fiscal 2005 to the first quarter of fiscal 2006. Pro forma production services gross margin is not affected by royalty obligations to Ray Dolby.

 

Operating Expenses

 

     Fiscal Quarter Ended

    Change

 
     December 31,
2004


    December 30,
2005


    $

    %

 
     (unaudited)              
     ($ in thousands)  

Operating expenses:

                              

Selling, general and administrative

   $ 32,857     $ 36,537     $ 3,680     11 %

Percentage of total revenue

     39 %     40 %              

Research and development

     8,289       7,942       (347 )   (4 )%

Percentage of total revenue

     10 %     9 %              

Settlements

     (2,000 )     —         2,000     —    

Percentage of total revenue

     (2 %)     —                  
    


 


 


 

Total operating expenses

   $ 39,146     $ 44,479     $ 5,333     14 %
    


 


 


 

 

Selling, General and Administrative. Selling, general and administrative expense consists primarily of personnel and personnel-related expenses, facility costs and professional service fees for our sales, marketing and administrative functions. The $3.7 million, or 11%, increase from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was principally due to a $1.9 million increase in stock-based compensation expense due to the adoption of SFAS 123R, a $1.4 million increase in compensation and benefits costs due to growth in headcount and annual pay rates coupled with a $0.6 million rise in occupancy costs to accommodate our headcount growth. In addition, we incurred a $0.8 million charge in the first quarter of fiscal 2006 associated with recognizing the results of our subsidiary, Lake Technology Limited, on a current basis rather than one quarter in arrears, as well as increases in depreciation expense due to amortization of software implementations and leasehold improvements completed in fiscal 2005 and professional and consulting expenses due to IT support services. These increases were partially offset by a decrease of $1.5 million in promotional expenses as well as the inclusion of an additional week in the first quarter of fiscal 2005 compared to the 13 weeks included in the first quarter of fiscal 2006.

 

Research and Development. Research and development expense consists primarily of compensation and benefits related costs for personnel responsible for the research and development of new technologies and products. The $0.3 million, or 4%, decrease in research and development expense from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was primarily driven by the inclusion of an additional week in the first quarter of fiscal 2005 compared to the 13 weeks of the first quarter of fiscal 2006 as well as a decrease in engineer consulting costs, partially offset by increased compensation and benefits costs due to growth in headcount and annual pay rates.

 

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Settlements. Settlements include interest and penalties related to the collection of royalties and resolution of disputes in our favor or against us. Settlements of royalty disputes from licensees that specifically represent unpaid royalties are recorded as licensing revenue in the period payment is received, if all other revenue recognition criteria have been met. Settlements of other disputes, such as disputes with implementation licensees from which we typically do not receive royalties, are recorded as settlements. In the first quarter of fiscal 2005, we recognized $2.0 million in connection with the settlement of disputes with two of our implementation licensees regarding violation of the terms of their licensing agreements with us.

 

Other Income, Net

 

     Fiscal Quarter Ended

   Change

 
     December 31,
2004


   December 30,
2005


   $

   %

 
     (unaudited)            
     ($ in thousands)  

Other income, net

   $ 287    $ 3,699    $ 3,412    1,189 %

 

Other income, net, primarily consists of interest income earned on cash and cash equivalent balances, offset by interest expense on outstanding balances on our facility debt obligations. Also included are gains and losses on interest rate swap agreements associated with our facility debt obligations and foreign exchange rate fluctuations. Other income, net was $3.7 million in the first quarter of fiscal 2006 compared to $0.3 million in the first quarter of fiscal 2005. The increase in the first quarter of fiscal 2006 was primarily due to increased interest earned on our higher cash and cash equivalent balances as a result of the February 2005 IPO.

 

Income Taxes

 

     Actual
Fiscal Quarter Ended


    Pro Forma
Fiscal Quarter Ended


 
     December 31,
2004


    December 30,
2005


    December 31,
2004


    December 30,
2005


 
     (unaudited)  
     ($ in thousands)  

Income taxes:

                                

Provision for income taxes

   $ 7,743     $ 10,486     $ 12,260     $ 10,486  

Effective tax rate

     42 %     37 %     42 %     37 %

 

Our effective tax rate is based upon projection of annual fiscal year results. In the first quarter of fiscal 2005, our effective tax rate was 42%, while our effective tax rate for fiscal 2005 was 41%. Our effective tax rate for the first quarter of fiscal 2006 was 37%, lower than in the first quarter of fiscal 2005, primarily due to a smaller loss from a foreign subsidiary compared to the first quarter of fiscal 2005 and a change in the classification of certain stock-based awards. We expect our effective tax rate for fiscal year 2006 to be approximately 40% to 43%.

 

Liquidity and Capital Resources

 

Our financial position includes cash and cash equivalents of $372.4 million and $404.5 million at September 30, 2005 and December 30, 2005, respectively. We believe that our cash, cash equivalents and potential cash flow from operations will be sufficient to satisfy our cash requirements through at least the next 12 months.

 

Operating Activities

 

Our principal sources of liquidity are our cash and cash equivalents as well as the cash flow we generate from our operations. Cash provided by operating activities is net income adjusted for certain non-cash items and changes in certain asset and liability balances. Our operating activities generated net cash of $31.0 million and $28.7 million in the first quarter of fiscal 2005 and the first quarter of fiscal 2006, respectively. The decrease in cash flow provided by operations from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was due primarily to an increase in accounts receivable balances related to patent pool administration activities compared to the same quarter of fiscal 2005 and a decrease in accounts payable to related parties, partially offset by an increase in net income and fluctuations in operating assets and liabilities.

 

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Investing Activities

 

Our investing activities are primarily related to capital expenditures associated with the purchases of office equipment, building fixtures, computer hardware and software, leasehold improvements and production and test equipment, as well as purchases of intangible assets, such as rights to certain technologies.

 

Cash used in investing activities decreased $14.3 million from the first quarter of fiscal 2005 to the first quarter of fiscal 2006. In the first quarter of fiscal 2005, we made an $11.0 million payment for an exclusive irrevocable right to sublicense a third party’s technology to our customers. Capital expenditures decreased $3.1 million from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 primarily related to the completion of leasehold improvements and ERP implementations that occurred in fiscal 2005.

 

Financing Activities

 

In the first quarter of fiscal 2006, cash provided by financing activities increased $5.8 million compared to the first quarter of fiscal 2005 primarily due to tax benefits from the exercise of stock options and cash received from the exercise of stock options and the issuance of common stock related to our ESPP plan.

 

In the first quarter of fiscal 2006, we adopted SFAS 123R, using the modified prospective application transition method. Prior to our adoption of SFAS 123R, excess tax benefits from the exercise of stock options were reported as operating cash flows. SFAS 123R requires excess tax benefits be reported as a financing activity rather than as a reduction of taxes paid in operating activities.

 

Personal Holding Company Tax Matters

 

If we or any of our subsidiaries were to become liable for personal holding company tax, we expect that it is likely that instead of paying the personal holding company tax, we would elect to pay a dividend to our stockholders in an amount equal to all or a significant part of our undistributed personal holding company income. We expect that we would pay such a dividend out of our available working capital, which could significantly decrease our cash, unless we sought additional financing for this purpose. Any such financing might not be available on terms acceptable to us or at all. If instead of paying a dividend we elect to pay the tax, this could significantly increase our consolidated tax expense. We expect we would pay any such tax out of our available working capital, which could also significantly decrease our cash, unless we sought additional financing. For an explanation of personal holding company tax, refer to our “Critical Accounting Policies – Accounting for Income Taxes” for further explanation of matters related to personal holding tax.

 

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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Interest Rate Sensitivity

 

Cash and Cash Equivalents. As of December 30, 2005, we had cash and cash equivalents of $404.5 million, which consisted of highly liquid money market instruments with original maturities of three months or less. Utilizing our cash balance as of December 30, 2005, a hypothetical 1.0% change in interest rates would result in a $4.0 million impact to our interest income over a one-year period.

 

Interest Rate Swap Agreements. We have entered into interest rate swap agreements to manage our exposure to interest rate changes on our facility debt obligations. The swap agreements involve the exchange of fixed and variable interest rate payments without exchanging the notional principal amount. Gains and losses associated with the swap agreements are included in other income, net, in our consolidated statements of operations.

 

We do not utilize financial instruments for trading or other speculative purposes, nor do we utilize leveraged financial instruments.

 

Foreign Currency Exchange Risk

 

We maintain sales, marketing and business operations in foreign countries, most significantly in the United Kingdom. Consequently, we have exposure to adverse changes in exchange rates associated with our foreign business operations. Nearly all of our revenue is derived from transactions denominated in United States dollars. In fiscal 2005, we began selling more products in United States dollars from our United Kingdom branch and maintained the receipts in a United States dollar account in the United Kingdom. The functional currency of our United Kingdom branch is the British pound sterling. Therefore, we were required to remeasure balances that were in currencies other than the functional currency and recognize the impact of these foreign exchange rate fluctuations in our results of operations. As the balance in the account grew throughout fiscal 2005, our results of operations became exposed to foreign exchange gains and losses. In the first quarter of fiscal 2006, we converted much of the balance into British pound sterling, thereby greatly mitigating the exposure from fluctuations in foreign exchange rates on our statement of operations.

 

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ITEM 4 – CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

Subject to the limitations noted above, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the fiscal period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to ensure that information we are required to disclose in reports under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in our internal control over financial reporting during the fiscal quarter ended December 30, 2005, that have materially affected or are reasonably likely to affect, our internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

In May 2001, we filed a lawsuit against Lucent Technologies, Inc. and Lucent Technologies Guardian I, LLC together “Lucent,” contending that Lucent was wrongly asserting that our licensees using Dolby AC-3 audio compression technology required licenses to the patents at issue and seeking a declaration that the patents at issue are not infringed and/or are invalid. Lucent filed a counterclaim alleging that we have infringed the patents at issue. These patents generally involve a process and means for digitally encoding and decoding audio signals. On April 22, 2005, the U.S. District Court for the Northern District of California granted our motions for summary judgment, finding that we have not infringed, induced others to infringe, or contributed to the infringement of the patents at issue. In granting summary judgment of non-infringement, the court found that Lucent had not presented evidence from which a reasonable fact-finder could find that Dolby AC-3 technology infringes the patents at issue. In light of its finding of non-infringement, the court dismissed our invalidity claims. Lucent has appealed the court’s April 22, 2005, ruling granting summary judgment of non-infringement to the United States Federal Circuit Court of Appeals.

 

In addition, we are involved in various legal proceedings from time to time arising from the normal course of business activities, including claims of alleged infringement of intellectual property rights, commercial, employment and other matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could materially affect our future operating results or financial condition in a particular period.

 

ITEM 1A. RISK FACTORS

 

Because of the following factors, as well as other variables affecting our operating results and financial condition, past performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.

 

Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, our business will be materially harmed.

 

Maintaining and strengthening the “Dolby” brand is critical to maintaining and expanding both our products and services business and our technology licensing business, as well as to our ability to enter new markets for our sound and other technologies. Our continued success is due, in part, to our reputation for providing high quality products, services and technologies across a wide range of entertainment industries, including the consumer electronics products industry. If we fail to promote and maintain the Dolby brand successfully on either the products and services or the licensing sides of our business, our business and prospects will suffer. Moreover, we believe that the likelihood that our technologies will be adopted as industry standards in various markets and for various applications depends, in part, upon the strength of our brand, because professional organizations and industry participants are more likely to accept, as an industry standard, technologies developed by a well-respected and well-known brand. Maintaining and strengthening our brand will depend heavily on our ability to continue to develop innovative technologies for the entertainment industry and to continue to provide high quality products and services, which we may not do successfully. Moreover, because we engage in relatively little direct brand advertising, the promotion of our brand depends upon entertainment industry participants displaying our trademarks on their products that incorporate our technologies, such as film prints and consumer electronics products. Although we do not require our customers to place our brand on their products, we actively encourage them to do so. For example, we rely on consumer electronics product manufacturers that license our technologies to display our trademarks on their products in order to promote our brand. If our customers choose for any reason not to display our trademarks on their products, our ability to maintain or increase our brand awareness may be harmed, which would have an adverse effect on our business and prospects. In addition, if we fail to maintain high quality standards for our professional products, or if we fail to maintain high quality standards for the products that incorporate our technologies through the quality-control certification process that we require of our licensees, the strength of our brand could be adversely affected.

 

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We expect sales of traditional consumer DVD players to remain flat or decline in fiscal 2006. If this occurs, or alternative technologies in which we do not participate replace DVDs as a dominant medium for consumer video entertainment, our licensing revenue will be adversely affected.

 

Growth in our revenue over the past several years has been the result, in large part, of the rapid growth in sales of DVD players and home theatre systems incorporating our technologies. However, as the markets for DVD players mature, we expect sales of traditional consumer DVD players and consequently, revenue from our consumer electronics market, to remain flat or decline in fiscal 2006. Also, the industry has experienced a movement by discount retailers towards lower-end Chinese-made DVD players, which we believe will pose challenges in royalty collection and intellectual property enforcement in China. Additionally, some manufacturers are reducing the complexity of their low-end DVD players thereby decreasing the number of processors on which we earn licensing revenue. To the extent that sales of DVD players and home theatre systems continue to level off or decline, our licensing revenue will be adversely affected. Additionally, the adoption of recordable DVD players has been slower than anticipated and the market introduction of next generation DVD players has been delayed. There are currently two potential, incompatible formats for next generation high definition disk format proposed, and consumers might not react favorably to having to make a choice between formats. A delay in the release and consumer adoption of the next generation disk format, as well as the continued current pace of adoption of recordable DVD players, could adversely affect our licensing revenue. In addition, if new technologies are developed for use with DVDs or new technologies are developed that substantially compete with or replace DVDs as a dominant medium for consumer video entertainment, and if we are unable to develop and successfully market technologies that are incorporated into or compatible with such new technologies, our business, operating results and prospects will be adversely affected.

 

We are dependent on the sale by our licensees of products that incorporate our technologies, and a reduction in those sales would adversely affect our licensing revenue.

 

We derive most of our revenue from the licensing of our technologies to consumer electronics product manufacturers. We derived 73%, 73% and 75% of our total revenue from our technology licensing business in fiscal 2003, 2004 and 2005, respectively. We do not manufacture consumer electronics products ourselves and our licensing revenue is dependent on sales by our licensees of products that incorporate our technologies. We cannot control these manufacturers’ product development or commercialization efforts or predict their success. In addition, our license agreements, which typically require manufacturers of consumer electronics products and software developers to pay us a specified royalty for every electronics product shipped that incorporates our technologies, do not require these manufacturers to include our technologies in any specific number or percentage of units, and only a few of these agreements guarantee us a minimum aggregate licensing fee. Accordingly, if our licensees sell fewer products incorporating our technologies, or otherwise face significant economic difficulties, our revenue will decline. Some manufacturers have begun to reduce the complexity of their low-end DVD players, thereby decreasing the number of processors on which we earn licensing revenue in each player. Moreover, we have a widespread presence in certain markets for electronics products, such as the consumer electronics product market, which includes DVD players, audio/video receivers and other home theatre consumer electronics products, and, as a result, there is little room for us to further penetrate such markets. Lower sales of products incorporating our technologies could occur for a number of reasons. Changes in consumer tastes or trends, or changes in industry standards, may adversely affect our licensing revenue. Demand for new products incorporating our technologies could also be adversely affected by increasing market saturation, durability of products in the marketplace, competing products and alternate consumer entertainment options. In addition, our licensees, for whatever reason, may not choose to or may not be able to incorporate our technologies into their products in the future.

 

We face risks with respect to conducting business in China due to China’s historically limited recognition and enforcement of intellectual property and contractual rights.

 

We expect consumer electronics product manufacturing in China to continue to increase due to the lower manufacturing cost structure there as compared to other industrial countries. We also expect that our sales of professional products and production services in China will expand in the future to the extent that the use of digital surround sound technologies increases in China, including in movies, broadcast television and video games. We further expect that the sale of products incorporating our technologies will increase in China to the extent that Chinese consumers become more affluent. However, we face many risks in China, in large part due to China’s historically limited recognition and enforcement of contractual and intellectual property rights. The consumer electronics industry has experienced a movement by discount retailers towards lower-end Chinese-made DVD players, posing challenges for us in royalty collection and intellectual property enforcement in China. In particular, we have many times experienced, and expect to continue to experience, problems with Chinese consumer electronics product manufacturers failing to report or underreporting shipments of their products that incorporate our technologies or incorporating our technologies and trademarks into their products without our authorization and without paying us any licensing fees, which adversely affects our operating results. We may also experience

 

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difficulties in enforcing our intellectual property rights in China, where intellectual property rights are not as respected as they are in the United States, Japan and Europe. In addition, we have only limited patent protection in China, especially with respect to our Dolby Digital technologies, which may make it more difficult for us to enforce our intellectual property rights in China. We believe that it is critical that we strengthen existing relationships and develop new relationships with entertainment industry participants in China to increase our ability to enforce our intellectual property and contractual rights in China without relying solely on the Chinese legal system. If we are unable to develop, maintain and strengthen these relationships, our revenue from China could be adversely affected. However, developing, maintaining and strengthening relationships in China is especially difficult because of the multiple Chinese cultures and resulting fragmented nature of the Chinese economy. As a result, we must develop, maintain and strengthen relationships at each step of the entertainment chain in many different regions of China in order to successfully enforce our intellectual property and contractual rights in China.

 

If we fail to develop and deliver innovative technologies in response to changes in the entertainment industry, our business could decline.

 

The markets for our professional products and the markets for consumer electronics products using our licensed technologies are characterized by rapid change and technological evolution. We will need to expend considerable resources on research and development in the future in order to continue to design and deliver enduring, innovative entertainment products and technologies. Despite our efforts, we may not be able to develop and effectively market new products, technologies and services that adequately or competitively address the needs of the changing marketplace. In addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic, such as the shift from VHS tapes to DVDs for consumer playback of movies in homes and elsewhere. Our future success depends to a great extent on our ability to develop and deliver innovative technologies that are widely adopted in response to changes in the entertainment industry and that are compatible with the technologies or products introduced by other entertainment industry participants.

 

Our operating results may fluctuate depending upon when we receive royalty reports from our licensees.

 

Our quarterly operating results may fluctuate depending upon when we receive royalty reports from our licensees. We recognize license revenue only after we receive royalty reports from our licensees regarding the shipment of their products that incorporate our technologies. As a result, the timing of our revenue is dependent upon the timing of our receipt of those reports. In addition, it is not uncommon for royalty reports to include positive or negative corrective or retroactive royalties that cover extended periods of time. Furthermore, there have been times in the past when we have recognized an unusually large amount of licensing revenue from a licensee in a given quarter because not all of our revenue recognition criteria were met in prior periods. This can result in a large amount of licensing revenue from a licensee being recorded in a given quarter that is not necessarily indicative of the amounts of licensing revenue to be received from that licensee in future quarters, thus causing fluctuations in our operating results.

 

If our products and technologies fail to be adopted as in industry standards, our business prospects could be limited and our operating results could be adversely affected.

 

The entertainment industry depends upon industry standards to ensure the compatibility of its content across a wide variety of entertainment systems and products. Accordingly, we make significant efforts to design our products and technologies to address capabilities, quality and cost considerations so that they either meet, or, more importantly, are adopted as, industry standards across the broad range of entertainment industry markets in which we participate, as well as the markets in which we hope to compete in the future, including digital cinema. To have our products and technologies adopted as industry standards, we must convince a broad spectrum of professional organizations throughout the world, as well as our major customers and licensees who are members of such organizations, to adopt them as such and to ensure that other industry standards are consistent with our products and technologies. If our technologies are not adopted or do not remain as industry standards, our business, operating results and prospects could be materially and adversely affected. We expect that meeting, maintaining and establishing industry standard technologies will continue to be critical to our business in the future. In addition, the market for broadcast technologies has traditionally been heavily based upon industry standards, often set by governments or other regulatory bodies, and we expect this to continue to be the case in the future. If our technologies are not chosen as industry standards for broadcasting in particular geographic areas, this could adversely affect our ability to compete in these markets.

 

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It may be more difficult for us, in the future, to have our technologies adopted as individual industry standards to the extent that entertainment industry participants collaborate on the development of industry standard technologies.

 

Increasingly, standards-setting organizations are adopting or establishing technology standards for use in a wide-range of consumer electronics products. As a result, it is more difficult for individual companies to have their technologies adopted wholesale as an informal industry standard. We call this type of standard a “de facto” industry standard, meaning that the standard is not explicitly mandated by any industry standards-setting body but is nonetheless widely adopted. In addition, increasingly there are a large number of companies, including ones that typically compete against one another, involved in the development of new technologies for use in consumer entertainment products. As a result, these companies often license their collective intellectual property rights as a group, making it more difficult for any single company to have its technologies adopted widely as a de facto industry standard or to have its technologies adopted as an exclusive, explicit industry standard for consumer electronics products.

 

Even if our technologies are adopted as an industry standard for a particular market, market participants may not widely adopt our technologies.

 

Even when our technologies are mandated for a particular market by a standards-setting body, which we call an “explicit” industry standard, our technologies may not be the sole technologies adopted for that market as an industry standard. Accordingly, our operating results depend upon participants in that market choosing to adopt our technologies instead of competitive technologies that also may be acceptable under such standard. For example, the continued growth of our revenue from the broadcast market will depend upon both the continued adoption of digital television generally and the choice to use our technologies where it is an optional industry standard.

 

Our relationships with entertainment industry participants are particularly important to our products and services and our technology licensing businesses, and if we fail to maintain such relationships our business could be materially harmed.

 

If we fail to maintain and expand our relationships with a broad range of participants throughout the entertainment chain, including motion picture studios, broadcasters, video game designers, music producers and manufacturers of consumer electronics products, our business and prospects could be materially harmed. Relationships have historically played an important role in the entertainment industries that we serve, both on the professional and consumer sides of our business. For example, our products and services business is particularly dependent upon our relationships with the major motion picture studios and broadcasters, and our technology licensing business is particularly dependent upon our relationships with consumer electronics product manufacturers, software developers and integrated circuit, or IC, manufacturers. If we fail to maintain and strengthen these relationships, these entertainment industry participants may be more likely not to purchase and use our products, services and technologies, or create content incorporating our technologies, which could materially harm our business and prospects. In addition to directly providing substantially all of our revenue, these relationships are also critical to our ability to have our technologies adopted as industry standards. Moreover, if we fail to maintain our relationships, or if we are not able to develop relationships in new markets in which we intend to compete in the future, including markets for new technologies and expanding geographic markets such as China and India, our business, operating results and prospects could be materially and adversely affected. In addition, if major industry participants form strategic relationships that exclude us, whether on the products and services side or the licensing side of our business, our business and prospects could be materially adversely affected.

 

Third parties from whom we license technologies may challenge our calculation of the royalties we owe them for inclusion of their technologies in our products and licensed technologies, which could adversely affect our operating results, business and prospects.

 

In some cases, primarily in connection with the licensing of our Dolby Digital technologies, the products we sell and the technologies we license to our customers include intellectual property that we have licensed from third parties. Our agreements with these third parties generally require us to pay them royalties for that use, and give the third parties the right to audit our calculation of those royalties. As a result of such an audit, a third party could challenge the accuracy of our calculation. A successful challenge could increase the amount of royalties we have to pay to the third party, decrease our gross margin and adversely affect our operating results. Such a challenge could also impair our ability to continue to use and re-license intellectual property from that third party, which could adversely affect our business and prospects.

 

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We rely on our licensees to accurately prepare royalty reports in determining our licensing revenue, and if these reports are inaccurate, our operating results could be materially adversely affected.

 

Our licensing revenue is generated primarily from consumer electronics product manufacturers and software developers who license our technologies and incorporate them in their products. Under our existing arrangements, these licensees typically pay us a specified royalty for every product they ship that incorporates our technologies. We rely on our licensees to accurately report the number of units shipped that incorporate our technologies. We calculate our license fees, prepare our financial reports, projections and budgets, and direct our sales and product development efforts based on these reports we receive from our licensees. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately. This is especially true with respect to software incorporating our technologies because software can be copied relatively easily and we oftentimes do not have easy ways to determine how many copies have been made. Most of our license agreements permit us to audit our licensees’ records, but audits are generally expensive and time consuming and initiating audits could harm our customer relationships. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to which we are entitled, which would adversely affect our operating results. Conversely, to the extent that our licensees overstate the number of products incorporating our technologies, or report the products under the wrong categories, negative corrections could result in reductions of royalty revenue in subsequent periods. In addition, some of our licensees may begin to more closely scrutinize their past or future licensing statements which may result in an increased receipt of negative corrective statements.

 

Our licensing revenue depends in large part upon semiconductor manufacturers incorporating our technologies into integrated circuits, or ICs, for sale to our electronics product licensees and if, for any reason, our technologies are not incorporated in these ICs or fewer ICs are sold that incorporate our technologies, our operating results would be adversely affected.

 

Our licensing revenue from consumer electronics product manufacturers depends in large part upon the availability of integrated circuits, or ICs, that implement our technologies. IC manufacturers incorporate our technologies into these ICs, which are then incorporated in consumer electronics products. We do not manufacture these ICs, but rather depend on IC manufacturers to develop, produce and then sell them to licensed consumer electronics product manufacturers. We do not control the IC manufacturers’ decision whether or not to incorporate our technologies into their ICs, and we do not control their product development or commercialization efforts nor predict their success. As a result, if these IC manufacturers are unable or unwilling, for any reason, to implement our technologies into their ICs, or if, for any reason, they sell fewer ICs incorporating our technologies, our operating results will be adversely affected.

 

Our future success depends, in part, upon the growth of new and existing markets for our technologies and our ability to develop and adapt our technologies for those markets. If such markets fail to grow or we are unable to develop successful products for them, our business prospects could be limited.

 

We expect that the future growth of our licensing revenue will depend, in part, upon the growth of, and our successful participation in, new opportunities for our technologies, including:

 

    Digital television and radio broadcasting;

 

    HDTV;

 

    Personal computer technology;

 

    Video game consoles and video games;

 

    Home DVD recording;

 

    In-car entertainment systems;

 

    DVD-Audio;

 

    Personal audio and video players, including Internet music applications;

 

    Broadband Internet; and

 

    Mobile devices.

 

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The development of these markets depends on increased consumer demand for products that contain our technologies, which may not occur. Any failure of such markets to develop or consumer demand to grow would have a material adverse effect on our business and prospects. For example, in an effort to offer lower cost business PCs, PC manufacturers may exclude software DVD players in their business-oriented offerings, which may result in lowered demand for our technology. In another example, only a small number of automobile manufacturers currently offer in-car entertainment systems incorporating our surround sound technologies, and most of those that do limit those systems only to certain models. Additional manufacturers may not offer surround sound entertainment systems, and, even if they do, the car models on which surround sound may be offered are likely to be, at least initially, limited to the high end of these manufacturers’ lines. Whether our revenue from digital broadcast networks and broadband Internet services increases depends upon the expansion of digital broadcast technologies and broadband Internet as a medium of entertainment, which may not occur. In addition, even when our technologies are adopted as industry standards for a particular market, such market may not be fully developed. In such case, our success depends not only on whether our technologies are adopted as industry standards for such market, but also on the development of that market, which may not occur. Demand for our technologies in any of these developing markets may not continue to grow, and a sufficiently broad base of consumers and professionals may not adopt or continue to use these technologies. In addition, our ability to generate revenue from these markets may be limited to the extent that service providers in these markets choose to provide certain technologies and entertainment for little or no cost, such as many of the services provided in connection with broadband Internet services. Moreover, some of these markets are ones in which we have not previously participated and, because of our limited experience, we may not be able to adequately adapt our business and our technologies to the needs of customers in these fields.

 

If we do not identify opportunities and successfully execute our initiatives to participate in the emerging digital cinema market, our future prospects could be limited and our business could be adversely affected.

 

The cinema industry is in the early stages of the adoption of digital cinema for the distribution and exhibition of movies. Industry participants are discussing various business models to facilitate adoption of digital cinema by allocating the costs among industry participants, but no arrangements have yet emerged as definitive business models that will result in significant installations of digital cinema systems. If we do not identify, and successfully execute on, the business models that result in generating revenues from our digital cinema products and services, our future prospects in this market will be limited and our business could be adversely affected. Participating in some of the models under discussion may require us to depart from our traditional model of selling our professional products pursuant to one-time contracts, and could expose us to various risks we have not faced in the past. Furthermore, some of these models could cause our product sales and services margins to decline. For example, in the third quarter of fiscal 2005, we entered into a collaboration agreement with Walt Disney Pictures and Television to deploy digital cinema systems in selected theatres throughout the U.S. In connection with this deployment, we incurred charges of $1.4 million and $6.4 million in the fourth quarter of fiscal 2005 and the first quarter of fiscal 2006, respectively. We may incur similar charges in the future.

 

If the market for digital cinema does not develop, our future prospects could be limited and our business could be adversely affected.

 

The conversion of movie theatres from film to digital cinema will require significant expenditures, and we cannot predict how quickly digital cinema will become widely adopted, if at all. There are at present only a very limited number of movie theatres that have been converted to digital cinema and we expect that the conversion of theatres to digital cinema technologies, if it occurs, will be a long-term process due to both technological and financial obstacles. Depending on the business models that emerge, digital cinema may require a significant investment per screen by cinema operators. If the market for digital cinema fails to develop, or develops more slowly than expected, or if there is significant and sustained resistance by the motion picture industry or cinema operators to this technology or the cost of implementation, we may not realize significant returns on our investment in this area, which could adversely affect our operating results. In addition, because the conversion from film-based to digital cinema is in the early stages, it is impossible to predict accurately how the roles and allocation of costs among various industry participants may develop, if or how quickly digital cinema will be adopted and what, if any, industry standards may be adopted. In addition, it is possible that if a large number of cinema owners decide to convert their theatres to digital cinema over a relatively short period of time and our products are selected for these conversions, we may see an initial increase in professional product sales that will not likely be sustained over time.

 

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If our products and services in the market for digital cinema are not competitive, our future prospects could be limited and our business could be adversely affected.

 

Even if the market for digital cinema develops, we may not be successful in selling our products, technologies and services in this market, which could have a material adverse effect on our business and prospects. Our effort with respect to digital cinema is one of the areas where we are expanding our business beyond sound technology. As a result, our relative lack of experience in this area may harm our ability to compete successfully. A number of competitors and potential competitors, including Avica, Doremi, EVS, GDC, Kodak, NEC, QuVis and Sony, are developing similar or alternative solutions for digital cinema, some of which may provide cost or technological advantages over our products, technologies and services. In addition, our products, technologies and services may not be compatible with the products and technologies developed by other companies for digital cinema. Moreover, it is possible that we will be selling components or technologies that will be incorporated into products sold by other companies, which would be a departure from our traditional business of manufacturing our own professional products and could limit our ability to control the distribution and use of our professional products. In addition, we are building components of the digital cinema delivery solution that are not solely related to sound and we do not have a long track record of providing these types of products, which may adversely affect our ability to compete in the digital cinema market. Our competitors may develop entire system solutions for digital cinema, which could make the technologies that we develop for incorporation in digital cinema systems unnecessary. In addition, we expect that our digital cinema products, technologies and services may not be priced as low as those of our competitors, which may make it more difficult for us to compete or have our products and technologies become widely adopted.

 

If our digital cinema initiatives do not perform to expectations, our reputation may suffer and demand for our digital cinema products and services may not develop.

 

As we participate in digital cinema initiatives, if we or our equipment does not perform to expectations, our relationships with cinema industry participants may be adversely affected and our reputation may suffer, affecting the demand for our digital cinema products and services. Any negative publicity or negative impact relating to problems with our digital cinema initiatives could adversely affect the perception of our brand. Additionally, our current digital cinema products need to be upgraded to meet recommendations issued by the major studios for digital cinema. If we are unable successfully to engineer our products to meet these specifications, our ability to participate in the digital cinema market will be adversely affected.

 

If the sale of consumer electronics products incorporating our technologies does not grow in emerging markets, our ability to increase our licensing revenue may be limited.

 

We also expect that growth in our licensing revenue will depend, in part, upon the growth of sales of consumer electronics products incorporating our technologies in other countries, including China and India, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities. However, if our licensing revenue from the use of our technologies in these new markets or geographic areas does not expand, our prospects could be adversely affected.

 

We face significant competition in various markets, and if we are unable to compete successfully, our business will suffer.

 

The markets for entertainment industry technologies are highly competitive, and we face competitive threats and pricing pressure in our markets. Competitors on the professional side of our business include Avica, DTS, Doremi, EVS, GDC, Kodak, Microsoft, NEC, Panastereo, QuVis, Sony and UltraStereo. Competitors on the consumer side of our business include Coding Technologies, DTS, Fraunhofer Institute for Integrated Circuits, Philips, Microsoft, RealNetworks, Sony, SRS Labs and Thomson. In addition, other companies may become competitors in the future. The quality of sound produced by some of our competitors’ technologies may be perceived by some people as equivalent or superior to that produced by ours. In addition, some of our current and/or future competitors may have significantly greater financial, technical, marketing and other resources than we do, or may have more experience or advantages in the markets in which they compete. For example, Microsoft and RealNetworks may have an advantage over us in the market for Internet technologies because of their greater experience and presence in that market. In addition, some of our current or potential competitors, such as Microsoft and RealNetworks, may be able to offer integrated system solutions in certain markets for sound or non-sound entertainment technologies, including audio, video and rights management technologies related to personal computers or the Internet, which could make competing technologies that we develop unnecessary. By offering an integrated system solution, these potential competitors also may be able to offer competing technologies at lower prices than our technologies, which could adversely affect our operating results. Further, many of the consumer electronics products that include our sound technologies also include sound technologies developed by our competitors. As a result, we must continue to invest significant resources in research and development in order to enhance our technologies and our existing products

 

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and services and introduce new high-quality products and services to meet the wide variety of such competitive pressures. Our business will suffer if we fail to do so successfully.

 

Some of our customers are also our current or potential competitors, and if those customers were to choose to use their competing technologies rather than ours, our business and operating results would be adversely affected.

 

We face competitive risks in situations where our customers are also current or potential competitors. For example, Sony is a significant licensee customer and is a significant purchaser of our professional products and production services, but Sony is also a competitor with respect to certain of our professional and consumer technologies. Sony’s acquisition of Metro-Goldwyn-Mayer, which is also a significant purchaser of our professional products and production services, is expected to increase this potential competitive risk. In addition, Universal, a purchaser of our professional products and production services, has held an interest in DTS, one of our competitors. To the extent that our customers choose to utilize competing technologies they have developed or in which they have an interest, rather than use our technologies, our business and operating results could be adversely affected.

 

Pricing pressures on the electronics product manufacturers who incorporate our technologies into their products could limit the licensing fees we charge for our technologies, which could adversely affect our revenues.

 

The markets for the consumer electronics products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for consumer electronics products that include our sound technology, such as DVD players and home theatre systems, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, manufacturers have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies into the consumer electronics products that they sell. A decline in the licensing fees we charge could materially and adversely affect our operating results.

 

Surround sound technologies could be treated as a commodity in the future, which could adversely affect our business, operating results and prospects.

 

We believe that the success we have had licensing our surround sound technologies to consumer electronics product manufacturers is due, in part, to the strength of our brand and the perception that our technologies provide a high-quality solution for surround sound. However, as applications that incorporate surround sound technologies become increasingly prevalent, we expect more competitors to enter this field with other solutions. Furthermore, to the extent that competitors’ solutions are perceived, accurately or not, to provide the same advantages as our technologies, at a lower or comparable price, there is a risk that sound encoding technologies such as ours will be treated as commodities, resulting in loss of status of our technologies, decline in their use, and significant pricing pressure. To the extent that our audio technologies become a commodity, rather than a premium solution, our business, operating results and prospects could be adversely affected.

 

We have limited or no patent protection for our technologies in certain developing countries such as China and India, which could limit our ability to grow our business in these markets.

 

We have relatively few or no issued patents in certain countries, including China and India. For example, in China we have only limited patent protection, especially with respect to our Dolby Digital technologies. In India, we have no issued patents. As such, growing our licensing revenue in developing countries such as China and India will depend on our ability to obtain patent rights in these counties for existing and new technologies, which is uncertain. Moreover, because of the limitations of the legal systems in many of these countries, the effectiveness of patents obtained or that may in the future be obtained, if any, is likewise uncertain.

 

We face diverse risks in our international business, which could adversely affect our operating results.

 

We are dependent on international sales for a substantial amount of our total revenue. For fiscal 2003, 2004 and 2005, our sales outside the United States were 60%, 59% and 61%, respectively, of our professional products and production services revenue, and royalties from licensees outside the United States were 80%, 80% and 76%, respectively, of our licensing revenue. We expect that international and export sales will continue to represent a substantial portion of our revenue for the foreseeable future. This future revenue will depend to a large extent on the continued use and expansion of our technologies in entertainment industries worldwide. Increased worldwide use of our technologies is also an important factor in our future growth.

 

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Due to our reliance on sales to customers outside the United States, we are subject to the risks of conducting business internationally, including:

 

    Our ability to enforce our contractual and intellectual property rights, especially in those foreign countries that do not respect and protect intellectual property rights to the same extent as do the United States, Japan and European countries, which increases the risk of unauthorized, and uncompensated, use of our technology;

 

    United States and foreign government trade restrictions, including those which may impose restrictions on importation of programming, technology or components to or from the United States;

 

    Foreign government taxes, regulations and permit requirements, including foreign taxes that we may not be able to offset against taxes imposed upon us in the United States, and foreign tax and other laws limiting our ability to repatriate funds to the United States;

 

    Foreign labor laws, regulations and restrictions;

 

    Changes in diplomatic and trade relationships;

 

    Difficulty in staffing and managing foreign operations;

 

    Fluctuations in foreign currency exchange rates and interest rates, including risks related to any interest rate swap or other hedging activities we undertake;

 

    Political instability, natural disasters, war or events of terrorism; and

 

    The strength of international economies.

 

The licensing of patents constitutes a significant source of our revenue. If we are unable to replace expiring patents with new patents or proprietary technologies, our revenue could decline.

 

We hold patents covering much of the technology that we license to consumer electronics product manufacturers, and our licensing revenue is tied in large part to the life of those patents. Our right to receive royalties related to our patents terminates with the expiration of the last patent covering the relevant technologies. However, many of our licensees choose to continue to pay royalties for continued use of our trademarks and know-how even after the licensed patents have expired, although at a reduced royalty rate. Accordingly, to the extent that we do not continue to replace licensing revenue from technologies covered by expiring patents with licensing revenue based on new patents and proprietary technologies, our revenue could decline.

 

As of December 30, 2005, we had over 950 individual issued patents and over 1,000 pending patent applications in nearly 35 jurisdictions throughout the world. Our issued patents are scheduled to expire at various times through February 2025. Of these, 70 patents are scheduled to expire in calendar year 2006, 46 patents are scheduled to expire in calendar year 2007 and 19 patents are scheduled to expire in calendar year 2008. We derive our licensing revenue principally from our Dolby Digital technologies. Patents relating to our Dolby Digital technologies generally expire between 2008 and 2017, and patents relating to our Dolby Digital Plus technologies, an extension of Dolby Digital, expire between 2019 and 2020. In addition, the remaining patents relating to Dolby Digital Live technologies, an extension of Dolby Digital, are scheduled to expire in 2021.

 

We are, and may in the future be, subject to intellectual property rights claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

 

Companies in the technology and entertainment industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. We have faced such claims in the past and we expect to face similar claims in the future. For example, Lucent has asserted that we infringe certain patents held by them, prompting us to file a complaint for declaratory judgment of non-infringement and/or invalidity of such Lucent patents. These patents generally involve a process and means for encoding and decoding audio signals. Lucent contended that products incorporating our AC-3 technology infringe those patents. The U.S. District Court of Northern District of California recently granted our motions for summary judgment that we have not infringed the Lucent patents at issue and have not contributed to or induced infringement by others. In light of the court’s finding of non-infringement, it dismissed our claims that the Lucent patents are invalid. Lucent appealed the court’s ruling granting summary judgment of non-infringement to the United States Federal Circuit Court of Appeals. An adverse ruling for us on appeal and a subsequent

 

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determination against us in the Lucent litigation could materially impact our technology licensing business, which may seriously harm our financial condition and results of operations.

 

Any intellectual property claims, with or without merit, could be time-consuming, expensive to litigate or settle and could divert management resources and attention. In the past we have settled claims relating to infringement allegations and agreed to make payments in connection with such settlements. We expect that similar claims will be asserted against us in the future in the ordinary course of our business. For example, we recently received notice that an action had been filed against us alleging that our Dolby Virtual Speaker technology infringes certain U.S. patents held by Cooper Bauck Corp. An adverse determination in any intellectual property claim could require that we pay damages or stop using technologies found to be in violation of a third party’s rights and could prevent us from offering our products and services to others. In order to avoid these restrictions, we may have to seek a license for the technology. This license may not be available on reasonable terms, could require us to pay significant royalties and may significantly increase our operating expenses. The technologies also may not be available for license to us at all. As a result, we may be required to develop alternative non-infringing technologies, which could require significant effort and expense. If we cannot license or develop technologies for any infringing aspects of our business, we may be forced to limit our product and service offerings and may be unable to compete effectively. In addition, at times in the past, we have chosen to defend our licensees from third-party intellectual property infringement claims even where such defense was not contractually required, and we may choose to take on such defense in the future. Any of these results could harm our brand, our operating results and our financial condition. In addition, from time to time we are engaged in disputes regarding the licensing of our intellectual property rights, including matters related to our royalty rates and other terms of our licensing arrangements. These types of disputes can be asserted by our customers or prospective customers or by other third parties as part of negotiations with us or in private actions seeking monetary damages or injunctive relief, or in regulatory actions. In the past, licensees have threatened to initiate litigation against us regarding our licensing royalty rate practices, including potential antitrust claims. Damages and requests for injunctive relief asserted in claims like these could be material, and could have a significant impact on our business. Any disputes with our customers or potential customers or other third parties could adversely affect our business, results of operations and prospects.

 

Our licensing of industry standard technologies can be subject to limitations that could adversely affect our business and prospects.

 

When our technologies are adopted as explicit industry standards by a standards-setting body, we generally must agree to license such technologies on a fair, reasonable and non-discriminatory basis, which could limit our control over the use of these technologies. In these situations, we must often limit the royalty rates we charge for these technologies, which could adversely affect our gross margins. Furthermore, we may be unable to limit to whom we license such technologies, and may be unable to restrict many terms of the license. From time to time we may be subject to claims that our licenses of our industry standard technologies may not conform to the requirements of the standards-setting body. Private parties have raised this type of issue with us in the past. Allegations such as these could be asserted in private actions seeking monetary damages and injunctive relief, or in regulatory actions. Claimants in such cases could seek to restrict or change our licensing practices or our ability to license our technologies in ways that could injure our reputation and otherwise materially and adversely affect our business, operating results and prospects.

 

Licensing some of our technologies in “patent pools” is a different business model for us, and we may face many challenges in conducting this business.

 

In fiscal 2002, we began licensing some of our patents through our wholly-owned subsidiary Via Licensing Corporation in “patent pools” with other companies in an effort to ensure that our technologies are compatible with other technologies in the entertainment industry and to promote our technologies as industry standards. These patent pools allow product manufacturers streamlined access to certain foundational technologies and are comprised of a group of patents held by a number of companies, including us in some cases, and administered by Via Licensing. This is a different business model for us and we cannot predict all of the challenges we may face or whether we will be successful. For instance, Via Licensing licenses patents in areas such as wireless markets in which we have not competed previously. As a result, our control over the license of our technologies from these patent pools may be limited as compared to our traditional business model in which we license our patents as bundles of technologies and interact directly with our customers. In addition, our control over the application and quality control of our technologies that are included in these pools may be limited.

 

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Our ability to develop proprietary technology in markets in which “open standards” are adopted may be limited, which could adversely affect our ability to generate revenue.

 

Standards-setting bodies, such as those for digital cinema technologies, may require the use of so-called “open standards,” meaning that the technologies necessary to meet those standards are freely available without the payment of a licensing fee or royalty. The use of open standards may reduce our opportunity to generate revenue, as open standards technologies are based upon non-proprietary technology platforms in which no one company maintains ownership over the dominant technologies.

 

Events and conditions in the motion picture industry may affect sales of our professional products and production services.

 

Sales of our professional products and production services tend to fluctuate based on the underlying trends in the motion picture industry. In part, this is because our products have been so widely adopted in this industry. When box office receipts for the motion picture industry increase, we have typically seen sales of our professional products increase as well, as cinema owners are more likely to build new theatres and upgrade existing theatres with our more advanced cinema products when they are doing well financially. Conversely, when box office receipts are down cinema owners tend to scale back on plans to upgrade their systems or build new theatres. Our professional product sales are also subject to fluctuations based on events and conditions in the theatre industry generally that may or may not be tied to box office receipts in particular periods. In fiscal 2005 and the first quarter of fiscal 2006, decreased box office receipts and changes within the U.S. cinema industry, including recent restructuring and consolidations, appears to have delayed purchasing decisions by exhibitors. To a lesser extent, the sale of our professional products is influenced by the launch of new digital services by broadcasters. On the other hand, our production services revenue, both in the United States and internationally, is tied to the number of films being made by studios and independent filmmakers. The number of films that are produced can be affected by a number of factors, including strikes and work stoppages within the motion picture industry, as well as by the tax incentive arrangements that many foreign governments provide filmmakers to promote local filmmaking.

 

We may be unable to significantly expand our current professional product sales in the cinema industry because our professional products are already used by the vast majority of major cinema operators and major motion picture studios in the United States and much of the rest of the world. If the cinema industry does not expand, or if it contracts, the demand for our professional products will be adversely affected.

 

Our ability to further penetrate the market for motion picture sound technologies is limited because of the widespread use of our current professional products by major motion picture content creators, distributors and cinema operators. As a result, our future revenue from our professional products for the cinema industry will depend, in part, upon events and conditions in that industry—specifically, the continued production and distribution of motion pictures, and the construction of new theatres and the renovation of existing theatres, using our products and services. For example, in the late 1990s cinema operators in the United States built a large number of new cinema megaplexes. This initially resulted in increased sales of our cinema processors, but also resulted in an oversupply of screens in some markets. This oversupply led to significant declines in new theatre construction in the United States in the early 2000s, resulting in a corresponding decline in sales of our cinema processors. As a result, future growth in sales of our existing cinema products may be limited, and may decrease in the future, as the number of new cinemas being built and the number of existing cinemas without our products continues to decline.

 

The piracy of motion pictures could adversely affect the motion picture industry and therefore our operating results.

 

The construction of new screens and the renovation of existing theatres, as well as the continued production of new motion pictures, are also adversely impacted by the growth in piracy of motion pictures. Technological advances and the conversion of motion pictures into digital formats have made it easier to create, transmit and “share” high-quality unauthorized copies of motion pictures, including on pirated DVDs and on the Internet. If cinema operators decide to close a significant number of screens in the future or cut their capital spending as a result of piracy, demand for our playback systems and cinema processors will decline, which could negatively impact our operating results.

 

The demand for our current professional products and production services could decline if the film industry broadly adopts digital cinema.

 

If the film industry broadly adopts digital cinema, the demand for our current professional products and production services could decline. Such a decline in our products and services business could also adversely affect our technology licensing business, because the strength of our brand and our ability to use professional developments to advance our consumer licensing technologies would be impaired. If, in such circumstances, we are

 

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unable to adapt our professional products and production services or introduce new products for the market for digital cinema successfully, our business could be materially adversely affected.

 

If we are unable to expand our business into non-sound technologies, our future growth could be limited.

 

Our future growth will depend, in part, upon our expansion into areas beyond sound technologies. For example, in addition to our digital cinema initiative, we are exploring other areas that facilitate delivery of digital entertainment, such as technologies for processing digital moving images and content protection. We will need to spend considerable resources on research and development in the future in order to deliver innovative non-sound technologies. However, we have limited experience in these markets and, despite our efforts, we cannot predict whether we will be successful in developing and marketing non-sound products, technologies and services. In addition, many of these markets are relatively new and may not develop as we currently anticipate. Moreover, although we believe that many of the technological advances we may develop for digital cinema may have applicability in other areas, such as broadcasting or consumer electronics products, we may not ever be able to achieve these anticipated benefits in these other markets. A number of competitors and potential competitors may develop non-sound technologies similar to those that we develop, some of which may provide advantages over our products, technologies and services. Some of these competitors have much greater experience and expertise in the non-sound fields we may enter. The non-sound products, technologies and services we expect to market may not achieve or sustain market acceptance, may not meet the needs of the movie industry, and may not be accepted as industry standards. If we are unsuccessful in selling non-sound products, technologies and services, the future growth of our business may be limited. In addition, our efforts to enter or strengthen our positions in non-sound markets may be tied to the success of specific programs.

 

Fluctuations in our quarterly and annual operating results may adversely affect the value of our stock.

 

A number of factors, many of which are outside our control, may cause or contribute to significant fluctuations in our quarterly and annual revenue and operating results. These fluctuations may make financial planning and forecasting more difficult. In addition, these fluctuations may result in unanticipated decreases in our available cash, which could negatively impact our business and prospects. As discussed more fully below, these fluctuations also could increase the volatility of our stock price. Factors that may cause or contribute to fluctuations in our operating results and revenue include:

 

    Fluctuations in demand for our products and for the consumer electronics products of our licensees;

 

    Fluctuations in the timing of royalty reports we receive from our licensees, including late, sporadic or inaccurate reports;

 

    Sporadic payments we may be able to recover from companies utilizing our technologies without licenses;

 

    Corrections to licensees’ reports received in periods subsequent to those in which the original revenue was reported;

 

    Introduction or enhancement of products, services and technologies by us, our licensees and our competitors, and market acceptance of these new or enhanced products, services and technologies;

 

    Rapid, wholesale changes in technology in the entertainment industries in which we compete;

 

    Events and conditions in the motion picture industry, including box office receipts that affect the number of theatres constructed and the number of movies produced and exhibited the popularity of motion pictures generally and strikes by motion picture industry participants;

 

    The financial resources of cinema operators available to buy our products or to equip their theatres to accommodate upgraded or new technologies;

 

    Consolidation by participants in the markets in which we compete, which could result among other things in pricing pressure;

 

    The amount and timing of our operating costs and capital expenditures, including those related to the expansion of our business, operations and infrastructure;

 

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    Variations in the time-to-market of our technologies in the entertainment industries in which we operate;

 

    Seasonal electronics product shipment patterns by our consumer electronics product licensees and seasonal product purchasing patterns by customers of our professional products;

 

    The impact of, and our ability to react to, interruptions in the entertainment distribution chain, including as a result of work stoppages at our facilities, our customers’ facilities and other points throughout the entertainment distribution chain;

 

    Changes in business cycles that affect the markets in which we sell our products and services or the markets for consumer electronics products incorporating our technologies;

 

    Adverse outcomes of litigation or governmental proceedings, including any foreign, federal, state or local tax assessments or audits; and

 

    Costs of litigation and intellectual property protection.

 

One or more of the foregoing or other factors may cause our operating expenses to be disproportionately higher or lower or may cause our revenue and operating results to fluctuate significantly in any particular quarterly or annual period. Results from prior periods are thus not necessarily indicative of the results of future periods.

 

The loss of or interruption in operations of one or more of our key suppliers could materially delay or stop the production of our professional products and impair our ability to generate revenue.

 

Our reliance on outside suppliers for some of the key materials and components we use in manufacturing our professional products involves risks, including limited control over the price, timely delivery and quality of such components. We have no agreements with our suppliers to ensure continued supply of materials and components. Although we have identified alternate suppliers for most of our key materials and components, any required changes in our suppliers could cause material delays in our production operations and increase our production costs. In addition, our suppliers may not be able to meet our future production demands as to volume, quality or timeliness. Moreover, we rely on sole source suppliers for some of the components that we use to manufacture our professional products, including certain charged coupled devices, light emitting diodes and digital signal processors. These sole source suppliers may become unable or unwilling to deliver these components to us at an acceptable cost or at all, which could force us to redesign certain of our products. Our inability to obtain timely delivery of key components of acceptable quality, any significant increases in the prices of components, or the redesign of our professional products could result in material production delays, increased costs and reductions in shipments of our products, any of which could increase our operating costs, harm our customer relationships or materially and adversely affect our business and operating results.

 

Revenue from our professional products may suffer if our production processes encounter problems or if we are not able to match our production capacity to fluctuating levels of demand.

 

Our professional products are highly complex, and production difficulties or inefficiencies can interrupt production, resulting in our inability to deliver products on time in a cost effective manner, which could harm our competitive position. If production is interrupted at one of our two manufacturing facilities, we may not be able to shift production to the other facility on a timely basis, and customers may purchase products from our competitors. A shortage of manufacturing capacity for our professional products could adversely affect our operating results and damage our customer relationships. We generally cannot quickly adapt our manufacturing capacity to rapidly changing market conditions. Likewise, we may be unable to respond to fluctuations in customer demand. At times we under utilize our manufacturing facilities as a result of reduced demand for some of our professional products. Any inability to respond to fluctuations in customer demand for our professional products may adversely affect our gross margins.

 

Our professional products, from time to time, experience quality problems that can result in decreased sales and higher operating expenses.

 

Our professional products are complex and sometimes contain undetected software or hardware errors, particularly when first introduced or when new versions are released. In addition, our professional products are sometimes combined with or incorporated into products from other vendors, sometimes making it difficult to identify the source of a problem. These errors could result in a loss of or delay in market acceptance of our

 

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professional products or cause delays in delivering them and meeting customer demands, any of which could reduce our revenue and raise significant customer relations issues. In addition, if our professional products contain errors we could be required to replace or reengineer them, which would increase our costs. Moreover, if any such errors cause unintended consequences, we could face claims for product liability. Although we generally attempt to contractually limit liability for defective products to the cost of repairing or replacing these products, if these contract provisions are not enforced, or are unenforceable for any reason, or if liabilities arise that are not effectively limited, we could incur substantial costs in defending and settling product liability claims.

 

A loss of one or more of our key customers or licensees in any of our markets could adversely affect our operating results.

 

From time to time, one or a small number of our customers or licensees may represent a significant percentage of our professional products and services or licensing revenue. Although we have agreements with many of these customers, these agreements typically do not require any minimum purchases or minimum royalty fees and do not prohibit customers from purchasing products and services from competitors. A decision by any of our major customers or licensees not to use our technologies, or their failure or inability to pay amounts owed to us in a timely manner, or at all, whether due to strategic redirections or adverse changes in their businesses or for other reasons, could have a significant effect on our operating results.

 

We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.

 

Some of our operations use substances regulated under various federal, state, local and international laws governing the environment, including those governing the discharge of pollutants into the air and water, the management, disposal and labeling of hazardous substances and wastes and the cleanup of contaminated sites. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. The ultimate costs under environmental laws and the timing of these costs are difficult to predict. We also face increasing complexity in our product design as we adjust to new and future requirements relating to the materials composition of our products, including the restrictions on lead and other hazardous substances that will apply to specified electronic products put on the market in the European Union as of July 1, 2006 (Restriction on the Use of Hazardous Substances Directive 2002/95/EC, also known as the “RoHS Directive”) and similar legislation proposed for China. We are redesigning our products regulated under the RoHS Directive in order to be able to continue to offer them for sale within the European Union. For some products, substituting certain components containing regulated hazardous substances will be more difficult or costly, and the additional redesign efforts could result in production delays. Certain electronic products that we maintain in inventory may be rendered obsolete if not in compliance with the RoHS Directive, which could negatively impact our ability to generate revenue from those products. We could also face significant costs and liabilities in connection with product take-back legislation. The European Union Directive 2002/96/EC on Waste Electrical and Electronic Equipment Directive (also known as the “WEEE Directive”) requires producers of certain electrical and electronic equipment, including broadcast equipment, to be financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. As of December 2005, not all member states within the EU have enacted enabling legislation under the WEEE Directive, and in the absence of such legislation, it is difficult to determine the costs to comply with the WEEE Directive. Similar legislation may be enacted in other countries, such as China, and the United States, the cumulative impact of which could significantly increase our operating costs and adversely affect our operating results. We also expect that our operations, whether manufacturing or licensing, will be affected by other new environmental laws and regulations on an ongoing basis. Although we cannot predict the ultimate impact of any such new laws and regulations, they will likely result in additional costs or decreased revenue, and could require that we redesign or change how we manufacture our products, any of which could have a material adverse effect on our business.

 

Any inability to protect our intellectual property rights could reduce the value of our products, services and brand.

 

Our business is dependent upon our patents, trademarks, trade secrets, copyrights and other intellectual property rights. We derived 73%, 73% and 75% of our total revenue from licensing revenue in the fiscal years 2003, 2004 and 2005, respectively. Effective intellectual property rights protection, however, may not be available under the laws of every country in which our products and services and those of our licensees are distributed. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Any significant impairment of our intellectual property rights could harm our business or our ability to compete. In addition, protecting our intellectual property rights is costly and time consuming. We have taken steps in the past to enforce our intellectual property

 

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rights and expect to continue to do so in the future. However, it may not be practicable or cost effective for us to enforce our intellectual property rights fully, particularly in certain developing countries or where the initiation of a claim might harm our business relationships. For example, we have many times experienced, and expect to continue to experience, problems with Chinese consumer electronics product manufacturers incorporating our technologies into their products without our authorization. The industry has experienced a movement by discount retailers towards lower-end Chinese-made DVD players which we believe poses challenges in royalty collection and intellectual property enforcement in China. If we are unable to successfully identify and stop unauthorized use of our intellectual property, we could experience increased operational and enforcement costs both inside and outside China, which could adversely affect our financial condition and results of operations. We generally seek patent protection for our innovations. It is possible, however, that some of these innovations may not be protectable. In addition, given the costs of obtaining patent protection, we may choose not to protect certain innovations that later turn out to be important. Moreover, we have limited or no patent protection in certain foreign jurisdictions. For example, in China we have only limited patent protection, especially with respect to our Dolby Digital technologies, and in India we have no issued patents. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may later be found to be invalid or unenforceable. Moreover, we seek to maintain certain intellectual property as trade secrets. These trade secrets could be compromised by third parties, or intentionally or accidentally by our employees, which would cause us to lose the competitive advantage resulting from them.

 

It is possible that we may be treated as a personal holding company, which could adversely affect our operating results and financial condition.

 

The Internal Revenue Service may assert that we or any of our subsidiaries are currently, or previously have been, liable for personal holding company tax, plus interest and penalties, if applicable. In addition, we and our subsidiaries may be liable for personal holding company tax in the future. For United States federal income tax purposes, a corporation is generally considered to be a “personal holding company” under the United States Internal Revenue Code if (i) at any time during the last half of its taxable year more than 50% of its stock by value is owned, directly or indirectly, by virtue of the application of certain stock ownership attribution rules set forth in the Internal Revenue Code for purposes of applying the personal holding company rules, by five or fewer individuals and (ii) at least 60% of its adjusted ordinary gross income, as defined for United States federal income tax purposes, is “personal holding company income.” Personal holding company income is generally passive income, including royalty income, subject to certain exceptions such as qualifying software royalties. A personal holding company is subject to an additional tax on its undistributed after-tax income, calculated at the statutory tax rate, which is currently 15%. Since the personal holding company tax is imposed only on undistributed income, a personal holding company can avoid or mitigate liability for the tax, but not interest or penalties, by paying a dividend to its stockholders.

 

More than 50% of the value of our stock is held by Ray Dolby and stockholders considered affiliated with him pursuant to the stock ownership attribution rules applicable to personal holding companies. We expect this will continue to be the case in the foreseeable future. In addition, a significant portion of our income is from licensing fees, which may constitute personal holding company income. Currently, however, less than 60% of Dolby Laboratories’ adjusted ordinary gross income is personal holding company income.

 

However, the Internal Revenue Service may assert that we or one of our subsidiaries are currently, or previously have been, liable for personal holding company tax, plus interest and penalties, if applicable. In addition, we or our subsidiaries may be liable for personal holding company tax in the future. The treatment of certain items of our income and the income of our subsidiaries, for purposes of the personal holding company tax, may be subject to challenge. In the event that we or any of our subsidiaries is determined to be a personal holding company, or for prior taxable years, to have been a personal holding company, we or our subsidiary could be liable for additional taxes, and possibly interest and penalties, based on the undistributed income and the tax rate in effect at that time, but only if we or our subsidiary, as the case may be, decides not to fully abate the tax by the payment of a dividend, although such a dividend will not eliminate interest and penalties. In addition, we believe that there exists a meaningful risk that in the relatively near future the mix of our revenue will change so that more of our adjusted ordinary gross income may be classified as personal holding company income. In such event, it is possible that we or one of our subsidiaries could become liable for the personal holding company tax, assuming the ownership test continues to be met. In that case, we or our subsidiary, as the case may be, may be required to pay additional tax in the event we or the subsidiary decides not to fully abate the tax by the payment of a dividend. Because no claim or assessment has been made against us with respect to personal holding company taxes, we are unable to quantify the amount of any additional taxes, and possibly interest and penalties, for which we may be liable in the future for past

 

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periods or the amount of the dividend that we may pay to abate the tax. Furthermore, we are unable to quantify the amount of personal holding company tax that we may be liable for or the dividend that we may elect to pay for future periods as such amounts, if any, would be based upon the application of the rules discussed above to the results of our future operations. We have explored options to reduce our exposure and the exposure of our subsidiaries to the personal holding company tax in the future, as well as continue to actively monitor our current exposure.

 

If we or any of our subsidiaries were to pay personal holding company tax (and possibly interest and penalties), this could significantly increase our consolidated tax expense and adversely affect our operating results. In addition, if the statutory tax rate increases in the future, the amount of any personal holding company tax we or any of our subsidiaries may have to pay could increase significantly, further impairing our operating results. In that regard, the statutory tax rate, which is currently 15%, is scheduled to return to ordinary income tax rate levels for tax years beginning on or after January 1, 2009. If we are deemed to be a personal holding company and, instead of paying the personal holding company tax, we elect to pay a dividend to our stockholders in an amount equal to all or a significant part of our undistributed personal holding company income, we may consume a significant amount of cash resources and be unable to retain or generate working capital. This would adversely affect our financial condition. As a result, if we pay such a dividend, we may decide to seek additional financing, although that financing may not be available to us when and as required on commercially reasonable terms, if at all.

 

Failure to comply with applicable current and future government regulations could have a negative effect on our business.

 

Our operations and business practices are subject to federal, state and local government laws and regulations, as well as international laws and regulations, including those relating to consumer and other safety-related compliance for electronic equipment, as well as compulsory license requirements as a prerequisite to being included as part of the industry standards, such as the United States HDTV standard. Any failure by us to comply with the laws and regulations applicable to us or our products could result in our inability to sell those products, additional costs to redesign products to meet such laws and regulations, fines or other administrative actions by the agencies charged with enforcing compliance and, possibly, damages awarded to persons claiming injury as the result of our non-compliance. Changes in or enactment of new statutes, rules or regulations applicable to us could have a material adverse effect on our business.

 

Acquisitions could result in operating difficulties, dilution to our stockholders and other harmful consequences.

 

We have evaluated, and expect to continue to evaluate, a wide array of possible strategic transactions and acquisitions. For example, we consider these types of transactions in connection with our efforts to expand our business beyond sound technologies, such as in digital cinema and other technologies related to the delivery of digital entertainment. Although we cannot predict whether or not we will complete any such acquisition or other transactions in the future and have no current plans for any specific strategic transactions or acquisitions, any of these transactions could be material in relation to our financial condition and results of operations. The process of integrating an acquired company, business or technology may create unforeseen difficulties and expenditures. The areas where we may face risks include:

 

    Diversion of management time and focus from operating our business to acquisition integration challenges;

 

    Cultural challenges associated with integrating employees from acquired businesses into our organization;

 

    Retaining employees from businesses we acquire;

 

    The need to implement or improve internal controls, procedures and policies appropriate for a public company at businesses that prior to the acquisition lacked these controls, procedures and policies;

 

    Possible write-offs or impairment charges resulting from acquisitions;

 

    Unanticipated or unknown liabilities relating to acquired businesses; and

 

    The need to integrate acquired businesses’ accounting, management information, manufacturing, human resources and other administrative systems to permit effective management.

 

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Foreign acquisitions involve unique risks in addition to those mentioned above, including those related to integration of operations across different geographies, cultures and languages, currency risks and risks associated with the particular economic, political and regulatory environment in specific countries. Also, the anticipated benefit of our acquisitions may not materialize. Future acquisitions could result in potentially dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our operating results or financial condition. Future acquisitions may also require us to obtain additional equity or debt financing, which may not be available on favorable terms or at all.

 

The loss of members of our management team could substantially disrupt our business operations.

 

Our success depends to a significant degree upon the continued individual and collective contributions of our management team. A limited number of individuals have primary responsibility for managing our business, including our relationships with key customers and licensees. We have key executives and senior technical people who have been with us for a number of years, including over 150 employees who have been with us for over 10 years. These individuals, as well as the rest of our management team and key employees, are at-will employees, and we do not maintain any key-person life insurance policies. Losing the services of any key member of our team, whether from retirement, competing offers or other causes, could prevent us from executing our business strategy, cause us to lose key customer or licensee relationships, or otherwise materially affect our operations.

 

We rely on highly skilled personnel, and if we are unable to retain or motivate key personnel or hire qualified personnel, we may not be able to maintain our operations or grow effectively.

 

Our performance is largely dependent on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate and retain highly skilled personnel for all areas of our organization. In this regard, we currently plan to hire a number of employees throughout fiscal 2006 in response to our growth and our current initiatives and if we are unable to hire and train a sufficient number of qualified employees for any reason, we may not be able to implement our current initiatives or grow effectively. In this regard, we have in the past maintained a rigorous, highly selective and time-consuming hiring process. We believe that our approach to hiring has significantly contributed to our success to date. However, our highly selective hiring process has made it more difficult for us to hire a sufficient number of qualified employees, and, as we grow, our hiring process may prevent us from hiring the personnel we need in a timely manner. In addition, we are aware that certain of our competitors have directly targeted our employees. Moreover, the high cost of living in the San Francisco Bay Area, where our corporate headquarters and a significant portion of our operations are located, has been an impediment in attracting new employees and retaining existing employees in the past, and we expect that this high cost of living will continue to impair our ability to attract and retain employees in the future. Furthermore, for much of our history we have relied upon cash compensation arrangements, such as cash bonuses, rather than option grants, to motivate our employees. In recent years, we have granted options to key employees. Nonetheless, there is no assurance that either of these approaches will provide adequate incentives to attract, retain and motivate employees in the future. If we do not succeed in attracting excellent personnel and retaining and motivating existing personnel, our existing operations may suffer and we may be unable to grow effectively.

 

If we cannot maintain our corporate culture as we grow, we could lose the innovation, teamwork and focus that we believe our culture fosters, and our business may be harmed.

 

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, teamwork and a focus both on developing and strengthening long-term relationships with entertainment industry participants and on developing practical, enduring technology solutions for the entertainment industry. As we grow and change in response to the requirements of being a public company, we may find it difficult to maintain important aspects of our corporate culture, which could negatively affect our future success. We intend to continue to focus on developing technologies for the entertainment industries that provide long-term benefits, and we intend to keep our focus on long-term results.

 

We will incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could affect our operating results.

 

As a public company we have incurred and will continue to incur significant legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with recently adopted corporate governance requirements, including requirements under the Sarbanes-Oxley Act, as well as new rules implemented by the SEC and the NYSE. In addition, our management team will have to adapt to the requirements of being a public company, as most of our senior executive officers do not have significant experience in the public company environment. The expenses incurred by public companies generally for reporting and corporate governance purposes have increased.

 

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These rules and regulations have increased our legal and financial compliance costs and have made some activities more time-consuming and costly, although we are unable to currently estimate these costs with any degree of certainty. We do believe, however, that we will be able to fund these costs out of our available working capital. It is possible that these new rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage than used to be available. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as our executive officers.

 

If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and our investors’ views of us.

 

We have a complex business organization that is international in scope. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are in the process of documenting, reviewing and, if appropriate, improving our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. Both we and our independent auditors will periodically test our internal controls in connection with the Section 404 requirements and could, as part of that documentation and testing, identify areas for further attention or improvement. Implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may seriously affect our stock price.

 

Issues arising from the implementation of our new enterprise resource planning system could affect our operating results and ability to manage our business effectively.

 

We are currently implementing a PeopleSoft enterprise resource planning, or ERP, system over an anticipated three-year period ending in 2007 that is critical to our accounting, financial, operating and manufacturing functions. Implementing a new ERP system raises costs and risks inherent in the conversion to a new computer system, including disruption to our normal accounting procedures, potential delays and problems achieving accuracy in the conversion of electronic data. Failure to properly or adequately address these issues could result in increased costs, the diversion of management’s attention and resources and could materially adversely affect our operating results and ability to manage our business effectively. In addition, we do not know whether or not the acquisition of PeopleSoft by Oracle will affect the implementation and future use of our ERP system. To the extent that this acquisition delays, complicates or prevents the full implementation, future use or service of our ERP system, our operating results and financial condition could be adversely affected.

 

For the foreseeable future, Ray Dolby or his affiliates will be able to control the selection of all members of our board of directors, as well as virtually every other matter that requires stockholder approval, which will severely limit the ability of other stockholders to influence corporate matters.

 

At December 30, 2005, Ray Dolby and persons and entities affiliated with Ray Dolby owned approximately 65% of our Class A and Class B common stock, representing 92% of the combined voting power of our outstanding Class A and Class B common stock. Under our charter, holders of shares of Class B common stock may generally transfer such shares to family members, including spouses and descendents or the spouses or domestic partners of such descendents, without having the shares automatically convert into shares of Class A common stock. Because of this dual class structure, Ray Dolby, his affiliates, and his family members and descendents will, for the foreseeable future, have significant influence over our management and affairs, and will be able to control virtually all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other sales of our company or assets, even if they come to own considerably less than 50% of the total number of outstanding shares of our Class A and Class B common stock. Moreover, these persons may take actions in their own interests that you or our other stockholders do not view as beneficial. There is no threshold or time deadline at which the shares of Class B common stock will automatically convert into shares of Class A common stock. Assuming conversion of all shares of Class B common stock held by persons not affiliated with Ray Dolby into shares of Class A common stock, so long as Ray Dolby and his affiliates continue to hold shares of Class B common stock representing approximately 11% or more of the total number of outstanding shares of our Class A

 

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and Class B common stock, they will hold a majority of the combined voting power of the Class A and Class B common stock.

 

Future sales of shares by insiders could cause our stock price to decline.

 

If our founder, officers, directors or employees sell, or indicate an intention to sell, substantial amounts of our Class A common stock, including shares of Class A common stock issuable upon conversion of shares of Class B common stock, in the public market, the trading price of our Class A common stock could decline. As of December 30, 2005, we had outstanding a total of 104,749,003 shares of Class A and Class B common stock. Of these shares, 31,625,000 shares of Class A common stock were sold in our initial public offering by us and the selling stockholders.

 

As of December 30, 2005, our directors and executive officers held 69,024,785 shares of Class B common stock and vested options to purchase 652,472 shares of Class B common stock. We expect that any sale of our Class A common stock by our directors and executive officers would be subject to compliance with Rule 144 under the Securities Act.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

Sales of Unregistered Securities

 

In the quarter ended December 30, 2005, we issued an aggregate of 739,347 shares of our Class B common stock to certain employees, officers and directors upon the exercise of options awarded under our 2000 Stock Incentive Plan and from December 31, 2005 through February 1, 2006, we issued an aggregate of 419,798 shares of our Class B common stock to certain employees and officers upon the exercise of options awarded under our 2000 Stock Incentive Plan. We received aggregate proceeds of $1.2 million in the quarter ended December 30, 2005, and $0.6 million in the period from December 30, 2005 through February 1, 2006, as a result of the exercise of these options. We believe these transactions were exempt from the registration requirements of the Securities Act in reliance on Rule 701 thereunder as transactions pursuant to compensatory benefit plans and contracts relating to compensation as provided under Rule 701. As of February 1, 2006 options to purchase an aggregate of 9,333,115 shares of our Class B common stock and 1,557,200 shares of our Class A common stock remain outstanding. All issuances of shares of our Class B common stock pursuant to the exercise of these options will be made in reliance on Rule 701. All option grants made under the 2000 Stock Incentive Plan were made prior to the effectiveness of our initial public offering. No further option grants will be made under our 2000 Stock Incentive Plan.

 

None of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering.

 

Each share of our Class B common stock is convertible into one share of our Class A common stock at any time at the option of the holder or upon the affirmative vote of the holders of a majority of the shares of Class B common stock. In addition, each share of Class B common stock shall convert automatically into one share of Class A common stock upon any transfer, except for certain transfers described in our amended and restated certificate of incorporation.

 

Use of Proceeds from Public Offering

 

The Securities and Exchange Commission declared our registration statement, filed on Form S-1 (File No. 333-120614) under the Securities Act of 1933 in connection with the initial public offering of our Class A common stock, $0.001 par value, effective on February 16, 2005.

 

ITEM 6. EXHIBITS

 

          Incorporated by Reference Herein

Exhibit

Number


  

Description


   Form

   Date

    10.1*    Lease for 100 Potrero Avenue, San Francisco, California          
    10.2*    Lease for 130 Potrero Avenue, San Francisco, California          
    10.3*    Lease for 140 Potrero Avenue, San Francisco, California          
    31.1    Certification by the Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.          
    31.2    Certification by the Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.          
    32.1 ‡    Certification by the Chief Executive Officer and the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.          

* Denotes a management contract or compensatory plan or arrangement

 

Furnished herewith

 

45


Table of Contents

SIGNATURES

 

Pursuant to the requirements 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.

 

Date: February 7, 2006

 

DOLBY LABORATORIES, INC.

By:  

/s/ Kevin J. Yeaman

   

Kevin J. Yeaman

Chief Financial Officer

(Principal Financial and Accounting

Officer and Duly Authorized Officer)

 

46


Table of Contents

INDEX TO EXHIBITS

 

          Incorporated by Reference Herein

Exhibit
Number


  

Description


   Form

   Date

    10.1*    Lease for 100 Potrero Avenue, San Francisco, California          
    10.2*    Lease for 130 Potrero Avenue, San Francisco, California          
    10.3*    Lease for 140 Potrero Avenue, San Francisco, California          
    31.1    Certification by the Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.          
    31.2    Certification by the Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.          
    32.1 ‡    Certification by the Chief Executive Officer and the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.          

* Denotes a management contract or compensatory plan or arrangement

 

Furnished herewith

 

47

Lease for 100 Potrero Avenue

Exhibit 10.1

LEASE AGREEMENT

(100 Potrero)

 

BETWEEN

 

RAY DOLBY AND DAGMAR DOLBY, AS TRUSTEES OF THE

DOLBY FAMILY TRUST, DATED MAY 7, 1999, and

RAY AND DAGMAR DOLBY REAL ESTATE INVESTMENTS, L.P.,

a California limited partnership,

 

COLLECTIVELY,

AS LANDLORD

 

AND

 

DOLBY LABORATORIES, INC.,

a California corporation,

 

AS TENANT


TABLE OF CONTENTS

 

Basic Lease Information

   iv

1.

  

Definitions

   1
     1.1   

Location of Definitions; Basic Lease Information

   1

2.

  

Premises

   1
     2.1   

Premises Defined

   1
     2.2   

Measurement of Premises

   1

3.

  

Term

   3
     3.1   

Term Commencement

   3

4.

  

Rent; Additional Charges

   3
     4.1   

Annual Rental

   3
     4.2   

Additional Charges

   3
     4.3   

Late Charges

   3

5.

  

Net Lease; Taxes and Assessments

   4
     5.1   

Net Lease

   4
     5.2   

Payment of Taxes and Assessments

   4

6.

  

Utilities

   6
     6.1   

Utility Expenses

   6
     6.2   

Interruption of Utilities

   7

7.

  

Condition of Premises

   7

8.

  

Common Areas

   7
     8.1   

Right to Use Common Areas

   7

9.

  

Use

   7
     9.1   

Office Use

   7
     9.2   

No Nuisance

   8
     9.3   

Compliance with Laws

   8
     9.4   

Hazardous Materials

   8

10.

  

Alterations and Tenant’s Property

   9
     10.1   

Alterations

   9
     10.2   

Removal of Property

   10

11.

  

Repairs and Other Work

   10
     11.1   

Tenant’s Obligations

   10
     11.2   

Conditions Applicable to Repairs and Other Work

   11
     11.3   

Landlord’s Obligations

   11

12.

  

Liens

   12

13.

  

Subordination

   12

14.

  

Inability to Perform

   13

15.

  

Destruction

   13
     15.1   

Repair

   13

 

i


     15.2   

Tenant’s Right to Terminate

   14
     15.3   

Landlord’s Right to Terminate

   15
     15.4   

Extent of Repair Obligations

   15
     15.5   

Waiver of Subrogation

   15
     15.6   

Non-Application of Certain Statutes

   16

16.

  

Insurance

   16

17.

  

Eminent Domain

   16
     17.1   

Effect of Taking

   16
     17.2   

Award

   17
     17.3   

Abatement of Rent

   17
     17.4   

Temporary Taking

   17

18.

  

Assignment and Subletting

   17
     18.1   

Consent Required

   17
     18.2   

Notice

   18
     18.3   

No Release

   19
     18.4   

Entity Transfers

   19
     18.5   

Assumption of Obligations

   19
     18.6   

No Signs

   20
     18.7   

Non-Application of Certain Statutes

   20

19.

  

Security Systems and Programs

   20

20.

  

Default

   20
     20.1   

Events of Default

   20
     20.2   

Remedies

   21
     20.3   

Reletting

   23
     20.4   

Landlord’s Right to Perform Tenant’s Obligations

   24
     20.5   

Remedies Cumulative

   24

21.

  

Indemnity; Interest on Overdue Obligations

   24
     21.1   

Indemnity

   24
     21.2   

Interest on Past Due Obligations

   25

22.

  

Landlord’s Access to Premises

   25

23.

  

Notices

   25

24.

  

No Waiver

   26

25.

  

Estoppel Certificates

   26

26.

  

Rules and Regulations

   26

27.

  

Tenant’s Taxes

   26

28.

  

Corporate Authority

   26

29.

  

Miscellaneous

   27
     29.1   

Financial Statements

   27
     29.2   

Successors and Assigns

   27
     29.3   

Severability

   27

 

ii


     29.4   

Applicable Law

   27
     29.5   

Integration; Interpretation

   27
     29.6   

Quiet Enjoyment

   27
     29.7   

Holding Over

   28
     29.8   

Broker’s Commissions

   28
     29.9   

Recovery Against Landlord

   28
     29.10   

Amendments

   28
     29.11   

Attorneys’ Fees

   29
     29.12   

Exhibits and Schedules

   29

30.

  

Option to Extend Term

   29

31.

  

Roof Access

   32

32.

  

Signage

   33

33.

  

Parking

   33

 

Exhibits:

 

A    Diagram/Description of Premises
B    List of Defined Terms
C    Rules and Regulations

 

Schedule I:        Tenant’s Insurance Requirements

 

iii


BASIC LEASE INFORMATION

 

BUILDING:   

100 Potrero Avenue San

Francisco California

    
LANDLORDS ADDRESS:   

3340 Jackson Street

San Francisco, California 94118

Telephone: (415) 563-6947

Facsimile: (415) 563-4004

    
     with a copy to:     
    

Morrison & Foerster LLP

425 Market Street

San Francisco, California 94105-2482

Attn: Craig B. Etlin

Telephone: (415) 268-7456

Facsimile: (415) 268-7522

    
TENANTS ADDRESS:   

100 Potrero Avenue

San Francisco California

Attn: Steve Kelly

Telephone: (415) 645-5162

Facsimile: (415) 645-4000

    
     with a copy to:     
    

Farella Braun & Martel

235 Montgomery Street

San Francisco, California 94104

Attn: Anthony D. Ratner

Telephone: (415) 954-4448

Facsimile: (415) 954-4480

    
COMMENCEMENT DATE:   

January 1, 2006

   (3.1)
EXPIRATION DATE:   

December 31, 2013

   (3.1)
RENTABLE AREA OF PREMISES:   

69,641 square feet (subject to adjustment pursuant to Section 2.2)

   (2.1)
DIAGRAM OF PREMISES:   

See Exhibit A

    
BASE RENT:   

Monthly: $81,247.83 (subject to adjustment pursuant to Section 2.2)

    
    

Annual: $974,974.00 (subject to adjustment pursuant to Section 2.2)

   (4.1)

 

iv


USE:   

General office use and multi-media production, engineering and research and development

   (9.1)
PARKING:   

Parking Areas: 150 Hampshire, San Francisco (entire lot)

   (33)
    

Monthly Charge for use of entire parking lot: $10,640.00

    

 

v


OFFICE LEASE

 

THIS LEASE, dated as of December 31, 2005, is between RAY DOLBY AND DAGMAR DOLBY, AS TRUSTEES OF THE DOLBY FAMILY TRUST, DATED MAY 7, 1999, and RAY AND DAGMAR DOLBY REAL ESTATE INVESTMENTS, L.P., a California limited partnership (collectively, “Landlord”), and DOLBY LABORATORIES, INC., a California corporation (“Tenant”). Landlord and Tenant hereby covenant and agree as follows:

 

1. DEFINITIONS

 

  1.1 Location of Definitions; Basic Lease Information

 

For convenience of reference only defined terms and the sections in which they are defined are set forth in Exhibit B. The Basic Lease Information is hereby incorporated into and made a part of this Lease.

 

2. PREMISES

 

  2.1 Premises Defined

 

Landlord leases to Tenant and Tenant hires from Landlord on the terms and conditions contained in this Lease the Premises specified in the Basic Lease Information. The Premises consist of the entire Building (as described in the Basic Lease Information). As used herein, the term “Building” shall include the land underlying the Building, the Building structure and all rentable areas and improvements therein, and all common areas, walkways, facilities and other amenities appurtenant to or serving all or any portion of the Building (the “Building Common Areas”) situated within and adjacent or appurtenant to the Building which primarily or exclusively serve the Building, as determined from time to time by Landlord in its reasonable discretion.

 

Tenant accepts the Rentable Area as specified in the Basic Lease Information as the Rentable Area of the Premises and such area shall not be subject to recalculation. The terms “common area” and “common areas” shall mean spaces, facilities, and installations such as toilets, janitor, telephone, electrical, and mechanical rooms and closets, trash facilities, stairs, public lobbies, corridors and other circulation areas, wherever located in the Building. Tenant understands and agrees that the Premises shall be leased by Tenant in its as-is condition.

 

  2.2 Measurement of Premises

 

(a) Landlord and Tenant acknowledge that the rentable area of the Premises set forth in the Basic Lease Information was determined by Tenant’s architect, Collins Henderson (“Tenant’s Architect”). Within thirty (30) days after the Commencement Date, Tenant shall deliver to Landlord or a licensed architect designated by Landlord experienced in commercial office design (“Landlord’s Architect”), electronic “CAD” drawings of the Premises prepared by Tenant’s Architect, along with the detailed calculations of the square footage of the Premises derived therefrom. Landlord shall have a period ending ninety (90) days after the Commencement Date to verify the measurement of the Premises and notify Tenant if it disputes the calculation of the

 

1


rentable area, as set forth in the Basic Lease Information, and to provide the calculation of the rentable area of the Premises as determined by Landlord’s Architect to Tenant. If Landlord determines prior to the expiration of said ninety (90) day period that it will not dispute the calculation of rentable area, it shall notify Tenant of such determination in writing. Landlord’s Architect shall be provided reasonable access to the Premises upon reasonable advance notice to inspect the Premises in connection with the verification of such measurement. If Landlord fails to notify Tenant within the time period provided above that it objects to the calculation of the rental area, as set forth in the Basic Lease Information, Landlord shall be deemed to have accepted such calculation and there shall be no adjustment to the rentable area or Base Rent pursuant to this Section 2.2. If Landlord timely notifies objects to the calculation of the rental area, as set forth in the Basic Lease Information, Landlord and Tenant shall arrange a meeting with both Landlord’s Architect and Tenant’s Architect, to occur within thirty (30) days after Tenant’s receipt of Landlord’s notice of objection, to determine the reasons for the discrepancy and to attempt to reach agreement upon the calculation of the rentable area of the Premises. If Landlord and Tenant are not able to reach such agreement within fifteen (15) days after such meeting, or if such meeting does not occur, then within sixty (60) days after Tenant’s receipt of Landlord’s notice of objection, Landlord’s Architect and Tenant’s Architect shall designate a third licensed architect experienced in commercial office design (the “Third Architect”) who shall be provided with electronic “CAD” drawings of the Premises prepared by Tenant’s Architect, but shall not be provided with the calculations or determination of square footage made by either Tenant’s Architect or Landlord’s Architect. The Third Architect shall not have performed services for either Landlord or Tenant within five (5) years preceding his or her appointment. If Landlord’s Architect and Tenant’s Architect are not able to agree upon the Third Architect, either party may apply to the President of the San Francisco chapter of the American Institute of Architects to appoint the Third Architect, who shall meet the criteria set forth above. The Third Architect shall be provided reasonable access to the Premises upon reasonable advance notice to inspect the Premises in connection with the verification of such measurement. Within thirty (30) days after appointment of the Third Architect, the Third Architect shall present his determination of the rentable area of the Premises to Landlord and Tenant at a meeting for such purpose. If the rentable area as determined by the Third Architect is exactly equal to the average of the rentable area as determined by Landlord’s Architect and Tenant’s Architect, respectively, then the rentable area as determined by the Third Architect shall be the rentable area for all purposes of this Lease. In all other cases, the rentable area of the Premises for all purposes of this Lease shall be that determined by Landlord’s Architect or Tenant’s Architect, whichever is closest to the rentable areas as determined by the Third Architect. Landlord shall pay all fees and expenses of Landlord’s Architect, Tenant shall pay all fees and expenses of Tenant’s Architect, and Landlord and Tenant shall each pay one-half of the fees and expenses of the Third Architect. All determinations of rentable area pursuant hereto shall be made in accordance with the methods of measuring rentable area as described in the Standard Method for Measuring Floor Area in Office Buildings, ANSI Z65.1 1996, promulgated by the Building Owners and Managers Association (BOMA) International.

 

(b) In the event the procedure set forth in Section 2.2(a) above results in an adjustment in the rentable area of the Premises, then the Base Rent payable hereunder shall be adjusted (retroactively to the Commencement Date) to be an amount per annum (payable in monthly installments as provided herein) equal to $14.00 per rentable square foot multiplied by the square footage of the rentable area of the Premises, as so adjusted, and Landlord and Tenant shall

 

2


promptly execute an amendment to this Lease to reflect the adjustment of the rentable area and the Base Rent, and Tenant shall pay any additional Base Rent payable hereunder as a result of such adjustment to Landlord within thirty (30) days after the meeting at which the Third Architect’s determination of the rentable area is revealed to Landlord and Tenant.

 

3. TERM

 

  3.1 Term Commencement

 

The Premises are leased for a term (the “Term”) commencing on the Commencement Date as set forth in the Basic Lease Information. The Term of this Lease shall expire on the Expiration Date.

 

4. RENT; ADDITIONAL CHARGES

 

  4.1 Annual Rental

 

Tenant shall pay to Landlord during the Term at the address set forth in the Basic Lease Information, without demand, offset or deduction, Base Rent as set forth in the Basic Lease Information. Base Rent shall be payable on or before the first day of each month, in advance. If the Commencement Date or the Expiration Date should occur on a day other than the first or last day of a calendar month, respectively, then the Base Rent for such period shall be prorated.

 

  4.2 Additional Charges

 

Tenant shall pay to Landlord as and when due all charges, Impositions (as defined below) and tax reimbursements, fees, expenses, and all other amounts as provided in this Lease (“Additional Charges”), except to the extent that Tenant pays Impositions directly to the appropriate taxing authority as provided in Section 5.2 below. Unless otherwise specifically provided for herein, all Additional Charges shall be due on the later of twenty (20) days after Tenant’s receipt of Landlord’s invoice for the Additional Charges or the first day of the month following Tenant’s receipt of Landlord’s invoice for the Additional Charges. Base Rent and Additional Charges shall constitute the “Rent” payable by Tenant for the Premises.

 

  4.3 Late Charges

 

If Tenant fails to pay any Rent within five (5) days after written notice from Landlord that Tenant has failed to pay the same, such unpaid amounts will be subject to a late payment charge equal to five percent (5%) of the unpaid amounts in each instance. This late payment charge has been agreed upon by Landlord and Tenant, after negotiation, as liquidated damages and a reasonable estimate of the additional administrative costs and detriment that will be incurred by Landlord as a result of any such failure by Tenant, the actual damages and costs thereof being extremely difficult if not impossible to determine.

 

3


5. NET LEASE; TAXES AND ASSESSMENTS

 

  5.1 Net Lease

 

Without limiting any of the provisions of this Lease, the Base Rent and any Additional Charges payable to Landlord hereunder shall be absolutely net to Landlord and shall be paid without assertion of any counterclaim, setoff, deduction or defense and without any abatement, suspension, deferment or reduction, except only as otherwise expressly provided in Sections 15 and 17 of this Lease, and shall not be reduced, offset or diminished, directly or indirectly, by any cost, charge or expense payable hereunder by Tenant in connection with the Premises and/or the Building or any part thereof. Except as specifically provided otherwise in this Lease, under no circumstances or conditions, whether now existing or hereafter arising, and whether within or beyond the present contemplation of the parties, shall Landlord be expected or required to make any payment of any kind or incur any obligation whatsoever with respect to the Premises, or otherwise have any obligation or liability with respect to the Premises; provided that the foregoing shall not be construed to require Tenant (i) to perform any obligations of Landlord under any contract or agreement entered into by Landlord with any third party to which Tenant or any Tenant Affiliate (other than Landlord) is not a party, or (ii) to assume any liability for any obligations of Landlord arising under any mortgage or deed of trust granted by Landlord encumbering the Premises, including payment of debt service on any obligation secured thereby, provided that the foregoing shall not be construed to relieve Tenant from complying with and performing any express obligations of Tenant under this Lease that may also constitute covenants or obligations of Landlord under any such contract or agreement entered into by Landlord with any third party or under any mortgage or deed of trust.

 

  5.2 Payment of Taxes and Assessments

 

(a) “Impositions” shall mean all real property taxes and general and special assessments, transit charges, fees or assessments, housing fund assessments, security charges, maintenance fees, payments in lieu of taxes, fees or charges, and any tax, fee, assessment, charge or excise levied or assessed (whether at the date of this Lease or thereafter) (i) on the Building or any portion thereof or Landlord’s interest therein, or on Landlord’s personal property used in the operation of the Building, (ii) on the use or occupancy of the Building or any portion thereof, including, without limitation, any tax or levy made against Rent or gross receipts from the Building, (iii) in connection with the business of renting space in the Building, or in connection with entering into this Lease or any other lease with respect to the Building, or (iv) for housing, police, fire, or other governmental services provided by any governmental or public entity to the extent allocable to and collected by a lien upon the Building. Impositions shall also include any other tax, fee, or charge that may be levied or assessed as a substitute for any other Impositions. Impositions shall not include those amounts payable by Tenant pursuant to Section 27. Tenant and Landlord acknowledge that Proposition 13 was adopted by the voters of the State of California in the June, 1978 election and that assessments, taxes, fees, levies and charges may be imposed by governmental agencies for such purposes as fire protection, street, sidewalk, road, utility construction and maintenance, refuse removal and for other governmental services which may formerly have been provided without charge to property owners or occupants. It is the intention of the parties that all new and increased assessments, taxes, fees, levies and charges due

 

4


to any cause whatsoever are to be included within the definition of Impositions for purposes of this Lease.

 

(b) Tenant’s Obligation to Pay. Without limiting the generality of Section 5.1, but subject to Section 5.2(d) below, Tenant shall pay all Impositions allocable to the Premises during the Term or any holdover period on or before the date due, and in any event before delinquency and before any fine, interest or penalty may become due or be imposed by operation of law for nonpayment; provided, however, that: (i) Landlord shall pay or, if paid by Tenant, shall reimburse Tenant for any Impositions to the extent that the same are allocable to periods after the Expiration Date (or, if Tenant holds over following the Expiration Date, to periods after the actual date of surrender of the Premises by Tenant); and (ii) if any assessment is permitted by law to be paid in installments without additional charge or penalty, Tenant may pay such assessments in installments, but in no event later than the actual due date for such installments. Without limiting the foregoing, or any other provision hereof, if any fines, penalties or interest charges are imposed as a result of any failure by Tenant to pay any Impositions as and when required under this Section 5.2 or as a result of an unsuccessful contest of any Impositions by Tenant pursuant to Section 5.2(d) below, Tenant shall be obligated to pay the same within ten (10) business days after imposition thereof, unless Tenant exercises its right to contest such fines, penalties or interest charges pursuant to Section 5.2(d) below and provides a bond or other assurance of payment for such fines, penalties or interest charges as provided in Section 5.2(d) below.

 

(c) Direct Payment. Tenant shall pay all Impositions directly to the applicable taxing authority, and shall deliver to Landlord, within ten (10) days after payment thereof, true and correct copies of the receipted bills or other reasonable evidence showing such payment of all Impositions required to have been paid as of such date. Landlord shall cooperate with Tenant to cause all bills for Impositions to be sent directly to Tenant, but if the tax collection agency will not so agree, then Landlord shall tender all bills to Tenant promptly upon Landlord’s receipt, and in such event, if Landlord fails to tender any such bill to Tenant within the later of (i) ten (10) Business Days following the date of Landlord’s receipt of such bill from the taxing authority or (ii) twenty (20) Business Days prior to the date on which the tax, or installment thereof, represented by such bill shall become delinquent, then (A) Tenant shall not be in default hereunder for failure to make timely payment of such Imposition until the expiration of twenty (20) business days following the date on which Tenant shall receive a copy of such bill from Landlord, and (B) if Tenant has not received any tax bill from Landlord or the taxing authority prior to the twentieth (20th) Business Day before the date on which the applicable tax payment shall become delinquent, Tenant may deliver written notice to Landlord requesting Landlord to promptly forward any tax bill that may have been delivered to Landlord for the tax period in question, and if Landlord fails to deliver any such tax bill that has actually been received by Landlord from the taxing authority prior to the receipt of Tenant’s notice within ten (10) days following Landlord’s receipt of such notice from Tenant, Landlord shall be obligated to pay any penalties incurred by Tenant for late payment of such tax bill which are not reasonably avoidable by Tenant. Subject to the foregoing terms of this Section 5.2(c), if Tenant shall at any time fail to pay any Impositions when due and shall fail to cure such default within the applicable period provided under Section 20.1(f) below, then Landlord shall have the right at any time thereafter to require that Tenant pay monthly installments of Impositions into an impound account maintained by Landlord or an escrowee designated by Landlord (an “Impound

 

5


Account”). Tenant shall not be entitled to receive any interest or other return on any funds on deposit in any Impound Account, and any funds so held in any Impound Account may be commingled with other funds of Landlord or Landlord’s escrowee, or other parties depositing funds in such Impound Account, as applicable; provided that, except as otherwise provided upon the occurrence of an Event of Default, any funds held in an Impound Account maintained by Landlord or an escrowee designated by Landlord shall be used and disbursed by Landlord or such escrowee (subject to reduction for payment of customary account charges) for payment of the Impositions in respect of which such deposits have been made, and for no other purpose unless an Event of Default has occurred and is continuing.

 

(d) Right to Contest. Tenant shall have the right, at its sole cost and expense, to contest the full or partial amount or validity of any Imposition by appropriate administrative and legal proceedings, either in its own name or jointly with Landlord if Landlord so elects. Landlord shall cooperate with Tenant in any reasonable manner requested by Tenant, provided that (i) Tenant shall reimburse Landlord as Additional Charges hereunder for Landlord’s actual out-of-pocket costs incurred in connection with any such contest, (ii) no action by Tenant in connection with such contest shall expose Landlord to personal liability for the payment of any Impositions, and (iii) Tenant shall not be authorized to settle any such action if an Event of Default has occurred and is continuing. Tenant may postpone payment of any contested Imposition pending prompt and diligent prosecution of any such proceedings and appeals, but only if Tenant shall post a bond or other assurance of payment or performance with Landlord, an escrow designated by Landlord, or the court or administrative agency or other legal authority having jurisdiction over the contest, to ensure payment of all sums ultimately determined to be due by Tenant.

 

6. UTILITIES

 

  6.1 Utility Expenses

 

Tenant shall make its own arrangements for, and shall pay the full cost of, providing all water, sewer use, sewer discharge fees and permit costs and sewer connection fees, gas, heat, electricity, refuse pick-up, janitorial service, telephone, telecommunications, and all materials and services or other utilities (collectively, “Utilities”) that Tenant deems necessary or desirable for its occupancy and use of the Premises, all of which Utilities shall, at the request of Landlord and at Tenant’s sole cost and expense, be billed or metered separately to the Premises and/or Tenant, together with all taxes, assessments, charges and penalties added to or included within such cost. Tenant acknowledges that Landlord, Tenant, the Premises and/or the Building may become subject to the rationing of Utility services or restrictions on Utility use as required or recommended by a public utility company or provider, governmental agency or other similar entity having jurisdiction thereof. Tenant acknowledges and agrees that its tenancy and occupancy hereunder shall be subject to such rationing or restrictions as may be imposed upon Landlord, Tenant, the Premises, the Building, and Tenant shall in no event be excused or relieved from any covenant or obligation to be kept or performed by Tenant by reason of any such rationing or restrictions. Tenant agrees to comply with all energy conservation programs implemented by Landlord by reason of any rationing, restrictions or applicable laws, requirements or recommendations of governmental agencies or public utility companies or providers.

 

6


  6.2 Interruption of Utilities

 

Landlord shall not be liable for any loss, injury or damage to property caused by or resulting from any variation, interruption, or failure of Utilities due to any cause whatsoever, or from failure to make any repairs or perform any maintenance. No temporary interruption or failure of such services incident to the making of repairs, alterations, improvements, or due to accident, strike, or conditions or other events shall be deemed an eviction of Tenant or relieve Tenant from any of its obligations hereunder. In no event shall Landlord be liable to Tenant for any damage to the Premises or for any loss, damage or injury to any property therein or thereon occasioned by bursting, rupture, leakage or overflow of any plumbing or other pipes (including, without limitation, water, steam, and/or refrigerant lines), sprinklers, tanks, drains, drinking fountains or washstands, or other similar cause in, above, upon or about the Premises or the Building. Tenant hereby waives any and all rights under California Civil Code Section 1932(1) and Sections 1941 and 1942 or any other similar laws, statutes or ordinances now or hereafter in effect, including, without limitation, any right to terminate this Lease, vacate the Premises, and/or make repairs and deduct the expense thereof from the Rent.

 

7. CONDITION OF PREMISES

 

Tenant agrees and acknowledges that Tenant has been in possession of the Premises prior to the Commencement Date pursuant to that certain Master Lease between Ray M Dolby, as landlord, and DLI Realty Corp., a California corporation, as tenant, dated as of June 1, 1980, as amended by that certain Amendment to Master Lease, dated as of October 1, 1982, as amended by that certain Amendment Two to Master Lease, dated as of July 15, 1985, and as further amended by that certain Amendment No. 3 to Master Lease, dated as of July 15, 1986 (as amended, the “Original Lease”). Tenant further agrees and acknowledges that the Premises are suitable for Tenant’s use, and that Tenant shall lease the Premises in its as-is condition. Landlord makes no representation or warranty as to (i) the nature, quality or condition of the Premises or the Building, or (ii) the nature, quality or suitability for Tenant’s business of the Building or the Premises, and Tenant shall have no rights against Landlord by reason of any claimed deficiencies therein.

 

8. COMMON AREAS

 

  8.1 Right to Use Common Areas

 

Tenant and Tenant’s agents, representatives, employees and visitors, shall have the exclusive right to use during the Term the Building Common Areas, subject to Landlord’s reasonable rules and regulations and the provisions of this Lease.

 

9. USE

 

  9.1 Office Use

 

The Premises shall be used for general office and multi-media production, engineering and research and development purposes only.

 

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  9.2 No Nuisance

 

Tenant shall not allow, suffer or permit the Premises or any use thereof to constitute a nuisance, to violate any insurance policy restrictions, or to unreasonably interfere with the safety, comfort or enjoyment of the Building by Landlord or its customers, invitees or any others lawfully in, upon or about the Building.

 

  9.3 Compliance with Laws

 

Tenant, at Tenant’s expense, shall comply with, and cause all of Tenant’s agents, employees, contractors, representatives, and visitors to comply with, all applicable laws, ordinances, rules and regulations of governmental authorities applicable to the Premises or the Building or the use or occupancy thereof, including, without limitation, the federal Americans With Disabilities Act, as amended (collectively, “Laws”); provided that Tenant shall not be obligated pursuant to this Section 9.3 to make or pay for any structural elements of the Building, or any Building Common Areas, unless such alterations are required as a result of Tenant’s actions or Tenant’s default under this Lease during the term of this Lease or the Original Lease or result from or are associated with alterations or improvements to the Premises made by or for Tenant during the term of this Lease or the Original Lease.

 

  9.4 Hazardous Materials

 

Tenant shall not cause or suffer or permit any Hazardous Material, as defined below, to be brought upon, kept, used, discharged, deposited or released in, on, or about the Premises and/or the Building by Tenant, or any of Tenant’s agents, employees, representatives, contractors or visitors, provided that Tenant may keep on the Premises such Hazardous Materials as are customarily used by typical office tenants and are maintained in full compliance with all applicable laws. Tenant shall indemnify, defend (with legal counsel reasonably satisfactory to Landlord), and hold Landlord harmless from and against any and all claims, damages, losses, costs, liabilities and expenses (including, without limitation, diminution in value or use of the Building, attorneys’ fees, consultant fees and expert fees) which arise during or after the Term (including the term of the Original Lease) as a result of any breach by Tenant of this Section 9.4 or any contamination on or affecting the Premises and/or the Building which is caused by Tenant or any of Tenant’s agents, employees, representatives, contractors or visitors. This indemnification obligation shall survive any termination of this Lease and shall include, without limitation, costs incurred in connection with any investigation of site conditions and any clean-up, remedial, removal or restoration work on or affecting the Premises and/or the Building. “Hazardous Material” means any hazardous, toxic or dangerous substance, material or waste which currently is or hereafter becomes regulated by or under any local, state or federal governmental authority or environmental law, including, without limitation, (i) all chlorinated solvents, (ii) petroleum products or by-products, (iii) asbestos, (iv) polychlorinated biphenyls, and (v) mold or mold-like substances.

 

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10. ALTERATIONS AND TENANTS PROPERTY

 

  10.1 Alterations

 

(a) Tenant shall not before or during the Term make or suffer to be made any alterations, additions or improvements in or to the Premises (herein collectively called “Alterations”) without first obtaining Landlord’s written approval thereof based on detailed plans and specifications submitted by Tenant. Landlord’s approval may be withheld in Landlord’s sole and absolute discretion if any Alterations could in Landlord’s judgment affect the structure of the Building or the electrical, mechanical, heating, ventilation or air conditioning, life safety or plumbing systems of the Building (collectively the “Building Systems”), be visible from outside the Premises, or require additional code compliance or similar work not included in the Alterations; otherwise, Landlord’s consent shall not be unreasonably withheld. Without limiting the foregoing, all Alterations shall also be subject to the provisions of Section 11.2 below. Notwithstanding the foregoing, Tenant shall be permitted to make Alterations that do not affect the structure of the Building or the Building Systems that in the aggregate do not exceed Two Hundred Fifty Thousand Dollars ($250,000.00) without the prior written consent of Landlord; provided, however, that Tenant shall provide Landlord copies of all permits, plans and other related documents in connection with such Alterations.

 

(b) Any Alteration to the Premises shall be at Tenant’s sole cost and expense, in compliance with all applicable Laws and all requirements requested by Landlord, including, without limitation, the requirements of any insurer providing coverage for the Premises or the Building or any part thereof, and in accordance with plans and specifications approved in writing by Landlord, and shall be constructed and installed by a contractor reasonably approved in writing by Landlord. As a further condition to giving consent, with respect to Alterations that could affect the structural components of the Building Systems or which in the aggregate exceed One Million Dollars ($1,000,000.00) in cost, Landlord may require Tenant to provide Landlord, at Tenant’s sole cost and expense, a payment and performance bond in form reasonably acceptable to Landlord, in a principal amount not less than the estimated costs of such Alterations, to ensure Landlord against any liability for mechanics’ and materialmen’s liens and to ensure completion of work. Before Alterations may begin, valid building permits or other permits or licenses required must be furnished to Landlord, and, once the Alterations begin, Tenant will diligently and continuously pursue their completion. Landlord may monitor construction of the Alterations and Tenant shall reimburse Landlord for its reasonable costs (including, without limitation, the costs of any construction manager retained by Landlord) in reviewing plans and documents and in monitoring construction. Tenant shall maintain during the course of construction, at its sole cost and expense, builders’ risk insurance for the amount of the completed value of the Alterations on an all-risk non-reporting form covering all improvements under construction, including building materials, and other insurance in amounts and against such risks as Landlord shall reasonably require in connection with the Alterations. In addition to and without limitation on the generality of the foregoing, Tenant shall ensure that its contractor(s) procure and maintain in full force and effect during the course of construction a “broad form” commercial general liability and property damage policy of insurance naming Landlord, Tenant and Landlord’s lenders, if any, as additional insureds. The minimum limit of coverage of the aforesaid policy shall be in the amount of not less than Three Million Dollars ($3,000,000.00) for injury or death of one person in any one accident or occurrence and in the

 

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amount of not less than Three Million Dollars ($3,000,000.00) for injury or death of more than one person in any one accident or occurrence, and shall contain a severability of interest clause or a cross liability endorsement. Such insurance shall further insure Landlord and Tenant against liability for property damage of at least Three Million Dollars ($3,000,000.00).

 

(c) Tenant agrees not to proceed to make any Alterations, notwithstanding consent from Landlord to do so, until Tenant notifies Landlord in writing of the date Tenant desires to commence construction or installation of such Alterations and Landlord has approved such date in writing, in order that Landlord may post appropriate notices to avoid any liability to contractors or material suppliers for payment for Tenant’s improvements. Tenant will at all times permit such notices to be posted and to remain posted until the completion of work.

 

  10.2 Removal of Property

 

All Alterations shall become the property of Landlord, and shall be surrendered to Landlord, upon the expiration or earlier termination of this Lease; except for movable equipment, trade fixtures, personal property and furniture owned by Tenant (“Tenant Owned Property”). At Landlord’s sole election made at the time that Landlord approves any Alterations, such Alterations shall be removed from the Premises at Tenant’s sole cost and expense at the expiration or sooner termination of this Lease, and the Premises shall be restored, at Tenant’s sole cost and expense, to their condition before the making of such Alterations, and such obligations shall survive the expiration or any earlier termination of this Lease.

 

11. REPAIRS AND OTHER WORK

 

  11.1 Tenant’s Obligations

 

At Tenant’s sole cost and expense (except as provided in Section 11.3 below), Tenant shall at all times during the Term maintain the Premises in good, clean and sanitary condition and, at Tenant’s cost and expense, make all repairs and replacements as and when necessary to preserve the Premises in good working order and condition, including glass, windows, window frames, window casements, skylights, interior and exterior doors, door frames and door closers; interior lighting (including, without limitation, light bulbs and ballasts), the plumbing and electrical systems serving the Premises, all communications systems serving the Premises, Tenant’s signage, interior demising walls and partitions, equipment, interior painting and interior walls and floors, exterior walls, foundations, roof, other structural components, Tenant’s security systems in or about or serving the Premises and cause the fire alarm systems serving the Premises to be monitored by a monitoring or protective services firm reasonably approved by Landlord in writing. Tenant shall not do nor shall Tenant allow Tenant’s agents, advisors, employees, partners, shareholders, directors, invitees and independent contractors (collectively, “Tenant’s Agents”) to do anything to cause any damage, deterioration or unsightliness to the Premises or the Building; provided that Tenant shall not be obligated to repair or maintain the Building Systems that do not exclusively serve the Premises or the structural elements of the Building unless such repair or maintenance is necessitated by any act of Tenant, its agents, representatives, employees, contractors or visitors (subject to Section 15.5 below). Landlord shall not be liable for, and there shall be no abatement of Rent with respect to, any injury to or interference with Tenant’s business arising from any repairs, maintenance, alteration or

 

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improvement in or to any portion of the Premises and/or the Building, or in or to any fixtures, appurtenances or equipment therein. Tenant hereby waives the provisions of Sections 1941 and 1942 and 1932(1), respectively, of the California Civil Code and any similar law now or hereafter in effect, as such laws relate to the condition of the Premises or Tenant’s right to effect repairs in or to the Premises and deduct the cost thereof from the Rent.

 

  11.2 Conditions Applicable to Repairs and Other Work

 

All repairs, replacements, and reconstruction (including, without limitation, all Alterations) made by or on behalf of Tenant shall be made and performed (a) at Tenant’s cost and expense (except as provided in Section 11.3 below) and at such time and in such manner as Landlord may reasonably require, (b) by contractors or mechanics reasonably approved by Landlord, (c) so as to be at least equal in quality of materials and workmanship to the original work or installation, (d) in accordance with such reasonable requirements as Landlord may impose with respect to insurance to be obtained by Tenant, (e) in accordance with all applicable laws and regulations of governmental authorities having jurisdiction over the Premises and all Rules and Regulations for the Building adopted by Landlord from time to time, (f) so as not to interfere with the use and enjoyment of the Building by Landlord, other tenants of the Building or any other persons, and (g) in compliance with such other requirements as Landlord may reasonably impose (including, without limitation, a requirement that Tenant furnish Landlord with as-built drawings upon completion of the work). No approval by Landlord of any work done by or for Tenant in or at the Premises, including any Alterations, shall be construed to impose any liability on Landlord with respect to the design, construction, quality, operation, sufficiency, safety or any other attribute thereof. Landlord shall not be required to inspect or otherwise review any work done by or for Tenant in or at the Premises, and any inspection of such work which Landlord may elect to make will be solely for the protection of Landlord’s interests and will not expose Landlord to any liability with respect to such work or any conditions relating thereto.

 

  11.3 Landlord’s Obligations

 

Notwithstanding the provisions of Sections 11.1 and 11.2 above, subject to compliance with the provisions of this Section 11.3, Landlord shall reimburse Tenant for the costs reasonably incurred by Tenant for maintenance, repair and replacement of the roof (including membrane), except for costs to the extent necessitated by Tenant’s installation, maintenance or removal of any Roof Equipment (as defined below), foundations, and exterior walls of the Building. Except in the case of an emergency, Landlord shall not be obligated to reimburse any such costs, unless such costs have been authorized in advance by Landlord or deemed to have been authorized, as provided below in this Section 11.3. In the event any such costs are incurred as a result of an emergency, Tenant shall notify Landlord of such emergency and the need to incur such costs as soon as reasonably practicable thereafter, and shall only incur such costs as are reasonably necessary (as determined by Tenant in its reasonable discretion) to stabilize the Building and avoid further damage to the Building or injury to any persons prior obtaining Landlord’s approval of such costs. If Tenant desires to perform any repair or maintenance costs for which it intends to seek reimbursement by Landlord pursuant to this Section 11.3, except in the case of an emergency, Tenant shall request Landlord’s approval of the costs to be incurred prior to incurring the same. Any such request shall be in writing, and shall include a copy of proposal(s) from the contractor(s) Tenant desires to hire to perform the same. Landlord shall not

 

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unreasonably withhold its approval of any such request that is reasonably necessary to maintain such components of the Building to the standard to which Tenant has historically maintained such components of the Building during its occupancy thereof, including occupancy during the term of the Original Lease. Landlord’s failure to respond to any such request within ten (10) business days after receipt thereof shall be deemed to constitute Landlord’s approval of such request, so long as the request from Tenant includes a statement advising Landlord that its failure to respond within such ten (10) business day period shall be deemed to constitute its approval thereof. Any costs incurred by Tenant for which Landlord is responsible to pay in accordance with this Section 11.3 shall be reimbursed by Landlord within thirty (30) days after receipt of an invoice from Tenant, which shall be accompanied by copies of the underlying invoices from the contractor(s) performing such work, evidence that Tenant has paid the cost of such work in full, and a statement from Tenant certifying that such work has been completed to Tenant’s satisfaction. Any amounts not paid by Landlord within such thirty (30) day period shall bear interest from and after the thirty-first (31st) day at the rate of interest provided in Section 21.2 below.

 

12. LIENS

 

Tenant shall keep the Premises and the Building free from any liens arising from any acts or omissions of Tenant, or Tenant’s agents, employees, representatives, contractors or visitors. Tenant shall, within fifteen (15) days following notice of the imposition of any such lien, cause the same to be released of record by payment or posting of a bond fully satisfactory to Landlord in form and substance, and if Tenant fails to do so Landlord shall have, in addition to all other remedies provided herein and by law, the right (but not the obligation) to cause the lien to be released by such means as Landlord shall deem proper, including, without limitation, payment of the claim giving rise to such lien. All such sums paid by Landlord and all expenses incurred by it in connection therewith shall be Additional Charges payable by Tenant. Landlord shall have the right at all times to post and keep posted on the Premises any notices permitted or required by law, or that Landlord shall deem proper for the protection of Landlord, the Premises, the Building and any other party having an interest therein, from mechanics’, materialmen’s and other liens. In addition to all other requirements contained in this Lease, Tenant shall give to Landlord at least five (5) business days’ prior written notice of commencement of any construction or other work of improvement by or for Tenant on the Premises.

 

13. SUBORDINATION

 

This Lease and Tenant’s rights and interests thereunder shall be subject and subordinate at all times to (a) all existing and future ground leases or underlying leases affecting the Building or any other portion of the Building, and (b) the lien of any existing or future mortgage, deed of trust, or other security instrument in any amount for which the Building or any other portion of the Building or any interest therein is specified as security. Notwithstanding the foregoing, Landlord or the holder of any such ground or underlying lease or such lien shall have the right to cause the same to be subordinated to this Lease, and in such event Tenant shall, at the option of the party who succeeds to the interest of Landlord under this Lease upon any termination of any such ground or underlying lease or upon any foreclosure or assignment in lieu of foreclosure relating to such lien, attorn to and become the tenant of such successor in interest to Landlord, provided that such successor in interest shall recognize and agree to be bound by the terms of

 

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this Lease so long as Tenant is not in default. The foregoing provisions shall be self operative and no further instrument shall be required to effect the provisions of this Section; provided that Tenant covenants and agrees to execute and deliver, within ten (10) days after demand by Landlord and in the form requested by Landlord, any additional documents evidencing the foregoing. Notwithstanding anything contained in this Section 13 to the contrary, the subordination of this Lease to any future mortgage, deed of trust or security instrument is expressly conditioned on delivery to Tenant of a commercially reasonable subordination, non-disturbance and attornment agreement from the beneficiary(ies) thereof.

 

14. INABILITY TO PERFORM

 

If by reason of acts of God, governmental restrictions, strikes, labor disturbances, shortages of materials or supplies, or any other cause or event beyond Landlord’s reasonable control, whether similar or dissimilar to the foregoing, Landlord is unable to perform or is delayed in performing any of Landlord’s obligations under this Lease, no such inability or delay shall (a) constitute an actual or constructive eviction, in whole or in part, (b) entitle Tenant to any abatement or reduction of Rent, (c) relieve Tenant from any of its obligations under this Lease, or (d) impose any liability upon Landlord or its agents or contractors by reason of inconvenience or annoyance to Tenant or by reason of injury to or interruption of Tenant’s business, or otherwise. The provisions of this Lease shall supersede California Civil Code Section 1932(1) as it relates to the condition of the Premises or Tenant’s occupancy thereof, and Tenant hereby waives any right to terminate this Lease under Section 1932(1) or under any similar laws, statutes or ordinances now or hereafter in effect.

 

15. DESTRUCTION

 

  15.1 Repair

 

(a) If the Premises are damaged by fire or other perils (“Damaged Property”) covered by extended coverage insurance, Landlord shall, at Landlord’s option:

 

(i) In the event of total destruction (which shall mean destruction or damage in excess of fifty percent (50%) of the full insurable value thereof) of the Premises, elect either to commence promptly to repair and restore the Premises and prosecute the same diligently to completion, in which event this Lease shall remain in full force and effect; or not to repair or restore the Premises, in which event this Lease shall terminate. Landlord shall give Tenant written notice of its intention within thirty (30) days after the date (the “Casualty Discovery Date”) Landlord obtains actual knowledge of such damage or destruction. If Landlord elects not to restore the Premises, this Lease shall be deemed to have terminated as of the date of such total destruction.

 

(ii) In the event of a partial destruction (which shall mean destruction or damage to an extent not exceeding fifty percent (50%) of the full insurable value thereof) of the Premises for which Landlord will receive insurance proceeds sufficient to cover the cost to repair and restore such partial destruction and, if the damage thereto is such that the Premises may be substantially repaired or restored to its condition existing immediately prior to such damage or destruction within two hundred forty (240) days from the Casualty Discovery Date, Landlord

 

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shall commence and proceed diligently with the work of repair and restoration, in which event the Lease shall continue in full force and effect. If such repair and restoration requires longer than two hundred forty (240) days or if the insurance proceeds therefor (plus any amounts Tenant may elect or is obligated to contribute) are not sufficient to cover the cost of such repair and restoration, Landlord may elect either to so repair and restore, in which event the Lease shall continue in full force and effect, or not to repair or restore, in which event the Lease shall terminate. In either case, Landlord shall give written notice to Tenant of its intention within sixty (60) days after the Casualty Discovery Date. If Landlord elects not to restore the Premises, this Lease shall be deemed to have terminated as of the date of such partial destruction.

 

(iii) Notwithstanding anything to the contrary contained in this Section, in the event of damage to the Premises occurring during the last twelve (12) months of the Term, either Landlord or Tenant may elect to terminate this Lease by written notice of such election given to the other party within thirty (30) days after the Casualty Discovery Date.

 

(b) If the Premises are damaged by any peril not covered by extended coverage insurance, and the cost to repair such damage exceeds any amount Tenant may agree to contribute, Landlord may elect either to commence promptly to repair and restore the Premises and prosecute the same diligently to completion, in which event this Lease shall remain in full force and effect; or not to repair or restore the Premises, in which event this Lease shall terminate. Landlord shall give Tenant written notice of its intention within sixty (60) days after the Casualty Discovery Date. If Landlord elects not to restore the Premises, this Lease shall be deemed to have terminated as of the date on which Tenant surrenders possession of the Premises to Landlord, except that if the damage to the Premises materially impairs Tenant’s ability to continue its business operations in the Premises, then this Lease shall be deemed to have terminated as of the date such damage occurred.

 

(c) In the event of repair and restoration as herein provided, the monthly installments of Base Rent shall be abated proportionately in the ratio which Tenant’s use of the Premises is impaired during the period of such repair or restoration, but only to the extent of rental interruption insurance proceeds actually received by Landlord; it being acknowledged that Landlord has no obligation to carry, or to require Tenant to carry, for Landlord’s benefit, rental interruption insurance. Except as expressly provided in the immediately preceding sentence with respect to abatement of Base Rent, Tenant shall have no claim against Landlord for, and hereby releases Landlord and Landlord’s Agents from responsibility for and waives its entire claim of recovery for any cost, loss or expense suffered or incurred by Tenant as a result of any damage to or destruction of the Premises or the Building or the repair or restoration thereof, including, without limitation, any cost, loss or expense resulting from any loss of use of the whole or any part of the Premises or the Building and/or any inconvenience or annoyance occasioned by such damage, repair or restoration.

 

  15.2 Tenant’s Right to Terminate

 

In the event (i) such damage causes all or any material portion of the Premises to be unusable by Tenant for the normal operation of Tenant’s business on the Premises and in Landlord’s reasonable opinion such damage to the Premises cannot be repaired within two hundred forty (240) days from the Casualty Discovery Date so as to make the Premises

 

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reasonably usable by Tenant for the normal operation of Tenant’s business on the Premises, or (ii) the Term will expire within one (1) year from the Casualty Discovery Date and Tenant fails to extend the term in accordance with any right expressly granted in this Lease within thirty (30) days after the date of damage, then Tenant may terminate this Lease by delivery of written notice to Landlord within fifteen (15) days after the date on which Landlord’s opinion regarding time and repair is delivered to Tenant. Upon termination, Rent shall be equitably apportioned by Landlord as of the Casualty Discovery Date, with due consideration being given to the extent to which Tenant actually continues to operate its business on the Premises following the damage, provided that Tenant shall only be entitled to abatement of rent to the extent of rental interruption insurance proceeds actually received by Landlord; it being acknowledged that Landlord has no obligation to carry, or to require Tenant to carry, for Landlord’s benefit, rental interruption insurance.

 

  15.3 Landlord’s Right to Terminate

 

In the event (i) the Building is totally or substantially destroyed, or (ii) the cost of repair of the Building or any other portion of the Building following the damage or destruction equals or exceeds fifty percent (50%) of the replacement cost of the Building and such cost is not fully covered by insurance proceeds actually paid or payable to Landlord (and not required to be paid over to Landlord’s mortgagee); or (iii) the Term will expire within one (1) year from the Casualty Discovery Date and Tenant fails to extend the term in accordance with any right expressly granted in this Lease within thirty (30) days after the Casualty Discovery Date; or (iv) the Damaged Property cannot, in Landlord’s reasonable opinion, be repaired within two hundred forty (240) days after the Casualty Discovery Date or be feasibly restored to substantially the same condition as immediately prior to the damage, then Landlord may elect to terminate this Lease (A) by delivery of written notice to Tenant within thirty (30) days after the Casualty Discovery Date (in the case of a termination pursuant to clauses (i), (ii) or (iv) above, or (B) by delivery of written notice to Tenant within forty-five (45) days after the Casualty Discovery Date (in the case of a termination pursuant to clause (iii) above).

 

  15.4 Extent of Repair Obligations

 

If this Lease is not terminated pursuant to Section 15.1, 15.2 or 15.3 above, Landlord shall repair the structure of the Building and all improvements (except those constructed or installed by or on behalf of Tenant, if any) in the Premises, and Tenant shall repair all other portions of the Premises. All such repairs shall be performed in a good and workmanlike manner and shall, to the extent feasible, restore the items repaired to substantially the same usefulness, design and construction as existed immediately before the damage. All work by Tenant shall be performed in accordance with the requirements of Section 11.2. In the event of any termination of this Lease, the proceeds from any insurance carried by Landlord and paid by reason of damage to or destruction of the Building or any portion thereof shall belong to and be paid solely to Landlord.

 

  15.5 Waiver of Subrogation

 

Landlord and Tenant hereby mutually waive their respective rights of recovery against each other for any loss insured (or required to be insured by this Lease) by fire, extended coverage and other property insurance policies existing for the benefit of the respective parties. Each party

 

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shall obtain any special policy endorsements, if required to evidence compliance with such waiver.

 

  15.6 Non-Application of Certain Statutes

 

The provisions of this Lease constitute an express agreement between Landlord and Tenant with respect to any and all damage to, or destruction of, all or any part of the Premises or any other portion of the Building. Any statute or regulation of the State of California or any other governmental authority or body, including, without limitation, California Civil Code Sections 1932(2), 1933(4), 1941 and 1942, relating to any rights or obligations of a landlord and tenant upon damage or destruction of the leased premises shall have no application to this Lease or any damage or destruction to all or any part of the Premises or any other portion of the Building, and Tenant hereby waives the provisions of any such statute or regulation.

 

16. INSURANCE

 

Tenant shall during the Term, at Tenant’s sole cost and expense, provide insurance coverage conforming in all respects to the requirements of Schedule I (Tenant’s Insurance Requirements) attached hereto. Tenant shall not do anything, or suffer or permit anything to be done, in, on or about the Premises or the Building that shall invalidate or be in conflict with the provisions of any fire or other insurance policies covering the Building, the Building, or any property located therein or thereon. Tenant, at Tenant’s cost and expense, shall comply with, and shall cause all occupants of the Premises to comply with, all applicable customary rules, orders, regulations or requirements of any board of fire underwriters or other similar body.

 

17. EMINENT DOMAIN

 

  17.1 Effect of Taking

 

If the entirety of the Premises is condemned or taken (or any transfer is made in lieu thereof), other than a temporary taking, before or during the Term for public or quasi-public use (each of which events shall be referred to as a “taking”), this Lease shall automatically terminate as of the earlier of the date (the “effective date of taking”) (i) of the vesting of title in the condemning authority, or (ii) the date the condemning authority is authorized to take possession of the Premises. If only a part of the Premises is so taken, this Lease shall automatically terminate as to the portion of the Premises so taken as of the effective date of taking. If any portion of the Building is taken so as to render the Building incapable of economically feasible operation as reasonably determined by Landlord, this Lease may be terminated by Landlord, as of the effective date of taking, by written notice to Tenant given at any time prior to the effective date of taking. If a portion of the Premises or the Building is taken so as to render the Premises or the remaining portion thereof permanently unusable by Tenant for the normal operation of Tenant’s business on the Premises, as reasonably determined by Tenant, this Lease may be terminated by Tenant as of the date of the effective date of such taking, by written notice to Landlord given at any time prior to the effective date of taking. If this Lease is not terminated as a result of a taking, Landlord shall restore the Building to an architecturally whole unit; provided, however, that Landlord shall not be obligated to expend on such restoration more than the amount of the condemnation award actually received by Landlord (and not required to be

 

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paid over to Landlord’s mortgagee), nor do more work than that described in Section 15.4, unless Tenant pays to Landlord in advance (and without any credit against Rent or any other obligation of Tenant under this Lease) the difference between the cost of such restoration and the amount of the condemnation award so actually received by Landlord.

 

  17.2 Award

 

Landlord shall be entitled to the entire award for any taking, including, without limitation, any award made for the value of the leasehold estate created by this Lease. No award for any partial or entire taking shall be apportioned, and Tenant hereby assigns to Landlord any award that may be made in any taking; provided, however, that nothing contained herein shall be deemed to give Landlord any interest in any separate award made to Tenant for its relocation expenses, the taking of personal property and fixtures belonging to Tenant, the unamortized value of improvements made or paid for by Tenant, or the interruption of or damage to Tenant’s business.

 

  17.3 Abatement of Rent

 

In the event of a partial taking that does not result in a termination of this Lease as to the entire Premises, the Rent shall abate in proportion to the portion of the Premises so taken or rendered unusable by Tenant for the normal operation of Tenant’s business on the Premises. The provisions of this Lease specifically supersede California Code of Civil Procedure Sections 1265.120 and 1265.130 or any similar statute or regulation now or hereafter in effect relating to abatement of rent or termination of a lease in the event of a taking or condemnation of the Premises and/or any portion of the Building, and Tenant hereby waives the provisions of any such statute or regulation.

 

  17.4 Temporary Taking

 

If all or any portion of the Building or the Premises is taken for a limited period of time before or during the Term, this Lease shall remain in full force and effect; provided, however, that the Rent shall abate during such limited period in proportion to the portion of the Premises that is rendered not usable by Tenant by reason of such taking. Landlord shall be entitled to receive the entire award made in connection with any such temporary taking.

 

18. ASSIGNMENT AND SUBLETTING

 

  18.1 Consent Required

 

(a) Neither Tenant nor any sublessee (at any tier) or assignee of Tenant shall, directly or indirectly, voluntarily or by operation of law, sell, assign, encumber, pledge or otherwise transfer or hypothecate all or any part of the Premises or Tenant’s leasehold estate hereunder (each such act is herein referred to as an “Assignment”), or sublet the Premises or any portion thereof or permit the Premises to be occupied by anyone other than Tenant (each such act is herein referred to as a “Sublease”), without Landlord’s prior written consent in each instance, which consent shall not be unreasonably withheld; provided, however, that no Event of Default has occurred and is then continuing, nor has any event occurred which with the giving of notice or the passage of time, or both, would constitute a default hereunder. Any Assignment or Sublease that is not in

 

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compliance with this Section 18 shall be void. The acceptance of Rent by Landlord from a proposed assignee, sublessee or occupant of the Premises shall not constitute consent to any Assignment or Sublease by Landlord. In the event Landlord approves any Assignment or Sublease, fifty percent (50%) of the excess, after amortization of the reasonable cost of (i) leasing commissions, (ii) attorneys’ fees and (iii) tenant improvement costs actually incurred by Tenant in connection with such Sublease or Assignment, of the total amount of rent and other consideration paid under or in consideration for any such Sublease or Assignment over the Rent payable hereunder, shall be payable to Landlord as Additional Charges.

 

(b) Notwithstanding anything to the contrary contained in Section 18.1(a) above, upon prior written notice to Landlord, and provided that the Tenant Affiliate (as defined below) agrees to assume all of Tenant’s obligations under this Lease, Tenant shall have the right (to be exercised no more than three (3) times during the Term) to assign this Lease or to sublease the Premises or any part thereof to a Tenant Affiliate in accordance with the terms of this Section 18.1(b) and Section 18.2(b) below. In the event Tenant proposes to enter into such an assignment or sublease with a Tenant Affiliate, then Tenant shall provide Landlord with the information required to be delivered pursuant to Section 18.2(a) below prior to entering into such assignment or sublease. As used herein, a “Tenant Affiliate” shall mean an entity that (A) controls, is controlled by or is under common control with, Tenant, or (B) acquires all or substantially all of the business and assets of Tenant or results from a merger or consolidation with Tenant; and a party shall be deemed to “control” another party for purposes of the aforesaid definition only if the first party owns more than fifty percent (50%) of the stock or other beneficial interests of the second party.

 

  18.2 Notice

 

(a) Any request by Tenant for Landlord’s consent to a specific Assignment or Sublease shall include (i) the name of the proposed assignee, sublessee or occupant, (ii) the nature of the proposed assignee’s sublessee’s or occupant’s business to be carried on in the Premises, (iii) a copy of the proposed Assignment or Sublease, and (iv) such financial and other information as Landlord may reasonably request concerning the proposed assignee, sublessee or occupant or its business. Landlord shall have a response period of fifteen (15) business days after receipt of all information reasonably necessary to evaluate the proposed Assignment or Sublease in which to respond in writing to Tenant’s request, either approving the proposed Assignment or Sublease or stating the reasons for any disapproval. Tenant shall pay to Landlord the reasonable costs of processing each request for approval of an Assignment or Sublease plus the reasonable amount of all direct and indirect expenses incurred by Landlord arising from any assignee, occupant or sublessee taking occupancy.

 

(b) Without otherwise limiting the criteria upon which Landlord may withhold its consent, Landlord shall be entitled to consider all reasonable criteria including, but not limited to, the following: (i) whether or not the proposed subtenant or assignee is engaged in a business which, and the use of the Premises will be in an manner which, is in keeping with the then character and nature of all other tenancies in the Building; (ii) whether the use to be made of the Premises by the proposed subtenant or assignee would be prohibited by any other portion of this Lease, including, but not limited to, any rules and regulations then in effect, or under applicable Laws, and whether such use imposes a greater load upon the Premises and the Building services then

 

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imposed by Tenant; (iii) the business reputation of the proposed individuals who will be managing and operating the business operations of the assignee or subtenant, and the long-term financial and competitive business prospects of the proposed assignee or subtenant; and (iv) the creditworthiness and financial stability of the proposed assignee or subtenant in light of the responsibilities involved. In any event, Landlord may withhold its consent to any assignment or sublease, if the actual use proposed to be conducted in the Premises or portion thereof conflicts with the provisions of Section 9 above or with any other lease which restricts the use to which any space in the Building may be put.

 

  18.3 No Release

 

No consent by Landlord to any Assignment or Sublease by Tenant, and no specification in this Lease of a right of Tenant to make any Assignment or Sublease without the consent of Landlord, shall relieve the party originally named as Tenant hereunder (Dolby Laboratories, Inc., a California corporation (“Dolby California”)) or any assignee of Tenant’s interest hereunder, of any obligation to be performed by Tenant under this Lease. The consent by Landlord to any Assignment or Sublease shall not relieve Tenant or any successor of Tenant from the obligation to obtain Landlord’s express written consent to any other Assignment or Sublease.

 

  18.4 Entity Transfers

 

Any sale, assignment or other transfer, including, without limitation, by consolidation, merger or reorganization, of fifty percent (50%) or more (whether in a single transaction or series of transfers) of the equity ownership or beneficial interests in Tenant, if Tenant is a corporation, trust or limited liability company, or of any general partnership interest in Tenant if Tenant is a general or limited partnership, shall be an Assignment for purposes of this Lease, unless following such sale assignment or other transfer or transaction, Tenant is either Dolby Laboratories, Inc., a Delaware corporation, or its successor by merger or consolidation (collectively, “Dolby Delaware”) or a wholly-owned direct or indirect subsidiary of Dolby Delaware (a “Dolby Subsidiary”; Dolby Delaware and Dolby Subsidiaries are collectively referred to herein as “Dolby Entities” and individually as a “Dolby Entity”). If Tenant is a corporation, the provisions of this Section 18.4 shall not apply at any time when the stock of Tenant is traded on a national exchange, and if Tenant is a Dolby Subsidiary, the provisions of this Section 18.4 shall not apply to any transfer of stock in Dolby Delaware at any time when the stock of Dolby Delaware is traded on a national exchange.

 

  18.5 Assumption of Obligations

 

Each assignee or other transferee of Tenant’s interest hereunder shall assume all obligations of Tenant under this Lease and shall be and remain liable jointly and severally with Tenant for the payment of Rent, and for the performance of all the terms, covenants, conditions and agreements herein contained on Tenant’s part to be performed for the Term. Each sublessee of all or any portion of the Premises shall, as a condition to such sublease, agree in writing for the benefit of and pursuant to a written instrument satisfactory to Landlord (a) to comply with all provisions of this Lease applicable to the subleased premises (other than the amount of Rent payable under this Lease in the case of any sublease of less than all of the Premises), and (b) that, at Landlord’s option, such sublease (and all further subleases of any portion of the Premises)

 

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shall terminate upon any termination of this Lease, regardless of whether or not such termination is voluntary, or such sublessee shall attorn to Landlord on and subject to all provisions of the sublease.

 

  18.6 No Signs

 

Tenant shall not, without Landlord’s consent, place or allow to be placed in, on or about the Building any sign or other notice indicating Tenant’s desire to assign this Lease or sublet the Premises.

 

  18.7 Non-Application of Certain Statutes

 

Tenant acknowledges and agrees that the restrictions, conditions and limitations imposed by this Section 18 on Tenant’s ability to assign or transfer this Lease or any interest herein, to sublet the Premises or any part thereof, to transfer or assign any right or privilege appurtenant to the Premises, or to allow any other person to occupy or use the Premises or any portion thereof, are, for the purposes of California Civil Code Section 1951.4, as amended from time to time, and for all other purposes, reasonable at the time that the Lease was entered into, and shall be deemed to be reasonable at the time that Tenant seeks to assign or transfer this Lease or any interest herein, to sublet the Premises or any part thereof, to transfer or assign any right or privilege appurtenant to the Premises, or to allow any other person to occupy or use the Premises or any portion thereof.

 

19. SECURITY SYSTEMS AND PROGRAMS

 

Landlord shall have no obligation or liability to Tenant, or any of Tenant’s agents, employees, representatives, contractors or visitors, to provide any safety or security devices on or for the Building or for the manner or quality of any such devices or services that Landlord may elect to provide on or for the Building. The risk that any safety or security device, service or program may not be effective, or may malfunction or be circumvented, is assumed by Tenant with respect to the property, personnel, and interests of Tenant, and any of Tenant’s agents, employees, representatives, contractors and visitors, and Tenant shall obtain insurance coverage to the extent Tenant desires protection against criminal acts or other losses. Tenant agrees to cooperate fully at Tenant’s expense with any reasonable safety or security program developed by Landlord on or for the Building or required by law.

 

20. DEFAULT

 

  20.1 Events of Default

 

The occurrence of any one or more of the following events shall constitute an “Event of Default” on the part of Tenant under this Lease:

 

(a) Failure of Tenant to make any payment of Rent when and as the same becomes due, and such failure continues for five (5) days after written notice from Landlord of such failure;

 

(b) Failure of Tenant to perform any obligation of Tenant under this Lease, other than as described in any other subsection of this Section 20.1, where such failure shall continue for

 

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thirty (30) days after notice of such failure by Landlord to Tenant; provided that if more than thirty (30) days are reasonably required for cure of such failure, Tenant shall not be deemed to be in default if Tenant commences such cure within such thirty (30) day period and thereafter diligently prosecutes such cure to completion and actually completes such cure within sixty (60) days after the giving of the aforesaid written notice;

 

(c) The filing by or against Tenant of any action or proceeding under any federal or state insolvency, reorganization, bankruptcy or other debtor relief statute now or hereafter existing (unless in the case of such action taken against Tenant, the same is dismissed within sixty (60) days); or the appointment of a trustee or receiver for Tenant or its business, or the attachment of Tenant’s leasehold estate in the Premises or Tenant’s assets at the Premises, unless the same is dismissed within thirty (30) days after such appointment or attachment;

 

(d) Abandonment of this Lease has been established pursuant to the procedure described in Civil Code Section 1951.3.

 

(e) An assignment or sublease, or attempted assignment or sublease, of this Lease or the Premises by Tenant contrary to the provision of Section 18, unless such assignment or sublease is expressly conditioned upon Tenant having received Landlord’s consent thereto;

 

(f) Any insurance required to be maintained by Tenant pursuant to this Lease shall be canceled or terminated or shall expire or be reduced or materially changed, except as permitted in this Lease, and Tenant fails to procure the required insurance within three (3) business days after written notice from Landlord;

 

(g) Any failure by Tenant to discharge any lien or encumbrance placed on the Building in violation of this Lease within ten (10) days after the date such lien or encumbrance is filed or recorded against the Building; and

 

(h) Failure of Tenant to execute and deliver to Landlord any estoppel certificate within the time periods and in the manner required by Section 25, and/or failure by Tenant to deliver to Landlord any financial statement within the time period and in the manner required by Section 29.1.

 

  20.2 Remedies

 

Upon the occurrence of a default by Tenant under this Lease that is not remedied by Tenant within the applicable cure periods specified in Section 20.1, Landlord shall have the following rights and remedies in addition to and without limiting any and all other rights and remedies available to Landlord at law or in equity:

 

(a) The rights and remedies provided by California Civil Code Section 1951.2, including, without limitation, the right to terminate Tenant’s right to possession of the Premises and to recover the amounts specified in California Civil Code Subsections 1951.2(a)(1)-(4);

 

(b) In the event of any Default by Tenant, then in addition to any other remedies available to Landlord at law or in equity and under this Lease, Landlord shall have the immediate option to terminate this Lease and all rights of Tenant hereunder by giving written notice of such intention

 

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to terminate. In the event that Landlord shall elect to so terminate this Lease then Landlord may recover from Tenant:

 

(i) the worth at the time of award of any unpaid Rent and any other sums due and payable which have been earned at the time of such termination; plus

 

(ii) the worth at the time of award of the amount by which the unpaid Rent and any other sums due and payable which would have been earned after termination until the time of award exceeds the amount of such rental loss Tenant proves could have been reasonably avoided; plus

 

(iii) the worth at the time of award of the amount by which the unpaid Rent and any other sums due and payable for the balance of the term of this Lease after the time of award exceeds the amount of such rental loss that Tenant proves could be reasonably avoided; plus

 

(iv) any other amount necessary to compensate Landlord for all the detriment proximately caused by Tenant’s failure to perform its obligations under this Lease or which in the ordinary course would be likely to result therefrom, including, without limitation, (A) any costs or expenses incurred by Landlord (1) in retaking possession of the Premises; (2) in maintaining, repairing, preserving, restoring, replacing, cleaning, altering, remodeling or rehabilitating the Premises or any affected portions of the Building, including such actions undertaken in connection with the reletting or attempted reletting of the Premises to a new tenant or tenants; (3) for leasing commissions, advertising costs and other expenses of reletting the Premises; or (4) in carrying the Premises, including taxes, insurance premiums, utilities and security precautions; (B) any unearned brokerage commissions paid in connection with this Lease; (C) reimbursement of any previously waived or abated Base Rent or Additional Charges or any free rent or reduced rental rate granted hereunder; and (D) any concession made or paid by Landlord to the benefit of Tenant in consideration of this Lease including, but not limited to, any moving allowances, contributions, payments or loans by Landlord for tenant improvements or build-out allowances, if any, or assumptions by Landlord of any of Tenant’s previous lease obligations; plus

 

(v) such reasonable attorneys’ fees incurred by Landlord as a result of a default, and costs in the event suit is filed by Landlord to enforce such remedy; and plus

 

(vi) at Landlord’s election, such other amounts in addition to or in lieu of the foregoing as may be permitted from time to time by applicable law.

 

As used in subparagraphs (i) and (ii) above, the “worth at the time of award” is computed by allowing interest at an annual rate equal to twelve percent (12%) per annum or the maximum rate permitted by law, whichever is less. As used in subparagraph (iii) above, the “worth at the time of award” is computed by discounting such amount at the discount rate of the Federal Reserve Bank of San Francisco at the time of award, plus one percent (1%). Tenant waives redemption or relief from forfeiture under California Code of Civil Procedure Sections 1174 and 1179, or under any other pertinent present or future Law, in the event Tenant is evicted or Landlord takes possession of the Premises by reason of any Default of Tenant hereunder.

 

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(c) The rights and remedies provided by California Civil Code Section 1951.4, including, without limitation, the right to continue the Lease in effect after Tenant’s breach and abandonment and recover any and all Rent as it becomes due. Acts of maintenance or preservation, efforts to relet the Premises or the appointment of a receiver upon Landlord’s initiative to protect its interest under this Lease, shall not in and of themselves constitute a termination of Tenant’s right to possession;

 

(d) The right, with or without terminating this Lease, in compliance with applicable law, to enter the Premises and remove all persons and property, to store such property in a public warehouse or elsewhere at the cost of and for the account of Tenant, and to sell such property and apply the proceeds thereof pursuant to applicable California law;

 

(e) The right to have a receiver appointed for Tenant, upon application by Landlord, to take possession of the Premises and to apply any rental collected from the Premises;

 

(f) The right to specific performance of any or all of Tenant’s obligations hereunder, and to damages for delay in or failure of such performance; and

 

(g) The right to remedy such default at Tenant’s expense, upon two (2) days’ prior notice to Tenant except that prior notice shall not be required in the case of an imminent threat to life or safety of any person or to the impairment of the Building or its efficient operation.

 

  20.3 Reletting

 

In the event that Landlord shall elect to re-enter as provided in Section 20.2 or shall take possession of the Premises pursuant to legal proceeding or pursuant to any notice provided by law, then if Landlord does not elect to terminate this Lease as provided in Section 20.2, Landlord may from time to time, without terminating this Lease, relet the Premises or any part thereof for such term or terms and at such rental or rentals and upon such other terms and conditions as Landlord in its sole discretion may deem advisable with the right to make alterations and repairs to the Premises in Landlord’s sole discretion. In the event that Landlord shall elect to so relet, then rentals received by Landlord from such reletting shall be applied in the following order: (i) to reasonable attorneys’ fees incurred by Landlord as a result of a Default and costs in the event suit is filed by Landlord to enforce such remedies; (ii) to the payment of any indebtedness other than Rent due hereunder from Tenant to Landlord; (iii) to the payment of any costs of such reletting; (iv) to the payment of the costs of any alterations and repairs to the Premises; (v) to the payment of Rent due and unpaid hereunder; and (vi) the residue, if any, shall be held by Landlord and applied in payment of future Rent and other sums payable by Tenant hereunder as the same may become due and payable hereunder. Should that portion of such rentals received from such reletting during any month, which is applied to the payment of Rent hereunder, be less than the Rent payable during the month by Tenant hereunder, then Tenant shall pay such deficiency to Landlord. Such deficiency shall be calculated and paid monthly. Tenant shall also pay to Landlord, as soon as ascertained, any costs and expenses incurred by Landlord in such reletting or in making such alterations and repairs not covered by the rentals received from such reletting.

 

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  20.4 Landlord’s Right to Perform Tenant’s Obligations

 

(a) Without limiting the rights and remedies of Landlord contained in Sections 20.2 and 20.3 above, if Tenant shall be in default in the performance of any of the terms, provisions, covenants or conditions to be performed or complied with by Tenant pursuant to this Lease, then Landlord may at Landlord’s option, without any obligation to do so, and without notice to Tenant perform any such term, provision, covenant, or condition, or make any such payment and Landlord by reason of so doing shall not be liable or responsible for any loss or damage thereby sustained by Tenant or anyone holding under or through Tenant or any of Tenant’s Agents.

 

(b) Without limiting the rights of Landlord under Sections 20.2 and 20.3 above, Landlord shall have the right at Landlord’s option, without any obligation to do so, to perform any of Tenant’s covenants or obligations under this Lease without notice to Tenant in the case of an emergency, as determined by Landlord in its sole and absolute judgment, or if Landlord determines, in its sole and absolute judgment, that such action is necessary or desirable to avoid imminent harm to the Premises or any persons.

 

(c) If Landlord performs any of Tenant’s obligations hereunder in accordance with this Section 20.4, the full amount of the cost and expense incurred or the payment so made or the amount of the loss so sustained shall immediately be owing by Tenant to Landlord, and Tenant shall promptly pay to Landlord upon demand, as Additional Charges, the full amount thereof with interest thereon from the date of payment by Landlord at the lower of (i) ten percent (10%) per annum, or (ii) the highest rate permitted by applicable law.

 

  20.5 Remedies Cumulative

 

The exercise of any remedy provided by law or the provisions of this Lease shall not exclude any other remedies. Tenant hereby waives any right of redemption or relief from forfeiture following termination of, or exercise of any remedy by Landlord with respect to, this Lease.

 

21. INDEMNITY; INTEREST ON OVERDUE OBLIGATIONS

 

  21.1 Indemnity

 

Except to the extent caused by the gross negligence or willful misconduct of Landlord, Tenant shall indemnify, defend (using legal counsel reasonably satisfactory to Landlord), and hold harmless Landlord, all officers, directors and shareholders of Landlord, all partners or members of any partnership or limited liability company constituting Landlord, and each of their respective officers, directors, shareholders, employees, servants and agents, all mortgagees or beneficiaries of Landlord’s interest in all or any portion of the Building (sometimes collectively referred to herein as “Landlord Related Entities”) from and against any and all claims, losses, costs, liabilities, damages and expenses, including, without limitation, reasonable attorneys’ fees (collectively, “Claims and Liabilities”), that are incurred in connection with or arise from (a) any default by Tenant in the observance or performance of any of the terms, covenants, conditions or other obligations of this Lease, (b) the use or occupancy or manner of use or occupancy of the Premises or the Building by Tenant or any person occupying the Premises, (c) any occurrence or happening on the Premises between the Commencement Date and the time Landlord has

 

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accepted surrender of the Premises, (d) any negligence or willful act or omission of Tenant or any assignee or subtenant of the Premises or any of their respective agents, employees, representatives, contractors or visitors while on the Building, or (e) Landlord’s inability to obtain access to any portion of the Premises with respect to which Landlord has not been furnished a key (if locked) or access has been otherwise restricted.

 

  21.2 Interest on Past Due Obligations

 

Any amount due from Tenant to Landlord under this Lease which is not paid within five (5) days from the date when due shall bear interest from the due date until paid at the lesser of the highest rate then permitted by law or a rate per annum equal to four percent (4%) plus the highest rate identified as the “prime rate” in the Wall Street Journal between the date such amount was due and the date such payment was received. Payment of such interest shall not excuse or cure any default under this Lease.

 

22. LANDLORDS ACCESS TO PREMISES

 

Landlord reserves for itself and its agents, employees and contractors the right to enter the Premises at all reasonable times (upon reasonable telephonic notice, if possible) to inspect the Premises, to supply any service to be provided by Landlord to Tenant hereunder, to show the Premises to prospective purchasers, mortgagees, beneficiaries or (during the last twelve (12) months of the Term) prospective tenants, to post notices of nonresponsibility, to determine whether Tenant is complying with its obligations under this Lease, and to alter, improve or repair the Premises or any other portion of the Building. Tenant shall not place any locks on any interior doors in the Premises without the consent of Landlord and without providing Landlord with copies of the keys for such locks. In the event of an emergency, Landlord shall have the right to enter the Premises at any time without notice. Landlord shall have the right to use any and all means that Landlord may deem necessary or proper to open doors in an emergency, in order to obtain entry to any portion of the Premises. Tenant hereby waives any claim for damages for any injury or inconvenience to or interference with Tenant’s business, any loss of occupancy or quiet enjoyment of the Premises, any right to abatement of Rent, or any other loss occasioned by Landlord’s exercise of any of its rights under this Section 22. Tenant waives all rights to consequential damages (including, without limitation, damages for lost profits and lost opportunities) arising in connection with Landlord’s exercise of its rights under this Section 22.

 

23. NOTICES

 

Any payment required to be made by Tenant to Landlord, and any bills, statements, notices, demands, requests or other communications given or required to be given under this Lease, shall be effective only if rendered or given in writing, sent by personal delivery or registered or certified mail, return receipt requested, by overnight courier service, or by electronically confirmed facsimile transmission with a following copy by first class mail, addressed (a) to Tenant at the Premises, (b) to Landlord at the address set forth in the Basic Lease Information, or (c) to such other address as either Landlord or Tenant may designate as its new address in California for such purpose by notice given to the other in accordance with the provisions of this Section 23. Any such bill, statement, notice, demand, request or other communication shall be deemed to have been rendered or given on the date of receipt or refusal to accept delivery.

 

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24. NO WAIVER

 

No provision of this Lease may be waived, and no breach thereof shall be waived, except by a written instrument signed by the party against which the enforcement of the waiver is sought. No failure by Landlord to insist upon the strict performance of any obligation of Tenant under this Lease, and no course of conduct between Landlord and Tenant, shall constitute a waiver of any breach or a waiver or modification of any term, covenant or condition of this Lease. No payment by Tenant of a lesser amount than the aggregate of all Rent then due under this Lease shall be deemed to be other than on account of the first items of such Rent then accruing or becoming due, unless Landlord elects otherwise.

 

25. ESTOPPEL CERTIFICATES

 

Either party, at any time and from time to time, within ten (10) days after written request from the other party, shall execute, acknowledge and deliver to the other party, addressed (at the requesting party’s request) to any prospective purchaser, ground or underlying lessor, or mortgagee or beneficiary of any part of the Building or Tenant’s leasehold interest therein, an estoppel certificate in form and substance reasonably designated by the requesting party. The non-requesting party’s failure to do so within such ten (10) day period shall be conclusive that all facts set forth in the proposed certificate are true and correct.

 

26. RULES AND REGULATIONS

 

Tenant shall at all times observe and comply with, and cause all occupants of the Premises to observe and comply with, the rules and regulations attached to this Lease as Exhibit C, and with all reasonable modifications thereof from time to time adopted by Landlord (the “Rules and Regulations”).

 

27. TENANTS TAXES

 

In addition to all other sums to be paid by Tenant under this Lease, Tenant shall pay, before delinquency, any and all taxes levied or assessed during the Term, whether or not now customary or within the contemplation of the parties hereto, (a) upon, measured by or reasonably attributable to Tenant’s improvements, equipment, furniture, fixtures and other personal property located in the Premises, including, without limitation, all Alterations, (b) upon or measured by any Rent payable under this Lease, including, without limitation, any gross income tax or excise tax levied by any federal, state or local governmental body with respect to the receipt of such rental by Landlord; (c) upon or with respect to the possession, leasing, operation, management, maintenance, alteration, repair, use or occupancy by Tenant of the Premises or any portion thereof; or (d) upon this transaction or any document to which Tenant is a party creating or transferring an interest or an estate in the Premises.

 

28. CORPORATE AUTHORITY

 

Each person executing this Lease on behalf of Tenant or any entity constituting Tenant at any ownership tier hereby represents and warrants that such person is duly authorized and has full right, power and authority to enter into this Lease and bind Tenant, without qualification.

 

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29. MISCELLANEOUS

 

  29.1 Financial Statements

 

Upon Landlord’s written request from time to time (not more frequently than once per year), Tenant shall promptly furnish Landlord with certified financial statements reflecting Tenant’s then-current financial condition, in such form and detail as Landlord may reasonably request; provided, however, that if Tenant is a corporation, then so long as the stock of Tenant is traded on a national exchange, Tenant may furnish its annual or most recent quarterly report instead of financial statements.

 

  29.2 Successors and Assigns

 

Without limiting Section 18 and subject to Section 29.9, the terms, covenants and conditions in this Lease shall bind and inure to the benefit of Landlord and Tenant and their respective representatives, successors and assigns.

 

  29.3 Severability

 

If any provision of this Lease or the application thereof to any person or circumstance shall, to any extent, be invalid or unenforceable, the remainder of this Lease, or the application of such provision to any other persons or circumstances, shall not be affected thereby, and each provision of this Lease shall remain in effect and shall be enforceable to the fullest extent permitted by law.

 

  29.4 Applicable Law

 

This Lease shall be governed by and construed in accordance with the laws of the State of California, without giving effect to any principles of conflicts of law.

 

  29.5 Integration; Interpretation

 

The terms of this Lease (including, without limitation, the Exhibits and Schedules hereto) are intended by the parties as a final expression of their agreement with respect to such terms as are included in this Lease and may not be contradicted by evidence of any prior or contemporaneous agreement, arrangement, understanding or negotiation (whether oral or written). The word “including” shall mean “including, without limitation,” the singular shall include the plural and vice-versa, and each gender shall include any other gender. Time is of the essence of each and every provision of this Lease.

 

  29.6 Quiet Enjoyment

 

Upon Tenant paying the Rent and performing all of Tenant’s obligations under this Lease, Tenant may peacefully and quietly enjoy the Premises during the Term as against all persons or entities claiming by or through Landlord; subject, however, to the provisions of this Lease, including Section 13.

 

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  29.7 Holding Over

 

If Tenant holds over after the expiration or earlier termination of the Term, the Term shall not be extended thereby, and Tenant shall pay Base Rent equal to one hundred fifty percent (150%) of the Base Rent payable during the final full lease year (exclusive of abatements, if any), together with an amount reasonably estimated by Landlord for the monthly Additional Charges and other sums payable under this Lease, and such holding over shall otherwise be on the terms and conditions herein specified so far as applicable (but expressly excluding all renewal or extension rights).

 

  29.8 Broker’s Commissions

 

Each party represents and warrants to the other that it has not entered into any agreement or incurred or created any obligation which might require the other party to pay any broker’s commission, finder’s fee or other commission or fee relating to the leasing of the Premises other than Colliers International and The CAC Group. Tenant shall be responsible for the payment of any compensation due Colliers International, and Landlord shall be responsible for the payment of any compensation due The CAC Group. Each party shall indemnify, defend and hold harmless the other and the other’s constituent partners and members, and their respective officers, directors, agents and employees, from and against (i) its failure to pay any compensation due Colliers International, in the case of Tenant, or its failure to pay any compensation due The CAC Group, in the case of Landlord, and (ii) any and all claims and liabilities for any such commissions or fees made by anyone else claiming by or through the indemnifying party.

 

  29.9 Recovery Against Landlord

 

Tenant shall look solely to Landlord’s interest in the Building for any recovery of any judgment or other award against Landlord arising out of or relating to any obligations of Landlord under this Lease or any acts or omissions of Landlord in connection with the Premises or the Building. Neither Landlord nor any Landlord Related Entities shall be personally liable for any such judgment or award. In the event that any Landlord transfers or conveys its interest in the Building, all liabilities and obligations on the part of such Landlord under this Lease accruing after the effective date of such transfer or conveyance shall terminate and Tenant shall have no further claim against the transferring Landlord with respect to the performance thereof, and all such liabilities and obligations, including responsibility for the application or return of any security deposit, shall be binding upon the new owner.

 

  29.10 Amendments

 

No amendments or modifications of this Lease or any agreements in connection therewith shall be valid unless in writing duly executed by both Landlord and Tenant. No amendment to this Lease shall be binding on any mortgagee or beneficiary of Landlord (or purchaser at any foreclosure sale) unless such mortgagee or beneficiary shall have consented thereto in writing.

 

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  29.11 Attorneys’ Fees

 

If either party commences an action against the other party arising out of or in connection with this Lease, or institutes any proceeding in a bankruptcy or similar court which has jurisdiction over the other party or any or all of its property or assets, the prevailing party shall be entitled to recover from the losing party reasonable attorneys’ fees and court costs, including fees incurred on appeal and any other post-judgment proceeding.

 

  29.12 Exhibits and Schedules

 

Exhibits A through C and Schedule I, are attached hereto and by this reference incorporated herein.

 

30. OPTION TO EXTEND TERM

 

(a) Landlord hereby grants to original Tenant the option (“Extension Option”) to extend the Term of this Lease for two (2) additional terms (each, an “Option Term”) of five (5) years each upon and subject to the terms and conditions set forth in this Section. The Extension Option shall be exercised, if at all, by written notice given to Landlord no more than fifteen (15) months and no less than twelve (12) months prior to the Expiration Date of the Term (or the First Option Term, in the case of the exercise of the second Extension Option). If Tenant exercises an Extension Option, each of the terms, covenants and conditions of this Lease (including responsibility for repair and maintenance of the Premises and responsibility for payment of Impositions) shall apply during the Option Term as though the expiration date of such Option Term was the date originally set forth herein as the Expiration Date of the Term, provided that (i) the Base Rent to be paid during the applicable Option Term shall be the Prevailing Market Rental (as hereinafter defined) for the Premises for the applicable Option Term, (ii) the Expiration Date for this Lease shall become the expiration date for the applicable Option Term; and (iii) there shall be no additional option terms following the second Option Term. Anything contained herein to the contrary notwithstanding, if Tenant is in monetary or material non-monetary default under any of the terms, covenants or conditions of this Lease either at the time Tenant exercises the Extension Option or at any time thereafter prior to the commencement date of the Option Term (in either event beyond any applicable notice and cure periods), Landlord shall have, in addition to all of Landlord’s other rights and remedies provided in this Lease, the right to terminate the Extension Option upon notice to Tenant. As used herein, the term “Prevailing Market Rental” for the Premises shall mean the Base Rent that Landlord could obtain for the Option Term from a third party desiring to lease the Premises for the Option Term taking into account (1) the quality and condition of the Building and the Premises, (2) the services provided under the terms of this Lease, (3) the responsibility for repair and maintenance of the Premises and responsibility for payment of Impositions as set forth herein, (3) the base rent and all other monetary payments then being obtained for new leases of space comparable to the Premises in the Building or, in the event that no other rentable areas of the Building are leased to other tenants, other buildings of comparable quality and condition as the Building and having comparable uses and located in the vicinity of the Building, and the services and allocation of responsibility for repair and maintenance and payment of taxes under such other leases, and (4) allowances for the construction of tenant improvements provided for such comparable space, the payment of leasing commissions or moving expenses, rental abatement concessions, if any,

 

29


being granted such tenants in connection with such comparable space, and other reasonable monetary and nonmonetary tenant inducements being granted such tenants in connection with such comparable space.

 

(b) If Tenant exercises an Extension Option, Landlord shall send to Tenant a notice setting forth the Prevailing Market Rental for the Premises for the Option Term on or before the date that is two hundred seventy (270) days prior to the Expiration Date of the Term (or the First Option Term, in the case of the exercise of the second Extension Option). If Tenant disputes Landlord’s determination of the Prevailing Market Rental for the Option Term, Tenant shall, within thirty (30) days after the date of Landlord’s notice setting forth the Prevailing Market Rental for the Option Term, send to Landlord a notice stating that Tenant disagrees with Landlord’s determination of Prevailing Market Rental for the Option Term and elects to resolve the disagreement as provided below in subparagraph (c) below. If Tenant does not send to Landlord a notice as provided in the previous sentence, Landlord’s determination of the Prevailing Market Rental shall be conclusive and shall be the basis for determining the Base Rent to be paid by Tenant hereunder during the Option Term. If Tenant elects to resolve the disagreement as provided in subparagraph (c) below and such procedures shall not have been concluded prior to the commencement date of the Option Term, Tenant shall pay Base Rent to Landlord hereunder adjusted to reflect the Prevailing Market Rental as stated by Landlord in its original notice to Tenant of Landlord’s determination thereof. If the amount of Prevailing Market Rental as finally determined pursuant to subparagraph (c) below is greater than Landlord’s determination, Tenant shall pay to Landlord the difference between the amount paid by Tenant and the Prevailing Market Rental as so determined pursuant to subparagraph (c) below within thirty (30) days after the determination. If the Prevailing Market Rental as finally determined pursuant to subparagraph (c) below is less than Landlord’s determination, the difference between the amount paid by Tenant and the Prevailing Market Rental as so determined pursuant to subparagraph (c) below shall be credited against the next installments of Base Rent due from Tenant to Landlord hereunder.

 

(c) Any disagreement regarding the Prevailing Market Rental as defined in this Section shall be resolved as follows:

 

(i) Within thirty (30) days after Tenant’s written response to Landlord’s notice to Tenant of the Prevailing Market Rental, Landlord and Tenant shall meet no less than two (2) times, at a mutually agreeable time and place, to attempt to resolve any such disagreement.

 

(ii) If within the thirty (30) day period referred to in clause (i) above, Landlord and Tenant cannot reach agreement as to the Prevailing Market Rental, they shall each select one appraiser with the qualifications set forth in Section 30(c)(vi) below (each, an “Appraiser”) to determine the Prevailing Market Rental. The two (2) Appraisers shall meet within ten (10) business days after the second Appraiser is appointed and, if within ten (10) business days after such first meeting the two Appraisers are unable to agree promptly upon a determination of Prevailing Market Rental, they shall appoint a third Appraiser, who shall be a competent and impartial person with qualifications set forth in Section 30(c)(vi) below. If they are unable to agree upon such appointment within five (5) business days after expiration of said ten (10) day period, the third Appraiser shall be selected by the parties themselves, if they can agree thereon, within a further period of ten (10) business days. If the parties do not so agree, then either party,

 

30


on behalf of both, may request appointment of such a qualified person by J.A.M.S./ENDISPUTE in San Francisco (“JAMS”). Request for appointment shall be made in writing with a copy given to the other party. Each party agrees that JAMS shall have the power to make the appointment. The three (3) Appraisers shall decide the dispute, if it has not previously been resolved, by following the procedure set forth in Section 30(c)(iii) below.

 

(iii) Where the issue cannot be resolved by agreement between the two Appraisers selected by Landlord and Tenant or settlement between the parties during the course of arbitration, the issue shall be resolved by the three Appraisers in accordance with the following procedure. The Appraisers selected by each of the parties shall state in writing their respective determinations of the Prevailing Market Rental, supported by the reasons therefor with counterpart copies to each party. The Appraisers shall arrange for a simultaneous exchange of such proposed resolutions. The role of the third Appraiser shall be to select which of the two proposed resolutions most closely approximates his determination of Prevailing Market Rental. The third Appraiser shall have no right to propose a middle ground or any modification of either of the two proposed resolutions. The resolution he chooses as most closely approximating his determination shall constitute the decision of the Appraisers and be final and binding upon the parties.

 

(iv) If any Appraiser fails, refuses or is unable to act, his successor shall be appointed by him, but in the case of the third Appraiser, his successor shall be appointed in the same manner as provided for appointment of the third Appraiser. The Appraisers shall attempt to decide the issue within ten (10) business days after the appointment of the third Appraiser. Any decision in which the Appraiser appointed by Landlord and the Appraiser appointed by Tenant concur shall be binding and conclusive upon the parties. Each party shall pay the fees and costs of its own counsel.

 

(v) The Appraisers shall render their decision and award in writing with counterpart copies to each party. The Appraisers shall have no power to modify the provisions of this Lease.

 

(vi) All Appraisers specified pursuant to this subparagraph (c) shall be a licensed appraisers in the State of California, with the “MAI” designation of from the Appraisal Institute, and with not less than ten (10) years’ experience appraising commercial properties in the City and County of San Francisco. Each party shall pay the cost of the Appraiser selected by such party and one-half of the cost of the third Appraiser plus one-half of any other reasonable third party costs (excluding legal fees and disbursements) incurred in resolving the dispute pursuant to this Section.

 

If the commencement date of the Option Term is other than on the first day of a calendar month, then the installment of Base Rent payable on the first day of any month during which an increase in the Base Rent, as provided for hereinabove, is to occur shall be prorated based on the number of days in such month prior to the effective date of the increase and the number of days in such month on or after the effective date of the increase.

 

31


31. ROOF ACCESS

 

Subject to Landlord’s prior written approval of the plans and specifications therefor (including, without limitation, the location, size, and color of the equipment and all associated cabling and wiring to be installed by Tenant throughout the Building, including any penetrations of the roof membrane of the Building), such approval not to be unreasonably withheld, conditioned or delayed, during the Term, Tenant may, at its sole cost and expense, construct and maintain one or more antennae and satellite dishes on the roof of the Building together with related cabling and equipment (collectively, the “Roof Equipment”). Notwithstanding the foregoing, the location(s) of any penetration of the roof membrane of the Building shall be determined by Landlord in its sole and absolute discretion. For the purposes herein, it shall be reasonable for Landlord to withhold its approval of the installation of any such Roof Equipment which (i) will require the relocation of any conduit, wiring or cabling located within the Major Vertical Penetrations of the Building (as hereinafter defined), (ii) will, in Landlord’s reasonable judgment, damage or impair the structural integrity of the Building (including the roof), (iii) will result in an unsafe condition affecting Landlord’s employees or contractors authorized to have access to the roof, or (iv) will interfere with any then existing equipment of Landlord located on the roof, or interfere with any then existing equipment or services of any third party. Upon receipt of Landlord’s prior written approval of the plans and specifications as set forth herein, Tenant shall erect the Roof Equipment in accordance with the approved plans and specifications, in a good and workmanlike manner, in accordance with all applicable Laws now in force or hereafter enacted and all other requirements of Landlord, and after Tenant has received all requisite approvals therefor (the “Applicable Requirements”). Tenant shall at all times operate and maintain the Roof Equipment in a good, clean and safe condition, in accordance with the Applicable Requirements. Tenant shall provide Landlord with reasonable advance written notice prior to entering upon the roof of the Building so that Landlord may, if it so desires, have a representative accompany Tenant onto the roof. Upon the expiration or sooner termination of this Lease or Tenant’s right to possession of the Premises, Tenant shall, at Tenant’s sole cost and expense, promptly remove the Roof Equipment, including, without limitation, all associated wiring and cabling throughout the Building, and repair any damage to the Building resulting therefrom. If Tenant fails to remove the Roof Equipment on or before the expiration or sooner termination of this Lease or Tenant’ right to possession of the Premises, Landlord may, at Tenant’s expense, remove the Roof Equipment and perform the related restoration and repair work, and use, dispose of or take such other actions with respect to the Roof Equipment as Landlord may deem appropriate, all without compensation or payment to Tenant. Tenant shall indemnify, defend, protect and hold harmless Landlord and the Landlord Parties from all claims arising from or in any way directly or indirectly relating to the construction, installation, maintenance, use, operation or removal of the Roof Equipment. The rights granted to Tenant pursuant to this Section 31 are personal to Dolby California, and may not be assigned, except to any Tenant Affiliate or Dolby Entity. As used herein, “Major Vertical Penetrations” shall mean the area or areas within Building stairs (excluding the landing at each floor), elevator shafts, flues, vents, stacks, pipe shafts and vertical ducts and the like, that service more than one floor of the Building. The area with Major Vertical Penetrations shall be bounded and defined by the interior surface of the perimeter walls thereof (or the extended plane of such walls over areas that are not enclosed). Major Vertical Penetrations shall exclude, however, areas for the specific use of Tenant or installed at the request of Tenant, such as special stairs or elevators.

 

32


32. SIGNAGE

 

All signs, notices and graphics of every kind or character, visible in or from public corridors, the Building Common Area or the exterior of the Premises shall be subject to Landlord’s prior written approval, not to be unreasonably withheld, conditioned or delayed. Without limiting the foregoing and subject to Landlord’s prior approval of the plans and specifications thereof (including, without limitation, the design, location, and size), Tenant shall have the right (“Exterior Signage Rights”) to install tenant identification signage on the exterior of the Building (the “Sign”), at Tenant’s sole cost and expense and in accordance with all applicable Laws (including any requirements set forth by the applicable agencies in the City and County of San Francisco) (the “Signage Requirements”). Tenant shall erect the Sign in accordance with the plans and specifications approved by Landlord, in a good and workmanlike manner, and at all times thereafter, Tenant shall maintain, at its sole cost and expense, the Sign in a good, clean and safe condition and in accordance with the Signage Requirements, including all repairs and replacements thereto. Upon the occurrence of any event of default and/or upon the termination or earlier expiration of this Lease, Tenant shall promptly remove the Sign, in which event Tenant shall be responsible for and shall repair any damage to the Building resulting therefrom. Tenant’s Exterior Signage Rights hereunder are personal to Dolby California, and, except with respect to an assignment to a Tenant Affiliate or Dolby Entity in connection with an assignment of this Lease, may not be assigned or transferred without the prior written consent of Landlord, which consent may be given or withheld or given upon conditions in Landlord’s sole and absolute discretion. Tenant shall be responsible for obtaining all permits and approvals (governmental and private) necessary for the installation and maintenance of the Sign. If Tenant fails to remove the Sign as required under this Section 32, Landlord shall have the right, at Tenant’s expense, to remove the Sign. Tenant shall indemnify, defend and protect Landlord and the Landlord Parties and hold Landlord and the Landlord Parties harmless from and against any and all, proceedings, losses, costs, damages, causes of action, liabilities, injuries or expenses arising out of or related to Tenant’s exercise of the Exterior Signage Rights granted hereunder, including, without limitation, any claims of injury to or death of persons or damage to property occurring or resulting directly or indirectly from the installation or maintenance of the Sign on the Building.

 

33. PARKING

 

Provided that Tenant shall not then be in default under the terms and conditions of the Lease beyond applicable cure periods; and provided, further, that Tenant shall comply with and abide by Landlord’s parking rules and regulations from time to time in effect, during the Term of this Lease Tenant shall be entitled to use all of the surface parking spaces located at the Parking Area, as the same may be striped or re-striped by Tenant from time to time. Tenant shall pay as Additional Charges the monthly parking fee set forth in the Basic Lease Information. Said monthly fee shall be paid in the same manner as Base Rent hereunder, regardless of whether or not Tenant uses the parking spaces in the Parking Area. “Parking Area” shall mean all the parking spaces located at 150 Hampshire in San Francisco, California.

 

Each automobile shall, at Landlord’s option to be exercised from time to time, bear a permanently affixed and visible identification sticker to be provided by Landlord. The license granted hereunder is for self-service parking only and does not include additional rights or

 

33


services. Neither Landlord nor Landlord’s Agents shall be liable for: (i) loss or damage to any vehicle or other personal property parked or located upon or within such parking spaces or any Parking Areas whether pursuant to this license or otherwise and whether caused by fire, theft, explosion, strikes, riots or any other cause whatsoever; or (ii) injury to or death of any person in, about or around such parking spaces or any Parking Areas or any vehicles parking therein or in proximity thereto whether caused by fire, theft, assault, explosion, riot or any other cause whatsoever and Tenant hereby waives any claim for or in respect to the above and against all claims or liabilities arising out of loss or damage to property or injury to or death of persons, or both, relating to any of the foregoing. Tenant shall not assign any of its rights hereunder and in the event an attempted assignment is made, it shall be void.

 

In the event any tax, surcharge or regulatory fee is at any time imposed by any governmental authority upon or with respect to parking or vehicles parking in the parking spaces referred to herein, Tenant shall pay such tax, surcharge or regulatory fee as Additional Charge under this Lease, such payments to be made in advance and from time to time as required by Landlord (except that they shall be paid monthly with Base Rent payments if permitted by the governmental authority).

 

34


IN WITNESS WHEREOF, Landlord and Tenant have each caused their duly authorized representatives to execute this Lease on their behalf as of the date first above written.

 

LANDLORD:

       
   

/s/ Ray Dolby

    RAY DOLBY, as Trustee of the
    Dolby Family Trust, dated May 7, 1999
   

/s/ Dagmar Dolby

    DAGMAR DOLBY, as Trustee of the
    Dolby Family Trust, dated May 7, 1999
   

RAY AND DAGMAR DOLBY REAL ESTATE

INVESTMENTS, L.P.,

a California limited partnership

   

By

 

/s/ Ray Dolby

              Ray Dolby, as Trustee of the Dolby Family
       

      Trust, dated May 7, 1999, its general partner

   

By

 

/s/ Dagmar Dolby

              Dagmar Dolby, as Trustee of the Dolby Family
       

      Trust, dated May 7, 1999, its general partner

TENANT:

 

DOLBY LABORATORIES, INC.,

    a California corporation
   

By

 

/s/ Bill Jasper

    Its   President and Chief Executive Officer

 

35


EXHIBIT A

 

DIAGRAM/DESCRIPTION OF PREMISES

 

See Attached

 

A–1


EXHIBIT B

 

LIST OF DEFINED TERMS

 

Additional Charges

   3

Alterations

   9

Applicable Requirements

   32

Appraiser

   30

Assignment

   17

Base Rent

   iv

Building

   iv, 1

Building Common Areas

   1

Building Systems

   9

Casualty Discovery Date

   13

Claims and Liabilities

   24

common area

   1

common areas

   1

Damaged Property

   13

Dolby California

   19

Dolby Delaware

   19

Dolby Entities

   19

Dolby Entity

   19

Dolby Subsidiary

   19

effective date of taking

   16

Event of Default

   20

Expiration Date

   iv

Extension Option

   29

Exterior Signage Rights

   33

Hazardous Material

   8

Impositions

   4

Impound Account

   6

JAMS

   31

Landlord

   1

Landlord Related Entities

   24

Landlord’s Architect

   1

Laws

   8

Major Vertical Penetrations

   32

Option Term

   29

Original Lease

   7

Parking Area

   33

Premises

   iv

Prevailing Market Rental

   29

prime rate

   25

Rent

   3

Rentable Area

   iv

Roof Equipment

   32

Rules and Regulations

   26

 

B–1


Sign

   33

Signage Requirements

   33

Sublease

   17

taking

   16

Tenant

   1

Tenant Affiliate

   18

Tenant Owned Property

   10

Tenant’s Agents

   10

Tenant’s Architect

   1

Term

   3

Third Architect

   2

Utilities

   6

worth at the time of award

   22

 

B–2


EXHIBIT C

 

RULES AND REGULATIONS

 

1. The sidewalks, halls, passages, exits, entrances, elevators, malls, and stairways of the Building shall not be obstructed by Tenant or any of Tenant’s agents, employees, representatives, contractors or visitors (“Tenant Parties”), or used by Tenant or any Tenant Party for any purpose other than for ingress to or egress from the Premises. The halls, passages, exits, entrances, corridors and stairways of the Building are not for the use of the general public, except as and where designated by Landlord, and Landlord shall in all cases retain the right to control and prevent access thereto of all persons whose presence in the judgment of Landlord might be prejudicial to the safety, character, reputation or interests of the Building and any tenants thereof, provided that nothing herein contained shall be construed to prevent such access to persons with whom Tenant normally deals in the ordinary course of its business, unless such persons are engaged in illegal or dangerous activities. Tenant and Tenant Parties shall not go upon the roof of the Building, except in areas that Landlord may designate from time to time.

 

2. No awning canopy or other projection of any kind over or around the windows or entrances of the Premises shall be installed by Tenant, and only such window coverings as are Building standard shall be used in the Premises.

 

3. The Premises shall not be used for lodging or sleeping, and no cooking shall be done or permitted by Tenant on the Premises, except that the preparation of food in microwave ovens and machines for vending coffee, tea, hot chocolate and similar small food or drink items for Tenant and its employees shall be permitted.

 

4. No additional locking devices shall be installed without the prior written consent of Landlord. Landlord may make reasonable charges for the removal of any additional lock or any bolt installed on any door of the Premises without the prior consent of Landlord. Tenant shall in each case furnish Landlord with a key for any such lock. Tenant, upon the termination of its tenancy, shall deliver to Landlord all keys to doors in the Building and the Premises.

 

5. Landlord shall have the right to prescribe the method of reinforcement or weight distribution (as Landlord shall determine in its sole discretion) for all equipment, materials, supplies, furniture or other property brought into the Building that will impose a load of more than fifty (50) pounds per square foot. Landlord will not be responsible for loss of or damage to any such property from any cause (except to the extent resulting from the gross negligence or willful misconduct of Landlord or its agents, employees or contractors), and all damage done to the Building by moving or maintaining Tenant’s property shall be repaired at the expense of Tenant.

 

6. Tenant shall not use or suffer to be used or kept in the Premises or the Building any kerosene, gasoline or flammable or combustible fluids or materials except as customarily used in offices, or use any method of heating or air conditioning other than that supplied by Landlord.

 

7. Tenant shall use reasonable efforts to ensure that all doors and windows of the Premises are closed and securely locked and all water faucets, water apparatus and utilities are shut off at such time as Tenant’s employees leave the Premises.

 

C–1


8. The toilet rooms, toilets, urinals, wash bowls and other apparatus shall not be used for any purpose other than that for which they were constructed, no foreign substance of any kind whatsoever shall be deposited therein, and any damage resulting to such facilities from misuse by Tenant or its employees or invitees shall be paid for by Tenant.

 

9. Except as permitted in this Lease, Tenant shall not sell, or permit the sale from the Premises of, or use or permit the use of any sidewalk or corridor in or adjacent to the Building for the sale of, newspapers, magazines, periodicals, theater tickets or any other goods, merchandise or service, nor shall Tenant carry on, or permit or allow any employee or other person to carry on, business in or from the Premises for the service or accommodation of occupants of any other portion of the Building, nor shall the Premises be used for manufacturing or assembly of any kind, or for any business or activity other than that specifically provided for in this Lease.

 

10. Tenant shall not install any radio or television antenna, microwave dish, telecommunications apparatus, loudspeaker, or other device on the roof or exterior walls of the Building or any other portion of the Building, except as expressly set forth in the Lease.

 

11. Tenant and Tenant Parties shall not use in the Premises, or in the common areas of the Building or of any other building in the Building, any handtrucks except those equipped with rubber tires and side guards or such other material-handling equipment as Landlord may approve, and Tenant shall use reasonable efforts to cause its invitees to comply with the provisions of this Section. No other vehicles of any kind shall be brought by Tenant or any Tenant Party into the Building or any other Building in the Building, or kept in or about the Premises.

 

12. Tenant shall store all its trash and garbage within the Premises until removal. All trash placed in any portion of the Building for pick-up shall be placed in locations and containers approved by Landlord.

 

13. All loading, unloading and delivery of merchandise, supplies, materials, garbage and refuse shall be made only through such entryways and elevators and at such times as Landlord shall designate. While loading and unloading, Tenant and any Tenant Party shall not obstruct or permit the obstruction of the entryways to the Building or any other building in the Building or any tenant’s space therein.

 

14. Canvassing, soliciting, peddling or distribution of handbills or any other written material in the Building is prohibited, and Tenant shall cooperate to prevent such acts.

 

15. Tenant shall not permit the use or the operation of any video or mechanical games or pay telephones on the Premises.

 

16. Landlord may direct the use of all pest extermination and scavenger contractors to eliminate pests caused or introduced into the Premises by Tenant or any Tenant Party at such intervals as Landlord may require, at Tenant’s sole cost and expense.

 

17. Any requests made by Tenant of Landlord shall be made by telephone or in person by Tenant’s designated representative at the office of the Building, as designated from time to time

 

C–2


by Landlord. Employees of Landlord shall not perform any work or do anything outside of their regular duties unless under special instructions from Landlord.

 

18. Landlord may waive any one or more of these Rules and Regulations for the benefit of any particular tenant or tenants, and no such waiver by Landlord shall be construed as a waiver of these Rules and Regulations in favor of any other tenant or tenants or prevent Landlord from thereafter enforcing any Rule or Regulation against any or all tenants of the Building.

 

19. These Rules and Regulations are in addition to, and shall not be construed in any way to modify, alter or amend, in whole or part, any terms, covenants, agreements and conditions of the Lease or any other lease of premises in the Building which may expressly contradict these Rules and Regulations.

 

20. Landlord reserves the right to make such other and reasonable rules and regulations as in its judgment may from time to time be needed for the safety, care and cleanliness of the Building, and for the preservation of good order therein.

 

21. Tenant shall not obtain for use in the Premises or the Building ice, drinking water, food, beverage, towel or other similar services, except at reasonable hours and under reasonable regulations fixed by Landlord.

 

22. Tenant shall be entitled to its proportionate share (based on rentable area) of listings in the Building lobby directory. All signage, lettering or other writing or decoration on or visible from the exterior of the Premises shall require Landlord’s reasonable prior written approval.

 

C–3


SCHEDULE I

 

TENANTS INSURANCE REQUIREMENTS

 

During the Term of this Lease, and during any period prior to the commencement of the Term in which Tenant shall enter onto, occupy or use the Premises, Tenant shall provide at Tenant’s cost and expense the following insurance coverage:

 

1. Property Insurance. Tenant shall provide insurance coverage, for the mutual benefit of Landlord and Tenant, for all risks of physical loss or damage due to fire and such other hazards that would be covered by an insurance policy issued on a Special Form Cause of Loss basis, insuring the full replacement value of the Premises, including the Building, any Alterations, Tenant’s trade fixtures, furnishings, equipment, plate glass, signs and all other items of personal property of Tenant (“Property Policy”). The Property Policy shall:

 

(a) include coverage for, and specifically state that coverage is provided for, windstorms, hail and terrorism; provided, however, that the terrorism coverage provided by the Property Policy shall be reasonably acceptable to Landlord and maintained during the term of the Lease on terms which Landlord shall reasonably require in accordance with prudent practices by owners of similar types of property in similar geographic locations as the Property, and shall only be required to the extent that same is available at a commercially reasonable cost;

 

(b) have a deductible no greater than $250,000 per occurrence so long as the Tenant is a Dolby Entity, otherwise, no greater than $5,000 per occurrence;

 

(c) contain a replacement cost endorsement;

 

(d) if Tenant is not a Dolby Entity, and if required by Landlord, contain rental loss coverage for a period of twelve (12) months in an amount sufficient to cover all Base Rent and Additional Charges payable during such period; and

 

(e) if requested by Landlord, contain a lender’s loss payable endorsement containing provisions equivalent to those provisions contained in Form 438BFU and naming any lender designated by Landlord.

 

2. Liability Insurance. Tenant shall provide broad form commercial general liability insurance, and automobile liability insurance, each with a minimum combined single limit of liability of at least $1,000,000 per occurrence, and excess liability under one or more policies in an aggregate amount of at least $30,000,000 per occurrence; Such broad form commercial general liability insurance shall include products and completed operations liability insurance, fire legal liability insurance, contractual liability insurance (provided that the amount of such insurance shall not be a limitation on Tenant’s indemnity obligations under this Lease), and such other coverage as Landlord may reasonably require from time to time. Tenant’s liability insurance policies shall have a deductible no greater than $250,000 per occurrence so long as the Tenant is a Dolby Entity, otherwise, no greater than $5,000 per occurrence.

 

1


3. Workers Compensation Insurance. Tenant shall maintain statutory worker’s compensation insurance with an employer’s liability limit of at least $1,000,000 covering all of Tenant’s employees.

 

4. Earthquake Insurance. Tenant shall not be required to obtain earthquake insurance with respect to the Premises, provided that if Tenant does obtain earthquake insurance, it shall cause such policy to name Landlord and Tenant as named insureds, as their interest may appear (provided if such earthquake insurance is provided under a blanket policy, Landlord shall be a named insured, by endorsement, with respect to the Premises only).

 

5. Form of Policies. All insurance policies required to be carried by Tenant under this Lease shall (i) be written by companies rated A VIII or better in “Best’s Insurance Guide” or having an equivalent rating from a reputable financial rating agency such as Moody’s or Standard & Poors, and not prohibited from doing business in California, (ii) name Landlord and any other parties designated by Landlord as additional insureds, in the case of liability insurance, and name Landlord and Tenant as named insureds, as their interest may appear, in the case of any Property Policies (provided if Tenant’s Property Policy is a blanket policy, Landlord shall be a named insured, by endorsement, with respect to the Premises only), (iii) as to liability coverages, be written on an “occurrence” basis, (iv) provide that Landlord shall receive thirty (30) days’ notice from the insurer before any cancellation or change in coverage, and (v) contain a provision that no act or omission of Tenant shall affect or limit the obligation of the insurer to pay the amount of any loss sustained. Each such policy shall contain a provision that such policy and the coverage evidenced thereby shall be primary and non-contributing with respect to any policies carried by Landlord and that any coverage carried by Landlord shall be excess insurance. Tenant shall be liable for payment of any deductible in the event of any loss, claim or casualty. Tenant shall deliver reasonably satisfactory evidence of such insurance to Landlord on or before the Commencement Date, and thereafter at least thirty (30) days before the expiration dates of expiring policies; and in the event Tenant shall fail to procure such insurance or to deliver reasonably satisfactory evidence thereof within five (5) business days after written notice from Landlord of such failure, Landlord may, at its option and in addition to Landlord’s other remedies in the event of a default by Tenant hereunder, procure such insurance for the account of Tenant, and the cost thereof shall be paid to Landlord as Additional Charges. The limits of the insurance required under this Lease shall not limit any obligation or liability of Tenant under this Lease.

 

2

Lease for 130 Potrero Avenue

Exhibit 10.2

LEASE AGREEMENT

(130 Potrero)

 

BETWEEN

 

RAY DOLBY AND DAGMAR DOLBY, AS TRUSTEES OF THE

DOLBY FAMILY TRUST, DATED MAY 7, 1999, and

RAY AND DAGMAR DOLBY REAL ESTATE INVESTMENTS, L.P.,

a California limited partnership,

 

COLLECTIVELY,

AS LANDLORD

 

AND

 

DOLBY LABORATORIES, INC.,

a California corporation,

 

AS TENANT


TABLE OF CONTENTS

 

Basic Lease Information

   iv

1.

  

Definitions

   1
     1.1   

Location of Definitions; Basic Lease Information

   1

2.

  

Premises

   1
     2.1   

Premises Defined

   1

3.

  

Term

   1
     3.1   

Term Commencement

   1

4.

  

Rent; Additional Charges

   2
     4.1   

Annual Rental

   2
     4.2   

Additional Charges

   2
     4.3   

Late Charges

   2

5.

  

Net Lease; Taxes and Assessments

   2
     5.1   

Net Lease

   2
     5.2   

Payment of Taxes and Assessments

   3

6.

  

Utilities

   5
     6.1   

Utility Expenses

   5
     6.2   

Interruption of Utilities

   5

7.

  

Condition of Premises

   6

8.

  

Common Areas

   6
     8.1   

Right to Use Common Areas

   6

9.

   Use         6
     9.1   

Office Use

   6
     9.2   

No Nuisance

   6
     9.3   

Compliance with Laws

   6
     9.4   

Hazardous Materials

   7

10.

  

Alterations and Tenant’s Property

   7
     10.1   

Alterations

   7
     10.2   

Removal of Property

   8

11.

  

Repairs and Other Work

   9
     11.1   

Tenant’s Obligations

   9
     11.2   

Conditions Applicable to Repairs and Other Work

   9
     11.3   

Landlord’s Obligations

   10

12.

  

Liens

   10

13.

  

Subordination

   11

14.

  

Inability to Perform

   11

15.

  

Destruction

   12
     15.1   

Repair

   12
     15.2   

Tenant’s Right to Terminate

   13

 

i


     15.3   

Landlord’s Right to Terminate

   13
     15.4   

Extent of Repair Obligations

   14
     15.5   

Waiver of Subrogation

   14
     15.6   

Non-Application of Certain Statutes

   14

16.

  

Insurance

   14

17.

  

Eminent Domain

   15
     17.1   

Effect of Taking

   15
     17.2   

Award

   15
     17.3   

Abatement of Rent

   15
     17.4   

Temporary Taking

   16

18.

  

Assignment and Subletting

   16
     18.1   

Consent Required

   16
     18.2   

Notice

   17
     18.3   

No Release

   17
     18.4   

Entity Transfers

   17
     18.5   

Assumption of Obligations

   18
     18.6   

No Signs

   18
     18.7   

Non-Application of Certain Statutes

   18

19.

  

Security Systems and Programs

   19

20.

  

Default

   19
     20.1   

Events of Default

   19
     20.2   

Remedies

   20
     20.3   

Reletting

   22
     20.4   

Landlord’s Right to Perform Tenant’s Obligations

   22
     20.5   

Remedies Cumulative

   23

21.

  

Indemnity; Interest on Overdue Obligations

   23
     21.1   

Indemnity

   23
     21.2   

Interest on Past Due Obligations

   23

22.

  

Landlord’s Access to Premises

   23

23.

  

Notices

   24

24.

  

No Waiver

   24

25.

  

Estoppel Certificates

   24

26.

  

Rules and Regulations

   25

27.

  

Tenant’s Taxes

   25

28.

  

Corporate Authority

   25

29.

  

Miscellaneous

   25
     29.1   

Financial Statements

   25
     29.2   

Successors and Assigns

   25
     29.3   

Severability

   25
     29.4   

Applicable Law

   26

 

ii


     29.5   

Integration; Interpretation

   26
     29.6   

Quiet Enjoyment

   26
     29.7   

Holding Over

   26
     29.8   

Broker’s Commissions

   26
     29.9   

Recovery Against Landlord

   27
     29.10   

Amendments

   27
     29.11   

Attorneys’ Fees

   27
     29.12   

Exhibits and Schedules

   27

30.

  

Option to Extend Term

   27

31.

  

Roof Access

   30

32.

  

Signage

   31

33.

  

Landlord’s Right to Park Bus

   32

 

Exhibits:

 

A    Diagram/Description of Premises
B    List of Defined Terms
C    Rules and Regulations

 

Schedule I:        Tenant’s Insurance Requirements

 

iii


BASIC LEASE INFORMATION

 

BUILDING:   

130 Potrero Avenue

San Francisco California

    
LANDLORDS ADDRESS:   

3340 Jackson Street

San Francisco, California 94118

Telephone: (415) 563-6947

Facsimile: (415) 563-4004

    
     with a copy to:     
    

Morrison & Foerster LLP

425 Market Street

San Francisco, California 94105-2482

Attn: Craig B. Etlin

Telephone: (415) 268-7456

Facsimile: (415) 268-7522

    
TENANTS ADDRESS:   

100 Potrero Avenue

San Francisco California

Attn: Steve Kelly

Telephone: (415) 645-5162

Facsimile: (415) 645-4000

    
     with a copy to:     
    

Farella Braun & Martel

235 Montgomery Street

San Francisco, California 94104

Attn: Anthony D. Ratner

Telephone: (415) 954-4448

Facsimile: (415) 954-4480

    
COMMENCEMENT DATE:   

January 1, 2006

   (3.1)
EXPIRATION DATE:   

December 31, 2013

   (3.1)
RENTABLE AREA OF PREMISES:   

14,071 square feet

   (2.1)
DIAGRAM OF PREMISES:   

See Exhibit A

    
BASE RENT:   

Monthly: $10,553.25

    
    

Annual: $126,639.00

   (4.1)
USE:   

Warehouse and Storage

   (9.1)

 

iv


OFFICE LEASE

 

THIS LEASE, dated as of December 31, 2005, is between RAY DOLBY AND DAGMAR DOLBY, AS TRUSTEES OF THE DOLBY FAMILY TRUST, DATED MAY 7, 1999, and RAY AND DAGMAR DOLBY REAL ESTATE INVESTMENTS, L.P., a California limited partnership (collectively, “Landlord”), and DOLBY LABORATORIES, INC., a California corporation (“Tenant”). Landlord and Tenant hereby covenant and agree as follows:

 

1. DEFINITIONS

 

  1.1 Location of Definitions; Basic Lease Information

 

For convenience of reference only defined terms and the sections in which they are defined are set forth in Exhibit B. The Basic Lease Information is hereby incorporated into and made a part of this Lease.

 

2. PREMISES

 

  2.1 Premises Defined

 

Landlord leases to Tenant and Tenant hires from Landlord on the terms and conditions contained in this Lease the Premises specified in the Basic Lease Information. The Premises consist of the entire Building (as described in the Basic Lease Information). As used herein, the term “Building” shall include the land underlying the Building, the Building structure and all rentable areas and improvements therein, and all common areas, walkways, facilities and other amenities appurtenant to or serving all or any portion of the Building (the “Building Common Areas”) situated within and adjacent or appurtenant to the Building which primarily or exclusively serve the Building, as determined from time to time by Landlord in its reasonable discretion.

 

Tenant accepts the Rentable Area as specified in the Basic Lease Information as the Rentable Area of the Premises and such area shall not be subject to recalculation. The terms “common area” and “common areas” shall mean spaces, facilities, and installations such as toilets, janitor, telephone, electrical, and mechanical rooms and closets, trash facilities, stairs, public lobbies, corridors and other circulation areas, wherever located in the Building. Tenant understands and agrees that the Premises shall be leased by Tenant in its as-is condition.

 

3. TERM

 

  3.1 Term Commencement

 

The Premises are leased for a term (the “Term”) commencing on the Commencement Date as set forth in the Basic Lease Information. The Term of this Lease shall expire on the Expiration Date.

 

1


4. RENT; ADDITIONAL CHARGES

 

  4.1 Annual Rental

 

Tenant shall pay to Landlord during the Term at the address set forth in the Basic Lease Information, without demand, offset or deduction, Base Rent as set forth in the Basic Lease Information. Base Rent shall be payable on or before the first day of each month, in advance. If the Commencement Date or the Expiration Date should occur on a day other than the first or last day of a calendar month, respectively, then the Base Rent for such period shall be prorated.

 

  4.2 Additional Charges

 

Tenant shall pay to Landlord as and when due all charges, Impositions (as defined below) and tax reimbursements, fees, expenses, and all other amounts as provided in this Lease (“Additional Charges”), except to the extent that Tenant pays Impositions directly to the appropriate taxing authority as provided in Section 5.2 below. Unless otherwise specifically provided for herein, all Additional Charges shall be due on the later of twenty (20) days after Tenant’s receipt of Landlord’s invoice for the Additional Charges or the first day of the month following Tenant’s receipt of Landlord’s invoice for the Additional Charges. Base Rent and Additional Charges shall constitute the “Rent” payable by Tenant for the Premises.

 

  4.3 Late Charges

 

If Tenant fails to pay any Rent within five (5) days after written notice from Landlord that Tenant has failed to pay the same, such unpaid amounts will be subject to a late payment charge equal to five percent (5%) of the unpaid amounts in each instance. This late payment charge has been agreed upon by Landlord and Tenant, after negotiation, as liquidated damages and a reasonable estimate of the additional administrative costs and detriment that will be incurred by Landlord as a result of any such failure by Tenant, the actual damages and costs thereof being extremely difficult if not impossible to determine.

 

5. NET LEASE; TAXES AND ASSESSMENTS

 

  5.1 Net Lease

 

Without limiting any of the provisions of this Lease, the Base Rent and any Additional Charges payable to Landlord hereunder shall be absolutely net to Landlord and shall be paid without assertion of any counterclaim, setoff, deduction or defense and without any abatement, suspension, deferment or reduction, except only as otherwise expressly provided in Sections 15 and 17 of this Lease, and shall not be reduced, offset or diminished, directly or indirectly, by any cost, charge or expense payable hereunder by Tenant in connection with the Premises and/or the Building or any part thereof. Except as specifically provided otherwise in this Lease, under no circumstances or conditions, whether now existing or hereafter arising, and whether within or beyond the present contemplation of the parties, shall Landlord be expected or required to make any payment of any kind or incur any obligation whatsoever with respect to the Premises, or otherwise have any obligation or liability with respect to the Premises; provided that the foregoing shall not be construed to require Tenant (i) to perform any obligations of Landlord under any contract or agreement entered into by Landlord with any third party to which Tenant

 

2


or any Tenant Affiliate (other than Landlord) is not a party, or (ii) to assume any liability for any obligations of Landlord arising under any mortgage or deed of trust granted by Landlord encumbering the Premises, including payment of debt service on any obligation secured thereby, provided that the foregoing shall not be construed to relieve Tenant from complying with and performing any express obligations of Tenant under this Lease that may also constitute covenants or obligations of Landlord under any such contract or agreement entered into by Landlord with any third party or under any mortgage or deed of trust.

 

  5.2 Payment of Taxes and Assessments

 

(a) “Impositions” shall mean all real property taxes and general and special assessments, transit charges, fees or assessments, housing fund assessments, security charges, maintenance fees, payments in lieu of taxes, fees or charges, and any tax, fee, assessment, charge or excise levied or assessed (whether at the date of this Lease or thereafter) (i) on the Building or any portion thereof or Landlord’s interest therein, or on Landlord’s personal property used in the operation of the Building, (ii) on the use or occupancy of the Building or any portion thereof, including, without limitation, any tax or levy made against Rent or gross receipts from the Building, (iii) in connection with the business of renting space in the Building, or in connection with entering into this Lease or any other lease with respect to the Building, or (iv) for housing, police, fire, or other governmental services provided by any governmental or public entity to the extent allocable to and collected by a lien upon the Building. Impositions shall also include any other tax, fee, or charge that may be levied or assessed as a substitute for any other Impositions. Impositions shall not include those amounts payable by Tenant pursuant to Section 27. Tenant and Landlord acknowledge that Proposition 13 was adopted by the voters of the State of California in the June, 1978 election and that assessments, taxes, fees, levies and charges may be imposed by governmental agencies for such purposes as fire protection, street, sidewalk, road, utility construction and maintenance, refuse removal and for other governmental services which may formerly have been provided without charge to property owners or occupants. It is the intention of the parties that all new and increased assessments, taxes, fees, levies and charges due to any cause whatsoever are to be included within the definition of Impositions for purposes of this Lease.

 

(b) Tenant’s Obligation to Pay. Without limiting the generality of Section 5.1, but subject to Section 5.2(d) below, Tenant shall pay all Impositions allocable to the Premises during the Term or any holdover period on or before the date due, and in any event before delinquency and before any fine, interest or penalty may become due or be imposed by operation of law for nonpayment; provided, however, that: (i) Landlord shall pay or, if paid by Tenant, shall reimburse Tenant for any Impositions to the extent that the same are allocable to periods after the Expiration Date (or, if Tenant holds over following the Expiration Date, to periods after the actual date of surrender of the Premises by Tenant); and (ii) if any assessment is permitted by law to be paid in installments without additional charge or penalty, Tenant may pay such assessments in installments, but in no event later than the actual due date for such installments. Without limiting the foregoing, or any other provision hereof, if any fines, penalties or interest charges are imposed as a result of any failure by Tenant to pay any Impositions as and when required under this Section 5.2 or as a result of an unsuccessful contest of any Impositions by Tenant pursuant to Section 5.2(d) below, Tenant shall be obligated to pay the same within ten (10) business days after imposition thereof, unless Tenant exercises its right to contest such

 

3


fines, penalties or interest charges pursuant to Section 5.2(d) below and provides a bond or other assurance of payment for such fines, penalties or interest charges as provided in Section 5.2(d) below.

 

(c) Direct Payment. Tenant shall pay all Impositions directly to the applicable taxing authority, and shall deliver to Landlord, within ten (10) days after payment thereof, true and correct copies of the receipted bills or other reasonable evidence showing such payment of all Impositions required to have been paid as of such date. Landlord shall cooperate with Tenant to cause all bills for Impositions to be sent directly to Tenant, but if the tax collection agency will not so agree, then Landlord shall tender all bills to Tenant promptly upon Landlord’s receipt, and in such event, if Landlord fails to tender any such bill to Tenant within the later of (i) ten (10) Business Days following the date of Landlord’s receipt of such bill from the taxing authority or (ii) twenty (20) Business Days prior to the date on which the tax, or installment thereof, represented by such bill shall become delinquent, then (A) Tenant shall not be in default hereunder for failure to make timely payment of such Imposition until the expiration of twenty (20) business days following the date on which Tenant shall receive a copy of such bill from Landlord, and (B) if Tenant has not received any tax bill from Landlord or the taxing authority prior to the twentieth (20th) Business Day before the date on which the applicable tax payment shall become delinquent, Tenant may deliver written notice to Landlord requesting Landlord to promptly forward any tax bill that may have been delivered to Landlord for the tax period in question, and if Landlord fails to deliver any such tax bill that has actually been received by Landlord from the taxing authority prior to the receipt of Tenant’s notice within ten (10) days following Landlord’s receipt of such notice from Tenant, Landlord shall be obligated to pay any penalties incurred by Tenant for late payment of such tax bill which are not reasonably avoidable by Tenant. Subject to the foregoing terms of this Section 5.2(c), if Tenant shall at any time fail to pay any Impositions when due and shall fail to cure such default within the applicable period provided under Section 20.1(f) below, then Landlord shall have the right at any time thereafter to require that Tenant pay monthly installments of Impositions into an impound account maintained by Landlord or an escrowee designated by Landlord (an “Impound Account”). Tenant shall not be entitled to receive any interest or other return on any funds on deposit in any Impound Account, and any funds so held in any Impound Account may be commingled with other funds of Landlord or Landlord’s escrowee, or other parties depositing funds in such Impound Account, as applicable; provided that, except as otherwise provided upon the occurrence of an Event of Default, any funds held in an Impound Account maintained by Landlord or an escrowee designated by Landlord shall be used and disbursed by Landlord or such escrowee (subject to reduction for payment of customary account charges) for payment of the Impositions in respect of which such deposits have been made, and for no other purpose unless an Event of Default has occurred and is continuing.

 

(d) Right to Contest. Tenant shall have the right, at its sole cost and expense, to contest the full or partial amount or validity of any Imposition by appropriate administrative and legal proceedings, either in its own name or jointly with Landlord if Landlord so elects. Landlord shall cooperate with Tenant in any reasonable manner requested by Tenant, provided that (i) Tenant shall reimburse Landlord as Additional Charges hereunder for Landlord’s actual out-of-pocket costs incurred in connection with any such contest, (ii) no action by Tenant in connection with such contest shall expose Landlord to personal liability for the payment of any Impositions, and (iii) Tenant shall not be authorized to settle any such action if an Event of

 

4


Default has occurred and is continuing. Tenant may postpone payment of any contested Imposition pending prompt and diligent prosecution of any such proceedings and appeals, but only if Tenant shall post a bond or other assurance of payment or performance with Landlord, an escrow designated by Landlord, or the court or administrative agency or other legal authority having jurisdiction over the contest, to ensure payment of all sums ultimately determined to be due by Tenant.

 

6. UTILITIES

 

  6.1 Utility Expenses

 

Tenant shall make its own arrangements for, and shall pay the full cost of, providing all water, sewer use, sewer discharge fees and permit costs and sewer connection fees, gas, heat, electricity, refuse pick-up, janitorial service, telephone, telecommunications, and all materials and services or other utilities (collectively, “Utilities”) that Tenant deems necessary or desirable for its occupancy and use of the Premises, all of which Utilities shall, at the request of Landlord and at Tenant’s sole cost and expense, be billed or metered separately to the Premises and/or Tenant, together with all taxes, assessments, charges and penalties added to or included within such cost. Tenant acknowledges that Landlord, Tenant, the Premises and/or the Building may become subject to the rationing of Utility services or restrictions on Utility use as required or recommended by a public utility company or provider, governmental agency or other similar entity having jurisdiction thereof. Tenant acknowledges and agrees that its tenancy and occupancy hereunder shall be subject to such rationing or restrictions as may be imposed upon Landlord, Tenant, the Premises, the Building, and Tenant shall in no event be excused or relieved from any covenant or obligation to be kept or performed by Tenant by reason of any such rationing or restrictions. Tenant agrees to comply with all energy conservation programs implemented by Landlord by reason of any rationing, restrictions or applicable laws, requirements or recommendations of governmental agencies or public utility companies or providers.

 

  6.2 Interruption of Utilities

 

Landlord shall not be liable for any loss, injury or damage to property caused by or resulting from any variation, interruption, or failure of Utilities due to any cause whatsoever, or from failure to make any repairs or perform any maintenance. No temporary interruption or failure of such services incident to the making of repairs, alterations, improvements, or due to accident, strike, or conditions or other events shall be deemed an eviction of Tenant or relieve Tenant from any of its obligations hereunder. In no event shall Landlord be liable to Tenant for any damage to the Premises or for any loss, damage or injury to any property therein or thereon occasioned by bursting, rupture, leakage or overflow of any plumbing or other pipes (including, without limitation, water, steam, and/or refrigerant lines), sprinklers, tanks, drains, drinking fountains or washstands, or other similar cause in, above, upon or about the Premises or the Building. Tenant hereby waives any and all rights under California Civil Code Section 1932(1) and Sections 1941 and 1942 or any other similar laws, statutes or ordinances now or hereafter in effect, including, without limitation, any right to terminate this Lease, vacate the Premises, and/or make repairs and deduct the expense thereof from the Rent.

 

5


7. CONDITION OF PREMISES

 

Tenant agrees and acknowledges that Tenant has been in possession of the Premises prior to the Commencement Date pursuant to that certain Master Lease between Ray M Dolby, as landlord, and DLI Realty Corp., a California corporation, as tenant, dated as of June 1, 1980, as amended by that certain Amendment to Master Lease, dated as of October 1, 1982, as amended by that certain Amendment Two to Master Lease, dated as of July 15, 1985, and as further amended by that certain Amendment No. 3 to Master Lease, dated as of July 15, 1986 (as amended, the “Original Lease”). Tenant further agrees and acknowledges that the Premises are suitable for Tenant’s use, and that Tenant shall lease the Premises in its as-is condition. Landlord makes no representation or warranty as to (i) the nature, quality or condition of the Premises or the Building, or (ii) the nature, quality or suitability for Tenant’s business of the Building or the Premises, and Tenant shall have no rights against Landlord by reason of any claimed deficiencies therein.

 

8. COMMON AREAS

 

  8.1 Right to Use Common Areas

 

Tenant and Tenant’s agents, representatives, employees and visitors, shall have the exclusive right to use during the Term the Building Common Areas, subject to Landlord’s reasonable rules and regulations and the provisions of this Lease.

 

9. USE

 

  9.1 Office Use

 

The Premises shall be used for warehouse and storage purposes only.

 

  9.2 No Nuisance

 

Tenant shall not allow, suffer or permit the Premises or any use thereof to constitute a nuisance, to violate any insurance policy restrictions, or to unreasonably interfere with the safety, comfort or enjoyment of the Building by Landlord or its customers, invitees or any others lawfully in, upon or about the Building.

 

  9.3 Compliance with Laws

 

Tenant, at Tenant’s expense, shall comply with, and cause all of Tenant’s agents, employees, contractors, representatives, and visitors to comply with, all applicable laws, ordinances, rules and regulations of governmental authorities applicable to the Premises or the Building or the use or occupancy thereof, including, without limitation, the federal Americans With Disabilities Act, as amended (collectively, “Laws”); provided that Tenant shall not be obligated pursuant to this Section 9.3 to make or pay for any structural elements of the Building, or any Building Common Areas, unless such alterations are required as a result of Tenant’s actions or Tenant’s default under this Lease during the term of this Lease or the Original Lease or result from or are associated with alterations or improvements to the Premises made by or for Tenant during the term of this Lease or the Original Lease.

 

6


  9.4 Hazardous Materials

 

Tenant shall not cause or suffer or permit any Hazardous Material, as defined below, to be brought upon, kept, used, discharged, deposited or released in, on, or about the Premises and/or the Building by Tenant, or any of Tenant’s agents, employees, representatives, contractors or visitors, provided that Tenant may keep on the Premises such Hazardous Materials as are customarily used by typical office tenants and are maintained in full compliance with all applicable laws. Tenant shall indemnify, defend (with legal counsel reasonably satisfactory to Landlord), and hold Landlord harmless from and against any and all claims, damages, losses, costs, liabilities and expenses (including, without limitation, diminution in value or use of the Building, attorneys’ fees, consultant fees and expert fees) which arise during or after the Term (including the term of the Original Lease) as a result of any breach by Tenant of this Section 9.4 or any contamination on or affecting the Premises and/or the Building which is caused by Tenant or any of Tenant’s agents, employees, representatives, contractors or visitors. This indemnification obligation shall survive any termination of this Lease and shall include, without limitation, costs incurred in connection with any investigation of site conditions and any clean-up, remedial, removal or restoration work on or affecting the Premises and/or the Building. “Hazardous Material” means any hazardous, toxic or dangerous substance, material or waste which currently is or hereafter becomes regulated by or under any local, state or federal governmental authority or environmental law, including, without limitation, (i) all chlorinated solvents, (ii) petroleum products or by-products, (iii) asbestos, (iv) polychlorinated biphenyls, and (v) mold or mold-like substances.

 

10. ALTERATIONS AND TENANTS PROPERTY

 

  10.1 Alterations

 

(a) Tenant shall not before or during the Term make or suffer to be made any alterations, additions or improvements in or to the Premises (herein collectively called “Alterations”) without first obtaining Landlord’s written approval thereof based on detailed plans and specifications submitted by Tenant. Landlord’s approval may be withheld in Landlord’s sole and absolute discretion if any Alterations could in Landlord’s judgment affect the structure of the Building or the electrical, mechanical, heating, ventilation or air conditioning, life safety or plumbing systems of the Building (collectively the “Building Systems”), be visible from outside the Premises, or require additional code compliance or similar work not included in the Alterations; otherwise, Landlord’s consent shall not be unreasonably withheld. Without limiting the foregoing, all Alterations shall also be subject to the provisions of Section 11.2 below. Notwithstanding the foregoing, Tenant shall be permitted to make Alterations that do not affect the structure of the Building or the Building Systems that in the aggregate do not exceed Two Hundred Fifty Thousand Dollars ($250,000.00) without the prior written consent of Landlord; provided, however, that Tenant shall provide Landlord copies of all permits, plans and other related documents in connection with such Alterations.

 

(b) Any Alteration to the Premises shall be at Tenant’s sole cost and expense, in compliance with all applicable Laws and all requirements requested by Landlord, including, without limitation, the requirements of any insurer providing coverage for the Premises or the Building or any part thereof, and in accordance with plans and specifications approved in writing

 

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by Landlord, and shall be constructed and installed by a contractor reasonably approved in writing by Landlord. As a further condition to giving consent, with respect to Alterations that could affect the structural components of the Building Systems or which in the aggregate exceed One Million Dollars ($1,000,000.00) in cost, Landlord may require Tenant to provide Landlord, at Tenant’s sole cost and expense, a payment and performance bond in form reasonably acceptable to Landlord, in a principal amount not less than the estimated costs of such Alterations, to ensure Landlord against any liability for mechanics’ and materialmen’s liens and to ensure completion of work. Before Alterations may begin, valid building permits or other permits or licenses required must be furnished to Landlord, and, once the Alterations begin, Tenant will diligently and continuously pursue their completion. Landlord may monitor construction of the Alterations and Tenant shall reimburse Landlord for its reasonable costs (including, without limitation, the costs of any construction manager retained by Landlord) in reviewing plans and documents and in monitoring construction. Tenant shall maintain during the course of construction, at its sole cost and expense, builders’ risk insurance for the amount of the completed value of the Alterations on an all-risk non-reporting form covering all improvements under construction, including building materials, and other insurance in amounts and against such risks as Landlord shall reasonably require in connection with the Alterations. In addition to and without limitation on the generality of the foregoing, Tenant shall ensure that its contractor(s) procure and maintain in full force and effect during the course of construction a “broad form” commercial general liability and property damage policy of insurance naming Landlord, Tenant and Landlord’s lenders, if any, as additional insureds. The minimum limit of coverage of the aforesaid policy shall be in the amount of not less than Three Million Dollars ($3,000,000.00) for injury or death of one person in any one accident or occurrence and in the amount of not less than Three Million Dollars ($3,000,000.00) for injury or death of more than one person in any one accident or occurrence, and shall contain a severability of interest clause or a cross liability endorsement. Such insurance shall further insure Landlord and Tenant against liability for property damage of at least Three Million Dollars ($3,000,000.00).

 

(c) Tenant agrees not to proceed to make any Alterations, notwithstanding consent from Landlord to do so, until Tenant notifies Landlord in writing of the date Tenant desires to commence construction or installation of such Alterations and Landlord has approved such date in writing, in order that Landlord may post appropriate notices to avoid any liability to contractors or material suppliers for payment for Tenant’s improvements. Tenant will at all times permit such notices to be posted and to remain posted until the completion of work.

 

  10.2 Removal of Property

 

All Alterations shall become the property of Landlord, and shall be surrendered to Landlord, upon the expiration or earlier termination of this Lease; except for movable equipment, trade fixtures, personal property and furniture owned by Tenant (“Tenant Owned Property”). At Landlord’s sole election made at the time that Landlord approves any Alterations, such Alterations shall be removed from the Premises at Tenant’s sole cost and expense at the expiration or sooner termination of this Lease, and the Premises shall be restored, at Tenant’s sole cost and expense, to their condition before the making of such Alterations, and such obligations shall survive the expiration or any earlier termination of this Lease.

 

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11. REPAIRS AND OTHER WORK

 

  11.1 Tenant’s Obligations

 

At Tenant’s sole cost and expense (except as provided in Section 11.3 below), Tenant shall at all times during the Term maintain the Premises in good, clean and sanitary condition and, at Tenant’s cost and expense, make all repairs and replacements as and when necessary to preserve the Premises in good working order and condition, including glass, windows, window frames, window casements, skylights, interior and exterior doors, door frames and door closers; interior lighting (including, without limitation, light bulbs and ballasts), the plumbing and electrical systems serving the Premises, all communications systems serving the Premises, Tenant’s signage, interior demising walls and partitions, equipment, interior painting and interior walls and floors, exterior walls, foundations, roof, other structural components, Tenant’s security systems in or about or serving the Premises and cause the fire alarm systems serving the Premises to be monitored by a monitoring or protective services firm reasonably approved by Landlord in writing. Tenant shall not do nor shall Tenant allow Tenant’s agents, advisors, employees, partners, shareholders, directors, invitees and independent contractors (collectively, “Tenant’s Agents”) to do anything to cause any damage, deterioration or unsightliness to the Premises or the Building; provided that Tenant shall not be obligated to repair or maintain the Building Systems that do not exclusively serve the Premises or the structural elements of the Building unless such repair or maintenance is necessitated by any act of Tenant, its agents, representatives, employees, contractors o