UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.   20549









FORM
10-Q


(Mark
One)





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





For the
quarterly period ended March 31, 2010





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


For the
transition period from _____________ to ___________


Commission
file number 333-124829





ZOO
ENTERTAINMENT, INC.


(Exact
name of Registrant as Specified in Its Charter)


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





3805
      Edwards Road, Suite 400
              Cincinnati,
      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 o





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 o No o





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
definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):




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




Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).


Yes  o  No x





As of May
14, 2010, there were 4,643,744 shares of the Registrant’s common stock, par
value $0.001 per share, issued and 4,630,741 shares outstanding, as adjusted for
the one-for-600 reverse stock split of the Registrant’s common stock effectuated
on May 10, 2010.









ZOO
ENTERTAINMENT, INC.




Table
of Contents




PageItem
      1.
                    
                    Financial
      StatementsCondensed
      Consolidated Balance Sheets as of March 31, 2010 (Unaudited) and
      December 31, 2009
                    F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three Months
      Ended March 31, 2010 and 2009
                    F-
      2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Three Months
      Ended March 31, 2010 and 2009
                    F-
      3Condensed
      Consolidated Statement of Stockholders’ Equity (Unaudited) for the Three
      Months Ended March 31, 2010
                    F-
      4Notes
      to Condensed Consolidated Financial Statements
                    F-
      5 - F-21Item
      2.
                    
                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                    1Item
      3.
                    
                    Quantitative
      and Qualitative Disclosure About Market Risk
                    6Item
      4T.
                    
                    Controls
      and Procedures
                    6PART
      II - OTHER INFORMATIONItem
      1.
                    
                    Legal
      Proceedings
                    8Item
      1A.
                    
                    Risk
      Factors
                    8Item
      2.
                    
                    Unregistered
      Sales of Equity Securities and Use of Proceeds
                    8Item
      3.
                    
                    Defaults
      Upon Senior Securities
                    8Item
      4.
                    
                    (Removed
      and Reserved)
                    8Item
      5.
                    
                    Other
      Information
                    8Item
      6.
                    
                    Exhibits
                    8Signatures
                    9









PART
I - FINANCIAL INFORMATION




ITEM
1.   FINANCIAL STATEMENTS




Zoo
Entertainment, Inc. and Subsidiaries
 Condensed
Consolidated Balance Sheets
 (in
thousands except share and per share amounts)
  March
      31, 2010
                                        
                                        
                                        December
      31, 2009(unaudited)ASSETSCurrent
      AssetsCash
                                        
                                        $
                                        838
                                        
                                        
                                        $
                                        2,664Accounts
      receivable and due from factor, net ofallowances for returns
      and discounts of $803 and $835
                                        
                                        
                                        4,948
                                        
                                        
                                        
                                        4,022Inventory
                                        
                                        
                                        3,284
                                        
                                        
                                        
                                        2,103Prepaid
      expenses and other current assets
                                        
                                        
                                        1,643
                                        
                                        
                                        
                                        2,409Product
      development costs, net
                                        
                                        
                                        5,512
                                        
                                        
                                        
                                        4,399Deferred
      tax assets
                                        
                                        
                                        564
                                        
                                        
                                        
                                        578Total
      Current Assets
                                        
                                        
                                        16,789
                                        
                                        
                                        
                                        16,175Fixed
      assets, net
                                        
                                        
                                        196
                                        
                                        
                                        
                                        141Intangible
      assets, net
                                        
                                        
                                        15,257
                                        
                                        
                                        
                                        15,733Total
      Assets
                                        
                                        $
                                        32,242
                                        
                                        
                                        $
                                        32,049LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable
                                        
                                        $
                                        3,390
                                        
                                        
                                        $
                                        3,330Financing
      arrangements
                                        
                                        
                                        3,019
                                        
                                        
                                        
                                        1,659Customer
      advances
                                        
                                        
                                        1,099
                                        
                                        
                                        
                                        3,086Accrued
      expenses and other current liabilities
                                        
                                        
                                        2,407
                                        
                                        
                                        
                                        2,333Notes
      payable, current portion
                                        
                                        
                                        120
                                        
                                        
                                        
                                        120Total
      Current Liabilities
                                        
                                        
                                        10,035
                                        
                                        
                                        
                                        10,528Notes
      payable, non-current portion
                                        
                                        
                                        180
                                        
                                        
                                        
                                        180Deferred
      tax liabilities
                                        
                                        
                                        3,283
                                        
                                        
                                        
                                        3,461Other
      long-term liabilities
                                        
                                        
                                        2,695
                                        
                                        
                                        
                                        2,770Total
      Liabilities
                                        
                                        
                                        16,193
                                        
                                        
                                        
                                        16,939Commitments
      and ContingenciesStockholders'
      EquityPreferred
      Stock, par value $0.001, 5,000,000 authorizedSeries
      A, 0 issued and outstanding at March 31, 2010, 1,389,684 issued and
      outstanding at December 31, 2009
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1Series
      B, 0 issued and outstanding at March 31, 2010 1,188,439 issued and
      outstanding at December 31, 2009
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1Common
      Stock, par value $0.001, 3,500,000,000 authorized, 4,643,744 issued
      and 4,630,741 outstanding atMarch 31, 2010 and 250,000,000
      authorized, 65,711issued and 52,708
      outstanding at December 31, 2009
                                        
                                        
                                        5
                                        
                                        
                                        
                                        -Additional
      paid-in-capital
                                        
                                        
                                        65,360
                                        
                                        
                                        
                                        64,714Accumulated
      deficit
                                        
                                        
                                        (44,847
                                        )
                                        
                                        
                                        (45,137
                                        )Treasury
      Stock, at cost, 13,003 at March 31, 2010and December 31,
      2009
                                        
                                        
                                        (4,469
                                        )
                                        
                                        
                                        (4,469
                                        )Total
      Stockholders' Equity
                                        
                                        
                                        16,049
                                        
                                        
                                        
                                        15,110Total
      Liabilities and Stockholders' Equity
                                        
                                        $
                                        32,242
                                        
                                        
                                        $
                                        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 Ended March 31, 2010 and 2009
 (in
thousands except share and per share amounts)
  Three Months Ended March 31,2010
                                                          
                                                          
                                                          2009Revenue
                                                          
                                                          $
                                                          17,132
                                                          
                                                          
                                                          $
                                                          13,884Cost
      of goods sold
                                                          
                                                          
                                                          13,515
                                                          
                                                          
                                                          
                                                          11,483Gross
      profit
                                                          
                                                          
                                                          3,617
                                                          
                                                          
                                                          
                                                          2,401Operating
      expenses:General
      and administrative (includes stock-based compensation of $246 and
      $22)
                                                          
                                                          
                                                          1,605
                                                          
                                                          
                                                          
                                                          1,394Selling
      and marketing
                                                          
                                                          
                                                          836
                                                          
                                                          
                                                          
                                                          863Research
      and development
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          80Depreciation
      and amortization
                                                          
                                                          
                                                          500
                                                          
                                                          
                                                          
                                                          434Total
      operating expenses
                                                          
                                                          
                                                          2,941
                                                          
                                                          
                                                          
                                                          2,771Income
      (loss) from operations
                                                          
                                                          
                                                          676
                                                          
                                                          
                                                          
                                                          (370
                                                          )Interest
      expense, net
                                                          
                                                          
                                                          253
                                                          
                                                          
                                                          
                                                          1,033Income
      (loss) from operations before income tax expense
                                                          
                                                          
                                                          423
                                                          
                                                          
                                                          
                                                          (1,403
                                                          )Income
      tax expense
                                                          
                                                          
                                                          133
                                                          
                                                          
                                                          
                                                          -Net
      income (loss)
                                                          
                                                          $
                                                          290
                                                          
                                                          
                                                          $
                                                          (1,403
                                                          )Earnings
      (loss) per common share - basic and diluted:Earnings
      (loss) per common share - basic
                                                          
                                                          $
                                                          0.26
                                                          
                                                          
                                                          $
                                                          (22.01
                                                          )Earnings
      (loss) per common share - diluted
                                                          
                                                          $
                                                          0.10
                                                          
                                                          
                                                          $
                                                          (22.01
                                                          )Weighted
      average common shares outstanding - basic
                                                          
                                                          
                                                          1,098,947
                                                          
                                                          
                                                          
                                                          63,740Weighted
      average common shares outstanding - diluted
                                                          
                                                          
                                                          2,873,225
                                                          
                                                          
                                                          
                                                          63,740
  See
accompanying notes to condensed consolidated financial statements
  F-2
 
 Zoo
Entertainment, Inc. and Subsidiaries
 Unaudited
Condensed Consolidated Statements of Cash Flow
 For
the Three Months Ended March 31, 2010 and 2009
 (in
thousands)
  Three
      Months Ended March 31,2010
                                
                                
                                2009Operating
      activities:Net
      income (loss)
                                
                                $
                                290
                                
                                
                                $
                                (1,403
                                )Adjustments
      to reconcile net income (loss) from operations to net cash (used in)
      provided by operating activities:Depreciation
      and amortization
                                
                                
                                500
                                
                                
                                
                                434Amortization
      of deferred debt discount
                                
                                
                                -
                                
                                
                                
                                858Deferred
      income taxes
                                
                                
                                (164
                                )
                                
                                
                                -Stock-based
      compensation
                                
                                
                                246
                                
                                
                                
                                22Other
      changes in assets and liabilities, net
                                
                                
                                (3,979
                                )
                                
                                
                                559Net
      cash (used in) provided by operating activities
                                
                                
                                (3,107
                                )
                                
                                
                                470Investing
      activities:Purchases
      of fixed assets
                                
                                
                                (79
                                )
                                
                                
                                (2
                                )Net
      cash used in investing activities
                                
                                
                                (79
                                )
                                
                                
                                (2
                                )Financing
      activities:Net
      borrowings (repayments) in connection with financing
      facilities
                                
                                
                                1,360
                                
                                
                                
                                (849
                                )Net
      cash provided by (used in) financing activities
                                
                                
                                1,360
                                
                                
                                
                                (849
                                )Net
      decrease in cash
                                
                                
                                (1,826
                                )
                                
                                
                                (381
                                )Cash
      at beginning of period
                                
                                
                                2,664
                                
                                
                                
                                849Cash
      at end of period
                                
                                $
                                838
                                
                                
                                $
                                468
 
 See
accompanying notes to condensed consolidated financial statements
  F-3
 
 Zoo
Entertainment, Inc. and Subsidiaries
 Unaudited
Condensed Consolidated Statement of Stockholders' Equity
 For
the Three Months Ended March 31, 2010
 (in
thousands)
  Preferred
      StockSeries
      A
                        
                        
                        Series
      B
                        
                        
                        Common
      Stock
                        
                        
                        Additional
                        
                        
                        Accumulated
                        
                        
                        Treasury
      StockShares
                        
                        
                        Par
      Value
                        
                        
                        Shares
                        
                        
                        Par
      Value
                        
                        
                        Shares
                        
                        
                        Par
      Value
                        
                        
                        Paid-in-Capital
                        
                        
                        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
                        
                        
                        
                        110
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        111Issuance
      of management options accrued for in 2009 as a liability
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        403
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        403Stock-based
      compensation 2010
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -
                        
                        
                        
                        135
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        135Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        290
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        290Balance
      at March 31, 2010
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        -
                        
                        
                        $
                        -
                        
                        
                        
                        4,644
                        
                        
                        $
                        5
                        
                        
                        $
                        65,360
                        
                        
                        $
                        (44,847
                        )
                        
                        
                        13
                        
                        
                        $
                        (4,469
                        )
                        
                        $
                        16,049
  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.  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 noteholders 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.  
The Company was engaged in acquiring and exploring mineral properties until
September 30, 2007 when this activity was abandoned. The Company had been
inactive until July 7, 2008 when the Company entered into an Agreement and Plan
of Merger, as subsequently amended on September 12, 2008, with DFTW Merger Sub,
Inc., a Delaware corporation and a wholly-owned subsidiary of the Company
(“Merger Sub”), Zoo Games, Inc., 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.





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 this reverse merger, and
the financial statements of the Company for all periods presented represent the
historical activity of Zoo Games and include the activity of Zoo beginning on
September 12, 2008, the effective date of the reverse merger.





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 was 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.


F-5




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.





NOTE
2.   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.  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 condensed consolidated financial
statements of the Company together with the Company’s management discussion and
analysis in the Company’s Annual Report on Form 10-K for the year ended December
31, 2009.  The Company’s results for the three months ended March 31,
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 accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosure of contingent assets and liabilities at the dates of the
financial statements and the reported amounts of revenue and expenses during the
reporting periods. The estimates affecting the 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





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





If the
financial condition and operations of our customers deteriorate, our risk of
collection could increase substantially. A majority of our trade receivables are
derived from sales to major retailers and distributors. In October 2008, we
entered into an agreement with Atari, Inc. where sales from October 24, 2008
through March 31, 2009 for all customers that Atari deemed acceptable would be
through Atari, and Atari would prepay us for the cost of goods and they would
bear the credit risk from the ultimate customer. This agreement was
subsequently amended to include sales to certain customers through March 31,
2010. As of March 31, 2010, the receivable due from Atari was approximately $2.0
million, before allowances, which is included in accounts receivable in the
condensed consolidated balance sheet. Our five largest ultimate customers
accounted for approximately 87% (of which the following customers constituted
balances greater than 10%: customer A-35%, customer B-24% and customer C-10%)
and 85% (of which the following customers constituted balances greater than 10%:
customer A-14%, customer C-20%, customer D-27% and customer E-15%) of net
revenue for the three months ended March 31, 2010 and 2009, respectively. These
five largest customers accounted for 53% of our gross accounts receivable
as of March 31, 2010. We believe that the receivable balances from Atari
and our customers do not represent a significant credit risk based on past
collection experience. During the three months ended March 31, 2010 and 2009, we
sold approximately $4.2 million and $0, respectively, of receivables to our
factor with recourse.  The factored receivables were approximately $2.8
million and $1.4 million of our gross accounts receivable and due from factor,
net as of March 31, 2010 and December 31, 2009, respectively. We
regularly review our outstanding receivables for potential bad debts and have
had no history of significant write-offs due to bad debts.


F-6




Inventory





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




Product
Development Costs




We
utilize third party product developers to develop the titles we
publish.




We
frequently enter into agreements with third party 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.




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.




In
December 2007, the Financial Accounting Standards Board (“FASB”) issued FASB
Accounting Standards Update (“ASC”) Topic 808-10-15, “Accounting for
Collaborative Arrangements” (“ASC 808-10-15”), which 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 rights
holders generally provide for guaranteed minimum royalty payments for use of
their intellectual property.




F-7





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





Licensing
fees are capitalized on the 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, 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.





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





We review
all long-lived assets whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable, including assets to be
disposed of by sale, whether previously held and used or newly acquired. We
compare the carrying amount of the asset to the estimated undiscounted future
cash flows expected to result from the use of the asset. If the carrying amount
of the asset exceeds estimated expected undiscounted future cash flows, we
record an impairment charge for the difference between the carrying amount of
the asset and its fair value. The estimated fair value is generally measured by
discounting expected future cash flows at our incremental borrowing rate or fair
value, if available.  The Company determined that no impairment for
definite lived intangible assets was identified in the three months ended March
31, 2010 or 2009.




Revenue
Recognition





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





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





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





Allowances
for Returns, Price Concessions and Other Allowances





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





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




F-8


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





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





Consideration
Given to Customers and Received from Vendors





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





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





Equity-Based
Compensation





We issued
restricted common stock and options to purchase shares of common stock of the
Company to certain members of management and employees during the three months
ended March 31, 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 our stock price and estimated exercise behavior.  We
used the current market price to determine the fair value of the stock price for
the grant made during the period ended March 31, 2009, and used the price of our
equity raise in the fourth quarter of 2009 to determine the fair value of the
stock price for the grant made during the period ended March 31, 2010.  The
following table summarizes the assumptions and variables used by us to compute
the weighted average fair value of stock option grants:





Three MonthsEnded March 31,2010
                      
                      
                      2009Risk-free
      interest rate
                      
                      
                      3.00
                      %
                      
                      
                      1.36
                      %Expected
      stock price volatility
                      
                      
                      60.0
                      %
                      
                      
                      70.0
                      %Expected
      term until exercise (years)
                      
                      
                      5
                      
                      
                      
                      5Expected
      dividend yield
                      
                      None
                      
                      
                      None





For the
three months ended March 31, 2010 and 2009, we estimated the implied volatility
for publicly traded options on our common shares as the expected volatility
assumption required in the Black-Scholes option-pricing model. The
selection of the implied volatility approach was based upon the historical
volatility of companies with similar businesses and capitalization and our
assessment that implied volatility is more representative of future stock price
trends than historical volatility.





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


F-9




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.  An
unvested restricted stock grant totaling 191,087 shares as of March 31, 2010 is
excluded from the basic earnings (loss) per share.   Diluted EPS
is computed by dividing the net income applicable to common stockholders for the
period by the weighted average number of shares of common stock outstanding and
common stock equivalents, which includes warrants and options outstanding during
the same period. For the period ended March 31, 2010, 2,914 warrants and 4,321
options were anti-dilutive because their exercise price exceeded the average
stock price over the period. Therefore, they are excluded from the diluted EPS
calculation.  For the period ended March 31, 2009, the inclusion of
the 10,837 warrants and 5,144 options outstanding as of March 31, 2009 were
anti-dilutive because we had net losses from the period. Therefore, the dilutive
net loss per share is the same as the basic net loss per share.





Income
Taxes





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





Fair
Value Measurement





In
accordance with “Fair Value Measurements and Disclosures,” Topic 820 of the FASB
(“Topic 820”), ASC defines fair value 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


·
            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
March 31, 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.




NOTE
3.   INVENTORY





Inventory
consisted of:


(Amounts in Thousands)March 31, 2010
                      
                      
                      December 31, 2009Finished
      products
                      
                      $
                      2,771
                      
                      
                      $
                      1,247Parts
      and supplies
                      
                      
                      513
                      
                      
                      
                      856Totals
                      
                      $
                      3,284
                      
                      
                      $
                      2,103




Estimated
product returns included in inventory at March 31, 2010 and December 31, 2009
were $189,000 and $261,000, respectively.


F-10




NOTE
4.   PREPAID EXPENSES AND OTHER CURRENT ASSETS





Prepaid
expenses and other current assets consisted of:





(Amounts in Thousands)March 31,
                        2010
                      
                      
                      December 31, 2009Vendor
      advances for inventory
                      
                      $
                      190
                      
                      
                      $
                      1,545Prepaid
      royalties
                      
                      
                      820
                      
                      
                      
                      474Other
      prepaid expenses
                      
                      
                      633
                      
                      
                      
                      390Totals
                      
                      $
                      1,643
                      
                      
                      $
                      2,409





NOTE
5.   PRODUCT DEVELOPMENT COSTS





Our
capitalized product development costs for the three months ended March 31, 2010
were as follows (amounts in thousands):




Product
      development costs, net - December 31, 2009
                        
                        $
                        4,399New
      product development costs incurred
                        
                        
                        2,072Amortization
      of product development costs
                        
                        
                        (959
                        )Product
      development costs, net – March 31, 2010
                        
                        $
                        5,512




NOTE
6.   INTANGIBLE ASSETS, NET





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





Estimated
                  
                  
                  
                  
                  (Amounts in Thousands)Useful
                  
                  Gross
                  
                  
                  March 31, 2010
                  
                  
                  December 31, 2009Lives
                  
                  Carrying
                  
                  
                  Accumulated
                  
                  
                  Net Book
                  
                  
                  Net Book(Years)
                  
                  Amount
                  
                  
                  Amortization
                  
                  
                  Value
                  
                  
                  ValueContent
                  
                  10
                  
                  $
                  14,965
                  
                  
                  $
                  2,991
                  
                  
                  $
                  11,974
                  
                  
                  $
                  12,345Trademarks
                  
                  10
                  
                  
                  1,510
                  
                  
                  
                  346
                  
                  
                  
                  1,164
                  
                  
                  
                  1,201Customer
      relationships
                  
                  10
                  
                  
                  2,749
                  
                  
                  
                  630
                  
                  
                  
                  2,119
                  
                  
                  
                  2,187Totals
                  
                  
                  
                  $
                  19,224
                  
                  
                  $
                  3,967
                  
                  
                  $
                  15,257
                  
                  
                  $
                  15,733





Amortization
expense related to intangible assets was $476,000 and $412,000 for the three
months ended March 31, 2010 and 2009, respectively.





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




Year Ending December 31,
                            
                            (Amounts in Thousands)Balance
      of 2010
                            
                            $
                            1,4462011
                            
                            
                            1,9222012
                            
                            
                            1,9222013
                            
                            
                            1,9222014
                            
                            
                            1,922Thereafter
                            
                            
                            6,123Total
                            
                            $
                            15,257




F-11


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





The
amounts outstanding as of March 31, 2010 and December 31, 2009 were
approximately $1.1 million and $759,000, respectively. The interest rate is
prime plus 4.0% on outstanding advances. As of March 31, 2010 and December 31,
2009, the effective interest rate was 7.25%.  The charges and interest
expense on the advances are included in the cost of goods sold in the
accompanying condensed consolidated statement of operations and were $203,000
and $40,000 for the three months ended March 31, 2010 and 2009,
respectively.





On April
6, 2010, Zoo Publishing, the Company and Wells Fargo entered into an amendment
to the existing 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 $407,000 for the next twelve months
and to $400,000 for the following twelve months if the agreement is renewed for
an additional year; (iii) reduce the interest rate to prime plus 2% on
outstanding advances and (ii) extend its term until April 5, 2011, subject to
automatic renewal for successive twelve 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 $32,000.





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 agreement with Working Capital Solutions, Inc. (“WCS”), which utilizes
existing accounts receivable in order to provide working capital to fund all
aspects of our continuing business operations. We entered into a new factoring
agreement with WCS on September 29, 2009 (the “Factoring Agreement”). 
Under the terms of the Factoring Agreement, we sell our receivables to the
factor, with recourse. The factor, in its sole discretion, determines whether or
not it will accept each receivable based upon the credit risk factor of each
individual receivable or account. Once a receivable is accepted by the factor,
the factor provides funding subject to the terms and conditions of the factoring
and security agreement. The amount remitted to us by the factor equals the
invoice amount of the receivable adjusted for any discounts or allowances
provided to the account, less 25% which is deposited into a reserve account
established pursuant to the agreement, less allowances and fees. In the event of
default, valid payment dispute, breach of warranty, insolvency or bankruptcy on
the part of the receivable account, the factor can require the receivable to be
repurchased by us in accordance with the agreement. The amounts to be paid by us
to the factor for any accepted receivable include a factoring fee of 0.6% for
each ten (10) day period the account is open. Since the factor acquires the
receivables with recourse, we record the gross receivables including amounts due
from our customers to the factor and we record a liability to the factor for
funds advanced to us from the factor. During the three months ended March 31,
2010 and 2009, we sold approximately $4.2 million and $0, respectively, of
receivables to the factor with recourse.  At March 31, 2010 and December
31, 2009, accounts receivable and due from factor included approximately $2.8
million and approximately $1.4 million of amounts due from our customers to the
factor.  The factor had an advance outstanding to the Company of
approximately $1.9 million and $900,000 as of March 31, 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 facility, on September 29,
2009, Mark Seremet, President, Chief Executive Officer and a director of the
Company and Zoo Games, and David Rosenbaum, the President of Operations of Zoo
Publishing, entered into a Guaranty with 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.


F-12




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.





Atari
Agreement





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari will
resell the products to wholesalers and retailers that are acceptable to Atari in
North America. The agreement initially expired on March 31, 2009, but was
amended to extend the term for certain customers until March 31, 2010. This
agreement provided for Atari to prepay to the Company for the cost of goods and
pay the balance due within 15 days of shipping the product. Atari’s fees
approximate 10% of our standard selling price and they have been recorded as a
reduction in revenue. During the three months ended March 31, 2010 and
2009, we recorded approximately $8.6 million and $15.7 million, respectively, of
net sales to Atari.  Atari takes a reserve from the initial payment for
potential customer sales allowances, returns and price protection that is
analyzed and reviewed within a sixty day period to be liquidated no later than
July 31, 2010.  As of March 31, 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 March 31, 2010 and December 31, 2009, Atari owed
the Company approximately $2.0 million and approximately $1.8 million,
respectively, before allowances, for goods already shipped which are recorded in
accounts receivable and due from factor.





Other Customer Advance –
Solutions 2 Go, Inc.





On August
31, 2009, Zoo Publishing entered into an exclusive distribution agreement with
Solutions 2 Go Inc., a Canadian corporation (“S2G Inc.”) and an Exclusive
Distribution Agreement with Solutions 2 Go, LLC, a California limited liability
company (“S2G LLC,” and together with S2G Inc., “S2G”), pursuant to which Zoo
Publishing granted to S2G the exclusive rights to market, sell and distribute
certain video games, related software and products, with respect to which Zoo
Publishing owns rights, in the territories specified therein.  In
connection with these distribution agreements, on August 31, 2009, the
Company entered into an Advance Agreement (the “Advance Agreement”) with S2G,
pursuant to which S2G made a payment to the Company in the amount of $1,999,999,
in advance of S2G’s purchases of certain products pursuant to
these distribution agreements. From August 31, 2009 until recoupment of the
advance in full, interest on the outstanding amount shall accrue at the rate of
ten percent (10%) per annum. Interest expense of $30,000 is recorded for the
three months ended March 31, 2010.  The amount of any unrecouped advance
outstanding shall be repaid in its entirety to S2G no later than September 15,
2010. The advance shall be recouped, in whole or in part, from sales generated
by S2G of products purchased by S2G under the distribution agreements. A
percentage of the gross margin on the S2G sales shall be applied
to  recoupment of the advance until the earlier of (i) the date on
which the amount of the unrecouped advance has been reduced to zero or (ii)
September 15, 2010, on which any unrecouped advance shall be repaid. As of March
31, 2010 and December 31, 2009, the balance remaining on the advance was
approximately $1.1 million and $1.4 million, respectively, and  is
included in customer advances in the current liabilities section of the
condensed consolidated balance sheets.




F-13


Notwithstanding
the foregoing, if, at any time prior to the recoupment of the advance in full,
the Company receives proceeds in connection with any sale of securities, or
otherwise raises additional capital, exceeding an aggregate of $5.0 million,
other than under a defined anticipated qualified financing, the entire
unrecouped advance under the advance agreement shall at once become due and
payable in full as of the funding date of the additional capital transaction
without written notice of acceleration to the Company.  Additional capital
transaction shall include, but not be limited to, the sale or issuance of any
security by the Company, or any subsidiary of the Company, of any kind or
character whatsoever, where “security” is given its broadest meaning including
stock, warrants, options, convertible notes, and similar instruments of all
types.





In consideration
of S2G entering into the Advance Agreement, the Company agreed to issue to S2G
Inc. a warrant to purchase 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 to acquire 12,777 shares was issued on August 31, 2009.  The
warrant was valued at $400,000 using the Black-Scholes model and this cost will
be amortized over twelve months through interest expense.  For the three
months ended March 31, 2010, $100,000 of additional interest expense was
recorded in the condensed consolidated statement of operations for this
advance.




The
advance is guaranteed by Messrs. Seremet and Rosenbaum and another
employee.  Messrs. Seremet and Rosenbaum did not receive any additional
compensation for this guarantee.  The employee who guaranteed the advance
was granted 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
8.   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
components of income tax expense for the three months ended March 31, 2010
and 2009 are as follows (in thousands):





Three
      Months Ended
                                March
      31,2010
                              
                              
                              2009Current:Federal
                              
                              $
                              271
                              
                              
                              $
                              —State
                              
                              
                              26
                              
                              
                              
                              77Total
      Current
                              
                              
                              297
                              
                              
                              
                              77Deferred:Federal
                              
                              
                              (149
                              )
                              
                              
                              -State
                              
                              
                              (15
                              )
                              
                              
                              (77
                              )Total
      Deferred
                              
                              
                              (164
                              )
                              
                              
                              (77
                              )Total
                              
                              $
                              133
                              
                              
                              $
                              -





We paid
$38,000 and $0 to various state jurisdictions for income taxes during the three
months ended March 31, 2010 and 2009, respectively.





The
reconciliations of income tax expense computed at the U.S. statutory tax rates
to income tax expense for the three months ended March 31, 2010 and 2009 are as
follows:


F-14






Three Months Ended
                              March 31,2010
                            
                            
                            2009Tax
      at U.S. federal income tax rates
                            
                            
                            (34.0
                            )%
                            
                            
                            (34.0
                            )%State
      taxes, net of federal income tax benefit
                            
                            
                            (1.8
                            )
                            
                            
                            (12.1
                            )Change
      in valuation allowance
                            
                            
                            -
                            
                            
                            
                            34.4Nondeductible
      expenses and other
                            
                            
                            4.4
                            
                            
                            
                            11.7(31.4
                            )%
                            
                            
                            0.0
                            %




Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the
Company's deferred tax assets and liabilities as of March 31, 2010 and
December 31, 2009 are as follows (in thousands):





March 31, 2010
                          
                          
                          December 31, 2009Current
                          
                          
                          Long-Term
                          
                          
                          Current
                          
                          
                          Long-TermDeferred tax assets:Net
      operating loss carriedforwards
                          
                          $
                          -
                          
                          
                          $
                          654
                          
                          
                          $
                          -
                          
                          
                          $
                          719Capital
      loss carryforwards
                          
                          
                          
                          
                          
                          
                          431
                          
                          
                          
                          
                          
                          
                          
                          431Allowance
      for returns and discounts
                          
                          
                          299
                          
                          
                          
                          -
                          
                          
                          
                          315
                          
                          
                          
                          -Bonus
      and other accruals
                          
                          
                          320
                          
                          
                          
                          -
                          
                          
                          
                          363
                          
                          
                          
                          -Non-qualified
      options
                          
                          
                          -
                          
                          
                          
                          658
                          
                          
                          
                          -
                          
                          
                          
                          569Alternative
      minimum  tax credit carryforward
                          
                          
                          135
                          
                          
                          
                          -
                          
                          
                          
                          135
                          
                          
                          
                          -Gross
      deferred tax assets
                          
                          
                          754
                          
                          
                          
                          1,743
                          
                          
                          
                          813
                          
                          
                          
                          1,719Valuation
      allowance
                          
                          
                          (130
                          )
                          
                          
                          (301
                          )
                          
                          
                          (138
                          )
                          
                          
                          (293
                          )Net
      deferred tax assets
                          
                          
                          624
                          
                          
                          
                          1,442
                          
                          
                          
                          675
                          
                          
                          
                          1,426Deferred
      tax liabilities:Property
      and equipment
                          
                          
                          -
                          
                          
                          
                          (16
                          )
                          
                          
                          -
                          
                          
                          
                          (17
                          )Inventory
                          
                          
                          (60
                          )
                          
                          
                          -
                          
                          
                          
                          (97
                          )
                          
                          
                          -Intangibles
                          
                          
                          -
                          
                          
                          
                          (4,709
                          )
                          
                          
                          -
                          
                          
                          
                          (4,870
                          )Total
      deferred tax liabilities
                          
                          
                          (60
                          )
                          
                          
                          (4,725
                          )
                          
                          
                          (97
                          )
                          
                          
                          (4,887
                          )Net
      deferred tax asset (liability)
                          
                          $
                          564
                          
                          
                          $
                          (3,283
                          )
                          
                          $
                          578
                          
                          
                          $
                          (3,461
                          )




As of
March 31, 2010, the Company had approximately $1.2 million of available capital
loss carryforwards which expire in 2013.  A valuation allowance of
approximately $431,000 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
March 31, 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
$3.0 million which will be available to offset taxable state income during the
carryforward period. The state NOL will also begin to expire in 2028.  The
tax benefit of this item is reflected in the above table of deferred tax assets
and liabilities.





NOTE
9.  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 March 31,
2010.  All references to common stock reflect theone-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.


F-15





Common
Stock





As of
March 31, 2010, there were 4,643,744 shares of common stock issued and
4,630,741 shares of common stock outstanding.





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.  The fair value of the restricted common stock grants was
determined to be $397,000, based on the price of our equity raise in the fourth
quarter of 2009and a marketability discount.  The stock-based
compensation expense recorded in the three months ended March 31, 2010 is
$111,000 and $286,000 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 2,316,140 shares of common stock
and 1,188,439 shares of Series B Preferred Stock automatically converted into
1,980,732 shares of common stock.  See below for descriptions and
features of the Series A Preferred Stock and Series B Preferred
Stock.





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





NumberOutstandingNon-Vested
      shares at December 31, 2009
                        
                        
                        -Shares
      granted
                        
                        
                        281,104Shares
      vested
                        
                        
                        (90,017
                        )Non-Vested
      shares at March 31, 2010
                        
                        
                        191,087




Preferred
Stock





As of
March 31, 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, 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”). The consents we received constituted the only
stockholder approval required for the Charter Amendment under the Delaware
General Corporation Law (the “DGCL”) and our existing Certificate of
Incorporation and Bylaws. Pursuant to Rule 14c-2 of the Securities Exchange
Act of 1934, as amended, this amendment was not effected until a date that was
at least 20 calendar days following the date we first mailed the definitive
Information Statement to our 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 our 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.


F-16




On
November 20, 2009, the Company entered into a securities purchase agreement (the
“SPA”) with certain investors, consummating an approximately $4.2 million
convertible preferred equity raise, pursuant to which the Company 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 (1) 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.





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 (1) 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. As of December 31, 2008, an aggregate of
1,625 shares of restricted common stock of the Company were outstanding under
the Company’s 2007 Plan, and 42 shares of common stock were reserved for future
issuance under this plan.





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 this plan remain 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 Company’s 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
Company’s 2007 Employee, Director and Consultant Stock 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
respectively. 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, in as much as guarantees were in place
and presumed vesting had taken place, and was included in accrued expenses in
the December 31, 2009 consolidated balance sheet.  The stock-based
compensation expense recorded in the three months ended March 31, 2010 is
$28,000, and $111,000 will be expensed throughout the remaining vesting period
of the options until November 2012.


F-17




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 Company’s 2007 Plan.





A summary
of the status of the Company’s outstanding stock options as of March 31,
2010 and changes during the period then ended are presented below:





March
      31, 2010WeightedAverageNumber of
                        
                        
                        ExerciseShares
                        
                        
                        PriceOutstanding at beginning of
      period
                        
                        
                        4,321
                        
                        
                        $
                        774.00Granted (outside of the 2007
      Plan)
                        
                        
                        1,260,917
                        
                        
                        
                        1.95Canceled
                        
                        
                        -
                        
                        
                        
                        -Outstanding at end of period
                        
                        
                        1,265,238
                        
                        
                        
                        4.59Options exercisable at end of
      period
                        
                        
                        3,253
                        
                        
                        $
                        888.00





The fair
value of options granted during the three months ended March 31, 2010 was
$903,000, of which $403,000 was accrued for in 2009 as a liability.





The
following table summarizes information about outstanding stock options at
March 31, 2010:





Options
      Outstanding
                          
                          
                          Options
      ExercisableWeighted-AverageRemaining
                          
                          
                          Weighted-
                          
                          
                          
                          
                          
                          Weighted-Range of
                          
                          
                          
                          
                          Contractual
                          
                          
                          Average
                          
                          
                          
                          
                          
                          AverageExercise
                            Prices
                          
                          NumberOutstanding
                          
                          
                          Life
                            (Years)
                          
                          
                          ExercisePrice
                          
                          
                          NumberExercisable
                          
                          
                          ExercisePrice$1,548.00
                          
                          
                          280
                          
                          
                          
                          3.2
                          
                          
                          $
                          1,548
                          
                          
                          
                          280
                          
                          
                          $
                          1,548$1,350.00
                          
                          
                          353
                          
                          
                          
                          3.5
                          
                          
                          
                          1,350
                          
                          
                          
                          118
                          
                          
                          
                          1,350$912.00
                          
                          
                          2,438
                          
                          
                          
                          3.3
                          
                          
                          
                          912
                          
                          
                          
                          2,438
                          
                          
                          
                          912$180.00
                          
                          
                          1,250
                          
                          
                          
                          3.8
                          
                          
                          
                          180
                          
                          
                          
                          417
                          
                          
                          
                          180$2.46
                          
                          
                          585,645
                          
                          
                          
                          10.0
                          
                          
                          
                          2.46
                          
                          
                          
                          -
                          
                          
                          
                          -$1.50
                          
                          
                          675,272
                          
                          
                          
                          10.0
                          
                          
                          
                          1.50
                          
                          
                          
                          -
                          
                          
                          
                          -$1.50
      to $1,548
                          
                          
                          1,265,238
                          
                          
                          
                          10.0
                          
                          
                          $
                          4.59
                          
                          
                          
                          3,253
                          
                          
                          $
                          888




F-18


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





Weighted-AverageWeighted-Average
                      
                      
                      RemainingNumber
                      
                      
                      Fair Value at
                      
                      
                      Contractual LifeOutstanding
                      
                      
                      Grant
        Date
                      
                      
                      (Years)Non-Vested
      shares at December 31, 2009
                      
                      
                      1,485
                      
                      
                      $
                      1,350
                      
                      
                      
                      4.4Options
      Granted
                      
                      
                      1,260,917
                      
                      
                      
                      1.95
                      
                      
                      
                      10.0Options
      Vested
                      
                      
                      (417
                      )
                      
                      
                      180
                      
                      
                      
                      3.5Options
      forfeited or expired
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Non-Vested
      shares at March 31, 2010
                      
                      
                      1,261,985
                      
                      
                      $
                      3.48
                      
                      
                      
                      10.0





As of
March 31 2010, there was  $527,000 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 1.5 to 4.0
years.





The
intrinsic value of options outstanding at March 31, 2010 is $0.





Warrants





As part
of the equity raise on November 20, 2009 and on December 16, 2009, we 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. In the event of any subdivision, combination, consolidation,
reclassification or other change of common stock into a lesser number, a greater
number or a different class of stock, the number of shares of common stock
deliverable upon exercise of the warrants will be proportionally decreased or
increased, as applicable, but the exercise price of the warrants will remain at
$0.01 per share.





As of
March 31, 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 March 31, 2010
and changes during the period then ended are presented below:





March
      31, 2010WeightedAverageNumber of
                                            
                                            
                                            ExerciseWarrants
                                            
                                            
                                            PriceOutstanding
      at beginning of period
                                            
                                            
                                            1,039,703
                                            
                                            
                                            $
                                            6.82Granted
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Exercised
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Outstanding
      at end of period
                                            
                                            
                                            1,039,703
                                            
                                            
                                            $
                                            6.82Warrants
      exercisable at March 31, 2010
                                            
                                            
                                            1,039,703
                                            
                                            
                                            $
                                            6.82





The
following table summarizes information about outstanding and exercisable
warrants at March 31, 2010:




F-19




Warrants
      Outstanding and ExercisableWeighted-Average
                            
                            
                            Weighted-Remaining
                            
                            
                            AverageRange
      of
                            
                            Number
                            
                            
                            Contractual
                            
                            
                            ExerciseExercise
      Prices
                            
                            Outstanding
                            
                            
                            Life
      (Years)
                            
                            
                            Price$1,704.00
                            
                            
                            2,383
                            
                            
                            
                            3.1
                            
                            
                            $
                            1,704.00$1,278.00
                            
                            
                            531
                            
                            
                            
                            3.1
                            
                            
                            
                            1,278.00$180.00
                            
                            
                            12,777
                            
                            
                            
                            4.6
                            
                            
                            
                            180.00$6.00
                            
                            
                            6,818
                            
                            
                            
                            3.5
                            
                            
                            
                            6.00$0.01
                            
                            
                            1,017,194
                            
                            
                            
                            4.6
                            
                            
                            
                            0.01$0.01
      to $1,704.00
                            
                            
                            1,039,703
                            
                            
                            
                            4.7
                            
                            
                            $
                            6.82





NOTE
10.   INTEREST, NET


(Amounts in Thousands)Three
                                  Months Ended March 31,2010
                                
                                
                                2009Interest
      arising from amortization of debt discount
                                
                                $
                                -
                                
                                
                                $
                                858Interest
      on various notes
                                
                                
                                30
                                
                                
                                
                                175Interest
      arising from amortization of Solutions 2 Go warrants
                                
                                
                                100
                                
                                
                                
                                -Interest
      on financing arrangements
                                
                                
                                123
                                
                                
                                
                                -Interest
      expense, net
                                
                                $
                                253
                                
                                
                                $
                                1,033





NOTE
11.   SUPPLEMENTAL CASH FLOW INFORMATION





Supplemental
cash flow information for the three months ended March 31, 2010 and 2009 is as
follows:




(Amounts in Thousands)Three
      Months Ended
                                    March
      31,2010
                                  
                                  
                                  2009Changes
      in other assets and liabilities:Accounts
      receivable and due from factor
                                  
                                  $
                                  (926
                                  )
                                  
                                  $
                                  536Inventory
                                  
                                  
                                  (1,181
                                  )
                                  
                                  
                                  976Prepaid
      expenses and other current assets
                                  
                                  
                                  766
                                  
                                  
                                  
                                  (166
                                  )Product
      development costs
                                  
                                  
                                  (1,113
                                  )
                                  
                                  
                                  (371
                                  )Accounts
      payable
                                  
                                  
                                  60
                                  
                                  
                                  
                                  726Customer
      advances
                                  
                                  
                                  (1,987
                                  )
                                  
                                  
                                  -Accrued
      expenses and other current liabilities
                                  
                                  
                                  402
                                  
                                  
                                  
                                  (1,142
                                  )Net
      changes in other assets and liabilities
                                  
                                  $
                                  (3,979
                                  )
                                  
                                  $
                                  559Cash
      paid during the period for interest
                                  
                                  $
                                  123
                                  
                                  
                                  $
                                  -Cash
      paid during the period for taxes
                                  
                                  $
                                  38
                                  
                                  
                                  $
                                  -Non-cash
      investing and financing activities:Transfer
      of option liability to equity
                                  
                                  $
                                  403
                                  
                                  
                                  $
                                  -Par
      Value of Preferred Series A Stock converted to Common
      Stock
                                  
                                  $
                                  1
                                  
                                  
                                  $
                                  -Par
      Value of Preferred Series B Stock converted to Common
      Stock
                                  
                                  $
                                  1
                                  
                                  
                                  $
                                  -




F-20





NOTE
12.   LITIGATION





We are
involved, from time to time, in various 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
these 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.





NOTE
13.   RELATED PARTY TRANSACTIONS





On April
6, 2009, we 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, we entered into a letter agreement with each of Mark Seremet and David
Rosenbaum (the “Fee Letters”), pursuant to which, in consideration for Messrs.
Seremet and Rosenbaum entering into the guaranty with Wells Fargo for the full
and prompt payment and performance by the Company and its subsidiaries of the
obligations in connection with a purchase order financing (the “Loan”), we
agreed to compensate Mr. Seremet in the amount of $10,000 per month, and Mr.
Rosenbaum in the amount of $7,000 per month, for so long as the executive
remains employed while the Guaranty and Loan remain in full force and
effect. If the Guaranty is not released by the end of the month following
termination of employment of either Messrs. Seremet or Rosenbaum, the monthly
fee shall be doubled for each month thereafter until the Guaranty is
removed.





Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the Company’s
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 $0.40 per
share are exercised on that date but not counting the potential conversion to
equity of any outstanding convertible notes that have not yet been converted
and, inclusive of any options or other equity securities or securities
convertible into equity securities of the Company that each may own on the Grant
Date. The options 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.    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 9 for the valuation of the
options.)




NOTE
14.   SUBSEQUENT EVENTS





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 will be
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.


F-21





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


AND
RESULTS OF OPERATIONS





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





We are a
developer, publisher and distributor of video game software for use on major
platforms including Nintendo’s Wii, DS and GBA, Sony’s PlayStation Portable
(“PSP”), PlayStation 2 (“PS2”) and PlayStation 3 (“PS3”), and Apple’s
iPhone.  We are also a distributor of video game software for use on
Microsoft’s Xbox 360.   In addition, we intend to publish packaged
entertainment software titles for use on a variety of other gaming platforms
including Sony’s PlayStation 3. We will also seek to create and sell
downloadable games for Microsoft’s Xbox Live Arcade, Sony’s PlayStation 3
Network, Nintendo’s Virtual Console, and for use on personal computers
(“PCs”).




Our
current video game titles are targeted at various demographics but primarily at
the lower-priced “value” market. In some instances, these titles are based on
licenses of well-known intellectual property and, in other cases, based
on  original intellectual property. We enter into agreements with
content providers and video game development studios for the creation of our
video games.





We also
operate a site called IndiePubGames.com (formerly 2beegames.com) which can be
found at www.indiepubgames.com.  We
hold contests for independent developers whereby they can enter their games to
win monetary prizes and potential publishing arrangements with
us.  This site allows us to attract fresh intellectual property, lower
production costs, decrease time to market, and improve margins.





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 September 12, 2008,
the Company merged with Zoo Games.  Effective as of the closing of the
Zoo Games 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
was treated as the acquirer for accounting purposes in the reverse merger and
the financial statements of the Company represent the historical activity of Zoo
Games and consolidate the activity of Zoo Games beginning on September 12, 2008,
the effective date of the reverse merger.





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




1


The major
acquisition that remains a significant part of Zoo Games was the acquisition of
Zoo Publishing in December 2007.  The acquisition of Zoo Publishing
provided Zoo Games with a profitable core business, North American distribution
and further enhanced its experienced management team.  Zoo Publishing
continues to exploit its development expertise, in combination with its sales,
marketing and licensing expertise, to target the rapidly expanding market for
casual games, particularly on Nintendo’s platforms, where Zoo Publishing has
experienced considerable success. By nurturing and growing this business unit,
Zoo Games believes it will be able to rapidly build a much larger distribution
network, enabling it to place a significant number of software titles with major
retailers.




The financial statements of Zoo
Entertainment and Zoo Games include operations of each subsidiary or division
from the date that they were acquired. Currently, the Company has
determined that it operates in one segment in the United
States.




Results
of Operations





For
the Three Months Ended March 31, 2010 as compared to the Three Months Ended
March 31, 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 March 31,2010
                              
                              
                              2009Revenue
                              
                              $
                              17,132
                              
                              
                              
                              100
                              %
                              
                              $
                              13,884
                              
                              
                              
                              100
                              %Cost
      of goods sold
                              
                              
                              13,515
                              
                              
                              
                              79
                              
                              
                              
                              11,483
                              
                              
                              
                              83Gross
      profit
                              
                              
                              3,617
                              
                              
                              
                              21
                              
                              
                              
                              2,401
                              
                              
                              
                              17Operating
      expenses:General
      and administrative
                              
                              
                              1,605
                              
                              
                              
                              9
                              
                              
                              
                              1,394
                              
                              
                              
                              10Selling
      and marketing
                              
                              
                              836
                              
                              
                              
                              5
                              
                              
                              
                              863
                              
                              
                              
                              6Research
      and development
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              80
                              
                              
                              
                              1Depreciation
      and amortization
                              
                              
                              500
                              
                              
                              
                              3
                              
                              
                              
                              434
                              
                              
                              
                              3Total
      operating expenses
                              
                              
                              2,941
                              
                              
                              
                              17
                              
                              
                              
                              2,771
                              
                              
                              
                              20Income
      (loss) from operations
                              
                              
                              676
                              
                              
                              
                              4
                              
                              
                              
                              (370
                              )
                              
                              
                              (3
                              )Interest
      expense, net
                              
                              
                              253
                              
                              
                              
                              1
                              
                              
                              
                              1,033
                              
                              
                              
                              7Income
      (loss) from operations before income tax expense
                              
                              
                              423
                              
                              
                              
                              3
                              
                              
                              
                              (1,403
                              )
                              
                              
                              (10
                              )Income
      tax expense
                              
                              
                              133
                              
                              
                              
                              1
                              
                              
                              
                              -
                              
                              
                              
                              -Net
      income (loss)
                              
                              $
                              290
                              
                              
                              
                              2
                              %
                              
                              $
                              (1,403
                              )
                              
                              
                              (10
                              )%Earnings
      (loss) per common share - basic
                              
                              $
                              0.26
                              
                              
                              
                              
                              
                              
                              $
                              (22.01
                              )Earnings
      (loss) per common share - diluted
                              
                              $
                              0.10
                              
                              
                              
                              
                              
                              
                              $
                              (22.01
                              )




2





Net Revenues. Net revenues
for the three months ended March 31, 2010 were approximately $17.1 million,
compared to approximately $13.9 million for the three months ended March 31,
2009, all consisting of casual game sales in North America.  The
breakdown of gross sales by platform is:





Three Months Ended March 31,2010
                        
                        
                        2009Nintendo
      Wii
                        
                        
                        68
                        %
                        
                        
                        64
                        %Nintendo
      DS
                        
                        
                        32
                        %
                        
                        
                        32
                        %SONY
      PS2
                        
                        
                        0
                        %
                        
                        
                        2
                        %Microsoft
      Xbox
                        
                        
                        0
                        %
                        
                        
                        2
                        %




The
biggest sellers during the 2010 period were (i) Deal or No Deal on the Nintendo
Wii platform, (ii) Deer Drive bundled with our gun blaster for the Nintendo Wii
platform, and (iii) Dream Chronicles on the Nintendo DS platform.  The
various Wii games bundled with our gun blaster accounted for approximately 21%
of our sales during the 2010 period, accounting for most of the sales increase
from the 2009 period to the 2010 period.  The biggest sellers during
the 2009 period were (i) Deal or No Deal, (ii) M&M Kart Racing, and (iii)
Calvin Tucker’s Redneck Jamboree, all on the Nintendo Wii
platform.  The 2010 period consisted of approximately 1.53 million
units sold in North America at an average gross price of $11.22, while the 2009
period consisted of approximately 1.46 million units sold in North America at an
average gross price of $10.04.   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.   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 March 31, 2010 was approximately $3.6 million, or 21%
of net revenue, while the gross profit for the three months ended March 31, 2009
was approximately $2.4 million, or 17% of net revenue. The costs included in the
cost of goods sold consist of manufacturing and packaging costs, royalties due
to licensors relating to the current period’s revenues and the amortization of
product development costs relating to the current period’s revenues. The Atari
sales agreement was in place for all sales during the entire 2009 period and
Atari’s fees recorded as a reduction in revenue during the 2009 period were
approximately $1.6 million (10% of total gross revenue). The Atari agreement was
in place for only certain sales during the 2010 period and Atari’s fees recorded
as a reduction in revenue during the 2010 period were $625,000 (4% of total
gross revenue).  For those sales that were not distributed through
Atari, the Company pays the shipping costs.  The shipping costs during
the 2010 period were 3% higher, as a percentage of revenues, in 2010 than in
2009 when Atari was responsible for all shipping costs. The net improvement to
the gross margin in the 2010 period from the 2009 period was due mainly to the
reduction in the percentage of sales distributed through Atari of
3%.





General and Administrative Expenses.General and administrative expenses for the three months ended March 31,
2010 were approximately $1.6 million as compared to $1.4 million for the
comparable period in 2009.  The 2010 period included $246,000 of
non-cash stock-based compensation due to the issuance of stock and options to
certain directors and employees, while the 2009 period included only $22,000 of
non-cash stock-based compensation.  Without this stock-based
compensation, the general and administrative expenses actually decreased less
than 1% from the 2009 to 2010 period.





Selling and Marketing Expenses.Selling and marketing expenses decreased 3% to $836,000 for the three
months ended March 31, 2010 from $863,000 for the three months ended March 31,
2009 due primarily to lower average salaries, partially offset by increased
sales commissions during the 2010 period as compared with the prior
year.  These expenses all relate to the sales of casual games in North
America and consist primarily of the salaries, commissions and related costs for
Zoo Publishing.





Research and Development Expenses.Research and development expenses for the three months ended March 31,
2010 were $0 as compared to $80,000 for the three months ended March 31, 2009.
This expense is generally a direct result of our decision to discontinue the
development of certain games.  The 2009 expense resulted from
discontinuing one video game project during the period while none were
discontinued during the 2010 period.





Depreciation and Amortization
Expenses.Depreciation and amortization costs for the three months ended
March 31, 2010 were $500,000 as compared to $434,000 in the prior period. Both
periods include $412,000 resulting from the amortization of intangibles acquired
from the Zoo Publishing acquisition. The 2010 period also includes $65,000
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.


3




Interest Expense.Interest expense for the three months ended March 31, 2010 was $253,000
as compared to approximately $1.0 million for the three months ended March 31,
2009.  The 2010 period includes $30,000 of interest on the Solutions 2
Go loan and $100,000 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
$117,000.  The 2009 period includes $698,000 of non-cash interest
expense relating to the amortization on the Zoo Entertainment Notes, $135,000 of
interest relating to the Zoo Entertainment Notes and approximately $195,000 of
interest on the various promissory notes due to the sellers of Zoo Publishing of
which $160,000 is non-cash interest imputed at the then market
rate.





Income Tax Benefit.We
recorded an income tax expense of $133,000 for the three months ended March 31,
2010 against pretax income of $423,000.  For the three months ended
March 31, 2009, we recorded no income tax benefit against the $1.4 million
pretax loss because we had already maximized the benefit of our loss
carryforward.





Earnings (Loss) Per Common
Share.The basic earnings per share for the three months ended
March 31, 2010 was $0.26 based on a weighted average shares outstanding for the
period of approximately 1.1 million, while the basic loss per common share for
the three months ended March 31, 2009 was $(22.01), based on a weighted average
shares outstanding for the period of approximately 64,000.  The
diluted earnings per share for the three months ended March 31, 2010 was $0.10
based on a weighted average shares outstanding for the period of approximately
2.9 million, while the basic loss per common share for the three months ended
March 31, 2009 was $(22.01), based on a weighted average shares outstanding for
the period of approximately 64,000.




Liquidity
and Capital Resources





We earned
net income of $290,000 for the three months ended March 31, 2010 and incurred a
net loss of approximately $1.4 million for the three months ended March 31,
2009. Our principal source of cash during the 2010 period was from the use of
our purchase order and receivable financing arrangements and cash generated from
operations. Net cash used in operating activities for the three months ended
March 31, 2010 was $3.1 million, consisting primarily of the use of customer
advances for product sales in the quarter, product development costs, building
inventory for future sales and an increase in receivables as we became less
dependent on prepayments from Atari.  Net cash provided by operating
activities for the three months ended March 31, 2009 was $470,000, primarily
consisting of reduction in inventory and accounts receivable and an increase in
accounts payable, offset by payments of accrued expenses and product development
costs.





Zoo
Publishing takes advances from our factor, Working Capital Solutions, Inc.
(“WCS”), which utilizes existing accounts receivable in order to provide working
capital to fund all aspects of our continuing business operations. Under the
terms of our factoring and security agreement (the “Factoring Agreement”), our
receivables are sold to the factor, with recourse. The factor, in its sole
discretion, determines whether or not it will accept each receivable based upon
the credit risk factor of each individual receivable or account. Once a
receivable is accepted by the factor, the factor provides funding, subject to
the terms and conditions of the Factoring Agreement. The amount remitted to us
by the factor equals the invoice amount of the receivable adjusted for any
discounts or allowances provided to the account, less 25% which is deposited
into a reserve account established pursuant to the 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, 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 the factor for any accepted
receivable include a factoring fee of 0.6% for each ten (10) day period the
account is open.   For the three months ended March 31, 2010, we
sold approximately $4.2 million of receivables to the factor with recourse and
paid fees of $117,000.  At March 31, 2010, accounts receivable and due
from factor included approximately $2.8 million of amounts due from our
customers to the factor.  The factor had an advance outstanding to the
Company of approximately $1.9 million as of March 31, 2010.





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.


4





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





The
amount outstanding to Wells Fargo as of March 31, 2010 was approximately $1.1
million. The interest rate is prime plus 4.0% on outstanding advances and, as of
March 31, 2010, the effective interest rate was 7.25%.  The charges and
interest expense on the advances are included in the cost of goods sold in the
accompanying condensed consolidated statement of operations and were $203,000
and $40,000 for the three months ended March 31, 2010 and 2009,
respectively.





On April
6, 2010, Zoo Publishing, the Company and Wells Fargo entered into an amendment
to the existing 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
twelve months and to $400,000 for the following twelve months if the agreement
is renewed for an additional year; (iii) reduce the interest rate to prime plus
2% on outstanding advances and (ii) extend its term until April 5, 2011, subject
to automatic renewal for successive twelve 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.





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari 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 March 31, 2010.





We
believe the existing cash and cash generated from operations 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.




5


Critical
Accounting Policies and Estimates





There
were no changes to our critical accounting policies and estimates since the year
ended December 31, 2009.  A complete description of our critical
accounting policies and estimates can be found in our Annual Report on Form 10-K
for the year ended December 31, 2009, filed with the Securities and Exchange
Commission on March 31, 2010, and also in Note 2 to the unaudited condensed
consolidated financial statements included in this quarterly report for the
period ended March 31, 2010.




Off-Balance
Sheet Arrangements




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




Fluctuations
in Operating Results and Seasonality




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




ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Not
applicable as we are a smaller reporting company.





ITEM
4T.  CONTROLS AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures


Our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, has evaluated the effectiveness of our disclosure controls
and procedures, 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,
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.




6


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.  We are
committed to addressing this in 2010 and we will reassess our accounting and
finance staffing levels to determine and seek the appropriate accounting
resources to be added to our staff to handle the existing
workload.




Changes
in Controls and Procedures





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




7




PART
II - OTHER INFORMATION





ITEM  1.  LEGAL
PROCEEDINGS





We are
involved, from time to time, 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 these 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.





ITEM
1A.  RISK FACTORS





There
have been no material changes in our risk factors from those disclosed in our
Annual Report on Form 10-K for the year ended December 31, 2009, filed with the
Securities and Exchange Commission on March 31, 2010.





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





All
unregistered sales of equity securities made during the quarterly period were
previously reported on Current Reports on Form 8-K.




ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





None.





ITEM 4. (Removed and
Reserved)




ITEM
5.  OTHER INFORMATION





None.





ITEM
6.  EXHIBITS





31.1
            
            Certification
      of Chief Executive Officer. †31.2
            
            Certification
      of Chief Financial Officer. †32.1
            
            Certification
      by Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of
      2002. †





† Filed
herewith






8





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 17, 2010




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




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




9




EXHIBIT
INDEX




31.1
            
            Certification
      of Chief Executive Officer. †31.2
            
            Certification
      of Chief Financial Officer. †32.1
            
            Certification
      by Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of
      2002. †




† Filed
herewith


10