UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.   20549










FORM
10-Q


(Mark
One)





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





For the
quarterly period ended September 30, 2009





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


For the
transition period from _____________ to ___________


Commission
file number 333-124829





ZOO
ENTERTAINMENT, INC.


(Exact
name of Registrant as Specified in Its Charter)


Delaware
            71-1033391(State
      or other jurisdiction of incorporation or
              organization
      )
            (I.R.S.
      Employer Identification No.)





2121
      Avenue of the Stars, Suite 2550,
              Los
      Angeles, CA
            90067(Address
      of Principal Executive Offices)
            (Zip
      Code)(310)
      601-2500(Registrant’s
      telephone number, including area
code)





Indicate
by check mark whether the Registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.


Yes
  x  No
  ̈





Indicate
by check mark whether the Registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes  ̈    No 
 ̈





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




Large
      Accelerated filer ̈
            Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              (do
      not check if a smaller reporting company)
            Smaller
      reporting company x




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





As of
November 17, 2009, there were 39,425,755 shares of the Registrant’s common
stock, par value $0.001 per share, issued and 31,624,429 shares
outstanding.







ZOO
ENTERTAINMENT, INC.




Table
of Contents





PagePART
      I - FINANCIAL INFORMATIONItem
      1.
                      
                      Financial
      StatementsCondensed
      Consolidated Balance Sheets as of September 30, 2009 (Unaudited) and
      December 31, 2008
                      
                      F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three and Nine
      Months Ended September 30, 2009 and 2008
                      
                      F-
      2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Nine Months
      Ended September 30, 2009 and 2008
                      
                      F-
      3Condensed
      Consolidated Statement of Stockholders’ Equity (Deficiency) and Other
      Comprehensive Loss (Unaudited) for the Nine Months Ended September 30,
      2009
                      
                      F-
      4Notes
      to Condensed Consolidated Financial Statements
                      
                      F-
      5 - F-27Item
      2.
                      
                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      1Item
      3.
                      
                      Quantitative
      and Qualitative Disclosure About Market Risk
                      
                      14Item
      4T.
                      
                      Controls
      and Procedures
                      
                      14PART
      II - OTHER INFORMATIONItem
      1.
                      
                      Legal
      Proceedings
                      
                      15Item
      1A.
                      
                      Risk
      Factors
                      
                      15Item
      2.
                      
                      Unregistered
      Sales of Equity Securities and Use of Proceeds
                      
                      15Item
      3.
                      
                      Defaults
      Upon Senior Securities
                      
                      16Item 4.
                      
                      Submission
      of Matters to a Vote of Security Holders
                      
                      16Item
      5.
                      
                      Other
      Information
                      
                      16Item
      6.
                      
                      Exhibits
                      
                      16Signatures
                      
                      17





Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


(In Thousands Except Share and Per
Share Amounts)





September 30, 2009
                  
                  
                  December 31, 2008 *(unaudited)ASSETSCurrent
      AssetsCash
                  
                  $
                  533
                  
                  
                  $
                  849Accounts
      receivable, net of allowances for returns and discounts of $713 and
      $1,160
                  
                  
                  3,254
                  
                  
                  
                  1,832Inventory
                  
                  
                  2,176
                  
                  
                  
                  3,120Prepaid
      expenses and other current assets
                  
                  
                  4,374
                  
                  
                  
                  2,124Product
      development costs, net
                  
                  
                  5,739
                  
                  
                  
                  5,338Deferred
      tax asset
                  
                  
                  491
                  
                  
                  
                  688Total
      Current Assets
                  
                  
                  16,567
                  
                  
                  
                  13,951Fixed
      assets, net
                  
                  
                  232
                  
                  
                  
                  214Goodwill
                  
                  
                  -
                  
                  
                  
                  14,704Intangible
      assets, net
                  
                  
                  8,914
                  
                  
                  
                  14,747Total
      Assets
                  
                  $
                  25,713
                  
                  
                  $
                  43,616LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIENCY)Current
      LiabilitiesAccounts
      payable
                  
                  $
                  5,597
                  
                  
                  $
                  5,709Financing
      arrangements
                  
                  
                  3,503
                  
                  
                  
                  849Customer
      advances
                  
                  
                  5,241
                  
                  
                  
                  1,828Accrued
      expenses and other current liabilities
                  
                  
                  2,980
                  
                  
                  
                  3,099Notes
      payable, net of discount of $0 and $145- current portion
                  
                  
                  120
                  
                  
                  
                  1,803Convertible
      notes payable, net of discount of $0 and $1,576, including accrued
      interest of $656 and $240
                  
                  
                  11,806
                  
                  
                  
                  9,814Total
      Current Liabilities
                  
                  
                  29,247
                  
                  
                  
                  23,102Notes
      payable, net of discount of $0 and $885- non current
    portion
                  
                  
                  180
                  
                  
                  
                  1,772Deferred
      tax liability
                  
                  
                  491
                  
                  
                  
                  688Other
      long-term liabilities
                  
                  
                  2,920
                  
                  
                  
                  620Total
      Liabilities
                  
                  
                  32,838
                  
                  
                  
                  26,182Commitments
      and ContingenciesStockholders'
      Equity (Deficiency)Preferred
      Stock, par value $0.001, 5,000,000 shares authorized, none issued and
      outstanding
                  
                  
                  -
                  
                  
                  
                  -Common
      Stock, par value $0.001, 250,000,000 shares authorized, 39,425,755 issued
      and 31,624,429 outstanding September 30, 2009 and 38,243,937 issued and
      outstanding December 31, 2008
                  
                  
                  39
                  
                  
                  
                  38Additional
      Paid-in-capital
                  
                  
                  53,264
                  
                  
                  
                  52,692Accumulated
      deficit
                  
                  
                  (55,967
                  )
                  
                  
                  (31,940
                  )Treasury
      Stock, at cost, 7,801,326 shares September 30,2009 and 2,237,376 shares
      December 31, 2008
                  
                  
                  (4,469
                  )
                  
                  
                  (3,356
                  )Accumulated
      other comprehensive income
                  
                  
                  8
                  
                  
                  
                  -Total
      Stockholders' Equity (Deficiency)
                  
                  
                  (7,125
                  )
                  
                  
                  17,434Total
      Liabilities and Stockholders' Equity (Deficiency)
                  
                  $
                  25,713
                  
                  
                  $
                  43,616





*Derived
from audited financials





See
accompanying notes to condensed consolidated financial
statements


F-1


Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statements of Operations (Unaudited)


(In
Thousands Except Share and Per Share Amounts)





Three Months Ended September 30,
                
                
                Nine Months Ended September 30,2008
                
                
                2009
                
                
                2008
                
                
                2009Revenue
                
                $
                8,583
                
                
                $
                7,865
                
                
                $
                30,136
                
                
                $
                22,364Cost
      of goods sold
                
                
                6,662
                
                
                
                5,093
                
                
                
                25,887
                
                
                
                18,306Gross
      profit
                
                
                1,921
                
                
                
                2,772
                
                
                
                4,249
                
                
                
                4,058Operating
      expenses:General
      and administrative expenses
                
                
                1,750
                
                
                
                4,037
                
                
                
                5,010
                
                
                
                7,436Selling
      and marketing expenses
                
                
                548
                
                
                
                1,352
                
                
                
                2,073
                
                
                
                3,269Research
      and development expenses
                
                
                —
                
                
                
                2
                
                
                
                370
                
                
                
                1,481Impairment
      of goodwill and other intangible assets
                
                
                22,000
                
                
                
                —
                
                
                
                22,000
                
                
                
                —Depreciation
      and amortization
                
                
                504
                
                
                
                434
                
                
                
                1,373
                
                
                
                1,325Total
      operating expenses
                
                
                24,802
                
                
                
                5,825
                
                
                
                30,826
                
                
                
                13,511Loss
      from operations
                
                
                (22,881
                )
                
                
                (3,053
                )
                
                
                (26.577
                )
                
                
                (9,453
                )Interest
      expense, net
                
                
                (370
                )
                
                
                (1,554
                )
                
                
                (2,403
                )
                
                
                (2,533
                )Gain
      on legal settlement
                
                
                —
                
                
                
                —
                
                
                
                4,328
                
                
                
                —Other
      income – insurance recovery
                
                
                860
                
                
                
                —
                
                
                
                860
                
                
                
                —Loss
      from continuing operations before income tax benefit
                
                
                (22,391
                )
                
                
                (4,607
                )
                
                
                (23,792
                )
                
                
                (11,986
                )Income
      tax benefit
                
                
                —
                
                
                
                2,542
                
                
                
                —
                
                
                
                3,600Loss
      from continuing operations
                
                
                (22,391
                )
                
                
                (2,065
                )
                
                
                (23,792
                )
                
                
                (8,386
                )Loss
      from discontinued operations
                
                
                (235
                )
                
                
                (1,731
                )
                
                
                (235
                )
                
                
                (4,279
                )Net
      loss
                
                $
                (22,626
                )
                
                $
                (3,796
                )
                
                $
                (24,027
                )
                
                $
                (12,665
                )Loss
      per share – basic and diluted:Continuing
      operations
                
                $
                (0.72
                )
                
                $
                (0.08
                )
                
                $
                (0.70
                )
                
                $
                (0.40
                )Discontinued
      operations
                
                
                (0.01
                )
                
                
                (0.06
                )
                
                
                (0.01
                )
                
                
                (0.20
                )Net
      loss
                
                $
                (0.72
                )
                
                $
                (0.14
                )
                
                $
                (0.70
                )
                
                $
                (0.60
                )Weighted
      average shares outstanding:Basic
      and diluted
                
                
                31,213,362
                
                
                
                27,051,407
                
                
                
                34,126,320
                
                
                
                21,058,233





See
accompanying notes to condensed consolidated financial
statements


F-2


Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statements of Cash Flow (Unaudited)


(In
Thousands)





Nine
      Months Ended September 30,2009
                
                
                2008Operating
      Activities:Net
      loss
                
                $
                (24,027
                )
                
                $
                (12,665
                )Loss
      from discontinued operations
                
                
                (235
                )
                
                
                (4,279
                )Net
      loss from continuing operations
                
                
                (23,792
                )
                
                
                (8,386
                )Adjustments
      to reconcile net loss from continuing operations to net cash used in
      operating activities::Gain
      on legal settlement
                
                
                (4,328
                )
                
                
                —Impairment
      of goodwill and other intangible assets
                
                
                22,000
                
                
                
                —Depreciation
      and amortization
                
                
                1,373
                
                
                
                1,325Amortization
      of deferred debt discount
                
                
                1,870
                
                
                
                2,126Deferred
      income taxes
                
                
                —
                
                
                
                (3,899
                )Stock
      based compensation
                
                
                566
                
                
                
                1,908Other
      changes in assets and liabilities, net
                
                
                (412
                )
                
                
                (10,323
                )Net
      cash used in continuing operations
                
                
                (2,723
                )
                
                
                (17,249
                )Net
      cash used in discontinued operations
                
                
                —
                
                
                
                (2,491
                )Net
      cash used in operating activities
                
                
                (2,723
                )
                
                
                (19,740
                )Investing
      activities:Purchases
      of fixed assets
                
                
                (92
                )
                
                
                (65
                )Purchases
      of intangible assets
                
                
                (162
                )
                
                
                —Cash
      received from acquisition of Driftwood
                
                
                —
                
                
                
                1,669Net
      cash (used in) provided by investing activities
                
                
                (254
                )
                
                
                1,604Financing
      activities:Proceeds
      from sale of equity securities
                
                
                7
                
                
                
                6,118Net
      borrowings in connection with financing facilities
                
                
                2,654
                
                
                
                5,422Proceeds
      from Driftwood issuance of convertible notes – pre-merger
                
                
                —
                
                
                
                7,823Proceeds
      from issuance of convertible notes – post merger
                
                
                —
                
                
                
                1,000Net
      cash provided by financing activities
                
                
                2,661
                
                
                
                20,363(Decrease)
      increase in cash
                
                
                (316
                )
                
                
                2,227Cash
      at beginning of period
                
                
                849
                
                
                
                138Cash
      at end of period
                
                $
                533
                
                
                $
                2,365





See
accompanying notes to condensed consolidated financial
statements


F-3


Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statement of Stockholders' Equity (Deficiency) and Other
Comprehensive Loss (Unaudited)


For
the Nine Months Ended September 30, 2009


(In
Thousands)





Preferred
      Stock
                                  
                                  
                                  Common
      Stock
                                  
                                  
                                  Additional
                                  
                                  
                                  Accumulated
                                  
                                  
                                  Treasury
      Stock
                                  
                                  
                                  Accumulated
                                    Other
                                    ComprehensiveShares
                                  
                                  
                                  Par
                                    Value
                                  
                                  
                                  Shares
                                    Issued
                                  
                                  
                                  Par
                                    Value
                                  
                                  
                                  Paid-in-
                                    Capital
                                  
                                  
                                  Deficit
                                  
                                  
                                  Shares
                                  
                                  
                                  Cost
                                  
                                  
                                  Income
                                  
                                  
                                  TotalBalance
      December 31, 2008
                                  
                                  
                                  —
                                  
                                  
                                  $
                                  —
                                  
                                  
                                  
                                  38,244
                                  
                                  
                                  $
                                  38
                                  
                                  
                                  $
                                  52,692
                                  
                                  
                                  $
                                  (31,940
                                  )
                                  
                                  
                                  2,237
                                  
                                  
                                  $
                                  (3,356
                                  )
                                  
                                  $
                                  —
                                  
                                  
                                  $
                                  17,434Stock-based
      compensation
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  66
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  66Value
      of shares returned to treasury from settlement of
    litigation
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  5,564
                                  
                                  
                                  
                                  (1,113
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  (1,113
                                  )Warrants
      exercised
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  682
                                  
                                  
                                  
                                  1
                                  
                                  
                                  
                                  6
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  7Shares
      issued for personal guaranty
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  500
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  100
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  100Value
      of warrant issued for distribution agreement
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  400
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  400Net
      loss
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  (24,027
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  (24,027
                                  )Adjustment
      for foreign currency translation
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  8
                                  
                                  
                                  
                                  8Other
      comprehensive loss
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  (24,019
                                  )Balance
      September 30, 2009
                                  
                                  
                                  —
                                  
                                  
                                  $
                                  —
                                  
                                  
                                  
                                  39,426
                                  
                                  
                                  $
                                  39
                                  
                                  
                                  $
                                  53,264
                                  
                                  
                                  $
                                  (55,967
                                  )
                                  
                                  
                                  7,801
                                  
                                  
                                  $
                                  (4,469
                                  )
                                  
                                  $
                                  8
                                  
                                  
                                  $
                                  (7,125
                                  )





See
accompanying notes to condensed consolidated financial
statements


F-4


Zoo
Entertainment, Inc. And Subsidiaries


Notes to
Condensed Consolidated Financial Statements


(Unaudited)





NOTE
1.   DESCRIPTION OF ORGANIZATION AND REVERSE MERGER





Zoo
Entertainment, Inc., (“Zoo” or the “Company”) was incorporated under the laws of
the State of Nevada on February 13, 2003 under the name Driftwood Ventures,
Inc. On December 20, 2007, the Company reincorporated in Delaware and
increased its authorized capital stock from 75,000,000 shares to 80,000,000
shares, consisting of 75,000,000 shares of common stock, par value $0.001, per
share, and 5,000,000 shares of preferred stock, par value $0.001, per
share.  In August 2009, the Company increased its authorized shares of
common stock to 250,000,000, par value $0.001 per share. On November 20, 2009,
as a result of the Company consummating an approximately $4.2 million preferred
equity raise, the Company will issue series A preferred stock (“Series A
Preferred Stock”).  Concurrently, as a result of the aforementioned
preferred equity raise, the Company will convert approximately $11.8 million of
existing debt and related accrued interest into series B preferred stock
(“Series B Preferred Stock”). The Series A Preferred Stock and the Series B
Preferred Stock will convert into common shares of the Company upon a sufficient
increase in authorized common shares of the Company. (See Note 20 for further
details in connection with the conversion features).   The Company was
engaged in acquiring and exploring mineral properties until September 30, 2007
when this activity was abandoned. The Company had been inactive until July
7, 2008 when the Company entered into an Agreement and Plan of Merger, as
subsequently amended on September 12, 2008 with DFTW Merger Sub, Inc., a
Delaware corporation and a wholly-owned subsidiary of the Company (“Merger
Sub”), Zoo Games, Inc. (“Zoo Games”) (formerly known as Green Screen Interactive
Software, Inc.) and a stockholder representative, pursuant to which Merger Sub
would merge with and into Zoo Games, with Zoo Games as the surviving corporation
through an exchange of common stock of Zoo Games for common stock of the Company
(the “Merger”). On December 3, 2008, Driftwood Ventures, Inc. changed its name
to Zoo Entertainment, Inc.





On
September 12, 2008, upon the completion of the Merger, each outstanding share of
Zoo Games common stock, $0.001 par value per share (the “Zoo Games Common
Stock”) on a fully-converted basis, converted automatically into and became
exchangeable for shares of the Company’s common stock, $0.001 par value per
share based on an exchange ratio equal to 7.023274. In addition, by virtue of
the Merger, each of the 334,983 options to purchase shares of Zoo Games Common
Stock (the “Zoo Games Options”) outstanding under Zoo Games’ 2008 Long-Term
Incentive Plan were assumed by the Company, subject to the same terms and
conditions as were applicable under such plan immediately prior to the Merger,
and converted into 243,040 options to purchase shares of the Company’s common
stock at an exercise price of $2.58 per share, 421,396 options to purchase
shares of the Company’s common stock at an exercise price of $2.25 per share and
1,688,240 options to purchase shares of the Company’s common stock at an
exercise price of $1.52 per share. The 246,243 warrants to purchase shares of
Zoo Games Common Stock outstanding at the time of the Merger (the “Zoo Games
Warrants”) were assumed by the Company and converted into 1,411,186 warrants to
acquire shares of the Company’s common stock at an exercise price of $2.84 and
318,246 warrants to acquire shares of the Company’s common stock at an exercise
price of $2.13 per share. The merger consideration consisted of (i) 26,098,303
shares of the Company’s common stock, (ii) the reservation of 2,352,677 shares
of the Company’s common stock that are required for the assumption of the Zoo
Games Options and (iii) the reservation of 1,729,432 shares of the Company’s
common stock that are required for the assumption of the Zoo Games
Warrants.





Zoo Games
was treated as the acquirer for accounting purposes in this reverse merger and
the financial statements of the Company for all periods presented represent the
historical activity of Zoo Games and include the activity of Zoo beginning on
September 12, 2008, the date of the reverse merger. As a result of the reverse
merger, the equity transactions for the period from March 23, 2007 to September
12, 2008 have been adjusted to reflect this
recapitalization.


F-5


Zoo
Games, a Delaware corporation, is a developer, publisher and distributor of
interactive entertainment software for use on all major platforms including
Nintendo’s Wii and DS, Sony’s PSP and PlayStation 3, Microsoft’s Xbox 360, and
personal computers (PCs). Zoo Games sells primarily to major retail chains and
video game distributors. Zoo Games began business in March 2007, acquired the
assets of Supervillain Studios, Inc. (“SVS”) on June 13, 2007, acquired the
stock of Zoo Publishing, Inc. (“Zoo Publishing”) on December 18, 2007 and
acquired the stock of Zoo Digital Publishing Limited (“Zoo Digital”) on April 4,
2008. The consolidated financial statements include the results of their
operations from their respective acquisition dates. We also acquired an interest
in Cyoob, Inc., also known as Repliqa (“Repliqa”), on June 28, 2007. During
January 2008, Zoo Games’ board of directors made a determination to discontinue
its involvement with the operations of Repliqa. During September 2008, Zoo Games
sold SVS back to its original owners. In November 2008, Zoo Games sold Zoo
Digital back to its original owners. Repliqa, SVS and Zoo Digital have been
reflected as discontinued operations for all periods presented. In May
2009, we entered into a license agreement with New World IP (Licensor”) pursuant
to which the Licensor granted to Zoo Publishing all of the Licensor’s rights to
substantially all the intellectual property of Empire Interactive Europe, Ltd.
for a minimum royalty of $2.6 million. In June 2009, we formed a new company
called Zoo Entertainment Europe Ltd., a 100% subsidiary of Zoo Games, Inc. based
in the United Kingdom for the purpose of sales and distribution of our product
in Europe.





Currently,
the Company has determined that it operates in one segment and will focus on
developing, publishing and distributing interactive entertainment software under
the Zoo brand both in North American and international markets.





On May
16, 2008, Zoo Games converted from a limited liability company to a
C-corporation and changed its name to Green Screen Interactive Software, Inc.
from Green Screen Interactive Software, LLC. In August 2008, it changed its name
to Zoo Games, Inc.





NOTE
2.   GOING CONCERN





These
consolidated financial statements have been prepared assuming the Company
will continue as a going concern. The Company has incurred losses since
inception, resulting in an accumulated deficit of approximately $56.0
million and a working capital deficiency of approximately $12.7 million at
September 30, 2009. For the nine months ended September 30, 2009 the Company
generated negative cash flows from operations of approximately $2.7
million, and for the year ended December 31, 2008 the Company generated negative
cash flows from operations of approximately $12.1 million. Although the
Company’s business plan anticipates the generation of positive cash flow, there
is no assurance that it will succeed in doing so.  An inability to
meet its business goals would raise substantial doubt as to the Company's
ability to continue as a going concern. In addition, the Company has various
notes maturing in February 2010 with an aggregate face value of approximately
$11.2 million, $11.8M including accrued interest. On November 2, 2009, the
Company and its Senior Secured Convertible Note Holders amended the Senior
Convertible Note whereby the parties agreed that if the Company raises at least
$4 million in new capital prior to February 2, 2010, the notes will
automatically convert into equity.  On November 20, 2009, the
requisite Senior Secured Convertible Note Holders agreed to convert their debt
into Preferred Shares of the Company that will ultimately convert into common
shares that would represent 36.5% of the equity of the Company on a pro-forma
basis.





The
Company’s ability to continue as a going concern is dependent on, among other
factors, the following major short term actions:  i.) its ability to
generate cash flow from operations sufficient to maintain its daily business
activities ii.) its ability to raise capital from outside sources through the
sale of equity or debt instruments primarily to fund the ongoing development and
acquisition of new games and iii.) the restructuring of its maturing note
obligations. Management’s active efforts in this regard include trade
arrangements for advance payments secured by future sales, an agreement with its
note holders as detailed above, as well as operational steps to increase cash
flow through an increase in both the quantity and quality of its product
releases. There can be no assurance that all or any of these actions will meet
with success.





On
November 20, 2009, the Company consummated a $4.2 million convertible preferred
stock equity raise and converted approximately $11.8 million of debt including
related accrued interest into preferred stock, improving its working capital by
$16.0 million and putting the Company into a positive net working capital
position on a pro-forma basis as of September 30, 2009.





These
condensed consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded assets, or the
amounts of and classification of liabilities that might be necessary as a result
of this uncertainty.


F-6


NOTE
3.   BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING
POLICIES





Principles
of Consolidation and Interim Financial Information





The
accompanying unaudited interim condensed consolidated financial statements were
prepared in accordance with accounting principles generally accepted in the
United States of America and the interim financial statement rules and
regulations of the Securities and Exchange Commission. Accordingly, they do
not include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of
management, these statements include all adjustments (consisting only of normal
recurring adjustments) necessary for a fair presentation of the Condensed
Consolidated Financial Statements. The financial statements should be read
in conjunction with the financial statements of the Company together with the
Company’s management discussion and analysis in the Company’s Form 10-K Annual
Report for the year ended December 31, 2008 filed with the Securities and
Exchange Commission on April 15, 2009. The results for the three months and
nine months ended September 30, 2009 might not be indicative of the results for
the full year or any future period.





The
condensed consolidated financial statements of the Company include the accounts
of Zoo Games and its wholly and majority owned subsidiaries, Supervillain
Studios LLC, Zoo Publishing, Zoo Entertainment Europe Ltd., Zoo Digital
Publishing Limited and Repliqa during the periods that each subsidiary was
directly or indirectly owned by Zoo Games. All intercompany accounts and
transactions are eliminated in consolidation.





Use
of Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosure of contingent assets and liabilities at the dates of the
financial statements and the reported amounts of revenue and expenses during the
reporting periods. The estimates affecting the consolidated financial statements
that are particularly significant include the recoverability of product
development costs, lives of intangibles, realization of goodwill and
intangibles, allocation of purchase price, valuation of equity instruments,
valuation of inventories and the adequacy of allowances for returns, price
concessions and doubtful accounts. Actual amounts could differ from these
estimates.





Concentration
of Credit Risk





We
maintain cash balances at what we believe are several high quality financial
institutions. While we attempt to limit credit exposure with any single
institution, balances often exceed FDIC insurable amounts.





If the
financial condition and operations of our customers deteriorate, our risk of
collection could increase substantially. A majority of our trade receivables are
derived from sales to major retailers and distributors. In October 2008, we
entered into an agreement with Atari, Inc. where sales from October 24, 2008
through March 31, 2009 for all customers that Atari deemed acceptable would be
through Atari and Atari would prepay us for the cost of goods and they would
bear the credit risk from the ultimate customer. This agreement was
subsequently amended to include sales to certain customers through March 31,
2010. As of September 30, 2009, Atari had prepaid us approximately $3.2 million
which is included in customer advances in current liabilities in the condensed
consolidated balance sheet and the receivable due from Atari was $264,000,
before allowances, which is included in accounts receivable in the condensed
consolidated balance sheet. Our five largest ultimate customers for the
nine months ended September 30, 2009 accounted for approximately 77% of the
gross revenue for the period. We believe that the receivable balances from
Atari and our ultimate customers do not represent a significant credit risk
based on past collection experience. During the nine months ended September 30,
2009, we sold $832,000 of receivables to the factor with
recourse.  There were $832,000 of receivables from our factor included
in our gross accounts receivable as of September 30, 2009 and $0 as of
December 31, 2008. We regularly review our outstanding receivables for potential
bad debts and have had no history of significant write-offs due to bad
debts.


F-7


Inventory





Inventory,
primarily consisting of finished goods, is stated at the lower of actual cost or
market. We periodically evaluate the carrying value of our inventory and make
adjustments as necessary. Estimated product returns are included in the
inventory balances and also recorded at the lower of actual cost or
market.





Product
Development Costs





We
utilized both internal development teams and third party product developers to
develop the titles we publish.





We
capitalized internal product development costs (including stock-based
compensation, specifically identifiable employee payroll expense and incentive
compensation costs related to the completion and release of titles) as well as
third party production and other content costs, subsequent to establishing
technological feasibility of a title. Technological feasibility of a product
includes the completion of both technical design documentation and game design
documentation. Amortization of such capitalized costs is recorded on a
title-by-title basis in cost of goods sold using the proportion of current year
revenues to the total revenues expected to be recorded over the life of the
title. With the sale of SVS in September 2008, we no longer have any
internal development studios or related costs.





We
frequently enter into agreements with third party developers that require us to
make advance payments for game development and production services. In exchange
for our advance payments, we receive the exclusive publishing and distribution
rights to the finished game title as well as, in some cases, the underlying
intellectual property rights. Such agreements allow us to fully recover the
advance payments to the developers at an agreed royalty rate earned on the
subsequent retail sales of such product, net of any agreed costs. We capitalize
all advance payments to developers as product development costs. On a
product-by-product basis, we reduce product development costs and record a
corresponding amount of research and development expense for any costs incurred
by third party developers prior to establishing technological feasibility of a
product as these advances are expended. We typically enter into agreements with
third party developers after completing the technical design documentation for
our products and, therefore, record the design costs leading up to a signed
development contract as research and development expense. We also generally
contract with third party developers that have proven technology and experience
in the genre of the video game being developed, which often allows for the
establishment of technological feasibility early in the development cycle. In
instances where the documentation of the design and technology are not in place
prior to an executed contract, we monitor the product development process and
require our third party developers to adhere to the same technological
feasibility standards that applied to our internally developed
products.





We also
capitalize advance payments as product development costs when advances are made
subsequent to establishing technological feasibility of a video game title and
amortize them, on a title-by-title basis, as product development costs in cost
of goods sold. Royalty amortization is recorded using the proportion of current
year unit sales and revenues to the total unit sales and revenues expected to be
recorded over the life of the title.





At each
balance sheet date, or earlier if an indicator of impairment exists, we evaluate
the recoverability of capitalized development costs, advance development
payments and any other unrecognized minimum commitments that have not been paid,
using an undiscounted future cash flow analysis, and charge any amounts that are
deemed unrecoverable to cost of goods sold if the product has already been
released. If the product is discontinued prior to completion, any prepaid
unrecoverable advances are charged to research and development expense. We use
various measures to estimate future revenues for our product titles, including
past performance of similar titles and orders for titles prior to their release.
For sequels, the performance of predecessor titles is also taken into
consideration.





Prior to
establishing technological feasibility, we expense research and development
costs as incurred. During the three months ended September 30, 2009 and 2008, we
wrote-off $0 and $2,000, respectively and during the nine months ended September
30, 2009 and 2008, we wrote-off $370,000 and approximately $1.5 million,
respectively, of expense relating to costs incurred for the development of games
that were abandoned during those periods. Those costs are included in our
statement of operations under research and development
expenses.


F-8


Licenses
and Royalties





Licenses
consist of payments and guarantees made to holders of intellectual property
rights for use of their trademarks, copyrights, technology or other intellectual
property rights in the development of our products. Agreements with rights
holders generally provide for guaranteed minimum royalty payments for use of
their intellectual property. When significant performance remains to be
completed by the licensor, we record payments when actually paid.





Certain
licenses extend over multi-year periods and encompass multiple game titles. In
addition to guaranteed minimum payments, these licenses frequently contain
provisions that could require us to pay royalties to the license holder, based
on pre-agreed unit sales thresholds.





Licensing
fees are capitalized on the balance sheet in prepaid expenses and are amortized
as royalties in cost of goods sold on a title-by-title basis at a ratio of
current period revenues to the total revenues expected to be recorded over the
remaining life of the title. Similar to product development costs, we review our
sales projections quarterly to determine the likely recoverability of our
capitalized licenses as well as any unpaid minimum obligations. When management
determines that the value of a license is unlikely to be recovered by product
sales, capitalized licenses are charged to cost of goods sold, based on current
and expected revenues, in the period in which such determination is made.
Criteria used to evaluate expected product performance and to estimate future
sales for a title include: historical performance of comparable titles; orders
for titles prior to release; and the estimated performance of a sequel title
based on the performance of the title on which the sequel is based.





Goodwill
and Intangible Assets





Goodwill
is the excess of purchase price paid over identified intangible and tangible net
assets of acquired companies. Intangible assets consist of trademarks, customer
relationships, content and product development. Certain intangible assets
acquired in a business combination are recognized as assets apart from goodwill.
Identified intangibles other than goodwill are generally amortized using the
straight-line method over the period of expected benefit ranging from one to ten
years, except for intellectual property, which are usage-based intangible assets
that are amortized using the shorter of the useful life or expected revenue
stream.





The
Company performs a goodwill impairment test at least on an annual basis and
whenever events or changes in circumstances indicate that the carrying value may
not be recoverable from estimated future cash flows. We will perform tests
of impairment in the fourth quarter of each fiscal year or earlier if indicators
of impairment exist. We determine the fair value of each reporting unit
using a discounted cash flow analysis and compare such values to the respective
reporting unit's carrying amount.





The
Company incurred a triggering event on November 20, 2009 based on the equity
infusion of approximately $4.0 million for 50% ownership interest in the Company
and the conversion of the existing convertible debt, which resulted in the
Company estimating its pro-forma market capitalization to be approximately $8.0
million as of September 30, 2009.  Accordingly, the Company recorded
an estimated impairment charge in September 2009 of $22.0 million to be applied
as a $14.7 million reduction of goodwill and a $7.3 million reduction of content
in other intangibles.  The Company will perform a formal impairment
analysis during the fourth quarter of 2009 and adjust the impairment estimates
accordingly, if necessary.





Impairment
of Long-Lived Assets, Including Definitive Life Intangible Assets





We review
all long-lived assets whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable, including assets to be
disposed of by sale, whether previously held and used or newly acquired. We
compare the carrying amount of the asset to the estimated undiscounted future
cash flows expected to result from the use of the asset. If the carrying amount
of the asset exceeds estimated expected undiscounted future cash flows, we
record an impairment charge for the difference between the carrying amount of
the asset and its fair value. The estimated fair value is generally measured by
discounting expected future cash flows at our incremental borrowing rate or fair
value, if available.


F-9


Revenue
Recognition





We earn
our revenue from the sale of internally developed interactive software titles
and from the sale of titles developed by and/or licensed from third party
developers ("Publishing Revenue").





We
recognize Publishing Revenue upon the transfer of title and risk of loss to our
customers.  Accordingly, we recognize revenue for software titles when
there is (1) persuasive evidence that an arrangement with the customer exists,
which is generally a customer purchase order, (2) the product is delivered, (3)
the selling price is fixed or determinable and (4) collection of the
customer receivable is deemed probable. Our payment arrangements with customers
typically provide net 30 and 60-day terms. Advances received from customers are
reported on the consolidated balance sheet as customer advances, included in
current liabilities until we meet our performance obligations, at which point we
recognize the revenue.





Revenue
is recognized after deducting estimated reserves for returns, price concessions
and other allowances. In circumstances when we do not have a reliable basis to
estimate returns and price concessions or are unable to determine that
collection of a receivable is probable, we defer the revenue until such time as
we can reliably estimate any related returns and allowances and determine that
collection of the receivable is probable.





Allowances
for Returns, Price Concessions and Other Allowances





We may
accept returns and grant price concessions in connection with our publishing
arrangements. Following reductions in the price of our products, we grant price
concessions that permit customers to take credits for unsold merchandise against
amounts they owe us. Our customers must satisfy certain conditions to allow them
to return products or receive price concessions, including compliance with
applicable payment terms and confirmation of field inventory
levels.





Although
our distribution arrangements with customers do not give them the right to
return titles or to cancel firm orders, we sometimes accept returns from our
distribution customers for stock balancing and make accommodations to customers,
which include credits and returns, when demand for specific titles fall below
expectations.





We make
estimates of future product returns and price concessions related to current
period product revenue based upon, among other factors, historical experience
and performance of the titles in similar genres, historical performance of a
hardware platform, customer inventory levels, analysis of sell-through rates,
sales force and retail customer feedback, industry pricing, market conditions
and changes in demand and acceptance of our products by consumers.





Significant
management judgments and estimates must be made and used in connection with
establishing the allowance for returns and price concessions in any accounting
period. We believe we can make reliable estimates of returns and price
concessions. However, actual results may differ from initial estimates as a
result of changes in circumstances, market conditions and assumptions.
Adjustments to estimates are recorded in the period in which they become
known.





Consideration
Given to Customers and Received from Vendors





We have
various marketing arrangements with retailers and distributors of our products
that provide for cooperative advertising and market development funds, among
others, which are generally based on single exchange transactions. Such amounts
are accrued as a reduction to revenue when revenue is recognized, except for
cooperative advertising which is included in selling and marketing expense if
there is a separate identifiable benefit and the benefit's fair value can be
established.





We
receive various incentives from our manufacturers, including up-front cash
payments as well as rebates based on a cumulative level of purchases. Such
amounts are generally accounted for as a reduction in the price of the
manufacturer's product and included as a reduction of inventory or cost of goods
sold, based on (1) a ratio of current period revenue to the total revenue
expected to be recorded over the remaining life of the product or (2) an agreed
upon per unit rebate, based on actual units manufactured during the
period.


F-10


Equity-Based
Compensation





We issued
options and warrants to purchase shares of common stock of the Company to
certain management and employees during 2009 and 2008.  We record
compensation expense over the requisite service period based on their relative
fair values.





The fair
value of our equity-based compensation is estimated using the Black-Scholes
option-pricing model. This model requires the input of assumptions regarding a
number of complex and subjective variables that will usually have a significant
impact on the fair value estimate. These variables include, but are not limited
to, the volatility of our stock price and estimated exercise
behavior.  The following table summarizes the assumptions and
variables used by us to compute the weighted average fair value of stock option
grants:





For the Nine
      MonthsEnded September 30,2009
                                  
                                  
                                  2008Risk-free
      interest rate
                                  
                                  
                                  3.45
                                  %
                                  
                                  
                                  3.45
                                  %Expected
      stock price volatility
                                  
                                  
                                  60.0
                                  %
                                  
                                  
                                  45.0
                                  %Expected
      term until exercise (years)
                                  
                                  
                                  5
                                  
                                  
                                  
                                  5Dividends
                                  
                                  None
                                  
                                  
                                  None





For the
nine months ended September 30, 2009 and 2008, we estimated the implied
volatility for publicly traded options on our common shares as the expected
volatility assumption required in the Black-Scholes option-pricing
model. The selection of the implied volatility approach was based upon the
historical volatility of companies with similar businesses and capitalization
and our assessment that implied volatility is more representative of future
stock price trends than historical volatility.





Loss
Per Share





Basic
loss per share ("EPS") is computed by dividing the net loss applicable to common
stockholders for the period by the weighted average number of shares of common
stock outstanding during the same period. Diluted EPS is computed by dividing
the net income applicable to common stockholders for the period by the weighted
average number of shares of common stock outstanding and common stock
equivalents, which includes warrants and options outstanding during the same
period. Since the inclusion of the 13,486,072 warrants and 2,589,811 options
outstanding as of September 30, 2009 and the 7,320,341 warrants and 2,352,676
options outstanding as of September 30, 2008 are anti-dilutive because of
losses, the dilutive loss per share is the same as the basic loss per
share.





Income
Taxes





Zoo Games
was a limited liability company from inception until May 16, 2008, when we
converted to a corporation. As a limited liability company, we were not required
to provide for any corporate tax. The loss from the Company’s operations was
passed to the unit holders via Form K-1 and the unit holders are responsible for
any resulting taxes. One of our subsidiaries, Zoo Publishing, was not a limited
liability company and we therefore were required to record a corporate tax
provision upon the acquisition of Zoo Publishing.





As a
corporation, we recognize deferred taxes under the asset and liability method of
accounting for income taxes. Under the asset and liability method, deferred
income taxes are recognized for differences between the financial statement and
tax basis of assets and liabilities at currently enacted statutory tax rates for
the years in which the differences are expected to reverse. The effect on
deferred taxes of a change in tax rates is recognized in income in the period
that includes the enactment date. Valuation allowances are established when we
determine that it is more likely than not that such deferred tax assets will not
be realized.





Fair
Market Value of Financial Instruments





The
carrying value of cash, accounts receivable, inventory, accounts payable,
accrued expenses, due to factor, and advances from customers are reasonable
estimates of the fair values because of their short-term maturity. Notes
payable are recorded net of the discount which is computed as the difference
between the market interest rate that the Company would pay for financing at the
time the note is issued and the stated interest rate on the note. The
convertible notes that were issued with warrants are recorded net of the
unamortized discount applied to the warrants.


F-11





Recently
Issued Accounting Pronouncements





Effective
January 1, 2009, the Company adopted ASC Topic 815 which clarifies the
determination of whether an instrument (or an embedded feature) is indexed to an
entity’s own stock. The adoption of ASC Topic 815 did not have a significant
impact on our results of operations or financial position.





Effective
June 30, 2009, the Company adopted ASC Topic 855 which provides guidance on
management's assessment of subsequent events and the requirement to disclose the
date through which subsequent events have been evaluated. The Company has
evaluated subsequent events through November 23, 2009 for this quarterly
report on Form 10-Q for the quarter ended September 30, 2009. The adoption
of ASC Topic 855 did not have any impact on the Company's consolidated financial
position or results of operations.





In June
2009, the FASB issued ASC Topic 105 which establishes the FASB Accounting
Standards Codification as the single source of authoritative GAAP for all
non-governmental entities, with the exception of the SEC and its staff. ASC
Topic 105 changes the referencing and organization of accounting guidance and is
effective for interim and annual periods ending after September 15, 2009. Since
it is not intended to change or alter existing GAAP, the Codification did not
have any impact on the Company’s financial condition or results of
operations.  Going forward, the Board will not issue new standards in
the form of Statements, FASB Staff Positions, or Emerging Issues Task Force
Abstracts; instead, it will issue Accounting Standards Updates. The FASB will
not consider Accounting Standards Updates as authoritative in their own right;
these updates will serve only to update the Codification, provide background
information about the guidance, and provide the bases for conclusions on the
change(s) in the Codification. In the description of Accounting Standards
Updates that follows, references in “italics” relate to Codification Topics and
Subtopics, and their descriptive titles, as appropriate.





Accounting
Standards Updates Not Yet Effective





In June
2009, an update was made to “Consolidation – Consolidation of
Variable Interest Entities.”Among other things, the update replaces the
calculation for determining which entities, if any, have a controlling financial
interest in a variable interest entity (VIE) from a quantitative based risks and
rewards calculation, to a qualitative approach that focuses on identifying which
entities have the power to direct the activities that most significantly impact
the VIE’s economic performance and the obligation to absorb losses of the VIE or
the right to receive benefits from the VIE. The update also requires ongoing
assessments as to whether an entity is the primary beneficiary of a VIE
(previously, reconsideration was only required upon the occurrence of specific
events), modifies the presentation of consolidated VIE assets and liabilities,
and requires additional disclosures about a company’s involvement in VIEs. This
update will be effective for the company beginning January 1, 2010. Management
is currently evaluating the effect that adoption of this update will have, if
any, on the company’s consolidated financial position and results of operations
when it becomes effective in 2010.





Other
Accounting Standards Updates not effective until after September 30, 2009, are
not expected to have a significant effect on the company’s consolidated
financial position or results of operations.





NOTE
4.   DISCONTINUED OPERATIONS





The loss
from discontinued operations for the three and nine months ended September 30,
2009 of $235,000 relates to a write-off of a receivable from the disposition of
Zoo Digital that was determined to be uncollectible in the three months ended
September 30, 2009.


F-12


The loss
from discontinued operations for the three and nine months ended September
30, 2008 is summarized as follows:





(Amounts in Thousands)Three Months Ended
                          September 30, 2008
                        
                        
                        Nine Months Ended
                          September 30, 2008Supervillain
                        
                        $
                        1,644
                        
                        
                        $
                        3,174Zoo
      Digital
                        
                        
                        527
                        
                        
                        
                        1,204Repliqa
                        
                        
                        -
                        
                        
                        
                        219Online
      concept
                        
                        
                        25
                        
                        
                        
                        147Tax
      benefit
                        
                        
                        (465
                        )
                        
                        
                        (465
                        )Loss
      from discontinued operations
                        
                        $
                        1,731
                        
                        
                        $
                        4,279





The
revenues from the discontinued operations for the three and nine months ended
September 30, 2008 were $951,000 and approximately $1.9 million,
respectively.





NOTE
5.   INVENTORY





Inventory
consisted of:


(Amounts in Thousands)September 30,
                      
                      
                      December 31,2009
                      
                      
                      2008Finished
      products
                      
                      $
                      1,568
                      
                      
                      $
                      2,939Parts
      and supplies
                      
                      
                      608
                      
                      
                      
                      181Totals
                      
                      $
                      2,176
                      
                      
                      $
                      3,120


Estimated
product returns included in inventory at September 30, 2009 and December 31,
2008 were $122,000 and $337,000, respectively.





NOTE
6.   PREPAID EXPENSES AND OTHER CURRENT ASSETS





Prepaid
expense and other current assets consisted of:





(Amounts in Thousands)September30,2009
                                  
                                  
                                  December31,2008Vendor
      advances for inventory
                                  
                                  $
                                  3,174
                                  
                                  
                                  $
                                  555Prepaid
      royalties
                                  
                                  
                                  689
                                  
                                  
                                  
                                  1,072Income
      taxes receivable
                                  
                                  
                                  -
                                  
                                  
                                  
                                  55Other
      prepaid expenses
                                  
                                  
                                  511
                                  
                                  
                                  
                                  442Totals
                                  
                                  $
                                  4,374
                                  
                                  
                                  $
                                  2,124





NOTE
7.   PRODUCT DEVELOPMENT COSTS





Details
of our capitalized product development costs were as follows:





(Amounts in thousands)September 30,
                      
                      
                      December 31,2009
                      
                      
                      2008Product
      development costs, internally developed,net of
amortization
                      
                      $
                      25
                      
                      
                      $
                      170Product
      development costs, externally developed,net of
amortization
                      
                      
                      5,714
                      
                      
                      
                      5,168Totals
                      
                      $
                      5,739
                      
                      
                      $
                      5,338





NOTE
8.   GOODWILL and INTANGIBLE ASSETS, NET





In the
three months ended September 2009, we recorded impairment of goodwill and other
intangible assets of $22.0 million.  The impairment was computed based
on the November 2009 equity infusion of at least $4.0 million for 50% of the
Company and converting the existing convertible debt, resulting in an estimated
pro-forma market capitalization of approximately $8.0 million as of September
30, 2009.  The impairment was applied $14.7 million to goodwill and
$7.3 million to the content portion of other intangible assets.  The
Company will perform a formal impairment analysis during the fourth quarter of
2009 and adjust the impairment estimates accordingly, if
necessary.


F-13


The
following table sets forth the components of the intangible assets subject to
amortization:





Estimated
                                      
                                      
                                      
                                      
                                      (Amounts in Thousands)
                                        September30,2009
                                      
                                      December 31, 2008Useful
                                      
                                      GrossLives
                                      
                                      Carrying
                                      
                                      
                                      Accumulated
                                      
                                      
                                      
                                      
                                      Net Book
                                      
                                      Net Book(Years)
                                      
                                      Amount
                                      
                                      
                                      Amortization
                                      
                                      
                                      Impairment
                                      
                                      Value
                                      
                                      ValueContent
                                      
                                      10
                                      
                                      
                                      $
                                      14,965
                                      
                                      
                                      $
                                      2,250
                                      
                                      
                                      $
                                      7,296
                                      
                                      
                                      $
                                      5,419
                                      
                                      
                                      $
                                      10,931Trademarks
                                      
                                      10
                                      
                                      
                                      
                                      1,510
                                      
                                      
                                      
                                      271
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      1,239
                                      
                                      
                                      
                                      1,353Customer
      relationships
                                      
                                      10
                                      
                                      
                                      
                                      2,749
                                      
                                      
                                      
                                      493
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      2,256
                                      
                                      
                                      
                                      2,463Totals
                                      
                                      
                                      
                                      
                                      
                                      $
                                      19,224
                                      
                                      
                                      $
                                      3,014
                                      
                                      
                                      $
                                      7,296
                                      
                                      
                                      $
                                      8,914
                                      
                                      
                                      $
                                      14,747





Amortization
expense related to intangible assets was $476 and $411 for the three months
ended September 30, 2009 and 2008, respectively and was approximately $1.3
million and $1.2 million for the nine months ended September 30, 2009 and
2008, respectively.





In May
2009, we entered into a license agreement with New World IP, LLC (“Licensor”)
pursuant to which the Licensor granted to Zoo Publishing all of the Licensor’s
rights to substantially all the intellectual property of Empire Interactive
Europe, LLC for a minimum royalty of $2.6 million to be paid within two
years.  At any time prior to April 1, 2011, Zoo Publishing has the
option to purchase all rights in and to the Games.  At any time after
April 1, 2011, Licensor has the right to sell all rights in and to the
Games to Zoo Publishing. The $2.6 million of costs related to this agreement
have been capitalized and are included in Intangible Assets and will be
amortized over ten years, while $2.3 million of the liability is recorded in
other long-term liabilities and $300,000 is recorded in accrued expenses in the
balance sheet.





The
following table presents the estimated amortization of intangible assets, based
on our present intangible assets, for the next five years as
follows:




Year Ending December 31,
                      
                      (Amounts
      in Thousands)Balance
      of 2009
                      
                      $
                      2232010
                      
                      
                      8912011
                      
                      
                      8912012
                      
                      
                      8912013
                      
                      
                      891Thereafter
                      
                      
                      5,127Total
                      
                      $
                      8,914





NOTE
9.   CREDIT AND FINANCING ARRANGEMENTS, ATARI AGREEMENT AND OTHER
CUSTOMER ADVANCES





In
connection with the Zoo Publishing acquisition, the Company entered into the
following credit and finance arrangements:





The
Company and Zoo Publishing entered into a purchase order financing agreement
with Transcap Trade Finance, LLC (“Transcap”) on December 19, 2007. This
agreement made the Company a party to a Master Purchase Order Assignment
Agreement dated August 20, 2001 pursuant to which Transcap agreed to provide
purchase order financing to or for the benefit of Zoo Publishing. Total advances
under the factoring arrangement include letters of credit for purchase order
financing and is limited to $10.0 million. The amounts outstanding as of
September 30, 2009 and December 31, 2008 were approximately $2.9 million and
$855,000, respectively. The interest rate is prime plus 4.0% on outstanding
advances. As of September 30, 2009 and December 31, 2008, the effective interest
rates were 7.25%.  The charges and interest expense on the advances
are included in the cost of goods sold in the accompanying condensed
consolidated statement of operations.


F-14


On April
6, 2009, we entered into an amended and restated purchase order financing
arrangement with Wells Fargo Bank, National Association (“Wells Fargo”) pursuant
to an amended and restated master purchase order assignment agreement (the
“Assignment Agreement”). The Assignment Agreement amended and restated in
its entirety the master purchase order assignment agreement between Transcap and
Zoo Publishing, dated as of August 20, 2001, as amended.





Pursuant
to the Assignment Agreement, the Company will assign purchase orders received
from customers to Wells Fargo, and request that Wells Fargo purchase the
required materials to fulfill such purchase orders. Wells Fargo, which may
accept or decline the assignment of specific purchase orders, will retain us to
manufacture, process and ship ordered goods, and will pay us for our services
upon Wells Fargo’s receipt of payment from the customers for such ordered
goods. Upon payment in full of the purchase order invoice by the applicable
customer to Wells Fargo, Wells Fargo will re-assign the applicable purchase
order to us. We will pay to Wells Fargo a fee upon their funding of each
purchase order and we commit to pay a total fee for twelve months in the
aggregate amount of $337,500. If the fees earned during the twelve month period
do not exceed $337,500, we are required to pay the difference between the
$337,500 and the amounts already paid on the earlier of the twelve month
anniversary of the date of the Assignment Agreement, or the date of termination
of the Assignment Agreement. Wells Fargo is not obligated to provide
purchase order financing under the Assignment Agreement if the aggregate
outstanding funding exceeds $5,000,000. The Assignment Agreement is for an
initial term of twelve months, and shall continue thereafter for successive
twelve month renewal terms unless either party terminates the Assignment
Agreement by written notice to the other no later than 30 days prior to the end
of the initial term or any renewal term. If the term of the Assignment
Agreement is renewed for one or more twelve month terms, for each such twelve
month term, we will pay to Wells Fargo a commitment fee in the sum of $337,500,
to be offset against actual fees paid by us upon their payment of each purchase
order, to be paid on the earlier of the twelve month anniversary of such renewal
date or the date of termination of the Assignment Agreement. The initial
and renewal commitment fees are subject to waiver if certain product volume
requirements are met.





In
connection with the Assignment Agreement, on April 6, 2009 we also entered into
an amended and restated security agreement and financing statement (the
“Security Agreement”) with Wells Fargo. The Security Agreement amends and
restates in its entirety that certain security agreement and financing
statement, by and between Transcap and Zoo Publishing, dated as of August 20,
2001. Pursuant to the Security Agreement, we granted to Wells Fargo a first
priority security interest in certain of our assets as set forth in the Security
Agreement, as well as a subordinate security interest in certain other of our
assets (the “Common Collateral”), which security interest is subordinate to the
security interests in the Common Collateral held by certain of our senior
lenders, as set forth in the Security Agreement.





Also in
connection with the Assignment Agreement, on April 6, 2009, Mark Seremet,
President, Chief Executive Officer and a director of Zoo Entertainment and Zoo
Games, and David Rosenbaum, the President of Operations of Zoo Publishing,
entered into a Guaranty with Wells Fargo, pursuant to which Messrs. Seremet and
Rosenbaum agreed to guaranty the full and prompt payment and performance of the
obligations under the Assignment Agreement and the Security
Agreement.





On May
12, 2009, the Company entered into a letter agreement with each of Mark Seremet
and David Rosenbaum (the “Fee Letters”), pursuant to which, in consideration for
Messrs. Seremet and Rosenbaum entering into the Guaranty with Wells Fargo for
the full and prompt payment and performance by the Company and its subsidiaries
of the obligations in connection with a purchase order financing (the “Loan”),
the Company agreed to compensate Mr. Seremet in the amount of $10,000 per month,
and Mr. Rosenbaum in the amount of $7,000 per month, for so long as the
executive remains employed while the Guaranty and Loan remain in full force and
effect. If the Guaranty is not released by the end of the month following
termination of employment of either Messrs. Seremet or Rosenbaum, the monthly
fee shall be doubled for each month thereafter until the Guaranty is
removed.


F-15


Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the Company’s
2007 Employee, Director and Consultant Stock Plan, as amended to each of Messrs.
Seremet and Rosenbaum, on such date that is the earlier of the conversion of at
least 25% of all currently existing convertible debt of the Company into equity,
or November 8, 2009 (the earlier of such date, the “Grant Date”), an option to
purchase that number of shares of the Company’s common stock equal to 6% and 3%
respectively, of the then issued and outstanding shares of common stock, based
on a fully diluted current basis assuming those options and warrants that have
an exercise price below $0.40 per share are exercised on that date but not
counting the potential conversion to equity of any outstanding convertible notes
that have not yet been converted and, inclusive of any options or other equity
securities or securities convertible into equity securities of the Company that
each may own on the Grant Date. The options shall be issued at an exercise
price equal to the fair market value of the Company’s common stock on the Grant
Date and pursuant to the Company’s standard form of nonqualified stock option
agreement; provided however that in the event the Guaranty has not been released
by Wells Fargo Bank as of the date of the termination of the option due to
termination of service, the option termination date shall be extended until the
earlier of the date of the release of the Guaranty or the expiration of the ten
year term of the option. In addition any options owned by Messrs. Seremet
and Rosenbaum as of the Grant Date with an exercise price that is higher than
the exercise price of the new options shall be cancelled as of the Grant Date.
The Company estimated the value of the arrangements to be approximately $200,000
as of September 30, 2009 and is included as compensation in the nine months
ended September 30, 2009, and has been included in accrued expenses. Once the
options are issued, we will adjust the expense accordingly.  As part of the
November 2009 financing, Messrs. Seremet and Rosenbaum agreed to amend their
respective Fee Letters, pursuant to which: in the case of Mr. Seremet, the
Company will pay to Mr. Seremet a fee of $10,000 per month for so long as the
Guaranty remains in full force and effect, but only for a period ending on
November 20, 2010; and, in the case of Mr. Rosenbaum, the Company will pay to
Mr. Rosenbaum a fee of $7,000 per month for so long as the Guaranty remains in
full force and effect, but only for a period ending on November 20,
2010.  In addition, the amended Fee Letters provides that, in
consideration of each of their continued personal guarantees, the Company’s
Board of Directors has approved an increase in the issuance of an option to
purchase (restricted stock or other incentives intended to comply with Section
409A of the Internal Revenue Code, equal to) a 6.25% ownership interest, to each
of Mr. Seremet and Mr. Rosenbaum respectively.





Zoo
Publishing uses a factor to approve credit and to collect the proceeds from a
portion of its sales. In August 2008, Zoo Publishing entered into a
factoring agreement with Working Capital Solutions, Inc., which utilizes
existing accounts receivable in order to provide working capital to fund all
aspects of our continuing business operations. A new factoring agreement was
entered into on September 29, 2009 with Working Capital Solutions,
Inc.  Under the terms of our factoring and security agreement, we sell
our receivables to the factor, with recourse. The factor, in its sole
discretion, determines whether or not it will accept each receivable based upon
the credit risk factor of each individual receivable or account. Once a
receivable is accepted by the factor, the factor provides funding subject to the
terms and conditions of the factoring and security agreement. The amount
remitted to us by the factor equals the invoice amount of the receivable
adjusted for any discounts or allowances provided to the account, less 25% which
is deposited into a reserve account established pursuant to the agreement, less
allowances and fees. In the event of default, valid payment dispute, breach of
warranty, insolvency or bankruptcy on the part of the receivable account, the
factor can require the receivable to be repurchased by us in accordance with the
agreement. The amounts to be paid by us to the factor for any accepted
receivable include a factoring fee of 0.6% for each ten (10) day period the
account is open. Since the factor acquires the receivables with recourse,
we record the gross receivables including amounts due from our customers to the
factor and we record a liability to the factor for funds advanced to us from the
factor. During the nine months ended September 30, 2009, we sold $832,000 of
receivables to the factor with recourse.  At September 30, 2009,
accounts receivable included $832,000 of amounts due from our customers to the
factor and the factor had an advance outstanding to the Company of $624,000. At
December 31, 2008, accounts receivable did not include any amounts due from our
customers to the factor and the factor did not have any advance outstanding to
the Company. In connection with the factoring facility, on September 29, 2009,
Mark Seremet, President, Chief Executive Officer and a director of the Company
and Zoo Games, and David Rosenbaum, the President of Operations of Zoo
Publishing, entered into a Guaranty with Working Capital Solutions, Inc.,
pursuant to which Messrs. Seremet and Rosenbaum agreed to guaranty the full and
prompt payment and performance of the obligations under factoring and security
agreement.


F-16


Atari
Agreement





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari will
resell the products to wholesalers and retailers that are acceptable to Atari in
North America. The agreement initially expired on March 31, 2009, but was
amended to extend the term for certain customers until March 31, 2010. This
agreement provided for Atari to prepay to the Company for the cost of goods and
pay the balance due within 15 days of shipping the product. Atari’s fees
approximate 10% of our standard selling price and they have been recorded as a
reduction in revenue. During the three and nine months ended September 30,
2009, we recorded approximately $2.5 million and $23.5 million, respectively, of
net sales to Atari.  Atari takes a reserve from the initial payment
for potential customer sales allowances, returns and price protection that is
analyzed and reviewed within a sixty day period to be liquidated no later than
July 31, 2010.  As of September 30, 2009 and December 31, 2008,
Atari had prepaid the Company approximately $3.2 million and approximately $1.8
million, respectively, for goods not yet shipped which is recorded as customer
advances in current liabilities. Also, as of September 30, 2009 and
December 31, 2008, Atari owed the Company $264,000 and approximately $1.8
million, respectively, before allowances, for goods already shipped which are
recorded in accounts receivable.





Other Customer
Advance–
Solutions 2 Go, Inc.





On August
31, 2009, Zoo Publishing entered into an Exclusive Distribution Agreement with
Solutions 2 Go Inc., a Canadian corporation (“S2G Inc.”) and an Exclusive
Distribution Agreement with Solutions 2 Go, LLC, a California limited liability
company (“S2G LLC,” and together with S2G Inc., “S2G”), pursuant to which Zoo
Publishing granted to S2G the exclusive rights to market, sell and distribute
certain video games, related software and products, with respect to which Zoo
Publishing owns rights, in the territories specified therein.  In
connection with these distribution agreements, on August 31, 2009, the
Company entered into an Advance Agreement (the “Advance Agreement”) with S2G,
pursuant to which S2G made a payment to the Company in the amount of $1,999,999,
in advance of S2G’s purchases of certain products pursuant to
these distribution agreements. From August 31, 2009 until recoupment of the
advance in full, interest on the outstanding amount shall accrue at the rate of
ten percent (10%) per annum. The amount of any unrecouped advance outstanding
shall be repaid in its entirety to S2G no later than September 15, 2010. The
advance shall be recouped, in whole or in part, from sales generated by S2G of
products purchased by S2G under the distribution agreements. A percentage of the
gross margin on the S2G Sales shall be applied to a recoupment of the advance
until the earlier of (i) the date on which the amount of the unrecouped advance
has been reduced to zero or (ii) September 15, 2010, on which any unrecouped
advance shall be repaid. As of September 30, 2009, the balance remaining on the
advance is $1,986,000 and this is included in customer advances in the current
liabilities section of the balance sheet.





Notwithstanding
the foregoing, if, at any time prior to the recoupment of the advance in full,
the Company receives proceeds in connection with any sale of securities, or
otherwise raises additional capital, exceeding an aggregate of five million
dollars ($5,000,000), other than under the anticipated qualified financing, (as
defined below), the entire unrecouped advance under the advance agreement shall
at once become due and payable in full as of the funding date of the additional
capital transaction without written notice of acceleration to the
Company.  Additional capital transaction shall include, but not be
limited to the sale or issuance of any security by the Company, or any
subsidiary of the Company, of any kind or character whatsoever, where “security”
is given its broadest meaning including stock, warrants, options, convertible
notes, and similar instruments of all types.





In consideration
of S2G entering into the advance agreement, the Company agreed to issue to S2G
Inc. a warrant to purchase 7,665,731 shares of the Company’s common
stock (or such other number of shares of Common Stock that on the warrant
grant date (as defined below), represents 6% of the Company’s modified
fully-diluted shares, computed as if all outstanding convertible stock, warrants
and stock options that are, directly or indirectly, convertible into Common
Stock at a price of $0.75 or less, have been so converted), upon the occurrence
of an anticipated qualified financing, which means (i) the consummation of the
sale of shares of Common Stock by the Company which results in aggregate gross
proceeds to the Company of at least $4,000,000 and (ii) the conversion of the
Company’s senior secured convertible notes, in the aggregate original principal
amount of $11,150,000, into shares of Common Stock.  The warrant will
have a term of five years and an exercise price equal to $0.30.  The
warrant to acquire 7,665,731 shares was issued on August 31,
2009.  The warrant was valued at $400,000 using the Black-Scholes
model and this cost will be amortized over twelve months through interest
expense.  For the period ended September 30, 2009, $33,000 of interest
expense is recorded in the statement of operations.


F-17


The
advance is guaranteed by Messrs. Seremet, Rosenbaum and another
employee.  Messrs. Seremet and Rosenbaum did not receive any
additional compensation for this guarantee.  The employee who
guaranteed the advance was granted 500,000 shares of common
stock.  The value of the shares issued was computed at $100,000 and is
recorded in the general and administrative expenses in the three months ended
September 30, 2009.





NOTE
10.   ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES





Accrued
expenses and other current liabilities consisted of:





(Amounts in Thousands)September 30,
                    
                    
                    December 31,2009
                    
                    
                    2008Due
      to customers
                    
                    $
                    612
                    
                    
                    
                    710Obligation
      arising from Zoo Publishing acquisition
                    
                    
                    93
                    
                    
                    
                    254Obligations
      relating to Cyoob acquisition
                    
                    
                    100
                    
                    
                    
                    100Obligations
      to compensate current and former employees
                    
                    
                    650
                    
                    
                    
                    720Royalty
                    
                    
                    888
                    
                    
                    
                    252Operating
      expenses
                    
                    
                    637
                    
                    
                    
                    982Interest
                    
                    
                    -
                    
                    
                    
                    81Totals
                    
                    $
                    2,980
                    
                    
                    $
                    3,099





NOTE
11.   NOTES PAYABLE





Outstanding
notes payable, net of unamortized discounts, are as follows:





(Amounts in Thousands)September 30,
                  
                  
                  December 31,2009
                  
                  
                  2008Zoo
      Entertainment convertible notes, net of discounts attributable to the
      warrant value of $0 and $1,576
                  
                  $
                  11,150
                  
                  
                  $
                  9,574Interest
      on convertible notes
                  
                  
                  656
                  
                  
                  
                  2403.9% Zoo
      Publishing notes, net of discount of $0 and $1,030
                  
                  
                  -
                  
                  
                  
                  2,5362.95%
      note due June 2012 assumed from Zoo Publishing acquisition
                  
                  
                  300
                  
                  
                  
                  3708.25%
      Wachovia demand note assumed from Zoo Publishing
      acquisition
                  
                  
                  -
                  
                  
                  
                  45Note
      assumed from Zoo Publishing acquisition, 12% interest
                  
                  
                  -
                  
                  
                  
                  25Employee
      loans, payable on demand
                  
                  
                  -
                  
                  
                  
                  331Zoo
      Publishing employee loans at 4% interest
                  
                  
                  -
                  
                  
                  
                  268Totals
                  
                  
                  12,106
                  
                  
                  
                  13,389Current
      portion
                  
                  
                  11,926
                  
                  
                  
                  11,617Non-current
      portion
                  
                  $
                  180
                  
                  
                  $
                  1,772





The
principal and interest amounts for the Zoo Entertainment convertible notes were
converted into equity as part of the November 2009 financing.





The face
amounts of the notes payable as of September 30, 2009 are due as
follows:





(Amounts in Thousands)YearEndingDecember
                            
                            AmountDueBalance
      of 2009
                            
                            $
                            11,2002010
                            
                            
                            1202011
                            
                            
                            1202012
                            
                            
                            10Total
                            
                            $
                            11,450


F-18


Zoo
Entertainment Notes





On July
7, 2008, as amended on July 15, 2008 and July 31, 2008, the Company entered into
a note purchase agreement under which the purchasers agreed to provide loans to
the Company in the aggregate principal amount of $9.0 million, in consideration
for the issuance and delivery of senior secured convertible promissory
notes. In connection with the issuance of such notes, the Company issued to
the note holders warrants to purchase 8,181,818 shares of common stock of the
Company. The notes bear an interest rate of five percent (5%) for the one year
term of the note commencing from issuance, unless extended. Upon the occurrence
of an investor sale, as defined in the notes, the entire outstanding principal
amount of the notes and any accrued interest thereon will be automatically
converted into shares of common stock of the Company determined by dividing the
note balance by the lesser of (i) an amount equal to the price per share of
investor stock paid by the purchasers of such shares in connection with the
investor sale, or (ii) $2.00; provided, that in the event that the investor sale
is for less than $1.00 per share, then the notes will only be automatically
convertible with the consent of the Company.  In connection with the note
purchase agreement, the Company satisfied a management fee obligation by issuing
additional senior secured convertible promissory notes in the principal amount
of $750,000 and warrants to purchase 681,818 shares of common stock of the
Company. All of the warrants have a five year term and an exercise price of
$0.01 per share. Pursuant to a security agreement, by and among the Company and
the purchasers, dated as of July 7, 2008, as amended on August 12, 2008, the
Company granted a security interest in all of its assets to each of the
purchasers to secure the Company’s obligations under the notes.





On
September 26, 2008, the Company entered into a note purchase agreement pursuant
to which the purchasers agreed to provide a loan to the Company in the aggregate
principal amount of $1.4 million, in consideration for the issuance and delivery
of senior secured convertible promissory notes. In connection with the issuance
of such notes, the Company also issued warrants to purchase 1,272,726
shares of common stock of the Company to the note holders. The notes bear
an interest rate of five percent (5%) for the time period beginning on September
26, 2008 and ending on September 26, 2009, unless extended. On October 6, 2009,
the maturity date was extended to November 2, 2009 and on November 2, 2009, the
maturity date was subsequently extended to February 2, 2010.  Upon the
occurrence of an investor sale, as defined in the notes, the entire outstanding
principal amount of the notes and any accrued interest thereon will be
automatically converted into shares of common stock of the Company determined by
dividing the note balance by the lesser of (i) an amount equal to the price per
share of investor stock paid by the purchasers of such shares in connection with
the investor sale, or (ii) $2.00; provided, that in the event that the investor
sale is for less than $1.00 per share, then the notes will only be automatically
convertible with the consent of the Company. The warrants have a five year term
and an exercise price of $0.01 per share. Pursuant to a security agreement, by
and among the Company and the purchasers, dated September 26, 2008, the Company
granted a security interest in all of its assets to each of the purchasers to
secure the Company’s obligations under the notes.





The total
principal amount of all of the notes described above is approximately $11.15
million, $9.8 million of which was incurred prior to the date of the reverse
merger. The warrants issued with all the notes were valued at approximately $5.9
million by the Company and an independent valuation firm. We used the income and
market valuation approaches to derive the Company’s business enterprise value
and then used the Black-Scholes option-pricing model, applying discounts for
illiquidity and dilution, to calculate the value of the warrants. The total
deferred debt discount of $5.9 million is amortized over the one year life of
the notes. Prior to September 12, 2008, 4,545,455 warrants were exercised and
the interest expense related to the discount of these warrants was accelerated.
As of September 12, 2008, the deferred debt discount of the existing notes was
approximately $2.4 million and the net value of the notes recorded as of
September 12, 2008 was approximately $7.8 million. On September 26, 2008, we
issued $1.0 million of the notes and 909,090 of the warrants which were valued
at $527,000 using consistent valuation methodologies as those used for all the
previously issued notes. As of September 30, 2009, the net deferred debt
discount of all the notes is $0 and the net value of the notes recorded as of
September 30, 2009 is approximately $11.8 million including $656,000 of accrued
interest.


F-19





On June
26, 2009, the Company entered into Amendment No. 2 to Senior Secured Convertible
Note (“Amendment No. 2”), with the requisite holders (the “Holders”) of the
Company’s senior secured convertible notes issued in the aggregate principal
amount of $11.15 million.  Pursuant to Amendment No. 2, the parties
agreed to extend the maturity date of the notes that were originally scheduled
to mature during July 2009 to August 31, 2009, or, if the Company receives
comments from the SEC with respect to the Information Statement Pursuant to
Section 14(c) (the “Information Statement”) that the Company filed on July 7,
2009 in connection with an amendment to the Company’s Certificate of
Incorporation authorizing a sufficient number of shares of the Company’s common
stock to permit the conversion of the notes (“Certificate of Amendment”),
September 15, 2009. The Company did not receive comments from the SEC with
respect to the Information Statement and, as such, the maturity dates of such
notes shall be August 31, 2009. Amendment No. 2 also provides that the notes
shall automatically convert into shares of the Company’s common stock effective
immediately on the date by which the following two events have occurred,
regardless of the order in which they occur: (a) the effectiveness of the filing
the Certificate of Amendment, and (b) the consummation of a financing by the
Company for which such sale results in aggregate gross proceeds to the Company
of at least $4.0 million. Notwithstanding, if the notes do not convert on or
prior to the revised maturity date, Amendment No. 2 provides that the provisions
of Amendment No. 2 with respect to automatic conversion shall become null and
void and shall be of no further effect. In consideration of the Holders’
execution and delivery of Amendment No. 2, the Company entered into a letter
agreement, dated as of June 26, 2009, pursuant to which the Company granted to
the Holders registration rights which require the Company to file with the SEC a
registration statement covering the resale of the shares of common stock
issuable upon conversion of the notes, within 30 calendar days after receipt of
approval of the Company’s stockholders of the Certificate of Amendment or 60
calendar days following the closing of a financing by the Company for which such
sale results in aggregate gross proceeds to the Company of at least $4.0
million, whichever is later.  The Company entered into subsequent
amendments with the Holders extending the maturity date to November 2, 2009 and
then subsequently to February 2, 2010.  On November 20, 2009, the
requisite Senior Secured Convertible Note Holders agreed that if the Company
raises a minimum of $4.0 million new capital, they will convert their debt into
convertible preferred shares of the Company that will ultimately convert into
common shares that represent 36.5% of the equity of the Company. As a result of
the Company consummating an approximately $4.2 million preferred equity raise on
November 20, 2009, upon which approximately $11.8 million of existing debt
including related accrued interest converted into convertible preferred equity,
the Company will issue shares of Series B Preferred stock to the Senior
Convertible Note Holders in exchange for their Notes.





Zoo
Publishing Notes





In
connection with the acquisition of Zoo Publishing, the Company issued various
promissory notes (“Zoo Publishing Note”) in an aggregate of approximately $6.8
million. Approximately $1.8 million of principal was payable at the earlier of
the Company’s completion of another round of financing or by December 2008 with
the $5.0 million balance to be paid in two installments pursuant to the “Zoo
Publishing Note.” The first installment of $2.5 million of principal together
with accrued interest at the rate of 3.9% per annum would be due on the earlier
of June 18, 2009 and the date on which the Company consummates a round of equity
financing of $40.0 million or more. The balance of the Zoo Publishing Note
(including accrued interest) would be payable December 18, 2010. In connection
with the aforementioned note, the Company recorded a debt discount of
approximately $2.3 million. For the three and nine months ended
September 30, 2009, amortization of deferred debt discount and interest
expense was $0, $294,000, $0 and $64,000, respectively. For the three and
nine months ended September 30, 2008, amortization of deferred debt
discount and interest expense was $146,000, $754,000, $32,000 and $164,000,
respectively. In July 2008, the $6.8 million of notes were restructured and
approximately $3.2 million of this debt was converted to common stock of the
Company based on fair value and of the remaining $3.6 million, approximately
$1.1 million became due September 18, 2009, $113,000 became due September 18,
2010, $2.0 million became due December 18, 2010 and approximately $316,000
became due July 31, 2011.





In
connection with the Settlement Agreement dated June 18, 2009 (See Notes 14 and
18), all the Zoo Publishing Notes were cancelled and no cash payments were
required to be made for either the principal amounts of the notes or the
interest accrued. The net amount of the obligation relieved for the Zoo
Publishing Notes was approximately $3.0 million and is included in the gain on
legal settlement on the statement of operations (see Note 14).





In
connection with the acquisition of Zoo Publishing, the Company also assumed a
liability of $1.2 million as part of the Zoo Publishing purchase price. Other
notes payable assumed from the Zoo Publishing acquisition included:





·
            $200,000
      demand note with 12.0% percent interest per annum, callable in six months,
      minimum guaranteed interest per renewal is $12,000. The note is guaranteed
      by the Zoo Publishing President. The note was totally paid off by
      March 31, 2009.





·
            Zoo
      Publishing purchased treasury stock from a former employee in December
      2006 for the amount of $650,000. The balance on the note as of
      September 30, 2009 was $300,000; $120,000 is classified as current
      and $180,000 is classified as long-term. The payments are due monthly and
      the amount of the payment is $10,000 per
month.


F-20


NOTE
12.   INCOME TAXES





Through
May 15, 2008, the Company and certain of its consolidated subsidiaries were
taxed as a partnership under the provisions of the Internal Revenue
Code. Accordingly, the losses incurred by the Company and those
subsidiaries through May 15, 2008 were allocated to the respective members and
reported on their individual tax returns. Effective May 16, 2008, the
Company changed its tax status from a partnership to a corporation and, as a
result, began filing consolidated corporate tax returns with its domestic
subsidiaries. The provision for income taxes is based on income recognized
for financial statement purposes and includes the effects of temporary
differences between such income and that recognized for tax return purposes as
well as the deferred tax assets and liabilities recognized for existing timing
items relating to the Company's change in tax status.





The
components of income tax benefit for the nine months ended September 30,
2009 are as follows (in thousands):





Current:Federal
                    
                    $
                    —State
                    
                    
                    152Total
      Current
                    
                    
                    152Deferred:Federal
                    
                    
                    —State
                    
                    
                    (152)Total
      Deferred
                    
                    
                    (152)Total
                    
                    $
                    —




We paid
$20,000 to various state jurisdictions for income taxes during the nine months
ended September 30, 2009.





The
reconciliation of income tax benefit computed at the U.S. statutory tax rates to
income tax benefit for the nine months ended September 30, 2009
is:





Tax
      at U.S. federal income tax rates
                        
                        
                        (34.0
                        )%State
      taxes, net of federal income tax benefit
                        
                        
                        (2.5
                        )%Valuation
      allowance
                        
                        
                        14.4
                        %Nondeductible
      expenses and other
                        
                        
                        22.1
                        %0.0
                        %





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the
Company's deferred tax assets and liabilities as of September 30, 2009 are
as follows (in thousands):





Deferred tax assets:
                      
                      Current
                      
                      
                      Long TermNet
      operating loss carried forward
                      
                      $
                      -
                      
                      
                      $
                      3,625Capital
      loss carried forward
                      
                      
                      -
                      
                      
                      
                      515Allowance
      for doubtful accounts
                      
                      
                      371
                      
                      
                      
                      -Bonus
      and other accruals
                      
                      
                      542
                      
                      
                      
                      36Interest
      on convertible notes
                      
                      
                      260
                      
                      
                      
                      -Non-qualified
      options
                      
                      
                      -
                      
                      
                      
                      520Gross
      deferred tax assets
                      
                      
                      1,173
                      
                      
                      
                      4,696Valuation
      allowance
                      
                      
                      (682)
                      
                      
                      
                      (2,732
                      )Net
      deferred tax assets
                      
                      
                      491
                      
                      
                      
                      1,964Deferred
      tax liabilities:Property
      and equipment
                      
                      
                      -
                      
                      
                      
                      (23
                      )Intangibles
                      
                      
                      -
                      
                      
                      
                      (2,432
                      )Total
      deferred tax liabilities
                      
                      
                      -
                      
                      
                      
                      (2,455
                      )Net
      deferred tax asset (liability)
                      
                      $
                      491
                      
                      
                      $
                      (491
                      )


F-21


The
Company has approximately $1.2 million of available capital loss carried forward
which expires in 2013. A valuation allowance of approximately $515,000 has
been recognized to offset the deferred tax assets related to these carried
forward. The Company currently does not have any capital gains to utilize
against this capital loss. If realized, the tax benefit of this item will
be applied to reduce future capital gains of the
Company.  Additionally, a valuation allowance of approximately $2.9
million has been recognized to offset the net remaining deferred tax assets in
excess of deferred tax liabilities because we cannot reasonably project if and
when we will generate enough taxable income to utilize any of the deferred tax
assets.





As of
September 30, 2009, the Company has U.S. federal net operating loss (NOL)
carried forward of approximately $8.4 million which are available to be
used to offset taxable U.S. income during the carried forward period. The
federal NOL will begin to expire in 2028. The Company has various state net
operating loss carried forward of approximately $9.4 million which will be
available to offset taxable state income during the carried forward period. The
state NOL will also begin to expire in 2028.  The tax benefit of these
items is reflected in the above table of deferred tax assets and
liabilities.  Generally, Section 382 of the Internal Revenue Code
imposes limits on the utilization of net operating loss carryforwards if the
Company experiences a greater than 50% change of ownership in a three year
period.  The Company will conduct a study to determine if it has had
the requisite change of ownership for section 382 to apply.  If the
requisite change of ownership has occurred or occurs in the future, the
utilization of the net operating loss carryforwards may be
limited.


NOTE
13.  STOCKHOLDERS’ EQUITY (DEFICIENCY) AND STOCK-BASED COMPENSATION
ARRANGEMENTS





Common
Stock





The
Company has authorized 250,000,000 shares of common stock, par value $0.001, and
5,000,000 preferred shares, par value $0.001. As of September 30, 2009,
there were 39,425,755 shares of common stock issued and 31,624,429 shares of
common stock outstanding.




On June
26, 2009, our Board of Directors and stockholders holding approximately 63.6% of
our outstanding common stock approved an amendment to our Certificate of
Incorporation to increase the number of authorized shares of common stock from
75,000,000 shares to 250,000,000 shares (the “Share Increase”). The consents we
have received constitute the only stockholder approval required for the Share
Increase under the Delaware General Corporation Law (the “DGCL”) and our
existing Certificate of Incorporation and Bylaws. Pursuant to Rule 14c-2 of
the Securities Exchange Act of 1934, as amended, stockholder approval of these
amendments will become effective on or after such date that is approximately 20
calendar days following the date we first mailed the Information Statement to
our stockholders. After such date, the board of directors may implement the
Share Increase at any time, at its discretion, by filing a Certificate of
Amendment to our Certificate of Incorporation with the Secretary of State of the
State of Delaware. The Information Statement was first sent to our
stockholders on July 31, 2009. The board of directors effectuated the Share
Increase on August 26, 2009.





In
conjunction with the settlement of the litigation with the sellers of Zoo
Publishing on June 18, 2009 (see Notes 14 and 17), the sellers returned
5,563,950 shares of common stock to the Company.  These shares were
valued at $0.20 and recorded as treasury shares.





Options





As of
December 31, 2008, the Company’s 2007 Employee, Director and Consultant Stock
Plan allowed for an aggregate of 1,000,000 shares of common stock with respect
to which stock rights may be granted and a 250,000 maximum number of shares of
common stock with respect to which stock rights may be granted to any
participant in any fiscal year. As of December 31, 2008, an aggregate of
975,000 shares of restricted common stock of the Company are outstanding under
the Company’s 2007 Employee, Director and Consultant Stock Plan, and 25,000
shares of common stock were reserved for future issuance under this
plan.


F-22


On
January 14, 2009, the Company’s Board of Directors approved and adopted an
amendment to the 2007 Employee, Director and Consultant Stock Plan, which
increased the number of shares of common stock that may be issued under the
plan from 1,000,000 shares to 4,000,000 shares, and increased the maximum number
of shares of common stock with respect to which stock rights may be granted to
any participant in any fiscal year from 250,000 shares to 750,000 shares. All
other terms of the plan remain in full force and effect.





On
January 14, 2009, the Company granted Mr. Seremet an option to purchase 750,000
shares of the Company’s common stock at an exercise price of $0.30 per share,
pursuant to the Company’s 2007 Plan, as amended. There were no other options
issued during the nine months ended September 30, 2009.





On May
12, 2009, the Company entered into a letter agreement with each of Mark Seremet
and David Rosenbaum, pursuant to which, in consideration for Messrs. Seremet and
Rosenbaum entering into a Guaranty with Wells Fargo for the full and prompt
payment and performance by the Company and its subsidiaries of the obligations
in connection with a purchase order financing (the “Loan”) (see Note 18), the
Company agreed to grant under the Company’s 2007 Employee, Director and
Consultant Stock Plan, as amended to each of Messrs. Seremet and Rosenbaum, on
such date that is the earlier of the conversion of at least 25% of all currently
existing convertible debt of the Company into equity, or November 8, 2009 (the
earlier of such date, the “Grant Date”), an option to purchase that number of
shares of the Company’s common stock equal to 6% and 3% respectively, of the
then issued and outstanding shares of common stock, based on a fully diluted
current basis assuming those options and warrants that have an exercise price
below $0.40 per share are exercised on that date but not counting the potential
conversion to equity of any outstanding convertible notes that have not yet been
converted and, inclusive of any options or other equity securities or securities
convertible into equity securities of the Company that each may own on the Grant
Date. The options shall be issued at an exercise price equal to the fair
market value of the Company’s common stock on the Grant Date and pursuant to the
Company’s standard form of nonqualified stock option agreement; provided however
that in the event the Guaranty has not been released by Wells Fargo as of the
date of the termination of the option due to termination of service, the option
termination date shall be extended until the earlier of the date of the release
of the Guaranty or the expiration of the ten year term of the option. In
addition any options owned by Messrs. Seremet and Rosenbaum as of the Grant Date
with an exercise price that is higher than the exercise price of the new options
shall be cancelled as of the Grant Date. As part of the November 2009
financing, Messrs. Seremet and Rosenbaum agreed to amend their respective letter
agreements, pursuant to which, in consideration of each of their continued
personal guarantees, the Company’s Board of Directors has approved an increase
in the issuance of an option to purchase (restricted stock or other incentives
intended to comply with Section 409A of the Internal Revenue Code, equal
to) a 6.25% ownership interest, to each of Mr. Seremet and Mr. Rosenbaum
respectively.





As of
September 30, 2009, there was approximately $185,000 of unrecognized
compensation cost related to non-vested stock option awards, which is expected
to be recognized over a remaining weighted-average vesting period of 2.0 - 2.2
years.





The
intrinsic value of options outstanding at September 30, 2009 is
$0.





Warrants





On August
31, 2009, in consideration of Solutions 2 GO Inc. entering into an
advance agreement with the Company, we issued to Solutions 2 GO Inc. a warrant
to purchase 7,665,731 shares of the Company’s common stock, par value $0.001 per
share. The warrants have a term of five years and an exercise price equal
to $0.30.





As of
September 30, 2009, there were 13,486,072 warrants outstanding. All are
currently exercisable and have a five-year life, expiring in 2012 through
2014.


F-23





NOTE
14.  GAIN ON LEGAL SETTLEMENT





On June
18, 2009, we settled a lawsuit brought by the former sellers of Zoo Publishing,
resulting in a net gain on legal settlement of approximately $4.3 million. (See
Note 17)





The
settlement eliminated the following Company’s obligations totaling
$3,925,000:


·
            outstanding
      notes with a face value of $3,565,900, discounted as of June 18, 2009 for
      $736,000 and interest accrued of
$219,000


·
            employee
      loans totaling $574,000


·
            other
      obligations for an aggregate amount of
$302,000





In
conjunction with the settlement of the litigation with the sellers of Zoo
Publishing, the sellers returned 5,563,950 shares of common stock to the
Company. These treasury shares were valued at $0.20 and included as part of the
gain on legal settlement for approximately $1.1 million.





The
Company’s remaining cash obligations and litigation expense amounted to
approximately $710,000, resulting in a total net gain on settlement of
approximately $4.3 million.





NOTE
15.   INSURANCE RECOVERY





During
the 2009 period, our third party warehouse received $860,000 from their
insurance company relating to losses incurred by us from a fire in October
2008.  Those proceeds were applied against other amounts due to the
third party warehouse by reducing our payables and are reported as other income
in the statement of operations.





NOTE 16.   INTEREST,
NET


(Amounts
      in Thousands)Three
      Months Ended
                  
                  
                  Nine
      Months EndedSeptember
      30,
                  
                  
                  September
      30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Interest
      arising from amortization of debt discount
                  
                  $
                  180
                  
                  
                  $
                  1,205
                  
                  
                  $
                  1,870
                  
                  
                  $
                  1,813Interest
      on various notes
                  
                  
                  190
                  
                  
                  
                  349
                  
                  
                  
                  533
                  
                  
                  
                  725Less
      interest income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (5
                  )Interest
      expense, net
                  
                  $
                  370
                  
                  
                  $
                  1,554
                  
                  
                  $
                  2,403
                  
                  
                  $
                  2,533





NOTE
17.   SUPPLEMENTAL CASH FLOW INFORMATION





Supplemental
cash flow information for the nine months ended September 30, 2009 and 2008 is
as follows:





(Amounts
      in Thousands)2009
                    
                    
                    2008Changes
      in other assets and liabilities:Accounts
      receivable
                    
                    $
                    (1,422
                    )
                    
                    $
                    (4,020
                    )Inventory
                    
                    
                    944
                    
                    
                    
                    (154
                    )Prepaid
      expenses and other current assets
                    
                    
                    (2,118
                    )
                    
                    
                    (3,532
                    )Product
      development costs
                    
                    
                    (401
                    )
                    
                    
                    (3,854
                    )Accounts
      payable
                    
                    
                    (112
                    )
                    
                    
                    989Customer
      advances
                    
                    
                    3,413Accrued
      expenses and other current liabilities
                    
                    
                    (716
                    )
                    
                    
                    248Net
      changes in other assets and liabilities
                    
                    $
                    (412
                    )
                    
                    $
                    (10,323
                    )Cash
      paid during the period of interest
                    
                    $
                    -
                    
                    
                    $
                    92Cash
      paid during the period of taxes
                    
                    $
                    20
                    
                    
                    $
                    6Non-cash
      investing and financing activities:Receipt
      of 5,563,950 shares for partial settlement of litigation
                    
                    $
                    1,113
                    
                    
                    $
                    -Notes
      and obligations relieved for partial settlement of
    litigation
                    
                    $
                    3,925
                    
                    
                    $
                    -Acquisition
      of Intangible for long-term obligation
                    
                    $
                    2,600
                    
                    
                    $
                    -Issuance
      of 1,580,237 shares for partial payment of Zoo Digital
                    
                    $
                    -
                    
                    
                    $
                    4,086Exchange
      of debt for equity at original face value
                    
                    $
                    -
                    
                    
                    $
                    6,266


F-24





NOTE
18.   LITIGATION





On February
19, 2009, Susan Kain Jurgensen, Steven Newton, Mercy Gonzalez, Bruce Kain,
Wesley Kain, Raymond Pierce and Cristie Walsh filed a complaint against Zoo
Publishing, Zoo Games and Zoo in the Supreme Court of the State of New York, New
York County, index number 09 / 102381 alleging claims
for breach of certain loan agreements and employment
agreements, intentional interference and fraudulent transfer.
The complaint sought compensatory damages, punitive damages and preliminary
and permanent injunctive relief, among other remedies. On June 18, 2009, we
reached a settlement whereby we agreed to pay to the plaintiffs an aggregate of
$560,000 (the “Settlement Amount”) in full satisfaction of the disputed claims,
without any admission of any liability of wrongdoing as follows: (a) $300,000 on
June 26, 2009; (b) $60,000 on or before the earlier of (i) the date that is 90
days from June 18, 2009 or (ii) the date the Company obtains new and available
financing, including any amounts currently held in escrow that will be released
from escrow after June 18, 2009, in any form and from any source, in an amount
totaling at least $2,000,000; (c) $100,000 on or before December 18, 2009; and
(d) $100,000 on or before June 18, 2010. To date, $300,000 of the Settlement
Amount has been paid to the plaintiffs. The Zoo Publishing Notes and all other
notes, employment,  agreements, loan agreements, options, warrants and
other agreements  relating to the plaintiffs (except with respect to
that certain Employment Agreement between Zoo Publishing and Cristie Walsh) were
terminated and all outstanding obligations of the Company related to these
agreements were cancelled. In addition, the plaintiffs returned to us an
aggregate of 5,563,950 shares of our common stock owned by them prior to such
date.





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., the claimant Revolution Partners, LLC was seeking money damages for
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We settled this claim in June 2009 for $140,000, of
which $120,000 was paid as of September 30, 2009.  The balance is
included in accounts payable as of September 30, 2009 and was paid in October
2009.





We are
also involved in various other legal proceedings and claims incident to the
normal conduct of our business. Although it is impossible to predict the outcome
of any legal proceeding and there can be no assurances, we believe that our
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material adverse effect on our financial condition, results of
operations or cash flows.





NOTE
19.   RELATED PARTY TRANSACTIONS





We leased
office space in New York from 575 Broadway Associates, LLC, a company owned
principally by one of our principal investors, from April 2007 to October 2008.
We paid rent expense of $0 and $209,000 during the nine months ended September
30, 2009 and 2008, respectively, to this related party.





Certain
Zoo Publishing employees loaned us an aggregate of up to $765,000 in 2008 on a
short-term basis. The Company accrued interest at 4% per annum and all amounts
were cancelled as part of the Settlement Agreement (see Note 11).





On April
6, 2009, we entered into an amended and restated purchase order financing
arrangement with Wells Fargo Bank, National Association (“Wells Fargo”) pursuant
to an amended and restated master purchase order assignment agreement (the
“Assignment Agreement”). In connection with the Assignment Agreement, on April
6, 2009 we also entered into an amended and restated security agreement and
financing statement (the “Security Agreement”) with Wells Fargo, pursuant to
which we granted to Wells Fargo a first priority security interest in certain of
our assets as set forth in the Security Agreement, as well as a subordinate
security interest in certain other of our assets (the “Common Collateral”),
which security interest is subordinate to the security interests in the Common
Collateral held by certain of our senior lenders, as set forth in the Security
Agreement. Also in connection with the Assignment Agreement, on April 6, 2009,
Mark Seremet, President and Chief Executive Officer of Zoo Games and a director
of Zoo Entertainment, and David Rosenbaum, the President of Zoo Publishing,
entered into a Guaranty with Wells Fargo, pursuant to which Messrs. Seremet and
Rosenbaum agreed to guaranty the full and prompt payment and performance of the
obligations under the Assignment Agreement and the Security Agreement. On May
12, 2009, we entered into a letter agreement with each of Mark Seremet and David
Rosenbaum (the “Fee Letters”), pursuant to which, in consideration for Messrs.
Seremet and Rosenbaum entering into the Guaranty with Wells Fargo for the full
and prompt payment and performance by the Company and its subsidiaries of the
obligations in connection with a purchase order financing (the “Loan”), we
agreed to compensate Mr. Seremet in the amount of $10,000 per month, and Mr.
Rosenbaum in the amount of $7,000 per month, for so long as the executive
remains employed while the Guaranty and Loan remain in full force and
effect. If the Guaranty is not released by the end of the month following
termination of employment of either Messrs. Seremet or Rosenbaum, the monthly
fee shall be doubled for each month thereafter until the Guaranty is
removed.


F-25





Additionally,
pursuant to the Fee Letters, we agreed to grant under the Company’s 2007
Employee, Director and Consultant Stock Plan, as amended to each of Messrs.
Seremet and Rosenbaum, on such date that is the earlier of the conversion of at
least 25% of all currently existing convertible debt of the Company into equity,
or November 8, 2009 (the earlier of such date, the “Grant Date”), an option to
purchase that number of shares of our common stock equal to 6% and 3%
respectively, of the then issued and outstanding shares of common stock, based
on a fully diluted current basis assuming those options and warrants that have
an exercise price below $0.40 per share are exercised on that date but not
counting the potential conversion to equity of any outstanding convertible notes
that have not yet been converted and, inclusive of any options or other equity
securities or securities convertible into our equity securities that each may
own on the Grant Date. The options shall be issued at an exercise price
equal to the fair market value of our common stock on the Grant Date and
pursuant to our standard form of nonqualified stock option agreement; provided
however that in the event the Guaranty has not been released by Wells Fargo Bank
as of the date of the termination of the option due to termination of service,
the option termination date shall be extended until the earlier of the date of
the release of the Guaranty or the expiration of the ten year term of the
option. In addition, any options owned by Messrs. Seremet and Rosenbaum as
of the Grant Date with an exercise price that is higher than the exercise price
of the new options shall be cancelled as of the Grant Date.  As part
of the November 2009 financing, Messrs. Seremet and Rosenbaum agreed to amend
their respective Fee Letters, pursuant to which: in the case of Mr. Seremet, the
Company will pay to Mr. Seremet a fee of $10,000 per month for so long as the
Guaranty remains in full force and effect, but only for a period ending on
November 20, 2010; and, in the case of Mr. Rosenbaum, the Company will pay to
Mr. Rosenbaum a fee of $7,000 per month for so long as the Guaranty remains in
full force and effect, but only for a period ending on November 20,
2010.  In addition, the amended Fee Letters provides that, in
consideration of each of their continued personal guarantees, the Company’s
Board of Directors has approved an increase in the issuance of an option to
purchase (restricted stock or other incentives intended to comply with Section
409A of the Internal Revenue Code, equal to) a 6.25% ownership interest, to
each of Mr. Seremet and Mr. Rosenbaum respectively.





NOTE
20.   SUBSEQUENT EVENTS





On
November 2, 2009, the Company entered into Amendment No. 5 to Senior Secured
Convertible Note with the requisite holders of the Company’s outstanding senior
secured convertible notes issued in the aggregate principal amount of
$11,150,000.  The amendment further extends the maturity date of the
notes to February 2, 2010.  Also, the amendment provides that the
notes shall automatically convert into shares of common stock upon the
consummation of a sale of shares of common stock that results in aggregate gross
proceeds to the Company of at least $4,000,000, at a price per share equal to
$0.20.   Notwithstanding, if the notes do not convert on or prior
to February 2, 2010, the amendment provides that the provisions of the notes, as
amended, with respect to automatic conversion shall become null and void and
shall be of no further effect.





On
November 20, 2009, the Company entered into Amendment No. 6 to Senior Secured
Convertible Note with the requisite holders of the Company’s outstanding senior
secured convertible notes issued in the aggregate principal amount of
$11,150,000.  The amendment provides that, among other things, the
outstanding principal balance and all accrued and unpaid interest under the
notes shall convert into shares of the Company’s Series B Preferred Stock upon
the consummation of an investor sale that results in aggregate gross proceeds to
the Company of at least $4,000,000, at a rate of one (1) share of Series B
Preferred Stock for each $10.00 of value of the note.   Moreover,
the amendment provides that the notes shall no longer be deemed to be
outstanding and all rights with respect to the notes shall immediately cease and
terminate upon automatic conversion, except for the right of each holder to
receive the shares to which it is entitled as a result of such
conversion.


F-26




On
November 20, 2009, the Company entered into a securities purchase agreement (the
“SPA”) with certain investors, consummating an approximately $4.2 million
convertible preferred equity raise, pursuant to which the Company will issue
Series A Preferred Stock that will convert into common shares of the Company
upon an increase in sufficient authorized common shares, representing 50% of the
equity of the Company. The Series A Preferred Stock will have a rate of one (1)
share of Series A Preferred Stock for each $2.50 of value of the investment
amount. In addition, on November 20, 2009, the lead investor under the SPA, will
receive a warrant to purchase shares of the Company’s common stock, par value
$0.001 per share.   Moreover, Messrs. Seremet and Rosenbaum
agreed to amend their respective fee letters, pursuant to which: in the case of
Mr. Seremet, the Company will pay to Mr. Seremet a fee of $10,000 per month for
so long as the personal guarantees in connection with certain financing
arrangements remain in full force and effect, but only for a period ending on
November 20, 2010; and, in the case of Mr. Rosenbaum, the Company will pay to
Mr. Rosenbaum a fee of $7,000 per month for so long as the personal guarantees
in connection with certain financing arrangement remains in full force and
effect, but only for a period ending on November 20, 2010.  In
addition, the amended Fee Letters provides that, in consideration of each of
their continued personal guarantees, the Company’s Board of Directors has
approved an increase in the issuance of an option to purchase (restricted stock
or other incentives intended to comply with Section 409A of the Internal Revenue
Code, equal to) a 6.25% ownership interest, to each of Mr. Seremet and Mr.
Rosenbaum respectively.  In addition, as a result of the Company
consummating an approximately $4.2 million preferred equity raise, the Company
will convert approximately $11.8 million of existing debt and related accrued
interest into Series B Preferred Stock. The Series A Preferred Stock and the
Series B Preferred Stock will convert into common shares of the Company upon a
sufficient increase in authorized common shares of the Company.





F-27




ITEM
2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION


AND
RESULTS OF OPERATIONS





In this
section, references to “we,” “us,” “our,” “ours,” and “the Company” refer to Zoo
Entertainment, Inc. (formerly known as Driftwood Ventures, Inc.) and its
operating and wholly-owned subsidiary, Zoo Games, Inc. (formerly known as Green
Screen Interactive Software, Inc.) and its operating and wholly owned
subsidiaries, Zoo Publishing, Inc. (formerly known as Destination Software,
Inc.) and Zoo Entertainment Europe Ltd.





The
following discussion should be read in conjunction with, and is qualified in its
entirety by, the financial statements and the notes thereto included in this
report. This discussion contains certain forward-looking statements that involve
substantial risks and uncertainties. When used in this report, the words
"anticipate," "believe," "estimate," "expect” and similar expressions as they
relate to our management or us are intended to identify such forward-looking
statements. Our actual results, performance or achievements could differ
materially from those expressed in, or implied by, these forward-looking
statements. Historical operating results are not necessarily indicative of the
trends in operating results for any future period.





Recent
Events





On
November 20, 2009, we consummated a convertible preferred equity raise of
approximately $4.2 million and converted approximately $11.8 million of debt,
including related accrued interest, to convertible preferred
equity.  The convertible preferred equity will convert to common
shares as soon as we have the sufficient number of common shares
authorized.  This transaction eliminates all of our long term
convertible debt and significantly improves our working capital
position.





Background
and History





We are a
developer, publisher and distributor of video game software for use on major
platforms including Nintendo’s Wii, DS, GBA, Sony’s PSP and PlayStation
2. In addition, we intend to publish packaged entertainment software titles
for use on a variety of other gaming platforms, including Sony’s PlayStation 3
and Microsoft’s Xbox 360. We will also seek to create and sell downloadable
games for Microsoft’s Xbox Live Arcade, Sony’s PlayStation 3 Network, Nintendo’s
Virtual Console, iPhone and for use on personal computers (PCs). Our
current video game titles are targeted at various demographics, primarily at a
lower-priced “value” title. In some instances, these titles are based on
licenses of well known properties and, in other cases based on original
properties. We collaborate and enter into agreements with content providers and
video game development studios for the creation of our video
games.


1





Zoo
Entertainment, Inc. was originally incorporated in the State of Nevada on
February 13, 2003 under the name Driftwood Ventures, Inc. On December 20,
2007, through a merger, the Company reincorporated in the State of Delaware as a
public shell company with no operations.





On July
7, 2008, the Company entered into an Agreement and Plan of Merger, as
subsequently amended on September 12, 2008 (the “Merger Agreement”) with DFTW
Merger Sub, Inc., a Delaware corporation and a wholly-owned subsidiary of the
Company (“Merger Sub”), Zoo Games and a stockholder representative, pursuant to
which Merger Sub would merge with and into Zoo Games, with Zoo Games as the
surviving corporation through an exchange of common stock of Zoo Games for
common stock of the Company (the “Merger”).





On
September 12, 2008, the Company, Merger Sub, Zoo Games and the stockholder
representative completed the Merger and each outstanding share of Zoo Games
common stock, $0.001 par value per share (the “Zoo Games Common Stock”), on a
fully-converted basis, converted automatically into and became exchangeable for
shares of the Company’s common stock, $0.001 par value per share, based on an
exchange ratio equal to 7.023274. In addition, each of the 334,983 options to
purchase shares of Zoo Games Common Stock (the “Zoo Games Options”) outstanding
under Zoo Games’ 2008 Long-Term Incentive Plan were assumed by the Company,
subject to the same terms and conditions as were applicable under such plan
immediately prior to the Merger, and converted into 243,040 options to purchase
shares of the Company’s common stock at an exercise price of $2.58 per share,
421,396 options to purchase shares of the Company’s common stock at an exercise
price of $2.25 per share and 1,688,240 options to purchase shares of the
Company’s common stock at an exercise price of $1.52 per share. The 246,243
warrants to purchase shares of Zoo Games Common Stock outstanding at the time of
the Merger (the “Zoo Games Warrants”) were assumed by the Company and converted
into 1,411,186 warrants to acquire shares of the Company’s common stock at an
exercise price of $2.84 and 318,246 warrants to acquire shares of the Company’s
common stock at an exercise price of $2.13 per share. The merger consideration
consisted (i) 26,098,303 shares of the Company’s common stock, (ii) the
reservation of 2,352,677 shares of the Company’s common stock that are required
for the assumption of the Zoo Games Options and (iii) the reservation of
1,729,432 shares of the Company’s common stock that are required for the
assumption of the Zoo Games Warrants.





Upon the
closing of the Merger, as the sole remedy for the Zoo Games stockholders’
indemnity obligations, on behalf of the Zoo Games stockholders pursuant to the
Merger Agreement, the Company deposited 2,609,861 shares of the Company’s common
stock, otherwise payable to such stockholders, into escrow to be held by the
escrow agent in accordance with the terms and conditions of an escrow
agreement.





Effective
as of the closing of the Merger, Zoo Games became the Company’s wholly-owned
subsidiary. As a result thereof, the historical and current business
operations of Zoo Games now comprise the Company’s principal business
operations.





Zoo Games
is treated as the acquirer for accounting purposes in this reverse merger and
the financial statements of the Company represent the historical activity of Zoo
Games and consolidate the activity of Zoo beginning on September 12, 2008, the
date of the reverse merger.





Zoo Games
commenced operations in March 2007 as Green Screen Interactive Software, LLC, a
Delaware limited liability company, and in May 2008, converted to a Delaware
corporation. On August 14, 2008, it changed its name to Zoo Games, Inc. Since
its initial organization and financing, Zoo Games embarked on a strategy of
partnering with and/or acquiring companies with compelling intellectual
property, distribution capabilities, and/or management with demonstrated records
of success.





In June
2007, Zoo Games acquired the assets of Supervillain Studios, Inc. which were
held by the wholly-owned subsidiary of Zoo Games, Supervillain Studios,
LLC. The acquisition provided Zoo Games with access to proprietary high end
casual gaming content, established video game designers, technical experts and
producers capable of providing Zoo Games with high quality, original casual
games. On July 22, 2008, Zoo Games released Order Up!, its first offering from
Supervillain. In our effort to refocus our cash on our core business, the
Company sold the assets of Supervillain Studios LLC back to its original owners
on September 16, 2008.


2





In
December 2007, Zoo Games acquired the capital stock of Zoo Publishing. The
acquisition of Zoo Publishing provided Zoo Games with a profitable core
business, North American distribution, and further enhanced its experienced
management team. Zoo Publishing distributes software titles throughout North
America and generated over $30 million in annual revenue in 2007. Zoo Publishing
expects to exploit its development expertise, in combination with its sales,
marketing and licensing expertise, to target the rapidly expanding market for
casual games, particularly on Nintendo’s platforms, where Zoo Publishing has
experienced considerable success. By nurturing and growing this business unit,
Zoo Games believes it will be able to rapidly build a much larger distribution
network, enabling it to place a significant number of software titles with major
retailers.





In April
2008, Zoo Games acquired the capital stock of Zoo Digital Publishing Limited
(“Zoo Digital”), a business operated in the United Kingdom. This acquisition
provided Zoo Games with a profitable core business in the United Kingdom,
European distribution, and further enhanced its experienced management team. Zoo
Digital distributes software titles throughout Europe and generated over $6.8
million in annual revenue in 2007. In our effort to refocus our cash on our
core business operations, the Company sold Zoo Digital back to its original
owners on November 28, 2008.





In June
2009, the Company formed a new company in the United Kingdom that is a 100%
owned subsidiary of Zoo Games called Zoo Entertainment Europe Ltd. (“Zoo
Europe”) that will focus on the sales and distribution of our products in
Europe. Zoo Europe incurred initial start-up costs and began to record
revenues during the quarter ended September 30, 2009.  The activity of
Zoo Europe is immaterial through the period ended September 30, 2009, and the
Company records all operating activities as one segment.





The
financial statements of Zoo Entertainment include operations of each division
from the date that they were acquired. The results for Supervillain,
Repliqa and Zoo Digital are included in discontinued operations for the three
and nine months ended September 30, 2008.


3


Three
Months Ended September 30, 2009 As Compared to the


Three
Months Ended September 30, 2008








Results
of Operations





The
following table sets forth, for the period indicated the amount and percentage
of net revenue for significant line items in our statement of
operations:


(Amounts
      in Thousands Except Per Share Data)For
      the Three Months Ended September 302009
                                
                                
                                2008Revenue
                                
                                $
                                8,583
                                
                                
                                
                                100
                                %
                                
                                $
                                7,865
                                
                                
                                
                                100
                                %Cost
      of goods sold
                                
                                
                                6,662
                                
                                
                                
                                78
                                %
                                
                                
                                5,093
                                
                                
                                
                                65
                                %Gross
      profit
                                
                                
                                1,921
                                
                                
                                
                                22
                                %
                                
                                
                                2,772
                                
                                
                                
                                35
                                %Operating
      expenses:General
      and administrative expenses
                                
                                
                                1,750
                                
                                
                                
                                20
                                %
                                
                                
                                4,037
                                
                                
                                
                                51
                                %Selling
      and marketing expenses
                                
                                
                                548
                                
                                
                                
                                6
                                %
                                
                                
                                1,352
                                
                                
                                
                                17
                                %Research
      and development expenses
                                
                                
                                —
                                
                                
                                
                                —
                                %
                                
                                
                                2
                                
                                
                                
                                —
                                %Impairment
      of goodwill and other intangible assets
                                
                                
                                22,000
                                
                                
                                
                                256
                                %
                                
                                
                                —
                                
                                
                                
                                —
                                %Depreciation
      and amortization
                                
                                
                                504
                                
                                
                                
                                6
                                %
                                
                                
                                434
                                
                                
                                
                                6
                                %Total
      operating expenses
                                
                                
                                24,802
                                
                                
                                
                                289
                                %
                                
                                
                                5,825
                                
                                
                                
                                74
                                %Loss
      from operations
                                
                                
                                (22,881
                                )
                                
                                
                                (267
                                )%
                                
                                
                                (3,053
                                )
                                
                                
                                (39
                                )%Interest
      expense, net
                                
                                
                                (370
                                )
                                
                                
                                (4
                                )%
                                
                                
                                (1,554
                                )
                                
                                
                                (20
                                )%Other
      income – insurance recovery
                                
                                
                                860
                                
                                
                                
                                10
                                %
                                
                                
                                —Loss
      from continuing operations before income tax benefit
                                
                                
                                (22,391
                                )
                                
                                
                                (
      261
                                )%
                                
                                
                                (4,607
                                )
                                
                                
                                (59
                                )%Income
      tax benefit
                                
                                
                                -
                                
                                
                                
                                —
                                %
                                
                                
                                2,542
                                
                                
                                
                                32
                                %Loss
      from continuing operations
                                
                                
                                (22,391
                                )
                                
                                
                                (
      261
                                )%
                                
                                
                                (2,065
                                )
                                
                                
                                (26
                                )%Loss
      from discontinued operations, net of tax benefit
                                
                                
                                (235
                                )
                                
                                
                                (3
                                )%
                                
                                
                                (1,731
                                )
                                
                                
                                (22
                                )%Net
      loss
                                
                                $
                                (22,626
                                )
                                
                                
                                ( 264
                                )%
                                
                                $
                                (3,796
                                )
                                
                                
                                (48
                                )%Loss
      per share from continuing operations
                                
                                $
                                (0.72
                                )
                                
                                
                                
                                
                                
                                $
                                (0.08
                                )





Net
Revenues





Net
revenues for the three months ended September 30, 2009 were approximately $8.6
million, an increase of approximately 9% over the sales for the three months
ended September 30, 2008 which were approximately $7.9 million, primarily
consisting of casual game sales in North America. The sales in the 2009
period are recorded net of the $265,000 fee to Atari for the period; without
this fee, the sales increase from 2008 to 2009 would be 12%. The breakdown of
gross sales by platform is:





Three
      Months Ended September 30,2009
                      
                      
                      2008Nintendo
      Wii
                      
                      
                      72
                      %
                      
                      
                      52
                      %Nintendo
      DS
                      
                      
                      27
                      %
                      
                      
                      44
                      %Microsoft
      Xbox
                      
                      
                      1
                      %
                      
                      
                      0
                      %Nintendo
      GBA
                      
                      
                      0
                      %
                      
                      
                      1
                      %SONY
      PS2
                      
                      
                      0
                      %
                      
                      
                      2
                      %SONY
      PSP
                      
                      
                      0
                      %
                      
                      
                      1
                      %





The
biggest sellers during the 2009 period were (i) Deal or No Deal on the Nintendo
Wii platform, (ii) Hello Kitty - Big City Dreams on the Nintendo DS platform,
and (iii) Build ‘N Race on the Nintendo Wii platform. The biggest sellers during
the 2008 period were (i) Order Up, (ii) M&M Kart Racing and (iii) Chicken
Shoot, all on the Nintendo Wii platform. The 2009 period consisted of
approximately 873,000 units sold at an average gross price of $9.38, while the
2008 period consisted of approximately 663,000 units sold at an average gross
price of $10.86.


4





Gross
Profit





Gross
profit for the three months ended September 30, 2009 was approximately $1.9
million or 22% of net revenue, while the gross profit for the three months ended
September 30, 2008 was approximately $2.8 million, or 35% of net revenue. The
costs included in the cost of goods sold consist of manufacturing and packaging
costs, royalties due to licensors relating to the current period’s revenues and
the amortization of product development costs relating to the current period’s
revenues. The Atari sales agreement was in place during the entire 2009 period
and the Atari’s fees that are recorded as a reduction in revenue during this
period were approximately $265,000 as compared to $0 in the corresponding period
in 2008. During the 2008 period, 18% of the revenues were derived from the Wii
Order Up game which was introduced at a high price point and resulted in an
unusually high gross margin that period.  There were no similar items
introduced during the comparable period in 2009.





General
and Administrative Expenses





General
and administrative expenses for the three months ended September 30 2009
were approximately $1.8 million as compared to $4.0 million for the comparable
period in 2008. The reduction in costs from the 2008 period to the 2009
period resulted primarily from a reduction in corporate salaries and related
costs. During the three months ended September 30, 2009 the Company incurred
approximately $285,000 in costs related to its European sales
office.





Selling
and Marketing Expenses





Selling
and marketing expenses for the three months ended September 30, 2009 and 2008
were $548,000 and approximately $1.4 million, respectively. These
expenses all relate to the sales of casual games in North America and consist
primarily of the salaries, commissions and related costs for Zoo Publishing. Due
to the Atari sales agreement in 2009, we incurred a lower percentage of
distribution costs in the 2009 period versus the 2008 period.





Impairment
of Goodwill and Other Intangible Assets





Impairment
of goodwill and other intangible assets was $22.0 million in the September 2009
period, representing a reduction of $14.7 million of goodwill and $7.3 million
of content in other intangible assets.  This was based on the November
2009 equity infusion of approximately $4.0 million for 50% ownership interest in
the Company and conversion of the existing convertible debt, resulting in a
pro-forma market capitalization of approximately $8.0 million as of September
30, 2009.  The Company will perform a formal impairment analysis
during the fourth quarter of 2009 and adjust the impairment estimates
accordingly, if necessary.





Depreciation
and Amortization Expenses





Depreciation
and amortization costs for the three months ended September 30, 2009 were
$504,000 as compared to $434,000 in the prior period. Both periods include
$412,000 resulting from the amortization of intangibles acquired from the Zoo
Publishing acquisition. The 2009 period includes $65,000 resulting from the
amortization of intangibles acquired from the Empire IP
acquisition.  The balance relates to depreciation of fixed assets
during the period.





Interest
Expense





Interest
expense for the 2009 period was $370,000 as compared to approximately $1.6
million for the 2008 period. The 2009 period includes $180,000 of non-cash
interest expense relating to the amortization on the Zoo Entertainment Notes,
$139,000 of interest relating to the Zoo Entertainment Notes and approximately
$51,000 of interest related to the advance for the Canadian distribution
rights.  The 2008 period includes $922,000 of non-cash interest
expense relating to the accelerated amortization of the debt discount resulting
from the early extinguishment of debt and $320,000 of interest on the various
promissory notes due to the sellers of Zoo Publishing of which $262,000 is
non-cash interest imputed at the then market rate.


5





Other
Income – Insurance Recovery





During
the 2009 period, our third party warehouse received $860,000 from their
insurance company relating to losses incurred by us from a fire in October
2008.  Those proceeds were applied against other amounts due to the
third party warehouse and are reported as Other Income in 2009.





Income
Tax Benefit





We did
not record any income tax benefit for the three months ended September 30, 2009
as compared to $2.5 million for the three months ended September 30, 2008. As of
December 31, 2008, we had already maximized the allowable amount of deferred
taxes, so no additional tax benefits could be recorded for the 2009
period.





Loss
from Discontinued Operations





During
the three months ended September 30, 2009, we wrote-off $235,000 relating to the
balance due from the sale of Zoo Digital in 2008 because it was determined to be
uncollectible during this period.  During the three months ended
September 30, 2008, we generated a loss of approximately $1.7 million, net of
tax benefit, from three operating divisions which were subsequently
discontinued, so the net losses relating to those operations are recorded
separately as a loss from discontinued operations. The loss relating to
Supervillain was approximately $1.6 million, the loss relating to Zoo Digital
was $527,000, the loss relating to Repliqa was $25,000 and the tax benefit
related to these losses was $465,000.





Loss
per Share from Continuing Operations





The loss
per share from continuing operations for the three months ended September 30,
2009 was $0.72, based on a weighted average shares outstanding for the period of
31.2 million, versus a loss per share from continuing operations of $0.08, based
on a weighted average shares outstanding of 27.1 million for the three months
ended September 30, 2008.


6


Nine
Months Ended September 30, 2009 As Compared to the


Nine
Months Ended September 30, 2008





Results
of Operations





The
following table sets forth, for the period indicated the amount and percentage
of net revenue for significant line items in our statement of
operations:


(Amounts
      in Thousands Except Per Share Data)For
      the Nine Months Ended September 30,2009
                              
                              
                              2008Revenue
                              
                              $
                              30,136
                              
                              
                              
                              100
                              %
                              
                              $
                              22,364
                              
                              
                              
                              100
                              %Cost
      of goods sold
                              
                              
                              25,887
                              
                              
                              
                              86
                              %
                              
                              
                              18,306
                              
                              
                              
                              82
                              %Gross
      profit
                              
                              
                              4,249
                              
                              
                              
                              14
                              %
                              
                              
                              4.058
                              
                              
                              
                              18
                              %Operating
      expenses:General
      and administrative expenses
                              
                              
                              5,010
                              
                              
                              
                              17
                              %
                              
                              
                              7,436
                              
                              
                              
                              33
                              %Selling
      and marketing expenses
                              
                              
                              2,073
                              
                              
                              
                              7
                              %
                              
                              
                              3,269
                              
                              
                              
                              15
                              %Research
      and development expenses
                              
                              
                              370
                              
                              
                              
                              1
                              %
                              
                              
                              1,481
                              
                              
                              
                              7
                              %Impairment
      of goodwill and other intangible assets
                              
                              
                              22,000
                              
                              
                              
                              73
                              %
                              
                              
                              —
                              
                              
                              
                              —
                              %Depreciation
      and amortization
                              
                              
                              1,373
                              
                              
                              
                              5
                              %
                              
                              
                              1,325
                              
                              
                              
                              6
                              %Total
      operating expenses
                              
                              
                              30,826
                              
                              
                              
                              102
                              %
                              
                              
                              13,511
                              
                              
                              
                              60
                              %Loss
      from operations
                              
                              
                              (26,577
                              )
                              
                              
                              (
      88
                              )%
                              
                              
                              (9,453
                              )
                              
                              
                              (42
                              )%Interest
      expense, net
                              
                              
                              (2,403
                              )
                              
                              
                              (
      8
                              )%
                              
                              
                              (2,533
                              )
                              
                              
                              (11
                              )%Gain
      on legal settlement
                              
                              
                              4,328
                              
                              
                              
                              14
                              %
                              
                              
                              —
                              
                              
                              
                              -
                              %Other
      income – insurance recovery
                              
                              
                              860
                              
                              
                              
                              3
                              %
                              
                              
                              —
                              
                              
                              
                              -
                              %Loss
      from continuing operations before income tax benefit
                              
                              
                              (23,792
                              )
                              
                              
                              (
      79
                              )%
                              
                              
                              (11,986
                              )
                              
                              
                              (54
                              )%Income
      tax benefit
                              
                              
                              -
                              
                              
                              
                              -
                              %
                              
                              
                              3,600
                              
                              
                              
                              16
                              %Loss
      from continuing operations
                              
                              
                              (23,792
                              )
                              
                              
                              (
      79
                              )%
                              
                              
                              (8,386
                              )
                              
                              
                              (37
                              )%Loss
      from discontinued operations net of tax benefit
                              
                              
                              (235
                              )
                              
                              
                              (1
                              )%
                              
                              
                              (4,279
                              )
                              
                              
                              (19
                              )%Net
      loss
                              
                              $
                              (24,027
                              )
                              
                              
                              ( 80
                              )%
                              
                              $
                              (12,665
                              )
                              
                              
                              (57
                              )%Loss
      per share from continuing operations
                              
                              $
                              (0.70
                              )
                              
                              
                              
                              
                              
                              $
                              (0.40
                              )





Net
Revenues





Net
revenues for the nine months ended September 30, 2009 were approximately $30.1
million, an increase of approximately 35% over the sales for the nine months
ended September 30, 2008 of approximately $22.4 million, primarily all
consisting of casual game sales in North America. The sales in the 2009
period are recorded net of the $2.7 million fee to Atari for the period; without
this fee, the sales increase from 2008 to 2009 would be 47%.  The
breakdown of gross sales by platform is:





Nine
      Months Ended September 30,2009
                        
                        
                        2008Nintendo
      Wii
                        
                        
                        65
                        %
                        
                        
                        35
                        %Nintendo
      DS
                        
                        
                        31
                        %
                        
                        
                        60
                        %Microsoft
      Xbox
                        
                        
                        2
                        %
                        
                        
                        0
                        %SONY
      PS2
                        
                        
                        2
                        %
                        
                        
                        1
                        %Nintendo
      GBA
                        
                        
                        0
                        %
                        
                        
                        2
                        %SONY
      PSP
                        
                        
                        0
                        %
                        
                        
                        2
                        %





The
biggest sellers during the 2009 period were (i) Deal or No Deal, (ii) M&M
Kart Racing, and (iii) M&M Beach Party, all on the Nintendo Wii platform.
The biggest sellers during the 2008 period were (i) the compilation of Battle
Ship, Connect 4, Sorry & Trouble on the Nintendo DS platform, (ii) M&M
Kart Racing on the Nintendo Wii platform and (iii) the compilation of Clue,
Perfection & Aggravation on the Nintendo DS platform. The 2009 period
consisted of approximately 3.4 million units sold at an average price of $9.54
as compared to approximately 2.1 million units sold for an average price of
$10.19.


7





Gross
Profit





Gross
profit for the nine months ended September 30, 2009 was approximately $4.2
million, or 14% of net revenue, while the gross profit for the nine months ended
September 30, 2008 was approximately $4.1 million, or 18% of net revenue. The
costs included in the cost of goods sold consist of manufacturing and packaging
costs, royalties due to licensors relating to the current period’s revenues and
the amortization of product development costs relating to the current period’s
revenues. The Atari sales agreement was in place during the entire 2009 period
and Atari’s fees recorded as a reduction in revenue during this period were
approximately $2.7 million as compared to $0 in the corresponding period in
2008.  As part of our business plan to focus on higher margin games and
more cost effective product licenses, we opted to discontinue certain
lower-margin products in the 2009 period through the accelerated sale of such
products at lower than normal prices. This resulted in a significant amount of
sales at very low margins, which along with royalty fees and amortization of
product development costs resulted in a low overall gross margin for the 2009
period. The 2008 period included a close-out initiative for a license that
terminated during that period resulting in similar low overall margins for the
2008 period.





General
and Administrative Expenses





General
and administrative expenses for the nine months ended September 30 2009
were approximately $5.0 million as compared to $7.4 million for the comparable
period in 2008. The decrease in costs from the 2008 period to the 2009
period resulted primarily from a reduction in corporate salaries and related
costs. During the nine months ended September 30, 2009 the Company incurred
approximately $405,000 in cost for its European sales office.





Selling
and Marketing Expenses





Selling
and marketing expenses for the nine months ended September 30, 2009 and 2008
were approximately $2.1 million and $3.3 million, respectively. These expenses
all relate to the sales of casual games in North America and consist primarily
of the salaries, commissions and related costs for Zoo Publishing. Due to the
Atari sales agreement in 2009, we incurred a lower percentage of distribution
costs in the 2009 period versus the 2008 period.





Research
and Development Expenses





Research
and development expenses for the nine months ended September 30, 2009 were
approximately $370,000 as compared to approximately $1.5 million for the nine
months ended September 30, 2008. These expenses are a direct result of our
decision to discontinue the development of certain games during these periods.
The Company has modified its business model to focus on casual products which
carry significantly lower development risks and costs.





Impairment
of Goodwill and Other Intangible Assets





Impairment
of goodwill and other intangible assets was $22.0 million in the September 2009
period, representing a reduction of $14.7 million of goodwill and $7.3 million
of content in other intangible assets.  This was based on the November
2009 equity infusion of approximately $4.0 million for 50% ownership interest in
the Company and conversion of the existing convertible debt, resulting in a
pro-forma market capitalization of approximately $8.0 million as of September
30, 2009.  The Company will perform a formal impairment analysis
during the fourth quarter of 2009 and adjust the impairment estimates
accordingly, if necessary.





Depreciation
and Amortization Expenses





Depreciation
and amortization costs for the nine months ended September 30, 2009 were
approximately $1.4 million as compared to approximately $1.3 million in the
prior period. Both periods include approximately $1.2 million resulting from the
amortization of intangibles acquired from the Zoo Publishing acquisition. The
2009 period includes $65,000 resulting from the amortization of intangibles
acquired from the Empire IP acquisition.  The balance relates to
depreciation of fixed assets during the period.


8





Interest
Expense





Interest
expense for the 2009 period was approximately $2.4 million as compared to
approximately $2.5 million for the 2008 period. The 2009 period includes
approximately $1.6 million of non-cash interest expense relating to the
amortization on the Zoo Entertainment Notes, $418,000 of interest relating to
the Zoo Entertainment Notes and approximately $358,000 of interest on the
various promissory notes due to the sellers of Zoo Publishing of which $293,000
is non-cash interest imputed at the then market rate. The 2008 period includes
$922,000 of non-cash interest expense relating to the accelerated amortization
of the debt discount resulting from the early extinguishment of debt,
approximately $1.1 million of interest on the various promissory notes due to
the sellers of Zoo Publishing of which approximately $1.0 million is non-cash
interest imputed at the then market rate and $536,000 of interest expense on
other notes including the Zoo Entertainment Notes.





Gain
on Legal Settlement





During
the 2009 period, we settled a lawsuit brought by the former sellers of Zoo
Publishing, resulting in a net gain on settlement of approximately $4.3 million.
The settlement eliminated the Company’s obligations for certain outstanding
notes, employee loans and other obligations for an aggregate amount of
approximately $3.9 million. The settlement returned approximately 5.6 million
shares to treasury valued at approximately $1.1 million. The Company’s remaining
cash obligations and litigation expense amounted to approximately $710,000,
resulting in a net gain on settlement of approximately $4.3
million.





Other
Income – Insurance Recovery





During
the 2009 period, our third party warehouse received $860,000 from their
insurance company relating to losses incurred by us from a fire in October
2008.  Those proceeds were applied against other amounts due to the
third party warehouse and are reported as Other Income in 2009.





Income
Tax Benefit





We did
not record any income tax benefit for the nine months ended September 30, 2009.
As of December 31, 2008, we had already maximized the allowable amount of
deferred taxes, so no additional tax benefits could be recorded for the 2009
period. During the nine months ended September 30, 2008, we recorded a tax
benefit of approximately $3.6 million.





Loss
from Discontinued Operations





During
the nine months ended September 30, 2009, we wrote-off $235,000 relating to the
balance due from the sale of Zoo Digital in 2008 because it was determined to be
uncollectible during this period.   During the nine months ended
September 30, 2008, we incurred an aggregate of approximately $4.3 million in
losses, net of tax benefit, from four operating divisions which were
subsequently discontinued, so the net losses relating to those operations are
recorded separately as a loss from discontinued operations. The loss relating to
Supervillain was approximately $3.2 million, the loss relating to Zoo Digital
was approximately $1.2 million, the loss relating to Repliqa was $219,000 and
the loss relating to the on-line concept was $147,000.  The tax
benefit related to the discontinued operations was $465,000.





Loss
per Share from Continuing Operations





The loss
per share from continuing operations for the nine months ended September 30,
2009 was $0.70, based on a weighted average shares outstanding for the period of
34.1 million, versus a loss per share from continuing operations of $0.40, based
on a weighted average shares outstanding of 21.1 million for nine months ended
September 30, 2008.


9





Liquidity
and Capital Resources





We
incurred a loss from continuing operations of approximately $23.8 million for
the nine months ended September 30, 2009 and a net loss of approximately $8.4
million from continuing operations for the nine months ended September 30, 2008.
Our principal source of cash during the 2009 period was from the use of our
purchase order and receivable financing and cash generated from operations. Net
cash used in operating activities for the nine months ended September 30, 2009
was approximately $2.7 million, while net cash used in continuing operations for
the nine months ended September 30, 2008 was $17.2 million. The specifics
of the Atari sales agreement, which was in effect during the 2009 period, where
Atari prepays the Company for the cost of goods and pays the balance due
within 15 days of shipping the product, resulted in significant improvements for
our cash provided from operations in the 2009 period, as compared to the 2008
period.  The November 2009 $4.2 million equity raise and conversion of
the convertible notes to equity put the company into a positive working capital
position and better positioned to meet its working capital needs.





Zoo
Entertainment Notes





On July
7, 2008, as amended on July 15, 2008 and July 31, 2008, we entered into a note
purchase agreement under which the purchasers agreed to provide loans to us in
the aggregate principal amount of $9.0 million, in consideration for the
issuance and delivery of senior secured convertible promissory notes. As partial
inducement to purchase the notes, we issued to the purchasers warrants to
purchase 8,181,818 shares of our common stock. The notes bear an interest rate
of five percent (5%) for the one year term of the note commencing from issuance,
unless extended. Upon the occurrence of an investor sale, as defined in the
notes, the entire outstanding principal amount of the notes and any accrued
interest thereon will be automatically converted into shares of our common stock
determined by dividing the note balance by the lesser of (i) an amount equal to
the price per share of investor stock paid by the purchasers of such shares in
connection with the investor sale, or (ii) $2.00; provided, that in the event
that the investor sale is for less than $1.00 per share, then the notes will
only be automatically convertible with our consent. All of the warrants have a
five year term and an exercise price of $0.01 per share. Pursuant to a
security agreement, by and among the Company and the purchasers, dated as of
July 7, 2008, as amended on August 12, 2008, we granted a security interest in
all of our assets to each of the purchasers to secure our obligations under the
notes.





On
September 26, 2008, we entered into a note purchase agreement with four
investors, pursuant to which the purchasers agreed to provide a loan to us in
the aggregate principal amount of $1.4 million, in consideration for the
issuance and delivery of senior secured convertible promissory notes. As partial
inducement to purchase the notes, we issued to the purchasers warrants to
purchase 1,272,726 shares of our common stock. The notes bear an interest
rate of five percent (5%) for the time period beginning on September 26, 2008
and ending on September 26, 2009, unless extended.  The term of the
notes was subsequently amended to mature on November 2, 2009 and then to
February 2, 2010.  Upon the occurrence of an investor sale, as defined
in the notes, the entire outstanding principal amount of the notes and any
accrued interest thereon will be automatically converted into shares of our
common stock determined by dividing the note balance by the lesser of (i) an
amount equal to the price per share of investor stock paid by the purchasers of
such shares in connection with the investor sale, or (ii) $2.00; provided, that
in the event that the investor sale is for less than $1.00 per share, then the
notes will only be automatically convertible with our consent. The warrants have
a five year term and an exercise price of $0.01 per share. Pursuant to a
security agreement, by and among the Company and the purchasers, dated as of
September 26, 2008, we granted a security interest in all of our assets to each
of the purchasers to secure our obligations under the notes.





On June
26, 2009, the Company entered into Amendment No. 2 to Senior Secured Convertible
Note (“Amendment No. 2”), with the requisite holders (the “Holders”) of the
Company’s senior secured convertible notes issued in the aggregate principal
amount of $11.15 million. Pursuant to Amendment No. 2, the parties agreed to
extend the maturity date of the notes that were originally scheduled to mature
during July 2009 to August 31, 2009, or, if the Company receives comments from
the SEC with respect to the Information Statement Pursuant to Section 14(c) (the
“Information Statement”) that the Company filed on July 7, 2009 in connection
with an amendment to the Company’s Certificate of Incorporation authorizing a
sufficient number of shares of the Company’s common stock to permit the
conversion of the notes (“Certificate of Amendment”), September 15, 2009. The
Company did not receive comments from the SEC with respect to the Information
Statement and, as such, the maturity dates of such notes shall be August 31,
2009. Amendment No. 2 also provides that the notes shall automatically convert
into shares of the Company’s common stock effective immediately on the date by
which the following two events have occurred, regardless of the order in which
they occur: (a) the effectiveness of the filing the Certificate of Amendment,
and (b) the consummation of a financing by the Company for which such sale
results in aggregate gross proceeds to the Company of at least $4.0 million.
Notwithstanding, if the notes do not convert on or prior to the revised maturity
date, Amendment No. 2 provides that the provisions of Amendment No. 2 with
respect to automatic conversion shall become null and void and shall be of no
further effect. In consideration of the Holders’ execution and delivery of
Amendment No. 2, the Company entered into a letter agreement, dated as of June
26, 2009, pursuant to which the Company granted to the Holders registration
rights which require the Company to file with the SEC a registration statement
covering the resale of the shares of common stock issuable upon conversion of
the notes, within 30 calendar days after receipt of approval of the Company’s
stockholders of the Certificate of Amendment or 60 calendar days following the
closing of a financing by the Company for which such sale results in aggregate
gross proceeds to the Company of at least $4.0 million, whichever is later. The
Company entered into subsequent amendments with the Holders extending the
maturity date to November 2, 2009 and then subsequently to February 2,
2010. On November 20, 2009, the requisite Senior Secured Convertible Note
Holders agreed that if the Company raises a minimum of $4.0 million new capital,
they will convert their debt into convertible preferred shares of the Company
that will ultimately convert into common shares that represent 36.5% of the
equity of the Company. As a result of the Company consummating an approximately
$4.2 million preferred equity raise on November 20, 2009, upon which
approximately $11.8 million of existing debt including related accrued interest
converted into convertible preferred equity, the Company will issue shares of
Series B Preferred stock to the Senior Convertible Note Holders in exchange for
their Notes.


10





Zoo
Publishing Notes





In
connection with Zoo Games’ acquisition of Zoo Publishing, there was an
outstanding 3.9% promissory note for the benefit of the former shareholders of
Zoo Publishing in the aggregate principal amount of $2,957,500. Of that amount,
$1,137,500 of the principal plus accrued and unpaid interest was scheduled to be
paid on or before September 18, 2009 and the remaining $1,820,000 plus accrued
and unpaid interest was scheduled to be paid on or before December 18, 2010.
Also in connection with the acquisition of Zoo Publishing, Zoo Games was
required to pay an individual an aggregate of $608,400. Of that amount, $292,500
was due on December 18, 2010 and $315,900 was scheduled to be paid on July 31,
2011, in cash or our common stock based on the fair market value of our common
stock as of July 31, 2011, at the election of Zoo Games. In connection with the
Settlement Agreement dated June 18, 2009, all the Zoo Publishing Notes and the
note to the individual were cancelled and no cash payments were required to be
made for either the principal amounts of the notes or the interest accrued. The
net amount of the obligations relieved for the Zoo Publishing Notes was
approximately $3.0 million and is included in the Gain on Settlement on the
Statement of Operations.





As part
of the acquisition of Zoo Publishing, Zoo Games was required to pay $1,200,000
to an employee of Zoo Publishing. Of that amount, as of September 30, 2009, Zoo
Games paid $487,000; $93,000 is past due and $620,000 will be paid on July 31,
2011, in cash or our common stock based on the fair market value of our common
stock as of July 31, 2011, at the election of Zoo Games.





Zoo
Publishing has additional debt outstanding which debt existed prior to Zoo
Games’ acquisition of that subsidiary. As of September 30, 2009, Zoo Publishing
owes approximately $300,000 as a result of the repurchase of certain
stock from a former stockholder. The terms of this note are repayment in
monthly increments of $10,000.





Zoo
Publishing also takes advances from our factor, Working Capital Solutions, Inc.,
which utilizes existing accounts receivable in order to provide working capital
to fund all aspects of our continuing business operations. Under the terms of
our factoring and security agreement, our receivables are sold to the factor,
with recourse. The factor, in its sole discretion, determines whether or not it
will accept each receivable based upon the credit risk factor of each individual
receivable or account. Once a receivable is accepted by the factor, the factor
provides funding, subject to the terms and conditions of the factoring and
security agreement. The amount remitted to us by the factor equals the invoice
amount of the receivable adjusted for any discounts or allowances provided to
the account, less 25% which is deposited into a reserve account established
pursuant to the agreement, less allowances and fees. In the event of default,
valid payment dispute, breach of warranty, insolvency or bankruptcy on the part
of the receivable account, the factor can require the receivable to be
repurchased by us in accordance with the agreement. The amounts to be paid by us
to the factor for any accepted receivable include a factoring fee of 0.6% for
each ten (10) day period the account is open. We began to use the factor
again in September 2009 and as of September 30, 2009, we had factored $832,000
of invoices and received $624,000 advance against these
receivables.


11





In
addition to the receivable financing agreement with Working Capital Solutions,
Inc., Zoo Publishing also utilizes purchase order financing with Transcap Trade
Finance, LLC, to fund the manufacturing of video game products. Under the terms
of our agreement, we assign purchase orders received to Transcap Trade Finance,
LLC, which may accept or decline the assignment of specific purchase orders. The
purchase order financing allows us to order manufactured video game product from
the manufacturer. Upon receipt of a purchase order, Transcap Trade Finance, LLC
opens a letter of credit to the video game product manufacturer. The letter of
credit permits us to order the video game product to satisfy the purchase orders
and projected purchase orders submitted by our accounts. The interest rate is
prime plus 4.0% on outstanding advances.





On April
6, 2009, we entered into an amended and restated purchase order financing
arrangement with Wells Fargo Bank, National Association (“Wells Fargo”) pursuant
to an amended and restated master purchase order assignment agreement (the
“Assignment Agreement”). The Assignment Agreement amended and restated in
its entirety the master purchase order assignment agreement between Transcap
Trade Finance, LLC and Zoo Publishing, dated as of August 20, 2001, as
amended.





Pursuant
to the Assignment Agreement, the Company will assign purchase orders received
from customers to Wells Fargo, and request that Wells Fargo purchase the
required materials to fulfill such purchase orders. Wells Fargo, which may
accept or decline the assignment of specific purchase orders, will retain us to
manufacture, process and ship ordered goods, and will pay us for our services
upon Wells Fargo’s receipt of payment from the customers for such ordered
goods. Upon payment in full of the purchase order invoice by the applicable
customer to Wells Fargo, Wells Fargo will re-assign the applicable purchase
order to us. We will pay to Wells Fargo a fee upon their funding of each
purchase order and we commit to pay a total fee for twelve months in the
aggregate amount of $337,500. If the fees earned during the twelve month period
do not exceed $337,500, we are required to pay the difference between the
$337,500 and the amounts already paid on the earlier of the twelve month
anniversary of the date of the Assignment Agreement, or the date of termination
of the Assignment Agreement. Wells Fargo is not obligated to provide
purchase order financing under the Assignment Agreement if the aggregate
outstanding funding exceeds $5,000,000. The Assignment Agreement is for an
initial term of twelve months, and shall continue thereafter for successive
twelve month renewal terms unless either party terminates the Assignment
Agreement by written notice to the other no later than 30 days prior to the end
of the initial term or any renewal term. If the term of the Assignment
Agreement is renewed for one or more twelve month terms, for each such twelve
month term, we will pay to Wells Fargo a commitment fee in the sum of $337,500,
to be offset against actual fees paid by us upon their payment of each purchase
order, to be paid on the earlier of the twelve month anniversary of such renewal
date or the date of termination of the Assignment Agreement. The initial
and renewal commitment fees are subject to waiver if certain product volume
requirements are met.





In
connection with the Assignment Agreement, on April 6, 2009 we also entered into
an amended and restated security agreement and financing statement (the
“Security Agreement”) with Wells Fargo. The Security Agreement amends and
restates in its entirety that certain security agreement and financing
statement, by and between Transcap Trade Finance, LLC and Zoo Publishing,
dated as of August 20, 2001. Pursuant to the Security Agreement, we granted
to Wells Fargo a first priority security interest in certain of our assets as
set forth in the Security Agreement, as well as a subordinate security interest
in certain other of our assets (the “Common Collateral”), which security
interest is subordinate to the security interests in the Common Collateral held
by certain of our senior lenders, as set forth in the Security
Agreement.





Also in
connection with the Assignment Agreement, on April 6, 2009, Mark Seremet,
President and Chief Executive Officer of Zoo Games and a director of Zoo
Entertainment, and David Rosenbaum, the President of Zoo Publishing, entered
into a Guaranty with Wells Fargo, pursuant to which Messrs. Seremet and
Rosenbaum agreed to guaranty the full and prompt payment and performance of the
obligations under the Assignment Agreement and the Security
Agreement.





On May
12, 2009, the Company entered into a letter agreement with each of Mark Seremet
and David Rosenbaum (the “Fee Letters”), pursuant to which, in consideration for
Messrs. Seremet and Rosenbaum entering into the Guaranty with Wells Fargo for
the full and prompt payment and performance by the Company and its subsidiaries
of the obligations in connection with a purchase order financing (the “Loan”),
the Company agreed to compensate Mr. Seremet in the amount of $10,000 per month,
and Mr. Rosenbaum in the amount of $7,000 per month, for so long as the
executive remains employed while the Guaranty and Loan remain in full force and
effect. If the Guaranty is not released by the end of the month following
termination of employment of either Messrs. Seremet or Rosenbaum, the monthly
fee shall be doubled for each month thereafter until the Guaranty is
removed.


12





Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the Company’s
2007 Employee, Director and Consultant Stock Plan, as amended to each of Messrs.
Seremet and Rosenbaum, on such date that is the earlier of the conversion of at
least 25% of all currently existing convertible debt of the Company into equity,
or November 8, 2009 (the earlier of such date, the “Grant Date”), an option to
purchase that number of shares of the Company’s common stock equal to 6% and 3%
respectively, of the then issued and outstanding shares of common stock, based
on a fully diluted current basis assuming those options and warrants that have
an exercise price below $0.40 per share are exercised on that date but not
counting the potential conversion to equity of any outstanding convertible notes
that have not yet been converted and, inclusive of any options or other equity
securities or securities convertible into equity securities of the Company that
each may own on the Grant Date. The options shall be issued at an exercise
price equal to the fair market value of the Company’s common stock on the Grant
Date and pursuant to the Company’s standard form of nonqualified stock option
agreement; provided however that in the event the Guaranty has not been released
by Wells Fargo Bank as of the date of the termination of the option due to
termination of service, the option termination date shall be extended until the
earlier of the date of the release of the Guaranty or the expiration of the ten
year term of the option. In addition any options owned by Messrs. Seremet
and Rosenbaum as of the Grant Date with an exercise price that is higher than
the exercise price of the new options shall be cancelled as of the Grant
Date.





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari will
resell the products to wholesalers and retailers that are acceptable to Atari in
North America. This agreement provides for Atari to prepay to the Company for
the cost of goods and pay the balance due within 15 days of shipping the
product. Atari’s fees approximate 10% of our standard selling
price. Atari takes a reserve from the initial payment for potential
customer sales allowances, returns and price protection that is analyzed and
reviewed within a sixty day period to be liquidated no later than July 31,
2010. The agreement initially expired on March 31, 2009, but was amended to
extend the term for certain customers until March 31, 2010.





With the
November 2009 $4.2 million equity raise and the conversion of all our
convertible notes into equity, we believe the existing cash and cash generated
from operations are sufficient to meet our immediate operating requirements,
along with our current financial arrangements. We may need to raise additional
capital to strengthen our cash position, facilitate expansion, pursue strategic
investments or to take advantage of business opportunities as they
arise.





The
report of our independent auditors on our financial statements for the fiscal
year ended December 31, 2008 includes an explanatory paragraph raising doubt
about the Company’s ability to continue as a going concern.





Critical
Accounting Policies and Estimates





There
were no changes to our critical accounting policies and estimates since the year
ended December 31, 2008. A complete description of our critical accounting
polices and estimates can be found in our Annual Report on Form 10-K for the
year ended December 31, 2008, filed with the Securities and Exchange Commission
on April 15, 2009 and also in Note 3 to the unaudited condensed consolidated
financial statements included in this quarterly report for the period ended
September 30, 2009.





Recently
Issued Accounting Pronouncements





See Note
3 to the unaudited condensed consolidated financial statements included in this
quarterly report for the period ended September 30, 2009.


13


Off-Balance
Sheet Arrangements





We do not
have any relationships with unconsolidated entities or financial partners, such
as entities often referred to as structured finance or special purpose entities,
which would have been established for the purpose of facilitating off-balance
sheet arrangements or other contractually narrow or limited purposes. In
addition, we do not have any undisclosed borrowings or debt, and we have not
entered into any synthetic leases. We are, therefore, not materially exposed to
any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.





Fluctuations
in Operating Results and Seasonality





We
experience fluctuations in quarterly and annual operating results as a result
of: the timing of the introduction of new titles; variations in sales of titles
developed for particular platforms; market acceptance of our titles; development
and promotional expenses relating to the introduction of new titles, sequels or
enhancements of existing titles; projected and actual changes in platforms; the
timing and success of title introductions by our competitors; product returns;
changes in pricing policies by us and our competitors; the size and timing of
acquisitions; the timing of orders from major customers; order cancellations;
and delays in product shipment. Sales of our products are also seasonal, with
peak shipments typically occurring in the fourth calendar quarter as a result of
increased demand for titles during the holiday season. Quarterly and annual
comparisons of operating results are not necessarily indicative of future
operating results.





ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Not
applicable as we are a smaller reporting company.





ITEM
4T.  CONTROLS AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





Our
management is responsible for establishing and maintaining adequate internal
controls over financial reporting, as defined in Exchange Act
Rules 13a-15(e) and 15d-15(e), as of the end of the period covered by this
report. Based on the evaluation of the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this report, our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) were not effective at a reasonable assurance level.





Our
management has determined that we have a material weakness in our internal
control over financial reporting related to not having a sufficient number of
personnel with the appropriate level of experience and technical expertise to
appropriately resolve non-routine and complex accounting matters or to evaluate
the impact of new and existing accounting pronouncements on our consolidated
financial statements while completing the financial statements close
process.





Until
this deficiency in our internal control over financial reporting is remediated,
there is a reasonable possibility that a material misstatement to our annual or
interim consolidated financial statements could occur and not be prevented or
detected by our internal controls in a timely manner.





We are
committed to appropriately addressing this matter in 2009 and we have engaged
additional qualified personnel to assist in these areas. We will continue to
reassess our accounting and finance staffing levels to ensure that we have the
appropriate accounting resources to handle the existing workload.





Changes
in Controls and Procedures





There
were no changes in our internal controls over financial reporting identified in
connection with the evaluation of such internal control that occurred during the
during the period covered by this report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.


14


PART
II - OTHER INFORMATION





ITEM  1.  LEGAL
PROCEEDINGS





On February
19, 2009, Susan Kain Jurgensen, Steven Newton, Mercy Gonzalez, Bruce Kain,
Wesley Kain, Raymond Pierce and Cristie Walsh filed a complaint against Zoo
Publishing, Zoo Games and Zoo in the Supreme Court of the State of New York, New
York County, index number 09 / 102381 alleging claims
for breach of certain loan agreements and employment
agreements, intentional interference and fraudulent transfer.
The complaint sought compensatory damages, punitive damages and preliminary
and permanent injunctive relief, among other remedies. On June 18, 2009, we
reached a settlement whereby we agreed to pay to the plaintiffs an aggregate of
$560,000 (the “Settlement Amount”) in full satisfaction of the disputed claims,
without any admission of any liability of wrongdoing as follows: (a) $300,000 on
June 26, 2009; (b) $60,000 on or before the earlier of (i) the date that is 90
days from June 18, 2009 or (ii) the date the Company obtains new and available
financing, including any amounts currently held in escrow that will be released
from escrow after June 18, 2009, in any form and from any source, in an amount
totaling at least $2,000,000; (c) $100,000 on or before December 18, 2009; and
(d) $100,000 on or before June 18, 2010. To date, $360,000 of the Settlement
Amount has been paid to the plaintiffs. The Zoo Publishing Notes and all other
notes, employment, agreements, loan agreements, options, warrants and other
agreements relating to the plaintiffs (except with respect to that certain
Employment Agreement between Zoo Publishing and Cristie Walsh) were terminated
and all outstanding obligations of the Company related to these agreements were
cancelled. In addition, the plaintiffs returned to us an aggregate of 5,563,950
shares of our common stock owned by them prior to such date.





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., the claimant Revolution Partners, LLC was seeking money damages for a
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We settled this claim in June 2009 for $140,000,
$120,000 of which was paid as of September 30, 2009 and the balance is included
in accounts payable as of September 30, 2009 and was paid in full in October
2009.





We are
also involved in various other legal proceedings and claims incident to the
normal conduct of our business. Although it is impossible to predict the outcome
of any legal proceeding and there can be no assurances, we believe that our
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material adverse effect on our financial condition, results of
operations or cash flows.





ITEM
1A.  RISK FACTORS





There
have been no material changes in our risk factors from those disclosed in our
Annual Report on Form 10-K for the year ended December 31, 2008, filed with the
Securities and Exchange Commission on April 15, 2009.





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





Issuer
Purchases of Equity Securities





Period
                
                (a) Total Number of
                  Shares (or Units)
                  Purchased
                
                
                (b) Average Price Paid
                  per Share (or Unit)
                
                
                (c)
                  Total Number of
                  Shares (or Units)
                  Purchased as Part of
                  Publicly Announced
                  Plans or Programs
                
                
                (d)
                  Maximum Number
                  (or Approximate
                  Dollar Value) of
                  Shares (or Units)
                  that May Yet Be
                  Purchased Under
                  the Plans or
                  ProgramsJuly
      1, 2009- July 31, 2009August
      1, 2009- August 31, 2009
                
                
                500,000
                (1)
                
                
                
                (1)September1,
      2009- September 30, 2009





(1)
            On
      August 31, 2009, in consideration for an employee entering into a guaranty
      with Solutions 2 Go Inc. and Solutions 2 Go, LLC for the full and prompt
      payment and performance by the Company and its subsidiaries of the
      obligations in connection with an advance agreement, the Company entered
      into a letter agreement with the employee, pursuant to which, among other
      things, the Company agreed to deliver to the employee 500,000 shares of
      common stock.


15




ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





None.





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





On June
26, 2009, the Company received, in lieu of a meeting, written consents from the
holders of 19,346,362 shares of common stock, representing approximately 63.6%
of the total issued and outstanding shares of common stock, approving an
amendment to the Company’s Certificate of Incorporation to increase the number
of authorized shares of common stock from 75,000,000 shares to 250,000,000
shares.





ITEM
5.  OTHER INFORMATION





None.





ITEM
6.  EXHIBITS





10.1
            
            Amendment
      No. 3 to Senior Secured Convertible Note, dated as of August 31, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.2
            
            Note
      Purchase Agreement Waiver and Consent, dated as of August 31, 2009, by and
      among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.3
            
            Advance
      Agreement, by and among Zoo Entertainment, Inc., Solutions 2 Go Inc. and
      Solutions 2 Go LLC, dated as of August 31, 2009.10.4
            
            Exclusive
      Distribution Agreement, by and between Zoo Publishing, Inc. and Solutions
      2 Go Inc. and Solutions 2 Go LLC, dated as of August 31,
    2009.10.5
            
            Exclusive
      Distribution Agreement, by and between Zoo Publishing, Inc. and Solutions
      2 Go LLC, dated as of August 31, 2009.10.6
            
            Warrant
      to Purchase 7,665,731 shares of Common Stock of Zoo Entertainment,
      Inc.10.7
            
            Amendment
      1 to Fee Letter Agreement, by and between Zoo Entertainment, Inc. and Mark
      Seremet, dated as of August 31, 2009.10.8
            
            Amendment
      1 to Fee Letter Agreement, by and between Zoo Entertainment, Inc. and
      David Rosenbaum, dated as of August 31, 2009.10.9
            
            Continuing
      Personal Guaranty of Mark Seremet for the benefit of Solutions 2 Go Inc.
      and Solutions 2 Go LLC, dated as of August 31, 2009.10.10
            
            Continuing
      Personal Guaranty of David Rosenbaum for the benefit of Solutions 2 Go
      Inc. and Solutions 2 Go LLC, dated as of August 31,
  2009.10.11
            
            Amendment
      No. 4 to Senior Secured Convertible Note, dated as of October 6, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.12
            
            Amendment
      No. 5 to Senior Secured Convertible Note, dated as of November 2, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.31.1
            
            Certification
      of Chief Executive Officer. †31.2
            
            Certification
      of Chief Financial Officer. †32.1
            
            Certification
      by Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of
      2002. †





† Filed
herewith


16


SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





Dated: November
23, 2009





ZOO
      ENTERTAINMENT, INC/s/ Mark SeremetMark
      Seremet
              President
      and Chief Executive Officer
              (Principal
      Executive Officer)





/s/ David FremedDavid
      Fremed
              Chief
      Financial Officer
              (Principal
      Financial Officer)





17




EXHIBIT
INDEX




10.1
            
            Amendment
      No. 3 to Senior Secured Convertible Note, dated as of August 31, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.2
            
            Note
      Purchase Agreement Waiver and Consent, dated as of August 31, 2009, by and
      among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.3
            
            Advance
      Agreement, by and among Zoo Entertainment, Inc., Solutions 2 Go Inc. and
      Solutions 2 Go LLC, dated as of August 31, 2009.10.4
            
            Exclusive
      Distribution Agreement, by and between Zoo Publishing, Inc. and Solutions
      2 Go Inc. and Solutions 2 Go LLC, dated as of August 31,
    2009.10.5
            
            Exclusive
      Distribution Agreement, by and between Zoo Publishing, Inc. and Solutions
      2 Go LLC, dated as of August 31, 2009.10.6
            
            Warrant
      to Purchase 7,665,731 shares of Common Stock of Zoo Entertainment,
      Inc.10.7
            
            Amendment
      1 to Fee Letter Agreement, by and between Zoo Entertainment, Inc. and Mark
      Seremet, dated as of August 31, 2009.10.8
            
            Amendment
      1 to Fee Letter Agreement, by and between Zoo Entertainment, Inc. and
      David Rosenbaum, dated as of August 31, 2009.10.9
            
            Continuing
      Personal Guaranty of Mark Seremet for the benefit of Solutions 2 Go Inc.
      and Solutions 2 Go LLC, dated as of August 31, 2009.10.10
            
            Continuing
      Personal Guaranty of David Rosenbaum for the benefit of Solutions 2 Go
      Inc. and Solutions 2 Go LLC, dated as of August 31,
  2009.10.11
            
            Amendment
      No. 4 to Senior Secured Convertible Note, dated as of October 6, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.12
            
            Amendment
      No. 5 to Senior Secured Convertible Note, dated as of November 2, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.31.1
            
            Certification
      of Chief Executive Officer. †31.2
            
            Certification
      of Chief Financial Officer. †32.1
            
            Certification
      by Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of
      2002. †





† Filed
herewith


18