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 June 30, 2010




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




For the
transition period from _____________ to ___________




Commission
file number 333-124829




ZOO
ENTERTAINMENT, INC.


(Exact
name of Registrant as Specified in Its Charter)





Delaware
              
              71-1033391(State
      or other jurisdiction of incorporation or
              
              (I.R.S.
      Employer Identification No.)organization
      )3805
      Edwards Road, Suite 400
              
              45209Cincinnati,
      OH(Address
      of Principal Executive Offices)
              
              (Zip
      Code)




(513)
824-8297


(Registrant’s
telephone number, including area code)





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


Yes  x  No   ̈




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




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




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




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


Yes    ̈   No  x




As of
August 2, 2010, there were 6,243,744 shares of the Registrant’s common stock,
par value $0.001 per share, issued and 6,230,741 shares
outstanding.







ZOO
ENTERTAINMENT, INC.




Table
of Contents




PART
      I - FINANCIAL INFORMATIONPageItem
      1.
                Financial
      StatementsCondensed
      Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December
      31, 2009
                
                F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three Months and
      Six Months  Ended June 30, 2010 and 2009
                
                F-
      2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended
      June 30, 2010 and 2009
                
                F-
      3Condensed
      Consolidated Statement of Stockholders’ Equity (Unaudited) for the Six
      Months Ended June 30, 2010
                
                F-
      4Notes
      to Condensed Consolidated Financial Statements
                
                F-
      5 - F-26Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                1Item
      3.
                Quantitative
      and Qualitative Disclosure About Market Risk
                
                17Item
      4T.
                Controls
      and Procedures
                
                17PART
      II - OTHER INFORMATIONItem
      1.
                Legal
      Proceedings
                
                17Item
      1A.
                Risk
      Factors
                
                18Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                18Item
      3.
                Defaults
      Upon Senior Securities
                
                18Item
      4.
                (Removed
      and Reserved)
                
                18Item
      5.
                Other
      Information
                
                18Item
      6.
                Exhibits
                
                18Signatures
                
                19





Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


(in
thousands except share and per share amounts)




June
      30, 2010
                                      
                                      
                                      December
      31, 2009(unaudited)ASSETSCurrent
      AssetsCash
                                      
                                      $
                                      794
                                      
                                      
                                      $
                                      2,664Accounts
      receivable and due from factor, net ofallowances
      for returns and discounts of $793 and $835
                                      
                                      
                                      4,173
                                      
                                      
                                      
                                      4,022Inventory
                                      
                                      
                                      2,870
                                      
                                      
                                      
                                      2,103Prepaid
      expenses and other current assets
                                      
                                      
                                      1,836
                                      
                                      
                                      
                                      2,409Product
      development costs, net
                                      
                                      
                                      7,096
                                      
                                      
                                      
                                      4,399Deferred
      tax assets
                                      
                                      
                                      535
                                      
                                      
                                      
                                      578Total
      Current Assets
                                      
                                      
                                      17,304
                                      
                                      
                                      
                                      16,175Prepaid
      offering costs
                                      
                                      
                                      800
                                      
                                      
                                      
                                      -Fixed
      assets, net
                                      
                                      
                                      241
                                      
                                      
                                      
                                      141Intangible
      assets, net
                                      
                                      
                                      14,780
                                      
                                      
                                      
                                      15,733Total
      Assets
                                      
                                      $
                                      33,125
                                      
                                      
                                      $
                                      32,049LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable
                                      
                                      $
                                      4,897
                                      
                                      
                                      $
                                      3,330Financing
      arrangements
                                      
                                      
                                      3,054
                                      
                                      
                                      
                                      1,659Customer
      advances
                                      
                                      
                                      965
                                      
                                      
                                      
                                      3,086Accrued
      expenses and other current liabilities
                                      
                                      
                                      4,592
                                      
                                      
                                      
                                      2,333Notes
      payable, current portion
                                      
                                      
                                      120
                                      
                                      
                                      
                                      120Total
      Current Liabilities
                                      
                                      
                                      13,628
                                      
                                      
                                      
                                      10,528Notes
      payable, non-current portion
                                      
                                      
                                      180
                                      
                                      
                                      
                                      180Deferred
      tax liabilities
                                      
                                      
                                      3,007
                                      
                                      
                                      
                                      3,461Other
      long-term liabilities
                                      
                                      
                                      620
                                      
                                      
                                      
                                      2,770Total
      Liabilities
                                      
                                      
                                      17,435
                                      
                                      
                                      
                                      16,939Commitments
      and ContingenciesStockholders'
      EquityPreferred
      Stock, par value $0.001, 5,000,000 authorizedSeries
      A, 0 issued and outstanding at June 30, 2010,1,389,684
      issued and outstanding at December 31, 2009
                                      
                                      
                                      -
                                      
                                      
                                      
                                      1Series
      B, 0 issued and outstanding at June 30, 20101,188,439
      issued and outstanding at December 31, 2009
                                      
                                      
                                      -
                                      
                                      
                                      
                                      1Common
      Stock, par value $0.001, 3,500,000,000authorized,
      4,643,744 issued and 4,630,741 outstanding atJune
      30, 2010 and 250,000,000 authorized, 65,711issued
      and 52,708 outstanding at December 31, 2009
                                      
                                      
                                      5
                                      
                                      
                                      
                                      -Additional
      paid-in-capital
                                      
                                      
                                      65,477
                                      
                                      
                                      
                                      64,714Accumulated
      deficit
                                      
                                      
                                      (45,323
                                      )
                                      
                                      
                                      (45,137
                                      )Treasury
      Stock, at cost, 13,003 at June 30, 2010and
      December 31, 2009
                                      
                                      
                                      (4,469
                                      )
                                      
                                      
                                      (4,469
                                      )Total
      Stockholders' Equity
                                      
                                      
                                      15,690
                                      
                                      
                                      
                                      15,110Total
      Liabilities and Stockholders' Equity
                                      
                                      $
                                      33,125
                                      
                                      
                                      $
                                      32,049


See
accompanying notes to condensed consolidated financial
statements


F-1


Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Operations


For
the Three Months and Six Months Ended June 30, 2010 and 2009


(in
thousands except share and per share amounts)




Three
      Months Ended June 30,
                                
                                
                                Six
      Months Ended June 30,2010
                                
                                
                                2009
                                
                                
                                2010
                                
                                
                                2009Revenue
                                
                                $
                                10,470
                                
                                
                                $
                                7,669
                                
                                
                                $
                                27,602
                                
                                
                                $
                                21,553Cost
      of goods sold
                                
                                
                                7,957
                                
                                
                                
                                7,742
                                
                                
                                
                                21,472
                                
                                
                                
                                19,225Gross
      profit (loss)
                                
                                
                                2,513
                                
                                
                                
                                (73
                                )
                                
                                
                                6,130
                                
                                
                                
                                2,328Operating
      expenses:General
      and administrative (includes stock-basedcompensation
      of $117, $222, $362 and $244)
                                
                                
                                1,190
                                
                                
                                
                                1,866
                                
                                
                                
                                2,795
                                
                                
                                
                                3,260Selling
      and marketing
                                
                                
                                1,217
                                
                                
                                
                                662
                                
                                
                                
                                2,053
                                
                                
                                
                                1,525Research
      and development
                                
                                
                                -
                                
                                
                                
                                290
                                
                                
                                
                                -
                                
                                
                                
                                370Depreciation
      and amortization
                                
                                
                                491
                                
                                
                                
                                435
                                
                                
                                
                                991
                                
                                
                                
                                869Total
      operating expenses
                                
                                
                                2,898
                                
                                
                                
                                3,253
                                
                                
                                
                                5,839
                                
                                
                                
                                6,024Income
      (loss) from operations
                                
                                
                                (385
                                )
                                
                                
                                (3,326
                                )
                                
                                
                                291
                                
                                
                                
                                (3,696
                                )Interest
      expense, net
                                
                                
                                (368
                                )
                                
                                
                                (1,000
                                )
                                
                                
                                (621
                                )
                                
                                
                                (2,033
                                )Gain
      on legal settlement
                                
                                
                                -
                                
                                
                                
                                4,328
                                
                                
                                
                                -
                                
                                
                                
                                4,328Income
      (loss) from operations before income tax benefit
                                
                                
                                (753
                                )
                                
                                
                                2
                                
                                
                                
                                (330
                                )
                                
                                
                                (1,401
                                )Income
      tax benefit
                                
                                
                                277
                                
                                
                                
                                -
                                
                                
                                
                                144
                                
                                
                                
                                -Net
      income (loss)
                                
                                $
                                (476
                                )
                                
                                $
                                2
                                
                                
                                $
                                (186
                                )
                                
                                $
                                (1,401
                                )Earnings (loss) per common share - basic and
      diluted:Earnings
      (loss) per common share
                                
                                $
                                (0.11
                                )
                                
                                $
                                0.03
                                
                                
                                $
                                (0.07
                                )
                                
                                $
                                (23.61
                                )Weighted
      average common shares outstanding
                                
                                
                                4,431,346
                                
                                
                                
                                58,686
                                
                                
                                
                                2,765,146
                                
                                
                                
                                59,345





See
accompanying notes to condensed consolidated financial
statements


F-2


Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Cash Flow


For
the Six Months Ended June 30, 2010 and 2009


(in
thousands)




Six
      Months Ended June 30,2010
                              
                              
                              2009Operating
      activities:Net
      loss
                              
                              $
                              (186
                              )
                              
                              $
                              (1,401
                              )Adjustments
      to reconcile net loss from operations to net cash(used
      in) provided by operating activities:Gain
      on legal settlement
                              
                              
                              -
                              
                              
                              
                              (4,328
                              )Depreciation
      and amortization
                              
                              
                              991
                              
                              
                              
                              869Amortization
      of deferred debt discount
                              
                              
                              -
                              
                              
                              
                              1,690Deferred
      income taxes
                              
                              
                              (411
                              )
                              
                              
                              -Stock-based
      compensation
                              
                              
                              363
                              
                              
                              
                              244Other
      changes in assets and liabilities, net
                              
                              
                              (3,399
                              )
                              
                              
                              3,488Net
      cash (used in) provided by operating activities
                              
                              
                              (2,642
                              )
                              
                              
                              562Investing
      activities:Purchases
      of fixed assets
                              
                              
                              (138
                              )
                              
                              
                              (58
                              )Purchase
      of intellectual property
                              
                              
                              -
                              
                              
                              
                              (162
                              )Net
      cash used in investing activities
                              
                              
                              (138
                              )
                              
                              
                              (220
                              )Financing
      activities:Net
      borrowings (repayments) in connection with financing
      facilities
                              
                              
                              1,395
                              
                              
                              
                              (707
                              )Prepaid
      offering costs
                              
                              
                              (50
                              )
                              
                              
                              -Repayment
      of Solutions 2 Go customer advances
                              
                              
                              (435
                              )
                              
                              
                              -Net
      cash provided by (used in) financing activities
                              
                              
                              910
                              
                              
                              
                              (707
                              )Net
      decrease in cash
                              
                              
                              (1,870
                              )
                              
                              
                              (365
                              )Cash
      at beginning of period
                              
                              
                              2,664
                              
                              
                              
                              849Cash
      at end of period
                              
                              $
                              794
                              
                              
                              $
                              484





See
accompanying notes to condensed consolidated financial
statements


F-3


Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statement of Stockholders' Equity


For
the Six Months Ended June 30, 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
                      
                      
                      
                      135
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      136Issuance
      of management options accrued for in 2009 as a liability
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      403
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      403Stock-based
      compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      227
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      227Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (186
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (186
                      )Balance
      at June 30, 2010
                      
                      
                      -
                      
                      
                      $
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      -
                      
                      
                      
                      4,644
                      
                      
                      $
                      5
                      
                      
                      $
                      65,477
                      
                      
                      $
                      (45,323
                      )
                      
                      
                      13
                      
                      
                      $
                      (4,469
                      )
                      
                      $
                      15,690





See
accompanying notes to condensed consolidated financial
statements


F-4


Zoo
Entertainment, Inc. And Subsidiaries




Notes
to Condensed Consolidated Financial Statements




NOTE
1.  DESCRIPTION OF ORGANIZATION




Zoo
Entertainment, Inc. (“Zoo” or the “Company”) was incorporated under the laws of
the State of Nevada on February 13, 2003 under the name Driftwood Ventures, Inc.
On December 20, 2007, the Company reincorporated in Delaware and increased its
authorized capital stock from 75,000,000 shares to 80,000,000 shares, consisting
of 75,000,000 shares of common stock, par value $0.001 per share, and 5,000,000
shares of preferred stock, par value $0.001 per share.  The Company had
been inactive until July 7, 2008 when the Company entered into an Agreement and
Plan of Merger, as subsequently amended on September 12, 2008, with DFTW Merger
Sub, Inc., a Delaware corporation and a wholly-owned subsidiary of the Company
(“Merger Sub”), Zoo Games, Inc., a Delaware corporation (“Zoo Games”) (formerly
known as Green Screen Interactive Software, Inc.) and a stockholder
representative, pursuant to which Merger Sub merged with and into Zoo Games,
with Zoo Games surviving the merger and becoming a wholly-owned subsidiary of
the Company (the “Merger”).  In connection with the Merger, the outstanding
shares of common stock of Zoo Games were exchanged for shares of common stock of
the Company.  On December 3, 2008, Driftwood Ventures, Inc. changed its
name to Zoo Entertainment, Inc.  In August 2009, the Company increased its
authorized shares of common stock to 250,000,000, par value $0.001 per
share.  On November 20, 2009, as a result of the Company consummating an
approximately $4.2 million equity raise, the Company issued Series A Convertible
Preferred Stock (“Series A Preferred Stock”) and warrants. Concurrently, as a
result of the aforementioned preferred equity raise, the Company’s note holders
converted approximately $11.8 million of existing debt and related accrued
interest into Series B Convertible Preferred Stock (“Series B Preferred
Stock”).  On December 16, 2009, as a result of the Company consummating an
additional preferred equity raise of $776,000, the Company issued to investors
Series A Preferred Stock.  On March 10, 2010, the Company increased its
authorized shares of common stock to 3,500,000,000.  As a result, all of
the outstanding shares of Series A Preferred Stock and the Series B Preferred
Stock converted into shares of common stock of the Company on March 10,
2010.




Zoo Games
is a developer, publisher and distributor of interactive entertainment software
for use on all major platforms including Nintendo’s Wii and DS, Sony’s
PlayStation Portable (“PSP”), PlayStation 2 (“PS2”) and PlayStation 3 (“PS3”),
Microsoft’s Xbox 360, and personal computers (“PCs”).  Zoo Games sells
primarily to major retail chains and video game distributors.  Zoo Games
began business in March 2007 and, on December 18, 2007, acquired all of the
outstanding capital stock of Destination Software, Inc., which was later renamed
Zoo Publishing, Inc. (“Zoo Publishing”).




Zoo Games
was treated as the acquirer for accounting purposes in the Merger, and the
financial statements of the Company for all periods presented represent the
historical activity of Zoo Games and include the activity of Zoo beginning on
September 12, 2008, the effective date of the Merger.




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




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




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


F-5


NOTE
2.  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 Company’s management
discussion and analysis contained elsewhere herein and the consolidated
financial statements for the year ended December 31, 2009 included in the
Company’s Registration Statement on Form S-1/A (Registration No. 333-163937), as
filed on June 25, 2010. The Company’s results for the three and six months ended
June 30, 2010 might not be indicative of the results for the full year or any
future period.




The   condensed
consolidated financial statements of the Company include the accounts of Zoo
Games and its wholly-owned subsidiaries, Zoo Publishing and Zoo Entertainment
Europe Ltd.  All intercompany accounts and transactions are eliminated in
consolidation.




Use
of Estimates




The
preparation of financial statements in conformity with 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




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




If the
financial condition and operations of the Company’s customers deteriorate, its
risk of collection could increase substantially. A majority of the Company’s
trade receivables are derived from sales to major retailers and
distributors.  In October 2008, the Company entered into an agreement with
Atari, Inc. where sales from October 24, 2008 through March 31, 2009 for all
customers that Atari deemed acceptable would be through Atari, and Atari would
prepay the Company for the cost of goods and they would bear the credit risk
from the ultimate customer.  This agreement was subsequently amended to
include sales to certain customers through June 30, 2010.  As of June 30,
2010, the receivable due from Atari was approximately $768,000, before
allowances, which is included in accounts receivable and due from factor in the
condensed consolidated balance sheet.  The Company’s five largest ultimate
customers accounted for approximately 81% (of which the following customers
constituted balances greater than 10%:  customer A-44% and customer
B-12%) and 81% (of which the following customers constituted balances greater
than 10%: customer A-31%, customer C-26% and customer D-15%) of net revenue for
the three months ended June 30, 2010 and 2009, respectively.  The Company’s
five largest ultimate customers accounted for approximately 77% (of which the
following customers constituted balances greater than 10%: customer A-39% and
customer C-19%) and 79% (of which the following customers constituted balances
greater than 10%:  customer A-21%, customer C-23%, customer D-16% and
customer E-12%) of net revenue for the six months ended June 30, 2010 and 2009,
respectively.  These five largest customers accounted for 53% of the
Company’s gross accounts receivable as of June 30, 2010.  The Company
believes that the receivable balances from its customers do not represent a
significant credit risk based on past collection experience. During the six
months ended June 30, 2010 and 2009, the Company sold approximately $9.8 million
and $0, respectively, of receivables to its factor with recourse.  The
factored receivables were approximately $3.9 million and $1.4 million of the
Company’s gross accounts receivable and due from factor, net as of June 30, 2010
and December 31, 2009, respectively.  The Company regularly reviews its
outstanding receivables for potential bad debts and has had no history of
significant write-offs due to bad debts.


F-6


Inventory




Inventory
is stated at the lower of actual cost or market.  The Company periodically
evaluates the carrying value of its inventory and makes adjustments as
necessary.  Estimated product returns are included in the inventory
balances and also recorded at the lower of actual cost or market.




Product
Development Costs




The
Company utilizes third party product developers and frequently enters into
agreements with these developers that require it to make payments based on
agreed upon milestone deliverable schedules for game design and
enhancements.  The Company receives the exclusive publishing and
distribution rights to the finished game title as well as, in some cases, the
underlying intellectual property rights for that game.  The Company
typically enters into these development agreements after it has completed the
design concept for its products.  The Company contracts with third party
developers that have proven technology and the experience and ability to build
the designed video game as conceived by the Company.  As a result,
technological feasibility is determined to have been achieved at the time in
which the Company enters the agreement and it therefore capitalizes such
payments as prepaid product development costs.  On a product by product
basis, the Company reduces prepaid product development costs and 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, the Company
evaluates the recoverability of capitalized prepaid product development costs,
development payments and any other unrecognized minimum commitments that have
not been paid, using an undiscounted future cash flow analysis, and charge any
amounts that are deemed unrecoverable to cost of goods sold if the product has
already been released.  If the product development process is discontinued
prior to completion, any prepaid unrecoverable amounts are charged to research
and development expense.  The Company uses various measures to estimate
future revenues for its product titles, including past performance of similar
titles and orders for titles prior to their release.  For sequels, the
performance of predecessor titles is also taken into consideration.




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.  The Company’s arrangements with third party
developers are not considered collaborative arrangements because the third party
developers do not have significant active participation in the design and
development of the video games, nor are they exposed to significant risks and
rewards as their compensation is fixed and not contingent upon the revenue that
the Company will generate from sales of its product.  If the Company enters
into any future arrangements with product developers that are considered
collaborative arrangements, it will account for them
accordingly.


F-7


Licenses
and Royalties




Licenses
consist of payments and guarantees made to holders of intellectual property
rights for use of their trademarks, copyrights, technology or other intellectual
property rights in the development of the Company’s products.  Agreements
with holders of intellectual property rights generally provide for guaranteed
minimum royalty payments for use of their intellectual property.




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




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




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




The
Company reviews all long-lived assets whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable, including assets to be disposed of by sale, whether previously held
and used or newly acquired.  The Company compares the carrying amount of
the asset to the estimated undiscounted future cash flows expected to result
from the use of the asset.  If the carrying amount of the asset exceeds
estimated expected undiscounted future cash flows, the Company records an
impairment charge for the difference between the carrying amount of the asset
and its fair value.  The estimated fair value is generally measured by
discounting expected future cash flows at the Company’s incremental borrowing
rate or fair value, if available.  The Company determined that no
impairment for definite lived intangible assets was identified in the six months
ended June 30, 2010 or 2009.




Revenue
Recognition




The
Company earns its 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. The Company recognizes such revenue upon the transfer of
title and risk of loss to its customers.  Accordingly, the Company
recognizes revenue for software titles when there is (1) persuasive evidence
that an arrangement with the customer exists, which is generally a customer
purchase order, (2) the product is delivered, (3) the selling price is fixed or
determinable and (4) collection of the customer receivable is deemed
probable.  The Company’s payment arrangements with customers typically
provide net 30 and 60-day terms.  Advances received from customers are
reported on the condensed consolidated balance sheets as customer advances and
are included in current liabilities until the Company meets its performance
obligations, at which point it recognizes the revenue.




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


F-8


Allowances
for Returns, Price Concessions and Other Allowances




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




Although
the Company’s distribution arrangements with customers do not give them the
right to return titles or to cancel firm orders, the Company sometimes accepts
returns from its distribution customers for stock balancing and makes
accommodations to customers, which include credits and returns, when demand for
specific titles falls below expectations.




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




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




Consideration
Given to Customers and Received from Vendors




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




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




Equity-Based
Compensation




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




The fair
value of the options granted is estimated using the Black-Scholes option-pricing
model.  This model requires the input of assumptions regarding a number of
complex and subjective variables that will usually have a significant impact on
the fair value estimate.  These variables include, but are not limited to,
the volatility of the Company’s stock price and estimated exercise
behavior.  The Company used the current market price to determine the fair
value of the stock price for the grant made during the period ended June 30,
2009, and used the price of the Company’s equity raise in the fourth quarter of
2009 to determine the fair value of the stock price for the grant made on
February 11, 2010.  The following table summarizes the assumptions and
variables used by the Company to compute the weighted average fair value of
stock option grants:


F-9




Six
      Months
                  Ended
      June 30,2010
                
                
                2009Risk-free
      interest rate
                
                
                3.00
                %
                
                
                3.52
                %Expected
      stock price volatility
                
                
                60.0
                %
                
                
                70.0
                %Expected
      term until exercise (years)
                
                
                5
                
                
                
                5Expected
      dividend yield
                
                None
                
                
                None




For the
six months ended June 30, 2010 and 2009, the Company estimated the implied
volatility for publicly traded options on its common shares as the expected
volatility assumption required in the Black-Scholes option-pricing model. 
The selection of the implied volatility approach was based upon the historical
volatility of companies with similar businesses and capitalization and the
Company’s assessment that implied volatility is more representative of future
stock price trends than historical volatility.




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




Earnings
(Loss) Per Share




Basic
earnings (loss) per share (“EPS”) is computed by dividing the net income (loss)
applicable to common stockholders for the period by the weighted average number
of shares of common stock outstanding during the same period.  An unvested
restricted stock grant, of which 199,395 shares are outstanding as of June 30,
2010, is excluded from the basic EPS.  Diluted EPS is computed by dividing
the net income applicable to common stockholders for the period by the weighted
average number of shares of common stock outstanding and common stock
equivalents, which includes warrants and options outstanding during the same
period.  Since the inclusion of 1,039,703 warrants and 4,321 options as of
June 30, 2010 and the inclusion of the 10,837 warrants and 4,316 options
outstanding as of June 30, 2009 are anti-dilutive because the Company had net
losses for the periods, they are excluded from the calculation of diluted loss
per share and the diluted loss per share is the same as the basic loss per
share.




Income
Taxes




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




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


F-10


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
June 30, 2010 and December 31, 2009, the carrying value of cash, accounts
receivable and due from factor, inventory, prepaid expenses, accounts payable,
accrued expenses, due to factor, and advances from customers were reasonable
estimates of the fair values because of their short-term maturity.




NOTE
3.  INVENTORY




Inventory
consisted of:




(Amounts
      in Thousands)June
      30,
                        2010
                      
                      
                      December
      31,
                        2009Finished
      products
                      
                      $
                      2,250
                      
                      
                      $
                      1,247Parts
      and supplies
                      
                      
                      620
                      
                      
                      
                      856Totals
                      
                      $
                      2,870
                      
                      
                      $
                      2,103




Estimated
product returns included in inventory at June 30, 2010 and December 31, 2009
were $204,000 and $261,000, respectively.


F-11


NOTE
4.  PREPAID EXPENSES AND OTHER CURRENT ASSETS




Prepaid
expenses and other current assets consisted of:




(Amounts
      in Thousands)June
      30,
                      2010
                    
                    
                    December
      31,
                      2009Vendor
      advances for inventory
                    
                    $
                    868
                    
                    
                    $
                    1,545Prepaid
      royalties
                    
                    
                    711
                    
                    
                    
                    474Other
      prepaid expenses
                    
                    
                    257
                    
                    
                    
                    390Totals
                    
                    $
                    1,836
                    
                    
                    $
                    2,409




NOTE
5.  PRODUCT DEVELOPMENT COSTS




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




Product
      development costs, net - December 31, 2009
                    
                    $
                    4,399New
      product development costs incurred
                    
                    
                    4,286Amortization
      of product development costs
                    
                    
                    (1,589
                    )Product
      development costs, net - June 30, 2010
                    
                    $
                    7,096




Amortization
of product development costs for the three months ended June 30, 2010 and June
30, 2009 was $630,000 and approximately $1.5 million, respectively. 
Amortization of product development costs for the six months ended June 30, 2010
and June 30, 2009 was approximately $1.6 million and approximately $2.7 million,
respectively.


F-12


NOTE
6.  INTANGIBLE ASSETS, NET




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




(Amounts in Thousands)
                      
                      June 30, 2010
                    
                    
                    December 31, 2009Estimated
                      Useful
                      Lives
                      (Years)
                    
                    
                    Gross
                      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Net Book
                      Value
                    
                    
                    Net Book
                      ValueContent
                    
                    
                    10
                    
                    
                    $
                    14,965
                    
                    
                    $
                    3,361
                    
                    
                    $
                    11,604
                    
                    
                    $
                    12,345Trademarks
                    
                    
                    10
                    
                    
                    
                    1,510
                    
                    
                    
                    384
                    
                    
                    
                    1,126
                    
                    
                    
                    1,201Customer
      relationships
                    
                    
                    10
                    
                    
                    
                    2,749
                    
                    
                    
                    699
                    
                    
                    
                    2,050
                    
                    
                    
                    2,187Totals
                    
                    
                    
                    
                    
                    $
                    19,224
                    
                    
                    $
                    4,444
                    
                    
                    $
                    14,780
                    
                    
                    $
                    15,733




Amortization
expense related to intangible assets was $476,000 and $411,000 for the three
months ended June 30, 2010 and 2009, respectively, and $953,000 and $823,000 for
the six months ended June 30, 2010 and 2009, respectively.




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




Year
      Ending December 31,
                
                (Amounts
                  In
      Thousands)Balance
      of 2010
                
                $
                9692011
                
                
                1,9222012
                
                
                1,9222013
                
                
                1,9222014
                
                
                1,922Thereafter
                
                
                6,123Total
                
                $
                14,780


F-13


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 the Company’s agreement (the “Assignment Agreement”), the
Company assigns purchase orders received from customers to Wells Fargo, and
request that Wells Fargo purchase the required materials to fulfill such
purchase orders.  Wells Fargo, which may accept or decline the assignment
of specific purchase orders, retains the Company to manufacture, process and
ship ordered goods, and pays the Company for its services upon Wells Fargo’s
receipt of payment from the customers for such ordered goods. Upon payment in
full of the purchase order invoice by the applicable customer to Wells Fargo,
Wells Fargo re-assigns the applicable purchase order to the Company.  The
Company pays to Wells Fargo a commitment fee in the aggregate amount of $337,500
on the earlier of the anniversary of the date of the Assignment Agreement or the
date of termination of the Assignment Agreement.  Wells Fargo is not
obligated to provide purchase order financing under the Assignment Agreement if
the aggregate outstanding funding exceeds $5,000,000.  The Assignment
Agreement is for an initial term of 12 months, and continues thereafter for
successive 12 month renewal terms unless either party terminates the Assignment
Agreement by written notice to the other no later than 30 days prior to the end
of the initial term or any renewal term.  If the term of the Assignment
Agreement is renewed for one or more 12 month terms, for each such 12 month
term, the Company will pay to Wells Fargo a commitment fee in the sum of
$337,500, paid on the earlier of the anniversary of such renewal date or the
date of termination of the Assignment Agreement.  The initial and renewal
commitment fees are subject to waiver if certain product volume requirements are
met.




The
amounts outstanding as of June 30, 2010 and December 31, 2009 were approximately
$449,000 and $759,000, respectively, which is included in financing arrangements
in the current liability section of the condensed consolidated balance
sheet.  The interest rate on advances is prime plus 2.0%, effective April
6, 2010; prior to that date the interest rate on advances was prime plus 4.0%.
As of June 30, 2010 and December 31, 2009, the effective interest rate was 5.25%
and 7.25%, respectively.  The charges and interest expense on the advances
are included in the cost of goods sold in the
accompanying   condensed consolidated statements of operations
and were $149,000 and $50,000 for the three months ended June 30, 2010 and 2009,
respectively, and $352,000 and $94,000 for the six months ended June 30, 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
12 months and to $400,000 for the following 12 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 12 month terms unless either party terminates
the agreement with written notice 30 days prior to the end of the initial term
or any renewal term.  In consideration for the extension, the Company paid
to Wells Fargo an aggregate fee of approximately $32,000.


F-14


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 the Company’s continuing business operations.  The Company
entered into a new factoring agreement with WCS on September 29, 2009 (the
“Factoring Agreement”).  Under the terms of the Factoring Agreement, the
Company sells its 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 the Company 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 the Company in accordance with the
agreement.  The amounts to be paid by the Company 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, the Company records the gross receivables including amounts due from
its customers to the factor and it records a liability to the factor for funds
advanced to the Company from the factor. During the six months ended June 30,
2010 and 2009, the Company sold approximately $9.8 million and $0, respectively,
of receivables to the factor with recourse.  At June 30, 2010 and December
31, 2009, accounts receivable and due from factor included approximately $3.9
million and approximately $1.4 million of amounts due from the Company’s
customers to the factor, respectively.  The factor had an advance
outstanding to the Company of approximately $2.6 million and $900,000 as of June
30, 2010 and December 31, 2009, respectively which is included in financing
arrangements in the current liability section of the respective condensed
consolidated balance sheets.  In connection with the factoring 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.




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 the Company’s inventory and
impacted its cash flow from operations, the Company entered into an agreement
with Atari, Inc. (“Atari”).  This agreement became effective on October 24,
2008 and provided for Zoo Publishing to sell its products to Atari without
recourse and Atari 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 June 30, 2010.  This agreement provided for Atari to prepay to the
Company for the cost of goods and pay the balance due within 15 days of shipping
the product.  Atari’s fees approximate 10% of the Company’s standard
selling price and they have been recorded as a reduction in revenue. 
During the three months ended June 30, 2010 and 2009, the Company recorded
approximately $2.8 million and $6.5 million, respectively, of net sales to
Atari.  During the six months ended June 30, 2010 and 2009, the Company
recorded approximately $11.4 million and $22.2 million, respectively, of sales,
net of the fee 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 June 30, 2010 and December 31, 2009, Atari had
prepaid the Company $0 and approximately $1.5 million, respectively, for goods
not yet shipped which is recorded as customer advances in current
liabilities.  Also, as of June 30, 2010 and December 31, 2009, the
receivable due from Atari was $768,000 and approximately $1.8 million,
respectively, before allowances, for goods already shipped which are recorded in
accounts receivable and due from factor in the condensed consolidated balance
sheets.




F-15


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 $25,000 and $55,000 is recorded for the
three and six months ended June 30, 2010, respectively.  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
June 30, 2010 and December 31, 2009, the balance remaining on the advance was
approximately $965,000 and $1.4 million, respectively, and is included in
customer advances in the current liabilities section of the condensed
consolidated balance sheets.




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 12 months through interest expense. For the
three and six months ended June 30, 2010, $100,000 and $200,000, respectively,
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 a former employee.
Messrs. Seremet and Rosenbaum did not receive any additional compensation for
this guarantee.  The former employee who guaranteed the advance was granted
834 shares of common stock.  The value of the shares issued was computed at
$100,000 using the bid-ask spread of the Company’s stock price and is recorded
in the general and administrative expenses in the year ended December 31,
2009.




F-16


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 (benefit) for the six months ended June 30,
2010 are as follows (in thousands):




Six
      Months Ended
                                              June 30, 2010Current:Federal
                                            
                                            $
                                            232State
                                            
                                            
                                            35Total
      Current
                                            
                                            
                                            267Deferred:Federal
                                            
                                            
                                            (363
                                            )State
                                            
                                            
                                            (48
                                            )Total
      Deferred
                                            
                                            
                                            (411
                                            )Total
                                            
                                            $
                                            (144
                                            )




The
Company paid $38,000 and $0 to various state jurisdictions for income taxes
during the six months ended June 30, 2010 and 2009, respectively.




The
reconciliations of income tax expense computed at the U.S. statutory tax rates
to income tax expense (benefit) for the six months ended June 30, 2010 and 2009
are as follows:




Six
      Months
                      Ended
      June 30,2010
                    
                    
                    2009Tax
      at U.S. federal income tax rates
                    
                    
                    (34.0
                    )%
                    
                    
                    (34.0
                    )%State
      taxes, net of federal income tax benefit
                    
                    
                    (2.6
                    )
                    
                    
                    (2.5
                    )Change
      in valuation allowance
                    
                    
                    —
                    
                    
                    
                    2.4Nondeductible
      expenses and other
                    
                    
                    (7.0
                    )
                    
                    
                    34.1(43.6
                    )%
                    
                    
                    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 June 30, 2010 and December
31, 2009 are as follows (in thousands):


F-17




June
      30, 2010
                      
                      
                      December
      31, 2009Current
                      
                      
                      Long-Term
                      
                      
                      Current
                      
                      
                      Long-TermDeferred
      tax assets:Net
      operating loss carried forwards
                      
                      $
                      —
                      
                      
                      $
                      654
                      
                      
                      $
                      —
                      
                      
                      $
                      719Capital
      loss carryforwards
                      
                      
                      
                      
                      
                      
                      431
                      
                      
                      
                      
                      
                      
                      
                      431Allowance
      for returns and discounts
                      
                      
                      331
                      
                      
                      
                      —
                      
                      
                      
                      315
                      
                      
                      
                      —Bonus
      and other accruals
                      
                      
                      267
                      
                      
                      
                      —
                      
                      
                      
                      363
                      
                      
                      
                      —Non-qualified
      options
                      
                      
                      —
                      
                      
                      
                      780
                      
                      
                      
                      —
                      
                      
                      
                      569Alternative
      minimum tax credit carryforward
                      
                      
                      135
                      
                      
                      
                      —
                      
                      
                      
                      135
                      
                      
                      
                      —Gross
      deferred tax assets
                      
                      
                      733
                      
                      
                      
                      1,865
                      
                      
                      
                      813
                      
                      
                      
                      1,719Valuation
      allowance
                      
                      
                      (122
                      )
                      
                      
                      (309
                      )
                      
                      
                      (138
                      )
                      
                      
                      (293
                      )Net
      deferred tax assets
                      
                      
                      611
                      
                      
                      
                      1,556
                      
                      
                      
                      675
                      
                      
                      
                      1,426Deferred
      tax liabilities:Property
      and equipment
                      
                      
                      —
                      
                      
                      
                      (16
                      )
                      
                      
                      —
                      
                      
                      
                      (17
                      )Inventory
                      
                      
                      (76
                      )
                      
                      
                      —
                      
                      
                      
                      (97
                      )
                      
                      
                      —Intangibles
                      
                      
                      —
                      
                      
                      
                      (4,547
                      )
                      
                      
                      —
                      
                      
                      
                      (4,870
                      )Total
      deferred tax liabilities
                      
                      
                      (76
                      )
                      
                      
                      (4,563
                      )
                      
                      
                      (97
                      )
                      
                      
                      (4,887
                      )Net
      deferred tax asset (liability)
                      
                      $
                      535
                      
                      
                      $
                      (3,007
                      )
                      
                      $
                      578
                      
                      
                      $
                      (3,461
                      )




As of
June 30, 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
June 30, 2010, the Company has U.S. federal net operating loss (“NOL”)
carryforwards of approximately $1.5 million. As a result of statutory
limitations, the Company will only be able to utilize approximately $160,000 of
NOL and capital loss carryforwards per year.  The federal NOL will begin to
expire in 2028.  The Company has state NOL carryforwards of approximately
$2.9 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.


F-18


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 June 30,
2010.  All references to common stock reflect the one-for-600 reverse stock
split of the Company’s common stock, par value $0.001 per share, that became
effective on May 10, 2010, and all historical information has been restated to
reflect the reverse stock split.




Common
Stock




As of
June 30, 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 the Company’s equity raise in the fourth quarter of 2009
and a marketability discount.  The stock-based compensation expense
recorded in the three months and six months ended June 30, 2010 is $25,000 and
$136,000, respectively.  The remaining $261,000 will be expensed throughout
the remaining vesting period of the restricted common stock grants until
February 2013.




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




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




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.




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




Number
                        OutstandingNon-Vested
      shares at December 31, 2009
                      
                      
                      —Shares
      granted
                      
                      
                      281,104Shares
      vested
                      
                      
                      (81,709
                      )Non-Vested
      shares at June 30, 2010
                      
                      
                      199,395


F-19


Preferred
Stock




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




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




On
November 20, 2009, the Company entered into a securities purchase agreement with
certain investors, consummating an 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.


F-20


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




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




On May
12, 2009, the Company entered into a letter agreement with each of Mark Seremet
and David Rosenbaum, pursuant to which, in consideration for Messrs. Seremet and
Rosenbaum entering into a guaranty with Wells Fargo for the full and prompt
payment and performance by the Company and its subsidiaries of the obligations
in connection with a purchase order financing (the “Loan”), the Company agreed
to compensate Mr. Seremet in the amount of $10,000 per month, and Mr. Rosenbaum
in the amount of $7,000 per month, for so long as the executive remains employed
while the guaranty and Loan remain in full force and effect.  If the
guaranty is not released by the end of the month following termination of
employment of either Messrs. Seremet or Rosenbaum, the monthly fee shall be
doubled for each month thereafter until the guaranty is removed.  As part
of the November 2009 financing, Messrs. Seremet and Rosenbaum agreed to amend
their respective letter agreements, pursuant to which, in consideration of each
of their continued personal guarantees, the Company’s Board of Directors has
approved the issuance of an option to purchase restricted stock or other
incentives intended to comply with Section 409A of the Internal Revenue Code,
equal to a 6.25% ownership interest, to each of Mr. Seremet and Mr. Rosenbaum
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, and was included in
accrued expenses in the December 31, 2009 consolidated balance sheet.  The
stock-based compensation expense recorded in the three months and six months
ended June 30, 2010 is $29,000 and $57,000, respectively.  The remaining
$82,000 will be expensed throughout the remaining vesting period of the options
until May 2011.




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




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




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


F-21




June
      30, 2010Number
      of
                              Shares
                            
                            
                            Weighted
                              Average
                              Exercise
                              PriceOutstanding
      at December 31, 2009
                            
                            
                            4,321
                            
                            
                            $
                            774.00Granted
      (outside of the 2007 Plan)
                            
                            
                            1,260,917
                            
                            
                            
                            1.95Canceled
                            
                            
                            —
                            
                            
                            
                            —Outstanding
      at June 30, 2010
                            
                            
                            1,265,238
                            
                            
                            $
                            4.59Options
      exercisable at June 30, 2010
                            
                            
                            3,253
                            
                            
                            $
                            888.00




The fair
value of options granted during the six months ended June 30, 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 June
30, 2010:




Options Outstanding
                        
                        
                        Options ExercisableRange of
                          Exercise Prices
                        
                        Number
                          Outstanding
                        
                        
                        Weighted-
                          Average
                          Remaining
                          Contractual
                          Life (Years)
                        
                        
                        Weighted
                          - Average
                          Exercise
                          Price
                        
                        
                        Number
                          Exercisable
                        
                        
                        Weighted-
                          Average
                          Exercise
                          Price$1,548.00
                        
                        
                        280
                        
                        
                        
                        2.9
                        
                        
                        $
                        1,548
                        
                        
                        
                        280
                        
                        
                        $
                        1,548$1,350.00
                        
                        
                        353
                        
                        
                        
                        3.2
                        
                        
                        
                        1,350
                        
                        
                        
                        118
                        
                        
                        
                        1,350$912.00
                        
                        
                        2,438
                        
                        
                        
                        3.0
                        
                        
                        
                        912
                        
                        
                        
                        2,438
                        
                        
                        
                        912$180.00
                        
                        
                        1,250
                        
                        
                        
                        3.5
                        
                        
                        
                        180
                        
                        
                        
                        417
                        
                        
                        
                        180$2.46
                        
                        
                        585,645
                        
                        
                        
                        9.7
                        
                        
                        
                        2.46
                        
                        
                        
                        —
                        
                        
                        
                        —$1.50
                        
                        
                        675,272
                        
                        
                        
                        9.7
                        
                        
                        
                        1.50
                        
                        
                        
                        —
                        
                        
                        
                        —$1.50
      to $1,548
                        
                        
                        1,265,238
                        
                        
                        
                        9.7
                        
                        
                        $
                        4.59
                        
                        
                        
                        3,253
                        
                        
                        $
                        888


F-22


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




Number
                                      Outstanding
                                    
                                    
                                    Weighted-
                                      Average Fair
                                      Value at
                                      Grant Date
                                    
                                    
                                    Weighted-
                                      Average
                                      Remaining
                                      Contractual
                                      Life (Years)Non-Vested
      shares at December 31, 2009
                                    
                                    
                                    1,485
                                    
                                    
                                    $
                                    1,350.00
                                    
                                    
                                    
                                    4.1Options
      Granted
                                    
                                    
                                    1,260,917
                                    
                                    
                                    
                                    1.95
                                    
                                    
                                    
                                    9.7Options
      Vested
                                    
                                    
                                    (417
                                    )
                                    
                                    
                                    180.00
                                    
                                    
                                    
                                    3.2Options
      forfeited or expired
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Non-Vested
      shares at June 30, 2010
                                    
                                    
                                    1,261,985
                                    
                                    
                                    $
                                    3.48
                                    
                                    
                                    
                                    9.7




As of
June 30, 2010, there was $434,000 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 3.7 years.




The
intrinsic value of options outstanding at June 30, 2010 is approximately $7.6
million.




Warrants




As part
of the equity raise on November 20, 2009 and on December 16, 2009, the Company
issued warrants to purchase an aggregate of 1,017,194 shares of the Company’s
common stock.  The warrants have a five year term and an exercise price of
$0.01 per share.  The warrants contain customary limitations on the amount
that can be exercised.  Additionally, the warrants provide that they could
not be exercised until the effectiveness of the filing of an amendment to the
Company’s Certificate of Incorporation authorizing a sufficient number of shares
of common stock to permit the exercise of the warrants, which was completed on
March 10, 2010.  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
June 30, 2010, there were 1,039,703 warrants outstanding with terms expiring in
2012 through 2014, all of which are currently exercisable.




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


F-23




June
      30, 2010Number
      of
                            Warrants
                          
                          
                          Weighted
                            Average
                            Exercise
                            PriceOutstanding
      at December 31, 2009
                          
                          
                          1,039,703
                          
                          
                          $
                          6.82Granted
                          
                          
                          —
                          
                          
                          
                          —Exercised
                          
                          
                          —
                          
                          
                          
                          —Outstanding
      at June 30, 2010
                          
                          
                          1,039,703
                          
                          
                          $
                          6.82Warrants
      exercisable at June 30, 2010
                          
                          
                          1,039,703
                          
                          
                          $
                          6.82




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




Warrants Outstanding and ExercisableRange of
                        Exercise Prices
                      
                      Number
                        Outstanding
                      
                      
                      Weighted-
                        Average
                        Remaining
                        Contractual
                        Life (Years)
                      
                      
                      Weighted-
                        Average
                        Exercise
                        Price$1,704.00
                      
                      
                      2,383
                      
                      
                      
                      2.8
                      
                      
                      $
                      1,704.00$1,278.00
                      
                      
                      531
                      
                      
                      
                      2.8
                      
                      
                      
                      1,278.00$180.00
                      
                      
                      12,777
                      
                      
                      
                      4.3
                      
                      
                      
                      180.00$6.00
                      
                      
                      6,818
                      
                      
                      
                      3.2
                      
                      
                      
                      6.00$0.01
                      
                      
                      1,017,194
                      
                      
                      
                      4.3
                      
                      
                      
                      0.01$0.01
      to $1,704.00
                      
                      
                      1,039,703
                      
                      
                      
                      4.4
                      
                      
                      $
                      6.82




NOTE
10.  INTEREST, NET




(Amounts
      in Thousands)Three
      Months
                  Ended
      June 30,
                
                
                Six
      Months
                  Ended
      June 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Interest
      arising from amortization of debt discount
                
                $
                -
                
                
                $
                832
                
                
                $
                —
                
                
                $
                1,690Interest
      on various notes
                
                
                25
                
                
                
                168
                
                
                
                55
                
                
                
                343Interest
      arising from amortization of Solutions 2 Go warrants
                
                
                100
                
                
                
                -
                
                
                
                200
                
                
                
                —Interest
      on financing arrangements
                
                
                243
                
                
                
                -
                
                
                
                366
                
                
                
                —Interest
      expense, net
                
                $
                368
                
                
                $
                1,000
                
                
                $
                621
                
                
                $
                2,033


F-24


NOTE
11.  SUPPLEMENTAL CASH FLOW INFORMATION




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




(Amounts
      in Thousands)
                      Six
      Months
                      Ended
      June 30,2010
                    
                    
                    2009Changes
      in other assets and liabilities:Accounts
      receivable and due from factor
                    
                    $
                    (151
                    )
                    
                    $
                    1,302Inventory
                    
                    
                    (767
                    )
                    
                    
                    1,431Prepaid
      expenses and other current assets
                    
                    
                    573
                    
                    
                    
                    520Product
      development costs
                    
                    
                    (2,697
                    )
                    
                    
                    66Accounts
      payable
                    
                    
                    1,567
                    
                    
                    
                    716Customer
      advances
                    
                    
                    (1,686
                    )
                    
                    
                    —Accrued
      expenses and other current liabilities
                    
                    
                    (238
                    )
                    
                    
                    (547
                    )Net
      changes in other assets and liabilities
                    
                    $
                    (3,399
                    )
                    
                    $
                    3,488Cash
      paid during the period for interest
                    
                    $
                    366
                    
                    
                    $
                    —Cash
      paid during the period for taxes
                    
                    $
                    38
                    
                    
                    $
                    —Non-cash
      investing and financing activities:Transfer
      of option liability to equity
                    
                    $
                    403
                    
                    
                    $
                    —Par
      Value of Series A Preferred Stock converted to Common
Stock
                    
                    $
                    1
                    
                    
                    $
                    —Par
      Value of Series B Preferred Stock converted to Common
Stock
                    
                    $
                    1
                    
                    
                    $
                    —Prepaid
      offering costs included in accrued expenses
                    
                    $
                    750
                    
                    
                    $
                    —Receipt
      of 9,274 shares for partial settlement of litigation
                    
                    $
                    —
                    
                    
                    $
                    1,113Notes
      and obligations relieved for partial settlement of
    litigation
                    
                    $
                    —
                    
                    
                    $
                    3,925Acquisition
      of Intangible for long-term obligation
                    
                    $
                    —
                    
                    
                    $
                    2,600




NOTE
12.  LITIGATION




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




NOTE
13.  RELATED PARTY TRANSACTIONS




On April
6, 2009, the Company entered into an amended and restated purchase order
financing arrangement with Wells Fargo.  In connection with the amended
agreement, Mark Seremet, President and Chief Executive Officer of Zoo Games and
a director of Zoo Entertainment, and David Rosenbaum, the President of Zoo
Publishing, entered into a Guaranty with Wells Fargo, pursuant to which Messrs.
Seremet and Rosenbaum agreed to guaranty the full and prompt payment and
performance of the obligations under the Assignment Agreement and the Security
Agreement.  On May 12, 2009, the Company entered into a letter agreement
with each of Mark Seremet and David Rosenbaum (the “Fee Letters”), pursuant to
which, in consideration for Messrs. Seremet and Rosenbaum entering into the
guaranty with Wells Fargo for the full and prompt payment and performance by the
Company and its subsidiaries of the obligations in connection with a purchase
order financing (the “Loan”), the Company agreed to compensate Mr. Seremet in
the amount of $10,000 per month, and Mr. Rosenbaum in the amount of $7,000 per
month, for so long as the executive remains employed while the guaranty and Loan
remain in full force and effect.  If the guaranty is not released by the
end of the month following termination of employment of either Messrs. Seremet
or Rosenbaum, the monthly fee shall be doubled for each month thereafter until
the guaranty is removed.


F-25


Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the 2007 Plan, to
each of Messrs. Seremet and Rosenbaum, on such date that is the earlier of the
conversion of at least 25% of all currently existing convertible debt of the
Company into equity or November 8, 2009 (the earlier of such date, the “Grant
Date”), an option to purchase that number of shares of the Company’s common
stock equal to 6% and 3%, respectively, of the then issued and outstanding
shares of common stock, based on a fully diluted current basis assuming those
options and warrants that have an exercise price below $240 per share are
exercised on that date but not counting the potential conversion to equity of
any outstanding convertible notes that have not yet been converted and,
inclusive of any options or other equity securities or securities convertible
into equity securities of the Company that each may own on the Grant Date. 
The options were granted at an exercise price equal to the fair market value of
the Company’s common stock on the Grant Date and pursuant to the Company’s
standard form of nonqualified stock option agreement; provided however, that in
the event the guaranty has not been released by Wells Fargo Bank as of the date
of the termination of the option due to termination of service, the option
termination date shall be extended until the earlier of the date of the release
of the guaranty or the expiration of the ten year term of the option.  In
addition any options owned by Messrs. Seremet and Rosenbaum as of the Grant Date
with an exercise price that is higher than the exercise price of the new options
shall be cancelled as of the Grant Date.  As part of the November 2009
financing, Messrs. Seremet and Rosenbaum agreed to amend their respective Fee
Letters, pursuant to which:  in the case of Mr. Seremet, the Company
will pay to Mr. Seremet a fee of $10,000 per month for so long as the guaranty
remains in full force and effect, but only until November 20, 2010; and, in the
case of Mr. Rosenbaum, the Company will pay to Mr. Rosenbaum a fee of $7,000 per
month for so long as the guaranty remains in full force and effect, but only
until November 20, 2010.  In addition, the amended Fee Letters provide
that, in consideration of each of their continued personal guarantees, the
Company’s Board of Directors approved an increase in the issuance of an option
to purchase restricted stock or other incentives intended to comply with Section
409A of the Internal Revenue Code, equal to a 6.25% ownership interest, to each
of Messrs. Seremet and Rosenbaum, respectively.  On February 11, 2010, the
Company issued options to purchase 337,636 shares of common stock to each of
Messrs. Seremet and Rosenbaum in consideration for their continued personal
guarantees.  (See Note 9 for the valuation of the options.)




NOTE
14.  SUBSEQUENT EVENTS




On July
7, 2010, the Company entered into an underwriting agreement with Roth Capital
Partners, LLC, as representative of the several underwriters named in the
underwriting agreement, relating to the sale by the Company of 1,600,000 shares
of the Company’s common stock in a public offering, at a public offering price
of $6.00 per share.  The Company also granted the underwriters a 30-day
option to purchase up to an additional 240,000 shares of common stock from the
Company to cover over-allotments, if any.  The public offering closed on
July 12, 2010.  The net proceeds to the Company from the sale of the
shares, after deducting the underwriting discounts and commissions and offering
expenses of approximately $1.7 million, are approximately $7.9 million.  Of
these offering expenses, $50,000 was paid prior to June 30, 2010 and is included
in prepaid offering costs in the non-current assets section of the June 30, 2010
condensed consolidated balance sheet.




On July
7, 2010, the Company’s shares of common stock became listed and began trading on
the NASDAQ Capital Market under the symbol “ZOO.”  On July 12, 2010,
the Company’s changed its trading symbol to “ZOOG”.


F-26




ITEM
2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF




FINANCIAL
CONDITION AND RESULTS OF OPERATIONS




You
should read the following management discussion and analysis (“MD&A”)
together with our Condensed Consolidated Financial Statements and Notes thereto
included in this report.  This discussion contains forward-looking
statements that involve risks, uncertainties and assumptions.  Actual
results may differ materially from those anticipated in these forward-looking
statements as a result of various factors, including, but not limited to, those
presented under “Risk Factors” and elsewhere herein.




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,” “may,”
“should,” “could” and similar expressions as they relate to our management or us
are intended to identify such forward-looking statements.  Our actual
results, performance or achievements could differ materially from those
expressed in, or implied by, these forward-looking
statements.  Historical operating results are not necessarily
indicative of the trends in operating results for any future
period.




Overview




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




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




Zoo
Entertainment; Merger with Zoo Games




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


1


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




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




Zoo
Games




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




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




In May
2009, we formed a new company in the United Kingdom that is a wholly-owned
subsidiary of Zoo Games called Zoo Entertainment Europe Ltd. to focus on the
sales and distribution of our products in Europe.  In our effort to
refocus our cash on our core business operations, we discontinued the operations
of Zoo Europe effective December 2009.


2


Results
of Operations




For
the Three Months Ended June 30, 2010 as compared to the Three Months Ended June
30, 2009




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




(Amounts in Thousands Except Per Share Data)
                          For The Three Months Ended June 30,2010
                        
                        
                        2009Revenue
                        
                        $
                        10,470
                        
                        
                        
                        100
                        %
                        
                        $
                        7,669
                        
                        
                        
                        100
                        %Cost
      of goods sold
                        
                        
                        7,957
                        
                        
                        
                        76
                        
                        
                        
                        7,742
                        
                        
                        
                        101Gross
      profit (loss)
                        
                        
                        2,513
                        
                        
                        
                        24
                        
                        
                        
                        (73
                        )
                        
                        
                        (1
                        )Operating
      expenses:General
      and administrative
                        
                        
                        1,190
                        
                        
                        
                        11
                        
                        
                        
                        1,866
                        
                        
                        
                        24Selling
      and marketing
                        
                        
                        1,217
                        
                        
                        
                        12
                        
                        
                        
                        662
                        
                        
                        
                        9Research
      and development
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        290
                        
                        
                        
                        4Depreciation
      and amortization
                        
                        
                        491
                        
                        
                        
                        5
                        
                        
                        
                        435
                        
                        
                        
                        6Total
      operating expenses
                        
                        
                        2,898
                        
                        
                        
                        28
                        
                        
                        
                        3,253
                        
                        
                        
                        42Loss
      from operations
                        
                        
                        (385
                        )
                        
                        
                        (4
                        )
                        
                        
                        (3,326
                        )
                        
                        
                        (43
                        )Interest
      expense, net
                        
                        
                        368
                        
                        
                        
                        4
                        
                        
                        
                        1,000
                        
                        
                        
                        13Gain
      on legal settlement
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        4,328
                        
                        
                        
                        56Income
      (loss) from operations before income tax benefit
                        
                        
                        (753
                        )
                        
                        
                        (7
                        )
                        
                        
                        2
                        
                        
                        
                        -Income
      tax benefit
                        
                        
                        277
                        
                        
                        
                        3
                        
                        
                        
                        -
                        
                        
                        
                        -Net
      income (loss)
                        
                        $
                        (476
                        )
                        
                        
                        (5
                        )%
                        
                        $
                        2
                        
                        
                        
                        -
                        %Earnings
      (loss) per common share - basic and diluted
                        
                        $
                        (0.11
                        )
                        
                        
                        
                        
                        
                        $
                        0.03




Net Revenues.  Net
revenues for the three months ended June 30, 2010 were approximately $10.5
million, an increase of 37% over the revenues for the three months ended June
30, 2009 of approximately $7.7 million.  Sales in both periods consist
primarily of casual game sales in North America.  The breakdown of
gross sales by platform is as follows:




Three Months Ended June 30,2010
                    
                    
                    2009Nintendo
      Wii
                    
                    
                    83
                    %
                    
                    
                    61
                    %Nintendo
      DS
                    
                    
                    17
                    %
                    
                    
                    34
                    %Nintendo
      GBA
                    
                    
                    0
                    %
                    
                    
                    1
                    %Microsoft
      Xbox
                    
                    
                    0
                    %
                    
                    
                    4
                    %


3




The
biggest sellers during the 2010 period were (i) Chicken Blaster with our gun
blaster for the Nintendo Wii platform, (ii) Bigfoot Collision Course on the
Nintendo Wii platform, and (iii) Deal or No Deal on the Nintendo Wii
platform.  The various Wii games bundled with our gun blaster and
wheel peripherals accounted for approximately 35% of our revenue during the 2010
period and for most of the revenue increase from the 2009 period to the 2010
period.  The biggest sellers during the 2009 period were (i) M&M
Beach Party on the Nintendo Wii platform, (ii) M&M Kart Racing on the
Nintendo Wii platform, and (iii) M&M Kart Racing on the Nintendo DS
platform.  The 2010 period consisted of 962,000 units sold in North
America at an average gross price of $11.10, while the 2009 period consisted of
approximately 1.1 million units sold in North America at an average gross price
of $8.96.  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.  The 2009 period included sales of 534,000 units of
various products for a license that was discontinued in that period at lower
than normal prices.  Net sales allowances provided to customers for
returns, markdowns, price protection and other deductions was 4% of gross sales
for the three months ended June 30, 2010 as compared to 15% of gross sales for
the three months ended June 30, 2009 due to a large customer return 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 June 30, 2010
was approximately $2.5 million, or 24% of net revenue, while the gross profit
for the three months ended June 30, 2009 was $(73,000), or (1)% 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
$842,000.  For those sales that were not distributed through Atari,
the Company pays the shipping costs.  The net improvement to the gross
margin in the 2010 period from the 2009 period was partially due to the
reduction in the sales distributed through Atari.  Also, as part of
our business plan to focus on higher margin games and more cost effective
product licenses, we opted to discontinue certain lower-margin products in the
2009 period through the accelerated sale of such products at lower than normal
prices.  This resulted in a significant amount of sales at very low
margins which along with royalty fees and amortization of product development
costs resulted in a negative overall gross margin for the 2009
period.




General and Administrative
Expenses.  General and administrative expenses for the three
months ended June 30, 2010 were approximately $1.2 million as compared to
approximately $1.9 million for the comparable period in
2009.  Non-cash stock-based compensation included in general and
administrative expenses was $117,000 and $222,000 for the three months ended
June 30, 2010 and June 30, 2009, respectively.  The reduction of
headcount in New York and relocation of all general and administrative functions
to Ohio resulted in decreased payroll, consulting and related costs of
approximately $300,000 from the 2009 period to the 2010 period.  Costs
incurred for the European office during the 2009 period were $120,000; these did
not reoccur in 2010.  In addition, the 2009 period includes $150,000
of bad debt expense that did not reoccur in 2010.




Selling and Marketing
Expenses.  Selling and marketing expenses increased from
$662,000 to approximately $1.2 for the three months ended June 30, 2010 due
primarily to additional salaries and related costs for the increased headcount
for the sales and marketing team in Ohio.  The increase was also due
to approximately $200,000 of costs incurred for the launch and continued
marketing of the indiePub Games website during the second quarter of
2009.  Part of our digital initiative, indiePub Games is our website
for independent software developers to compete for prizes and publishing
contracts, and also serves as a destination site for gaming enthusiasts to play
free games, vote in contests and participate in the development of innovative
entertainment software.




Research and Development
Expenses.  Research and development expenses for the three
months ended June 30, 2010 were $0 as compared to $290,000 for the three months
ended June 30, 2009.  This expense was a direct result of our decision
to discontinue the development of certain games in the 2009
period.


4


Depreciation and Amortization
Expenses.  Depreciation and amortization costs for the three
months ended June 30, 2010 were $491,000 as compared to $435,000 in the
comparable period in 2009.  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.




Interest
Expense.  Interest expense for the three months ended June 30,
2010 was $368,000 as compared to $1.0 million for the three months ended June
30, 2009.  The 2010 period includes $25,000 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 $243,000.  The 2009 period includes $698,000 of non-cash interest
expense relating to the amortization on the Zoo Entertainment Notes, $139,000 of
interest relating to the Zoo Entertainment Notes and approximately $163,000 of
interest on the various promissory notes due to the sellers of Zoo Publishing of
which $133,000 is non-cash interest imputed at the then market
rate.  The Zoo Entertainment Notes were converted to equity in
November 2009 and the Zoo Publishing notes were cancelled in June 2009;
therefore, there is no interest costs related to these notes in
2010.




Gain on Legal
Settlement.  During the three month period ended June 30, 2009,
we settled a lawsuit brought by the former sellers of Zoo Publishing, resulting
in a net gain on settlement of approximately $4.3 million.  The
settlement eliminated the Company’s obligations for certain outstanding notes,
employee loans and other obligations for an aggregate amount of approximately
$3.9 million.  The settlement returned approximately 5.6 million
shares of common stock to treasury valued at approximately $1.1
million.  The Company’s remaining cash obligations and litigation
expense amounted to approximately $710,000, resulting in a net gain on
settlement of approximately $4.3 million.




Income Tax
Benefit.  We recorded an income tax benefit of $277,000 for the
three months ended June 30, 2010 against pretax loss of $753,000.  We
did not record any income tax benefit or expense for the three months ended June
30, 2009.




Earnings (loss) Per Common
Share.  The basic and diluted earnings (loss) per share for the
three months ended June 30, 2010 was $(0.11) based on a weighted average shares
outstanding for the period of approximately 4.4 million, while the basic and
diluted earnings per common share for the three months ended June 30, 2009 was
$0.03, based on a weighted average shares outstanding for the period of
58,686.


5


For
the Six Months Ended June 30, 2010 as Compared to the Six Months Ended June 30,
2009




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




(Amounts in Thousands Except Per Share Data)
                          For The Six Months Ended June 30,2010
                        
                        
                        2009Revenue
                        
                        $
                        27,602
                        
                        
                        
                        100
                        %
                        
                        $
                        21,553
                        
                        
                        
                        100
                        %Cost
      of goods sold
                        
                        
                        21,472
                        
                        
                        
                        78
                        
                        
                        
                        19,225
                        
                        
                        
                        89Gross
      profit
                        
                        
                        6,130
                        
                        
                        
                        22
                        
                        
                        
                        2,328
                        
                        
                        
                        11Operating
      expenses:General
      and administrative
                        
                        
                        2,795
                        
                        
                        
                        10
                        
                        
                        
                        3,260
                        
                        
                        
                        15Selling
      and marketing
                        
                        
                        2,053
                        
                        
                        
                        7
                        
                        
                        
                        1,525
                        
                        
                        
                        7Research
      and development
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        370
                        
                        
                        
                        2Depreciation
      and amortization
                        
                        
                        991
                        
                        
                        
                        4
                        
                        
                        
                        869
                        
                        
                        
                        4Total
      operating expenses
                        
                        
                        5,839
                        
                        
                        
                        21
                        
                        
                        
                        6,024
                        
                        
                        
                        28Income
      (loss) from operations
                        
                        
                        291
                        
                        
                        
                        1
                        
                        
                        
                        (3,696
                        )
                        
                        
                        (17
                        )Interest
      expense, net
                        
                        
                        621
                        
                        
                        
                        2
                        
                        
                        
                        2,033
                        
                        
                        
                        9Gain
      on legal settlement
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (4,328
                        )
                        
                        
                        20Loss
      from operations before income tax benefit
                        
                        
                        (330
                        )
                        
                        
                        (1
                        )
                        
                        
                        (1,401
                        )
                        
                        
                        (7
                        )Income
      tax benefit
                        
                        
                        144
                        
                        
                        
                        1
                        
                        
                        
                        -
                        
                        
                        
                        -Net
      loss
                        
                        $
                        (186
                        )
                        
                        
                        (1
                        )%
                        
                        $
                        (1,401
                        )
                        
                        
                        (7
                        )%Loss
      per common share - basic and diluted
                        
                        $
                        (0.07
                        )
                        
                        
                        
                        
                        
                        $
                        (23.61
                        )




Net Revenues.  Net
revenues for the six months ended June 30, 2010 were approximately $27.6
million, an increase of 28% over the revenues for the six months ended June 30,
2009 of approximately $21.6 million.  Sales in both periods consist
primarily of casual game sales in North America.




The
breakdown of gross sales by platform is as follows:


6




Six Months Ended June 30,2010
                  
                  
                  2009Nintendo
      Wii
                  
                  
                  73
                  %
                  
                  
                  62
                  %Nintendo
      DS
                  
                  
                  27
                  %
                  
                  
                  33
                  %Nintendo
      GBA
                  
                  
                  0
                  %
                  
                  
                  2
                  %Microsoft
      Xbox
                  
                  
                  0
                  %
                  
                  
                  3
                  %




The
biggest sellers during the 2010 period were (i) Deal or No Deal, (ii)
Chicken Blaster with our gun blaster, and (iii) Deer Drive with our gun blaster,
all on the Nintendo Wii platform.  The various Wii games bundled with our
gun blaster and wheel peripherals accounted for approximately 27% of our revenue
during the 2010 period and for most of the revenue increase from the 2009 period
to the 2010 period.  The biggest sellers during the 2009 period were
(i) M&M Kart Racing, (ii) M&M Beach Party, and (iii) Deal or No Deal,
all on the Nintendo Wii platform.  The 2010 period consisted of
approximately 2.5 million units sold in North America at an average gross price
of $11.17, while the 2009 period consisted of approximately 2.6 million units
sold in North America at an average gross price of $9.58.  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.  The 2009
period included sales of 534,000 units of various products for a license that
was discontinued in that period at lower than normal prices.  Net
sales allowances provided to customers for returns, markdowns, price protection
and other deductions was 4% of gross sales for the six months ended June 30,
2010 as compared to 9% of gross sales for the six months ended June 30, 2009 due
to a large customer return 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 six months ended June 30, 2010
was approximately $6.1 million, or 22% of net revenue, while the gross profit
for the six months ended June 30, 2009 was $2.3, or 11% 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 six months ended June 30, 2009
period were approximately $2.4 million.  For those sales that were not
distributed through Atari, the Company pays the shipping costs.  The
net improvement to the gross margin in the 2010 period from the 2009 period was
partially due to the reduction in the sales distributed through
Atari.  As part of our business plan to focus on higher margin games
and more cost effective product licenses, we opted to discontinue certain
lower-margin products in the 2009 period through the accelerated sale of such
products at lower than normal prices.  This resulted in a significant
amount of sales at very low margins which along with royalty fees and
amortization of product development costs resulted in a lower overall gross
margin for the 2009 period.




General and Administrative
Expenses.  General and administrative expenses for the six
months ended June 30, 2010 were approximately $2.8 million as compared to $3.3
million for the comparable period in 2009.  Non-cash stock-based
compensation included in general and administrative expenses was $362,000 and
$244,000 for the three months ended June 30, 2010 and June 30, 2009,
respectively.  The reduction of headcount in New York and relocation
of all general and administrative functions to Ohio resulted in decreased
payroll, consulting and related costs of approximately $135,000 from the 2009
period to the 2010 period.  Costs incurred for the European office
during the 2009 period were $120,000; these did not reoccur in
2010.  In addition, the 2009 period includes $150,000 of bad debt
expense and $185,000 of additional professional fees in the earlier part of the
year that did not reoccur in 2010.


7


Selling and Marketing
Expenses.  Selling and marketing expenses increased from $1.5
million for the six months ended June 30, 2009 to $2.1 for the six months ended
June 30, 2010 due primarily to additional salaries and related costs for the
increased headcount for the sales and marketing team in Ohio.  The
increase was also due to approximately $300,000 of costs incurred for the launch
and continued marketing of the indiePub Games website during
2010.  Part of our digital initiative, indiePub Games is our website
for independent software developers to compete for prizes and publishing
contracts, and also serves as a destination site for gaming enthusiasts to play
free games, vote in contests and participate in the development of innovative
entertainment software.




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




Depreciation and Amortization
Expenses.  Depreciation and amortization costs for the six
months ended June 30, 2010 were $991,000 as compared to $869,000 for the six
months ended June 30, 2009.  Both periods include $823,000 resulting
from the amortization of intangibles acquired from the Zoo Publishing
acquisition.  The 2010 period also includes $130,000 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.




Interest
Expense.  Interest expense for the six months ended June 30,
2010 was $621,000 as compared to approximately $2.0 million for the six months
ended June 30, 2009.  The 2010 period includes $55,000 of interest on
the Solutions 2 Go loan and $200,000 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 $360,000.  The six months ended June
30, 2009 includes approximately $1.4 million of non-cash interest expense
relating to the amortization on the Zoo Entertainment Notes, $279,000 of
interest relating to the Zoo Entertainment Notes and $358,000 of interest on the
various promissory notes due to the sellers of Zoo Publishing of which $293,000
is non-cash interest imputed at the then market rate.  The Zoo
Entertainment Notes were converted to equity in November 2009 and the Zoo
Publishing notes were cancelled in June 2009; therefore, there is no interest
costs related to these notes in 2010.




Gain on Legal
Settlement.  During the six month period ended June 30, 2009,
we settled a lawsuit brought by the former sellers of Zoo Publishing, resulting
in a net gain on settlement of approximately $4.3 million.  The
settlement eliminated the Company’s obligations for certain outstanding notes,
employee loans and other obligations for an aggregate amount of approximately
$3.9 million.  The settlement returned 9,274 shares to treasury valued
at approximately $1.1 million.  The Company’s remaining cash
obligations and litigation expense amounted to approximately $710,000, resulting
in a net gain on settlement of approximately $4.3 million.




Income Tax
Benefit.  We recorded an income tax benefit of $144,000 for the
six months ended June 30, 2010 against pretax loss of $330,000.  We
did not record any income tax expense or benefit for the six months ended June
30, 2009.




Loss Per Common
Share.  The basic and diluted loss per share for the six months
ended June 30, 2010 was $(0.07) based on a weighted average shares outstanding
for the period of approximately 2.8 million, while the basic and diluted loss
per common share for the six months ended June 30, 2009 was $(23.61), based on a
weighted average shares outstanding for the period of 59,345.




Liquidity
and Capital Resources




We
incurred a net loss of $186,000 for the six months ended June 30, 2010 and a net
loss of approximately $1.4 million for the six months ended June 30,
2009.  Our principal sources of cash during the six months ended June
30, 2010 were proceeds from the use of our purchase order and receivable
financing arrangements, and cash generated from operations throughout the
year.


8


Net cash
used in operating activities for the six months ended June 30, 2010 was
approximately $2.6 million, consisting primarily of the use of customer advances
for product sales in the current period, product development costs, building
inventory for future sales and an increase in receivables and due from factor as
we become less dependent upon payment from Atari.  This was offset by
an increase in account payable and accrued expenses due the timing of certain
payments.  Net cash provided by operating activities for the six
months ended June 30, 2009 was $562,000, primarily consisting of a reduction in
inventory and accounts receivable.




Net cash
used in investing activities for the six months ended June 30, 2010 was
$138,000, all for the purchase of fixed assets.  Net cash used in
investing activities for the six months ended June 30, 2009 was $220,000, of
which $162,000 was for an investment in intellectual property and $58,000 for
the purchase of fixed assets.




Net cash
provided by financing activities for the six month period ending June 30, 2010
was $910,000, which includes approximately $1.4 million of net borrowings from
the financing facilities offset by $50,000 of payments related to prepaid
offering costs and $435,000 of repayments of Solutions 2 Go customer
advances.  Net cash used in financing activities for the six month
period ending June 30, 2009 was $707,000 for net repayments in connection with
financing facilities.




Factoring
Facility




Zoo
Publishing has a factoring facility with our factor, Working Capital Solutions,
Inc.  (“WCS”), which utilizes existing accounts receivable in order to
provide working capital to fund our continuing business
operations.  Under the terms of our factoring and security agreement
(the “Factoring Agreement”), our receivables are sold to 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.  For the six months ended June 30, 2010 and 2009,
respectively, we sold approximately $9.8 million $0 of receivables to the factor
with recourse and paid fees of $245,000 during the 2010 period.  At
June 30, 2010 and December 31, 2009, accounts receivable and due from factor
included approximately $3.9 million and approximately $1.4 million,
respectively, of amounts due from our customers to the factor.  The
factor had an advance outstanding to the Company of approximately $2.6 million
and $900,000 as of June 30, 2010 and December 31, 2009,
respectively.




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




Purchase
Order Facility




In
addition to the receivable financing agreement with WCS, Zoo Publishing also
utilizes purchase order financing with Wells Fargo Bank, National Association
(“Wells Fargo”) to fund the manufacturing of video game
products.  Under the terms of that certain assignment agreement (the
“Assignment Agreement”), we assign purchase orders received from customers to
Wells Fargo, and request that Wells Fargo purchase the required materials to
fulfill such purchase orders.  Wells Fargo, which may accept or
decline the assignment of specific purchase orders, retains us to manufacture,
process and ship ordered goods, and pays us for our services upon Wells Fargo’s
receipt of payment from the customers for such ordered goods.  Upon
payment in full of the purchase order invoice by the applicable customer to
Wells Fargo, Wells Fargo re-assigns the applicable purchase order to
us.  We pay to Wells Fargo a commitment fee in the aggregate amount of
$337,500, on the earlier of the 12 month anniversary of the date of the
Assignment Agreement, or the date of termination of the Assignment
Agreement.  Wells Fargo is not obligated to provide purchase order
financing under the Assignment Agreement if the aggregate outstanding funding
exceeds $5,000,000.  The Assignment Agreement is for an initial term
of 12 months, and continues thereafter for successive 12 month renewal terms
unless either party terminates the Assignment Agreement by written notice to the
other no later than 30 days prior to the end of the initial term or any renewal
term.  If the term of the Assignment Agreement is renewed for one or
more 12 month terms, for each such 12 month term, we agreed to pay to Wells
Fargo a commitment fee in the sum of $337,500, which is payable upon the earlier
of the anniversary of such renewal date or the date of termination of the
Assignment Agreement.  The initial and renewal commitment fees are
subject to waiver if certain product volume requirements are
met.


9


The
amount outstanding to Wells Fargo as of June 30, 2010 and December 31, 2009 was
approximately $449,000 and $759,000, respectively.  The interest rate
is prime plus 2.0%, effective April 6, 2010; prior to that date the interest
rate on advances was prime plus 4%.  As of June 30, 2010 and December
31, 2009, the effective interest rate was 5.25% and 7.25%,
respectively.  The charges and interest expense on the advances are
included in the cost of goods sold in the accompanying condensed consolidated
statement of operations and were $352,000 and $94,000 for the six months ended
June 30, 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
12 months and to $400,000 for the following 12 months if the agreement is
renewed for an additional year; (ii) reduce the interest rate to prime plus 2%
on outstanding advances; and (iii) extend its term until April 5, 2011, subject
to automatic renewal for successive 12 month terms unless either party
terminates the agreement with written notice 30 days prior to the end of the
initial term or any renewal term.  In consideration for the extension,
the Company paid to Wells Fargo an aggregate fee of approximately
$32,000.




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




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




Stock
Split




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 authorize the reverse stock split, and our Board
of Directors authorized the implementation of the reverse stock split on April
23, 2010.  Effective on May 10, 2010, we filed with the Secretary of
State of the State of Delaware a Certificate of Amendment to our Certificate of
Incorporation, effecting a reverse stock split of our common stock at a ratio of
one-for-600.  As a result of the Reverse Stock Split, every 600 shares
of our issued and outstanding common stock were combined into one share of our
common stock.


10


July
2010 Equity Raise




On July
12, 2010, the Company closed on an underwritten public offering of 1,600,000
shares of the Company’s common stock at a public offering price of $6.00 per
share.  The net proceeds to the Company from the sale of the shares,
after deducting the underwriting discounts and commissions and offering expenses
of approximately $1.7 million, were approximately $7.9 million.  The
proceeds from this offering are being used to fund the development of
www.indiepubgames.com and other digital initiatives, the repayment of the
Solutions 2 Go advance and working capital and other general corporate
purposes.




Other




As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with
Atari.  This agreement became effective on October 24, 2008 and
provided for Zoo Publishing to sell its products to Atari without recourse and
Atari would resell the products to wholesalers and retailers that are acceptable
to Atari in North America.  This agreement provides for Atari to
prepay the Company for the cost of goods and pay the balance due within 15 days
of shipping the product.  Atari’s fees approximate 10% of our standard
selling price.  Atari takes a reserve from the initial payment for
potential customer sales allowances, returns and price protection that was
analyzed and reviewed within a sixty day period to be liquidated no later than
July 31, 2009.  The agreement initially expired on March 31, 2009, but
was amended to extend the term for certain customers until June 30,
2010.




Zoo
Entertainment Notes




On July
7, 2008, as amended, we entered into a note purchase agreement under which the
purchasers agreed to provide loans to us in the aggregate principal amount of
$9.0 million, in consideration for the issuance and delivery of senior secured
convertible promissory notes.  As partial inducement to purchase the
notes, we issued to the purchasers warrants to purchase 13,637 shares of our
common stock.  The notes had an interest rate of five percent (5%) for
the one year term of the note commencing from issuance, unless
extended.  All of the warrants have a five year term and an exercise
price of $6.00 per share.  In connection with the note purchase
agreement, we satisfied a management fee obligation by issuing additional senior
secured convertible promissory notes in the principal amount of $750,000 and
warrants to purchase 1,137 shares of our common stock.  All of the
warrants have a five year term and an exercise price of $6.00 per
share.




On
September 26, 2008, we entered into a note purchase agreement, as amended, with
four investors, pursuant to which the purchasers agreed to provide a loan to us
in the aggregate principal amount of $1.4 million, in consideration for the
issuance and delivery of senior secured convertible promissory
notes.  As partial inducement to purchase the notes, we issued to the
purchasers warrants to purchase 2,122 shares of our common stock.  The
notes had an interest rate of five percent (5%) for the time period beginning on
September 26, 2008 and ended on November 20, 2009.  The warrants have
a five year term and an exercise price of $6.00 per share.




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


11


Zoo
Publishing Notes




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




As part
of the acquisition of Zoo Publishing, Zoo Games was required to pay $1,200,000
to an employee of Zoo Publishing.  Of that amount, as of June 30,
2010, Zoo Games paid $580,000 and $620,000 will be paid on July 31, 2011, in
cash or our common stock based on the fair market value of our common stock as
of July 31, 2011, at the election of Zoo Games.




Zoo
Publishing has additional debt outstanding which debt existed prior to Zoo
Games’ acquisition of that subsidiary.  As of June 30, 2010, Zoo
Publishing owed approximately $300,000 as a result of the repurchase of certain
stock from a former stockholder.  The terms of this note are repayment
in monthly increments of $10,000.




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




Critical
Accounting Policies and Estimates




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




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


12


Revenue
Recognition




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




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




Allowances
for Returns and Price Concessions




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




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




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




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




Inventory




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




Product
Development Costs




We
utilize third party product developers to develop the titles we publish and we
frequently enter into agreements with these developers that require us to make
advance payments for game design and enhancements.  In exchange for
our advance payments, we receive the exclusive publishing and distribution
rights to the finished game title as well as, in some cases, the underlying
intellectual property rights for that game.  We typically enter into
these agreements after we have completed the design documentation for our
products.  We contract with third party developers that have proven
technology and the experience and ability to build the designed video
game.  As a result, technological feasibility is determined to have
been achieved at the time in which we enter the agreement and we therefore
capitalize such advance payments as prepaid product development
costs.  On a product by product basis, we reduce prepaid product
development costs and record amortization using the proportion of current year
unit sales and revenues to the total unit sales and revenues expected to be
recorded over the life of the title.


13


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 (“ASU”) 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
holders of intellectual property rights generally provide for guaranteed minimum
royalty payments for use of their intellectual property.  When
significant performance remains to be completed by the licensor, we record
payments when actually paid.  Certain licenses extend over multi-year
periods and encompass multiple game titles.  In addition to guaranteed
minimum payments, these licenses frequently contain provisions that could
require us to pay royalties to the license holder, based on pre-agreed unit
sales thresholds.




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


14


Asset
Impairment




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




Stock-based
Compensation




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




Income
Taxes




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




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




Recently
Issued Accounting Pronouncements




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




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




Accounting
Standards Updates Not Yet Effective




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


15


Off-Balance
Sheet Arrangements




We do not
have any relationships with unconsolidated entities or financial partners, such
as entities often referred to as structured finance or special purpose entities,
which would have been established for the purpose of facilitating off-balance
sheet arrangements or other contractually narrow or limited
purposes.  In addition, we do not have any undisclosed borrowings or
debt, and we have not entered into any synthetic leases.




Fluctuations
in Operating Results and Seasonality




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


16




ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Not
applicable as we are a smaller reporting company.




ITEM
4T.  CONTROLS AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




Our
management is responsible for establishing and maintaining adequate internal
controls over financial reporting, as defined in Exchange Act Rules 13a-15(e)
and 15d-15(e), as of the end of the period covered by this report.




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





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




Based on
the evaluation of the effectiveness of our disclosure controls and procedures as
of the end of the period covered by this report, our Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
(as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were not effective at
a reasonable assurance level.




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




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




We are
committed to appropriately addressing this matter in 2010 and we have engaged
additional qualified personnel to assist in these areas. We will continue to
reassess our accounting and finance staffing levels to ensure that we have the
appropriate accounting resources to handle the existing workload.




Changes
in Controls and Procedures




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




PART
II - OTHER INFORMATION




ITEM  1.  LEGAL
PROCEEDINGS




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


17


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




None.




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


18




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:
August 6, 2010




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


19




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


20