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 EXCHANGEACT
      OF 1934




For the
quarterly period ended September 30, 2010




 ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT
      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 400Cincinnati,
      OH
              
              45209(Address
      of Principal Executive Offices)
              
              (Zip
      Code)




(513)
      824-8297(Registrant’s
      telephone number, including area
code)





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


Yes x    No   ̈




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




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







ZOO
ENTERTAINMENT, INC.




Table
of Contents




PagePART
      I - FINANCIAL INFORMATIONItem
      1.
                                      
                                      Financial
      Statements.Condensed
      Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and
      December 31, 2009
                                      
                                      F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three Months and
      Nine Months  Ended September 30, 2010 and 2009
                                      
                                      F-
      2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Nine Months
      Ended September 30, 2010 and 2009
                                      
                                      F-
      3Condensed
      Consolidated Statement of Stockholders’ Equity (Unaudited) for the Nine
      Months Ended September 30, 2010
                                      
                                      F-
      4Notes
      to Condensed Consolidated Financial Statements
                                      
                                      F-
      5 - F-28Item
      2.
                                      
                                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
                                      
                                      3Item
      3.
                                      
                                      Quantitative
      and Qualitative Disclosure About Market Risk.
                                      
                                      20Item
      4T.
                                      
                                      Controls
      and Procedures.
                                      
                                      20PART
      II - OTHER INFORMATIONItem
      1.
                                      
                                      Legal
      Proceedings.
                                      
                                      21Item
      1A.
                                      
                                      Risk
      Factors.
                                      
                                      21Item
      2.
                                      
                                      Unregistered
      Sales of Equity Securities and Use of Proceeds.
                                      
                                      21Item
      3.
                                      
                                      Defaults
      Upon Senior Securities.
                                      
                                      21Item
      4.
                                      
                                      (Removed
      and Reserved).
                                      
                                      21Item
      5.
                                      
                                      Other
      Information.
                                      
                                      21Item
      6.
                                      
                                      Exhibits.
                                      
                                      21Signatures
                                      
                                      22


2


PART
I – FINANCIAL INFORMATION




ITEM
1.  FINANCIAL STATEMENTS.





Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


(in
thousands except share and per share amounts)




September 30,2010
                                            
                                            
                                            December 31,2009(unaudited)ASSETSCurrent
      AssetsCash
                                            
                                            $
                                            1,222
                                            
                                            
                                            $
                                            2,664Accounts
      receivable and due from factor, net ofallowances for returns and
      discounts of $787 and $835
                                            
                                            
                                            13,940
                                            
                                            
                                            
                                            4,022Inventory
                                            
                                            
                                            8,708
                                            
                                            
                                            
                                            2,103Prepaid
      expenses and other current assets
                                            
                                            
                                            1,606
                                            
                                            
                                            
                                            2,409Product
      development costs, net
                                            
                                            
                                            7,783
                                            
                                            
                                            
                                            4,399Deferred
      tax assets
                                            
                                            
                                            379
                                            
                                            
                                            
                                            578Total
      Current Assets
                                            
                                            
                                            33,638
                                            
                                            
                                            
                                            16,175Fixed
      assets, net
                                            
                                            
                                            248
                                            
                                            
                                            
                                            141Intangible
      assets, net
                                            
                                            
                                            14,304
                                            
                                            
                                            
                                            15,733Total
      Assets
                                            
                                            $
                                            48,190
                                            
                                            
                                            $
                                            32,049LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable
                                            
                                            $
                                            4,493
                                            
                                            
                                            $
                                            3,330Financing
      arrangements
                                            
                                            
                                            10,478
                                            
                                            
                                            
                                            1,659Customer
      advances
                                            
                                            
                                            815
                                            
                                            
                                            
                                            3,086Accrued
      expenses and other current liabilities
                                            
                                            
                                            5,705
                                            
                                            
                                            
                                            2,333Notes
      payable, current portion
                                            
                                            
                                            120
                                            
                                            
                                            
                                            120Total
      Current Liabilities
                                            
                                            
                                            21,611
                                            
                                            
                                            
                                            10,528Notes
      payable, non-current portion
                                            
                                            
                                            150
                                            
                                            
                                            
                                            180Deferred
      tax liabilities
                                            
                                            
                                            2,706
                                            
                                            
                                            
                                            3,461Other
      long-term liabilities
                                            
                                            
                                            -
                                            
                                            
                                            
                                            2,770Total
      Liabilities
                                            
                                            
                                            24,467
                                            
                                            
                                            
                                            16,939Commitments
      and ContingenciesStockholders'
      EquityPreferred
      Stock, par value $0.001, 5,000,000 shares authorizedSeries
      A, 0 issued and outstanding at September 30, 2010,1,389,684
      issued and outstanding at December 31, 2009
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1Series
      B, 0 issued and outstanding at September 30, 20101,188,439
      issued and outstanding at December 31, 2009
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1Common
      Stock, par value $0.001, 3,500,000,000 sharesauthorized,
      6,243,744 issued and 6,230,741 outstanding atSeptember
      30, 2010 and 250,000,000 authorized, 65,711issued
      and 52,708 outstanding at December 31, 2009
                                            
                                            
                                            6
                                            
                                            
                                            
                                            -Additional
      paid-in-capital
                                            
                                            
                                            73,195
                                            
                                            
                                            
                                            64,714Accumulated
      deficit
                                            
                                            
                                            (45,009
                                            )
                                            
                                            
                                            (45,137
                                            )Treasury
      Stock, at cost, 13,003 shares at September 30, 2010and December
      31, 2009
                                            
                                            
                                            (4,469
                                            )
                                            
                                            
                                            (4,469
                                            )Total
      Stockholders' Equity
                                            
                                            
                                            23,723
                                            
                                            
                                            
                                            15,110Total
      Liabilities and Stockholders' Equity
                                            
                                            $
                                            48,190
                                            
                                            
                                            $
                                            32,049





See
accompanying notes to condensed consolidated financial
statements


F-1




Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Operations


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


(in
thousands except share and per share amounts)




Three Months Ended September30,
                                
                                
                                Nine Months Ended 
September30,2010
                                
                                
                                2009
                                
                                
                                2010
                                
                                
                                2009Revenue
                                
                                $
                                17,581
                                
                                
                                $
                                8,583
                                
                                
                                $
                                45,183
                                
                                
                                $
                                30,136Cost
      of goods sold
                                
                                
                                13,894
                                
                                
                                
                                6,662
                                
                                
                                
                                35,366
                                
                                
                                
                                25,887Gross
      profit
                                
                                
                                3,687
                                
                                
                                
                                1,921
                                
                                
                                
                                9,817
                                
                                
                                
                                4,249Operating
      expenses:General
      and administrative (includes stock-based compensation of $127, $322, $489
      and $566)
                                
                                
                                1,052
                                
                                
                                
                                1,750
                                
                                
                                
                                3,847
                                
                                
                                
                                5,010Selling
      and marketing
                                
                                
                                1,307
                                
                                
                                
                                548
                                
                                
                                
                                3,360
                                
                                
                                
                                2,073Research
      and development
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                370Impairment
      of goodwill
                                
                                
                                -
                                
                                
                                
                                14,704
                                
                                
                                
                                -
                                
                                
                                
                                14,704Depreciation
      and amortization
                                
                                
                                506
                                
                                
                                
                                504
                                
                                
                                
                                1,497
                                
                                
                                
                                1,373Total
      operating expenses
                                
                                
                                2,865
                                
                                
                                
                                17,506
                                
                                
                                
                                8,704
                                
                                
                                
                                23,530Income
      (loss) from operations
                                
                                
                                822
                                
                                
                                
                                (15,585
                                )
                                
                                
                                1,113
                                
                                
                                
                                (19,281
                                )Interest
      expense, net
                                
                                
                                (343
                                )
                                
                                
                                (370
                                )
                                
                                
                                (964
                                )
                                
                                
                                (2,403
                                )Gain
      on legal settlement
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                4,328Other
      income - insurance recovery
                                
                                
                                -
                                
                                
                                
                                860
                                
                                
                                
                                -
                                
                                
                                
                                860Income
      (loss) from operations before income tax expense
                                
                                
                                479
                                
                                
                                
                                (15,095
                                )
                                
                                
                                149
                                
                                
                                
                                (16,496
                                )Income
      tax expense
                                
                                
                                (165
                                )
                                
                                
                                -
                                
                                
                                
                                (21
                                )
                                
                                
                                -Income
      (loss) from continuing operations
                                
                                
                                314
                                
                                
                                
                                (15,095
                                )
                                
                                
                                128
                                
                                
                                
                                (16,496
                                )Loss
      from discontinued operations
                                
                                
                                -
                                
                                
                                
                                (235
                                )
                                
                                
                                -
                                
                                
                                
                                (235
                                )Net
      income (loss)
                                
                                $
                                314
                                
                                
                                $
                                (15,330
                                )
                                
                                $
                                128
                                
                                
                                $
                                (16,731
                                )Earnings
      (loss) per common share - basic and
      diluted:Basic:Earnings
      (loss) per common share from continuing operations
                                
                                $
                                0.05
                                
                                
                                $
                                (290
                                )
                                
                                $
                                0.03
                                
                                
                                $
                                (290
                                )Loss
      per common share from discontinued operations
                                
                                
                                -
                                
                                
                                
                                (5
                                )
                                
                                
                                -
                                
                                
                                
                                (4
                                )Net
      earnings (loss) per share
                                
                                $
                                0.05
                                
                                
                                $
                                (295
                                )
                                
                                $
                                0.03
                                
                                
                                $
                                (294
                                )Weighted
      average common shares outstanding - basic
                                
                                
                                5,853,568
                                
                                
                                
                                52,023
                                
                                
                                
                                3,794,620
                                
                                
                                
                                56,878Diluted:Earnings
      (loss) per common share from continuing operations
                                
                                $
                                0.04
                                
                                
                                $
                                (290
                                )
                                
                                $
                                0.02
                                
                                
                                $
                                (290
                                )Loss
      per common share from discontinued operations
                                
                                
                                -
                                
                                
                                
                                (5
                                )
                                
                                
                                -
                                
                                
                                
                                (4
                                )Net
      earnings (loss) per share
                                
                                $
                                0.04
                                
                                
                                $
                                (295
                                )
                                
                                $
                                0.02
                                
                                
                                $
                                (294
                                )Weighted
      average common shares outstanding - diluted
                                
                                
                                7,383,590
                                
                                
                                
                                52,023
                                
                                
                                
                                5,577,703
                                
                                
                                
                                56,878





See
accompanying notes to condensed consolidated financial
statements


F-2




Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Cash Flow


For
the Nine Months Ended September 30, 2010 and 2009


(in
thousands)




Nine
      Months Ended September 30,2010
                          
                          
                          2009Operating
      activities:Net
      income (loss)
                          
                          $
                          128
                          
                          
                          $
                          (16,731
                          )Loss
      from discontinued operations
                          
                          
                          -
                          
                          
                          
                          (235
                          )Net
      income (loss) from continuing operations
                          
                          
                          128
                          
                          
                          
                          (16,496
                          )Adjustments
      to reconcile net income (loss) from operationsto net cash used in
      operating activities:Gain
      on legal settlement
                          
                          
                          -
                          
                          
                          
                          (4,328
                          )Impairment
      of goodwill
                          
                          
                          -
                          
                          
                          
                          14,704Depreciation
      and amortization
                          
                          
                          1,497
                          
                          
                          
                          1,373Amortization
      of deferred debt discount
                          
                          
                          -
                          
                          
                          
                          1,870Deferred
      income taxes
                          
                          
                          (556
                          )
                          
                          
                          -Stock-based
      compensation
                          
                          
                          489
                          
                          
                          
                          566Other
      changes in assets and liabilities:Accounts
      receivable and due from factor, net
                          
                          
                          (9,918
                          )
                          
                          
                          (1,422
                          )Inventory
                          
                          
                          (6,605
                          )
                          
                          
                          944Product
      development costs, net
                          
                          
                          (3,384
                          )
                          
                          
                          (401
                          )Customer
      advances
                          
                          
                          (1,686
                          )
                          
                          
                          1,413Prepaid
      expenses and other current assets
                          
                          
                          803
                          
                          
                          
                          (2,118
                          )Accounts
      payable
                          
                          
                          1,163
                          
                          
                          
                          (112
                          )Accrued
      expenses and other current liabilities
                          
                          
                          976
                          
                          
                          
                          (716
                          )Net
      cash used in operating activities
                          
                          
                          (17,093
                          )
                          
                          
                          (4,723
                          )Investing
      activities:Purchases
      of fixed assets
                          
                          
                          (175
                          )
                          
                          
                          (92
                          )Purchase
      of intellectual property
                          
                          
                          -
                          
                          
                          
                          (162
                          )Net
      cash used in investing activities
                          
                          
                          (175
                          )
                          
                          
                          (254
                          )Financing
      activities:Proceeds
      from sale of equity securities, net of $2,000 of costs in
    2010
                          
                          
                          7,592
                          
                          
                          
                          7Net
      borrowings in connection with financing facilities
                          
                          
                          8,819
                          
                          
                          
                          2,654(Repayment
      of) proceeds from Solutions 2 Go customer advances
                          
                          
                          (585
                          )
                          
                          
                          2,000Net
      cash provided by financing activities
                          
                          
                          15,826
                          
                          
                          
                          4,661Net
      decrease in cash
                          
                          
                          (1,442
                          )
                          
                          
                          (316
                          )Cash
      at beginning of period
                          
                          
                          2,664
                          
                          
                          
                          849Cash
      at end of period
                          
                          $
                          1,222
                          
                          
                          $
                          533





See
accompanying notes to condensed consolidated financial
statements


F-3




Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statement of Stockholders' Equity


For
the Nine Months Ended September 30, 2010


(in
thousands)




Preferred StockSeries A
                          
                          
                          Series B
                          
                          
                          Common Stock
                          
                          
                          Additional
                          
                          
                          Accumulated
                          
                          
                          Treasury StockShares
                          
                          
                          ParValue
                          
                          
                          Shares
                          
                          
                          ParValue
                          
                          
                          Shares
                          
                          
                          ParValue
                          
                          
                          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
                          
                          
                          
                          160
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          161Issuance
      of management options accrued for in 2009 as a liability
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          403
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          403Stock-based
      compensation
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          329
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          329Sale
      of Common Stock - July 2010, net of costs of $2,000
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,600
                          
                          
                          
                          1
                          
                          
                          
                          7,591
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          7,592Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          128
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          128Balance
      at September 30, 2010
                          
                          
                          -
                          
                          
                          $
                          -
                          
                          
                          
                          -
                          
                          
                          $
                          -
                          
                          
                          
                          6,244
                          
                          
                          $
                          6
                          
                          
                          $
                          73,195
                          
                          
                          $
                          (45,009
                          )
                          
                          
                          13
                          
                          
                          $
                          (4,469
                          )
                          
                          $
                          23,723





See
accompanying notes to condensed consolidated financial
statements


F-4




Zoo
Entertainment, Inc. and Subsidiaries




Notes
to Condensed Consolidated Financial Statements




NOTE
1.  DESCRIPTION OF ORGANIZATION




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




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




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




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




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




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


F-5


NOTE
2.  BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING
POLICIES




Principles
of Consolidation and Interim Financial Information




The
accompanying unaudited interim condensed consolidated financial statements were
prepared in accordance with accounting principles generally accepted in the
United States of America (“GAAP”) and the interim financial statement rules and
regulations of the Securities and Exchange Commission
(“SEC”).  Accordingly, they do not include all of the information and
footnotes required by GAAP for complete financial statements.  In the
opinion of management, these statements include all adjustments (consisting only
of normal recurring adjustments) necessary for a fair presentation of the
condensed consolidated financial statements.  The  condensed
consolidated financial statements should be read in conjunction with the
Company’s management discussion and analysis contained elsewhere herein and the
consolidated financial statements for the year ended December 31, 2009 included
in the Company’s Registration Statement on Form S-1/A (Registration No.
333-163937), as filed on June 25, 2010. The Company’s results for the three and
nine months ended September 30, 2010 might not be indicative of the results for
the full year or any future period.




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




Use
of Estimates




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




Concentration
of Credit Risk




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




If the
financial condition and operations of the Company’s customers deteriorate, its
risk of collection could increase substantially. A majority of the Company’s
trade receivables are derived from sales to major retailers and
distributors.  In October 2008, the Company entered into an agreement
with Atari, Inc. where sales from October 24, 2008 through March 31, 2009 for
all customers that Atari deemed acceptable would be through Atari, and Atari
would prepay the Company for the cost of goods and they would bear the credit
risk from the ultimate customer.  This agreement was subsequently
amended to include sales to certain customers through June 30,
2010.  The agreement with Atari expired on June 30, 2010 and, as of
September 30, 2010, there was no receivable due from Atari.  The
Company’s five largest ultimate customers accounted for approximately 83% (of
which the following customers constituted balances greater than
10%:  customer A-55% and customer B-11%) and 78% (of which the
following customers constituted balances greater than 10%: customer A-46% and
customer B-18%) of net revenue for the three months ended September 30, 2010 and
2009, respectively.  The Company’s five largest ultimate customers
accounted for approximately 81% (of which the following customers constituted
balances greater than 10%: customer A-46%, customer B- 11% and customer C-12%)
and 77% (of which the following customers constituted balances greater than 10%:
customer A-27%, customer B-18%, customer C-14% and customer D-11%) of net
revenue for the nine months ended September 30, 2010 and 2009,
respectively.  These five largest customers accounted for 85% of the
Company’s gross accounts receivable and due from factor as of September 30,
2010.  The Company believes that the receivable balances from its
customers do not represent a significant credit risk based on past collection
experience. During the nine months ended September 30, 2010 and 2009, the
Company sold approximately $17.8 million and $832,000, respectively, of
receivables to its factor with recourse.  The factored receivables
were approximately $6.5 million and $1.4 million of the Company’s accounts
receivable and due from factor, net as of September 30, 2010 and December 31,
2009, respectively.  The Company regularly reviews its outstanding
receivables for potential bad debts and has had no history of significant
write-offs due to bad debts.


F-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 records
amortization using the proportion of current year unit sales and revenues to the
total unit sales and revenues expected to be recorded over the life of the
title.




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




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


F-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 nine
months ended September 30, 2010 or 2009.




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




Revenue
Recognition




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




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


F-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
nine months ended September 30, 2010 and 2009.  Stock option grants
vest over periods ranging from immediate to four years and expire within ten
years of issuance.  Stock options that vest in accordance with service
conditions amortize over the applicable vesting period using the straight-line
method.




The fair
value of the options granted is estimated using the Black-Scholes option-pricing
model.  This model requires the input of assumptions regarding a
number of complex and subjective variables that will usually have a significant
impact on the fair value estimate.  These variables include, but are
not limited to, the volatility of the Company’s stock price and estimated
exercise behavior.  The Company used the current market price to
determine the fair value of the stock price for the grant made during the period
ended September 30, 2009, and used the price of the Company’s equity raise in
the fourth quarter of 2009 to determine the fair value of the stock price for
the grant made on February 11, 2010.  The Company used the current
market price to determine the fair value of the stock price for the grant made
in August 2010.  No other stock grants were made in
2010.  The following table summarizes the assumptions and variables
used by the Company to compute the weighted average fair value of stock option
grants:




F-9




Nine MonthsEnded September 30,2010
                                
                                
                                2009Risk-free
      interest rate
                                
                                
                                3.00
                                %
                                
                                
                                3.45
                                %Expected
      stock price volatility
                                
                                
                                60.0
                                %
                                
                                
                                60.0
                                %Expected
      term until exercise (years)
                                
                                
                                5
                                
                                
                                
                                5Expected
      dividend yield
                                
                                None
                                
                                
                                None




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




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




Earnings
(Loss) Per Share




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




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


F-10




Three
      Months Ended
                          
                          
                          Nine
      Months EndedSeptember
      30,
                          
                          
                          September
      30,2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Weighted
      average commonshares outstanding - basic
                          
                          
                          5,853,568
                          
                          
                          
                          52,023
                          
                          
                          
                          3,794,620
                          
                          
                          
                          56,878Options
      outstanding - dilutive
                          
                          
                          315,396
                          
                          
                          
                          -
                          
                          
                          
                          593,518
                          
                          
                          
                          -Warrants
      outstanding - dilutive
                          
                          
                          1,015,231
                          
                          
                          
                          -
                          
                          
                          
                          1,021,407
                          
                          
                          
                          -Non-vested
      shares
                          
                          
                          199,395
                          
                          
                          
                          -
                          
                          
                          
                          168,158
                          
                          
                          
                          -Weighted
      average commonshares outstanding –
      diluted
                          
                          
                          7,383,590
                          
                          
                          
                          52,023
                          
                          
                          
                          5,577,703
                          
                          
                          
                          56,878




Income
Taxes




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




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




Fair
Value Measurement




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




·
            Level
      1 — Unadjusted quoted market prices in active markets for identical assets
      or liabilities that the Company has the ability to access at the
      measurement date.




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




F-11


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




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




NOTE
3.  INVENTORY




Inventory
consisted of:




(Amounts in Thousands)September 30,
                    
                    
                    December 31,2010
                    
                    
                    2009Finished
      products, net
                    
                    $
                    2,047
                    
                    
                    $
                    1,247Parts
      and supplies, net
                    
                    
                    6,661
                    
                    
                    
                    856Totals
                    
                    $
                    8,708
                    
                    
                    $
                    2,103




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




NOTE
4.  PREPAID EXPENSES AND OTHER CURRENT ASSETS




Prepaid
expenses and other current assets consisted of:




(Amounts
      in Thousands)September 30,
                    
                    
                    December 31,2010
                    
                    
                    2009Vendor
      advances for inventory
                    
                    $
                    616
                    
                    
                    $
                    1,545Prepaid
      royalties
                    
                    
                    831
                    
                    
                    
                    474Other
      prepaid expenses
                    
                    
                    159
                    
                    
                    
                    390Totals
                    
                    $
                    1,606
                    
                    
                    $
                    2,409


F-12




NOTE
5.  PRODUCT DEVELOPMENT COSTS




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




Product
      development costs, net - December 31, 2009
                  
                  $
                  4,399New
      product development costs incurred
                  
                  
                  6,115Amortization
      of product development costs
                  
                  
                  (2,731
                  )Product
      development costs, net – September 30, 2010
                  
                  $
                  7,783




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




NOTE
6.  INTANGIBLE ASSETS, NET




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




(Amounts in Thousands)September 30, 2010
                                
                                
                                December 31, 2009EstimatedUseful
                                  Lives
                                
                                
                                GrossCarrying
                                
                                
                                Accumulated
                                
                                
                                Net Book
                                
                                
                                Net Book(Years)
                                
                                
                                Amount
                                
                                
                                Amortization
                                
                                
                                Value
                                
                                
                                ValueContent
                                
                                
                                10
                                
                                
                                $
                                14,965
                                
                                
                                $
                                3,731
                                
                                
                                $
                                11,234
                                
                                
                                $
                                12,345Trademarks
                                
                                
                                10
                                
                                
                                
                                1,510
                                
                                
                                
                                422
                                
                                
                                
                                1,088
                                
                                
                                
                                1,201Customer
      relationships
                                
                                
                                10
                                
                                
                                
                                2,749
                                
                                
                                
                                767
                                
                                
                                
                                1,982
                                
                                
                                
                                2,187Totals
                                
                                
                                
                                
                                
                                $
                                19,224
                                
                                
                                $
                                4,920
                                
                                
                                $
                                14,304
                                
                                
                                $
                                15,733




F-13


Amortization
expense related to intangible assets was $476,000 for both the three months
ended September 30, 2010 and 2009, and approximately $1.4 million and $1.3
million for the nine months ended September 30, 2010 and 2009,
respectively.




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




(AmountsYear Ending December 31,
                  
                  in Thousands)Balance
      of 2010
                  
                  $
                  4932011
                  
                  
                  1,9222012
                  
                  
                  1,9222013
                  
                  
                  1,9222014
                  
                  
                  1,922Thereafter
                  
                  
                  6,123Total
                  
                  $
                  14,304


F-14


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




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




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


F-15




Receivable
Financing




Zoo
Publishing uses a factor to approve credit and to collect the proceeds from a
portion of its sales.  In August 2008, Zoo Publishing entered into a
factoring and security agreement with Working Capital Solutions, Inc. (“WCS”),
which utilizes existing accounts receivable in order to provide working capital
to fund all aspects of the Company’s continuing business
operations.  The Company entered into a new factoring and security
agreement with WCS on September 29, 2009 (the “Factoring
Agreement”).  Under the terms of the Factoring Agreement, the Company
sells its receivables to WCS, with recourse.  WCS, in its sole
discretion, determines whether or not it will accept each receivable based upon
the credit risk factor of each individual receivable or account.  Once
a receivable is accepted by WCS, WCS provides funding subject to the terms and
conditions of the Factoring Agreement.  The amount remitted to the
Company by WCS equals the invoice amount of the receivable adjusted for any
discounts or allowances provided to the account, less 25% which is deposited
into a reserve account established pursuant to the Factoring Agreement, less
allowances and fees.  In the event of default, valid payment dispute,
breach of warranty, insolvency or bankruptcy on the part of the receivable
account, WCSr can require the receivable to be repurchased by the Company in
accordance with the Factoring Agreement.  The amounts to be paid by
the Company to WCS for any accepted receivable include a factoring fee of 0.6%
for each ten (10) day period the account is open.  Since WCS acquires
the receivables with recourse, the Company records the gross receivables
including amounts due from its customers to WCS and it records a liability to
WCS for funds advanced to the Company from WCS. During the nine months ended
September 30, 2010 and 2009, the Company sold approximately $17.8 million and
$0, respectively, of receivables to WCS with recourse.  At September
30, 2010 and December 31, 2009, accounts receivable and due from WCS included
approximately $6.5 million and approximately $1.4 million of amounts due from
the Company’s customers to WCS, respectively.  WCS had an advance
outstanding to the Company of approximately $4.6 million and $900,000 as of
September 30, 2010 and December 31, 2009, respectively which is included in
financing arrangements in the current liability section of the respective
condensed consolidated balance sheets.  In connection with the
Factoring Agreement, on September 29, 2009, Mark Seremet, President, Chief
Executive Officer and a director of the Company and Zoo Games, and David
Rosenbaum, the President of Operations of Zoo Publishing, entered into a
Guaranty with WCS, pursuant to which Messrs. Seremet and Rosenbaum agreed to
guaranty the full and prompt payment and performance of the obligations under
the Factoring Agreement.




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




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


F-16





Atari
Agreement





As a
result of a fire in October 2008 that destroyed the Company’s inventory and
impacted its cash flow from operations, the Company entered into an agreement
with Atari, Inc. (“Atari”).  This agreement became effective on
October 24, 2008 and provided for Zoo Publishing to sell its products to Atari
without recourse and Atari would resell the products to wholesalers and
retailers that are acceptable to Atari in North America.  The
agreement initially expired on March 31, 2009, but was amended to extend the
term for certain customers until June 30, 2010 and subsequently expired on June
30, 2010.  This agreement provided for Atari to prepay to the Company
for the cost of goods and pay the balance due within 15 days of shipping the
product.  Atari’s fees approximate 10% of the Company’s standard
selling price and they have been recorded as a reduction in
revenue.  During the three months ended September 30, 2009, the
Company recorded approximately $2.5 million of net sales to
Atari.  During the nine months ended September 30, 2010 and 2009, the
Company recorded approximately $11.4 million and $23.5 million, respectively, of
sales, net of the fee to Atari. As of September 30, 2010 and December 31,
2009, Atari had prepaid the Company $0 and approximately $1.5 million,
respectively, for goods not yet shipped which is recorded as customer advances
in current liabilities.  Also, as of September 30, 2010 and December
31, 2009, the receivable due from Atari was $0 and approximately $1.8 million,
respectively, before allowances, for goods already shipped which are recorded in
accounts receivable and due from factor in the condensed consolidated balance
sheets.




Other
Customer Advance — Solutions 2 Go, Inc.




On August
31, 2009, Zoo Publishing entered into an exclusive distribution agreement with
Solutions 2 Go Inc. (“S2G Inc.”) and an Exclusive Distribution Agreement with
Solutions 2 Go, LLC (“S2G LLC,” and together with S2G Inc., “S2G”), pursuant to
which Zoo Publishing granted to S2G the exclusive rights to market, sell and
distribute certain video games, related software and products, with respect to
which Zoo Publishing owns rights, in the territories specified
therein.  In connection with these distribution agreements, on August
31, 2009, the Company entered into an Advance Agreement (the “Advance
Agreement”) with S2G, pursuant to which S2G made a payment to the Company in the
amount of $1,999,999, in advance of S2G’s purchases of certain products pursuant
to these distribution agreements.  From August 31, 2009 until
recoupment of the advance in full, interest on the outstanding amount shall
accrue at the rate of ten percent (10%) per annum.  Interest expense
of $23,000 and $78,000 is recorded for the three and nine months ended September
30, 2010, respectively.  The amount of any unrecouped advance
outstanding was scheduled to be paid in its entirety if (i) the Company receives
proceeds in connection with any sale of securities, or otherwise raises
additional capital, exceeding an aggregate of $5.0 million, other than under a
defined anticipated qualified financing prior to September 15, 2010 or (ii) no
later than September 15, 2010.  The advance is recouped from sales
generated by S2G of products purchased by S2G under the distribution
agreements.  A percentage of the gross margin on the S2G sales shall
be applied to recoupment of the advance until the earlier of (i) the date on
which the amount of the unrecouped advance has been reduced to zero or (ii)
September 15, 2010, on which any unrecouped advance shall be
repaid.  S2G has agreed to extend the payment of the balance and
interest due until January 1, 2011 and will continue to reduce the balance due
by the margin earned on sales through that period. As of September 30, 2010 and
December 31, 2009, the balance remaining on the advance was approximately
$815,000 and $1.4 million, respectively, and is included in customer advances in
the current liabilities section of the condensed consolidated balance
sheets.  Any remaining unrecouped balance will be due on January 1,
2011.  Interest no longer accrues after September 30,
2010.




In
consideration of S2G entering into the Advance Agreement, the Company agreed to
issue to S2G Inc. a warrant to purchase 12,777 shares of the Company’s common
stock (or such other number of shares of common stock that on the warrant grant
date (as defined below), represents 6% of the Company’s modified fully-diluted
shares, computed as if all outstanding convertible stock, warrants and stock
options that are, directly or indirectly, convertible into common stock at a
price of $450 or less, have been so converted), upon the occurrence of an
anticipated qualified financing, which means (i) the consummation of the sale of
shares of common stock by the Company which results in aggregate gross proceeds
to the Company of at least $4,000,000 and (ii) the conversion of the Company’s
senior secured convertible notes (“Zoo Entertainment Notes”), in the aggregate
original principal amount of $11,150,000, into shares of common
stock.  The warrant will have a term of five years and an exercise
price equal to $180.  The warrant was issued on August 31,
2009.  The warrant was valued at $400,000 using the Black-Scholes
model and this cost was amortized over 12 months through interest expense. For
the three months ended September 30, 2010 and September 30, 2009, $67,000 and
$33,000, respectively, of additional interest expense was recorded in the
condensed consolidated statement of operations for this advance. For the nine
months ended September 30, 2010 and September 30, 2009, $267,000 and $33,000,
respectively, of additional interest expense was recorded in the condensed
consolidated statement of operations for this advance.


F-17


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





NOTE
8.  ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES




Accrued
expenses and other current liabilities consisted of:




(Amounts
      in Thousands)September
      30,
                                                                  
                                                                  
                                                                  December
      31,2010
                                                                  
                                                                  
                                                                  2009Obligations
      from the purchase of content intangible assets ($1,844 was classified as
      long-term until May 2010 when the obligation due May 2011 became
      current)
                                                                  
                                                                  $
                                                                  2,144
                                                                  
                                                                  
                                                                  $
                                                                  300Operating
      expenses
                                                                  
                                                                  
                                                                  1,012
                                                                  
                                                                  
                                                                  
                                                                  473Due
      to customers
                                                                  
                                                                  
                                                                  984
                                                                  
                                                                  
                                                                  
                                                                  18Obligations arising
      from acquisitions ($620 was classified as long-term until July 2010 when
      the obligation due in July 2011 became
      current)
                                                                  
                                                                  
                                                                  620
                                                                  
                                                                  
                                                                  
                                                                  233Royalties
                                                                  
                                                                  
                                                                  614
                                                                  
                                                                  
                                                                  
                                                                  430Interest
                                                                  
                                                                  
                                                                  238
                                                                  
                                                                  
                                                                  
                                                                  58Obligations
      to compensate current and former employees
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  561Other
                                                                  
                                                                  
                                                                  93
                                                                  
                                                                  
                                                                  
                                                                  260Totals
                                                                  
                                                                  $
                                                                  5,705
                                                                  
                                                                  
                                                                  $
                                                                  2,333


F-18


NOTE
9.  INCOME TAXES




The
provision for income taxes is based on income recognized for financial statement
purposes and includes the effects of temporary differences between such income
and that recognized for tax return purposes.




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




As of
September 30, 2010, the Company had approximately $1.2 million of available
capital loss carryforwards which expire in 2013.  A valuation
allowance of approximately $726,000 was recognized to offset the deferred tax
assets related to these carryforwards.  The Company currently does not
have any capital gains to utilize against this capital loss.  If
realized, the tax benefit of this item will be applied to reduce future capital
gains of the Company.




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


F-19


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




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




Common
Stock




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




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




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




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




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




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


F-20


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




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




Preferred
Stock




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




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




On
November 20, 2009, the Company entered into a securities purchase agreement with
certain investors, consummating an approximate $4.2 million convertible
preferred equity raise, pursuant to which the Company issued Series A Preferred
Stock that will convert into common shares of the Company upon an increase in
sufficient authorized common shares, representing 50% of the equity of the
Company.  The Series A Preferred Stock have a rate of one share of
Series A Preferred Stock for each $2.50 of value of the investment
amount.  The Company issued 1,180,282 shares of Series A Preferred
Stock on November 20, 2009.  On December 16, 2009, the Company
received an additional $776,000 from certain investors and issued an additional
209,402 shares of Series A Preferred Stock.


F-21


On
November 20, 2009, the Company entered into Amendment No. 6 to Senior Secured
Convertible Note with the requisite holders of the Company’s outstanding senior
secured convertible notes issued in the aggregate principal amount of
$11,150,000.  The amendment provided that, among other things, the
outstanding principal balance and all accrued and unpaid interest of $734,000
under the notes shall convert into shares of the Company’s Series B Preferred
Stock upon the consummation of an investor sale that results in aggregate gross
proceeds to the Company of at least $4,000,000, at a rate of one share of Series
B Preferred Stock for each $10.00 of value of the note. Moreover, the amendment
provided that the notes shall no longer be deemed to be outstanding and all
rights with respect to the notes shall immediately cease and terminate upon the
conversion, except for the right of each holder to receive the shares to which
it is entitled as a result of such conversion.  The Company issued
1,188,439 shares of Series B Preferred Stock on November 20, 2009 as a result of
the conversion of the above notes.




Options




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




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




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




On May
12, 2009, the Company entered into a letter agreement with each of Mark Seremet
and David Rosenbaum, pursuant to which, in consideration for Messrs. Seremet and
Rosenbaum entering into a guaranty with Wells Fargo for the full and prompt
payment and performance by the Company and its subsidiaries of the obligations
in connection with a purchase order financing (the “Loan”), the Company agreed
to compensate Mr. Seremet in the amount of $10,000 per month, and Mr. Rosenbaum
in the amount of $7,000 per month, for so long as the executive remains employed
while the guaranty and Loan remain in full force and effect.  If the
guaranty is not released by the end of the month following termination of
employment of either Messrs. Seremet or Rosenbaum, the monthly fee shall be
doubled for each month thereafter until the guaranty is removed.  As
part of the November 2009 financing, Messrs. Seremet and Rosenbaum agreed to
amend their respective letter agreements, pursuant to which, in consideration of
each of their continued personal guarantees, the Company’s Board of Directors
has approved the issuance of an option to purchase restricted stock or other
incentives intended to comply with Section 409A of the Internal Revenue Code,
equal to a 6.25% ownership interest, to each of Mr. Seremet and Mr.
Rosenbaum.  Subject to the effectiveness of an amendment to the
Company’s Certificate of Incorporation authorizing an increase in the number of
authorized shares of the Company’s common stock and the one-for-600 reverse
stock split, on February 11, 2010, the Company issued 337,636 options to
purchase shares of common stock to each of Mr. Seremet and Mr. Rosenbaum in
consideration for their continued personal guarantees.  The Company
performed a Black-Scholes valuation to determine the value of the arrangements
on February 11, 2010 to be $542,000.  Of the $542,000, $403,000 was
included as stock-based compensation expense in 2009 based on the value ascribed
for the period from November 20, 2009 to December 31, 2009, and was included in
accrued expenses in the December 31, 2009 consolidated balance
sheet.  The stock-based compensation expense recorded in the three
months and nine months ended September 30, 2010 is $29,000 and $85,000,
respectively.  The remaining $54,000 will be expensed throughout the
remaining vesting period of the options until May 2011.




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


F-22


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





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




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




September 30, 2010WeightedAverageNumber of
                              
                              
                              ExerciseShares
                              
                              
                              PriceOutstanding
      at December 31, 2009
                              
                              
                              4,321
                              
                              
                              $
                              774.00Granted
      (outside of the 2007 Plan)
                              
                              
                              1,330,917
                              
                              
                              
                              1.71Forfeited
                              
                              
                              (12,262
                              )
                              
                              
                              15.23Outstanding
      at September 30, 2010
                              
                              
                              1,322,976
                              
                              
                              $
                              4.53Options
      exercisable at September 30, 2010
                              
                              
                              688,251
                              
                              
                              $
                              5.90




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


F-23


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




Options Outstanding
                                              
                                              
                                              Options ExercisableWeighted-Average
                                              
                                              
                                              Weighted-Range of
                                              
                                              
                                              
                                              
                                              
                                              Remaining
                                              
                                              
                                              Average
                                              
                                              
                                              
                                              
                                              
                                              Weighted-Exercise
                                              
                                              
                                              Number
                                              
                                              
                                              Contractual
                                              
                                              
                                              Exercise
                                              
                                              
                                              Number
                                              
                                              
                                              AveragePrices
                                              
                                              
                                              Outstanding
                                              
                                              
                                              Life (Years)
                                              
                                              
                                              Price
                                              
                                              
                                              Exercisable
                                              
                                              
                                              Exercise Price$
                                              1,548.00
                                              
                                              
                                              
                                              274
                                              
                                              
                                              
                                              2.6
                                              
                                              
                                              $
                                              1,548
                                              
                                              
                                              
                                              274
                                              
                                              
                                              $
                                              1,548$
                                              1,350.00
                                              
                                              
                                              
                                              235
                                              
                                              
                                              
                                              2.9
                                              
                                              
                                              
                                              1,350
                                              
                                              
                                              
                                              156
                                              
                                              
                                              
                                              1,350$
                                              912.00
                                              
                                              
                                              
                                              2,438
                                              
                                              
                                              
                                              2.7
                                              
                                              
                                              
                                              912
                                              
                                              
                                              
                                              2,438
                                              
                                              
                                              
                                              912$
                                              180.00
                                              
                                              
                                              
                                              1,250
                                              
                                              
                                              
                                              3.2
                                              
                                              
                                              
                                              180
                                              
                                              
                                              
                                              417
                                              
                                              
                                              
                                              180$
                                              5.50
                                              
                                              
                                              
                                              70,000
                                              
                                              
                                              
                                              9.9
                                              
                                              
                                              
                                              5.50
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              5.50$
                                              2.46
                                              
                                              
                                              
                                              573,507
                                              
                                              
                                              
                                              9.4
                                              
                                              
                                              
                                              2.46
                                              
                                              
                                              
                                              104,232
                                              
                                              
                                              
                                              2.46$
                                              1.50
                                              
                                              
                                              
                                              675,272
                                              
                                              
                                              
                                              9.4
                                              
                                              
                                              
                                              1.50
                                              
                                              
                                              
                                              580,734
                                              
                                              
                                              
                                              1.50$
                                              1.50
      to $1,548
                                              
                                              
                                              
                                              1,322,976
                                              
                                              
                                              
                                              9.4
                                              
                                              
                                              $
                                              4.53
                                              
                                              
                                              
                                              688,251
                                              
                                              
                                              $
                                              5.90




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




Number
                      Outstanding
                    
                    
                    Weighted-
                      Average Fair
                      Value at
                      Grant Date
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Life (Years)Non-Vested
      options at December 31, 2009
                    
                    
                    1,485
                    
                    
                    $
                    1,350.00
                    
                    
                    
                    4.0Options
      Granted
                    
                    
                    1,330,917
                    
                    
                    
                    2.14
                    
                    
                    
                    9.5Options
      Vested
                    
                    
                    (685,415
                    )
                    
                    
                    1.83
                    
                    
                    
                    9.4Options
      forfeited or expired
                    
                    
                    (12,262
                    )
                    
                    
                    16.18
                    
                    
                    
                    —Non-Vested
      options at September 30, 2010
                    
                    
                    634,725
                    
                    
                    $
                    3.05
                    
                    
                    
                    9.4




As of
September 30, 2010, there was $525,000 of unrecognized compensation cost related
to non-vested stock option awards, which is expected to be recognized over a
remaining weighted-average vesting period of 1.2 to 3.9 years.


F-24


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




Warrants




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




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




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




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




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




Warrants Outstanding and ExercisableRange of
                      Exercise Prices
                    
                    
                    Number
                      Outstanding
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Life (Years)
                    
                    
                    Weighted-
                      Average
                      Exercise
                      Price$
                    1,704.00
                    
                    
                    
                    2,383
                    
                    
                    
                    2.5
                    
                    
                    $
                    1,704.00$
                    1,278.00
                    
                    
                    
                    531
                    
                    
                    
                    2.5
                    
                    
                    
                    1,278.00$
                    180.00
                    
                    
                    
                    12,777
                    
                    
                    
                    4.0
                    
                    
                    
                    180.00$
                    6.00
                    
                    
                    
                    6,818
                    
                    
                    
                    2.9
                    
                    
                    
                    6.00$
                    0.01
                    
                    
                    
                    1,017,194
                    
                    
                    
                    4.0
                    
                    
                    
                    0.01$
                    0.01
      to $1,704.00
                    
                    
                    
                    1,039,703
                    
                    
                    
                    4.1
                    
                    
                    $
                    6.82




F-25


NOTE
11.  INTEREST, NET




(Amounts in Thousands)Three Months
                  Ended September 30,
                
                
                Nine Months
                  Ended September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Interest
      arising from amortization of debt discount
                
                $
                -
                
                
                $
                180
                
                
                $
                —
                
                
                $
                1,870Interest
      on various notes
                
                
                23
                
                
                
                190
                
                
                
                78
                
                
                
                533Interest
      arising from amortization of Solutions 2 Go warrants
                
                
                67
                
                
                
                -
                
                
                
                267
                
                
                
                —Interest
      on financing arrangements
                
                
                253
                
                
                
                -
                
                
                
                619
                
                
                
                —Interest
      expense, net
                
                $
                343
                
                
                $
                370
                
                
                $
                964
                
                
                $
                2,403




NOTE
12.  SUPPLEMENTAL CASH FLOW INFORMATION




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




(Amounts in Thousands)
                        Nine Months
                        Ended September 30,2010
                      
                      
                      2009Cash
      paid during the period for interest
                      
                      $
                      516
                      
                      
                      $
                      -Cash
      paid during the period for taxes
                      
                      $
                      182
                      
                      
                      $
                      20Non-cash
      investing and financing activities:Transfer
      of option liability to equity
                      
                      $
                      403
                      
                      
                      $
                      —Par
      Value of Series A Preferred Stock converted to Common
Stock
                      
                      $
                      1
                      
                      
                      $
                      —Par
      Value of Series B Preferred Stock converted to Common
Stock
                      
                      $
                      1
                      
                      
                      $
                      —Receipt
      of 9,274 shares for partial settlement of litigation
                      
                      $
                      —
                      
                      
                      $
                      1,113Notes
      and obligations relieved for partial settlement of
    litigation
                      
                      $
                      —
                      
                      
                      $
                      3,925Acquisition
      of Intangible for long-term obligation
                      
                      $
                      —
                      
                      
                      $
                      2,600




NOTE
13.  LITIGATION




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


F-26




NOTE
14.  RELATED PARTY TRANSACTIONS




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




Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the 2007 Plan, to
each of Messrs. Seremet and Rosenbaum, on such date that is the earlier of the
conversion of at least 25% of all currently existing convertible debt of the
Company into equity or November 8, 2009 (the earlier of such date, the “Grant
Date”), an option to purchase that number of shares of the Company’s common
stock equal to 6% and 3%, respectively, of the then issued and outstanding
shares of common stock, based on a fully diluted current basis assuming those
options and warrants that have an exercise price below $240 per share are
exercised on that date but not counting the potential conversion to equity of
any outstanding convertible notes that have not yet been converted and,
inclusive of any options or other equity securities or securities convertible
into equity securities of the Company that each may own on the Grant
Date.  The options were granted at an exercise price equal to the fair
market value of the Company’s common stock on the Grant Date and pursuant to the
Company’s standard form of nonqualified stock option agreement; provided
however, that in the event the guaranty has not been released by Wells Fargo
Bank as of the date of the termination of the option due to termination of
service, the option termination date shall be extended until the earlier of the
date of the release of the guaranty or the expiration of the ten year term of
the option.  In addition any options owned by Messrs. Seremet and
Rosenbaum as of the Grant Date with an exercise price that is higher than the
exercise price of the new options shall be cancelled as of the Grant
Date.  As part of the November 2009 financing, Messrs. Seremet and
Rosenbaum agreed to amend their respective Fee Letters, pursuant to
which:  in the case of Mr. Seremet, the Company will pay to Mr.
Seremet a fee of $10,000 per month for so long as the guaranty remains in full
force and effect, but only until November 20, 2010; and, in the case of Mr.
Rosenbaum, the Company will pay to Mr. Rosenbaum a fee of $7,000 per month for
so long as the guaranty remains in full force and effect, but only until
November 20, 2010.  In addition, the amended Fee Letters provide that,
in consideration of each of their continued personal guarantees, the Company’s
Board of Directors approved an increase in the issuance of an option to purchase
restricted stock or other incentives intended to comply with Section 409A of the
Internal Revenue Code, equal to a 6.25% ownership interest, to each of Messrs.
Seremet and Rosenbaum, respectively.  On February 11, 2010, the
Company issued options to purchase 337,636 shares of common stock to each of
Messrs. Seremet and Rosenbaum in consideration for their continued personal
guarantees.  (See Note 10 for the valuation of the options and Note 15
for subsequent amendments to the Fee Letters.)




F-27




NOTE
15.  SUBSEQUENT EVENTS




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




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


F-28


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




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




Overview




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




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




Zoo
Entertainment; Merger with Zoo Games




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




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


3




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




Zoo
Games




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




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




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


4


Results
of Operations




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




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




(Amounts in Thousands Except Per Share Data)
                    For The Three Months Ended September 30,2010
                  
                  
                  2009Revenue
                  
                  $
                  17,581
                  
                  
                  
                  100
                  %
                  
                  $
                  8,583
                  
                  
                  
                  100
                  %Cost
      of goods sold
                  
                  
                  13,894
                  
                  
                  
                  79
                  
                  
                  
                  6,662
                  
                  
                  
                  78Gross
      profit
                  
                  
                  3,687
                  
                  
                  
                  21
                  
                  
                  
                  1,921
                  
                  
                  
                  22Operating
      expenses:General
      and administrative
                  
                  
                  1,052
                  
                  
                  
                  6
                  
                  
                  
                  1,750
                  
                  
                  
                  20Selling
      and marketing
                  
                  
                  1,307
                  
                  
                  
                  7
                  
                  
                  
                  548
                  
                  
                  
                  6Impairment
      of goodwill
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  14,704
                  
                  
                  
                  171Depreciation
      and amortization
                  
                  
                  506
                  
                  
                  
                  3
                  
                  
                  
                  504
                  
                  
                  
                  6Total
      operating expenses
                  
                  
                  2,865
                  
                  
                  
                  16
                  
                  
                  
                  17,506
                  
                  
                  
                  204Income
      (loss) from operations
                  
                  
                  822
                  
                  
                  
                  5
                  
                  
                  
                  (15,585
                  )
                  
                  
                  (182
                  )Interest
      expense, net
                  
                  
                  (343
                  )
                  
                  
                  (2
                  )
                  
                  
                  (370
                  )
                  
                  
                  (4
                  )Other
      income – insurance recovery
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  860
                  
                  
                  
                  10Income
      (loss) from operations before income tax expense
                  
                  
                  479
                  
                  
                  
                  3
                  
                  
                  
                  (15,095
                  )
                  
                  
                  (176
                  )Income
      tax expense
                  
                  
                  (165
                  )
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  -Income
      (loss) from continuing operations
                  
                  
                  314
                  
                  
                  
                  2
                  
                  
                  
                  (15,095
                  )
                  
                  
                  (176
                  )Loss
      from discontinued operations
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (235
                  )
                  
                  
                  (3
                  )Net
      income (loss)
                  
                  $
                  314
                  
                  
                  
                  2
                  %
                  
                  $
                  (15,330
                  )
                  
                  
                  (179
                  )%Earnings
      (loss) per common share - basic
                  
                  $
                  0.05
                  
                  
                  
                  
                  
                  
                  $
                  (295
                  )Earnings
      (loss) per common share - diluted
                  
                  $
                  0.04
                  
                  
                  
                  
                  
                  
                  $
                  (295
                  )




Net Revenues.  Net
revenues for the three months ended September 30, 2010 were approximately $17.6
million, an increase of 105% over the revenues for the three months ended
September 30, 2009 of approximately $8.6 million.  Sales in both
periods consist primarily of casual game sales in North America.  The
breakdown of gross sales by platform is as follows:




Three Months Ended September 30,2010
                  
                  
                  2009Nintendo
      Wii
                  
                  
                  74
                  %
                  
                  
                  72
                  %Nintendo
      DS
                  
                  
                  25
                  %
                  
                  
                  27
                  %SONY
      PS2
                  
                  
                  1
                  %
                  
                  
                  0
                  %Microsoft
      Xbox
                  
                  
                  0
                  %
                  
                  
                  1
                  %


5




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




Gross
Profit.  Gross profit for the three months ended September 30,
2010 was approximately $3.7 million, or 21% of net revenue, while the gross
profit for the three months ended September 30, 2009 was approximately $1.9
million, or 22% of net revenue.  The costs included in the cost of
goods sold consist of manufacturing and packaging costs, royalties due to
licensors relating to the current period’s revenues, the amortization of product
development costs relating to the current period’s revenues and interest charges
and fees paid to our purchase order financing facility to build the
inventory.  The slight decrease to the gross margin in the 2010 period
from the 2009 period was primarily due to the higher percentage of sales to
distributors in the 2010 period; our product is typically sold to distributors
at a lower price than when we sell the product direct to retailers.




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




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




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




Depreciation and Amortization
Expenses.  Depreciation and amortization costs for the three
months ended September 30, 2010 were $506,000 as compared to $504,000 in the
comparable period in 2009.  Both periods include $412,000 resulting
from the amortization of intangibles acquired from the Zoo Publishing
acquisition and $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.


6




Interest
Expense.  Interest expense for the three months ended September
30, 2010 was $343,000 as compared to $370,000 for the three months ended
September 30, 2009.  The 2010 period includes $23,000 of interest on
the Solutions 2 Go loan and $67,000 of non-cash interest relating to the
warrants issued for the Solutions 2 Go exclusive distribution
rights.  Interest paid by Zoo Publishing in the 2010 period for the
receivable factoring facility was $253,000.  The 2009 period includes
$180,000 of non-cash interest expense relating to the amortization on the Zoo
Entertainment Notes, $139,000 of interest relating to the Zoo Entertainment
Notes and $51,000 of interest releatd to the advance from Solutions 2
Go.  The Zoo Entertainment Notes were converted to equity in November
2009; therefore, there is no interest costs related to these notes in
2010.




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




Income Tax
Expense.  We recorded an income tax expense of $165,000 for the
three months ended September 30, 2010 against pre-tax income of
$479,000.  We did not record any income tax benefit for the three
months ended September 30, 2009 since we had already maximized the allowable
amount of deferred taxes.




Loss from Discontinued
Operations.During the three months ended September 30, 2009,
we wrote-off $235,000 relating to the balance due from the sale of Zoo Digital
in 2008 because it was determined to be uncollectible during this
period.




Earnings (loss) Per Common
Share.  The basic earnings per share for the three months ended
September 30, 2010 was $0.05 based on a weighted average shares outstanding for
the period of approximately 5.9 million and the diluted  earnings per
share for the three months ended September 30, 2010 was $0.04 based on a
weighted average shares outstanding for the period of approximately 7.6
million.  The basic and diluted loss per common share for the three
months ended September 30, 2009 was $295, based on a weighted average shares
outstanding for the period of 52,023.


7


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




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




(Amounts in Thousands Except Per Share Data)
                  For The Nine Months Ended September 30,2010
                
                
                2009Revenue
                
                $
                45,183
                
                
                
                100
                %
                
                $
                30,136
                
                
                
                100
                %Cost
      of goods sold
                
                
                35,366
                
                
                
                78
                
                
                
                25,887
                
                
                
                86Gross
      profit
                
                
                9,817
                
                
                
                22
                
                
                
                4,249
                
                
                
                14Operating
      expenses:General
      and administrative
                
                
                3,847
                
                
                
                9
                
                
                
                5,010
                
                
                
                17Selling
      and marketing
                
                
                3,360
                
                
                
                7
                
                
                
                2,073
                
                
                
                7Research
      and development
                
                
                -
                
                
                
                -
                
                
                
                370
                
                
                
                1Impairment
      of goodwill
                
                
                -
                
                
                
                -
                
                
                
                14,704
                
                
                
                49Depreciation
      and amortization
                
                
                1,497
                
                
                
                3
                
                
                
                1,373
                
                
                
                5Total
      operating expenses
                
                
                8,704
                
                
                
                19
                
                
                
                23,530
                
                
                
                78Income
      (loss) from operations
                
                
                1,113
                
                
                
                2
                
                
                
                (19,281
                )
                
                
                (64
                )Interest
      expense, net
                
                
                (964
                )
                
                
                (2
                )
                
                
                (2,403
                )
                
                
                (8
                )Gain
      on legal settlement
                
                
                
                
                
                
                
                
                
                
                4,328
                
                
                
                14Other
      income – insurance recovery
                
                
                -
                
                
                
                -
                
                
                
                860
                
                
                
                3Income
      (loss) from operations before income tax expense
                
                
                149
                
                
                
                -
                
                
                
                (16,496
                )
                
                
                (55
                )Income
      tax expense
                
                
                (21
                )
                
                
                -
                
                
                
                -
                
                
                
                -Income
      (loss) from continuing operations
                
                
                128
                
                
                
                -
                
                
                
                (16,496
                )
                
                
                (55
                )Loss
      from discontinued operations
                
                
                -
                
                
                
                -
                
                
                
                (235
                )
                
                
                (1
                )Net
      income (loss)
                
                $
                128
                
                
                
                -
                %
                
                $
                (16,731
                )
                
                
                (56
                )%Earnings
      (loss) per common share - basic
                
                $
                0.03
                
                
                
                
                
                
                $
                (294
                )Earnings
      (loss) per common share - diluted
                
                $
                0.02
                
                
                
                
                
                
                $
                (294
                )


8




Net Revenues.  Net
revenues for the nine months ended September 30, 2010 were approximately $45.2
million, an increase of 50% over the revenues for the nine months ended
September 30, 2009 of approximately $30.1 million.  Sales in both
periods consist primarily of casual game sales in North America.




The
breakdown of gross sales by platform is as follows:




Nine Months Ended September 30,2010
                  
                  
                  2009Nintendo
      Wii
                  
                  
                  73
                  %
                  
                  
                  65
                  %Nintendo
      DS
                  
                  
                  27
                  %
                  
                  
                  31
                  %Microsoft
      Xbox
                  
                  
                  0
                  %
                  
                  
                  2
                  %Sony
      PS2
                  
                  
                  0
                  %
                  
                  
                  2
                  %




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




Gross
Profit.  Gross profit for the nine months ended September 30,
2010 was approximately $9.8 million, or 22% of net revenue, while the gross
profit for the nine months ended September 30, 2009 was $4.3, or 14% of net
revenue.  The costs included in the cost of goods sold consist of
manufacturing and packaging costs, royalties due to licensors relating to the
current period’s revenues, the amortization of product development costs
relating to the current period’s revenues and interest charges and fees paid to
our purchase order financing facility to build the
inventory.   The Atari sales agreement was in place for all sales
during the entire 2009 period and Atari’s fees recorded as a reduction in
revenue during the nine months ended September 30, 2009 were approximately $2.7
million.  For the nine months ended September 30, 2010, Atari’s fees
recorded as a reduction in revenue were approximately $1.1
million.  For those sales that were not distributed through Atari, the
Company pays the shipping costs.  The net improvement to the gross
margin in the 2010 period from the 2009 period was partially due to the
reduction in the sales distributed through Atari.  As part of our
business plan to focus on higher margin games and more cost effective product
licenses, we opted to discontinue certain lower-margin products in the 2009
period through the accelerated sale of such products at lower than normal
prices.  This resulted in sales at very low margins, which along with
related royalty fees and amortization of product development costs resulted in a
lower overall gross margin for the 2009 period.


9


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




Selling and Marketing
Expenses.  Selling and marketing expenses increased from $2.1
million for the nine months ended September 30, 2009 to $3.4 million for the
nine months ended September 30, 2010 due primarily to additional salaries and
related costs for the increased headcount for the sales and marketing team in
Ohio.  The increase was also due to approximately $400,000 of costs
incurred for the launch and continued marketing of the indiePub Games website
during 2010.




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




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




Depreciation and Amortization
Expenses.  Depreciation and amortization costs for the nine
months ended September 30, 2010 were approximately $1.5 million as compared to
approximately $1.4 million for the nine months ended September 30,
2009.  Both periods include approximately $1.2 million resulting from
the amortization of intangibles acquired from the Zoo Publishing acquisition.
The 2010 period includes $195,000 resulting from the amortization of content
intangibles obtained from the New World IP license in May 2009, while the 2009
period only includes $65,000 for the amortization of those content
intangibles.  The balance relates to depreciation of fixed assets
during the period.




Interest
Expense.  Interest expense for the nine months ended September
30, 2010 was $964,000 as compared to approximately $2.4 million for the nine
months ended September 30, 2009.  The 2010 period includes $78,000 of
interest on the Solutions 2 Go loan and $267,000 of non-cash interest relating
to the warrants issued for the Solutions 2 Go exclusive distribution
rights.  Interest paid by Zoo Publishing in the 2010 period for the
receivable factoring facility was $619,000.  The nine months ended
September 30, 2009 includes approximately $1.6 million of non-cash interest
expense relating to the amortization on the Zoo Entertainment Notes, $418,000 of
interest relating to the Zoo Entertainment Notes and $358,000 of interest on the
various promissory notes due to the sellers of Zoo Publishing of which $293,000
is non-cash interest imputed at the then market rate.  The Zoo
Entertainment Notes were converted to equity in November 2009 and the Zoo
Publishing notes were cancelled in June 2009; therefore, there is no interest
costs related to these notes in 2010.




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


10




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




Income Tax
Expense.  We recorded an income tax expense of $21,000 for the
nine months ended September 30, 2010 against pre-tax income of
$149,000.  We did not record any income tax benefit for the nine
months ended September 30, 2009 since we had already maximized the allowable
amount of deferred taxes.




Loss from Discontinued
Operations.During the nine months ended September 30, 2009,
we wrote-off $235,000 relating to the balance due from the sale of Zoo Digital
in 2008 because it was determined to be uncollectible during this
period.




Earnings (loss) Per Common
Share.  The basic earnings per share for the nine months ended
September 30, 2010 was $0.03 based on a weighted average shares outstanding for
the period of approximately 3.7 million and the diluted  earnings per
share for the nine months ended September 30, 2010 was $0.02 based on a weighted
average shares outstanding for the period of approximately 6.0
million.  The basic and diluted loss per common share for the nine
months ended September 30, 2009 was $294, based on a weighted average shares
outstanding for the period of 56,878.




Liquidity
and Capital Resources




We
incurred net income of $128,000 for the nine months ended September 30, 2010 and
a net loss of approximately $16.7 million for the nine months ended September
30, 2009.  Our principal sources of cash during the nine months ended
September 30, 2010 were proceeds from the sale of equity securities, the use of
our purchase order and receivable financing arrangements, and cash generated
from operations throughout the period.




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




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




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


11




Factoring
Facility




Zoo
Publishing has a factoring facility with Working Capital Solutions,
Inc.  (“WCS”), which utilizes existing accounts receivable in order to
provide working capital to fund our continuing business
operations.  Under the terms of our factoring and security agreement
(the “Factoring Agreement”), our receivables are sold to WCS, with
recourse.  WCS, in its sole discretion, determines whether or not it
will accept each receivable based upon the credit risk factor of each individual
receivable or account.  Once a receivable is accepted by WCS, WCS
provides funding, subject to the terms and conditions of the Factoring
Agreement.  The amount remitted to us by WCS equals the invoice amount
of the receivable adjusted for any discounts or allowances provided to the
account, less 25%, which is deposited into a reserve account established
pursuant to the agreement, less allowances and fees.  In the event of
default, valid payment dispute, breach of warranty, insolvency or bankruptcy on
the part of the receivable account, the factor can require the receivable to be
repurchased by us in accordance with the Factoring Agreement.  The
amounts to be paid by us to WCS for any accepted receivable include a factoring
fee of 0.6% for each ten (10) day period the account is open.  For the
nine months ended September 30, 2010 and 2009, we sold approximately $17.8
million $0, respectively, of receivables to WCS with recourse and paid fees of
$494,000 during the 2010 period.  At September 30, 2010 and December
31, 2009, accounts receivable and due from WCS included approximately $6.5
million and approximately $1.4 million, respectively, of amounts due from our
customers to WCS.  WCS had an advance outstanding to the Company of
approximately $4.6 million and $900,000 as of September 30, 2010 and December
31, 2009, respectively.




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




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




Purchase
Order Facility




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


12




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




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




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




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




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


13




July
2010 Equity Raise




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




Other




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




Zoo
Entertainment Notes




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




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




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


14




Zoo
Publishing Notes




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




As part
of the acquisition of Zoo Publishing, Zoo Games was required to pay $1,200,000
to an employee of Zoo Publishing.  Of that amount, as of September 30,
2010, Zoo Games paid $580,000 and $620,000 will be paid on July 31, 2011, (See
Note 8) in cash or our common stock based on the fair market value of our common
stock as of July 31, 2011, at the election of Zoo Games.




Zoo
Publishing has additional debt outstanding which debt existed prior to Zoo
Games’ acquisition of that subsidiary.  As of September 30, 2010, Zoo
Publishing owed approximately $270,000 as a result of the repurchase of certain
stock from a former stockholder.  The terms of this note are repayment
in monthly increments of $10,000.




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




Critical
Accounting Policies and Estimates




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




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


15




Revenue
Recognition




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




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




Allowances
for Returns and Price Concessions




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




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




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




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




Inventory




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




Product
Development Costs




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


16




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




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




Licenses
and Royalties




Licenses
consist of payments and guarantees made to holders of intellectual property
rights for use of their trademarks, copyrights, technology or other intellectual
property rights in the development of our products.  Agreements with
holders of intellectual property rights generally provide for guaranteed minimum
royalty payments for use of their intellectual property.  When
significant performance remains to be completed by the licensor, we record
payments when actually paid.  Certain licenses extend over multi-year
periods and encompass multiple game titles.  In addition to guaranteed
minimum payments, these licenses frequently contain provisions that could
require us to pay royalties to the license holder, based on pre-agreed unit
sales thresholds.




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




Asset
Impairment




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


17




Stock-based
Compensation




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




Income
Taxes




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




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




Recently
Issued Accounting Pronouncements




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




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




Accounting
Standards Updates Not Yet Effective




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


18




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.


19




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.


20




ITEM
1A.  RISK FACTORS.




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




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




None.




ITEM
3.  DEFAULTS UPON SENIOR SECURITIES.




None.




ITEM
4. (Removed and Reserved).




ITEM
5.  OTHER INFORMATION.




None.




ITEM
6.  EXHIBITS .




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


31.1
            Certification
      of Chief Executive Officer.


31.2
            Certification
      of Chief Financial Officer.


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


21




SIGNATURES




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




Dated:
November 12, 2010




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


22




EXHIBIT
INDEX




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


31.1
            Certification
      of Chief Executive Officer.


31.2
            Certification
      of Chief Financial Officer.


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


23