**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-KSB**

 

| **x**                                                                                                                                                                                    | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                     |       |                                                                                                    |
| **For the fiscal year ended SEPTEMBER 30, 2007**                                                                                                                                         |
|                                                                                                                                                                                     |       |                                                                                                    |
| **o**                                                                                                                                                                                    | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                     |       |                                                                                                    |
| **For the transition period from                to            ** |

 

**Commission file No.  0-15338**

 

**PHOTOWORKS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Washington**                                                  | ** ** | **91-0964899**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (IRS Employer Identification No.) |

 

| **71 Columbia Street, Suite 200,  Seattle, WA** | ** ** | **98104**  |
|------------------------------------------------------|------------|------------|
| (Address of principal executive offices)             | ** ** | (Zip Code) |

 

| Registrant’s telephone number, including area code:               | ** ** | **(206) 281-1390** |
|------------------------------------------------------------------------|------------|--------------------|
|                                                                   |       |               |
| Securities registered pursuant to  Section 12(b) of the Act: | ** ** | **None**           |

 

Securities registeredpursuant to Section 12(g) of the Act:  **CommonStock, par value $.01 per share**

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to the filing requirements for the past 90 days. Yes:  x   No:  o

 

Check if there is nodisclosure of delinquent filers pursuant to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-KSB or any amendment to this Form 10-KSB.  x

 

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

 

Total revenue for the fiscal year ended September 30,2007 was $10,685,000.

 

As of December 19, 2007 the aggregate marketvalue of the Registrant’s Common Stock held by non-affiliates of the Registrantwas $10,119,451 based on the last sale price of the Registrant’s Common Stockas reported by the Over the Counter Bulletin Board Market.

 

As of December 4, 2007, there were issued andoutstanding 39,447,073 shares of Common Stock, par value $.01 per share.

 

**Documents incorporated by reference:**

 

Portions of the registrant’s definitive Proxy Statementto be delivered to shareholders in connection with the Annual Meeting ofShareholders, to be held in 2007, are incorporated by reference into Part III.

 

Transitional Small Business Disclosure Format (Checkone):  Yes: x   No: o

 

 

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**PART I**

 

**ITEM1 - BUSINESS**

 

**Description of Business**

 

**PHOTOWORKS, INC:** (“PhotoWorks” or the “Company”)is an online photography services company. With a 25-year national heritage(formerly known as Seattle FilmWorks), PhotoWorks helps photographers - bothfilm and digital - share and preserve their memories with innovative andinspiring products and services. Every day, photographers send film, memorycards and CDs, or go to www.photoworks.com, to upload, organize and email theirpictures, order prints, and create Signature Photo Cards and Custom PhotoBooks.

 

PhotoWorks was incorporated in WashingtonState in June 1976. The executive offices are located at 71 ColumbiaStreet, Suite 200, Seattle, Washington 98104, and the telephone number is(206) 281-1390. References to “PhotoWorks”, the “Company”, “we”, “us” and “our”in this report include PhotoWorks, Inc., and its wholly-ownedsubsidiaries.

 

**Forward-Looking Information**

 

This report contains forward-looking statementsincluding, without limitation, statements identified by an asterisk (*). Thesestatements relate to future events, product or service offerings or the futurefinancial performance of the Company. In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue”or the negative of such terms and other comparable terminology. Thesestatements only reflect expectations and estimates of the Company’s management.Actual events or results may differ materially from those expressed or impliedby such forward-looking statements. Relevant risks and uncertainties include,among others, those discussed in Item 1 of Part 1 under the heading “RiskFactors” and elsewhere in this report and those described from time to time inthe Company’s other filings with the Securities and Exchange Commission, pressreleases and other communications. All forward-looking statements contained inthis report reflect PhotoWorks’ expectations at the time of this report only,and the Company disclaims any responsibility to revise or update any suchforward-looking statement except as may be required by law.

 

**Overview**

 

During fiscal 2007, theCompany continued its strategy of transitioning from film processing revenue todigitally-based products and services. PhotoWorks now bridges the gap betweenthree distinct photo site strategies competing in the marketplace: share andstore sites, retail printing sites and self-publishing sites. The Company nowoffers these unique photo features and services in one comprehensive site.

 

The Company reported a net loss of$6,313,000, or a loss of $0.17 per share, for fiscal year 2007 compared to anet loss of $3,831,000 or a net loss of $0.19 per share for fiscal year 2006.Net loss for fiscal 2007 reflects a non-cash expense of $1,632,000 related tothe beneficial conversion of convertible debt that occurred in the firstquarter.

 

Digitalrevenue for fiscal 2007 grew 19% compared to fiscal 2006 and represented 71% oftotal revenue, compared to 55% in fiscal 2006. Gross margin as a percentage of net revenues for fiscal 2007 was 43%,consistent with fiscal 2006.

 

Totalrevenues decreased 8% to $10,685,000 in fiscal 2007 compared to $11,669,000 infiscal 2006. The 19% growth in digital revenue was offset by a 41% decline infilm revenue, reflecting the continuing industry-wide trend of decliningfilm-based processing volumes.

 

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On November 28,2007, the Company entered into an Agreement and Plan of Merger (the “MergerAgreement”) with AG.com, Inc., a Delaware corporation and subsidiary ofAmerican Greetings Corporation (“AG”), and Photo Merger Corp., a Washingtoncorporation and a wholly-owned subsidiary of AG which is an indirect, whollyowned subsidiary of American Greetings Corporation (the “Purchaser”),  pursuant to which, among other things, thePurchaser will commence a tender offer for all the outstanding common shares ofPhotoWorks, subject to the terms and conditions of the Merger Agreement.  Pursuant to the Merger Agreement, and uponthe terms and subject to the conditions thereof, the Purchaser will commence atender offer (the “Offer”) to acquire all the outstanding common shares ofPhotoWorks, par value $0.01 per share (“PhotoWorks Common Shares”), at a priceof $0.595 per share, to the selling shareholders in cash, without interestthereon (the “Offer Price”). Pursuant to the Merger Agreement, after theconsummation of the Offer, and subject to the satisfaction or waiver of certainconditions set forth in the Merger Agreement, the Purchaser will merge with andinto PhotoWorks (the “Merger”) and PhotoWorks will become a wholly-ownedsubsidiary of AG. At the effective time of the Merger, each issued andoutstanding PhotoWorks Common Share not acquired in the Offer (other thanPhotoWorks Common Shares held in treasury or PhotoWorks Common Shares held byshareholders who are entitled to exercise, and properly demand, dissenter’srights under Section 23B.13 of the Washington Business Corporation Act)will be automatically converted into the right to receive the Offer Price incash, without interest. The tender offer commenced on December 13, 2007 and,unless extended, will terminate on January 14, 2008.

 

**Operating Strategy**

 

The principal elements of our operatingstrategy are the introduction of innovative, convenient, easy-to-use digitalservices and products and a commitment to service and customer satisfaction. Wewill continue to emphasize excellent service, professional quality, andconvenience rather than try to be a low-price provider.

 

Management believes that providinghigh-quality services to the digital market is the key driver to our success.We believe that consumers will continue to convert from traditional film-basedcameras to digital cameras.

 

We have structured our operations so thatall of our product processing and delivery has been outsourced to third partyvendors. We believe this strategy will allow us to grow our business withoutsignificant additional capital investment for plant and equipment and to adjustin the event there are technology shifts in the production process.

 

We believe that our complementaryvalue-added services and products, including Custom Photo Books, SignaturePhoto Cards and gifts, promote customer loyalty and increase customer demand.Our commitment to ease of use and expanded service and product offerings isintended to support this strategy.  Wewill continue to focus in insuring that customer experience at every touchpoint is excellent and compelling.

 

**Risk Factors**

 

Inaddition to the other information in this report, the following risk factorsshould be carefully considered in evaluating us and our business. The risks anduncertainties described below are not the only ones we face. Additional risksand uncertainties not presently known to us or that we currently deemimmaterial also may impair our business operations. If any of the followingrisks occur, our business, financial condition, operating results and cashflows could be harmed.

 

**We may be unsuccessful in increasing revenues from digitalservices, which would adversely affect our results of operations.**

 

Ourbusiness model emphasizes the sale and distribution of products and servicesfor users of digital cameras.  We have developedadditional products and services designed to establish us as the choice fordigital camera users for printing, archiving, sharing, viewing and managingpersonal digital images. However, a number of other companies are attempting toestablish this position. Competitors in this area includeOfoto/EasyShareGallery (Ofoto was acquired by Kodak in June 2001),Snapfish (acquired by HP in April 2005), Shutterfly (an independentcompany) and other traditional providers of photofinishing services. We may notbe successful against this competition. The digital printing market has notbeen fully established. Even if we establish a strong position among consumersfor digital products and services, we may not be able to generate significantrevenues from this market.

 

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**We expect continued declines in film-based processing thatwill adversely affect our revenues.**

 

Wehave experienced significant declines in revenues from film-based processing ineach of the last four fiscal years and we believe this trend will continue. Webelieve that this is primarily attributable to declines in the mail orderphotofinishing market and the photofinishing industry in general.  In addition, we believe the market shift fromtraditional 35mm film to digital cameras will continue due to the decliningprices for printing and the rapid increase of the digital camera marketsincreased availability and consumer acceptance of digital cameras. As a result,our revenues from film-based processing are likely to continue to decline forthe foreseeable future.

 

**We may not be able to retain existing customers or acquirenew customers at a reasonable cost.**

 

Futurerevenues and profitability depend in large part on our ability to retain ourcurrent customers and our ability to acquire new digital customers at areasonable cost. Historically, we used direct-marketing programs offeringlow-priced or free introductory offers as our primary customer acquisitiontechnique. Over the past years, the cost for these programs has increased andwe have seen a decline in customer response rates. Our current marketingfocuses on customer reactivation and retention and opportunities to acquire newcustomers through online channels at a reasonable cost. Our customer acquisitionand retention efforts may not be effective. If we do not successfully acquirenew digital customers, retain our current customers, or market successfullyagainst competitors, our business, financial condition and operating resultscould be harmed.

 

**We rely on key vendors, suppliers and foreign sourcing.**

 

Wehave outsourced our mail order film processing and printing as well as ourdigital printing.  Our Custom PhotoBooks, Signature Photo Cards and keepsakes are produced by third-party vendors. The success of our business is dependentin part on the quality and service provided by our vendors.  If we experience significant quality orservice problems at one or more of our vendors, it could adversely affect ourbusiness.

 

Wehave no significant long-term purchase contracts or agreements to ensurecontinued supply, pricing or access to film, paper or chemicals. While webelieve that alternate sources of third-party providers are available, it ispossible that our vendors might not be able to continue to meet ourrequirements for services or supplies, or purchase services or supplies insufficient quantities or on terms as favorable to us as those currentlyavailable. Also, changing to an alternate vendor or supplier may cause delays,reduced quality or other problems.

 

Salesof our services and products on a direct-to-consumer mail-order basis largelydepend on the U.S. Postal Service and other common carriers for receipt oforders and delivery of our products. Any significant changes in the operationsof or prices charged by the U.S. Postal Service or other common carriers orextended interruptions in postal deliveries could harm our business, financialcondition and operating results.

 

**We may be adversely affected by actions of competitors.**

 

Themarket for consumer photofinishing and digital imaging services is highlycompetitive and still emerging. Many of our competitors have substantiallygreater financial, technical and other resources than we have. We facecompetition in consumer photofinishing and digital imaging services from otherdirect marketers, online companies, and competitors in other distributionchannels, including much larger companies. Many of these companies providephotofinishing services on a wholesale basis to independent retail outlets and,in some cases, through multiple retail outlets owned by the photofinisher oronline service providers. Many of these competitors also provide photofinishingservices within hours. There are no significant proprietary or other barriersto entry into the traditional photofinishing or digital imaging industry. Manyof our competitors offer similar photofinishing and digital imaging servicesand products at lower prices and with a more rapid turnaround time than weoffer. Our ability to compete effectively depends on our ability todifferentiate our services by offering innovative services and products andexemplary customer service and experience. Although we believe we are a leader in developing and marketinginnovative photo-related services and products, competitors can and do providesimilar services and products. There can be no assurance we will continue tocompete effectively through development of innovative services and products orthe provision of exemplary customer service and experience or that we willrespond appropriately to industry trends or to activities of competitors.

 

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**We may not be able to keep up with rapid technologicalchanges in the photofinishing industry.**

 

Thephotography industry is currently characterized by rapidly evolving technologyand consumer demand for services and products. The introduction of digitalservices and products that use new technologies could render existing servicesand products obsolete. Our future success will depend on our ability to adaptto new technologies and develop new or modify existing services, products andmarketing techniques to satisfy changing consumer needs and attract newcustomers. The expanded use of digital cameras has had a negative impact oncompanies such as PhotoWorks that have primarily processed traditionalfilm-based images and slides. The development of these or other newtechnologies, or failure by us to anticipate or successfully respond to suchdevelopments, could harm our business, financial condition and operatingresults.

 

**We experience fluctuations in quarterly results.**

 

Ourquarterly operating results will fluctuate for many reasons, including:

 

·         Seasonalityof consumer photographic activity,

·         Themix of products we sell,

·         Promotionalactivities we conduct,

·         Priceincreases by our suppliers,

·         Ourintroduction of new products,

·         Ourresearch and development activities,

·         Ourcompetitors’ actions,

·         Fluctuationsin the direct-to-consumer market,

·         Changesin usage of digital services and online commerce,

·         Changesin the photofinishing industry

·         Generaleconomic influences and conditions.

 

Demandfor our photo-related services and products are seasonal, with the highestvolume of photofinishing activity generally occurring during the summer monthsand holiday season. As a result, our operating results for any period do notnecessarily indicate the results that can be expected for any future period.Our operating results in a future period may be below the expectations ofpublic market analysts and investors which may cause the price of our commonstock to decline.

 

**Our management information systems and technology may not beviable.**

 

Wedepend on our management information systems, website and technology systems tocommunicate with customers, process orders, provide rapid response to customerinquiries, manage inventory, and purchase, sell and ship products efficiently.We periodically replace and upgrade certain components of our systems softwareand hardware. We take a number of precautions to prevent certain events fromoccurring that could disrupt our systems, including events associated withcontinuing software and hardware upgrades. Any damages or failures to ourcomputer equipment, technology systems and the information stored in our datacenter could harm our business, financial condition, and operating results.

 

**Governmental regulation could harm our business.**

 

Ouroperations, including our transmission of digital images over the Internet, aresubject to regulation by the U.S. Postal Service, the Federal Trade Commissionand various states, local, and private consumer protection and other regulatoryauthorities. In general, these regulations govern privacy, the manner in whichorders may be solicited, the form and content of advertisements, informationwhich must be provided to prospective customers, the time within which ordersmust be filled, obligations to customers if orders are not shipped within aspecified period of time, and the time within which refunds must be paid if theordered merchandise is unavailable or returned. Congress has enactedlegislation to specifically regulate online commerce and communications and has

 

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addressedsuch issues as the transmission of certain materials to children, intellectualproperty protection, taxation, and the transmission of sexually explicitmaterial. In addition, some states have enacted legislation that makes thetransmission of certain kinds of information, such as obscene content andinformation that facilitates the commission of criminal acts, a crime.

 

Otherlegislation could result in additional regulation or prohibition of thetransmission of certain types of content over the Internet. This legislationcould result in significant potential liability to us for content transmittedover our website, as well as additional costs and technological challenges incomplying with mandatory requirements. We do not assume responsibility to editthe content of our customers’ photographs, slides, digital images or personalhome pages unless responding to a specific complaint. Legislation whichimposes potential liability for content made available over the Internetthrough our website could require us to implement additional measures to reduceour exposure to such liability. This may require us to incur significant costsor discontinue certain service or product offerings. Although we carry generalliability insurance, such insurance may not cover potential claims of this typeor may not be adequate to compensate us for the amount of these liabilities.Any costs not covered by insurance incurred as a result of such liability orasserted liability could harm our business, financial condition and operatingresults.

 

**Sales of a substantial number of shares of our common stockinto the public market by major stockholders may result in significant downwardpressure on the price of our common stock and could affect the ability of ourstockholders to realize the current trading price of our common stock.**

 

Salesof a substantial number of shares of our common stock in the public marketcould cause a reduction in the market price of our common stock. We had39,447,073 shares of common stock issued and outstanding as of December 4,2007.  At that date, 6 shareholdersowned, directly or indirectly, approximately 69% of the outstanding commonstock.  If one or more of thoseshareholders decided to sell a significant portion of their holdings, it couldcause the price of our stock to decline substantially.

 

**Trading on the OTC Bulletin Board may be sporadic because itis not a stock exchange, and stockholders may have difficulty reselling theirshares.**

 

Ourcommon stock is quoted on the OTC Bulletin Board. Trading in stock quoted onthe OTC Bulletin Board is often thin and characterized by wide fluctuations intrading prices, due to many factors that may have little to do with the Company’soperations or business prospects. Moreover, the OTC Bulletin Board is not astock exchange, and trading of securities on the OTC Bulletin Board is oftenmore sporadic than the trading of securities listed on a quotation system likeNASDAQ or a stock exchange like AMEX Accordingly, you may have difficultyreselling any of the shares you purchase from the selling stockholders.

 

**Some of our existing shareholders can exert control over usand may not make decisions that are in the best interests of all shareholders.**

 

As of December 4, 2007, officers,directors, and shareholders holding more than 5% of our outstanding sharescollectively controlled approximately 50% of our outstanding common stock. As aresult, these shareholders, if they act together, would be able to exert asignificant degree of influence over our management and affairs and overmatters requiring shareholder approval, including the election of directors andapproval of significant corporate transactions. Accordingly, this concentrationof ownership may harm the market price of our ordinary shares by delaying orpreventing a change in control of us, even if a change is in the best interestsof our other shareholders. In addition, the interests of this concentration ofownership may not always coincide with the interests of other shareholders, andaccordingly, they could cause us to enter into transactions or agreements thatwe would not otherwise consider. Entities controlled by Messrs. Waechter, Holland Goodrich (all Company Board Members) have agreed to tender all theirshares, representing 44.9% of Photoworks Common Shares, and vote for themerger.

 

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**Marketing**

 

**Products and Services**

 

PhotoWorks offers a variety of creativehigh-quality products and services through which it seeks to differentiateitself from its competitors. Our online services offer immediate viewing andsharing of images online and quick turnaround for products and we believe weare highly competitive in this market. Mail-order photofinishing is generallylonger than many alternative sources for photofinishing services and turnaroundtime for traditional mail-in processing services remains a competitivedisadvantage for us.

 

PhotoWorks has an established tradition ofservice and product innovation for both traditional and digital camera users.Our Signature Photo Cards are differentiated from other online offerings bytheir high-end design and professional quality and our Custom Photo Books allowconsumers to easily custom design online a personal memento of photographicmemories into a professionally printed and bound book.

 

**Customer Service and Support**

 

The direct-to-consumer photofinishingbusiness involves contacts with a large number of customers. We believe thatproviding exemplary customer satisfaction and experience is critical to ourongoing success. PhotoWorks has a 100% satisfaction-guarantee policy underwhich we will provide a full refund if a customer’s complaint cannot otherwisebe resolved. As of September 30, 2007, we had a customer service staff of13. These personnel have direct access to our database and are trained to promotecertain of our services and products, as well as to answer questions regardingorder status and use of PhotoWorks’ digital and online services.

 

PhotoWorks maintains a website on theInternet (www.photoworks.com). Our current website incorporates leadingtechnology with an easy to use and intuitive user experience. While online,customers may use the PhotoWorks(TM) service to privately upload, view, store,share, manage or email their photos to friends and family, and order PhotoWorks’Custom Photo Books and Signature Photo Cards, as well as keepsakes, prints andreprints. Customers may also obtain the status of their orders, access answersto frequently asked questions, and send email messages to customer service.

 

**Technology Systems**

 

We have implemented technology to supportcustomer order processing, image archiving, and Internet accessibility. Theseservices and systems use a combination of proprietary technologies andcommercially available, licensed technologies. Internal development is focusedon creating and enhancing the specialized, proprietary software that is uniqueto the business. We use a set of applications for:

 

·                  Accepting and validating customer orders

·                  Archiving images

·                  Internet image viewing, ordering prints andother products

·                  Managing shipment of products to customersbased on various ordering criteria

 

Systems are designed based on industrystandard architectures and have been designed to reduce downtime in the eventof outages or catastrophic occurrences. The systems provide a 24-hour-a-day,seven-day-a-week availability. We use load balancing systems and redundantservers to provide for fault tolerance. Our systems are located in secure locations with redundant powersources.

 

The market in which PhotoWorks competes ischaracterized by rapidly changing technology, evolving industry standards,frequent new service and product announcements and enhancements, and changingcustomer demands.  Accordingly, futuresuccess will depend on our ability to:

 

·                  Adapt to rapidly changing technologies

·                  Adapt services to evolving industry standards

·                  Continually improve the performance,scalability, features, and reliability of service in response to competitiveservice and product offerings and evolving demands of the marketplace

 

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Failure to adapt to such changes would have amaterial adverse effect on our business, results of operations, and financialcondition.

 

**Competition**

 

The major competitors in our market areKodak, Snapfish (owned by HP) and Shutterfly. In addition to these majorcompetitors there are numerous other companies that offer onlinephoto-finishing services.

 

We believe that our success in the digitaland photography industry will be based on our ability to generate brandawareness through the introduction of innovative and differentiated productsand services such as our Signature Photo Cards and Custom Photo Books and theprovision of exemplary customer service at every touch-point. We offer premiumquality and competitive prices for our digital and film-based print services.Other competitors can and do provide similar services and products.  There are no significant proprietary or otherbarriers to entry into the digital or consumer photofinishing industry.

 

The digital photography industry ischaracterized by rapidly evolving technology and consumer demand for servicesand products. The introduction of photographic services and products involvingnew technologies could render existing services and products obsolete.  Our future success will depend on our abilityto adapt to new technologies and develop new or modify existing services andproducts to satisfy evolving consumer needs. For example, the commercialization of digital imaging technologies ishaving an adverse impact on the photofinishing industry and has among otherfactors, accounted for our declines in revenues. The development of new technologiesor any failure by us to anticipate or successfully respond to such developmentscould have a material adverse effect on our business, financial condition andoperating results.  See “Risk Factors.”

 

**ProprietaryTechnology**

 

We currently market our services and productsunder registered and common-law trademarks and service marks, includingPhotoWorks®, Seattle Film Works®, PhotoMail®, PhotoStreamer®, Pictures OnDiskTM, Photo ClutchTM and Pictures On DiskTMon CD. See “Risk Factors.”

 

We consider a large portion of our websiteand infrastructure processes to be proprietary. We make limited patent filings,in part to avoid disclosure of our competitive strengths. However, we doattempt to protect our proprietary rights through a combination of copyright, trademarkand trade secret laws, employee and third-party nondisclosure agreements,restricting access to certain portions of our premises, and contractualrestrictions on use and disclosure in our end-user licenses. The legal andpractical enforceability and extent of liability for violations of licenseagreements are unclear.

 

This Report contains trademarks other thanthose of PhotoWorks.

 

**GovernmentalRegulation**

 

PhotoWorks’ operations, includingtransmission of digital images over the Internet, are subject to regulation bythe U.S. Postal Service, the Federal Trade Commission, and various state,local, and private consumer protection and other regulatory authorities. Ingeneral, these regulations govern the manner in which orders may be solicited,the form and content of advertisements, privacy issues, information which mustbe provided to prospective customers, the time within which orders must befilled, obligations to customers if orders are not shipped within a specifiedperiod of time and the time within which refunds must be paid if the orderedmerchandise is unavailable or returned. Congress has enacted legislation tospecifically regulate online commerce and communications and has addressed suchissues as the transmission of certain materials to children, intellectualproperty protection, taxation, and the transmission of sexually explicitmaterial. In addition, some states have enacted legislation that makes thetransmission of certain kinds of information, such as obscene content andinformation that facilitates the commission of criminal acts, a crime.

 

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Legislation enacted by Congress and the statelegislatures could result in additional regulation or prohibition of thetransmission of certain types of content over the Internet or in the impositionof taxes or fees on transactions conducted over the Internet.  This could result in significant potentialliability to PhotoWorks, as well as additional costs and technologicalchallenges in complying with mandatory requirements.  See “Risk Factors.”

 

**EnvironmentalCompliance**

 

Since November 2005, all of ourphotofinishing has been provided by third party vendors.  Prior to that date, our photofinishingoperations involved the use of several chemicals which are subject to federal,state and local governmental regulations relating to the storage, use, handlingand disposal of such chemicals. We actively monitored our compliance withapplicable regulations and worked with regulatory authorities to ensure compliance.To the best of our knowledge, we have never received a significant citation orfine for failure to comply with applicable environmental requirements.  We decommissioned our film processingfacility during 4th quarter 2005. The costs of environmentalcompliance were immaterial in fiscal years 2007 and 2006.

 

**Employees**

 

As of September 30, 2007, PhotoWorks had60 full-time employees, allocated as follows: 8 in administration, 15 inmarketing and business development, 17 in technology and development, 13 incustomer service and 7 in film order entry and operations. None of ouremployees are covered by a collective bargaining agreement, and we believerelations with our employees are good.

 

**ExecutiveOfficers of the Registrant**

 

The executive officers of PhotoWorks as of December 4,2007 were:

 
| **Name**         | ** ** | **Age** | ** ** | **Position**                                                   | ** ** |
|------------------|------------|---------|------------|----------------------------------------------------------------|------------|
| Andrew Wood      |       | 53      |       | President / Chief Executive Officer                            |       |
| David Douglass   |       | 51      |       | Vice President / Chief Financial Officer, Corporate  Secretary |       |
| Daniel Zimmerman |       | 42      |       | Vice President / Engineering                                   |       |

 

Andrew Wood has over 25 years of domesticand international experience in technology-enabled service industries. He hasheld CEO roles for over 15 years. Previously he served as CEO of Shutterfly,the national leading independent online photo finisher, where he streamlinedoperations, sharply focused company goals and guided the company toprofitability well ahead of schedule. He recently served as CEO of Wood-ASIO, aconsulting organization providing confidential assistance to technology andservice industry companies. He also served as CEO of Skybitz, a satellitetracking based service business, where sales traction, product stabilizationand development, and channel partnerships were significant challenges. Theseissues were resolved, along with a new $20M round of financing that broughtMotorola in as a strategic partner. Throughout his career, he has gainedexpertise in growing business operations in complex emerging markets. As CEO ofExel Logistics, he launched the North American business and successfullysteered the company’s revenue to $500M in four years, along with highprofitability. Andy has also worked with Coca Cola in the UK, where he was partof a team charged with energizing and restructuring the UK soft drinks market.He has advised a number of companies and VC’s, as well as serving on the Boardof two private companies in addition to PhotoWorks.

 

DavidDouglass joined theCompany in May 2007 and serves as its Vice President and Chief FinancialOfficer and Corporate Secretary (effective June 15, 2007). Mr. Douglassis a partner of Tatum, LLC, an executive services firm that provides strategicand operating leadership in finance and information technology. Prior tojoining Tatum, Mr. Douglass was involved in technology startups. He servedas CFO of The Cobalt Group (NASDAQ: CBLT) during its final venture capitalstages and IPO process. The Cobalt Group is a leading provider of internetproducts and services to the automotive industry. Prior to Cobalt, Mr. Douglassheld various

 

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positions at PACCAR Inc(NASDAQ: PCAR), a worldwide manufacturer of transportation equipment, includingthe positions of Director of Internal Audit and Managing Director of FodenTrucks, based in England. Mr. Douglass earned a B.A. summa cum laude fromthe University of Puget Sound and a M.B.A. from the University of Washington.He also attended Duke University’s Advanced Management Program at the FuquaSchool of Business. He is a certified public accountant (inactive).

 

Daniel Zimmerman joined PhotoWorks in May 2004 after PhotoWorksacquired assets of PhotoAccess Technologies. Zimmerman, who served as VicePresident of Engineering of PhotoAccess, has more than 20 years of experiencein software development, Desktop Publishing, and Internet development in thesoftware industry. Before PhotoAccess, Zimmerman worked on Internettechnologies for the Core Technology team at Adobe Systems, where he wasresponsible for delivering key technology components for all of Adobe’sproducts and was a key member of the PageMaker development team at AldusCorporation.

 

In February 2007, Mr. ThomasKelley, Vice President and Chief Marketing Officer, left the Company.  His responsibilities were assumed by Ms. LanaeWeir – Senior Director, Consumer Marketing.

 

In September 2006,Mr. Bruce Fischer was promoted from Controller of the Company to VicePresident - Finance & Chief Financial Officer.  Mr. Fischer left the Company inApril 2007.  Mr. David Douglassassumed the responsibilities of Vice President and Chief Financial Officer inMay 2007 and Corporate Secretary in June 2007.

 

**ITEM 2 –PROPERTIES**

 

The Company’s headquarters are located inSeattle, Washington. Our 15,030 square foot space is subject to a lease whichexpires in October 2011. The Company moved to this smaller office facilityin February 2006.  We believe theleased premises are suitable and adequate for their current intended use. Inthe opinion of management, the leased premises are adequately covered byinsurance.

 

We do not own any real property. We do not have apolicy pertaining to investments in real estate. Our current practice is toinvest solely in short-term money market securities.

 

**ITEM 3 - LEGAL PROCEEDINGS**

 

We are involved in various routine legalproceedings in the ordinary course of our business, none of which individuallyor in the aggregate is material to our financial condition.

 

**ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

**None.**

 

**PART II**

 

**ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK**

 

Our Common Shares are traded on the Overthe Counter Bulletin Board (OTCBB) under the symbol “PHTW.OB.” The followingtable sets forth, for the periods indicated, the high and low bid prices of ourCommon Shares as reported on the OTCBB.

 

10

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| ** **                                | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------|------------|----------|------------|---------|------------|
| **Fiscal  Year Ended September 30, 2007** |       |     |       |    |       |
| First Quarter                             |       | $        | 0.62       |    | $          | 0.25 |   |
| Second Quarter                            |       | 0.59     |       | 0.30    |       |
| Third Quarter                             |       | 0.40     |       | 0.22    |       |
| Fourth Quarter                            |       | 0.45     |       | 0.19    |       |
|                                      |       |     |       |    |       |
| **Fiscal  Year Ended September 30, 2006** |       |     |       |    |       |
| First Quarter                             |       | $        | 0.65       |    | $          | 0.35 |   |
| Second Quarter                            |       | 0.52     |       | 0.29    |       |
| Third Quarter                             |       | 0.53     |       | 0.25    |       |
| Fourth Quarter                            |       | 0.70     |       | 0.30    |       |

 

On December 4, 2007 the Company’s CommonShares was held by an estimated 3,100 shareholders.

 

The Company has never declared or paid cashdividends on its common stock and does not anticipate paying any dividends inthe foreseeable future. The Company is restricted under the covenants of a bankagreement that supports its corporate credit cards from declaring any dividendson shares of its capital stock without the bank’s prior consent.

 

**ITEM 6 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

**Forward-Looking Information**

 

This Report contains forward-lookingstatements relate to future events, product or service offerings or the futurefinancial performance of PhotoWorks. In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue”or the negative of such terms and other comparable terminology. Thesestatements only reflect expectations and estimates of PhotoWorks’ management.Actual events or results may differ materially from those expressed or impliedby such forward-looking statements. Relevant risks and uncertainties include,among others, those discussed in Item 1 of Part 1 under the heading “RiskFactors” and elsewhere in this Report and those described from time to time inPhotoWorks’ other filings with the Securities and Exchange Commission, pressreleases and other communications. All forward-looking statements contained inthis report reflect expectations at the time of this report only, andPhotoWorks disclaims any responsibility to revise or update any suchforward-looking statement except as may be required by law.

 

**Controls and Procedures**

 

As of September 30, 2007, as part ofour annual internal audit, we carried out an evaluation, under the supervision ofthe Audit Committee members, the Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14.Based upon that evaluation, the Chief Executive Officer and the Chief FinancialOfficer concluded that our disclosure controls and procedures are effective totimely alert them to any material information relating to the Company(including its consolidated subsidiaries) that must be included in our periodicSEC filings. There have been no significant changes in the Company’s internalcontrols or in other factors that could significantly affect internal controlssubsequent to their evaluation.

 

11

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We will continue to review and evaluate thedesign and effectiveness of our disclosure controls and procedures on anongoing basis and to improve our controls and procedures over time and correctany deficiencies that we may discover in the future. Our goal is to ensure thatour senior management has timely access to all material financial andnon-financial information concerning our business. While we believe the presentdesign of our disclosure controls and procedures is effective to achieve ourgoal, future events affecting our business may cause us to modify ourdisclosure controls and procedures.

 

**Overview**

 

PhotoWorks is an online photographyservices company. With a 25-year national heritage (formerly known as SeattleFilmWorks), PhotoWorks helps photographers - both film and digital - share andpreserve their memories with innovative and inspiring products and services.Every day, photographers send film, memory cards and CDs, or go towww.photoworks.com to upload, organize and email their pictures, order prints,and create Signature Photo Cards and Custom Photo Books.

 

To promote our services and products, werely primarily on online marketing channels and direct marketing. We believeour innovative products and commitment to customer service promote customerloyalty and increase customer demand. We strive to increase both average ordersize and order frequency by informing our existing customer base of ourintegrated array of services and products. We also believe that our onlinearchive of customer images is a viable and economic opportunity to monetize acustomer’s “personal equity” by providing image storage and management servicesfor digital and film-based camera users and through photo output, in the formof Custom Photo Books, Signature Photo Cards, gifts, and digital prints andreprints. In addition we have utilized desk top software to help manage imagesstored on customer hard drives. (PhotoStreamer 2)  Our commitment to expanding our digitalservice and product offerings is intended to support this strategy. We useonline channels and other direct-marketing media to communicate withprospective customers and our existing and inactive customers. We also utilizea customer relationship management system (CRM) which we installed in December 2004to enhance our communication with new and existing customers.

 

Our net loss for fiscal 2007 was$6,313,000, compared to a net loss of $3,831,000 in 2006. The net loss forfiscal 2007 includes a non-cash interest expense of $1,632,000 resulting frombeneficial conversion of convertible debt. PhotoWorks embarked on acomprehensive restructuring plan in late 2003 and in 2005 the management teamcompleted the re-organization from a mail-order film processing business to aleading internet based photo-publishing service focused on the higher margin –and rapidly growing – digital photography market.

 

Cost of goods andservices consist of labor, postage, supplies, and fixed costs of productionrelated to our services, products, and third party billings for production servicesrendered. Personnel related costs are categorized in their respectivefunctional categories. Marketing expenses include costs associated withcustomer acquisition and retention, building brand awareness, and testing ofnew marketing programs. Engineering expenses consist primarily of costsincurred in ongoing development of our online image management, developingonline photo archiving and photo sharing services, other digital relatedservices, and creating and maintaining an infrastructure necessary to supportsystems for customer interaction. General and administrative expenses consistof costs related to management information systems, computer operations, humanresource functions, finance, legal, accounting, investor relations, and generalcorporate activities.

 

### **Critical AccountingPolicies**

### ** **

Management’s Discussion and Analysis ofFinancial Condition and Results of Operations discuss our consolidatedfinancial statements, which have been prepared in accordance with U.S.generally accepted

 

12

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accounting principles. The preparation ofthe financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, net revenues, and expenses.Our estimates and judgments are based upon our historical experience, knowledgeof economic and market factors and various other factors that we believe to berelevant given the circumstances and our best estimates for identified one timecosts relevant to the discontinuation of the in-house production capacity, theoutsourcing of all production, the writing off of redundant assets and theclean up of the production facility and the move to the new office building.Significant policies, methodologies, estimates, and the factors used therein,are reviewed on at least a quarterly basis with PhotoWorks’ Audit Committee.Actual results may differ from these estimates.

 

The following is a discussion of theestimates included in our financial statements that encompass matters of uncertainty,whereby different estimates could have reasonably been made or changes in suchestimates could have a material impact on the financial statements ofPhotoWorks.

 

*Revenue Recognition*

TheCompany recognizes revenue when realized or realizable and earned, which iswhen products are shipped or services are delivered. Nearly all of theCompany’s revenues are paid by credit card or by personal check prior to theshipment of the order.  At the timerevenue is recognized, the Company also records reductions to revenue forcustomer discounts and promotions in accordance with the provisions of EmergingIssues Task Force (EITF) Issue No. 01-09, “Accounting for Consideration Givenfrom a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”  The Company provides its customers with a 100%satisfaction guarantee. The vast majority of the Company’s products andservices will not be returned but customers can request a refund if notsatisfied. During fiscal 2007, refunds were $65,000 (0.61% of netrevenues).  During fiscal 2006, returnsand refunds were $92,000 (0.79% of net revenues. 

 

*Deferred Revenues*

 

Our deferred revenues relate to PrepaidPrint Credits and the Pick Your Prints product. With prepaid print credits,customers essentially receive discounted prices on digital products bypurchasing bulk quantities of print credits. No revenue is recognized at thetime the print credits are purchased. The revenue is deferred until the creditsare used to purchase actual products and the products have been shipped to thecustomer. The Pick Your Prints product, launched in late fiscal 2003, offersfilm developing with high-resolution scanning. For one price, the customerreceives their developed negatives and subsequently orders, online, only the printsthey want. The Company defers revenue from the initial film processing andscanning based on the relative fair value of the digital prints to all of theproduct components. This deferred revenue is recognized when customers orderand are shipped their digital prints. In October 2004, this product wasenhanced so that the print credits were extendable to all digital products.Given this enhancement and the relative newness of this product offering,management does not believe it can currently estimate, with reasonableaccuracy, any breakage on the above products. As more information becomesavailable over the life cycle of these products, management may be able toreasonably estimate a breakage factor, which may have a material impact onrevenues and gross margins.

 

*Stock Based Compensation*

InDecember 2004, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock BasedCompensations.” (“SFAS 123R”) This statement supersedes APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and its related implementationguidance. This statement establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. It also addresses transactions in which an entity incurs liabilitiesin exchange for goods or services that are based on the fair value of theentity’s equity instruments or that may be settled by the issuance of thoseequity instruments. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement does not change the accounting guidancefor share based payment transactions with parties other than employees providedin Statement of Financial Accounting Standards No. 123(R). This statement doesnot address the accounting for employee share ownership plans, which aresubject to AICPA Statement of Position 93-6, “Employers’ Accounting forEmployee Stock Ownership Plans.” The Company has adopted SFAS No. 123(R) andhas recognized $345,000, and $261,000 for employee stock compensation duringfiscal 2007 and 2006 respectively, in accordance with SFAS No. 123(R).

 

*Deferred Tax Assets*

 

We have gross deferred tax assets totaling$19,679, comprised primarily of net operating loss carry forwards. Due to ouroperating losses, the uncertainty of future profits, and limitations on theutilization of net operating loss carry forwards under IRC Section 382, wehave recorded a valuation allowance of $19,679 against our deferred tax assets.A more than 50% change in ownership will greatly restrict the use of theselosses in the future.

 

*RecentAccounting Pronouncements*

 

In September 2006, the FASB issued SFAS158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Benefits – an amendment of FASB Statements No. 87, 88, 106 and132(R).’This Statement  requires anemployer to recognize the overfunded or underfunded status of a defined benefitpostretirement plan (other than a multiemployer plan) as an asset or liabilityin its statement of financial position and to recognize changes in that fundedstatus in the year in which the changes occur through comprehensive income of abusiness entity or changes in unrestricted net assets of a not-for-profitorganization. This Statement also improves financial reporting by requiring anemployer to measure the funded status of a plan as of the date of its year-endstatement of financial position, with limited exceptions.  The Company does not have a defined benefitpension plan and therefore the Company has determined there will be no effecton the consolidated financials statements.

 

In February 2007, the FASB issued SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities –Including an amendment of FASB Statement No. 115.” (SFAS 159).  SFAS No. 159 permits entities to choose tomeasure eligible items at fair value at specified election dates and reportunrealized gains and losses on items for which the fair value option has beenelected in earnings at each subsequent reporting date.  SFAS No. 159 also establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities.  SFAS No. 159 is effectivefor fiscal years beginning after November 15, 2007.  Management is currently evaluating the impactof the provisions of SFAS 159 on the Company’s results of operations andfinancial position.

 

In December 2007, the FASB issued StatementNo. 141 (revised 2007), Business Combinations, and Statement No. 160,Noncontrolling Interests in Consolidated Financial Statements.  Statement No. 141 (revised 2007) requires anacquirer to measure the identifiable assets acquired, the liabilities assumedand any noncontrolling interest in the acquiree at their fair values on theacquisition date, and goodwill being the excess value over the net identifiableassets acquired.  The standard alsorequires the fair value measurement of certain other assets and liabilitiesrelated to the acquisition such as contingencies and research anddevelopment.  Statement No. 160 clarifiesthat a noncontrolling interest in a subsidiary should be reported as equity inthe consolidated financial statements. Consolidated net income should include the net income for both theparent and the noncontrolling interest with disclosure of both amounts on theconsolidated statement on income.  Thecalculation of earnings per share will continue to be based on income amountsattributable to the parent.  The Companyhas determined there will be no effect on the consolidated financialstatements.

 

 

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**Resultsof Operations**

 
| ** **                                                             | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                             | ** ** | **2007**             | ** ** | **2006** | ** ** |
| **Consolidated  Statements of Operation Data:**                        |       |                 |       |   |   |
| Total revenues                                                         |       | $                    | 10,685     |   | $ | 11,669 |   |
|                                                                   |       |                 |       |   |   |
| Gross profit                                                           |       | 4,600                |       | 4,972 |   |
|                                                                   |       |                 |       |   |   |
| Operating  expenses                                                    |       | 9,087                |       | 8,802 |   |
|                                                                   |       |                 |       |   |   |
| Net income  (loss)                                                     |       | (6,313               | )          | (3,831 | ) |
|                                                                   |       |                 |       |   |   |
| Net income  (loss) attributable to common shareholders                 |       | $                    | (6,313     | ) | $ | (3,831 | ) |
|                                                                   |       |                 |       |   |   |
| Diluted earnings  (loss) per share                                     |       | $                    | (0.17      | ) | $ | (0.19 | ) |
|                                                                   |       |                 |       |   |   |   |   |
| Diluted earnings  (loss) per share attributable to common shareholders |       | $                    | (0.17      | ) | $ | (0.19 | ) |
|                                                                   |       |                 |       |   |   |
| Weighted average  shares and equivalents outstanding -diluted          |       | 37,898,083           |       | 19,796,326 |   |
|                                                                   |       |                 |       |   |   |
| **Consolidated  Balance Sheet Data:**                                  |       |                 |       |   |   |
| Total assets                                                           |       | $                    | 2,068      |   | $ | 1,754 |   |
|                                                                   |       |                 |       |   |   |
| Long-term  obligations                                                 |       | 69                   |       | 1,639 |   |
|                                                                   |       |                 |       |   |   |
| Shareholders'  equity (deficit)                                        |       | $                    | (1,233     | ) | $ | (1,995 | ) |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

During fiscal 2007, theCompany continued its strategy of transitioning from film processing revenue todigitally-based products and services. PhotoWorks now bridges the gap betweenthree distinct photo site strategies competing in the marketplace: share andstore sites, retail printing sites and self-publishing sites. The Company nowoffers all of these unique photo features and services in one comprehensivesite.

 

Digital revenue forfiscal 2007 grew 19% compared to fiscal 2006 and represented 71% of totalrevenue, compared to 55% in fiscal 2006.

 

The Company had a seriesof accomplishments throughout the year including:

 

·                 Ten theme-oriented, photo sharingcommunity-based websites were launched, generating more than 90,000 pages viewsfrom 17,000 visitors since the launch in June 2007.

 

·                 New product introductions and upgradesincluded personalized cover books, new themes, significant increases inselection of gifts, new cards and better merchandising.

 

·                 Substantial revision to the Company’smain website to improve the user interface and offer members the opportunity toshare their photos and photo book projects easily (My Share Page) with theirpersonal communities.  At year end nearly3,700 unique My Share Pages had been created by members since the launchin June 2007.

 

·                 My Storefront e-commerce platform waslaunched in July 2007 as another key component of the Company’s strategyof efficient growth through viral marketing by tapping into social networks andcommunities.  My Storefront enablesPhotoworks.com members to sell their photo books, photo gifts, cards, calendarsand images for a profit while Photoworks.com handles all payment processing andproduct delivery.  At year end, theCompany hosted more than 400 My Storefronts.

 

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·                 The Company developed and launched asoftware “widget” that makes it very easy for PhotoWorks members to linkpersonal websites to their PhotoWorks My Share Page.

 

·                 Increased average revenue per active digital customer by 34% to $55.

 

·                 Increased average revenue per digital order by 19% to $33.

 

·                 The Company executed revenue sharing andother forms of agreements, intended to attract targeted customer groups to theCompany’s products and services, with partners in the marine communications,notebook PC manufacturing and wedding planning industries.

 

·                 The Company lowered its new customeracquisition costs while increasing digital revenues by 19% compared to fiscal2006, and substantially increasing overall revenue per customer and averageorder values, by refining its paid search and search engine optimizationstrategies and affiliate program terms.

 

·                 The Company’s public relations strategyhas presented PhotoWorks to more than 50 million viewers, readers and listenersduring the fiscal year.

 

·                 Re-launched its traditional filmprocessing business with a series of marketing promotions.

 

·                 Supply chain improvements that improvedefficiency and reduced costs.

 

During the second quarterof 2007, the Marketing organization was restructured with commensurate investmentand process and focus realignments.  The Operations organization wentthrough a leadership change with process and focus realignments as well. The Financial organization also went through leadership changes.

 

Net revenue decreased 8% to $10,685,000 infiscal 2007 compared to $11,669,000 in fiscal 2006. The decrease in net revenuefor fiscal year 2007 was due to a 41% decline in film-based processingrevenues, an overall trend for this line of business. Net revenue fromdigital-based processing increased in fiscal 2007 by 19% to $7,580,000 comparedto $6,372,000 in fiscal 2006.

 

Gross profit as a percentage of net revenuefor fiscal 2007 was 43% which is consistent with fiscal 2006.

 

Total operating expenses for fiscal 2007were $9,087,000 compared to $8,802,000 for fiscal 2006. Lower sales, marketing,customer service and general and administrative expenses were offset by higherengineering expenses resulting from hiring contractors to assist with software expansionand maintenance.

 

Marketing expenses in fiscal 2007 decreasedslightly to $3,462,000 compared to $3,473,000 in fiscal 2006.  Significantly reduced advertising expense wasoffset by higher personnel and consulting expenses.

 

Engineering expenses in fiscal 2007 were$2,375,000 compared to $1,943,000 in fiscal 2006. The increase of $432,000reflects higher personnel costs and the use of contract software developmentresources offset by lower bandwidth costs.

 

General and administrative expensesdecreased to $2,965,000 in fiscal 2007 compared to $3,081,000 in fiscal 2006due to lower personnel, credit card processing and general insurance costsoffset by higher legal fees and higher stock option compensation expense.

 

The other expense in fiscal 2007 was $1,876,000,compared to $1,000 in fiscal year 2006. The increase is mainly due to anon-cash interest expense resulting from a beneficial conversion of convertibledebt in the first quarter and fees paid to terminate or settle vendorcontracts.

 

**Liquidity and Capital Resources**

 

As of September 30, 2007, ourprincipal source of liquidity was approximately $958,000 of cash and cashequivalents. During the first quarter of fiscal 2007, we completed a privateplacement of common stock and warrants and raised approximately $3,751,000 inproceeds.  In addition, the Company soldconvertible notes and warrants in the fourth fiscal quarter 2007 in theaggregate principal amount of $1,000,000.

 

15

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The Company has experienced significantrevenue declines and has incurred operating losses in the past several years.For fiscal 2007, cash flow used in operations was $4,054,000, primarilyattributable to a net loss of $6,313,000 compared to prior year’s cash flowused in operations of $3,835,000. Cash and cash equivalents increased from$751,000 at the beginning of the fiscal year to $958,000 as of September 30,2007 and the Company’s current ratio declined from 0.59 to 0.51.

 

Management has taken various actions toreduce operating expenses drastically and to eliminate all fixed productoverhead expenses. Implementation of various cost reduction projects combinedwith the outsourcing of its entire production capacity resulted in the shutdown of the 45,000 square foot production facility and the move to a 15,000 squarefoot office. The impact of the project on our general and administrative costswas realized after the move to the new facility in the second quarter of 2006.

 

On February 14, 2006, the Companyentered into an agreement to sell up to $3,000,000 of conventional convertibledebentures and warrants. The first round of $2,500,000 was closed on May 30,2006. Sunra Capital Holdings, California Pacific Capital LLC, and the Company’sthen chief executive officer participated in the first round. The second roundof $500,000 was closed on August 22, 2006. Sunra Capital Holdings, VerbierSP Partnership L.P., Craig Hallum Partners, and Craig-Hallum Capital Group LLCparticipated in the second round. The debentures bear interest at 10% per annumwith interest payable on a quarterly basis commencing September 29, 2006and are convertible at a fixed price of $0.40 per common share of stock. Theprincipal is due and payable on March 29, 2011. In addition to thedebentures, warrants were issued to the debenture holders to purchase 1,250,000shares of common stock at an exercise price of $0.40. These warrants expirefive years after closing and the debentures were converted to common stock in October 2006.

 

The Company recorded $132,000 as a discountrelated to the issuance of the 1,250,000 warrants based on the fair value ofthe warrants on the closing date using the Black Scholes valuation model.

 

On September 6, 2007, the Company soldconventional convertible notes and warrants in the aggregate principal amountof $1,000,000.  The notes have a maturitydate of September 6, 2008 and bear interest at 12.5% per annum, payable onMarch 6, 2008 and at maturity. The notes are convertible into shares ofthe Company’s common stock by the holders at a fixed conversion price of $.40per share. In addition to the convertible notes, the Company also issuedwarrants to purchase common stock. For each $1,000 principal amount of notespurchased, an investor received warrants to acquire 625 Shares at $.40 pershare. The warrants expire on September 6, 2012.

 

Net cash from financing activities was$4,564,000 for fiscal 2007 compared to net cash provided of $2,922,000 infiscal 2006.

 

The ratio of current assets to currentliabilities was 0.51 at the end of fiscal 2007 compared to 0.59 at the end offiscal 2006.  The decrease in fiscal 2007is primarily due to the use of cash to fund operations.

 

In addition, Company forecasts indicated aneed for an additional capital infusion by the end of January 2008. See Note 3- Going Concern on page 28.

 

### **Inflation**

### ** **

Theresults of our operations have not been significantly affected by inflationduring the last two fiscal years.

 

**ITEM 7 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

See pages 19 through 38.

 

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** **

**PhotoWorks, Inc.**

**Seattle,Washington**

** **

**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

** **

We have audited theaccompanying balance sheet of PhotoWorks, Inc. as of September 30,2007, and the related statement of operations, stockholders’ equity (deficit)and cash flows for the year then ended. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of PhotoWorks, Inc. as of September 30,2007 and the results of its operations, stockholders’ equity (deficit) and itscash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanying financialstatements have been prepared assuming that the Company will continue as agoing concern.  As more fully describedin Note 3, the Company has incurred recurring operating losses and has ashareholder deficit.  These conditionsraise substantial doubt about the Company’s ability to continue as a goingconcern.  Management’s plans as to thesematters are also described in Note 3. The financial statements do not include any adjustments to reflect thepossible future effects on the recoverability and classification of assets orthe amounts and classification of liabilities that may result from the outcomeof this uncertainty.

 

 

/s/ PMB Helin Donovan,LLP

## Certified PublicAccountants

San Francisco, California

December 21, 2007

 

 

 

17

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PhotoWorks,Inc.

Seattle,Washington

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

 

We haveaudited the accompanying balance sheet of PhotoWorks, Inc. as of September 30,2006 and the related statement of operations, stockholders’ equity (deficit)and cash flows for the year then ended. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audit.

 

We conductedour audit in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of PhotoWorks, Inc. as of September30, 2006 and the results of its operations, stockholders’ equity (deficit) andits cash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

 

/s/ Williams& Webster, P.S.

CertifiedPublic Accountants

Spokane,Washington

December 29, 2006

 

 

18

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**PHOTOWORKS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands)**

 
| ** **                                                                                                                            | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                            | ** ** | ** **                   | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                            |       |                         |       |                         |       |
| ** **                                                                                                                            |       |                         |       |                         |       |
| **CURRENT  ASSETS**                                                                                                                   |       |                         |       |                         |       |
| Cash and cash  equivalents                                                                                                            |       | $                            | 958        |                         | $          | 751 |   |
| Cash -  restricted                                                                                                                    |       | 135                          |       | —                       |       |
| Receivables                                                                                                                           |       | 184                          |       | 172                          |       |
| Inventories                                                                                                                           |       | 107                          |       | 183                          |       |
| Prepaid expenses                                                                                                                      |       | 223                          |       | 146                          |       |
| Deferred loan  fees                                                                                                                   |       | 27                           |       |                         |       |
| **TOTAL  CURRENT ASSETS**                                                                                                             |       | 1,634                        |       | 1,252                        |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **PROPERTY  AND EQUIPMENT, NET**                                                                                                      |       | 367                          |       | 383                          |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **OTHER  ASSETS**                                                                                                                     |       |                         |       |                         |       |
| Software  development                                                                                                                 |       | 29                           |       | —                       |       |
| Long term vendor  receivable                                                                                                          |       | —                       |       | 95                           |       |
| Lease deposits                                                                                                                        |       | 38                           |       | 24                           |       |
| **TOTAL  OTHER ASSETS**                                                                                                               |       | 67                           |       | 119                          |       |
| **TOTAL  ASSETS**                                                                                                                     | ** ** | **$**                        | **2,068**  | ** **                   | **$**      | **1,754** | ** ** |
|                                                                                                                                  |       |                         |       |                         |       |
| **LIABILITIES  & STOCKHOLDERS' EQUITY (DEFICIT)**                                                                                 |       |                         |       |                         |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **CURRENT  LIABILITIES**                                                                                                              |       |                         |       |                         |       |
| Accounts payable                                                                                                                      |       | $                            | 1,343      |                         | $          | 1,136 |   |
| Current portion  of equipment loan                                                                                                    |       | 48                           |       | —                       |       |
| Accrued  compensation                                                                                                                 |       | 286                          |       | 370                          |       |
| Other accrued  expenses                                                                                                               |       | 138                          |       | 176                          |       |
| ITC penalty,  current portion                                                                                                         |       | 250                          |       | 201                          |       |
| Deferred  revenues                                                                                                                    |       | 262                          |       | 227                          |       |
| Debentures  payable, net of current portion and discount                                                                              |       | 905                          |       | —                       |       |
| **TOTAL  CURRENT LIABILITIES**                                                                                                        |       | 3,232                        |       | 2,110                        |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **LONG-TERM  LIABILITIES**                                                                                                            |       |                         |       |                         |       |
| ITC penalty,  non-current portion                                                                                                     |       | —                       |       | 250                          |       |
| Equipment loan -  net of current portion and loan fee                                                                                 |       | 69                           |       | —                       |       |
| Debentures  payable                                                                                                                   |       | —                       |       | 1,274                        |       |
| Debenture  interest                                                                                                                   |       | —                       |       | 115                          |       |
| **TOTAL  LONG-TERM LIABILITIES**                                                                                                      |       | 69                           |       | 1,639                        |       |
| **TOTAL  LIABILITIES**                                                                                                                |       | 3,301                        |       | 3,749                        |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                                                    |       | —                       |       | —                       |       |
|                                                                                                                                  |       |                         |       |                         |       |
| **STOCKHOLDERS'  EQUITY (DEFICIT)**                                                                                                   |       |                         |       |                         |       |
| Preferred stock,  2,000,000 shares authorized $0.01 par value, 0 shares issued and outstanding                                        |       |                         |       |                         |       |
| Common stock,  101,250,000 shares authorized, $0.01 par value; 39,447,073 and 19,799,922  shares issued and outstanding, respectively |       | 394                          |       | 198                          |       |
| Additional  paid-in capital                                                                                                           |       | 32,965                       |       | 26,086                       |       |
| Accumulated  deficit                                                                                                                  |       | (34,592                      | )          | (28,279                      | )          |
| **TOTAL  STOCKHOLDERS' EQUITY (DEFICIT)**                                                                                             |       | (1,233                       | )          | (1,995                       | )          |
|                                                                                                                                  |       |                         |       |                         |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS' EQUITY/DEFICIT**                                                                               | ** ** | **$**                        | **2,068**  | ** **                   | **$**      | **1,754** | ** ** |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

19

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**PHOTOWORKS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(in thousands)**

 
| ** **                                                                          | ** ** | **Year Ended  Septemeber 30,** | ** ** | **Year Ended  Septemeber 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                          | ** ** | **2007**                                 | ** ** | **2006**                                 | ** ** |
|                                                                                |       |                                     |       |                                     |       |
| **REVENUES**                                                                        |       |                                     |       |                                     |       |
| Digital                                                                             |       | $                                        | 7,580      |                                     | $          | 6,372 |   |
| Film                                                                                |       | 3,105                                    |       | 5,297                                    |       |
| **TOTAL  REVENUES**                                                                 |       | 10,685                                   |       | 11,669                                   |       |
|                                                                                |       |                                     |       |                                     |       |
| **COST OF  REVENUES**                                                               |       |                                     |       |                                     |       |
| Digital                                                                             |       | 4,484                                    |       | 3,570                                    |       |
| Film                                                                                |       | 1,601                                    |       | 3,127                                    |       |
| **TOTAL  COST OF REVENUES**                                                         |       | 6,085                                    |       | 6,697                                    |       |
|                                                                                |       |                                     |       |                                     |       |
| **GROSS  PROFIT**                                                                   |       | 4,600                                    |       | 4,972                                    |       |
|                                                                                |       |                                     |       |                                     |       |
| **OPERATING  EXPENSES**                                                             |       |                                     |       |                                     |       |
| Sales, marketing  and customer services                                             |       | 3,462                                    |       | 3,473                                    |       |
| Engineering                                                                         |       | 2,375                                    |       | 1,943                                    |       |
| General and  administrative                                                         |       | 2,965                                    |       | 3,081                                    |       |
| Depreciation and  amortization                                                      |       | 285                                      |       | 305                                      |       |
| **TOTAL  OPERATING EXPENSES**                                                       |       | 9,087                                    |       | 8,802                                    |       |
|                                                                                |       |                                     |       |                                     |       |
| **LOSS  FROM OPERATIONS**                                                           |       | (4,487                                   | )          | (3,830                                   | )          |
|                                                                                |       |                                     |       |                                     |       |
| **OTHER  INCOME (EXPENSE)**                                                         |       |                                     |       |                                     |       |
| Interest income  (expense)                                                          |       | 107                                      |       | (11                                      | )          |
| Beneficial  Conversion/non-cash interest                                            |       | (1,811                                   | )          | (153                                     | )          |
| Gain (Loss) on  sale of assets                                                      |       | (5                                       | )          | 90                                       |       |
| Other income  (expense), net                                                        |       | (117                                     | )          | 73                                       |       |
| **TOTAL  OTHER INCOME (EXPENSE)**                                                   |       | (1,826                                   | )          | (1                                       | )          |
|                                                                                |       |                                     |       |                                     |       |
| **LOSS  BEFORE INCOME TAXES**                                                       |       | (6,313                                   | )          | (3,831                                   | )          |
| **INCOME  TAX**                                                                     |       | —                                   |       | —                                   |       |
| **NET  LOSS**                                                                       |       | $                                        | (6,313     | )                                        | $          | (3,831 | ) |
| **BASIC  AND DILUTED NET LOSS PER COMMON SHARE**                                    |       | $                                        | (0.17      | )                                        | $          | (0.19 | ) |
|                                                                                |       |                                     |       |                                     |       |
| **WEIGHTED  AVERAGE NUMBER OF COMMON  STOCK SHARES OUTSTANDING, BASIC AND DILUTED** |       | 37,898,083                               |       | 19,796,326                               |       |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

20

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**PHOTOWORKS, INC.**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)**

**(in thousands)**

 
| ** **                                             | ** ** | **Common Stock**      | ** ** | **Additional** | ** ** | ** **           | ** ** | **Total**                | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|----------------|------------|----------------------|------------|--------------------------|------------|
| ** **                                             | ** ** | **Number  of Shares** | ** ** | **Amount**     | ** ** | **Paid-In  Capital** | ** ** | **Deficit  Accumulated** | ** ** | **Stockholders'  Equity (Deficit)** | ** ** |
| **Balance  as of September 24, 2005**                  | ** ** | **19,794,672**             | ** ** | **$**          | **198**    | ** **           | **$**      | **24,061**               | ** ** | **$** | **(24,448** | **)** | **$** | **(189** | **)** |
| Stock options  issued for services                     |       | —                     |       | —         |       | 261                  |       | —                   |       | 261 |   |
| Warrants issued  for convertible debt                  |       | —                     |       | —         |       | 132                  |       | —                   |       | 132 |   |
| Beneficial  Conversion Valuation on debt of $2,500,000 |       | —                     |       | —         |       | 1,272                |       | —                   |       | 1,272 |   |
| Beneficial  Conversion Valuation on debt of $500,000   |       | —                     |       | —         |       | 360                  |       | —                   |       | 360 |   |
| Stock Option  Exercised for Stock @$0.05 per share     |       | 5,250                      |       | —         |       | —               |       | —                   |       | — |   |
| Net loss @  September 30, 2006                         |       | —                     |       | —         |       | —               |       | (3,831                   | )          | (3,831 | ) |
| **Balance  as of September 30, 2006**                  |       | **19,799,922**             |       | **$**          | **198**    |                 | **$**      | **26,086**               |       | **$** | **(28,279** | **)** | **$** | **(1,995** | **)** |
| Debt converted  into common shares                     |       | 8,922,263                  |       | 89             |       | 3,034                |       | —                   |       | 3,123 |   |
| Common stock  issued for cash @ $0.35 per share        |       | 10,717,857                 |       | 107            |       | 3,644                |       | —                   |       | 3,751 |   |
| Stock options  issued for services                     |       | —                     |       | —         |       | 345                  |       | —                   |       | 345 |   |
| Financing fees  for stock purchase                     |       | —                     |       | —         |       | (305                 | )          | —                   |       | (305 | ) |
| Warrants issued  for convertible debt                  |       | —                     |       | —         |       | 161                  |       | —                   |       | 161 |   |
| Stock Option  Exercised for Stock @$0.05 per share     |       | 7,031                      |       | —         |       | —               |       | —                   |       | — |   |
| Net loss @  September 30, 2007                         |       | —                     |       | —         |       | —               |       | (6,313                   | )          | (6,313 | ) |
| **Balance  as of September 30, 2007**                  | ** ** | **39,447,073**             | ** ** | **$**          | **395**    | ** **           | **$**      | **32,965**               | ** ** | **$** | **(34,592** | **)** | **$** | **(1,233** | **)** |
|                                                        |            |                            |            |                |            |                      |            |                          |            |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these consolidated financialstatements.

 

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**PHOTOWORKS, INC.**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(in thousands)**

** **
| ** **                                                                   | ** ** | **Year Ended  September 30,** | ** ** | **Year Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                | ** ** | **2006**                                | ** ** |
|                                                                         |       |                                    |       |                                    |       |
| Net Loss                                                                     |       | $                                       | (6,313     | )                                       | $          | (3,831 | ) |
|                                                                         |       |                                    |       |                                    |       |
| Adjustments to  reconcile net loss to net cash used by operating activities: |       |                                    |       |                                    |       |
| Depreciation and  Amortization                                               |       | 285                                     |       | 305                                     |       |
| Loss (Gain) on  sale of assets                                               |       | 5                                       |       | (90                                     | )          |
| Stock option  compensation expense                                           |       | 345                                     |       | 261                                     |       |
| Beneficial  conversion and non-cash interest                                 |       | 1,803                                   |       | 115                                     |       |
| Discounts on  convertible debt                                               |       | 8                                       |       | 38                                      |       |
| Changes in:                                                                  |       |                                    |       |                                    |       |
| Cash -  restricted                                                           |       | (135                                    | )          | —                                  |       |
| Receivables                                                                  |       | 83                                      |       | 171                                     |       |
| Inventories                                                                  |       | 76                                      |       | (103                                    | )          |
| Prepaid expenses                                                             |       | (103                                    | )          | (86                                     | )          |
| Lease deposits  and long-term receivable                                     |       | (14                                     | )          | 89                                      |       |
| Deferred  revenues                                                           |       | 35                                      |       | (181                                    | )          |
| Accounts payable                                                             |       | 208                                     |       | 180                                     |       |
| Accrued  liabilities                                                         |       | (136                                    | )          | (628                                    | )          |
| ITC penalty                                                                  |       | (201                                    | )          | (75                                     | )          |
| Net cash used in  operating activities                                       |       | (4,054                                  | )          | (3,835                                  | )          |
|                                                                         |       |                                    |       |                                    |       |
| Cash flows from  investing activities:                                       |       |                                    |       |                                    |       |
| Purchase of  property, plant and equipment                                   |       | (298                                    | )          | (205                                    | )          |
| Proceeds from  sales of property, plant and equipment                        |       | (5                                      | )          | 90                                      |       |
| Net cash used in  investing activities                                       |       | (303                                    | )          | (115                                    | )          |
|                                                                         |       |                                    |       |                                    |       |
| Cash flows from  financing activities                                        |       |                                    |       |                                    |       |
| Proceeds from  issuance of subordinated debt                                 |       | 1,000                                   |       | 3,000                                   |       |
| Proceeds from  loan - Comerica Bank, net of loan fee                         |       | 140                                     |       | —                                  |       |
| Proceeds from  issuance of common stock                                      |       | 3,447                                   |       | —                                  |       |
| Repayment of  loan - Comerica Bank                                           |       | (23                                     | )          | —                                  |       |
| Payment on  convertible debt                                                 |       | —                                  |       | (65                                     | )          |
| Payment on  capital lease obligations                                        |       | —                                  |       | (13                                     | )          |
| Net cash  provided by financing activities                                   |       | 4,564                                   |       | 2,922                                   |       |
|                                                                         |       |                                    |       |                                    |       |
| Net increase  (decrease) in cash                                             |       | 207                                     |       | (1,028                                  | )          |
|                                                                         |       |                                    |       |                                    |       |
| Cash, beginning  of period                                                   |       | 751                                     |       | 1,779                                   |       |
| Cash, end of  period                                                         |       | $                                       | 958        |                                    | $          | 751 |   |
| SUPPLEMENTAL  DISCLOSURES:                                                   |       |                                    |       |                                    |       |
|                                                                         |       |                                    |       |                                    |       |
| Interest expense  paid                                                       |       | $                                       | 7          |                                    | $          | (11 | ) |
| Income tax  refund                                                           |       | $                                       | —     |                                    | $          | — |   |
|                                                                         |       |                                    |       |                                    |       |
| NON-CASH  INVESTING AND FINANCING ACTIVITIES:                                |       |                                    |       |                                    |       |
| Capital lease  obligation incurred                                           |       | $                                       | —     |                                    | $          | — |   |
| Conversion of $3  million of debentures into common stock                    |       | $                                       | 3,123      |                                    | $          | — |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**PHOTOWORKS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 – BASIS OF PRESENTATION**

 

**PHOTOWORKS, INC:** (“PhotoWorks” or the “Company”) is an online photographyservices company. With a 25-year national heritage (formerly known as SeattleFilmWorks), PhotoWorks helps photographers - both film and digital - share andpreserve their memories with innovative and inspiring products and services.Every day, photographers send film, memory cards and CDs, or go towww.photoworks.com to upload, organize and email their pictures, order prints,and create Signature Photo Cards and Custom Photo Books.

 

PhotoWorks wasincorporated in Washington State in June 1976. The executive offices arelocated at 71 Columbia Street, Suite 200, Seattle, Washington 98104, andthe telephone number is (206) 281-1390. References to “PhotoWorks”, the “Company”,“we”, “us” and “our” in this prospectus include PhotoWorks, Inc., and itswholly-owned subsidiaries.

 

Our consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States, or GAAP. The preparation of theseconsolidated financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenues,costs and expenses and related disclosures. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances. Uncertainties, with respect to such estimates andassumptions are inherent in the preparation of the Company’s financialstatements; accordingly, it is possible that the actual results could differfrom these estimates and assumptions and could have a material effect on thereported amounts of the Company’s financial position and results of operations.

 

Effective June 30,2006, the Company changed its monthly financial closing cycle from fiscalperiod end dates to calendar month end dates.

 

**NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ANDRECENTLY ISSUED ACCOUNTING STANDARDS AND INTERPRETATIONS**

 

This summary ofsignificant accounting policies of PhotoWorks, Inc., is presented to assistin understanding the Company’s financial statements. The financial statementsand notes are representations of the Company’s management, which is responsiblefor their integrity and objectivity. These accounting policies conform toaccounting principles generally accepted in the United States of America, andhave been consistently applied in the preparation of the financial statements.

 

Cashand Cash Equivalents

 

Cash and cashequivalents include cash on hand and highly liquid short-term investments witha maturity date of three months or less on date of purchase.

 

Cash –Restricted

 

Cash – restrictedrepresents balances maintained in the Company’s securities account withComerica Bank equal to the principal balance of the Company’s loan outstandingwith Comerica Bank plus the balance on the Company’s credit cards with thebank.

 

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Accounts/OtherReceivables

 

Accounts and otherreceivables primarily include amounts due from vendors. The Company has a receivabledue from a vendor as part of a settlement over disputed services. Under theterms of the settlement, the Company receives $95,000 annually for 4 years. Thefirst payment was received in July 2004. The fair value of the receivablewas determined at the time of the settlement (February 2004). Managementbelieves the carrying amount of this receivable approximates its fair value andno risk of loss currently exists based on the financial strength of the vendor.See Note 13. The Company has trade receivables in the amount of $27,815,resulting primarily from the sale of inventory to a third party vendor, whichsubsequent to year end was collected. The vast majority of the Company’s cashreceipts are the result of credit card transactions, which are deposited withthe Company 2-5 days following the sale transaction. Accordingly, the Companyrecords these balances as “credit card receivables”. The Company has creditcard receivables in the amount of $56,071 and $74,008 at September 30,2007 and 2006, respectively. This account also reflects interest earned but notyet paid on cash balances of $5,089. Due to the nature of the receivables, thehistory of successful collection and the credit worthiness of the creditors,the Company has not recorded an allowance for doubtful accounts.

 

Propertyand Depreciation

 

Property, plant, andequipment are carried at cost. Depreciated and amortization of equipment andfixtures are computed principally using the straight-line method over theuseful lives of the various assets, ranging from three to five years.Expenditures for major remodeling and improvements of leased properties arecapitalized as leasehold improvements. Leasehold improvements are depreciatedover the lesser of the lease term or the estimated life of the leaseholdimprovement. Management reviews these estimates quarterly. See Note 5.

 

Impairmentof Long-lived Assets

 

The Company has adoptedthe policies of Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”. This standard establishesa single accounting model for long-lived assets to be disposed of by sale,including discontinued operations, and requires that these long-lived assets bemeasured at the lower of carrying amount or fair value, less cost to sell,whether reported in continuing operations or discontinued operations.Accordingly, the Company reviews the carrying amount of long-lived assets forimpairment where events or changes in circumstances indicate that the carryingamount may not be recoverable. The determination of any impairment wouldinclude a comparison of estimated future cash flows anticipated to be generatedduring the remaining life of the assets to the net carrying value of theassets. See Note 5.

 

Use ofEstimates

 

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. Actual results could differ from those estimates

 

Reclassifications

 

Certain amounts fromprior periods have been reclassified to conform to the current periodpresentation. This reclassification has resulted in no change to the Company’saccumulated equity/deficit or net losses presented. Specifically, $74,000 ofcredit card receivables as of September 30, 2006 has been reclassifiedfrom cash and cash equivalents to receivables. Credit card and other paymentprocessing fees in the amount of $415,000 for fiscal year 2006 have beenreclassified from cost of revenues to general and administrative expenses. TheCompany believes payment processing fees are administrative in nature andtherefore are not part of cost of revenues, the vast majority of which consistof payments to third party vendors. In addition, certain operating expenses forfiscal year 2006 have been reclassified to conform to current year reportingpractices.

 

DerivativeInstruments

 

The Company accounts forderivative financial instruments in accordance with SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities”. All derivative instrumentsare recognized as either assets or

 

24

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liabilities and aremeasured at fair value. The Company does not use derivatives for trading orspeculative purposes.

 

DeferredRevenues

 

Deferred revenues relateprimarily to Prepaid Print Credits, and the Pick Your Prints product andprepaid gift certificates. The Company recognizes the revenue from theseofferings based on the relative fair values of the products contained in theoffers when such products are actually shipped.

 

Earnings(Loss) per share

 

The Company calculatesearnings per share based on the weighted average number of shares and dilutive commonstock equivalents outstanding during the period. Net loss per share is based onthe weighted average number of common shares outstanding during the period. TheCompany has adopted Statement of Financial Accounting Standards No. 128,which provides for calculation of “basic” and “diluted” earnings per share.Basic earnings per share includes no dilution and is computed by dividing netincome (loss) available to common shareholders by the weighted average commonshares outstanding for the period. Diluted earnings per share reflect thepotential dilution of securities that could share in the earnings of an entitysimilar to fully diluted earnings per share. Basic and diluted loss per shareamounts were the same, at the reporting dates, as the inclusion of common stockequivalents would have been anti-dilutive.

 

IncomeTaxes

 

The benefit or provisionfor federal income taxes is generally computed based on pretax income. However,the benefit or provision may differ from income taxes currently payable or receivable,because certain items of income and expense are recognized in different periodsfor financial reporting purposes than they are for federal income tax purposes.As more fully described in Note 9, the net operating losses for both book andtax purposes exceed amounts available for operating loss carry backs. Due tothe uncertainty of the recoverability of these deferred assets, a valuationallowance equal to the entire deferred tax asset has been recorded. See Note 9.

 

Inventories

 

Inventories are statedat the lower of cost (using the first-in, first-out method) or market.Inventories consist primarily of undeveloped film and photofinishing supplies.$102,463 of the Company’s inventory is held by third party vendors at September 30,2007 compared to $174,435 at September 30, 2006. During fiscal 2007, theCompany expensed $14,576 of obsolete inventory to cost of revenues.

 

FairValue of Financial Instruments

 

The carrying values offinancial instruments such as trade receivables, payables and accruals,approximate their fair values, based on the short-term maturities of theseinstruments. The ITC penalty, vendor settlement and capital lease obligationshave had no significant changes in interest rates or credit risk of theCompany; therefore, the carrying values of those financial instruments alsoapproximate their fair values.

 

Principlesof Consolidation

 

The consolidatedfinancial statements include PhotoWorks, Inc. and its wholly-ownedsubsidiaries. Significant inter-company accounts and transactions have beeneliminated in consolidation.

 

StockBased Compensation

 

In December 2004,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 123, “Accounting for Stock Based Compensations.”(“SFAS 123R”) This statement supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and its related implementation guidance. Thisstatement establishes standards for the accounting for transactions in which anentity exchanges its equity instruments for goods or services. It alsoaddresses transactions in which an entity incurs liabilities in exchange forgoods or services that are based on the fair value of the entity’s equityinstruments or that may be settled by the issuance of those equity instruments.This statement focuses primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. Thisstatement does not change the

 

25

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accounting guidance forshare based payment transactions with parties other than employees provided inStatement of Financial Accounting Standards No. 123(R). This statementdoes not address the accounting for employee share ownership plans, which aresubject to AICPA Statement of Position 93-6, “Employers’ Accounting forEmployee Stock Ownership Plans.” The Company has adopted SFAS No. 123(R) andhas recognized $345,000, and $261,000 for employee stock compensation duringfiscal 2007 and 2006 respectively, in accordance with SFAS No. 123(R).

 

The fair value for theoptions was estimated at the date of grant using a Black-Scholes option pricingmodel with the following weighted-average assumptions on the option grant date:

 
| ** **                   | ** ** | **FY 2007** | ** ** | **FY2006** | ** ** |
|------------------------------|------------|-------------|------------|------------|------------|
| Risk free interest rate      |       | 4.7         | %          | 2.3        | %          |
| Expected volatility          |       | 70          | %          | 55         | %          |
| Expected Option Life (Years) |       | 3.5         |       | 5.0        |       |
| Dividend yield               |       | 0           | %          | 0          | %          |

 

RevenueRecognition

 

The Company recognizesrevenue when realized or realizable and earned, which is when products areshipped or services are delivered. Nearly all of the Company’s revenues arepaid by credit card or by personal check prior to the shipment of the order. Atthe time revenue is recognized, the Company also records reductions to revenuefor customer discounts and promotions in accordance with the provisions ofEmerging Issues Task Force (EITF) Issue No. 01-09, “Accounting forConsideration Given from a Vendor to a Customer (Including a Reseller of theVendor’s Products).” The Company provides its customers with a 100%satisfaction guarantee. The vast majority of the Company’s products andservices will not be returned but customers can request a refund if notsatisfied. During fiscal 2007, refunds were $65,000 (0.61% of net revenues). Duringfiscal 2006, returns and refunds were $92,000 (0.79% of net revenues.

 

SoftwareDevelopment

 

Pursuant to Statement ofPosition 98-1 as amplified by EITF 00-2, “Accounting for Web Site DevelopmentCosts.”, the Company is capitalizing payroll and payroll-related costs ofemployees directly involved in the application development stage of the Company’sinternally developed data warehouse and reporting project. The project has beenundertaken to solely meet the Company’s internal analysis and reporting needs. Preliminaryproject stage costs and training costs have been expensed as incurred. Duringfiscal 2007, the Company capitalized $28,866 in software development costs.

 

Shippingand Handling Costs

 

Amounts charged tocustomers and costs incurred by the Company related to shipping and handlingare included in total revenues and cost of revenues, respectively, inaccordance with EITF Issue No. 00-10, “Accounting for Shipping andHandling Fees and Costs”.

 

AdvertisingCosts

 

Advertising costs arerecorded as expenses when incurred. Costs of printed direct mail promotionalmaterials are recorded as expenses during the period in which they are mailedor otherwise disseminated to customers. Advertising costs were $535,000 and $1,539,000for the fiscal years 2007 and 2006, respectively.

 

AccountingMethod

 

The Company’s financialstatements are prepared using the accrual basis of accounting in accordancewith accounting principles generally accepted in the United States of America.

 

Accountingfor Convertible Notes and Securities with Beneficial Conversion Features

 

Following guidance byEITF 00-27, the Company allocates proceeds received from convertible notesand/or securities first to warrants granted to the note holders. The value ofthe warrants and the beneficial conversion

 

26

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feature are recorded onthe balance sheet as a debt discount and as an increase to shareholders equity.The discounts are amortized over the life of the loans.

 

AccountingPronouncements – Recent

 

The Securities andExchange Commission released Staff Accounting Bulletin No. 108, “Consideringthe Effects of Prior Year Misstatements When Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”), in September 2006. SAB 108provides guidance on how the effects of the carryover or reversal of prior yearfinancial statement misstatements should be considered in quantifying a currentyear misstatement. Prior practice allowed the evaluation of materiality on thebasis of (1) the error quantified as the amount by which the current yearincome statement was misstated (“rollover method”) or (2) the cumulativeerror quantified as the cumulative amount by which the current year balancesheet was misstated (“iron curtain method”). Reliance on either method in prioryears could have resulted in misstatement of the financial statements. Theguidance provided in SAB 108 requires both methods to be used in evaluatingmateriality. Immaterial prior year errors may be corrected with the firstfiling of prior year financial statements after adoption. The cumulative effectof the correction would be reflected in the opening balance sheet withappropriate disclosure of the nature and amount of each individual errorcorrected in the cumulative adjustment, as well as a disclosure of the cause ofthe error and that the error had been deemed to be immaterial in the past. SAB108 is effective for fiscal year 2007. The company has incurred no materialeffect on our financial position or results of operations at September 30,2007 due to this Bulletin.

 

SFAS 157, “Fair ValueMeasurements” - In September 2006, the Financial Accounting Standard Boardissued its Statement of Financial Accounting Standards No. 157, “*Fair Value Measurements”*(“SFAS No. 157”).SFAS No. 157 defines fair value, establishes a framework for measuringfair value and expands disclosures about fair value measurements. SFAS No. 157is effective for the Company as of January 1, 2008. The Company iscurrently evaluating the impact, if any, of SFAS No. 157 on itsconsolidated financial statements.

 

In September 2006,the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Benefits – an amendment of FASB Statements No. 87,88, 106 and 132(R).’This Statement requires an employer to recognize theoverfunded or underfunded status of a defined benefit postretirement plan(other than a multiemployer plan) as an asset or liability in its statement offinancial position and to recognize changes in that funded status in the yearin which the changes occur through comprehensive income of a business entity orchanges in unrestricted net assets of a not-for-profit organization. ThisStatement also improves financial reporting by requiring an employer to measurethe funded status of a plan as of the date of its year-end statement offinancial position, with limited exceptions. The Company does not have adefined benefit pension plan and therefore the Company has determined therewill be no effect on the consolidated financials statements.

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities – Including an amendment of FASB Statement No. 115.”(SFAS 159). SFAS No. 159 permits entities to choose to measure eligibleitems at fair value at specified election dates and report unrealized gains andlosses on items for which the fair value option has been elected in earnings ateach subsequent reporting date. SFAS No. 159 also establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 is effective for fiscal years beginning after November 15,2007. Management is currently evaluating the impact of the provisions of SFAS159 on the Company’s results of operations and financial position.

 

In December 2007,the FASB issued Statement No. 141 (revised 2007), Business Combinations,and Statement No. 160, Noncontrolling Interests in Consolidated FinancialStatements. Statement No. 141 (revised 2007) requires an acquirer tomeasure the identifiable assets acquired, the liabilities assumed and anynoncontrolling interest in the acquiree at their fair values on the acquisitiondate, and goodwill being the excess value over the net identifiable assetsacquired. The standard also requires the fair value measurement of certainother assets and liabilities related to the acquisition such as contingenciesand research and development. Statement No. 160 clarifies that anoncontrolling interest in a subsidiary should be reported as equity in theconsolidated financial statements. Consolidated net income should include thenet income for both the parent and the noncontrolling

 

27

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interest with disclosureof both amounts on the consolidated statement on income. The calculation ofearnings per share will continue to be based on income amounts attributable tothe parent. The Company has determined there will be no effect on theconsolidated financial statements.

 

In June 2006, theFinancial Accounting Standard Board issued FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes – an Interpretation for FASB Statement No. 109”(“FIN 48”), which prescribes a recognition threshold and measurement attributefor the financial statement recognition and measurement for a tax positiontaken or expected to be taken in a tax return. FIN 48 also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearbeginning after December 15, 2006. The Company does not expect theadoption of FIN 48 to have a material impact on its financial reporting.

 

In March 2006, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 156, “Accounting for Servicing of Financial Assets—anamendment of FASB Statement No. 140.” This statement requires an entity torecognize a servicing asset or servicing liability each time it undertakes anobligation to service a financial asset by entering into a servicing contractin any of the following situations: a transfer of the servicer’s financialassets that meets the requirements for sale accounting; a transfer of theservicer’s financial assets to a qualifying special-purpose entity in aguaranteed mortgage securitization in which the transferor retains all of theresulting securities and classifies them as either available-for-salesecurities or trading securities; or an acquisition or assumption of anobligation to service a financial asset that does not relate to financialassets of the servicer or its consolidated affiliates. The statement alsorequires all separately recognized servicing assets and servicing liabilitiesto be initially measured at fair value, if practicable, and permits an entityto choose either the amortization or fair value method for subsequentmeasurement of each class of servicing assets and liabilities. The statementfurther permits, at its initial adoption, a one-time reclassification ofavailable for sale securities to trading securities by entities with recognizedservicing rights, without calling into question the treatment of otheravailable for sale securities under Statement No. 115, provided that theavailable for sale securities are identified in some manner as offsetting theentity’s exposure to changes in fair value of servicing assets or servicingliabilities that a servicer elects to subsequently measure at fair value andrequires separate presentation of servicing assets and servicing liabilitiessubsequently measured at fair value in the statement of financial position andadditional disclosures for all separately recognized servicing assets andservicing liabilities. This statement is effective for fiscal years beginningafter September 15, 2006, with early adoption permitted as of thebeginning of an entity’s fiscal year. Management believes the adoption of thisstatement will have no immediate impact on the Company’s financial condition orresults of operations.

 

In February 2006,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 155, “Accounting for Certain Hybrid FinancialInstruments, an Amendment of FASB Standards No. 133 and 140” (hereinafter “SFASNo. 155”). This statement established the accounting for certainderivatives embedded in other instruments. It simplifies accounting for certainhybrid financial instruments by permitting fair value re-measurement for anyhybrid instrument that contains an embedded derivative that otherwise wouldrequire bifurcation under SFAS No. 133 as well as eliminating arestriction on the passive derivative instruments that a qualifyingspecial-purpose entity (“SPE”) may hold under SFAS No. 140. This statementallows a public entity to irrevocably elect to initially and subsequentlymeasure a hybrid instrument that would be required to be separated into a hostcontract and derivative in its entirety at fair value (with changes in fairvalue recognized in earnings) so long as that instrument is not designated as ahedging instrument pursuant to the statement. SFAS No. 140 previouslyprohibited a qualifying special-purpose entity from holding a derivativefinancial instrument that pertains to a beneficial interest other than anotherderivative financial instrument. This statement is effective for fiscal yearsbeginning after September 15, 2006, with early adoption permitted as ofthe beginning of an entity’s fiscal year. Management believes the adoption ofthis statement will have no immediate impact on the Company’s financialcondition or results of operations.

 

In May 2005, theFinancial Accounting Standards Board, issued Statement of Financial AccountingStandards (“SFAS, No. 154”), “Accounting Changes and Error Corrections,”which replaces Accounting Principles Board Opinion No. 20, “AccountingChanges,” and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial

 

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Statements — AnAmendment of APB Opinion No. 28”. SFAS No. 154 provides guidance onaccounting for and reporting changes in accounting principle and errorcorrections. SFAS No. 154 requires that changes in accounting principle beapplied retrospectively to prior period financial statements and is effectivefor fiscal years beginning after December 15, 2005. The Company does notexpect SFAS No. 154 to have a material impact on its consolidatedfinancial position, results of operations, or cash flows.

 

**NOTE 3 — GOINGCONCERN**

 

As shown in theaccompanying financial statements, the Company had negative working capital anda stockholders’ deficit at September 30, 2007. During fiscal 2007, the Companyreported a loss of $4,487,000 from operations and another net loss of $1,826,000from non-operating activities. Net cash flow used in operations was $4,054,000,while net financing activities raised $4,564,000.

 

The Company continues todevelop new products and services, attract new customers, improve itsoperational efficiencies and lower its production costs. However, the Companyis subject to certain risks similar to other companies serving the digitalproducts and services market including competition from other companies withgreater financial, technical and marketing resources. The Company is also atrisk to execute its current business plan. The Company will be required toraise additional funding to be able to continue as a going concern. Thesematters raise substantial doubt about the Company’s ability to continue as agoing concern. Refer to discussion of Merger Agreement on page 3.

 

**NOTE 4 - LEASES**

 

The Company negotiated acancellation of a lease contract for its 45,000 square foot operating facilityin Seattle, Washington effective January 3, 2006 and moved to a new 15,030square foot office in Seattle. Under the terms of the operating lease agreementfor the new office space, the Company has a monthly straight-line obligationover the life of the lease of $25,106 per month for 69 months which expires on October 31,2011. Other terms of the agreement include a rent prepayment of $100,000 to beapplied toward month’s four to eleven of the lease term, a security deposit of$24,424, no rent payment required for the first three months, and a reducedrate for the next six months.

 

Other than the leasedescribed above, the Company has no other leases as of September 30, 2007.

 

At September 30,2007, future payments under non-cancelable operating leases are as follows:

 
| ** **  | ** ** | **(in thousands)** | ** ** |
|-------------|------------|-------------------------|------------|
| Fiscal 2008 |       | 307                     |       |
| Fiscal 2009 |       | 322                     |       |
| Fiscal 2010 |       | 337                     |       |
| Fiscal 2011 |       | 352                     |       |
| Thereafter  |       | 29                      |       |
|        |       | $                       | 1,347      |   |
|             |            |                         |            |  |

 

Rental expense relatingto facilities operating leases for fiscal years 2007 and 2006 was $288,529, and$227,126 respectively. Rental expense relating to equipment operating leasesfor fiscal years 2007 and 2006 was $10,509 and $12,116, respectively. Interestexpense relating to the capital leases was $75 and $871 for fiscal years 2007and 2006 respectively.

 

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**NOTE 5 - PROPERTY, PLANT, AND EQUIPMENT**

 

Property, plant, andequipment, at cost, consist of the following:

 
| ** **                                       | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **(in thousands)**      | ** ** | **(in thousands)**      | ** ** |
| Property, plant  and equipment                   |       | $                            | 1,265      |                         | $          | 1,070 |   |
| Leasehold  improvements                          |       | 56                           |       | 56                           |       |
|                                             |       | 1,321                        |       | 1,126                        |       |
| Less:  accumulated depreciation and amortization |       | (954                         | )          | (743                         | )          |
|                                             |       | $                            | 367        |                         | $          | 383 |   |

 

Depreciation expense forfiscal year 2007 and 2006 was $285,000 and $305,000, respectively.

 

**NOTE6 – DEBT**

 

On March 7, 2007,the Company entered into a loan and security agreement with Comerica Bank in anamount not to exceed $500,000 due on June 7, 2010. The line is intended tofund capital purchases and a limited amount of software necessary to maintainquality of service to our customers. The loan bears interest at the prime rateplus 0.5% on the amount outstanding and is collateralized by a securityinterest in the equipment and software. The Company paid a loan origination feeof $5,000 which is being amortized to interest expense over 36 months; the unamortizedbalance at September 30, 2007 was $4,028. The principal balanceoutstanding on September 30, 2007 is $121,667, reflecting two borrowingstotaling $145,000 less principal payments of $23,333. For the quarter ended March 31,2007, the Company did not satisfy a loan covenant regarding maximum quarterlynet losses. During the third quarter ended June 30, 2007, the Companyrenegotiated selected terms of the loan thereby eliminating the maximumquarterly net loss covenant and agreeing to maintain balances in the Company’ssecurities account equal to the principal balance of the loan plus credit cardsowed to the bank. The Company’s ability to borrow was reinstated without impactto daily operations and the Company borrowed $45,000 during the third quarterof fiscal 2007. The Company was in compliance with all loan covenants as ofSeptember 30, 2007.

 

**NOTE 7 - CONVERTIBLE DEBENTURES AND WARRANTS TO PURCHASECOMMON STOCK**

 

Following guidance byEITF 00-27, the Company initially allocates proceeds received from convertiblenotes and/or securities to warrants granted to the note holders. The value ofthe warrants and the beneficial conversion feature are recorded on the balancesheet as a debt discount and as an increase to stockholders’ equity. Thediscounts are amortized over the life of the loans.

 

 In accordance withEITF 98-5 and 00-27, the amount of beneficial conversion is determined at thecommitment date of each debt instrument as the difference between the statedconversion price within the instrument and the fair market value at the date ofthe draw-down on the debt instrument.

 

On February 14,2006, the Company entered into an agreement to sell up to $2,500,000 ofconventional convertible debentures and warrants. The first round was closed onMay 30, 2006. Sunra Capital Holdings, California Pacific Capital LLC, andthe Company’s then chief executive officer participated in the first round. Thedebentures bear interest at 10% per annum with interest payable on a quarterlybasis commencing September 29, 2006 and are convertible at a fixed priceof $0.54 per common share of stock. The principal is due and payable on March 29,2011. In addition to the debentures, warrants were issued to the debentureholders to purchase 1,250,000 shares of common stock at an exercise price of$0.40. As of September 30, 2006, the Company had not paid the outstandingaccrued interest and subsequent to year end, all convertible debentures andoutstanding interest was converted into common stock. (See Note 13).

 

30

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The Company recorded$110,000 as discount related to the issuance of the warrants based on the fairvalue of the warrants on the closing date using a Black-Scholes valuationmodel. These warrants expire five years from the date of closing. The discounton convertible debentures will be amortized over 5 years using thestraight-line method and approximately $1,460 was recorded as amortization ofdiscount on debt at September 30, 2006.

 

On August 22, 2006,the Company issued convertible debentures and warrants in the amount of$500,000. The debentures bear interest at 10% per annum with interest payablesemi-annually on first business day if the months of March and September,commencing March 1, 2007, and are convertible at fixed rate of $0.40 percommon share of stock. The principal is due and payable on August 22,2011. In addition to the debentures, warrants were issued to the debentureholders to purchase 450,000 shares of common stock at exercise price of $0.40per share. The Company recorded $132,000 as a debt discount related to theissuance of the warrants based on fair market value of the warrants on theclosing date using the Black-Scholes valuation model. The discount onconvertible debentures will be amortized over 5 years using the straight-linemethod and approximately $1,838 was recorded as amortization of discount ondebt as September 30, 2006.

 

On August 22, 2006,the Company assessed the fair value of the stock in relation to the $2.5million in convertible debentures for the potential equity derivative which iscaused by the increase in fair value of the stock over the conversion price ofconvertible debt. The issuance of $500,000 convertible debentures in August reducedthe conversion price from $0.54 to $0.40 for the $2.5 million convertibledebentures. The Company recorded a beneficial conversion of approximately$1,632,000 computed at the intrinsic value that was the difference between theconversion price of $0.40 and market price of $0.60. The discount onconvertible debentures will be amortized over 5 years using the straight-linemethod and approximately $35,000 was recorded as amortization at September 30,2006.

 

In October 2006these two rounds of bridge financing were converted to 8,922,269 shares ofcommon stock at $0.35 per share. This eliminated the bridge loan liability of$3,000,000. All unamortized discounts on the convertible debentures were fullyexpensed as interest at the time of conversion.

 

Asof September 30, 2006, of the $3.0 million in convertibledebentures and accrued interest outstanding, approximately $2,136,000 isconsidered to be held by related parties.

 

In October 2006, theCompany sold 8,860,714 shares of common stock at $0.35 per share forapproximately $3,100,000. In addition to the shares of common stock, the newshareholders were issued 2,215,179 in warrants to purchase additional shares at$0.50 per share. Along with the new shareholders, an additional 357,143 inwarrants were issued to the investors who contributed to a Private InvestmentIn Public Entity (PIPE loan) in August 2006.

 

In November 2006,the Company sold an additional 1,857,143 shares of common stock at $0.35 pershare for approximately $650,000 less fees. Along with the shares of commonstock, the new shareholders were issued 464,286 in warrants to purchase additionalshares of common stock at $0.50 per share.

 

On September 6,2007, the Company sold convertible notes and warrants in the aggregateprincipal amount of $1,000,000. The notes have a maturity date of September 6,2008 and bear interest at 12.5% per annum, payable on March 6, 2008 and atmaturity. The notes are convertible into shares of the Company’s common stockby the holders at an initial conversion price of $.40 per share. In addition tothe convertible notes, the Company also issued warrants to purchase commonstock. For each $1,000 principal amount of notes purchased, an investorreceived warrants to acquire 625 Shares at $.40 per share. The warrants expireon September 6, 2012. The Company recorded $104,000 as a debt discountrelated to the issuance of the warrants based on fair market value of thewarrants on the closing date using the Black-Scholes valuation model. Thediscount on these convertible debentures will be amortized over 1 year usingthe straight-line method. Approximately $8,700 was recorded during fiscal 2007as amortization of discount on debt on these debentures. Of the $1,000,000convertible debentures outstanding at September 30, 2007, $350,000 isconsidered to be held by related parties. Entities

 

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controlled by Mr. JosephWaechter purchased $250,000 of convertible notes and 156,250 warrants on thesame terms as other investors.

 

**NOTE 8 – OUTSOURCE AGREEMENT**

 

In January 2005, the Company signed anagreement with District Photo, Inc. to process all of the Company’s mailorder film processing and film reprint orders. On September 24, 2007, theCompanyterminated the agreement with District Photo prior to the end of its initialterm and entered into an amendment to an existing contract with Qualex PhotoInc. to have photo processing services performed. The Company paid DistrictPhoto a $66,000 fee for early termination of the contract. The contract withQualex expires on May 31, 2010.

 

**NOTE 9 - INCOME TAXES**

 

The Company has incurredsignificant operating losses in recent years and, therefore, has not generallyincurred income tax expense. The following are the components of the income taxprovision for the fiscal years ended September 30, 2007 and 2006:

 
| ** **           | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------|------------|----------|------------|----------|------------|
| Income tax provision |       |     |       |     |       |
| Current              |       | $        | —     |     | $          | — |   |
| Deferred             |       | —   |       | —   |       |
| Total                |       | $        | —     |     | $          | — |   |

 

The Company hasdetermined that its deferred tax assets do not satisfy the more likely than notcriteria set forth in Statement of Financial Accounting Standards No. 109,“Accounting for Income Taxes” (SFAS No. 109). Accordingly, a valuationallowance has been recorded against the applicable deferred tax assets andtherefore no tax benefit has been recorded in the accompanying statement ofoperations. The Company’s deferred tax assets (liabilities) were as follows asof September 30:

 
| ** **                              | ** ** | **9/30/2007**           | ** ** | **9/30/2006** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|---------------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Deferred tax  asset components:         |       |                    |       |          |       |
| Net operating  loss carry-forwards      |       | $                       | 19,311     |          | $          | 17,418 |   |
| Tax credits                             |       | 318                     |       | 318           |       |
| Other                                   |       | 50                      |       | 50            |       |
|                                    |       | 19,679                  |       | 17,786        |       |
| Deferred tax  asset valuation allowance |       | (19,679)                |       | (17,786       | )          |
| Deferred tax  assets                    |       | $                       | —     |          | $          | — |   |
|                                    |       |                    |       |          |       |
| Deferred tax  liabilities               |       | $                       | —     |          | $          | — |   |

 

The Company has deferredtax assets, comprised primarily of net operating loss carry-forwards. Due tooperating losses, the uncertainty of future profits and limitations on theutilization of net operating loss carry-forwards under IRC Section 382, avaluation allowance has been recorded to fully offset the Company’s deferredtax assets.

 

The net operating losscarry-forwards of approximately $49,506 begin expiring in 2020. A more than 50%change in ownership will greatly restrict the use of these losses in thefuture.

 

The valuation allowanceincreased approximately $1,893 during the year ended September 30, 2007.

 

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The reconciliation of the statutory and effective income tax rates isas follows:

 
| ** **                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Federal income  tax rate                       |       | 34       | %          | 34       | %          |
| State income tax  rate, net of federal benefit |       | 0        |       | 0        |       |
| Change in valuation  allowance                 |       | -11      |       | -26      |       |
| Other                                          |       | -23      |       | -8       |       |
| Effective income  tax rate                     |       | 0        |       | 0        |       |

 

**NOTE 10 - STOCKHOLDERS’ DEFICIT**

 

CommonStock

 

During fiscal 2006, theCompany issued 5,250 shares of common stock at $0.05 per share for the exerciseof stock options in the amount of $263. As of September 30, 2006, theCompany had not received the cash and recorded a subscription receivable for$263. Subsequently, the Company received the cash during October 2006.

 

During fiscal 2007, theCompany issued 7,031 shares of common stock at $0.05 per share for the exerciseof stock options in the amount of $352.

 

In October 2006, theCompany sold 8,860,714 shares of common stock at $0.35 per share forapproximately $3,100,000. In addition to the shares of common stock, the new shareholderswere issued 2,215,179 in warrants to purchase additional shares at $0.50 pershare. Along with the new shareholders, an additional 357,143 in warrants wereissued to the investors who contributed to a Private Investment in PublicEntity (PIPE loan) in August 2006.

 

In November 2006,the Company sold an additional 1,857,143 shares of common stock at $0.35 pershare raising an additional $650,000 less fees. Along with the shares of commonstock, the new shareholders were issued 464,286 in warrants to purchaseadditional shares at $0.50 per share.

 

In October 2006investors in two rounds of bridge financing that occurred earlier in 2006, hadtheir investments converted to 8,922,269 shares of common stock at $0.35 pershare. This eliminated the bridge loan liability of $3,000,000.

 

CommonStock Warrants

 

 The Company hadthe following warrants outstanding as of September 30, 2007:

 
| **Issue date** | ** ** | **Warrants  Outstanding** | ** ** | **Exercise Price** | ** ** | **Expiration date** | ** ** |
|---------------------|------------|---------------------------|------------|-------------------------|------------|--------------------------|------------|
| 12/20/2000          |       |                      | 14,545     |                    | $          | 5.00                     |       | 12/20/2010 |   |
|                |       |                      |       |                    |       |                     |       |   |
| 7/23/2001           |       |                      | 10,000     |                    | $          | 3.30                     |       | 7/23/2011 |   |
|                |       |                      |       |                    |       |                     |       |   |
| 2/16/2005           |       |                      | 380,952    |                    | $          | 0.72                     |       | 2/16/2015 |   |
|                |       |                      |       |                    |       |                     |       |   |
| 7/27/2005           |       |                      | 361,906    |                    | $          | 1.05                     |       | 7/27/2015 |   |
|                |       |                      |       |                    |       |                     |       |   |
| 7/27/2005           |       |                      | 442,636    |                    | $          | 1.10                     |       | 7/27/2015 |   |
|                |       |                      |       |                    |       |                     |       |   |
| 5/31/2006           |       |                      | 1,250,000  |                    | $          | 0.40                     |       | 5/31/2011 |   |

 

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| 8/22/2006 |   |   | 450,000   |   | $      | 0.40   |   | 8/22/2011  |   |
|-----------|--------|--------|-----------|--------|--------|--------|--------|------------|--------|
|      |   |   |      |   |   |   |   |       |
| 8/31/2006 |   |   | 357,143   |   | $      | 0.50   |   | 8/31/2011  |   |
|      |   |   |      |   |   |   |   |       |
| 10/9/2006 |   |   | 2,215,179 |   | $      | 0.50   |   | 10/9/2011  |   |
|      |   |   |      |   |   |   |   |       |
| 11/15/06  |   |   | 1,214,536 |   | $      | 0.50   |   | 11/15/2011 |   |
|      |   |   |      |   |   |   |   |       |
| 9/6/2007  |   |   | 625,000   |   | $      | 0.40   |   | 9/6/2012   |   |
|      |   |   |      |   |   |   |   |       |
| Total     |   |   | 7,321,897 |   |   |   |   |       |

 

On September 6,2007, the Company sold conventional convertible debentures and warrants in theaggregate principal amount of $1,000,000. The notes have a maturity date of September 6,2008 and bear interest at 12.5% per annum, payable on March 6, 2008 and atmaturity. The notes are convertible into shares of the Company’s common stockby the holders at a fixed conversion price of $.40 per share. In addition tothe convertible notes, the Company also issued warrants to purchase commonstock. For each $1,000 principal amount of notes purchased, an investorreceived warrants to acquire 625 Shares exercisable at $.40 per share. Thewarrants expire on September 6, 2012. The closing price of the Company’sstock on September 6, 2007 was $.30. The fair market value of the warrantswas determined to be $104,000 using the Black Scholes valuation method

 

Dividends

 

The Company has neverdeclared or paid cash dividends on its common stock and does not anticipatepaying any dividends in the foreseeable future. The Company is restricted undercovenants of a bank agreement from declaring any dividends on shares of itscapital stock without the bank’s prior consent.

 

**NOTE 11 - STOCK OPTIONS**

 

In June, 2005, theCompany’s board of directors adopted the PhotoWorks, Inc. 2005 EquityIncentive Plan. Employees, consultants, independent contractors, advisors andagents are eligible to participate in this plan. Pursuant to this plan, optionsmay be granted to purchase up to 4,000,000 shares of common stock at pricesequal to the fair market value of the shares at the time the options aregranted.

 

During fiscal 2006, theCompany granted options to acquire 1,060,000 shares of common stock to officersand directors of the Company and 436,000 shares of common stock options toemployees. The Company recorded a compensation expense in the amount of$261,000 using the Black-Scholes valuation model. During fiscal 2006, 1,344,114common stock options had expired and were cancelled and 5,250 options wereexercised for $263.

 

During fiscal 2007, theCompany granted options to acquire 1,155,055 shares of common stock to officersand directors of the Company and 1,551,250 shares of common stock options toemployees. The Company recorded a compensation expense in the amount of$345,000 using the Black-Scholes valuation model. During fiscal 2007, 2,235,699common stock options expired and were cancelled and 7,031 options wereexercised for $352.

 

All of the options weregranted pursuant the Company’s 2005 Equity Incentive Plan at exercise pricesbetween $0.26 and $0.51 per share. All options vest ratably on a quarterlybasis over period of three to four years; except for certain options for which25% of the grant vested immediately with the remainder vesting over a three orfour year period.

 

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The following schedulesummarizes stock option activity for the last two fiscal years:

 
| ** **                                                                                                     | ** ** | **Number of  Shares** | ** ** | **Price Per  Share** | ** **  | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|---------------------------|-------------|------------------------------------------------|------------|
|                                                                                                           |       |                       |       |                      |        |                                           |       |
| Balance at  September 24, 2005                                                                                 |       | 2,756,364                  |       | $                         | 0.05 -$2.15 |                                           | $          | 0.69 |   |
| Granted during  2006                                                                                           |       | 1,496,000                  |       | $                         | 0.32 -$0.71 |                                           | $          | 0.49 |   |
| Expired/canceled  during 2006                                                                                  |       | (1,344,114                 | )          | $                         | 0.05 -$0.72 |                                           | $          | 0.59 |   |
| Exercised during  2006                                                                                         |       | (5,250                     | )          | $                         | 0.05        |                                           | $          | 0.05 |   |
|                                                                                                           |       |                       |       |                      |        |                                           |       |
| Balance at  September 30, 2006                                                                                 |       | 2,903,000                  |       | $                         | 0.05 -$2.15 |                                           | $          | 0.64 |   |
| Granted during  2007                                                                                           |       | 2,706,305                  |       | $                         | 0.26 -$0.51 |                                           | $          | 0.38 |   |
| Expired/canceled  during 2007                                                                                  |       | (2,235,699                 | )          | $                         | 0.05 -$0.71 |                                           | $          | 0.58 |   |
| Exercised during  2007                                                                                         |       | (7,031                     | )          | $                         | 0.05        |                                           | $          | 0.05 |   |
| Balance at  September 30, 2007                                                                                 |       | 3,366,575                  |       | $                         | 0.05 -$2.15 |                                           | $          | 0.44 |   |
|                                                                                                           |       |                       |       |                      |        |                                           |       |
| Total compensation costs related to nonvested  stock options as of September 30, 2007 |       | $                          | 588,542    |                      |        |                                           |       |   |
|                                                                                                           |       |                       |       |                      |        |                                           |       |
| Weighted average  period of nonvested stock options as of September 30, 2007                                   |       | 2.9                        |       | Years                     |        |                                           |       |
|                                                                                                                |            |                            |            |                           |             |                                                |            |  |  |  |

 

Options considered fullyvested as of September 30, 2007 and September 30, 2006 were 1,616,956and 1,142,938, respectively, at weighted average exercise prices of $0.33 and$0.64 respectively. The following schedule summarizes the weighted-averageremaining contractual life and weighted-average exercise price of optionsoutstanding and options exercisable as of September 30, 2007:

 
| **Options Outstanding**            | ** **  | **Options Exercisable**   | ** ** |
|-----------------------------------------|-------------|--------------------------------|------------|
| **Range of  Exercise Prices** | ** **  | **Options   Outstanding** | ** ** | **Remaining  Contractual  Life (Years)** | ** ** | **Weighted Average  Exercise  Price** | ** ** | **Options  Exercisable** | ** ** | **Weighted Average  Exercise  Price** | ** ** |
|                                    |        |                           |       |   |   |   |   |   |   |   |   |
| $                                       | 0.05 - 0.35 |                           | 1,535,250  |   | 4.8 |   | $ | 0.28 |   | 1,211,229 |   | $ | 0.27 |   |
| $                                       | 0.40 - 0.71 |                           | 1,812,575  |   | 5.4 |   | $ | 0.56 |   | 405,357 |   | $ | 0.52 |   |
| $                                       | 1.65 - 2.15 |                           | 18,750     |   | 3.3 |   | $ | 1.74 |   | 370 |   | $ | 1.71 |   |
|                                    |        | 3,366,575                      |       |   |   |   |   | 1,616,956 |   |   |   |

 

The per share weightedaverage fair value of stock options granted during fiscal years 2007 and 2006was $0.38 and $0.49, respectively.

 

**NOTE 12 - 401(K) RETIREMENTPLAN**

 

The Companymaintains a 401(k) Plan for substantially all employees. No matching orprofit sharing contributions were made to the plan for fiscal 2007 and 2006.

 

**NOTE 13 – COMMITMENTS - INTERNATIONALTRADE COMMISSION SETTLEMENT**

 

In September 2003,the Company negotiated a settlement agreement with the International TradeCommission (ITC), whereby the Company pays $250,000 in July for four yearsbeginning in 2004. The Company accrued a penalty amount of $875,000 ($1,000,000penalty net of imputed interest of $125,000 at an estimated borrowing rate of6%) in its fiscal 2003 financial statements for this matter. The Companyentered into an

 

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agreement whereby a third party agreed toparticipate in the settlement and to reimburse the Company $380,000, resultingin a net charge for the settlement of $620,000.

 

The Company was granted an extension to paythe third and fourth ITC payments of $250,000 each due in fiscal 2006 and2007.  The Company paid $49,000 in September 2006and $201,000 of the third payment in July 2007.   The fourth and final payment of $250,000 isdue in July 2008.

 

The Company had a receivable of $95,000 duefrom the third party at September 30, 2007. The Company expects to receivethe final payment of this receivable in July 2008.

 

**NOTE 14**–**CONTINGENCIES**

 

The Company is involved in various routinelegal proceedings in the ordinary course of its business, none of which are expectedto materially impact the Company results of operations.

 

**NOTE 15 - INVESTMENT INPRIVATELY HELD EQUITY SECURITY**

 

In April 2006, the Company grantedFobaz Foto Bazaar, a Cayman Islands corporation, (“FoBaz”), a fully paid,perpetual, irrevocable software development, support and distribution license,exclusive to the country of India, in exchange for a 30% interest in theCompany held in the form of common stock. The Company was also granted a position on the Board of Directors ofFoBaz, which is currently held by Mr. Edward Holl, a member of the Boardof Directors of the Company.  FoBazlaunched services in October 2006 and announced its retail operationsstrategy in January 2007.  Fobaz,privately held with no readily determinable fair market value, is in the veryearly stages of growth and revenue generation; has incurred substantial startupexpenses and is in the process of attempting to raise additional capital.  Accordingly, the Company has assigned no valueto its equity stake in FoBaz as of September 30, 2007.

 

**NOTE 16 – SUBSEQUENTEVENTS**

 

In October 25, 2007, the Companygranted options for 200,000 shares of common stock to Andrew Wood, the Company’sPresident and Chief Executive Officer. All options were granted pursuant to the Company’s 2005 Equity IncentivePlan at an exercise price of $0.26 per share. All options vest ratably on a monthly basis over a four year period.

 

On November 27, 2007, the Board ofDirectors awarded Andrew Wood, the Company’s President and Chief ExecutiveOfficer, a bonus of $125,000 (net of applicable tax withholdings) payable uponcompletion of the Merger Agreement with American Greetings. (See discussion ofmerger below)

 

On November 27, 2007, the Company’sBoard of Directors authorized the Company to enter into an option terminationagreement with Daniel Zimmerman, the Company’s Vice President of Engineering,to terminate options to purchase 10,500 shares of the Company’s Common Stockgranted to Mr. Zimmerman on October 18, 2004 in exchange for a cashbonus payment to Mr. Zimmerman of $5,772.50. Such options shall terminateon or prior to December 31, 2007 and the cash bonus payment shall be madeon or about January 25, 2008.

 

On November 28, 2007, the Company entered into anAgreement and Plan of Merger (the “Merger Agreement”) with AG.com, Inc., aDelaware corporation and subsidiary of American Greetings Corporation (“AG”),and Photo Merger Corp., a Washington corporation and a wholly-owned subsidiaryof AG which is an indirect, wholly owned subsidiary of American GreetingsCorporation (the “Purchaser”), pursuant to which, among other things, thePurchaser will commence a tender offer for all the outstanding 

 

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common shares of PhotoWorks, subject to the terms andconditions of the Merger Agreement. Pursuant to the Merger Agreement, and upon the terms and subject to theconditions thereof, the Purchaser will commence a tender offer (the “Offer”) toacquire all the outstanding common shares of PhotoWorks, par value $0.01 pershare (“PhotoWorks Common Shares”), at a price of $0.595 per share, to theselling shareholders in cash, without interest thereon (the “Offer Price”).Pursuant to the Merger Agreement, after the consummation of the Offer, andsubject to the satisfaction or waiver of certain conditions set forth in theMerger Agreement, the Purchaser will merge with and into PhotoWorks (the “Merger”)and PhotoWorks will become a wholly-owned subsidiary of AG. At the effectivetime of the Merger, each issued and outstanding PhotoWorks Common Share notacquired in the Offer (other than PhotoWorks Common Shares held in treasury orPhotoWorks Common Shares held by shareholders who are entitled to exercise, andproperly demand, dissenter’s rights under Section 23B.13 of the WashingtonBusiness Corporation Act) will be automatically converted into the right toreceive the Offer Price in cash, without interest.

 

The Merger Agreement includes customaryrepresentations, warranties and covenants of PhotoWorks, AG and the Purchaser.PhotoWorks has agreed to operate its business in the ordinary course until theMerger is effective. PhotoWorks has also agreed not to solicit or initiatediscussions with third parties regarding other proposals to acquire PhotoWorksand to certain other restrictions on its ability to respond to such proposals.The Merger Agreement also includes customary termination provisions for bothPhotoWorks and AG and provides that, in connection with the termination of theMerger Agreement under specified circumstances, PhotoWorks may be required topay to AG a termination fee of $1 million. The Purchaser’s obligation to acceptfor payment and pay for PhotoWorks Common Shares tendered in the Offer issubject to customary conditions, including, among other things, the requirementthat at least two-thirds of the outstanding PhotoWorks Common Shares on afully-diluted basis shall have been validly tendered in accordance with theterms of the Offer and not properly withdrawn. Subject to the terms of theMerger Agreement, PhotoWorks has granted the Purchaser an option to purchasethat number of newly-issued PhotoWorks Common Shares that is equal to one sharemore than the amount needed to give the Purchaser ownership of 90% of theoutstanding PhotoWorks Common Shares on a fully-diluted basis (the “Top-UpOption”). The Top-Up Option is exercisable only after AG and Purchaser ownbeneficially at least 80% of the outstanding PhotoWorks Common Shares as aresult of the Offer. The Purchaser will pay PhotoWorks the Offer Price for eachshare acquired upon exercise of the Top-Up Option.

 

On December 13, 2007, the Company filed Schedule14D-9 – Solicitation / Recommendation Statement Under Section 14(d)4 ofthe Securities Exchange Act of 1934 in conjunction with the Schedule TO – Offerto Purchase for Cash filed by American Greetings Corporation.

 

**ITEM 8 –CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

On September 5, 2007, the Audit Committee of theBoard of Directors of the Company dismissed Williams & Webster, P.S.as the independent accountant engaged to audit the Company’s financialstatements. The reports of Williams & Webster, P.S. on the Company’sfinancial statements for the past two fiscal years did not contain an adverseopinion or a disclaimer of opinion and were not qualified or modified as touncertainty, audit scope, or accounting principles. Williams & Webster’saudit report dated January 9, 2006 for the fiscal year ended September 24,2005 contained an explanatory paragraph regarding doubt about the Company’sability to continue as a going concern. In connection with the audits of theCompany’s financial statements for each of the two fiscal years ended September 30,2006 and September 24, 2005, and through the interim period from October 1,2006 through September 5, 2007, there were no disagreements with Williams &Webster, P.S. on any matters of accounting principles or practices, financialstatement disclosure, or auditing scope or procedures which, if not resolved tothe satisfaction of Williams & Webster, P.S., would have causedWilliams & Webster, P.S. to make reference to the matter in theirreport. There were no “reportable events” as that term is described in Item304(a)(1)(iv) of Regulation S-B. Williams & Webster, P.S. furnished a letter addressed to theSEC stating that it agrees with the above statements.

 

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On September 7, 2007, the AuditCommittee of the Board of Directors of the Company engaged PMB Helin Donovan,LLP as the independent accountant to audit the Company’s financial statementsfor the year ended September 30, 2007.

 

**ITEM 8A– CONTROLS AND PROCEDURES**

 

See Item 6 of Part II—“Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”

 

**PART III**

 

We have adopted the PhotoWorks Finance Codeof Professional Conduct (the code of ethics for senior financial officers), acode of ethics that applies to our Chief Executive Officer, Chief AccountingOfficer and Controller.

 

**ITEM 9 - Directors and Executive Officers**

 

The following are briefbiographies of each current director and executive officer of the Company(including present principal occupation or employment, and materialoccupations, positions or employment for the past five years). Unless otherwiseindicated, to the knowledge of the Company, no current director or executiveofficer of the Company has been convicted in a criminal proceeding during thelast five years and no director or executive officer of the Company was a partyto any judicial or administrative proceeding during the last five years (exceptfor any matters that were dismissed without sanction or settlement) thatresulted in a judgment, decree or final order enjoining the person from futureviolations of, or prohibiting activities subject to, federal or statesecurities laws, or a finding of any violation of federal or state securitieslaws. There are no family relationships between directors and executiveofficers of the Company.

 

**Paul B.Goodrich** became adirector in February 2000. Mr. Goodrich is a Managing Director ofMadrona Venture Group, L.L.C., an early-stage venture capital firm focused onthe Internet economy in the Northwest. Mr. Goodrich was formerly theSeattle Partner for a Chicago-based venture capital firm and a Partner withPerkins Coie, a Seattle law firm. He is a director of Sharebuilder Corporation.

 

**EdwardHoll** became adirector of the Company in October 2005.  He currently serves asPresident of California Atlantic Limited Inc., and Managing Member of MatinicusCapital Management LLC, both private investment firms. He also serves invarious advisory roles to private companies in which he invests as a privateinvestor.  Prior to this, Mr. Holl served as senior executive ofMerchants Group International, a California based private equity firm.  Mr. Hollhas 25 years experience in the financial industry having held various executiveand non-executive positions since 1982. He started his career with BatemanEichler Hill Richard Inc. of Los Angeles, where he co-founded the firm’s firstinvestment management group which accumulated over $1 billion in assets afterthree year of launch between 1986 and 1989.  Mr. Holl was a SeniorVice President with Shearson Lehman Brothers between 1990 and 1993 and later onChairman and CEO of two smaller broker dealers in northern California. Mr. Hollhas held a variety of board and advisory positions since 1982. Mr. Hollreceived a BA from Occidental College in Los Angeles, a C.E.P. from theInstitut D’Études Politiques de Paris in France and an MBA from the AndersonGraduate School of Management at the University of California, Los Angeles.

 

**Mark L.Kalow** became adirector in May 2004. Mr. Kalow co-founded and served as COO and CFOat Live Picture, Inc. in 1993. He also served as Interim CEO to sell LivePicture to MGI Software (transaction closed in June 1999). Morerecently, Mr. Kalow co-managed the U.S. venture capital activities of amajor Japanese strategic software and services investor, Trans Cosmos USA. Hisexperience also includes management

 

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positions in finance,product management and marketing at IBM, and as vice president oftelecommunications for two years at Chase Manhattan Bank.

 

**JosephWaechter** became adirector in August 2005. Mr. Waechter has served as a director andthe President of Sunra Capital Holdings, Ltd., an investment firm, since May 2002.He is also the Managing Partner of California Pacific Capital, LLC. Since 1998,he has been a director of Merchants Group International, an investment firm.From 1989 to December 1997, Mr. Waechter served as Chairman and ChiefExecutive Officer of United Micronesia Development Association, Inc., aholding company with investments in the tourism, telecommunications and airlineindustries. During that period, he served as a Director of ContinentalMicronesia, Inc., a commercial airline. From 1994 to 1997, Mr. Waechterserved as Chairman, Chief Executive Officer and a Director of DanaoInternational Holdings, a developer of golf, hotel and resort projects inVietnam. From 1972 to 1987, Mr. Waechter served in a number of positionswith DHL Worldwide Express, an international air express delivery company,including President and Chief Executive Officer from 1983 through 1987. Mr. Waechterholds a B.A. degree from San Francisco State University.

 

**AndrewWood** became adirector of the Company in June 2006 and became its President and ChiefExecutive Officer in August 2006.  Mr. Wood has over 25 years ofdomestic and international experience in technology-enabled service industries.He has held CEO roles for over 15 years.  Since 2001 he has served as CEOof Wood-ASIO, a privately-held consulting organization providing confidentialassistance to technology and service industry companies. Between 2001 and 2003he was CEO of Shutterfly, the national leading independent photofinisher, wherehe streamlined operations, sharply focused company goals and guided the companyto profitability well ahead of schedule. From 2003 to 2004 he was CEO ofSkyBitz, a satellite tracking-based service business, where sales traction,product stabilization and development, and channel partnerships weresignificant challenges. These issues were resolved, along with a new $20M roundof financing that brought in Motorola as a strategic partner. From 2005 to 2006he undertook the role of CEO of Fulmer Logistics, an agent-based third partylogistics organization where a revised strategic position was required.Throughout his career, he has gained expertise in growing business operationsin complex emerging markets. As CEO of Exel Logistics, he launched the NorthAmerican business and successfully steered the company’s revenues to $500M infour years, along with industry leading profitability. Andy has also workedwith Coca Cola in the UK, where he was part of a team charged with energizingand restructuring the UK soft drink’s market. He has advised a number ofcompanies and VC’s, as well as serving on the Board of two private companies inaddition to PhotoWorks.

 

**DavidDouglass**joinedthe Company in May 2007 and serves as its Vice President and ChiefFinancial Officer and Corporate Secretary (effective June 15, 2007). Mr. Douglassis a partner of Tatum, LLC, an executive services firm that provides strategicand operating leadership in finance and information technology. Prior tojoining Tatum, Mr. Douglass was involved in technology startups. He servedas CFO of The Cobalt Group (NASDAQ: CBLT) during its final venture capitalstages and IPO process. The Cobalt Group is a leading provider of internetproducts and services to the automotive industry. Prior to Cobalt, Mr. Douglassheld various positions at PACCAR Inc (NASDAQ: PCAR), a worldwide manufacturerof transportation equipment, including the positions of Director of InternalAudit and Managing Director of Foden Trucks, based in England. Mr. Douglassearned a B.A. summa cum laude from the University of Puget Sound and a M.B.A.from the University of Washington. He also attended Duke University’s AdvancedManagement Program at the Fuqua School of Business. He is a certified publicaccountant (inactive).

 

**DanielZimmerman** joinedPhotoWorks in May 2004 after PhotoWorks acquired assets of PhotoAccessTechnologies. Zimmerman, who served as Vice President of Engineering ofPhotoAccess, has more than 20 years of experience in software development,Desktop Publishing, and Internet development in the software industry. BeforePhotoAccess, Zimmerman worked on Internet technologies for the Core Technologyteam at Adobe Systems, where he was responsible for delivering key technologycomponents for all of Adobe’s products and was a key member of the PageMakerdevelopment team at Aldus Corporation.

 

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Mr. Thomas Kelley,the former Vice President and Chief Marketing Officer of the Company, left theCompany in February 2007.

 

Mr. Bruce Fischer, theformer Vice President and Chief Financial Officer of the Company, left theCompany in April 2007.

 

**ITEM 10 - Executive Compensation**

 

The following tables and descriptivematerials set forth information concerning compensation earned for servicesrendered to the Company by the Chief Executive Officer (the “CEO”), the ChiefFinancial Officer (the “CFO”) and the Company’s next most highlycompensated executive officer for fiscal year 2007 whose salary and bonus forthe fiscal year 2007 exceeded $100,000. Collectively, together with theCEO, these are the “Named Executive Officers”.

 

**Summary Compensation Table**

 
| **Name and Principal  Position**                                                    | ** ** | **Year** | ** ** | **Salary** | ** ** | **Bonus (1)** | ** ** | **Option Awards  (2)** | ** ** | **All Other   Compensation** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|---------------|------------|-----------------------------|------------|----------------------------------------|------------|-----------|------------|
| Andrew Wood –  President, Chief Executive Officer & Director                    |       | 2007     |       | $          | 250,000    |          | $          | 0                           |       | $                                      | 77,886     |      | $          | 47,714 | (3) | $ | 375,600 |   |
| David Douglass –  Vice President & Chief Financial Officer, Corporate Secretary |       | 2007     |       | $          | 116,308    |          | $          | 19,508                      |       | $                                      | 0          |      | $          | 0 |   | $ | 135,816 |   |
| Thomas Kelley,  Vice President/Chief Marketing Officer                                        |       | 2007     |       | $          | 158,697    |          | $          | 40,105                      |       | $                                      | 33,930     |      | $          | 0 |   | $ | 232,732 |   |
| Daniel Zimmerman  – Vice President of Engineering                                        |       | 2007     |       | $          | 164,423    |          | $          | 18,078                      |       | $                                      | 25,723     |      | $          | 0 |   | $ | 208,224 |   |

 

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(1)                                  Bonus awarded based on achievement ofgoals and objectives regarding revenue growth, earnings and cash management.

 

(2)                                  The value of the stock and option awardshas been computed in accordance with Statement of Financial Standards (SFAS) No. 123R,“Share-Based Payment,” which requires that we recognize as compensation expensethe value of all stock-based awards, including stock options, granted toemployees in exchange for services over the requisite service period, which istypically the vesting period. Refer to Stock Based Compensation on pages 24 and25.

 

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(3)                                  Mr. Wood’s employment agreementauthorizes the reimbursement of certain expenses associated with housing inSeattle and travel. 

 

**Narrative Discussion of Summary Compensation TableInformation**

 

The following provides a narrative discussion of thematerial factors which we believe are necessary to understand the informationdisclosed in the foregoing Summary Compensation Table. The following narrativedisclosure is separated into sections, with a separate section for each of ourNamed Executive Officers.

 

**Andrew Wood – President &Chief Executive Officer**

 

Mr. Andrew Woodbecame the Company’s President and Chief Executive Officer on August 16,2006. Pursuant to an employment agreement with the Company, Mr. Woodreceives a base salary of $250,000 per year. Mr. Wood also received agrant of options to purchase 500,000 Shares. The grant vests over four years,with 25% vested immediately and the remainder vesting ratably on a monthlybasis over the following four years. The exercise price was $.60 per share,which was the fair market value of the Company’s common stock on August 16,2006. The term of the options is five years. Mr. Wood received subsequentgrants during fiscal 2007 totaling 400,000 shares. In addition, the Companywill pay Mr. Wood an annual bonus up to 50% of his base salary based onmeeting mutually agreed objectives tied to Company revenue growth and earnings.The Company Board did not award Mr. Wood a bonus based on the Company’s fiscal2007 growth and earnings performance.

 

In connection with Mr. Woods’relocation to the Seattle area, the Company agreed to reimburse him for certaintravel costs and his accommodation costs in the Seattle area for a period ofsix months for a furnished one bedroom apartment or studio.  This arrangement has been extended through April 2008.  Upon termination of Mr. Wood’semployment by the Company other than for cause or his resignation for goodreason, he will be entitled to six months’ base salary as a severance payment.In order to receive the post-termination payments and/or benefits describedabove, Mr. Wood is required to sign a release of claims in favor of theCompany. 

 

On November 27,2007, the Company’s Board of Directors also awarded Mr. Wood, a cash bonuspayment of $125,000, payable upon closing of the transactions contemplated bythe Merger Agreement.

 

Long Term Incentive Awards - The amount included underthe column “Options Awards” in the Summary Compensation Table for Mr. Woodrepresents the dollar amount recognized as compensation expense with respect tothe stock options awarded to Mr. Wood reflected in our audited financialstatements for the 2007 fiscal year in accordance with Statement of FinancialAccounting Standards Statement No. 123(R).

 

Fringe Benefits and Perquisites - During fiscal 2007, Mr. Woodreceived reimbursement for certain travel and lodging expenses pursuant to hisemployment agreement.

 

**David Douglass –Vice President and Chief Financial Officer, Corporate Secretary**

 

Pursuant to its agreement with Tatum LLC,the Company pays Mr. Douglass a salary of $24,000 per month and aquarterly cash bonus of $4,000 per month subject to achievement of agreed upongoals. The Company has no obligation to provide Mr. Douglass any stock,employee retirement and/or 401(k) plan benefits. In lieu of Mr. Douglassparticipating in the Company-sponsored employee medical insurance benefit plan,the Company reimburses Mr. Douglass for amounts paid by him for medicalinsurance for himself and his family. Mr. Douglass’ employment with theCompany may be terminated by either party at any time without cause.

 

**Daniel Zimmerman– Vice President – Engineering**

 

Mr. Zimmerman’s salary was establishedat the discretion of the Compensation Committee. Mr. Zimmerman’s annualsalary was increased from $130,000 to $165,000 in October 2006.  Mr. Zimmerman is eligible to earn anincentive bonus based on the Company’s performance.  During fiscal 2007, the CompensationCommittee awarded a bonus of $18,078.  Inaddition, Mr. Zimmerman received stock option grants to purchase 170,575

 

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shares of common stock. Mr. Zimmermanis eligible to participate in the Company’s benefits plans on the same basis asall other salaried employees.

 

**Thomas Kelley –Former Vice President and Chief Marketing Officer**

 

Mr. Kelley left the Company in February 2007.  His salary, bonus and option awards weredetermined at the discretion of the Compensation Committee.  Mr. Kelley was eligible to participatein the Company’s benefits plans on the same basis as all other salariedemployees.

 

**ITEM 11 - Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters**

 

The following table setsforth information as of December 4, 2007 with respect to all shareholdersknown by the Company who beneficially own more than 5% of the Shares. Except as noted below, each person or entity has sole voting and investmentpower with respect to the shares shown.  The information in this table isbased solely on statements in filings with the SEC or other reliableinformation.

 
| **Name and Address of Beneficial Owner**                                                                                                                              | ** ** | **Amount and Nature of  Beneficial Ownership(1)** | ** ** | **Percent  of Class** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | ** **                                                            | ** ** | ** **                 | ** ** |
| California Pacific  Capital L.L.C. (2)  Sunra Holdings, Ltd.  Joseph Waechter, Director  50 California St. Suite 1500  San Francisco, CA 94111                                            |       | 13,363,087                                                            |       | 31.8                       |       |
|                                                                                                                                                                                           |       |                                                                  |       |                       |       |
| Matinicus LP (3)  HZ Partners, FBO Edward Holl  California Atlantic Limited, Inc.  Edward Holl, Director  John P. Zinn  268 Bush Street  San Francisco, CA 94104                          |       | 6,295,052                                                             |       | 15.6                       |       |
|                                                                                                                                                                                           |       |                                                                  |       |                       |       |
| J. Carlo Cannell (4)  Tristan Partners, L.P.  P.O. Box 3459  240 E. Deloney Ave.  Jackson, WY 83001                                                                                       |       | 2,857,143                                                             |       | 7.2                        |       |
|                                                                                                                                                                                           |       |                                                                  |       |                       |       |
| Alexandra Global Master  Fund Ltd. (5)  Alexandra Investment Management, LLC  Mikhail A. Filimonov  Citco Building, Wickams Cay  P.O. Box 662, Road Town  Tortola, British Virgin Islands |       | 2,857,143                                                             |       | 7.2                        |       |
|                                                                                                                                                                                           |       |                                                                  |       |                       |       |
| The Tahoma Fund L.L.C.  (6)  Orca Bay Capital Corporation  Orca Bay Partners, L.L.C.  Stanley McCammon  John E. McCaw, Jr.  Ross Chapin  P.O. Box 21749  Seattle, WA 98111           |       | 2,733,055                                                             |       | 6.9                        |       |

 

 

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*Less than 1%.

 

(1)                      Beneficial ownership of shares isdetermined in accordance with the rules of the SEC and generally includesany shares over which a person exercises sole or shared voting or investmentpower, or of which a person has the right to acquire ownership within60 days after December 4, 2007. Except as otherwise noted, eachperson or entity has sole voting and investment power with respect to theshares shown.  Unless otherwise noted,none of the shares shown as beneficially owned are subject to pledge.Calculations are based on a total of 39,447,073 Shares outstanding as of December 4,2007.

 

(2)                      The registered holder of these securitiesis Sunra Holdings, Ltd. (“Sunra”).  California Pacific Capital controlsSunra and Joseph Waechter controls California Pacific Capital.  The amountshown includes warrants, convertible notes and vested options to purchase2,513,392 Shares.

 

(3)                      Edward Holl and John P. Zinn are themanagers of entities that control Matinicus LP.  The amounts shown includewarrants, convertible notes and vested options to purchase 799,523 Shares.

 

(4)                      Mr. Cannell is the controllingmember of Cannell Capital, LLC (“Adviser”).  The Adviser acts as theinvestment sub adviser to The Cuttyhunk Fund Limited, investment adviser toAnegada Master Fund Limited, and TE Cannell Portfolio, Ltd and is the generalpartner of and investment adviser to Tonga Partners, L.P., Tristan Partners,L.P., and Kauai Partners, L.P.

 

(5)                      Alexandra Investment Management LLC (“Management”)serves as investment advisor to Alexandra Global Master Fund Ltd. (“Alexandra”).By reason of such relationship, Management may be deemed to share voting anddispositive power over the Shares owned by Alexandra. Management disclaimsbeneficial ownership of the Shares listed as beneficially owned by Alexandra orany other person. Mr. Filimonov serves as the Chairman, the ChiefExecutive Officer, a Managing Member and the Chief Investment Officer ofManagement. By reason of such relationships, Filimonov may be deemed to sharevoting and dispositive power  over the Shares listed as beneficially ownedby Management.  Filimonov disclaims beneficial ownership of the Shareslisted as beneficially owned by Management or any other person.

 

(6)                      Orca Bay Partners, L.L.C., (“Orca Bay”)is the Manager of The Tahoma Fund, L.L.C. Orca Bay Capital Corporation, StanleyMcCammon, John E. McCaw, Jr., and Ross Chapin are all affiliates of OrcaBay.

 

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**Outstanding Equity Awards at Fiscal Year-End**

 

Thefollowing table sets forth information regarding outstanding equity awards heldby our Named Executive Officers at the end of fiscal 2007:

 
| ** **                                                              | ** ** | **Option Awards**                                                               |
|-------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|
| **Name**                                                                | ** ** | **Number   of  Securities  Underlying  Unexercised  Options  (#)  Exercisable** | ** ** | **Number of  Securities  Underlying  Unexercised  Options  (#)  Unexercisable  (1)** | ** ** | **Option  Exercise Price  ($)** | ** ** | **Option Expiration  Date** |
| ** **                                                              | ** ** | ** **                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Andrew Wood (1)**                                                     |       | 25,000                                                                               |   | 50,000 |   | 0.31 |   | 6/21/2016 |
| President, Chief  Executive Officer & Director                 |       | 260,417                                                                              |   | 239,583 |   | 0.60 |   | 8/16/2011 |
|                                                                    |       | 100,000                                                                              |   | 300,000 |   | 0.51 |   | 10/16/2001 |
| TOTAL                                                                   |       | 385,417                                                                              |   | 589,583 |   |   |   |   |
|                                                                    |       |                                                                                 |   |   |   |   |   |   |
| **David Douglass**                                                      |       | 0                                                                                    |   | 0 |   | N/A |   | N/A |
| Vice  President & Chief Financial Officer, Corporate Secretary |       |                                                                                 |   |   |   |   |   |   |
|                                                                    |       |                                                                                 |   |   |   |   |   |   |
| **Daniel Zimmerman (2)**                                                |       | 17,083                                                                               |   | 2,917 |   | 0.71 |   | 5/3/2011 |
| Vice President of  Engineering                                          |       | 7,875                                                                                |   | 2,625 |   | 0.05 |   | 10/18/2011 |
|                                                                    |       | 99,823                                                                               |   | 29,677 |   | 0.71 |   | 8/31/2015 |
|                                                                    |       | 15,000                                                                               |   | 25,000 |   | 0.42 |   | 4/26/2016 |
|                                                                    |       | 33,394                                                                               |   | 100,181 |   | 0.51 |   | 10/16/2011 |
|                                                                    |       | 3,083                                                                                |   | 33,917 |   | 0.26 |   | 6/4/2012 |
| TOTAL                                                                   |       | 176,258                                                                              |   | 194,317 |   |   |   |   |
|                                                                    |       |                                                                                 |   |   |   |   |   |   |
| **Thomas Kelley (2)**                                                   |       | 8,333                                                                                |   | 1,667 |   | 0.71 |   | 6/1/2011 |
| Vice President; Chief  Marketing Officer                                |       | 25,000                                                                               |   | 5,000 |   | 0.71 |   | 6/1/2011 |
|                                                                    |       | 154,167                                                                              |   | 45,833 |   | 0.71 |   | 8/31/2015 |
|                                                                    |       | 40,073                                                                               |   | 120,218 |   | 0.51 |   | 10/16/2011 |
| TOTAL                                                                   |       | 227,573                                                                              |   | 172,718 |   |   |   |   |

 

----

(1) The initial option grant to Mr. Wood vested at the rate of 25% on the dateof grant, with remainder vesting in equal monthly installments over 48 months.The additional option grants to Mr. Wood vested at the rate of 1/48thof the total number of option shares per month, with such option shares fullyvested 4 years from the date of grant.

 

(2) The initial option grant to each of Mr. Zimmerman and Mr. Kelleyvested at the rate of 25% 1 year from the date of grant, with remainder vestingin equal monthly installments over the following 36 months. The additionaloption grants to Mr. Zimmerman and Mr. Kelley vested at the rate of1/48th of the total number of option shares per month, with suchoption shares fully vested 4 years from the date of grant.

 

**Potential Payments Upon Termination or Change InControl**

 

Pursuant to an employmentagreement with the Company, upon termination of the employment of Andrew Wood,the Company’s President and CEO, by the Company other than for “cause” or hisresignation for “good reason,” Mr. Wood will be entitled to six months’base salary as a severance payment. The payment of any such severance paymentsto Mr. Wood is conditioned on his signing a general release of theCompany.  On November 27, 2007, theCompany’s Board of Directors also awarded Mr. Wood, a cash bonus paymentof $125,000, payable upon closing of the transactions contemplated by theMerger Agreement.

** **

**DirectorCompensation**

 

The following tableindicates ownership of the Shares and of options, warrants and convertiblenotes that are currently exercisable or exercisable within 60 days of December 4,2007 by each director of the Company, each Named Executive Officer, and by alldirectors and executive officers as a group, all as of December 4,2007.  The address of each of the namedindividuals is c/o PhotoWorks, Inc., 71 Columbia Street, #200, Seattle, WA98104.

 

44

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| **Directors:**                                                              | ** ** | **Age**    | ** ** | **Amount and  Nature of  Beneficial  Ownership(1)** | ** ** | **Percent of  Class** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                  | ** ** | ** ** | ** ** | ** **                                                    | ** ** | ** **                 | ** ** |
| Edward Holl (2)                                                             |       | 48         |       | 6,295,052                                                     |       | 15.6                       |       |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Paul B. Goodrich (3)                                                        |       | 61         |       | 1,385,327                                                     |       | 3.5                        |       |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Mark Kalow (4)                                                              |       | 52         |       | 234,688                                                       |       |                       | *          |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Joseph Waechter   (5)                                                  |       | 54         |       | 13,363,087                                                    |       | 31.8                       |       |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Andrew Wood                                                                 |       | 53         |       | 483,333                                                       |       | 1.2                        |       |
|                                                                        |       |       |       |                                                          |       |                       |       |
| **Additional  Named Executives**:                                           |       |       |       |                                                          |       |                       |       |
| ** **                                                                  |       |       |       |                                                          |       |                       |       |
| David Douglass                                                              |       | 51         |       | 0                                                             |       |                       | *          |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Thomas Kelley                                                               |       | 39         |       | 0                                                             |       |                       | *          |
|                                                                        |       |       |       |                                                          |       |                       |       |
| Dan Zimmerman                                                               |       | 43         |       | 207,140                                                       |       |                       | *          |
|                                                                        |       |       |       |                                                          |       |                       |       |
| All current  directors and named executive officers  as a group (8 persons) |       |       |       | 21,999,743                                                    |       | 50.4                       |       |

 

----

* **Percent of class is less than 1%**

 

(1)                      Beneficial ownership of Shares isdetermined in accordance with the rules of the SEC and generally includesany Shares over which a person exercises sole or shared voting or investmentpower, or of which a person has the right to acquire ownership within60 days after December 4, 2007. Calculations are based on a total of39,447,073 Shares outstanding as of December 4, 2007.

 

(2)                      Mr. Holl holds options to purchase16,250 Shares directly that are exercisable within 60 days after December 4,2007.  The remaining Shares, warrants and convertible notes are held byentities of which Mr. Holl is a controlling person.

 

(3)                      Mr. Goodrich holds options topurchase 2,203 Shares directly that are exercisable within 60 days after December 4,2007. The remaining Shares are held by entities of which Mr. Goodrich is acontrolling person.

 

(4)                      Includes notes convertible into 125,000Shares and warrants to purchase 31,250 Shares held by Bruno DeLean, over which Mr. Kalowhas been granted a power of attorney.

 

(5)                      Shares, options, warrants and convertiblenotes are owned as follows:

 
| ** **                      | ** ** | **Shares** | ** ** | **Options** | ** ** | **Warrants** | ** ** | **Convertible Notes** | ** ** |
|---------------------------------|------------|------------|------------|-------------|------------|--------------|------------|----------------------------|------------|
|                            |       |       |       |        |       |         |       |                       |       |
| Sunra Holdings,  Ltd.           |       | 7,464,178  |       | 0           |       | 1,263,392    |       | 625,000                    |       |
| California  Pacific Capital LLC |       | 3,385,517  |       | 0           |       | 562,500      |       | 0                          |       |
| Joseph Waechter                 |       | 0          |       | 62,500      |       | 0            |       | 0                          |       |

 

Mr. Waechter controls both Sunra Holdings, Ltd.and California Pacific Capital LLC.

 

45

----

 

**Director Compensation**

 

The following table summarizes director compensation during the fiscalyear, other than adirector who also served as a Named Executive Officer.

 
| **Name**             | ** ** | **Fees Earned  or  Paid in  Cash** | ** ** | **Option  Awards  (1)** | ** ** | **All Other  Compensation** | ** ** | **Total** | ** ** |
|----------------------|------------|----------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|-----------|------------|
| Joseph Waechter |       | $                                            |  0    |                    | $          |  8,146                      |       |      |       | $ |  8,146 |   |
| Edward Holl          |       | $                                            | 0          |                    | $          | 960                              |       |      |       | $ | 960 |   |
| Paul Goodrich        |       | $                                            | 0          |                    | $          | 724                              |       |      |       | $ | 724 |   |
| Mark Kalow           |       | $                                            | 19,500     |                    | $          | 11,456                           |       |      |       | $ | 30,956 |   |

 

----

(1)   The amounts in this column represent thedollar amount recognized for financial statement reporting purposes withrespect to the 2007 fiscal year in accordance with FAS 123R. Refer toStock Based Compensation on pages 24 and 25.

 

(2)   As of the end of fiscal 2007, Mr. Waechterheld options to purchase an aggregate of 200,000 Common Shares, Mr. Holl heldoptions to purchase an aggregate of 60,000 Common Shares, Mr. Goodrich heldoptions to purchase an aggregate of 6,250 Common Shares and Mr. Kalow heldoptions to purchase an aggregate of 150,000 Common Shares.

 

Each independent directorreceives an annual retainer of $10,000 and a fee of $1,000 per board meetingattended in person and $200 for each board meeting attendedtelephonically.  The Chair of the Audit Committee receives an additionalannual retainer of $5,000.  Members of the Audit Committee who areindependent receive a fee of $1,000 per meeting attended in person and $200 permeeting attended telephonically. Messrs. Waechter, Holl and Goodrichagreed to serve without cash compensation during fiscal 2007.

 

On November 1, 2006,the Company Board approved grants of stock options to two directors, Mr. JosephWaechter and Mr. Mark Kalow. The options were granted pursuant to theCompany’s 2005 Equity Incentive Plan. Mr. Waechter received a grant ofoptions to purchase 200,000 Shares and Mr. Kalow received a grant ofoptions to purchase 60,000 Shares. The exercise price is $.35, which was thefair market value on the date of grant. The options vest ratably on a quarterlybasis over a four year period. For Mr. Waechter, options to purchase37,500 Shares were vested immediately upon grant. The options expire on November 1,2011.

 

On May 21, 2007, theCompany Board approved a grant of stock options to purchase 60,000 shares todirector Mr. Edward Holl. The exercise price is $.35, which was the fair marketvalue on the date of grant. The options vest ratably on a monthly basis throughJanuary 2011 and expire on May 21, 2012. The options were granted pursuant tothe Company’s 2005 Equity Incentive Plan.

 

**ITEM 12 - Certain Relationships and Related Transactions and DirectorIndependence**

 

On September 6,2007, the Company sold convertible notes and warrants in the aggregateprincipal amount of $1,000,000.  The notes have a maturity date of September 6, 2008 and bearinterest at 12.5% per annum, payable on March 6, 2008 and at maturity. Thenotes are convertible into shares of the Company’s common stock by the holdersat an initial conversion price of $.40 per share. In addition to theconvertible notes, the Company also issued warrants to purchase common stock.For each $1,000 principal amount of notes purchased, an investor receivedwarrants to acquire 625 Shares at $.40 per share. The warrants expire on September 6,2012. Entities controlled by Mr. Joseph Waechter purchased $250,000 ofconvertible notes and 156,250 warrants on the same terms as other investors.

 

**ITEM 13 -   Exhibits**

 

**ITEM 14 -   Principal AccountantFees and Services**

 

46

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The following tablepresents the fees for services rendered by Williams & Webster P.S.during fiscal 2007 and 2006.

 
| ** **                 | ** ** | **Fiscal 2007** | ** ** | **Fiscal 2006** | ** ** |
|----------------------------|------------|----------------------|------------|----------------------|------------|
| Audit fees                 |       | $                    | 36,770     |                 | $          | 76,846 |   |
| Audit-related  fees (401k) |       | $                    | 0          |                 | $          | 22,271 |   |
| Tax fees                   |       | $                    | 4,905      |                 | $          | 8,576 |   |
| All other fees             |       | $                    | 638        |                 | $          | 0 |   |

 

The Audit Committee didconsider whether the provision of non-audit services is compatible with theprincipal accountants’ independence and concluded that the provision of othernon-audit services has been compatible with maintaining the independence of theCompany’s external auditors.  Allservices provided by Williams & Webster P.S. to the Company must bepre-approved by the Audit Committee or a designated member of the AuditCommittee.

 

**PART IV**

 

**ITEM 15– Exhibits and Financial Statement Schedules**

 
| **a.** | ** ** | **Index to Consolidated Financial Statements and Consolidated Financial Statement Schedules** | ** ** | ** ** | ** ** |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|

 
|   (1) |   | Consolidated Financial  Statements                                                                                                       |   |   |   |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|            |   |                                                                                                                                     |   |   |   |
|            |   | Report of PMB  Helin Donovan LLP, Independent Registered Public Accounting Firm                                                          |   |   |   |
|            |   |                                                                                                                                     |   |   |   |
|            |   | Consolidated Balance  Sheets as of September 30, 2007 and September 30, 2006                                                   |   |   |   |
|            |   |                                                                                                                                     |   |   |   |
|            |   | Consolidated  Statements of Operations for the years ended September 30, 2007, and  September 30, 2006                         |   |   |   |
|            |   |                                                                                                                                     |   |   |   |
|            |   | Consolidated  Statements of Shareholders’ Equity (Deficit) for the years ended  September 30, 2007 and September 30, 2006 |   |   |   |
|            |   |                                                                                                                                     |   |   |   |
|            |   | Consolidated  Statements of Cash Flows for the years ended September 30, 2007, and  September 30, 2006                         |   |   |   |
|            |   |                                                                                                                                     |   |   |   |
|            |   | Notes to  Consolidated Financial Statements                                                                                              |   |   |   |

 

All other schedules have been omittedbecause the required information is included in the consolidated financialstatements or the notes thereto, or is not applicable or required.

 

**b.Exhibits**

 

A copyof the Company’s Annual Report on Form 10-KSB, including all documents asexhibits, is available without charge upon written request to the CorporateSecretary, PhotoWorks, Inc., 71 Columbia Street, Suite 200, Seattle,WA 98104. Documents may also be requested by emailing your request to: ir@photoworks.com

 

47

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| **Exhibit Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                             |
|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                                                                     |
| 3.1                     |       | Bylaws of the Company,  as amended and restated on September 23, 2004. (Incorporated by  reference to Form 10-K for the year ended September 25, 2004.)                                                                                   |
|                    |       |                                                                                                                                                                                                                                                     |
| 3.2                     |       | Articles of Amendment  to Articles of Incorporation of PhotoWorks, Inc. dated February 9,  2000. (Incorporated by reference to Exhibit 3.1 filed with the Company’s  Form 8-K filed February 16, 2000.)                    |
|                    |       |                                                                                                                                                                                                                                                     |
| 3.3                     |       | Articles of Amendment  to Articles of Incorporation of PhotoWorks, Inc. dated April 24,  2001. (Incorporated by reference to Exhibit 3.1 filed with the Company’s  8-K filed April 27, 2001.)                                   |
|                    |       |                                                                                                                                                                                                                                                     |
| 3.4                     |       | Articles of Correction  to Articles of Incorporation of PhotoWorks, Inc dated April 25, 2001.  (Incorporated by reference to Exhibit 3.2 filed with the Company’s 8-K  filed April 27, 2001.)                                        |
|                    |       |                                                                                                                                                                                                                                                     |
| 3.5                     |       | Third Amendment to  Articles of Incorporation of PhotoWorks, Inc. (Incorporated by reference  to Form 8-K filed July 19, 2005)                                                                                                            |
|                    |       |                                                                                                                                                                                                                                                     |
| 3.6                     |       | Amendment to Articles  of Incorporation of PhotoWorks, Inc. (Incorporated by reference to  Form 8-K filed June 22, 2006)                                                                                                                  |
|                    |       |                                                                                                                                                                                                                                                     |
| 4.1                     |       | Form of Warrant  (Incorporated by reference to Form 8-K dated June 2, 2006)                                                                                                                                                               |
|                    |       |                                                                                                                                                                                                                                                     |
| 4.2                     |       | Form of  Convertible Note (Incorporated by reference to Form 8-K dated  June 2, 2006)                                                                                                                                                     |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.1                    |       |  Employment Agreement with Andrew Wood dated  August 16, 2006 (Incorporated by reference to Form 8-K dated  August 11, 2006)                                                                                                         |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.2                    |       | Agreement and Plan of  Merger among AG.com, Inc, PhotoMerger Corp. and PhotoWorks, Inc. dated  November 28, 2007. (Incorporated by reference to Form 8-K dated  November 28, 2007.)                                                  |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.3                    |       | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo  Merger Corp., PhotoWorks, Inc. and HZ Partners. (Incorporated by  reference to Form 8-K dated November 28, 2007.)                        |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.4                    |       | Share Tender Agreement dated  as of November 28, 2007 by and among AG.com, Inc.,Photo Merger  Corp., PhotoWorks, Inc. and Madrona Managing Director Fund LLC.  (Incorporated by reference to Form 8-K dated November 28, 2007.) |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.5                    |       | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo  Merger Corp., PhotoWorks, Inc. and California Pacific Holdings LLC.  (Incorporated by reference to Form 8-K dated November 28, 2007.)    |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.6                    |       | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo  Merger Corp., PhotoWorks, Inc. and Madrona Venture Fund I-A L.P  (Incorporated by reference to Form 8-K dated November 28, 2007.)        |
|                    |       |                                                                                                                                                                                                                                                     |
| 10.7                    |       | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo  Merger Corp., PhotoWorks, Inc. and Madrona Venture Fund I-B L.P  (Incorporated by reference to Form 8-K dated November 28, 2007.)        |

 

48

----

 
| 10.8   |   | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo Merger  Corp., PhotoWorks, Inc. and Matinicus L.P (Incorporated by reference to  Form 8-K dated November 28, 2007.)                                                                                                                                                                                                   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.9   |   | Share Tender Agreement  dated as of November 28, 2007 by and among AG.com, Inc.,Photo  Merger Corp., PhotoWorks, Inc. and Sunra Capital Holdings L.P  (Incorporated by reference to Form 8-K dated November 28, 2007.)                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.10  |   | Photofinishing Services  Agreement with District Photo dated January 18, 2005 (Exhibit for  which confidential treatment has been granted) (Incorporated by reference to  Form 10-Q for the quarter ended March 26, 2005.)                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.11  |   | Investor Rights  Agreement dated February 16, 2005 among PhotoWorks, Inc.,  SunraCapital Holdings, Ltd., Orca Bay Partners, Madrona Venture Fund I-A,  L.P.,Madrona Venture Fund I-B, L.P., Madrona Managing Director Fund, LLC, and  Matinicus LP (Incorporated by reference to Form 10-Q for the quarter  ended March 26, 2005.)                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.12  |   | Amended and Restated  Investor Rights Agreement dated February 16, 2005 among  PhotoWorks, Inc., Sunra Capital Holdings, Ltd., Orca Bay Partners,  Madrona VentureFund I-A, L.P., Madrona Venture Fund I-B, L.P., Madrona  Managing Director Fund, LLC,Tim and Alexa Carver, Stanley McCammon, Aaron  Singleton and Matinicus LP (Incorporated by reference to Form 10-Q for  the quarter ended March 26, 2005.) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.13  |   | Share Exchange  Agreement dated February 16, 2005 among PhotoWorks, Inc. and the  holders of Series A Preferred Stock named therein (Incorporated by  reference to Form 10-Q for the quarter ended March 26, 2005.)                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.14  |   | First Amendment to  Amended and Restated Investor Rights Agreement Dated February 16, 2005  of PhotoWorks, Inc. and Consent and Waiver dated February 16, 2005.  (Incorporated by reference to Form 10-Q for the quarter ended  June 25, 2005.)                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.15  |   | Convertible Note and  Warrant Purchase Agreement dated May 31, 2006. ((Incorporated by  reference to Form 8-K dated June 2, 2006)                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.16  |   | Investor Rights  Agreement dated May 31, 2006 (Incorporated by reference to Form 8-K  dated June 2, 2006)                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.17  |   | Common Stock and  Warrant Purchase Agreement dated October 5, 2006 (Incorporated by  reference to Form 8-K dated October 10, 2006)                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 23.1   |   | Consent of  Williams & Webster, P.S. Independent Registered Public Accounting  Firm.                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 23.2   |   | Consent of PMB Helin  Donovan, LLP, Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.1   |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act  of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.2   |   | Certification of Chief  Accounting Officer pursuant to Rule 13a-14 of the Securities Exchange  Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 32     |   | Certification of  Principal Executive Officers pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 99     |   | Code of Ethics for Senior Financial  Officers. (Incorporated by reference to Exhibit 99 filed with Company’s  Annual Report on Form 10-K for the year ended September 27, 2003.)                                                                                                                                                                                                                                 |

 

49

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**SIGNATURES**

 

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

 
|                          | **PHOTOWORKS, INC.**                   |
|-------------------------------|----------------------------------------|
|                          | (REGISTRANT)                           |
|                          |                                   |
|                          |                                   |
| DATED: December 31, 2007 |                                   | By: | /s/ Andrew L. Wood |   |
|                          | Andrew  L. Wood                        |
|                          | President  and Chief Executive Officer |
|                          | (Principal  Executive Officer)         |

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant and in the capacities and on thedates indicated.

 
| **NAME** | ** **                                        | **TITLE** | ** **                    | **DATE**                | ** ** |
|----------|---------------------------------------------------|-----------|-------------------------------|-------------------------|------------|
|     |                                              |      |                          |                    |       |   |
|     | /s/ Andrew L. Wood                                |      |                          | President and           |       | December 31, 2007 |   |
|     |      Andrew L.  Wood     |      | Chief Executive Officer       |                    |       |   |
|     |                                              |      | Director                      |                    |       |   |
|     |                                              |      | (Principal Executive Officer) |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ Paul B. Goodrich                              |      |                          | Director                |       | December 31, 2007 |   |
|     |      Paul B.  Goodrich   |      |                          |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ Edward Holl                                   |      |                          | Director                |       | December 31, 2007 |   |
|     |      Edward Holl         |      |                          |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ Mark L. Kalow                                 |      |                          | Director                |       | December 31, 2007 |   |
|     |      Mark L.  Kalow      |      |                          |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ Joseph Waechter                               |      |                          | Director                |       | December 31, 2007 |   |
|     |      Joseph  Waechter    |      |                          |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ David M. Douglass                             |      |                          | Chief Financial Officer |       | December 31, 2007 |   |
|     |      David M.  Douglass  |      |                          |                    |       |   |
|     |                                              |      |                          |                    |       |   |
|     | /s/ Ning Aroonvaragron                            |      |                          | Controller              |       | December 31, 2007 |   |
|     |      Ning  Aroonvaragron |      |                          |                    |       |   |
|          |                                                   |           |                               |                         |            |  |  |  |  |  |  |  |

 

50

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