UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q/A


Amendment No. 1


(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, 2010


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




For the transition period from _____________ to ___________





Commission file number 001-34796


ZOO ENTERTAINMENT, INC.


(Exact name of Registrant as Specified in Its Charter)


Delaware

71-1033391(State or other jurisdiction of incorporation or

(I.R.S. Employer Identification No.)organization )




3805 Edwards Road, Suite 400Cincinnati, OH

45209(Address of Principal Executive Offices)

(Zip Code)




(513) 824-8297(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  ̈
Smaller reporting company x(do not check if a smaller reporting company)




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 12, 2010, there were 6,243,744 shares of the Registrant’s common stock, par value $0.001 per share, issued and 6,230,741 shares outstanding.





Explanatory Note





This Quarterly Report on Form 10-Q/A (this “Form 10-Q/A”) of Zoo Entertainment, Inc. (the “Company”) is being filed to incorporate changes to the Quarterly Report on Form 10-Q filed by the Company on November 12, 2010 (the “Form 10-Q”) because the Company has identified certain transactions that were not originally recorded properly for the period ended September 30, 2010; specifically, transactions relating to revenue recognition, including royalty income, certain sales volume rebates earned by one customer and revenue recorded in connection with sales to one distributor. As part of the restatement process, the Company recorded adjustments for items that were previously considered insignificant and were either not recorded or recorded in the incorrect reporting period.Also, the Company is reclassifying certain selling costs from cost of goods sold to selling and marketing expense, as well as reclassifying certain product financing costs from cost of goods sold to interest expense.This Form 10-Q/A amends and restates the Form 10-Q in its entirety.







ZOO ENTERTAINMENT, INC.





Table of Contents


PagePART I - FINANCIAL INFORMATIONItem 1.

Financial Statements.Condensed Consolidated Balance Sheets as of September 30, 2010 (Restated) (Unaudited) and December 31, 2009

F-1Condensed Consolidated Statements of Operations (Unaudited) for the Three Months and Nine Months Ended September 30, 2010 (Restated) and 2009

F- 2Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2010 (Restated) and 2009

F- 3Condensed Consolidated Statement of Stockholders’ Equity (Unaudited) for the Nine Months Ended September 30, 2010 (Restated)

F- 4Notes to Condensed Consolidated Financial Statements

F- 5 - F-29Item 2.

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

3Item 3.

Quantitative and Qualitative Disclosure About Market Risk.

20Item 4T.

Controls and Procedures.

20PART II - OTHER INFORMATIONItem 1.

Legal Proceedings.

20Item 1A.

Risk Factors.

21Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds.

21Item 3.

Defaults Upon Senior Securities.

21Item 4.

(Removed and Reserved).

21Item 5.

Other Information.

21Item 6.

Exhibits.

21Signatures

22




2


PART I – FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS.





Zoo Entertainment, Inc. and Subsidiaries


Condensed Consolidated Balance Sheets


As of September 30, 2010 (Restated) and December 31, 2009


(in thousands except share and per share amounts)


September 30,

2010


December 31,

2009(restated)

(unaudited)ASSETSCurrent AssetsCash

$
1,222


$
2,664Accounts receivable and due from factor, net of allowances for returns and discounts of $787 and $835


13,380



4,022Inventory


8,708



2,103Prepaid expenses and other current assets


1,341



2,409Product development costs, net


7,783



4,399Deferred tax assets


379



578Total Current Assets


32,813



16,175Fixed assets, net


248



141Intangible assets, net


14,292



15,733Total Assets

$
47,353


$
32,049LIABILITIES AND STOCKHOLDERS' EQUITYCurrent LiabilitiesAccounts payable

$
4,493


$
3,330Financing arrangements


10,478



1,659Customer advances


815



3,086Accrued expenses and other current liabilities


6,350



2,333Notes payable, current portion


120



120Total Current Liabilities


22,256



10,528Notes payable, non-current portion


150



180Deferred tax liabilities


2,189



3,461Other long-term liabilities


-



2,770Total Liabilities


24,595



16,939Commitments and ContingenciesStockholders' EquityPreferred Stock, par value $0.001, 5,000,000 shares authorizedSeries A, 0 issued and outstanding at September 30, 2010,1,389,684 issued and outstanding at December 31, 2009


-



1Series B, 0 issued and outstanding at September 30, 20101,188,439 issued and outstanding at December 31, 2009


-



1Common Stock, par value $0.001, 3,500,000,000 sharesauthorized, 6,243,744 issued and 6,230,741 outstanding atSeptember 30, 2010 and 250,000,000 authorized, 65,711issued and 52,708 outstanding at December 31, 2009


6



-Additional paid-in-capital


73,195



64,714Accumulated deficit


(45,974
)


(45,137
)Treasury Stock, at cost, 13,003 shares at September 30, 2010 and December 31, 2009


(4,469
)


(4,469
)Total Stockholders' Equity


22,758



15,110Total Liabilities and Stockholders' Equity

$
47,353


$
32,049





See accompanying notes to condensed consolidated financial statements


F-1


Zoo Entertainment, Inc. and Subsidiaries


Unaudited Condensed Consolidated Statements of Operations


For the Three Months and Nine Months Ended September 30, 2010 (Restated) and 2009


(in thousands except share and per share amounts)


Three Months Ended

September 30,


Nine Months Ended

September 30,(restated)

2010


2009


(restated)

2010


2009Revenue

$
17,253


$
8,583


$
43,713


$
30,136Cost of goods sold


13,579



6,570



34,416



25,701Gross profit


3,674



2,013



9,297



4,435Operating expenses:General and administrative (includes stock-based compensation of $127, $322, $489 and $566)


1,052



1,750



3,847



5,010Selling and marketing


1,307



548



3,643



2,073Research and development


-



-



-



370Impairment of goodwill


-



14,704



-



14,704Depreciation and amortization


510



504



1,509



1,373Total operating expenses


2,869



17,506



8,999



23,530Income (loss) from operations


805



(15,493
)


298



(19,095
)Interest expense, net


(642
)


(462
)


(1,631
)


(2,589
)Gain on legal settlement


-



-



-



4,328Other income - insurance recovery


-



860



-



860Income (loss) from operations before income tax expense


163



(15,095
)


(1,333)



(16,496
)Income tax (expense) benefit


(56
)


-



496



-Income (loss) from continuing operations


107



(15,095
)


(837)



(16,496
)Loss from discontinued operations


-



(235
)


-



(235
)Net income (loss)

$
107


$
(15,330
)

$
(837)


$
(16,731
)Earnings (loss) per common share - basic and diluted:Basic:Earnings (loss) per common share from continuing operations

$
0.02


$
(290
)

$
(0.22)


$
(290
)Loss per common share from discontinued operations


-



(5
)


-



(4
)Net earnings (loss) per share

$
0.02


$
(295
)

$
(0.22)


$
(294
)Weighted average common shares outstanding - basic


5,853,568



52,023



3,794,620



56,878Diluted:Earnings (loss) per common share from continuing operations

$
0.01


$
(290
)

$
(0.22)


$
(290
)Loss per common share from discontinued operations


-



(5
)


-



(4
)Net earnings (loss) per share

$
0.01


$
(295
)

$
(0.22)


$
(294
)Weighted average common shares outstanding - diluted


7,383,590



52,023



3,794,620



56,878





See accompanying notes to condensed consolidated financial statements


F-2


Zoo Entertainment, Inc. and Subsidiaries


Unaudited Condensed Consolidated Statements of Cash Flow


For the Nine Months Ended September 30, 2010 (Restated) and 2009


(in thousands)


Nine Months Ended September 30,(restated)

2010


2009Operating activities:Net loss

$
(837)


$
(16,731
)Loss from discontinued operations


-



(235
)Net loss from continuing operations


(837)



(16,496
)Adjustments to reconcile net loss from operations to net cash used in operating activities:Gain on legal settlement


-



(4,328
)Impairment of goodwill


-



14,704Depreciation and amortization


1,509



1,373Amortization of deferred debt discount


-



1,870Deferred income taxes


(1,073
)


-Stock-based compensation


489



566Other changes in assets and liabilities:Accounts receivable and due from factor, net


(9,358
)


(1,422
)Inventory


(6,605
)


944Product development costs, net


(3,384
)


(401
)Customer advances


(1,686
)


1,413Prepaid expenses and other current assets


1,068



(2,118
)Accounts payable


1,163



(112
)Accrued expenses and other current liabilities


1,621



(716
)Net cash used in operating activities


(17,093
)


(4,723
)Investing activities:Purchases of fixed assets


(175
)


(92
)Purchase of intellectual property


-



(162
)Net cash used in investing activities


(175
)


(254
)Financing activities:Proceeds from sale of equity securities, net of $2,000 of costs in 2010


7,592



7Net borrowings in connection with financing facilities


8,819



2,654(Repayment of) proceeds from Solutions 2 Go customer advances


(585
)


2,000Net cash provided by financing activities


15,826



4,661Net decrease in cash


(1,442
)


(316
)Cash at beginning of period


2,664



849Cash at end of period

$
1,222


$
533





See accompanying notes to condensed consolidated financial statements


F-3


Zoo Entertainment, Inc. and Subsidiaries


Unaudited Condensed Consolidated Statement of Stockholders' Equity


For the Nine Months Ended September 30, 2010 (Restated)


(in thousands)


Preferred StockSeries A


Series B


Common Stock








Treasury StockShares


Par

Value


Shares


Par

Value


Shares


Par

Value


Additional

Paid-in- Capital


Accumulated

Deficit


Shares


Cost


TotalBalance at January 1, 2010


1,390


$
1



1,188


$
1



66


$
-


$
64,714


$
(45,137
)


13


$
(4,469
)

$
15,110Conversion of Series A Preferred Stock to Common Stock


(1,390
)


(1
)


-



-



2,316



2



(1
)


-



-



-



-Conversion of Series B Preferred Stock to Common Stock


-



-



(1,188
)


(1
)


1,981



2



(1
)


-



-



-



-Common Stock issued to directors


-



-



-



-



281



1



160



-



-



-



161Issuance of management options accrued for in 2009 as a liability


-



-



-



-



-



-



403



-



-



-



403Stock-based compensation


-



-



-



-



-



-



329



-



-



-



329Sale of Common Stock - July 2010, net of costs of $2,000


-



-



-



-



1,600



1



7,591



-



-



-



7,592Net loss


-



-



-



-



-



-



-



(837)



-



-



(837)Balance at September 30, 2010


-


$
-



-


$
-



6,244


$
6


$
73,195


$
(45,974
)


13


$
(4,469
)

$
22,758





See accompanying notes to condensed consolidated financial statements


F-4


Zoo Entertainment, Inc. and Subsidiaries


Notes to Condensed Consolidated Financial Statements


NOTE 1. DESCRIPTION OF ORGANIZATION


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. 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., a Delaware corporation (“Zoo Games”) (formerly known as Green Screen Interactive Software, Inc.) and a stockholder representative, pursuant to which Merger Sub merged with and into Zoo Games, with Zoo Games surviving the merger and becoming a wholly-owned subsidiary of the Company (the “Merger”). In connection with the Merger, the outstanding shares of common stock of Zoo Games were exchanged for shares of common stock of the Company. On December 3, 2008, Driftwood Ventures, Inc. changed its name to Zoo Entertainment, Inc. 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 equity raise, the Company issued Series A Convertible Preferred Stock (“Series A Preferred Stock”) and warrants. Concurrently, as a result of the aforementioned preferred equity raise, the Company’s note holders converted approximately $11.8 million of existing debt and related accrued interest into Series B Convertible Preferred Stock (“Series B Preferred Stock”). On December 16, 2009, as a result of the Company consummating an additional preferred equity raise of $776,000, the Company issued to investors Series A Preferred Stock. On March 10, 2010, the Company increased its authorized shares of common stock to 3,500,000,000. As a result, all of the outstanding shares of Series A Preferred Stock and the Series B Preferred Stock converted into shares of common stock of the Company on March 10, 2010.


On May 10, 2010, the Company effectuated a one-for-600 reverse stock split of its outstanding common stock, par value $0.001 per share, pursuant to previously obtained stockholder authorization. As a result of the reverse stock split, every 600 shares of the Company’s common stock were combined into one share of common stock. All common stock equity transactions have been adjusted to reflect the reverse stock split for all periods presented.


Zoo Games is a developer, publisher and distributor of interactive entertainment software for use on all major platforms including Nintendo’s Wii and DS, Sony’s PlayStation Portable (“PSP”), PlayStation 2 (“PS2”) and PlayStation 3 (“PS3”), 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 and, on December 18, 2007, acquired all of the outstanding capital stock of Destination Software, Inc., which was later renamed Zoo Publishing, Inc. (“Zoo Publishing”).


Zoo Games was treated as the acquirer for accounting purposes in the 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 effective date of the Merger.


The Company operates in one segment in the United States and focuses on developing, publishing and distributing interactive entertainment software under the Zoo brand both in North American and international markets.


Unless the context otherwise indicates, the use of the terms “we,” “our” or “us” refer to the Company and its operating subsidiaries, Zoo Games and Zoo Publishing.


F-5


NOTE 2. RESTATEMENT OF SEPTEMBER 30, 2010 FINANCIAL STATEMENTS




On April 13, 2011, Management of the Company, in consultation with the Audit Committee of the Board of Directors, concluded that there were errors in recording certain transactions in the Company’s previously filed unaudited consolidated financial statements for the three and nine months ended September 30, 2010, and that such statements should no longer be relied upon. These errors were identified while the Company was completing its analyses in connection with the 2010 fiscal year-end audit. Specifically, these errors relate to revenue recognition, including royalty income, certain sales volume rebates earned by one customer and revenue recorded in connection with sales to one distributor. As part of the restatement process, the Company recorded adjustments for items that were previously considered insignificant and were either not recorded or recorded in the incorrect reporting period.In addition, the Company is reclassifying certain selling costs from cost of goods sold to selling and marketing expense, as well as reclassifying certain product financing costs from cost of goods sold to interest expense.




The effects of the Company’s restatement, including the tax impact, on previously reported unaudited consolidated financial statements are summarized as follows, in thousands, except share and per share amounts:




Three and Nine Months Ended September 30, 2010




Unaudited Consolidated Balance Sheet

September 30,

2010


September 30,

2010As Previously

Reported


As RestatedAccounts receivable and due from factor, net

$
13,940


$
13,380Prepaid expenses and other current assets


1,606



1,341Total current assets


33,638



32,813Intangible assets, net


14,304



14,292Total assets


48,190



47,353Accrued expenses and other current liabilities


5,705



6,350Total current liabilities


21,611



22,256Deferred tax liabilities


2,706



2,189Total liabilities


24,467



24,595Accumulated deficit


(45,009
)


(45,974
)Total stockholders’ equity


23,723



22,758Total liabilities and stockholders’ equity


48,190



47,353







Unaudited Consolidated Statement of

Operations

Three Months

Ended

September

30, 2010


Three Months

Ended

September

30, 2010


Nine Months

Ended

September 30,

2010


Nine Months

Ended

September 30,

2010As Previously

Reported


As Restated


As Previously

Reported


As RestatedRevenue

$
17,581


$
17,253


$
45,183


$
43,713Cost of goods sold


13,894



13,579



35,366



34,416Gross profit


3,687



3,674



9,817



9,297Selling and marketing


1,307



1,307



3,360



3,643Depreciation and amortization


506



510



1,497



1,509Total operating expenses


2,865



2,869



8,704



8,999Income from operations


822



805



1,113



298Interest expense


(343
)


(642
)


(964
)


(1,631
)Income (loss) from operations before income taxes


479



163



149



(1,333
)Income tax(expense) benefit


(165
)


(56
)


(21
)


496Net income (loss)

$
314


$
107


$
128


$
(837
)Earnings (loss) per common share – basic and diluted:Net earnings (loss) per common share - basic

$
0.05


$
0.02


$
0.03


$
(0.22
)Net earnings (loss) per common share - diluted

$
0 04


$
0.01


$
0.02


$
(0.22
)




F-6





Unaudited Consolidated Statement of Cash Flow

Nine Months

Ended

September 30,

2010


Nine Months

Ended

September 30,

2010As Previously

Reported


As RestatedNet income

$
128


$
(837
)Deferred income taxes


(556
)


(1,073
)Changes in accounts receivable and due from factor, net


(9,918
)


(9,358
)Changes in prepaid expenses and other current assets


803



1,068Changes in accrued expenses and other current liabilities


976



1,621





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 (“GAAP”) and the interim financial statement rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP 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 condensed consolidated financial statements should be read in conjunction with the Company’s management discussion and analysis contained elsewhere herein and the consolidated financial statements for the year ended December 31, 2009 included in the Company’s Registration Statement on Form S-1/A (Registration No. 333-163937), as filed on June 25, 2010. The Company’s results for the three and nine months ended September 30, 2010 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-owned subsidiaries, Zoo Publishing and Zoo Entertainment Europe Ltd. All intercompany accounts and transactions are eliminated in consolidation.


Use of Estimates


The preparation of financial statements in conformity with GAAP 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 condensed consolidated financial statements that are particularly significant include the recoverability of product development costs, adequacy of allowances for returns, price concessions and doubtful accounts, lives and realization of intangibles, valuation of equity instruments and the valuation of inventories. Actual amounts could differ from these estimates.


Concentration of Credit Risk


The Company maintains cash balances at what it believes are several high quality financial institutions. While the Company attempts to limit credit exposure with any single institution, balances often exceed Federal Deposit Insurance Corporation insurable amounts.


If the financial condition and operations of the Company’s customers deteriorate, its risk of collection could increase substantially. A majority of the Company’s trade receivables are derived from sales to major retailers and distributors. In October 2008, the Company 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 the Company 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 June 30, 2010. The agreement with Atari expired on June 30, 2010 and, as of September 30, 2010, there was no receivable due from Atari. The Company’s five largest ultimate customers accounted for approximately 83% (of which the following customers constituted balances greater than 10%: customer A-55% and customer B-11%) and 78% (of which the following customers constituted balances greater than 10%: customer A-46% and customer B-18%) of net revenue for the three months ended September 30, 2010 and 2009, respectively. The Company’s five largest ultimate customers accounted for approximately 81% (of which the following customers constituted balances greater than 10%: customer A-46%, customer B- 11% and customer C-12%) and 77% (of which the following customers constituted balances greater than 10%: customer A-27%, customer B-18%, customer C-14% and customer D-11%) of net revenue for the nine months ended September 30, 2010 and 2009, respectively. These five largest customers accounted for 85% of the Company’s gross accounts receivable and due from factor as of September 30, 2010. The Company believes that the receivable balances from its customers do not represent a significant credit risk based on past collection experience. During the nine months ended September 30, 2010 and 2009, the Company sold approximately $17.8 million and $832,000, respectively, of receivables to its factor with recourse. The factored receivables were approximately $6.5 million and $1.4 million of the Company’s accounts receivable and due from factor, net as of September 30, 2010 and December 31, 2009, respectively. The Company regularly reviews its outstanding receivables for potential bad debts and has had no history of significant write-offs due to bad debts.


F-7


Reclassifications




The accompanying unaudited interim condensed consolidated financial statements for the three and nine months ended September 30, 2009 contain certain reclassifications to conform to the current period presentation.




Inventory


Inventory is stated at the lower of actual cost or market. The Company periodically evaluates the carrying value of its inventory and makes 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


The Company utilizes third party product developers and frequently enters into agreements with these developers that require it to make payments based on agreed upon milestone deliverable schedules for game design and enhancements. The Company receives the exclusive publishing and distribution rights to the finished game title as well as, in some cases, the underlying intellectual property rights for that game. The Company typically enters into these development agreements after it has completed the design concept for its products. The Company contracts with third party developers that have proven technology and the experience and ability to build the designed video game as conceived by the Company. As a result, technological feasibility is determined to have been achieved at the time in which the Company enters the agreement and it therefore capitalizes such payments as prepaid product development costs. On a product by product basis, the Company reduces prepaid product development costs and records amortization 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, the Company evaluates the recoverability of capitalized prepaid product development costs, 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 development process is discontinued prior to completion, any prepaid unrecoverable amounts are charged to research and development expense. The Company uses various measures to estimate future revenues for its 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.


The Financial Accounting Standards Board (“FASB”) Accounting Standards Topic 808-10-15, “Accounting for Collaborative Arrangements” (“ASC 808-10-15”), defines collaborative arrangements and requires collaborators to present the result of activities for which they act as the principal on a gross basis and report any payments received from (made to) the other collaborators based on other applicable authoritative accounting literature, and in the absence of other applicable authoritative literature, on a reasonable, rational and consistent accounting policy is to be elected. Effective January 1, 2009, the Company adopted the provisions of ASC 808-10-15. The adoption of this statement did not have an impact on the Company’s consolidated financial position, results of operations or cash flows. The Company’s arrangements with third party developers are not considered collaborative arrangements because the third party developers do not have significant active participation in the design and development of the video games, nor are they exposed to significant risks and rewards as their compensation is fixed and not contingent upon the revenue that the Company will generate from sales of its product. If the Company enters into any future arrangements with product developers that are considered collaborative arrangements, it will account for them accordingly.


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 the Company’s products. Agreements with holders of intellectual property rights generally provide for guaranteed minimum royalty payments for use of their intellectual property.


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 the Company to pay royalties to the license holder, based on pre-agreed unit sales thresholds.


Licensing fees are capitalized on the condensed consolidated 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, the Company reviews its sales projections quarterly to determine the likely recoverability of its 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.


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


The Company reviews 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. The Company compares 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, the Company records 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 the Company’s incremental borrowing rate or fair value, if available. The Company determined that no impairment for definite lived intangible assets was identified in the nine months ended September 30, 2010 or 2009.


As of September 30, 2009, the Company determined that all the goodwill then on the balance sheet was impaired and as such recorded an impairment charge of $14.7 million against the goodwill.


Revenue Recognition


The Company earns its revenue from the sale of interactive software titles developed by and/or licensed from third party developers. The Company recognizes such revenue upon the transfer of title and risk of loss to its customers. Accordingly, the Company recognizes 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. The Company’s payment arrangements with customers typically provide net 30 and 60-day terms. Advances received from customers are reported on the condensed consolidated balance sheets as customer advances and are included in current liabilities until the Company meets its performance obligations, at which point it recognizes the revenue.


Revenue is presented net of estimated reserves for returns, price concessions and other allowances. In circumstances when the Company does not have a reliable basis to estimate returns and price concessions or is unable to determine that collection of a receivable is probable, the Company defers the revenue until such time as it can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.


F-9


Allowances for Returns, Price Concessions and Other Allowances


The Company may accept returns and grant price concessions in connection with its publishing arrangements. Following reductions in the price of the Company’s products, we may grant price concessions that permit customers to take credits for unsold merchandise against amounts they owe us. The Company’s 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 the Company’s distribution arrangements with customers do not give them the right to return titles or to cancel firm orders, the Company sometimes accepts returns from its distribution customers for stock balancing and makes accommodations to customers, which include credits and returns, when demand for specific titles falls below expectations.


The Company makes 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 the Company’s 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. The Company believes it 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


The Company has various marketing arrangements with retailers and distributors of its 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.


The Company receives various incentives from its manufacturers, including 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.


Equity-Based Compensation


The Company issued restricted common stock and options to purchase shares of common stock of the Company to certain members of management and employees during the nine months ended September 30, 2010 and 2009. Stock option grants vest over periods ranging from immediate to four years and expire within ten years of issuance. Stock options that vest in accordance with service conditions amortize over the applicable vesting period using the straight-line method.


The fair value of the options granted 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 the Company’s stock price and estimated exercise behavior. The Company used the current market price to determine the fair value of the stock price for the grant made during the period ended September 30, 2009, and used the price of the Company’s equity raise in the fourth quarter of 2009 to determine the fair value of the stock price for the grant made on February 11, 2010. The Company used the current market price to determine the fair value of the stock price for the grant made in August 2010. No other stock grants were made in 2010. The following table summarizes the assumptions and variables used by the Company to compute the weighted average fair value of stock option grants:


F-10





Nine MonthsEnded September 30,2010


2009Risk-free interest rate


3.00
%


3.45
%Expected stock price volatility


60.0
%


60.0
%Expected term until exercise (years)


5



5Expected dividend yield

None


None




For the nine months ended September 30, 2010 and 2009, the Company estimated the implied volatility for publicly traded options on its 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 the Company’s assessment that implied volatility is more representative of future stock price trends than historical volatility.


The fair value of the restricted common stock grants in February 2010 was determined based on the price of the Company’s equity raise in the fourth quarter of 2009 and, where appropriate, a marketability discount.


Earnings (Loss) Per Share


Basic earnings (loss) per share (“EPS”) is computed by dividing the net income (loss) applicable to common stockholders for the period by the weighted average number of shares of common stock outstanding during the same period. A restricted stock grant, of which 199,395 shares are unvested as of September 30, 2010, is excluded from the basic EPS. 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, options and non-vested restricted shares outstanding during the same period. Since the inclusion of 1,039,703 warrants and 4,321 options for the nine months ended September 30, 2010 and the inclusion of 22,509 warrants and 4,321 options outstanding as of September 30, 2009 are anti-dilutive because the Company had net losses for those periods, they are excluded from the calculation of diluted loss per share and the diluted loss per share is the same as the basic loss per share.


The reconciliation from basic weighted average common shares outstanding to fully diluted weighted average common shares outstanding is as follows:


F-11




Three Months Ended


Nine Months EndedSeptember 30,


September 30,2010


2009


2010


2009(restated)Weighted average common shares outstanding - basic


5,853,568



52,023



3,794,620



56,878Options outstanding - dilutive


315,396



-



-



-Warrants outstanding - dilutive


1,015,231



-



-



-Non-vested shares


199,395



-



-



-Weighted average common shares outstanding – diluted


7,383,590



52,023



3,794,620



56,878


Income Taxes


The Company recognizes 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 as income in the period that includes the enactment date. Valuation allowances are established when the Company determines that it is more likely than not that such deferred tax assets will not be realized.


In accordance with the FASB Accounting Standards Codification Topic 740, the Company adopted standards that clarify the accounting and recognition for income tax positions taken or expected to be taken in the Company’s income tax returns. As a result of the implementation, the Company did not recognize any change in its tax liability. As of September 30, 2010, the Company believes it does not have any material unrecognized tax costs from tax positions taken during the current or any prior period. In addition, as of September 30, 2010, tax years 2007 through 2009 remain within the statute of limitations and are subject to examination by tax jurisdictions.


Fair Value Measurement


In accordance with Topic 820 of the FASB (“Topic 820”), “Fair Value Measurements and Disclosures”, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Topic 820 establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value into three broad levels as follows:


·
Level 1 — Unadjusted quoted market prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
 
 ·
Level 2 — Quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (i.e., interest rates, yield curves, etc.) and inputs that are derived principally from or corroborated by observable market data by correlation or other means.




F-12




·
Level 3 — Unobservable inputs that reflect assumptions about what market participants would use in pricing assets or liabilities based on the best information available.




As of September 30, 2010 and December 31, 2009, the carrying value of cash, accounts receivable and due from factor, inventory, prepaid expenses, accounts payable, accrued expenses, due to factor, and advances from customers were reasonable estimates of the fair values because of their short-term maturity. The carrying value of financing arrangements and notes payable are reasonable estimates of fair value because interest rates closely approximate market rates.


NOTE 4. INVENTORY


Inventory consisted of:


(Amounts in Thousands)September 30,


December 31,2010


2009Finished products, net

$
2,047


$
1,247Parts and supplies, net


6,661



856Totals

$
8,708


$
2,103




Estimated product returns included in inventory at September 30, 2010 and December 31, 2009 were $336,000 and $261,000, respectively.


NOTE 5. PREPAID EXPENSES AND OTHER CURRENT ASSETS


Prepaid expenses and other current assets consisted of:


(Amounts in Thousands)September 30,


December 31,2010


2009(restated)Vendor advances for inventory

$
316


$
1,545Prepaid royalties


831



474Other prepaid expenses


194



390Totals

$
1,341


$
2,409




F-13


NOTE 6. PRODUCT DEVELOPMENT COSTS


The Company’s capitalized product development costs for the nine months ended September 30, 2010 were as follows (amounts in thousands):


Product development costs, net - December 31, 2009

$
4,399New product development costs incurred


6,115Amortization of product development costs


(2,731
)Product development costs, net – September 30, 2010

$
7,783




Amortization of product development costs for the three months ended September 30, 2010 and September 30, 2009 was approximately $1.1 million for both periods. Amortization of product development costs for the nine months ended September 30, 2010 and September 30, 2009 was approximately $2.7 million and approximately $3.8 million, respectively.


NOTE 7. INTANGIBLE ASSETS, NET


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


Estimated





(Amounts in Thousands)Useful


Gross


September 30, 2010


December 31, 2009Lives


Carrying


Accumulated


Net Book


Net Book(Years)


Amount


Amortization


Value


ValueContent


10


$
14,965


$
3,743


$
11,222


$
12,345Trademarks


10



1,510



422



1,088



1,201Customer relationships


10



2,749



767



1,982



2,187Totals





$
19,224


$
4,932


$
14,292


$
15,733




F-14





Amortization expense related to intangible assets was $480,000 for both the three months ended September 30, 2010 and 2009, and approximately $1.4 million and $1.3 million for the nine months ended September 30, 2010 and 2009, respectively.


The following table presents the amortization of intangible assets, based on the Company’s present intangible assets, as follows:


(AmountsYear Ending December 31,

in Thousands)Balance of 2010

$
4812011


1,9222012


1,9222013


1,9222014


1,922Thereafter


6,123Total

$
14,292




F-15


NOTE 8. 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:


Purchase Order Financing


Zoo Publishing utilizes purchase order financing with Wells Fargo Bank, National Association (“Wells Fargo”) to fund the manufacturing of video game products. Under the terms of the Company’s agreement (the “Assignment Agreement”), the Company assigns purchase orders received from customers to Wells Fargo, and requests 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, retains the Company to manufacture, process and ship ordered goods, and pays the Company for its 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 re-assigns the applicable purchase order to the Company. The Company pays to Wells Fargo a commitment fee in the aggregate amount of $337,500 on the earlier of the 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 12 months, and continues thereafter for successive 12 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 12 month terms, for each such 12 month term, the Company will pay to Wells Fargo a commitment fee in the sum of $337,500, paid on the earlier of the 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.


The amounts outstanding as of September 30, 2010 and December 31, 2009 were approximately $5.9 million and $759,000, respectively, which is included in financing arrangements in the current liability section of the condensed consolidated balance sheets. The interest rate on advances is prime plus 2.0%, effective April 6, 2010; prior to that date the interest rate on advances was prime plus 4.0%. As of September 30, 2010 and December 31, 2009, the effective interest rate was 5.25% and 7.25%, respectively. The charges and interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and were $315,000 and $92,000 for the three months ended September 30, 2010 and 2009, respectively, and $667,000 and $186,000 for the nine months ended September 30, 2010 and 2009, respectively.


On April 6, 2010, Zoo Publishing, the Company and Wells Fargo entered into an amendment to the existing Assignment Agreement. Pursuant to the amendment, the parties agreed to, among other things: (i) increase the amount of funding available pursuant to the facility to $10,000,000; (ii) reduce the set-up funding fee to 2% and increase the total commitment fee to approximately $407,000 for the next 12 months and to $400,000 for the following 12 months if the Assignment Agreement is renewed for an additional year; (iii) reduce the interest rate to prime plus 2% on outstanding advances; and (iv) extend its term until April 5, 2011, subject to automatic renewal for successive 12 month terms unless either party terminates the agreement with written notice 30 days prior to the end of the initial term or any renewal term. In consideration for the extension, the Company paid to Wells Fargo an aggregate fee of approximately $32,000.


F-16


Receivable Financing


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 and security agreement with Working Capital Solutions, Inc. (“WCS”), which utilizes existing accounts receivable in order to provide working capital to fund all aspects of the Company’s continuing business operations. The Company entered into a new factoring and security agreement with WCS on September 29, 2009 (the “Factoring Agreement”). Under the terms of the Factoring Agreement, the Company sells its receivables to WCS, with recourse. WCS, 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 WCS, WCS provides funding subject to the terms and conditions of the Factoring Agreement. The amount remitted to the Company by WCS 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 Factoring 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, WCSr can require the receivable to be repurchased by the Company in accordance with the Factoring Agreement. The amounts to be paid by the Company to WCS for any accepted receivable include a factoring fee of 0.6% for each ten (10) day period the account is open. Since WCS acquires the receivables with recourse, the Company records the gross receivables including amounts due from its customers to WCS and it records a liability to WCS for funds advanced to the Company from WCS. During the nine months ended September 30, 2010 and 2009, the Company sold approximately $17.8 million and $0, respectively, of receivables to WCS with recourse. At September 30, 2010 and December 31, 2009, accounts receivable and due from WCS included approximately $6.5 million and approximately $1.4 million of amounts due from the Company’s customers to WCS, respectively. WCS had an advance outstanding to the Company of approximately $4.6 million and $900,000 as of September 30, 2010 and December 31, 2009, respectively which is included in financing arrangements in the current liability section of the respective condensed consolidated balance sheets. In connection with the Factoring Agreement, 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 WCS, pursuant to which Messrs. Seremet and Rosenbaum agreed to guaranty the full and prompt payment and performance of the obligations under the Factoring Agreement.




On April 1, 2010, Zoo Publishing, Zoo Games and the Company entered into a First Amendment to Factoring and Security Agreement (the “WCS Amendment”) with WCS. Pursuant to the WCS Amendment, the parties amended the Factoring Agreement to, among other things: (i) increase the maximum amount of funds available pursuant to the facility to $5,250,000; and (ii) extend its term to a period initially ending on April 1, 2012, subject to automatic renewal for successive one year periods unless Zoo Publishing terminates the Factoring Agreement with written notice 90 days prior to the next anniversary of the date of the Factoring Agreement, or unless Zoo Publishing terminates the Factoring Agreement on a date other than an anniversary date with 30 days prior written notice.




On October 1, 2010 Zoo Publishing, Zoo Games and the Company entered into a Second Amendment to Factoring and Security Agreement with WCS (the “WCS Second Amendment”). Pursuant to the WCS Second Amendment, the parties amended the Factoring Agreement to, among other things: (i) increase the maximum amount of funds available pursuant to the facility to $8,000,000; and (ii) extend its term to a period initially ending on September 30, 2012, subject to automatic renewal for successive one year periods unless Zoo Publishing terminates the Factoring Agreement with written notice 90 days prior to the next anniversary of the date of the Factoring Agreement, or unless Zoo Publishing terminates the Factoring Agreement on a date other than an anniversary date with 30 days prior written notice.




F-17


Atari Agreement





As a result of a fire in October 2008 that destroyed the Company’s inventory and impacted its cash flow from operations, the Company 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 would 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 June 30, 2010 and subsequently expired on June 30, 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 the Company’s standard selling price and they have been recorded as a reduction in revenue. During the three months ended September 30, 2009, the Company recorded approximately $2.5 million of net sales to Atari. During the nine months ended September 30, 2010 and 2009, the Company recorded approximately $10.8 million and $23.5 million, respectively, of sales, net of the fee to Atari. As of September 30, 2010 and December 31, 2009, Atari had prepaid the Company $0 and approximately $1.5 million, respectively, for goods not yet shipped which is recorded as customer advances in current liabilities. Also, as of September 30, 2010 and December 31, 2009, the receivable due from Atari was $0 and approximately $1.8 million, respectively, before allowances, for goods already shipped which are recorded in accounts receivable and due from factor in the condensed consolidated balance sheets.




Other Customer Advance — Solutions 2 Go, Inc.




On August 31, 2009, Zoo Publishing entered into an exclusive distribution agreement with Solutions 2 Go Inc. (“S2G Inc.”) and an Exclusive Distribution Agreement with Solutions 2 Go, LLC (“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. Interest expense of $23,000 and $78,000 is recorded for the three and nine months ended September 30, 2010, respectively. The amount of any unrecouped advance outstanding was scheduled to be paid in its entirety if (i) the Company receives proceeds in connection with any sale of securities, or otherwise raises additional capital, exceeding an aggregate of $5.0 million, other than under a defined anticipated qualified financing prior to September 15, 2010 or (ii) no later than September 15, 2010. The advance is recouped 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 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. S2G has agreed to extend the payment of the balance and interest due until January 1, 2011 and will continue to reduce the balance due by the margin earned on sales through that period. As of September 30, 2010 and December 31, 2009, the balance remaining on the advance was approximately $815,000 and $1.4 million, respectively, and is included in customer advances in the current liabilities section of the condensed consolidated balance sheets. Any remaining unrecouped balance will be due on January 1, 2011. Interest no longer accrues after September 30, 2010.




In consideration of S2G entering into the Advance Agreement, the Company agreed to issue to S2G Inc. a warrant to purchase 12,777 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 $450 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 (“Zoo Entertainment 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 $180. The warrant was issued on August 31, 2009. The warrant was valued at $400,000 using the Black-Scholes model and this cost was amortized over 12 months through interest expense. For the three months ended September 30, 2010 and September 30, 2009, $51,000 and $33,000, respectively, of additional interest expense was recorded in the condensed consolidated statement of operations for this advance. For the nine months ended September 30, 2010 and September 30, 2009, $267,000 and $33,000, respectively, of additional interest expense was recorded in the condensed consolidated statement of operations for this advance.


F-18


The advance is guaranteed by Messrs. Seremet and Rosenbaum and a former employee. Messrs. Seremet and Rosenbaum did not receive any additional compensation for this guarantee. The former employee who guaranteed the advance was granted 834 shares of common stock. The value of the shares issued was computed at $100,000 using the bid-ask spread of the Company’s stock price and is recorded in the general and administrative expenses in the year ended December 31, 2009.





NOTE 9. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES




Accrued expenses and other current liabilities consisted of:


(Amounts in Thousands)September 30,


December 31,2010


2009(restated)Obligations from the purchase of content intangible assets ($1,844 was classified as long-term until May 2010 when the obligation due May 2011 became current)

$
2,144


$
300Operating expenses


844



473Due to customers


1,797



18Obligations arising from acquisitions ($620 was classified as long-term until July 2010 when the obligation due in July 2011 became current)


620



233Royalties


614



430Interest


238



58Obligations to compensate current and former employees


-



561Other


93



260Totals

$
6,350


$
2,333




F-19


NOTE 10. INCOME TAXES


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.


The Company paid $182,000 and $20,000 to various state jurisdictions for income taxes during the nine months ended September 30, 2010 and 2009, respectively.


As of September 30, 2010, the Company had approximately $1.2 million of available capital loss carryforwards which expire in 2013. A valuation allowance of approximately $726,000 was recognized to offset the deferred tax assets related to these carryforwards. 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.


As of September 30, 2010, the Company has U.S. federal net operating loss (“NOL”) carryforwards of approximately $1.5 million. As a result of statutory limitations, the Company will only be able to utilize approximately $160,000 of NOL and capital loss carryforwards per year. The federal NOL will begin to expire in 2028. The Company has state NOL carryforwards of approximately $15.6 million which will be available to offset taxable state income during the carryforward period. The state NOL will also begin to expire in 2028.


F-20


NOTE 11. STOCKHOLDERS’ EQUITY AND STOCK-BASED COMPENSATION ARRANGEMENTS




The Company has authorized 3,500,000,000 shares of common stock, par value $0.001, and 5,000,000 shares of preferred stock, par value $0.001 as of September 30, 2010. All references to common stock reflect the one-for-600 reverse stock split of the Company’s common stock, par value $0.001 per share, that became effective on May 10, 2010, and all historical information has been restated to reflect the reverse stock split.




Common Stock




As of September 30, 2010, there were 6,243,744 shares of common stock issued and 6,230,741 shares of common stock outstanding.




On July 12, 2010, the Company completed the sale of 1,600,000 shares of the Company’s common stock in a public offering at a price of $6.00 per share. The net proceeds to the Company from the sale of the shares, after deducting the underwriting discounts and commissions and offering expenses of approximately $2.0 million, was approximately $7.6 million.




On May 4, 2010, the Company announced that its Board of Directors approved the implementation of a one-for-600 reverse stock split of its common stock pursuant to previously obtained stockholder authorization. The Company’s common stock began trading on a post-split basis on May 11, 2010. As a result of the reverse stock split, every 600 shares of the Company’s common stock were combined into one share of common stock. The reverse stock split affected all of the Company’s common stock, stock options and warrants outstanding immediately prior to the effective date of the reverse stock split. Any fractional share resulting from the reverse stock split was rounded up to the nearest whole number. The split reduced the number of the Company’s outstanding shares of common stock from 2,778,409,829 to 4,630,741 as of May 10, 2010.




On February 11, 2010, the Board of Directors approved the issuance of 281,104 shares of restricted common stock to various members of the Board of Directors. The fair value of the restricted common stock grants was determined to be $397,000, based on the price of the Company’s equity raise in the fourth quarter of 2009 and a marketability discount. The stock-based compensation expense recorded in the three months and nine months ended September 30, 2010 is $25,000 and $161,000, respectively. The remaining $236,000 will be expensed throughout the remaining vesting period of the restricted common stock grants until February 2013.




On January 13, 2010, a certificate of amendment to the Company’s Certificate of Incorporation (the “Certificate of Amendment”) to increase the Company’s authorized shares of common stock, par value $0.001 per share, from 250,000,000 shares to 3,500,000,000 shares was approved by the Company’s Board of Directors and by the Company’s stockholders holding a majority of the Company’s issued and outstanding shares of common stock. On March 10, 2010, the Company filed the Certificate of Amendment with the Secretary of State of the State of Delaware.




In conjunction with the increase in authorized shares, 1,389,684 shares of Series A Preferred Stock automatically converted into 2,316,145 shares of common stock and 1,188,439 shares of Series B Preferred Stock automatically converted into 1,980,739 shares of common stock. See below for descriptions and features of the Series A Preferred Stock and Series B Preferred Stock.


F-21


The following table summarizes the activity of non-vested outstanding restricted stock:




Number

OutstandingNon-Vested shares at December 31, 2009


—Shares granted


281,104Shares vested


(81,709
)Non-Vested shares at September 30, 2010


199,395




Preferred Stock


As of September 30, 2010, there were no shares of Series A Preferred Stock or Series B Preferred Stock issued or outstanding. As of December 31, 2009, there were 1,389,684 shares of Series A Preferred Stock and 1,188,439 shares of Series B Preferred Stock issued and outstanding. The Series A Preferred Stock and Series B Preferred Stock automatically converted to common shares of the Company at a rate of 1:1.667 on March 10, 2010 when there was a sufficient number of common shares authorized.




Preferred stock was issued in lieu of common stock in connection with the November and December 2009 equity raises because the Company did not have a sufficient number of shares of common stock authorized. On November 20, 2009, the Company determined that it had the requisite number of votes of its holders of common stock and preferred stock in order to effect an increase in its authorized shares of common stock as soon as practicable to allow for all the then outstanding preferred stock to automatically convert to common stock immediately upon the effectiveness of an amendment to the Company’s Certificate of Incorporation authorizing an increase in its authorized shares of common stock. On January 13, 2010, the Company’s Board of Directors and stockholders holding approximately 66.7% of the Company’s outstanding voting capital stock approved the Certificate of Amendment. The consents the Company received constituted the only stockholder approval required for the Certificate of Amendment under the Delaware General Corporation Law and the Company’s existing Certificate of Incorporation and Bylaws. Pursuant to Rule 14c-2 of the Securities Exchange Act of 1934, as amended, this amendment was not effected until a date that was at least 20 calendar days following the date the Company first mailed the definitive Information Statement to the Company’s stockholders pursuant to Section 14(c) regarding the stockholder approval by written consent of such amendment (the “Information Statement”). The Information Statement was first sent to the Company’s stockholders on February 16, 2010. On March 10, 2010, the Company increased the Company’s authorized shares of common stock, from 250,000,000 shares to 3,500,000,000 shares.




On November 20, 2009, the Company entered into a securities purchase agreement with certain investors, consummating an approximate $4.2 million convertible preferred equity raise, pursuant to which the Company issued 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 have a rate of one share of Series A Preferred Stock for each $2.50 of value of the investment amount. The Company issued 1,180,282 shares of Series A Preferred Stock on November 20, 2009. On December 16, 2009, the Company received an additional $776,000 from certain investors and issued an additional 209,402 shares of Series A Preferred Stock.


F-22


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 provided that, among other things, the outstanding principal balance and all accrued and unpaid interest of $734,000 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 share of Series B Preferred Stock for each $10.00 of value of the note. Moreover, the amendment provided 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 the conversion, except for the right of each holder to receive the shares to which it is entitled as a result of such conversion. The Company issued 1,188,439 shares of Series B Preferred Stock on November 20, 2009 as a result of the conversion of the above notes.




Options




As of December 31, 2008, the Company’s 2007 Employee, Director and Consultant Stock Plan (the “2007 Plan”) allowed for an aggregate of 1,667 shares of common stock with respect to which stock rights may be granted with no more than 417 shares of common stock with respect to which stock rights may be granted to any participant in any fiscal year.




On January 14, 2009, the Company’s Board of Directors approved and adopted an amendment to the 2007 Plan, which increased the number of shares of common stock that may be issued under this plan from 1,667 shares to 6,667 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 417 shares to 1,250 shares. All other terms of the 2007 Plan remained in full force and effect.




On January 14, 2009, the Company granted Mr. Seremet an option to purchase 1,250 shares of the Company’s common stock at an exercise price of $180 per share, pursuant to the 2007 Plan. There were no other options granted during the year ended December 31, 2009. As of December 31, 2009, 3,792 shares of common stock remained available for future issuance under the 2007 Plan.




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”), 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. 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 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. Subject to the effectiveness of an amendment to the Company’s Certificate of Incorporation authorizing an increase in the number of authorized shares of the Company’s common stock and the one-for-600 reverse stock split, on February 11, 2010, the Company issued 337,636 options to purchase shares of common stock to each of Mr. Seremet and Mr. Rosenbaum in consideration for their continued personal guarantees. The Company performed a Black-Scholes valuation to determine the value of the arrangements on February 11, 2010 to be $542,000. Of the $542,000, $403,000 was included as stock-based compensation expense in 2009 based on the value ascribed for the period from November 20, 2009 to December 31, 2009, and was included in accrued expenses in the December 31, 2009 consolidated balance sheet. The stock-based compensation expense recorded in the three months and nine months ended September 30, 2010 is $29,000 and $85,000, respectively. The remaining $54,000 will be expensed throughout the remaining vesting period of the options until May 2011.




On February 11, 2010, the Company granted options to purchase 585,645 shares of common stock to various employees, directors and consultants, outside of the 2007 Plan.


F-23


Also on February 11, 2010, the Company’s Board of Directors approved and adopted an amendment to the 2007 Plan, which increased the number of shares of common stock that may be issued under this plan from 6,667 shares to 1,208,409 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 1,250 shares to 300,000 shares. All other terms of the 2007 Plan remained in full force and effect.





On August 4, 2010, the Company granted options to purchase 70,000 shares of common stock to various employees at an exercise price of $5.50 per share, pursuant to the 2007 Plan.




A summary of the status of the Company’s outstanding stock options as of September 30, 2010 and changes during the period then ended are presented below:




September 30, 2010WeightedAverageNumber of


ExerciseShares


PriceOutstanding at December 31, 2009


4,321


$
774.00Granted (outside of the 2007 Plan)


1,330,917



1.71Forfeited


(12,262
)


15.23Outstanding at September 30, 2010


1,322,976


$
4.53Options exercisable at September 30, 2010


688,251


$
5.90




The fair value of options granted during the nine months ended September 30, 2010 was approximately $1.1 million, of which $403,000 was accrued for in 2009 as a liability.


F-24


The following table summarizes information about outstanding stock options at September 30, 2010:


Options Outstanding


Options ExercisableWeighted-Average


Weighted-Range of





Remaining


Average





Weighted-Exercise


Number


Contractual


Exercise


Number


AveragePrices


Outstanding


Life (Years)


Price


Exercisable


Exercise Price$
1,548.00



274



2.6


$
1,548



274


$
1,548$
1,350.00



235



2.9



1,350



156



1,350$
912.00



2,438



2.7



912



2,438



912$
180.00



1,250



3.2



180



417



180$
5.50



70,000



9.9



5.50



—



5.50$
2.46



573,507



9.4



2.46



104,232



2.46$
1.50



675,272



9.4



1.50



580,734



1.50$
1.50 to $1,548



1,322,976



9.4


$
4.53



688,251


$
5.90




The following table summarizes the activity of non-vested outstanding stock options:


Number

Outstanding


Weighted-

Average Fair

Value at

Grant Date


Weighted-

Average

Remaining

Contractual

Life (Years)Non-Vested options at December 31, 2009


1,485


$
1,350.00



4.0Options Granted


1,330,917



2.14



9.5Options Vested


(685,415
)


1.83



9.4Options forfeited or expired


(12,262
)


16.18



—Non-Vested options at September 30, 2010


634,725


$
3.05



9.4




As of September 30, 2010, there was $525,000 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 1.2 to 3.9 years.


F-25


The intrinsic value of options outstanding at September 30, 2010 is approximately $3.5 million.


Warrants


As part of the equity raise on November 20, 2009 and on December 16, 2009, the Company issued warrants to purchase an aggregate of 1,017,194 shares of the Company’s common stock. The warrants have a five year term and an exercise price of $0.01 per share. The warrants contain customary limitations on the amount that can be exercised. Additionally, the warrants provide that they could not be exercised until the effectiveness of the filing of an amendment to the Company’s Certificate of Incorporation authorizing a sufficient number of shares of common stock to permit the exercise of the warrants, which was completed on March 10, 2010.




As of September 30, 2010, there were 1,039,703 warrants outstanding with terms expiring in 2012 through 2014, all of which are currently exercisable.




A summary of the status of the Company’s outstanding warrants as of September 30, 2010 and changes during the period then ended are presented below:




September 30, 2010Number of

Warrants


Weighted

Average

Exercise

PriceOutstanding at December 31, 2009


1,039,703


$
6.82Granted


—



—Exercised


—



—Outstanding at September 30, 2010


1,039,703


$
6.82Warrants exercisable at September 30, 2010


1,039,703


$
6.82




The following table summarizes information about outstanding and exercisable warrants at September 30, 2010:


Warrants Outstanding and ExercisableRange of

Exercise Prices


Number

Outstanding


Weighted-

Average

Remaining

Contractual

Life (Years)


Weighted-

Average

Exercise

Price$
1,704.00



2,383



2.5


$
1,704.00$
1,278.00



531



2.5



1,278.00$
180.00



12,777



4.0



180.00$
6.00



6,818



2.9



6.00$
0.01



1,017,194



4.0



0.01$
0.01 to $1,704.00



1,039,703



4.1


$
6.82




F-26


NOTE 12. INTEREST, NET


(Amounts in Thousands)Three Months

Ended September 30,


Nine Months

Ended September 30,2010


2009


2010


2009(restated)





(restated)Interest arising from amortization of debt discount

$
-


$
180


$
—


$
1,870Interest on various notes


23



190



78



533Interest arising from amortization of Solutions 2 Go warrants


51



-



267



—Interest on financing arrangements


568



92



1,286



186Interest expense, net

$
642


$
462


$
1,631


$
2,589




NOTE 13. SUPPLEMENTAL CASH FLOW INFORMATION


Supplemental cash flow information for the nine months ended September 30, 2010 and 2009 is as follows:


(Amounts in Thousands)

Nine Months

Ended September 30,2010


2009Cash paid during the period for interest

$
1,183


$
186Cash paid during the period for taxes

$
182


$
20Non-cash investing and financing activities:Transfer of option liability to equity

$
403


$
—Par Value of Series A Preferred Stock converted to Common Stock

$
1


$
—Par Value of Series B Preferred Stock converted to Common Stock

$
1


$
—Receipt of 9,274 shares for partial settlement of litigation

$
—


$
1,113Notes and obligations relieved for partial settlement of litigation

$
—


$
3,925Acquisition of Intangible for long-term obligation

$
—


$
2,600




NOTE 14. LITIGATION


The Company is involved, from time to time, in various legal proceedings and claims incident to the normal conduct of its business. Although it is impossible to predict the outcome of any legal proceeding and there can be no assurances, the Company believes that these legal proceedings and claims, individually and in the aggregate, are not likely to have a material adverse effect on its consolidated financial condition, results of operations or cash flows.


F-27


NOTE 15. RELATED PARTY TRANSACTIONS




On April 6, 2009, the Company entered into an amended and restated purchase order financing arrangement with Wells Fargo. In connection with the amended agreement, 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.




Additionally, pursuant to the Fee Letters, the Company agreed to grant under the 2007 Plan, 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 $240 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 were granted 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 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 until 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 until November 20, 2010. In addition, the amended Fee Letters provide that, in consideration of each of their continued personal guarantees, the Company’s Board of Directors 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 Messrs. Seremet and Rosenbaum, respectively. On February 11, 2010, the Company issued options to purchase 337,636 shares of common stock to each of Messrs. Seremet and Rosenbaum in consideration for their continued personal guarantees. (See Note 11 for the valuation of the options and Note 16 for subsequent amendments to the Fee Letters.)




F-28


NOTE 16. SUBSEQUENT EVENTS




On October 1, 2010 Zoo Publishing, Zoo Games and the Company entered into the WCS Second Amendment. Pursuant to the WCS Second Amendment, the parties amended the Factoring Agreement to, among other things: (i) increase the maximum amount of funds available pursuant to the facility to $8,000,000; and (ii) extend its term to a period initially ending on September 30, 2012, subject to automatic renewal for successive one year periods unless Zoo Publishing terminates the Factoring Agreement with written notice 90 days prior to the next anniversary of the date of the Factoring Agreement, or unless Zoo Publishing terminates the Factoring Agreement on a date other than an anniversary date with 30 days prior written notice.




On October 1, 2010, the Company entered into an Amended and Restated Letter Agreement with each of Mark Seremet and David Rosenbaum, which amended and restated each of those Fee Letters, pursuant to which, in consideration of each of Messrs. Seremet and Rosenbaum entering into guarantees with each of: (i) Wells Fargo Bank, National Association in connection with the Company’s purchase order financing; (ii) Solutions 2 Go, Inc. to guaranty the payment of all indebtedness of the Company and its affiliates in connection with that certain Advance Agreement with Solutions 2 Go, Inc. and Solutions 2 Go, LLC; and (iii) WCS in connection with the Company’s accounts receivable financing, the Company agreed to compensate each of Messrs. Seremet and Rosenbaum $10,000 per month and $7,000 per month, respectively, in consideration for each of their guarantees under the Company’s purchase order financing with Wells Fargo Bank, National Association, for so long as such guarantees and loan remain in full force and effect. In addition, the amended and restated Fee Letters provide that the Company shall compensate each of Messrs. Seremet and Rosenbaum in consideration for each of their guarantees of the increased indebtedness incurred by the Company under the WCS Second Amendment, for so long as such guarantees and loan remain in full force and effect, an additional $25,000 on each of: October 1, 2010, January 1, 2011, April 1, 2011 and July 1, 2011.


F-29


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




You should read the following management discussion and analysis (“MD&A”) together with our Condensed Consolidated Financial Statements and Notes thereto included in this report. This discussion contains forward-looking statements that involve risks, uncertainties and assumptions. When used in this report, the words “anticipate,” “believe,” “estimate,” “expect,” “may,” “should,” “could” 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 as a result of various factors, including, but not limited to, those presented under “Risk Factors” and elsewhere herein. Historical operating results are not necessarily indicative of the trends in operating results for any future period. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.




Overview




We are a developer, publisher, and distributor of interactive entertainment software targeting family-oriented mass-market consumers with retail prices ranging from $9.99 to $49.99 per title. Unlike most video game companies, we typically conceive of game concepts internally and then utilize external development teams and resources to develop the software products. Our entertainment software is developed for use on major consoles, handheld gaming devices, personal computers, and mobile smart-phone devices. We currently develop and/or publish video games that operate on platforms including Nintendo’s Wii, DS, and Game Boy Advance, Sony’s PSP, PS2, and PS3, Microsoft’s Xbox 360 and Apple’s iPhone. We also develop and seek to sell downloadable games for emerging “connected services” including Microsoft’s Xbox Live Arcade, Sony’s PlayStation 3 Network, Nintendo’s Dsiware, facebook, and for use on PCs. In addition, as part of our digital initiative, we operate our website indiePub Games, www.indiepubgames.com, for independent software developers to compete for prizes and publishing contracts, and also serves as a destination site for gaming enthusiasts to play free games, vote in contests and participate in the development of innovative entertainment software.




Our current video game titles and overall business strategy target family-oriented, mass-market consumers. Rather than depending on a relatively limited number of “blockbuster” titles to generate our revenue, we focus on delivering a consistent portfolio and broad stream of strong titles at compelling values. In some instances, these titles are based on licenses of well-known properties such as Jeep, Hello Kitty, Shawn Johnson, and Remington, and in other cases, based on our original intellectual property. Our games span a diverse range of categories, including sports, family, racing, game-show, strategy and action-adventure, among others. In addition, we develop video game titles that are bundled with unique accessories such as fishing rods, bows, steering wheels, and guns, which help to differentiate our products and provide additional value to our target demographic. Our focus is to create more product and value for our customer while simultaneously putting downward pressure on our development expenditures and time to market.




Zoo Entertainment; Merger with Zoo Games




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 (the “Merger”). In connection with the Merger, all of the outstanding shares of common stock of Zoo Games were exchanged for common stock of the Company on September 12, 2008.


3


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




Zoo Games




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 December 2007, Zoo Games acquired the capital stock of Zoo Publishing. The acquisition of Zoo Publishing provided Zoo Games with North American distribution and further enhanced its experienced management team. Zoo Publishing distributes software titles throughout North America and exploits 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 May 2009, we formed a new company in the United Kingdom that is a wholly-owned subsidiary of Zoo Games called Zoo Entertainment Europe Ltd. to focus on the sales and distribution of our products in Europe. In our effort to refocus our cash on our core business operations, we discontinued the operations of Zoo Europe effective December 2009.


4


Results of Operations




For the Three Months Ended September 30, 2010 as Compared to the Three Months Ended September 30, 2009




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 30,2010


2009(restated)Revenue

$
17,253



100
%

$
8,583



100
%Cost of goods sold


13,579



79



6,570



77Gross profit


3,674



21



2,013



23Operating expenses:General and administrative


1,052



6



1,750



20Selling and marketing


1,307



8



548



6Impairment of goodwill


-



-



14,704



171Depreciation and amortization


510



3



504



6Total operating expenses


2,869



17



17,506



204Income (loss) from operations


805



5



(15,493
)


(181
)Interest expense, net


(642
)


(4
)


(462
)


(5
)Other income – insurance recovery


-



-



860



10Income (loss) from operations before income tax expense


163



1



(15,095
)


(176
)Income tax expense


(56
)


-



-



-Income (loss) from continuing operations


107



1



(15,095
)


(176
)Loss from discontinued operations


-



-



(235
)


(3
)Net income (loss)

$
107



1
%

$
(15,330
)


(179
)%Earnings (loss) per common share - basic

$
0.02






$
(295
)Earnings (loss) per common share - diluted

$
0.01






$
(295
)




Net Revenues. Net revenues for the three months ended September 30, 2010 were approximately $17.3 million, an increase of 101% over the revenues for the three months ended September 30, 2009 of approximately $8.6 million. Sales in both periods consist primarily of casual game sales in North America. The breakdown of gross sales by platform is as follows:


Three Months Ended September30,2010


2009Nintendo Wii


74
%


72
%Nintendo DS


25
%


27
%SONY PS2


1
%


0
%Microsoft Xbox


0
%


1
%




5


The biggest sellers during the 2010 period were (i) Martian Panic with our gun blaster for the Nintendo Wii platform, (ii) Deal or No Deal Special Edition on the Nintendo Wii platform, and (iii) Chicken Blaster with our gun blaster on the Nintendo Wii platform. The various Nintendo Wii games bundled with our gun blaster and wheel peripherals accounted for approximately 35% of our revenue during the 2010 period and for most of the revenue increase from the 2009 period to the 2010 period. These Nintendo Wii game bundles were comprised of 17 titles, of which no individual title accounted for more than 10% of our sales for the period. 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 2010 period consisted of approximately 1.9 million units sold in North America at an average gross price of $10.50, while the 2009 period consisted of approximately 873,000 units sold in North America at an average gross price of $9.38. The average price increase resulted primarily from the inclusion of the higher priced game bundles sold in 2010, offset, in part, by various older products that were sold at lower prices in the 2010 period than in the 2009 period. Sales allowances provided to customers for returns, markdowns, price protection and other deductions were 11% of gross sales for the three months ended September 30, 2010 as compared to 5% of gross sales for the three months ended September 30, 2009; the increase being due primarily to a large customer return in the 2010 period. In addition, we continue to increase our customer base and distribution channels, providing us with more outlets for the sales of our products.




Gross Profit. Gross profit for the three months ended September 30, 2010 was approximately $3.7 million, or 21% of net revenue, while the gross profit for the three months ended September 30, 2009 was approximately $2.0 million, or 23% 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, the amortization of product development costs relating to the current period’s revenues and interest charges and fees paid to our purchase order financing facility to build the inventory. The slight decrease to the gross margin in the 2010 period from the 2009 period was primarily due to the higher percentage of sales to distributors in the 2010 period; our product is typically sold to distributors at a lower price than when we sell the product direct to retailers.




General and Administrative Expenses. General and administrative expenses for the three months ended September 30, 2010 were approximately $1.1 million as compared to approximately $1.8 million for the comparable period in 2009. Non-cash stock-based compensation included in general and administrative expenses was $127,000 and $322,000 for the three months ended September 30, 2010 and September 30, 2009, respectively. The elimination of headcount in New York and relocation of all general and administrative functions to Ohio resulted in decreased payroll, consulting and related costs of approximately $500,000 from the 2009 period to the 2010 period




Selling and Marketing Expenses. Selling and marketing expenses increased from $548,000 to approximately $1.3 million for the three months ended September 30, 2010 due primarily to additional salaries and related costs for the increased headcount for the sales and marketing team in Ohio. The increase was also due to approximately $100,000 of costs incurred for the launch and continued marketing of the indiePub Games website during the third quarter of 2010.




Impairment of Goodwill.The Company incurred a triggering event as of September 30, 2009 based on the equity infusion of approximately $4.0 million for 50% ownership in our equity and the conversion of the existing convertible debt during the fourth quarter of 2009. As such, we performed an impairment analysis, resulting in the full impairment of goodwill of $14.7 million.




Depreciation and Amortization Expenses. Depreciation and amortization costs for the three months ended September 30, 2010 were $510,000 as compared to $504,000 in the comparable period in 2009. Both periods include $412,000 resulting from the amortization of intangibles acquired from the Zoo Publishing acquisition and $69,000 and $65,000, respectively resulting from the amortization of content intangibles obtained from the New World IP license in May 2009. The balance relates to depreciation of fixed assets during the period.


6


Interest Expense. Interest expense for the three months ended September 30, 2010 was $642,000 as compared to $462,000 for the three months ended September 30, 2009. The 2010 period includes $23,000 of interest on the Solutions 2 Go loan and $51,000 of non-cash interest relating to the warrants issued for the Solutions 2 Go exclusive distribution rights. Interest paid by Zoo Publishing in the 2010 period for the receivable factoring facility was $253,000 and for the purchase order facility was $315,000. 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, $51,000 of interest related to the advance from Solutions 2 Go and $92,000 for the purchase order facility. The Zoo Entertainment Notes were converted to equity in November 2009; therefore, there is no interest costs related to these notes in 2010.




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 in 2009.




Income Tax Expense. We recorded an income tax expense of $56,000 for the three months ended September 30, 2010 against pre-tax income of $163,000. We did not record any income tax benefit for the three months ended September 30, 2009 since we had already maximized the allowable amount of deferred taxes.




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.




Earnings (loss) Per Common Share. The basic earnings per share for the three months ended September 30, 2010 was $0.02 based on a weighted average shares outstanding for the period of approximately 5.9 million and the diluted earnings per share for the three months ended September 30, 2010 was $0.01 based on a weighted average shares outstanding for the period of approximately 7.4 million. The basic and diluted loss per common share for the three months ended September 30, 2009 was ($295), based on a weighted average shares outstanding for the period of 52,023.


7


For the Nine Months Ended September 30, 2010 as Compared to the Nine Months Ended September 30, 2009




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 30,2010


2009(restated)Revenue

$
43,713



100
%

$
30,136



100
%Cost of goods sold


34,416



79



25,701



85Gross profit


9,297



21



4,435



15Operating expenses:General and administrative


3,847



9



5,010



17Selling and marketing


3,643



8



2,073



7Research and development


-



-



370



1Impairment of goodwill


-



-



14,704



49Depreciation and amortization


1,509



3



1,373



5Total operating expenses


8,999



20



23,530



78Income (loss) from operations


298



1



(19,095
)


(63
)Interest expense, net


(1,631
)


(4
)


(2,589
)


(9
)Gain on legal settlement










4,328



14Other income – insurance recovery


-



-



860



3Loss from operations before income tax expense


(1,333)



(3
)


(16,496
)


(55
)Income tax benefit


496



1



-



-Loss from continuing operations


(837)



(2
)


(16,496
)


(55
)Loss from discontinued operations


-



-



(235
)


(1
)Net loss

$
(837)



(2)
%

$
(16,731
)


(56
)%Loss per common share - basic and diluted

$
(0.22)






$
(294
)




8


Net Revenues.Net revenues for the nine months ended September 30, 2010 were approximately $43.7 million, an increase of 45% over the revenues for the nine months ended September 30, 2009 of approximately $30.1 million. Sales in both periods consist primarily of casual game sales in North America.




The breakdown of gross sales by platform is as follows:




Nine Months Ended September 30,2010


2009Nintendo Wii


73
%


65
%Nintendo DS


27
%


31
%Microsoft Xbox


0
%


2
%Sony PS2


0
%


2
%




The biggest sellers during the 2010 period were (i) Deal or No Deal on the Nintendo Wii platform, (ii) Deer Drive with our gun blaster for the Nintendo Wii platform, and (iii) Martian Panic with our gun blaster for the Nintendo Wii platform. The various Nintendo Wii games bundled with our gun blaster and wheel peripherals accounted for approximately 31% of our revenue during the 2010 period and for most of the revenue increase from the 2009 period to the 2010 period. These Nintendo Wii game bundles were comprised of 17 titles, of which no individual title accounted for more than 10% of our sales for the period. 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 2010 period consisted of approximately 4.4 million units sold in North America at an average gross price of $10.41, while the 2009 period consisted of approximately 3.4 million units sold in North America at an average gross price of $9.54. The average price increase resulted primarily from the inclusion of the higher priced game bundles sold in 2010, offset, in part, by various older products that were sold at lower prices in the 2010 period than in the 2009 period. Sales allowances provided to customers for returns, markdowns, price protection and other deductions were 7% of gross sales for the nine months ended September 30, 2010 as compared to 8% of gross sales for the nine months ended September 30, 2009. The sales allowances in both periods included certain product returned that were subsequently sold or will be sold to other customers. In addition, we continue to increase our customer base and distribution channels, providing us with more outlets for the sales of our products.




Gross Profit. Gross profit for the nine months ended September 30, 2010 was approximately $9.3 million, or 21% of net revenue, while the gross profit for the nine months ended September 30, 2009 was $4.4, or 15% 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, the amortization of product development costs relating to the current period’s revenues and interest charges and fees paid to our purchase order financing facility to build the inventory. The Atari sales agreement was in place for all sales during the entire 2009 period and Atari’s fees recorded as a reduction in revenue during the nine months ended September 30, 2009 were approximately $2.7 million. For the nine months ended September 30, 2010, Atari’s fees recorded as a reduction in revenue were approximately $1.1 million. For those sales that were not distributed through Atari, the Company pays the shipping costs. The net improvement to the gross margin in the 2010 period from the 2009 period was partially due to the reduction in the sales distributed through Atari. 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 sales at very low margins, which along with related royalty fees and amortization of product development costs resulted in a lower overall gross margin for the 2009 period.


9


General and Administrative Expenses. General and administrative expenses for the nine months ended September 30, 2010 were approximately $3.8 million as compared to $5.0 million for the comparable period in 2009. Non-cash stock-based compensation included in general and administrative expenses was $489,000 and $566,000 for the nine months ended September 30, 2010 and September 30, 2009, respectively. The elimination of headcount in New York and relocation of all general and administrative functions to Ohio resulted in decreased payroll, consulting and related costs of approximately $700,000 from the 2009 period to the 2010 period. Costs incurred for the European office during the 2009 period were $120,000; these did not reoccur in 2010. In addition, the 2009 period includes $150,000 of bad debt expense and $185,000 of additional professional fees in the earlier part of the year that did not reoccur in 2010.




Selling and Marketing Expenses. Selling and marketing expenses increased from $2.1 million for the nine months ended September 30, 2009 to $3.6 million for the nine months ended September 30, 2010 due primarily to additional salaries and related costs for the increased headcount for the sales and marketing team in Ohio, as well as increased sales commissions in the 2010 period. The increase was also due to approximately $400,000 of costs incurred for the launch and continued marketing of the indiePub Games website during 2010.




Research and Development Expenses. Research and development expenses were $0 for the nine months ended September 30, 2010 compared to $370,000 for the nine months ended September 30, 2009. These expenses were a direct result of our decision to discontinue the development of certain games in the 2009 period. The Company has modified its business model to focus on casual products which carry significantly lower development risks and costs.




Impairment of Goodwill.The Company incurred a triggering event as of September 30, 2009 based on the equity infusion of approximately $4.0 million for 50% ownership in our equity and the conversion of the existing convertible debt during the fourth quarter of 2009. As such, we performed an impairment analysis, resulting in the full impairment of goodwill of $14.7 million.




Depreciation and Amortization Expenses. Depreciation and amortization costs for the nine months ended September 30, 2010 were approximately $1.5 million as compared to approximately $1.4 million for the nine months ended September 30, 2009. Both periods include approximately $1.2 million resulting from the amortization of intangibles acquired from the Zoo Publishing acquisition. The 2010 period includes $207,000 resulting from the amortization of content intangibles obtained from the New World IP license in May 2009, while the 2009 period only includes $65,000 for the amortization of those content intangibles. The balance relates to depreciation of fixed assets during the period.




Interest Expense. Interest expense for the nine months ended September 30, 2010 was approximately $1.6 million as compared to approximately $2.6 million for the nine months ended September 30, 2009. The 2010 period includes $78,000 of interest on the Solutions 2 Go loan and $267,000 of non-cash interest relating to the warrants issued for the Solutions 2 Go exclusive distribution rights. Interest paid by Zoo Publishing in the 2010 period for the receivable factoring facility was $619,000 and for the purchase order facility was $667,000. The nine months ended September 30, 2009 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 $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 2009 period also included $186,000 for the purchase order facility. The Zoo Entertainment Notes were converted to equity in November 2009 and the Zoo Publishing notes were cancelled in June 2009; therefore, there is no interest costs related to these notes in 2010.




Gain on Legal Settlement. During the nine month period ended September 30, 2009, 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 9,274 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.


10


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 Expense. We recorded an income tax benefit of $496,000 for the nine months ended September 30, 2010 against a pre-tax loss of approximately $1.3 million. We did not record any income tax benefit for the nine months ended September 30, 2009 since we had already maximized the allowable amount of deferred taxes.




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.




Loss Per Common Share. The basic and diluted loss per common share for the nine months ended September 30, 2010 was $0.22 based on a weighted average shares outstanding for the period of approximately 3.8 million. The basic and diluted loss per common share for the nine months ended September 30, 2009 was $294, based on a weighted average shares outstanding for the period of 56,878.




Liquidity and Capital Resources




We incurred a net loss of $837,000 for the nine months ended September 30, 2010 and a net loss of approximately $16.7 million for the nine months ended September 30, 2009. Our principal sources of cash during the nine months ended September 30, 2010 were proceeds from the sale of equity securities, the use of our purchase order and receivable financing arrangements, and cash generated from operations throughout the period.




Net cash used in operating activities for the nine months ended September 30, 2010 was approximately $17.1 million, consisting primarily of (i) an increase in receivables and due from factor resulting from increased sales of our products on standard payment terms during the period ended September 30, 2010 as compared to sales through a distributor that were primarily prepaid during the period prior to December 31, 2009, (ii) building inventory for projected sales for the fourth quarter of 2010 and (iii) product development costs incurred in connection with video games for release in the 2010 and 2011 periods. This was offset by an increase in accounts payable and accrued expenses due to the timing of certain payments. Net cash used in operating activities for the nine months ended September 30, 2009 was approximately $4.7 million, primarily consisting of an increase in accounts receivable and due from factor and prepaid inventory.




Net cash used in investing activities for the nine months ended September 30, 2010 was $175,000, all for the purchase of fixed assets. Net cash used in investing activities for the nine months ended September 30, 2009 was $254,000, of which $162,000 was for an investment in intellectual property and $92,000 for the purchase of fixed assets.




Net cash provided by financing activities for the nine month period ended September 30, 2010 was approximately $15.8 million, which includes: (i) approximately $7.6 million of proceeds, net of costs of approximately $2.0 million, from the sale of equity securities in July 2010, (ii) approximately $8.8 million of net borrowings from the purchase order and receivable financing facilities, (iii) offset by $585,000 of reductions to the customer advances from Solutions 2 Go. Net cash provided by financing activities for the nine month period ended September 30, 2009 was approximately $4.7 million, consisting of $2.0 million from the Solutions 2 Go advance and approximately $2.7 million of net proceeds in connection with the purchase order and receivable financing facilities.


11


Factoring Facility




Zoo Publishing has a factoring facility with Working Capital Solutions, Inc. (“WCS”), which utilizes existing accounts receivable in order to provide working capital to fund our continuing business operations. Under the terms of our factoring and security agreement (the “Factoring Agreement”), our receivables are sold to WCS, with recourse. WCS, 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 WCS, WCS provides funding, subject to the terms and conditions of the Factoring Agreement. The amount remitted to us by WCS 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 Factoring Agreement. The amounts to be paid by us to WCS for any accepted receivable include a factoring fee of 0.6% for each ten (10) day period the account is open. For the nine months ended September 30, 2010 and 2009, we sold approximately $17.8 million $0, respectively, of receivables to WCS with recourse and paid fees of $494,000 during the 2010 period. At September 30, 2010 and December 31, 2009, accounts receivable and due from WCS included approximately $6.5 million and approximately $1.4 million, respectively, of amounts due from our customers to WCS. WCS had an advance outstanding to the Company of approximately $4.6 million and $900,000 as of September 30, 2010 and December 31, 2009, respectively.




On April 1, 2010, Zoo Publishing, Zoo Games and the Company entered into a First Amendment to Factoring and Security Agreement pursuant to which the parties amended the Factoring Agreement to, among other things: (i) increase the maximum amount of funds available pursuant to the factoring facility to $5,250,000; and (ii) extend its term to a period initially ending on April 1, 2012, subject to automatic renewal for successive one year periods unless Zoo Publishing terminates the Factoring Agreement with written notice 90 days prior to the next anniversary of the date of the Factoring Agreement, or unless Zoo Publishing terminates the Factoring Agreement on a date other than an anniversary date with 30 days prior written notice.




On October 1, 2010, Zoo Publishing, Zoo Games and the Company entered into a Second Amendment to Factoring and Security Agreement pursuant to which the parties amended the Factoring Agreement to, among other things: (i) increase the maximum amount of funds available pursuant to the factoring facility to $8,000,000; and (ii) extend its term to a period initially ending on September 30, 2012, subject to automatic renewal for successive one year periods unless Zoo Publishing terminates the Factoring Agreement with written notice 90 days prior to the next anniversary of the date of the Factoring Agreement, or unless Zoo Publishing terminates the Factoring Agreement on a date other than an anniversary date with 30 days prior written notice.




Purchase Order Facility




In addition to the receivable financing agreement with WCS, Zoo Publishing also utilizes purchase order financing with Wells Fargo Bank, National Association (“Wells Fargo”) to fund the manufacturing of video game products. Under the terms of that certain assignment agreement (the “Assignment Agreement”), we 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, retains us to manufacture, process and ship ordered goods, and pays 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 re-assigns the applicable purchase order to us. We pay to Wells Fargo a commitment fee in the aggregate amount of $337,500, on the earlier of the 12 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 12 months, and continues thereafter for successive 12 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 12 month terms, for each such 12 month term, we agreed to pay to Wells Fargo a commitment fee in the sum of $337,500, which is payable upon the earlier of the 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.


12


The amount outstanding to Wells Fargo as of September 30, 2010 and December 31, 2009 was approximately $5.9 million and $759,000, respectively. The interest rate is prime plus 2.0%, effective April 6, 2010; prior to that date the interest rate on advances was prime plus 4%. As of September 30, 2010 and December 31, 2009, the effective interest rate was 5.25% and 7.25%, respectively. The charges and interest expense on the advances are included in interest expense in the accompanying condensed consolidated statement of operations and were $667,000 and $186,000 for the nine months ended September 30, 2010 and 2009, respectively.




On April 6, 2010, Zoo Publishing, the Company and Wells Fargo entered into an amendment to the existing Assignment Agreement. Pursuant to the amendment, the parties agreed to, among other things: (i) increase the amount of funding available pursuant to the facility to $10,000,000; (ii) reduce the set-up funding fee to 2% and increase the total commitment fee to approximately $407,000 for the next 12 months and to $400,000 for the following 12 months if the Assignment Agreement is renewed for an additional year; (iii) reduce the interest rate to prime plus 2% on outstanding advances; and (iv) extend its term until April 5, 2011, subject to automatic renewal for successive 12 month terms unless either party terminates the Assignment Agreement with written notice 30 days prior to the end of the initial term or any renewal term. In consideration for the extension, the Company paid to Wells Fargo an aggregate fee of approximately $32,000.




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.




On February 11, 2010, we issued options to purchase 337,636 shares of common stock to each of Mark Seremet and David Rosenbaum pursuant to the Fee Letters. The options have an exercise price of $1.50 per share and vest as follows: 72% vested immediately, 14% vest on May 12, 2010 and 14% vest on May 12, 2011. The options were subject to the effectiveness of an amendment to our Certificate of Incorporation to effectuate a one-for-600 reverse stock split of shares of our outstanding common stock.




On October 1, 2010, we entered into an Amended and Restated Letter Agreement with each of Mark Seremet and David Rosenbaum, which amended and restated each of the Fee Letters, pursuant to which, in consideration of each of Messrs. Seremet and Rosenbaum entering into guarantees with each of: (i) Wells Fargo Bank, National Association in connection with our purchase order financing; (ii) Solutions 2 Go, Inc. to guaranty the payment of all indebtedness of the Company and its affiliates in connection with that certain Advance Agreement with Solutions 2 Go, Inc. and Solutions 2 Go, LLC; and (iii) WCS in connection with our accounts receivable financing, we agreed to compensate each of Messrs. Seremet and Rosenbaum $10,000 per month and $7,000 per month, respectively, in consideration for each of their guarantees under the our purchase order financing with Wells Fargo Bank, National Association, for so long as such guarantees and loan remain in full force and effect. In addition, the amended and restated Fee Letters provide that we shall compensate each of Messrs. Seremet and Rosenbaum in consideration for each of their guarantees of the increased indebtedness incurred by the Company under the WCS Second Amendment, for so long as such guarantees and loan remain in full force and effect, $25,000 on each of: October 1, 2010, January 1, 2011, April 1, 2011 and July 1, 2011.


13


July 2010 Equity Raise




On July 12, 2010, the Company closed on an underwritten public offering of 1,600,000 shares of the Company’s common stock at a public offering price of $6.00 per share. The net proceeds to the Company from the sale of the shares, after deducting the underwriting discounts and commissions and offering expenses of approximately $2.0 million, were approximately $7.6 million. The proceeds from this offering are being used to fund working capital, the development of www.indiepubgames.com and other digital initiatives and other general corporate purposes.




Other




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. This agreement became effective on October 24, 2008 and provided for Zoo Publishing to sell its products to Atari without recourse and Atari would resell the products to wholesalers and retailers that are acceptable to Atari in North America. This agreement provides for Atari to prepay 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 was analyzed and reviewed within a sixty day period to be liquidated no later than July 31, 2009. The agreement initially expired on March 31, 2009, but was amended to extend the term for certain customers until June 30, 2010. Such agreement expired on June 30, 2010




Zoo Entertainment Notes




On July 7, 2008, as amended, 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 13,637 shares of our common stock. The notes had an interest rate of five percent (5%) for the one year term of the note commencing from issuance, unless extended. All of the warrants have a five year term and an exercise price of $6.00 per share. In connection with the note purchase agreement, we satisfied a management fee obligation by issuing additional senior secured convertible promissory notes in the principal amount of $750,000 and warrants to purchase 1,137 shares of our common stock. All of the warrants have a five year term and an exercise price of $6.00 per share.




On September 26, 2008, we entered into a note purchase agreement, as amended, 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 2,122 shares of our common stock. The notes had an interest rate of five percent (5%) for the time period beginning on September 26, 2008 and ended on November 20, 2009. The warrants have a five year term and an exercise price of $6.00 per share.




On November 20, 2009, the requisite holders (the “Holders”) of our senior secured convertible notes issued in the aggregate principal amount of $11.15 million described above agreed that if we raised a minimum of $4.0 million of new capital, they will convert their debt into shares of Series B Preferred Stock that will ultimately convert into shares of common stock representing approximately 36.5% of our equity. As a result of the consummation of our sale of Series A Preferred Stock resulting in gross proceeds to us of approximately $4.2 million, on November 20, 2009, approximately $11.9 million of principal plus accrued and unpaid interest underlying the notes converted into an aggregate of 1,188,439 shares of Series B Preferred Stock. On January 13, 2010, our Board of Directors and stockholders holding approximately 66.7% of our outstanding voting capital stock approved an amendment to our Certificate of Incorporation to increase the number of authorized shares of common stock from 250,000,000 shares to 3,500,000,000 shares (the “Charter Amendment”). On March 10, 2010, we filed the Charter Amendment with the Secretary of State of the State of Delaware. The Charter Amendment increased our authorized shares of common stock from 250,000,000 shares to 3,500,000,000 shares. Upon the filing of the Charter Amendment on March 10, 2010, all of the outstanding shares of Series B Preferred Stock automatically converted into 1,980,739 shares of our common stock.


14


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 consolidated 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, 2010, Zoo Games paid $580,000 and $620,000 will be paid on July 31, 2011, (See Note 9) 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, 2010, Zoo Publishing owed approximately $270,000 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.




We believe the existing cash, cash generated from operations and the equity raise described above are sufficient to meet our immediate operating requirements along with our current financial arrangements. However, we cannot assure you that this will be the case, and we may be required to obtain alternative or additional financing to maintain or expand our existing operations through the sale of our securities, an increase in our credit facilities or otherwise. The failure by us to obtain such financing, if needed, could have a material adverse effect upon our business, financial conditions and results of operations.




Critical Accounting Policies and Estimates




The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America ("GAAP") requires management to make estimates and assumptions about future events and apply judgments 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 net revenues and expenses during the reporting periods. We base our estimates and judgments on historical experience and current trends and other assumptions that management believes to be reasonable at the time our consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are fairly presented in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual amounts could differ significantly from these estimates.




We have identified the policies below as critical to our business operations and the understanding of our financial results and they require management's most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. The impact and any associated risks related to these policies on our business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.


15


Revenue Recognition




We recognize revenue upon the transfer of title and risk of loss to our customers. Accordingly, we recognize revenue for software when (1) there is persuasive evidence that an arrangement with our customer exists, which is generally a customer purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable, (4) collection of the customer receivable is deemed probable and (5) we do not have any continuing obligations. Our payment arrangements with customers typically provide net 30 and 60-day terms. Advances received from customers are reported on the balance sheet as deferred revenue until we meet our performance obligations, at which point we recognize the revenue.




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




Allowances for Returns and Price Concessions




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




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




We make estimates of future product returns and price concessions related to current period product revenue. We estimate the amount of future returns and price concessions for published titles based upon, among other factors, historical experience and performance of the titles in similar genres, historical performance of the 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, these estimates are inherently subjective and 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.




Inventory




Inventory is stated at the lower of actual cost or market. We estimate the net realizable value of slow-moving inventory on a title-by-title basis and charge the excess of cost over net realizable value to cost of sales.




Product Development Costs




We utilize third party product developers to develop the titles we publish and we frequently enter into agreements with these developers that require us to make advance payments for game design and enhancements. 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 for that game. We typically enter into these agreements after we have completed the design documentation for our products. We contract with third party developers that have proven technology and the experience and ability to build the designed video game. As a result, technological feasibility is determined to have been achieved at the time in which we enter the agreement and we therefore capitalize such advance payments as prepaid product development costs. On a product by product basis, we reduce prepaid product development costs and record amortization 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.


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At each balance sheet date, or earlier if an indicator of impairment exists, we evaluate the recoverability of capitalized prepaid product 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 development process 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.




The Financial Accounting Standards Board (“FASB”) Accounting Standards Topic 808-10-15, “Accounting for Collaborative Arrangements” (“ASC 808-10-15”), defines collaborative arrangements and requires collaborators to present the result of activities for which they act as the principal on a gross basis and report any payments received from (made to) the other collaborators based on other applicable authoritative accounting literature, and in the absence of other applicable authoritative literature, on a reasonable, rational and consistent accounting policy is to be elected. Effective January 1, 2009, the Company adopted the provisions of ASC 808-10-15. The adoption of this statement did not have an impact on the Company’s consolidated financial position, results of operations or cash flows. Our arrangements with third party developers are not considered collaborative arrangements because the third party developers do not have significant active participation in the design and development of the video games, nor are they exposed to significant risks and rewards as their compensation is fixed and not contingent upon the revenue that the Company will generate from sales of our product. If we enter into any future arrangements with product developers that are considered collaborative arrangements, we will account for them accordingly.




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 holders of intellectual property rights 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.




Amounts paid for licensing fees are capitalized on the balance sheet 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.




Asset Impairment




Long-Lived Assets Including Identifiable Intangibles. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount and the asset's residual value, if any. In turn, measurement of an impairment loss requires a determination of fair value, which is based on the best information available. We use internal discounted cash flow estimates, quoted market prices when available and independent appraisals, as appropriate, to determine fair value. We derive the required cash flow estimates from our historical experience and our internal business plans and apply an appropriate discount rate. See section above entitled “Asset Impairment.”


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Stock-based Compensation




Stock-based compensation expense is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, including, in the case of stock option awards, estimating expected stock volatility. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.




Income Taxes




Zoo Games was a limited liability company from inception until May 16, 2008 and followed all applicable United States tax regulations for a limited liability company. Effective May 16, 2008 when Zoo Games was incorporated, it became necessary for us to make certain estimates and assumptions to compute the provision for income taxes including allocations of certain transactions to different tax jurisdictions, amounts of permanent and temporary differences, the likelihood of deferred tax assets being recovered and the outcome of contingent tax risks. These estimates and assumptions are revised as new events occur, more experience is acquired and additional information is obtained. The impact of these revisions is recorded in income tax expense or benefit in the period in which they become known.




We account for uncertain income tax positions by recognizing in the consolidated financial statements only those tax positions we determine to be more likely than not of being sustainable upon examination, based on the technical merits of the positions, under the presumption that the taxing authorities have full knowledge of all relevant facts. The determination of which tax positions are more likely than not sustainable requires us to use significant judgments and estimates, which may or may not be borne out by actual results.




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.




In June 2009, the FASB issued ASC Topic 105 which establishes the FASB Accounting Standards Codification (the “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 our financial condition or results of operations. Going forward, FASB 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 (“ASUs”). The FASB will not consider ASUs 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.




Accounting Standards Updates Not Yet Effective




There are no ASUs that are effective after September 30, 2010 that are expected to have a significant effect on our consolidated financial position or results of operations.


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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.




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.


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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.




In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.





No system of controls can prevent errors and fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur. Controls can also be circumvented by individual acts of some people, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.




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 2010 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 period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




PART II - OTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS.




We are 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 consolidated financial condition, results of operations or cash flows.


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ITEM 1A. RISK FACTORS.




There have been no material changes in our risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, except as amended, updated and supplemented by the Company’s subsequent filings with the SEC, including the Company’s Registration Statement on Form S-1/A (Registration No. 333-163937), as filed on June 25, 2010.




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




None.




ITEM 3. DEFAULTS UPON SENIOR SECURITIES.




None.




ITEM 4. (Removed and Reserved).




ITEM 5. OTHER INFORMATION.




None.




ITEM 6. EXHIBITS .




10.1
Underwriting Agreement, by and between the Company and Roth Capital Partners, LLC, as representative of the several underwriters named in Schedule I thereto, dated July 7, 2010 (incorporated by reference to that Current Report on Form 8-K filed with the Securities and Exchange Commission on July 7, 2010).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.




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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: May 16, 2011




ZOO ENTERTAINMENT, INC/s/ Mark SeremetMark SeremetPresident and Chief Executive Officer(Principal Executive Officer)/s/ David FremedDavid FremedChief Financial Officer(Principal Financial Officer)




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EXHIBIT INDEX




10.1
Underwriting Agreement, by and between the Company and Roth Capital Partners, LLC, as representative of the several underwriters named in Schedule I thereto, dated July 7, 2010 (incorporated by reference to that Current Report on Form 8-K filed with the Securities and Exchange Commission on July 7, 2010).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.




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