UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.   20549







FORM
10-Q


(Mark
One)





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





For the
quarterly period ended June 30, 2009





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


For the
transition period from _____________ to ___________


Commission
file number 333-124829





ZOO
ENTERTAINMENT, INC.


(Exact
name of Registrant as Specified in Its Charter)


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





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





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


Yes
 x  No
  ̈





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





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




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




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





As of
August 14, 2009, there were 38,243,937 shares of the Registrant’s common stock,
par value $0.001 per share, issued and 30,442,611 shares
outstanding.









ZOO
ENTERTAINMENT, INC.




Table
of Contents





PagePART
      I - FINANCIAL INFORMATIONItem
      1.
                        Financial
      StatementsCondensed
      Consolidated Balance Sheets as of June 30, 2009 (Unaudited) and December
      31, 2008
                        F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three and Six
      Months Ended June 30, 2009 and 2008
                        F-
      2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended
      June 30, 2009 and 2008
                        F-
      3Condensed
      Consolidated Statement of Stockholders’ Equity (Unaudited) for the Six
      Months Ended June 30, 2009
                        F-
      4Notes
      to Condensed Consolidated Financial Statements
                        F-
      5 - F-23Item
      2.
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        1Item
      3.
                        Quantitative
      and Qualitative Disclosure About Market Risk
                        11Item
      4T.
                        Controls
      and Procedures
                        11PART
      II - OTHER INFORMATIONItem
      1.
                        Legal
      Proceedings
                        13Item
      1A.
                        Risk
      Factors
                        13Item
      2.
                        Unregistered
      Sales of Equity Securities and Use of Proceeds
                        13Item
      3.
                        Defaults
      Upon Senior Securities
                        14Item
      4.
                        Submission
      of Matters to a Vote of Security Holders
                        14Item
      5.
                        Other
      Information
                        14Item
      6.
                        Exhibits
                        14Signatures
                        15







Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


(In
Thousands Except Share and Per Share Amounts)





June 30, 2009
                                    
                                    
                                    December 31, 2008 *(Unaudited)ASSETSCurrent
      assets:Cash
                                    
                                    $
                                    484
                                    
                                    
                                    $
                                    849Accounts
      receivable, net of allowances for returns and discounts of $576 and
      $1,160
                                    
                                    
                                    530
                                    
                                    
                                    
                                    1,832Inventory
                                    
                                    
                                    1,689
                                    
                                    
                                    
                                    3,120Prepaid
      expenses and other current assets
                                    
                                    
                                    1,604
                                    
                                    
                                    
                                    2,124Product
      development costs, net
                                    
                                    
                                    5,272
                                    
                                    
                                    
                                    5,338Deferred
      tax asset
                                    
                                    
                                    659
                                    
                                    
                                    
                                    688Total
      current assets
                                    
                                    
                                    10,238
                                    
                                    
                                    
                                    13,951Fixed
      assets, net
                                    
                                    
                                    226
                                    
                                    
                                    
                                    214Goodwill
                                    
                                    
                                    14,704
                                    
                                    
                                    
                                    14,704Intangible
      assets, net
                                    
                                    
                                    16,686
                                    
                                    
                                    
                                    14,747Total
      assets
                                    
                                    $
                                    41,854
                                    
                                    
                                    $
                                    43,616LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
                                    
                                    $
                                    6,425
                                    
                                    
                                    $
                                    5,709Financing
      arrangements
                                    
                                    
                                    142
                                    
                                    
                                    
                                    849Accrued
      expenses and other current liabilities
                                    
                                    
                                    5,465
                                    
                                    
                                    
                                    5,167Notes
      payable, net of discount of $0 and $145 - current
    portion
                                    
                                    
                                    120
                                    
                                    
                                    
                                    1,803Convertible
      notes payable, net of discount of $180 and $1,576
                                    
                                    
                                    10,970
                                    
                                    
                                    
                                    9,574Total
      current liabilities
                                    
                                    
                                    23,122
                                    
                                    
                                    
                                    23,102Notes
      payable, net of discount of $0 and $885 - non current
      portion
                                    
                                    
                                    190
                                    
                                    
                                    
                                    1,772Deferred
      tax liability
                                    
                                    
                                    659
                                    
                                    
                                    
                                    688Other
      long-term liabilities
                                    
                                    
                                    2,920
                                    
                                    
                                    
                                    620Total
      liabilities
                                    
                                    
                                    26,891
                                    
                                    
                                    
                                    26,182Commitments
      and contingenciesStockholders'
      equity:Preferred
      stock, par value $0.001, 5,000,000 shares authorized, none issued and
      outstanding
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Common
      stock, par value $0.001, 75,000,000 shares authorized, 38,243,937
      issued and 30,442,611 outstanding June 30, 2009 and 38,243,937 issued and
      36,006,561 outstanding December 31, 2008
                                    
                                    
                                    38
                                    
                                    
                                    
                                    38Additional
      paid-in-capital
                                    
                                    
                                    52,736
                                    
                                    
                                    
                                    52,692Accumulated
      deficit
                                    
                                    
                                    (33,341)
                                    
                                    
                                    
                                    (31,940
                                    )Treasury
      stock, at cost , 7,801,326 shares June 30, 2009 and 2,237,376 shares
      December 31, 2008
                                    
                                    
                                    (4,469)
                                    
                                    
                                    
                                    (3,356
                                    )Other
      comprehensive loss
                                    
                                    
                                    (1)
                                    
                                    
                                    
                                    —Total
      stockholders' equity
                                    
                                    
                                    14,963
                                    
                                    
                                    
                                    17,434Total
      liabilities and stockholders' equity
                                    
                                    $
                                    41,854
                                    
                                    
                                    $
                                    43,616





* Derived
from audited financials





See
accompanying notes to condensed consolidated financial
statements


F-1





Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statements of Operations (Unaudited)


(In
Thousands Except Share and Per Share Amounts)





Three Months Ended June 30,
                
                
                Six Months Ended June 30,2009
                
                
                2008
                
                
                2009
                
                
                2008Revenue
                
                $
                7,669
                
                
                $
                5,470
                
                
                $
                21,553
                
                
                $
                14,499Cost
      of goods sold
                
                
                7,742
                
                
                
                4,406
                
                
                
                19,225
                
                
                
                13,213Gross
      profit (loss)
                
                
                (73
                )
                
                
                1,064
                
                
                
                2,328
                
                
                
                1,286Operating
      expenses:General
      and administrative expenses
                
                
                1,866
                
                
                
                2,280
                
                
                
                3,260
                
                
                
                3,399Selling
      and marketing expenses
                
                
                662
                
                
                
                1,053
                
                
                
                1,525
                
                
                
                1,917Research
      and development expenses
                
                
                290
                
                
                
                585
                
                
                
                370
                
                
                
                1,479Depreciation
      and amortization
                
                
                435
                
                
                
                443
                
                
                
                869
                
                
                
                891Total
      operating expenses
                
                
                3,253
                
                
                
                4,361
                
                
                
                6,024
                
                
                
                7,686Loss
      from operations
                
                
                (3,326
                )
                
                
                (3,297
                )
                
                
                (3,696
                )
                
                
                (6,400
                )Interest
      expense, net
                
                
                (1,000
                )
                
                
                (592
                )
                
                
                (2,033
                )
                
                
                (979
                )Gain
      on legal settlement
                
                
                4,328
                
                
                
                —
                
                
                
                4,328
                
                
                
                —Income
      (loss) from continuing operations before income tax
benefit
                
                
                2
                
                
                
                (3,889
                )
                
                
                (1,401
                )
                
                
                (7,379
                )Income
      tax benefit
                
                
                —
                
                
                
                1,058
                
                
                
                —
                
                
                
                1,058Income
      (loss) from continuing operations
                
                
                2
                
                
                
                (2,831
                )
                
                
                (1,401
                )
                
                
                (6,321
                )Loss
      from discontinued operations
                
                
                —
                
                
                
                (1,861
                )
                
                
                —
                
                
                
                (2,548
                ))Net
      income (loss)
                
                $
                2
                
                
                $
                (4,692
                )
                
                $
                (1,401
                )
                
                $
                (8,869
                )Earnings
      (loss) per share – basic and diluted:Continuing
      operations
                
                $
                0.00
                
                
                $
                (0.15
                )
                
                $
                (0.04
                )
                
                $
                (0.35
                )Discontinued
      operations
                
                
                —
                
                
                
                (0.10
                )
                
                
                —
                
                
                
                (0.14
                )Net
      income (loss)
                
                $
                0.00
                
                
                $
                (0.24
                )
                
                $
                (0.04
                )
                
                $
                (0.49
                )Weighted
      average shares outstanding:Basic
      and diluted
                
                
                35,211,711
                
                
                
                19,388,544
                
                
                
                35,606,940
                
                
                
                17,995,055





See
accompanying notes to condensed consolidated financial
statements


F-2





Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statements of Cash Flow (Unaudited)


(In
Thousands)





Six Months Ended June 30,2009
                    
                    
                    2008Operating
      Activities:Net
      loss
                    
                    $
                    (1,401
                    )
                    
                    $
                    (8,869
                    )Loss
      from discontinued operations
                    
                    
                    —
                    
                    
                    
                    (2,548
                    )Net
      loss from continuing operations
                    
                    
                    (1,401
                    )
                    
                    
                    (6,321
                    )Adjustments
      to reconcile net loss from continuing operations to net cash provided by
      (used in) operating activities:Gain
      on legal settlement
                    
                    
                    (4,328
                    )
                    
                    
                    —Depreciation
      and amortization
                    
                    
                    869
                    
                    
                    
                    891Amortization
      of deferred debt discount
                    
                    
                    1,690
                    
                    
                    
                    799Deferred
      income taxes
                    
                    
                    —
                    
                    
                    
                    (892
                    )Stock
      based compensation
                    
                    
                    244
                    
                    
                    
                    354Other
      changes in assets and liabilities, net
                    
                    
                    3,488
                    
                    
                    
                    391Net
      cash provided by (used in) continuing operations
                    
                    
                    562
                    
                    
                    
                    (4,778
                    )Net
      cash used in discontinued operations
                    
                    
                    —
                    
                    
                    
                    (2,729
                    )Net
      cash provided by (used in) operating activities
                    
                    
                    562
                    
                    
                    
                    (7,507
                    )Investing
      activities:Purchases
      of fixed assets
                    
                    
                    (58
                    )
                    
                    
                    (75
                    )Purchases
      of intangible assets
                    
                    
                    (162
                    )
                    
                    
                    —Net
      cash used in investing activities
                    
                    
                    (220
                    )
                    
                    
                    (75
                    )Financing
      activities:Proceeds
      from sale of equity securities
                    
                    
                    —
                    
                    
                    
                    6,118Net
      (repayments) borrowings in connection with financing
      facilities
                    
                    
                    (707
                    )
                    
                    
                    2,000Net
      cash (used in) provided by financing activities
                    
                    
                    (707
                    )
                    
                    
                    8,118(Decrease)
      increase in cash
                    
                    
                    (365
                    )
                    
                    
                    536Cash
      at beginning of period
                    
                    
                    849
                    
                    
                    
                    138Cash
      at end of period
                    
                    $
                    484
                    
                    
                    $
                    674





See
accompanying notes to condensed consolidated financial
statements


F-3


Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Statement of Stockholders' Equity (Unaudited)


For
the Six Months Ended June 30, 2009


(In
Thousands)





Accumulated
                            OtherPreferred Stock
                          
                          
                          Common Stock
                          
                          
                          Additional
                          
                          
                          Accumulated
                          
                          
                          Treasury Stock
                          
                          
                          ComprehensiveShares
                          
                          
                          Par
                            Value
                          
                          
                          Shares
                            Issued
                          
                          
                          Par
                            Value
                          
                          
                          Paid-in-
                            Capital
                          
                          
                          Deficit
                          
                          
                          Shares
                          
                          
                          Cost
                          
                          
                          Loss
                          
                          
                          TotalBalance
      December 31, 2008
                          
                          
                          —
                          
                          
                          $
                          —
                          
                          
                          
                          38,244
                          
                          
                          $
                          38
                          
                          
                          $
                          52,692
                          
                          
                          $
                          (31,940
                          )
                          
                          
                          2,237
                          
                          
                          $
                          (3,356
                          )
                          
                          $
                          -
                          
                          
                          $
                          17,434Stock-based
      compensation
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          44
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          44Value
      of shares returned to treasury from settlement of
    litigation
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          5,564
                          
                          
                          
                          (1,113
                          )
                          
                          
                          
                          
                          
                          
                          (1,113
                          )Net
      loss
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (1,401
                          )
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (1,401
                          )Adjustment
      for foreign currency translation
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (1
                          )
                          
                          
                          (1
                          )Balance
      June 30, 2009
                          
                          
                          —
                          
                          
                          $
                          —
                          
                          
                          
                          38,244
                          
                          
                          $
                          38
                          
                          
                          $
                          52,736
                          
                          
                          $
                          (33,341
                          )
                          
                          
                          7,801
                          
                          
                          $
                          (4,469
                          )
                          
                          $
                          (1
                          )
                          
                          $
                          14,963





See
accompanying notes to condensed consolidated financial statements




F-4




ZOO
ENTERTAINMENT, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)





NOTE
1.   DESCRIPTION OF ORGANIZATION AND REVERSE MERGER





Zoo
Entertainment, Inc., (“Zoo” or the “Company”) was incorporated under the laws of
the State of Nevada on February 13, 2003 under the name Driftwood Ventures,
Inc. On December 20, 2007, the Company reincorporated in Delaware and
increased its authorized capital stock from 75,000,000 shares to 80,000,000
shares, consisting of 75,000,000 shares of common stock, par value $0.001, per
share, and 5,000,000 shares of preferred stock, par value $0.001, per share. No
terms have been established for the preferred stock. The Company was engaged in
acquiring and exploring mineral properties until September 30, 2007 when this
activity was abandoned. The Company had been inactive until July 7, 2008
when the Company entered into an Agreement and Plan of Merger, as subsequently
amended on September 12, 2008, with DFTW Merger Sub, Inc., a Delaware
corporation and a wholly-owned subsidiary of the Company (“Merger Sub”), Zoo
Games, Inc. (“Zoo Games”) (formerly known as Green Screen Interactive Software,
Inc.) and a stockholder representative, pursuant to which Merger Sub would merge
with and into Zoo Games, with Zoo Games as the surviving corporation through an
exchange of common stock of Zoo Games for common stock of the Company (the
“Merger”). On December 3, 2008, Driftwood Ventures, Inc. changed its name to Zoo
Entertainment, Inc.





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





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





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


F-5





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





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





NOTE
2.   GOING CONCERN





These
consolidated financial statements have been prepared assuming the Company
will continue as a going concern. The Company has incurred losses since
inception, resulting in an accumulated deficit of approximately $33.3
million and a working capital deficiency of approximately $12.9 million at
June 30, 2009. For the six months ended June 30, 2009 the Company generated
$562,000 of cash flow from operations, but for the year ended December 31, 2008,
the Company generated negative cash flows from operations of approximately $12.1
million. Although the Company’s business plan anticipates the generation of
positive cash flow, there is no assurance that it will succeed in doing
so.  An inability to meet its business goals would raise substantial
doubt as to the Company's ability to continue as a going concern. In addition,
the Company has various promissory notes maturing in August 2009 and September
2009 with an aggregate face value of approximately $11.2 million.  On June
26, 2009, the Company entered into an agreement with its Senior Secured
Convertible Note holders whereby they agreed to convert their notes into equity
on or before August 31, 2009, contingent on the Company raising at least $4
million in new capital and the effectiveness of the filing of an amendment to
the Company’s Certificate of Incorporation authorizing a sufficient number of
shares of the Company’s common stock to permit the conversion of the
notes.





The
Company’s ability to continue as a going concern is dependent on among other
factors, the following major short term actions:  (i) its ability to
generate cash flow from operations sufficient to maintain its daily business
activities (ii) its ability to raise capital from outside sources through the
sale of equity or debt instruments primarily to fund the ongoing development and
acquisition of new games and (iii) the restructuring of its maturing note
obligations. Management’s active efforts in this regard include the retaining of
a registered broker dealer to raise up to $7 million in an unregistered private
placement, trade arrangements for advance payments secured by future sales, an
agreement with its note holders as detailed above, as well as operational steps
to increase cash flow through an increase in both the quantity and quality of
its product releases.  There can be no assurance that all or any of
these actions will meet with success.





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





NOTE
3.   BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING
POLICIES





Principles
of Consolidation and Interim Financial Information





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





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


F-6





Use
of Estimates




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





Concentration
of Credit Risk





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





If the
financial condition and operations of our customers deteriorate, our risk of
collection could increase substantially. A majority of our trade receivables are
derived from sales to major retailers and distributors. In October 2008, we
entered into an agreement with Atari, Inc. where sales from October 24, 2008
through March 31, 2009 for all customers that Atari deemed acceptable would be
through Atari and Atari would prepay us for the cost of goods and they would
bear the credit risk from the ultimate customer. This agreement was
subsequently amended to include sales to certain customers through March 31,
2010. As of June 30, 2009, Atari had prepaid us approximately $787,000 which is
included in customer advances in the accrued expenses and other current
liabilities in the condensed consolidated balance sheet and the receivable due
from Atari was approximately $1.0 million, before allowances, which is included
in accounts receivable in the condensed consolidated balance
sheet.  Our five largest ultimate customers for the six months ended
June 30, 2009 accounted for approximately 79% of the gross revenue for the
period. We believe that the receivable balances from Atari and our ultimate
customers do not represent a significant credit risk based on past collection
experience. There were no receivables from our factor included in our gross
accounts receivable as of June 30, 2009 and December 31, 2008. We regularly
review our outstanding receivables for potential bad debts and have had no
history of significant write-offs due to bad debts.





Inventory





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





Product
Development Costs





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





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





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


F-7


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





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





Prior to
establishing technological feasibility, we expense research and development
costs as incurred. During the three months ended June 30, 2009 and 2008, we
wrote-off $290,000 and $585,000, respectively and during the six months ended
June 30, 2009 and 2008, we wrote-off $370,000 and $1.5 million, respectively, of
expense relating to costs incurred for the development of games that were
abandoned during those periods. Those costs are included in our statement
of operations under research and development expenses.





Licenses
and Royalties





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





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





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





Goodwill
and Intangible Assets





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





The
Company accounts for its goodwill in accordance with Statement of Financial
Accounting Standards 142, “Goodwill and Other Intangibles.” Under this
standard, the Company is required to perform a goodwill impairment test at least
on an annual basis and whenever events or changes in circumstances indicate that
the carrying value may not be recoverable from estimated future cash
flows. We will perform tests of impairment in the fourth quarter of each
fiscal year or earlier if indicators of impairment exist. We determine the
fair value of each reporting unit using a discounted cash flow analysis and
compare such values to the respective reporting unit's carrying
amount.


F-8





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





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





Revenue
Recognition





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





We
recognize Publishing Revenue upon the transfer of title and risk of loss to our
customers. We apply the provisions of Statement of Position 97-2, "Software
Revenue Recognition", in conjunction with the applicable provisions of Staff
Accounting Bulletin No. 104, "Revenue Recognition." Accordingly, we recognize
revenue for software titles when there is (1) persuasive evidence that an
arrangement with the customer exists, which is generally a customer purchase
order, (2) the product is delivered, (3) the selling price is fixed or
determinable and (4) collection of the customer receivable is deemed
probable. Our payment arrangements with customers typically provide net 30 and
60-day terms. Advances received from customers are reported on the consolidated
balance sheet as customer advances, included in current liabilities until we
meet our performance obligations, at which point we recognize the
revenue.





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





Allowances
for Returns, Price Concessions and Other Allowances





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





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





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





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


F-9


Consideration
Given to Customers and Received from Vendors





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





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





Equity-Based
Compensation





We issued
options to purchase shares of common stock of the Company to certain management
and employees during 2009 and 2008. In accordance with SFAS 123(R), Share-Based
Payment, we record compensation expense over the requisite service period based
on their relative fair values.





The fair
value of our equity-based compensation is estimated using the Black-Scholes
option-pricing model. This model requires the input of assumptions regarding a
number of complex and subjective variables that will usually have a significant
impact on the fair value estimate. These variables include, but are not limited
to, the volatility of our stock price and estimated exercise behavior. The
assumptions and variables used for the current period grants were developed
based on SFAS 123(R) and Securities and Exchange Commission (“SEC”)
guidance contained in Staff Accounting Bulletin (SAB) No. 107, "Share-Based
Payment." The following table summarizes the assumptions and variables used by
us to compute the weighted average fair value of stock option
grants:





For the Six
      MonthsEnded June 30,2009
                        
                        
                        2008Risk-free
      interest rate
                        
                        
                        3.52
                        %
                        
                        
                        3.45
                        %Expected
      stock price volatility
                        
                        
                        70.0
                        %
                        
                        
                        45.0
                        %Expected
      term until exercise (years)
                        
                        
                        5
                        
                        
                        
                        5Dividends
                        
                        None
                        
                        
                        None





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





Earnings
(Loss) Per Share





Basic
earnings (loss) per share ("EPS") is computed by dividing the net loss
applicable to common stockholders for the period by the weighted average number
of shares of common stock outstanding during the same period. Diluted EPS is
computed by dividing the net income applicable to common stockholders for the
period by the weighted average number of shares of common stock outstanding and
common stock equivalents, which includes warrants and options outstanding during
the same period. Since the inclusion of the 6,502,159 warrants and 2,589,811
options outstanding as of June 30, 2009 and the 1,588,967 warrants and 2,139,324
options outstanding as of June 30, 2008 are anti-dilutive because of losses, the
dilutive loss per share is the same as the basic loss per share.





Income
Taxes





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


F-10


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





Fair
Market Value of Financial Instruments





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





Recently
Issued Accounting Pronouncements





In
December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements” (“SFAS No. 160”), which is an amendment of
Accounting Research Bulletin No. 51. This statement clarifies that a
non-controlling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as equity in the consolidated
financial statements. This statement changes the way the consolidated income
statement is presented, thus requiring consolidated net income to be reported at
amounts that include the amounts attributable to both parent and the
non-controlling interest. This statement is effective for the fiscal years, and
interim periods within those fiscal years, beginning on or after December 15,
2008. The adoption of SFAS No. 160 did not have a significant impact on our
results of operations or financial position.





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations” (“SFAS No. 141R”). This statement replaces FASB Statement No. 141,
“Business Combinations.” This statement retains the fundamental requirements in
SFAS 141 that the acquisition method of accounting (which SFAS No. 141 called
the purchase method) be used for all business combinations and for an acquirer
to be identified for each business combination. This statement defines the
acquirer as the entity that obtains control of one or more businesses in the
business combination and establishes the acquisition date as the date that the
acquirer achieves control. This statement requires an acquirer to recognize the
assets acquired, the liabilities assumed, and any non-controlling interest in
the acquiree at the acquisition date, measured at their fair values as of that
date, with limited exceptions specified in the statement. This statement applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. The adoption of SFAS No. 141R has not had a significant
impact on our results of operations or financial position.





In
February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB
Statement No. 15” (“FSP FAS 157-2”). FSP FAS 157-2 delays the effective
date of SFAS No. 157, “Fair Value Measurements”, for certain nonfinancial
assets and nonfinancial liabilities, except those that are recognized or
disclosed at fair value in the financial statements on a recurring basis (at
least annually). SFAS No. 157 establishes a framework for measuring fair
value and expands disclosures about fair value measurements. FSP FAS 157-2
defers the effective date of certain provisions of SFAS No. 157 to fiscal
years beginning after November 15, 2008, and interim periods within those
fiscal years, for items within the scope of this FSP. The adoption of FSP FAS
157-2 did not have a significant impact on our results of operations or
financial position.





In
April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful
Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors
an entity should consider in developing renewal or extension assumptions used in
determining the useful life of recognized intangible assets under SFAS
No. 142, “Goodwill and Other Intangible Assets.” This guidance for
determining the useful life of a recognized intangible asset applies
prospectively to intangible assets acquired individually or with a group of
other assets in either an asset acquisition or business combination. FSP FAS
142-3 is effective for fiscal years, and interim periods within those fiscal
years, beginning after December 15, 2008, and early adoption is prohibited.
The adoption of FSP FAS 142-3 did not have a significant impact on our results
of operations and financial position.





In
May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally
Accepted Accounting Principles” (“FAS 162”). FAS 162 is intended to improve
financial reporting by identifying a consistent framework, or hierarchy, for
selecting accounting principles to be used in preparing financial statements
that are presented in conformity with GAAP for nongovernmental entities. FAS 162
is effective 60 days following the SEC’s approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, “The Meaning of
Present Fairly in Conformity with Generally Accepted Accounting Principles.” We
do not expect the adoption of this statement to have a significant impact on our
results of operations or financial position.


F-11





On May 9,
2008, the FASB issued Staff Position ("FSP") APB 14-1, “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlements)” (“FSP APB 14-1”), which clarifies that
convertible debt instruments that may be settled in cash upon conversion
(including partial cash settlement) are not addressed by paragraph 12 of APB
Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants. The FSP specifies that issuers of such instruments should
separately account for the liability and equity components in a manner that will
reflect the entity's nonconvertible debt borrowing rate when interest cost is
recognized in subsequent periods. FSP APB 14-1 is effective for financial
statements issued for fiscal years beginning after December 15, 2008 and interim
periods within those fiscal years. The adoption of FSP APB 14-l did not have a
significant impact on our results of operations or financial
position.





Effective
January 1, 2009, the Company adopted EITF Issue No. 07-05,
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity’s Own Stock” (“EITF Issue No. 07-05”). EITF Issue No. 07-05
clarifies the determination of whether an instrument (or an embedded feature) is
indexed to an entity’s own stock, which would qualify as a scope exception under
SFAS No. 133. The adoption of EITF Issue No. 07-05 did not have a
significant impact on our results of operations or financial
position.





On
May 28, 2009, the FASB issued Statement No. 165, “Subsequent Events”
("SFAS No. 165"). Although SFAS No. 165 does not significantly change
current practice surrounding the disclosure of subsequent events, it provides
guidance on management's assessment of subsequent events and the requirement to
disclose the date through which subsequent events have been evaluated. SFAS
No. 165 became effective for the quarter ended June 30, 2009. The
Company has evaluated subsequent events through August 14, 2009 for this
quarterly report on Form 10-Q for the quarter ended June 30, 2009. The
adoption of SFAS No. 165 did not have any impact on the Company's
consolidated financial position or results of operations.





In June
2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles – a replacement of
FASB Statement No. 162” (FAS 168).  FAS 168 stipulates the FASB
Accounting Standards Codification is the single source of authoritative GAAP for
all non-governmental entities, with the exception of the SEC and its
staff.  FAS 168 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 is not expected to have any impact on the Company’s financial
condition or results of operations.





NOTE
4.   DISCONTINUED OPERATIONS





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





(Amounts in Thousands)Three Months
                            Ended June 30,
                            2008
                          
                          
                          Six Months
                            Ended June
                            30, 2008Supervillain
                          
                          $
                          1,111
                          
                          
                          $
                          1,530Zoo
      Digital
                          
                          
                          677
                          
                          
                          
                          677Repliqa
                          
                          
                          25
                          
                          
                          
                          219On-line
      concept
                          
                          
                          48
                          
                          
                          
                          122Loss
      from discontinued operations
                          
                          $
                          1,861
                          
                          
                          $
                          2,548





The
revenues from the discontinued operations for the three and six months ended
June 30, 2008 were 785,000 and $988,000, respectively.





NOTE
5.   INVENTORY





Inventory
consisted of:




(Amounts in Thousands)June 30,
                            
                            
                            December 31,2009
                            
                            
                            2008Finished
      products
                            
                            $
                            1,577
                            
                            
                            $
                            2,939Parts
      and supplies
                            
                            
                            112
                            
                            
                            
                            181Total
                            
                            $
                            1,689
                            
                            
                            $
                            3,120


F-12


Estimated
product returns included in inventory at June 30, 2009 and December 31, 2008
were $182,000 and $337,000, respectively.





NOTE
6.   PREPAID EXPENSES AND OTHER CURRENT ASSETS





Prepaid
expense and other current assets consisted of:





(Amounts in Thousands)June 30, 2009
                      
                      
                      December 31, 2008Vendor
      advances for inventory
                      
                      $
                      180
                      
                      
                      $
                      555Prepaid
      royalties
                      
                      
                      1,148
                      
                      
                      
                      1,072Income
      taxes receivable
                      
                      
                      -
                      
                      
                      
                      55Other
      prepaid expenses
                      
                      
                      276
                      
                      
                      
                      442Total
                      
                      $
                      1,604
                      
                      
                      $
                      2,124





NOTE
7.   PRODUCT DEVELOPMENT COSTS





Details
of our capitalized product development costs were as follows:





(Amounts in Thousands)June30,2009
                        
                        
                        December31,2008Product
      development costs, internallydeveloped,
      net of amortization
                        
                        $
                        80
                        
                        
                        $
                        170Product
      development costs, externally developed, net of
    amortization
                        
                        $
                        5,192
                        
                        
                        
                        5,168Total
                        
                        $
                        5,272
                        
                        
                        $
                        5,338




NOTE
8.   INTANGIBLE ASSETS, NET





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





(Amounts in Thousands)June30,2009
                          
                          
                          December31,2008EstimatedUseful
                          
                          GrossLives
                          
                          Carrying
                          
                          
                          Accumulated
                          
                          
                          Net Book
                          
                          
                          Net Book(Years)
                          
                          Amount
                          
                          
                          Amortization
                          
                          
                          Value
                          
                          
                          ValueContent
                          
                          10
                          
                          $
                          14,965
                          
                          
                          $
                          1,881
                          
                          
                          $
                          13,084
                          
                          
                          $
                          10,931Trademarks
                          
                          10
                          
                          
                          1,510
                          
                          
                          
                          233
                          
                          
                          
                          1,277
                          
                          
                          
                          1,353Customer
      relationships
                          
                          10
                          
                          
                          2,749
                          
                          
                          
                          424
                          
                          
                          
                          2,325
                          
                          
                          
                          2,463Total
                          
                          
                          
                          $
                          19,224
                          
                          
                          $
                          2,538
                          
                          
                          $
                          16,686
                          
                          
                          $
                          14,747





Amortization
expense related to intangible assets was $412,000 for the three months ended
June 30, 2009 and 2008 and was $823,000 for the six months ended June 30,
2009 and 2008.





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


F-13


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





(Amounts in Thousands)Year ending December 31,Balance
      of 2009
                          
                          $
                          5502010
                          
                          
                          1,9222011
                          
                          
                          1,9222012
                          
                          
                          1,9222013
                          
                          
                          1,922Thereafter
                          
                          
                          8,448Total
                          
                          $
                          16,686





NOTE
9.   CREDIT AND FINANCING ARRANGEMENTS AND ATARI
AGREEMENT





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




The
Company and Zoo Publishing entered into a purchase order financing agreement
with Transcap Trade Finance, LLC (“Transcap”) on December 19, 2007. This
agreement made the Company a party to a Master Purchase Order Assignment
Agreement dated August 20, 2001 pursuant to which Transcap agreed to provide
purchase order financing to or for the benefit of Zoo Publishing. Total advances
under the factoring arrangement include letters of credit for purchase order
financing and is limited to $10.0 million. The amounts outstanding as of
June 30, 2009 and December 31, 2008 were $142,000 and $855,000, respectively.
The interest rate is prime plus 4.0% on outstanding advances. As of June 30,
2009 and December 31, 2008, the effective interest rates were
7.25%.  The charges and interest expense on the advances are included
in the cost of goods sold in the accompanying condensed consolidated statement
of operations.




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





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


F-14


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





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





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





Additionally,
pursuant to the Fee Letters, the Company agreed to grant under the Company’s
2007 Employee, Director and Consultant Stock Plan, as amended to each of Messrs.
Seremet and Rosenbaum, on such date that is the earlier of the conversion of at
least 25% of all currently existing convertible debt of the Company into equity,
or November 8, 2009 (the earlier of such date, the “Grant Date”), an option to
purchase that number of shares of the Company’s common stock equal to 6% and 3%
respectively, of the then issued and outstanding shares of common stock, based
on a fully diluted current basis assuming those options and warrants that have
an exercise price below $0.40 per share are exercised on that date but not
counting the potential conversion to equity of any outstanding convertible notes
that have not yet been converted and, inclusive of any options or other equity
securities or securities convertible into equity securities of the Company that
each may own on the Grant Date. The options shall be issued at an exercise
price equal to the fair market value of the Company’s common stock on the Grant
Date and pursuant to the Company’s standard form of nonqualified stock option
agreement; provided however that in the event the Guaranty has not been released
by Wells Fargo Bank as of the date of the termination of the option due to
termination of service, the option termination date shall be extended until the
earlier of the date of the release of the Guaranty or the expiration of the ten
year term of the option. In addition any options owned by Messrs. Seremet
and Rosenbaum as of the Grant Date with an exercise price that is higher than
the exercise price of the new options shall be cancelled as of the Grant
Date.  The Company estimated the value of the arrangements to be
approximately $200,000 as of June 30, 2009 and is included as compensation in
the three and six months ended June 30, 2009, and has been included in accrued
expenses.  Once the options are issued, we will adjust the expense
accordingly.





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
new factoring agreement with Working Capital Solutions, Inc., which utilizes
existing accounts receivable in order to provide working capital to fund all
aspects of our continuing business operations. Under the terms of our factoring
and security agreement, we sell our receivables to the factor, with recourse.
The factor, in its sole discretion, determines whether or not it will accept
each receivable based upon the credit risk factor of each individual receivable
or account. Once a receivable is accepted by the factor, the factor provides
funding subject to the terms and conditions of the factoring and security
agreement. The amount remitted to us by the factor equals the invoice amount of
the receivable adjusted for any discounts or allowances provided to the account,
less 20% which is deposited into a reserve account established pursuant to the
agreement, less allowances and fees. In the event of default, valid payment
dispute, breach of warranty, insolvency or bankruptcy on the part of the
receivable account, the factor can require the receivable to be repurchased by
us in accordance with the agreement. The amounts to be paid by us to the factor
for any accepted receivable include a factoring fee of 0.6% for each ten (10)
day period the account is open.  Since the factor acquires the
receivables with recourse, we record the gross receivables including amounts due
from our customers to the factor and we record a liability to the factor for
funds advanced to us from the factor. At June 30, 2009 and December 31,
2008, accounts receivable did not include any amounts due from our customers to
the factor and the factor did not have any advance outstanding to the Company.
This facility is guaranteed by the Company’s President.


F-15





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari will
resell the products to wholesalers and retailers that are acceptable to Atari in
North America. The agreement initially expired on March 31, 2009, but was
amended to extend the term for certain customers until March 31,
2010.  This agreement provided for Atari to prepay to the Company for
the cost of goods and pay the balance due within 15 days of shipping the
product.  Atari’s fees approximate 10% of our standard selling price
and they have been recorded as a reduction in revenue.  During the
three and six months ended June 30, 2009, we recorded approximately $7.3
million and $21.0 million, respectively, of net sales to Atari.  Atari
takes a reserve from the initial payment for potential customer sales
allowances, returns and price protection that is analyzed and reviewed within a
sixty day period to be liquidated no later than July 31, 2010.  As of
June 30, 2009 and December 31, 2008, Atari had prepaid the Company $787,000
and approximately $1.8 million, respectively, for goods not yet shipped which is
recorded as customer advances in accrued expenses and other current
liabilities.  Also, as of June 30, 2009 and December 31, 2008,
Atari owed the Company approximately $1.0 million and $1.8 million,
respectively, before allowances, for goods already shipped which are recorded in
accounts receivable.





NOTE
10.   ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES





Accrued
expenses and other current liabilities consisted of:





(Amounts in Thousands)June 30, 2009
                                              
                                              
                                              December 31, 2008Customer
      advances ($787 in 2009 and $1,828 in 2008 is from Atari)
                                              
                                              $
                                              828
                                              
                                              
                                              $
                                              1,828Due
      to customers
                                              
                                              
                                              2,183
                                              
                                              
                                              
                                              710Obligation
      arising from Zoo Publishing acquisition
                                              
                                              
                                              153
                                              
                                              
                                              
                                              254Obligations
      relating to Cyoob acquisition
                                              
                                              
                                              100
                                              
                                              
                                              
                                              100Obligations
      to compensate current and former employees
                                              
                                              
                                              684
                                              
                                              
                                              
                                              720Royalty
                                              
                                              
                                              600
                                              
                                              
                                              
                                              252Operating
      expenses
                                              
                                              
                                              472
                                              
                                              
                                              
                                              982Interest
                                              
                                              
                                              445
                                              
                                              
                                              
                                              321Totals
                                              
                                              $
                                              5,465
                                              
                                              
                                              $
                                              5,167





NOTE
11.   NOTES PAYABLE





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





(Amounts in Thousands)Note Description
                                  
                                  June 30,
                                    2009
                                  
                                  
                                  December 31,
                                    2008Zoo
      Entertainment convertible notes, net of discounts attributable to the
      warrant value of $180 and $1,576
                                  
                                  $
                                  10,970
                                  
                                  
                                  $
                                  9,5743.9% Zoo
      Publishing notes, net of discount of $0 and $1,030
                                  
                                  
                                  -
                                  
                                  
                                  
                                  2,5362.95%
      note due June 2012 assumed from Zoo Publishing acquisition
                                  
                                  
                                  310
                                  
                                  
                                  
                                  3708.25%
      Wachovia demand note assumed from Zoo Publishing
      acquisition
                                  
                                  
                                  -
                                  
                                  
                                  
                                  45Note
      assumed from Zoo Publishing acquisition, 12% interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  25Employee
      loans, payable on demand
                                  
                                  
                                  -
                                  
                                  
                                  
                                  331Zoo
      Publishing employee loans at 4% interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  268Totals
                                  
                                  
                                  11,280
                                  
                                  
                                  
                                  13,149Current
      portion
                                  
                                  
                                  11,090
                                  
                                  
                                  
                                  11,377Non-current
      portion
                                  
                                  $
                                  190
                                  
                                  
                                  $
                                  1,772





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





(Amounts in Thousands)Year Ending December
                              
                              Amount DueBalance of 2009
                              
                              $
                              11,2102010
                              
                              
                              1202011
                              
                              
                              1202012
                              
                              
                              10Total
                              
                              $
                              11,460


F-16





Zoo
Entertainment Notes





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





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





The total
principal amount of all of the notes described above is approximately $11.2
million, $9.8 million of which was incurred prior to the date of the reverse
merger. The warrants issued with all the notes were valued at approximately $5.9
million by the Company and an independent valuation firm. We used the income and
market valuation approaches to derive the Company’s business enterprise value
and then used the Black-Scholes option-pricing model, applying discounts for
illiquidity and dilution, to calculate the value of the warrants.  The
total deferred debt discount of $5.9 million is amortized over the one year life
of the notes. Prior to September 12, 2008, 4,545,455 warrants were exercised and
the interest expense related to the discount of these warrants was accelerated.
As of September 12, 2008, the deferred debt discount of the existing notes was
approximately $2.4 million and the net value of the notes recorded as of
September 12, 2008 was approximately $7.8 million. On September 26, 2008, we
issued $1.0 million of the notes and 909,090 of the warrants which were valued
at $527,000 using consistent valuation methodologies as those used for all the
previously issued notes. As of June 30, 2009, the net deferred debt discount of
all the notes is $180,000 and the net value of the notes recorded as of June 30,
2009 is approximately $11.0 million.


F-17


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





Zoo
Publishing Notes





In
connection with the acquisition of Zoo Publishing, the Company issued various
promissory notes (“Zoo Publishing Note”) in an aggregate of approximately $6.8
million. Approximately $1.8 million of principal was payable at the earlier of
the Company’s completion of another round of financing or by December 2008 with
the $5.0 million balance to be paid in two installments pursuant to the “Zoo
Publishing Note.” The first installment of $2.5 million of principal together
with accrued interest at the rate of 3.9% per annum would be due on the earlier
of June 18, 2009 and the date on which the Company consummates a round of equity
financing of $40.0 million or more. The balance of the Zoo Publishing Note
(including accrued interest) would be payable December 18, 2010. In connection
with the aforementioned note, the Company recorded a debt discount of
approximately $2.3 million. For the three and six months ended June 30,
2009, amortization of deferred debt discount and interest expense were $134,000,
$294,000, $29,000 and $64,000, respectively. For the three and six months ended
June 30, 2008, amortization of deferred debt discount and interest expense
were $304,000, $608,000, $66,000 and $132,000, respectively. In July 2008,
the $6.8 million of notes were restructured and approximately $3.2 million of
this debt was converted to common stock of the Company based on fair value and
of the remaining $3.6 million, approximately $1.1 million became due September
18, 2009, $113,000 became due September 18, 2010, $2.0 million became due
December 18, 2010 and approximately $316,000 became due July 31,
2011.





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





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





·
                $200,000 demand note
      with 12.0% percent interest per annum, callable in six months, minimum
      guaranteed interest per renewal is $ 12,000. The note is guaranteed by the
      Zoo Publishing President. The note was totally paid off by March 31,
      2009; and
  ·
              Zoo
      Publishing purchased treasury stock from a former employee in December
      2006 for the amount of $650,000. The balance on the note as of
      June 30, 2009 was $310,000; $120,000 is classified as current and
      $190,000 is classified as long-term. The payments are due monthly and the
      amount of the payment is $10,000 per
month.





NOTE
12.   INCOME TAXES





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


F-18





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





Current:Federal
                            
                            $
                            —State
                            
                            
                            —Total
      Current
                            
                            
                            —Deferred:Federal
                            
                            
                            —State
                            
                            
                            —Total
      Deferred
                            
                            
                            —Total
                            
                            $
                            —





No income
taxes were paid during the six months ended June 30, 2009.





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





Tax
      at U.S. federal income tax rates
                    
                    
                    (34.0
                    )%State
      taxes, net of federal income tax benefit
                    
                    
                    (2.5
                    )%Valuation
      allowance
                    
                    
                    2.4
                    %Nondeductible
      expenses and other
                    
                    
                    34.1
                    %0.0
                    %





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





Deferred tax assets:
                                
                                Current
                                
                                
                                Long TermNet
      operating loss carried forward
                                
                                $
                                -
                                
                                
                                $
                                5,474Capital
      loss carried forward
                                
                                
                                -
                                
                                
                                
                                515Allowance
      for doubtful accounts
                                
                                
                                317
                                
                                
                                
                                -Bonus
      and other accruals
                                
                                
                                578
                                
                                
                                
                                -Interest
      on convertible notes
                                
                                
                                -
                                
                                
                                
                                198Non-qualified
      options
                                
                                
                                -
                                
                                
                                
                                421Gross
      deferred tax assets
                                
                                
                                895
                                
                                
                                
                                6,608Valuation
      allowance
                                
                                
                                (236)
                                
                                
                                
                                (1,739
                                )Net
      deferred tax assets
                                
                                
                                659
                                
                                
                                $
                                4,869Deferred
      tax liabilities:Property
      and equipment
                                
                                
                                -
                                
                                
                                
                                (23
                                )Intangibles
                                
                                
                                -
                                
                                
                                
                                (5,505
                                )Discount
      on notes
                                
                                
                                -
                                
                                
                                
                                -Total
      deferred tax liabilities
                                
                                
                                -
                                
                                
                                
                                (5,528
                                )Net
      deferred tax asset (liability)
                                
                                $
                                659
                                
                                
                                $
                                (659
                                )





The
Company has approximately $1.2 million of available capital loss carried forward
which expire in 2013. A valuation allowance of approximately $515,000 has
been recognized to offset the deferred tax assets related to these carried
forward. The Company currently does not have any capital gains to utilize
against this capital loss. If realized, the tax benefit of this item will
be applied to reduce future capital gains of the Company. Additionally, a
valuation allowance of approximately $1.9 million has been recognized to offset
the net remaining deferred tax assets in excess of deferred tax liabilities
because we cannot reasonably project if and when we will generate enough taxable
income to utilize any of the deferred tax assets.





As of
June 30, 2009, the Company has U.S. federal net operating loss (NOL)
carried forward of approximately $13.0 million which will be available to offset
taxable U.S. income during the carried forward period and are expected to be
fully realized. The federal NOL will begin to expire in 2023. The Company has
various state net operating loss carried forward of approximately $12.9 million
which will be available to offset taxable state income during the carried
forward period. The state NOL will also begin to expire in 2023.  The
tax benefit of these items is reflected in the above table of deferred tax
assets and liabilities.


F-19





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





Common
Stock





The
Company has authorized 75,000,000 shares of common stock, par value $0.001, and
5,000,000 preferred shares, par value $0.001. As of June 30, 2009, there
were 38,243,937 shares of common stock issued and 30,442,611 shares of common
stock outstanding.




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





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





Options





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





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





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





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


F-20


As of
June 30, 2009, there was approximately $171,000 of unrecognized
compensation cost related to non-vested stock option awards, which is expected
to be recognized over a remaining weighted-average vesting period of 2.2 - 2.5
years.





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





Warrants





As of
June 30, 2009, there were 6,502,159 warrants outstanding. All are currently
exercisable and have a five-year term.





There
were no warrants issued in the six months ended June 30, 2009.





NOTE
14.  GAIN ON LEGAL SETTLEMENT





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





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


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


·
            employee
      loans totaling $574,000


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





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





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





NOTE
15.   INTEREST, NET





(Amounts in Thousands)Three Months Ended June 30,
                  
                  
                  Six Months Ended June 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Interest
      arising form amortization of debt discount
                  
                  $
                  832
                  
                  
                  $
                  304
                  
                  
                  $
                  1,690
                  
                  
                  $
                  608Interest
      on various notes
                  
                  
                  168
                  
                  
                  
                  289
                  
                  
                  
                  343
                  
                  
                  
                  376Less
      interest income
                  
                  
                  -
                  
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  (5
                  )Interest
      expense, net
                  
                  $
                  1,000
                  
                  
                  $
                  592
                  
                  
                  $
                  2,033
                  
                  
                  $
                  979





NOTE
16.   SUPPLEMENTAL CASH FLOW INFORMATION





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





(Amounts in Thousands)2009
                    
                    
                    2008Changes
      in other assets and liabilities:Accounts
      receivable
                    
                    $
                    1,302
                    
                    
                    $
                    (907
                    )Inventory
                    
                    
                    1,431
                    
                    
                    
                    214Prepaid
      expenses and other current assets
                    
                    
                    520
                    
                    
                    
                    1,823Product
      development costs
                    
                    
                    66
                    
                    
                    
                    (2,293
                    )Accounts
      payable
                    
                    
                    716
                    
                    
                    
                    2,497Accrued
      expenses and other current liabilities
                    
                    
                    (547
                    )
                    
                    
                    (943
                    )Net
      changes in other assets and liabilities
                    
                    $
                    3,488
                    
                    
                    $
                    391Cash
      paid during the period of interest
                    
                    $
                    —
                    
                    
                    $
                    25Cash
      paid during the period of taxes
                    
                    $
                    —
                    
                    
                    $
                    6Non-cash
      investing and financing activities:Receipt
      of 5,563,950 shares for partial settlement of litigation
                    
                    $
                    1,113
                    
                    
                    $
                    —Notes
      and obligations relieved for partial settlement of
    litigation
                    
                    $
                    3,925
                    
                    
                    $
                    —Acquisition
      of Intangible for long-term obligation
                    
                    $
                    2,600
                    
                    
                    $
                    —Issuance
      of 1,580,237 shares for partial payment of Zoo Digital
                    
                    $
                    —
                    
                    
                    $
                    4,086Exchange
      of debt for equity at original face value
                    
                    $
                    —
                    
                    
                    $
                    550


F-21





NOTE
17.   LITIGATION





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





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., the claimant Revolution Partners, LLC was seeking money damages for a
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We settled this claim in June 2009 for $140,000;
$60,000 of which was paid as of June 30, 2009 and the balance is included in
accounts payable as of June 30, 2009, to be paid in four monthly installments
through October 2009.





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





NOTE
18.   RELATED PARTY TRANSACTIONS





We leased
office space in New York from 575 Broadway Associates, LLC, a company owned
principally by one of our principal investors, from April 2007 to October 2008.
We paid rent expense of $0 and $139,000 during the six months ended June 30,
2009 and 2008, respectively, to this related party.





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


F-22


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





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





NOTE
19.   SUBSEQUENT EVENTS





On July
31, 2009, we filed a Definitive Information Statement on Schedule 14C notifying
our stockholders of the approval by certain of our stockholders holding a
majority of our outstanding shares of common stock, by written consent, of an
amendment to the Company’s Certificate of Incorporation to increase the number
of authorized shares of common stock from 75,000,000 shares to 250,000,000
shares (the “Share Increase”).  The board of directors may implement
the Share Increase at any time at its discretion following August 20, 2009, by
filing a Certificate of Amendment to the Company’s Certificate of Incorporation
with the Secretary of State of the State of Delaware.


F-23





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


AND
RESULTS OF OPERATIONS





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





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





Background
and History





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





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





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





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





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


1


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





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





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





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





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





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





In June
2009, the Company formed a new company in the United Kingdom that is a
wholly-owned subsidiary of Zoo Games called Zoo Entertainment Europe Ltd. (“Zoo
Europe”) that will focus on the sales and distribution of our products in
Europe.  Zoo Europe is currently incurring start-up costs and we
expect that revenues will begin in the latter part of 2009.





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


2


Three
Months Ended June 30, 2009 As Compared to the Three Months Ended June 30,
2008





Results
of Operations





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




(Amounts in Thousands Except Per Share Data)For the Three Months Ended June 302009
                            
                            
                            2008Revenue
                            
                            $
                            7,669
                            
                            
                            
                            
                            
                            
                            $
                            5,470Cost
      of goods sold
                            
                            
                            7,742
                            
                            
                            
                            101%
                            
                            
                            
                            4,406
                            
                            
                            
                            81%Gross
      profit
                            
                            
                            (73)
                            
                            
                            
                            (1)%
                            
                            
                            
                            1,064
                            
                            
                            
                            19%Operating
      expenses:General
      and administrative expenses
                            
                            
                            1,866
                            
                            
                            
                            24%
                            
                            
                            
                            2,280
                            
                            
                            
                            42%Selling
      and marketing expenses
                            
                            
                            662
                            
                            
                            
                            9%
                            
                            
                            
                            1,053
                            
                            
                            
                            19%Research
      and development expenses
                            
                            
                            290
                            
                            
                            
                            4%
                            
                            
                            
                            585
                            
                            
                            
                            11%Depreciation
      and amortization
                            
                            
                            435
                            
                            
                            
                            6%
                            
                            
                            
                            443
                            
                            
                            
                            8%Total
      operating expenses
                            
                            
                            3,253
                            
                            
                            
                            42%
                            
                            
                            
                            4,361
                            
                            
                            
                            80%Loss
      from operations
                            
                            
                            (3,326)
                            
                            
                            
                            (43)%
                            
                            
                            
                            (3,297)
                            
                            
                            
                            (60)%Interest
      expense, net
                            
                            
                            (1,000)
                            
                            
                            
                            (13)%
                            
                            
                            
                            (592)
                            
                            
                            
                            (11)%Gain
      on legal settlement
                            
                            
                            4,328
                            
                            
                            
                            56%
                            
                            
                            
                            -
                            
                            
                            
                            0%Profit
      (loss) from continuing operations before income tax
benefit
                            
                            
                            2
                            
                            
                            
                            (12)%
                            
                            
                            
                            (3,889)
                            
                            
                            
                            (71)%Income
      tax benefit
                            
                            
                            -
                            
                            
                            
                            0%
                            
                            
                            
                            1,058
                            
                            
                            
                            19%Profit
      (loss) from continuing operations
                            
                            
                            2
                            
                            
                            
                            (12)%
                            
                            
                            
                            (2,831)
                            
                            
                            
                            (52)%Loss
      from discontinued operations
                            
                            
                            -
                            
                            
                            
                            0%
                            
                            
                            
                            (1,861)
                            
                            
                            
                            (34)%Net
      profit (loss)
                            
                            $
                            2
                            
                            
                            
                            (12)%
                            
                            
                            $
                            (4,692)
                            
                            
                            
                            (86)%Earnings
      (loss) per share from continuing operations
                            
                            $
                            0.00
                            
                            
                            
                            
                            
                            
                            $
                            (0.15)





Net
Revenues





Net
revenues for the three months ended June 30, 2009 were approximately $7.7
million, an increase of approximately 40% over the sales for the three months
ended June 30, 2008 which were approximately $5.5 million, all consisting of
casual game sales in North America.  The sales in the 2009 period are
recorded net of the $842,000 fee to Atari for the period; without this fee, the
sales increase from 2008 to 2009 would be 56%.  The breakdown of gross
sales by platform is:


Three Months Ended June 30,2009
                            
                            
                            2008Nintendo
      Wii
                            
                            
                            61
                            %
                            
                            
                            33
                            %Nintendo
      DS
                            
                            
                            34
                            %
                            
                            
                            61
                            %Nintendo
      GBA
                            
                            
                            1
                            %
                            
                            
                            1
                            %SONY
      PS2
                            
                            
                            0
                            %
                            
                            
                            2
                            %SONY
      PSP
                            
                            
                            0
                            %
                            
                            
                            3
                            %Microsoft
      Xbox
                            
                            
                            4
                            %
                            
                            
                            0
                            %





The
biggest sellers during the 2009 period were (i) M&M Beach Party on the
Nintendo Wii platform, (ii) M&M Kart Racing on the Nintendo Wii platform,
and (iii) M&M Kart Racing on the Nintendo DS platform. The biggest sellers
during the 2008 period were (i) Chicken Shoot, (ii) M&M Kart Racing and
(iii) Showtime Championship Boxing, all on the Nintendo Wii platform. The
2009 period consisted of approximately 1.1 million units sold at an average
gross price of $8.96, while the 2008 period consisted of approximately 500,000
units sold at an average gross price of $10.64.


3


Gross
Profit





Gross
profit for the three months ended June 30, 2009 was a loss of $73,000, or (1%)
of net revenue, while the gross profit for the three months ended June 30, 2008
was approximately $1.1 million, or 20% of net revenue. The costs included in the
cost of goods sold consist of manufacturing and packaging costs, royalties due
to licensors relating to the current period’s revenues and the amortization of
product development costs relating to the current period’s revenues. The Atari
sales agreement was in place during the entire 2009 period and the Atari’s fees
that are recorded as a reduction in revenue during this period were
approximately $842,000 as compared to $0 in the corresponding period in
2008.  As part of our business plan to focus on higher margin games
and more cost effective product licenses, we opted to discontinue certain
lower-margin products in the 2009 period through the accelerated sale of such
products at lower than normal prices.  This resulted in a significant
amount of sales at very low margins which along with royalty fees and
amortization of product development costs resulted in a negative overall gross
margin for the 2009 period.  There were no similar close-out
initiatives during the comparable period in 2008.





General
and Administrative Expenses





General
and administrative expenses for the three months ended June 30 2009 were
approximately $1.9 million as compared to $2.3 million for the comparable period
in 2008. The reduction in costs from the 2008 period to the 2009 period
resulted primarily from a reduction in corporate salaries and related costs.
During the three months ended June 30, 2009 the Company incurred approximately
$120,000 in startup cost for its new European sales office.





Selling
and Marketing Expenses





Selling
and marketing expenses for the three months ended June 30, 2009 and 2008 were
$662,000 and $1.1 million, respectively. These expenses all relate to the
sales of casual games in North America and consist primarily of the salaries,
commissions and related costs for Zoo Publishing.  Due to the Atari
sales agreement in 2009, we incurred a lower percentage of distribution costs in
the 2009 period vs. the 2008 period.





Research
and Development Expenses





Research
and development expenses for the three months ended June 30, 2009 were
approximately $290,000 as compared to $585,000 for the three months ended June
30, 2008. These expenses are a direct result of our decision to discontinue the
development of certain games during these periods. The Company has modified its
business model to focus on casual products which carry significantly lower
development risks and costs.





Depreciation
and Amortization Expenses





Depreciation
and amortization costs for the three months ended June 30, 2009 were $435,000 as
compared to $443,000 in the prior period. Both periods include $412,000
resulting from the amortization of intangibles acquired from the Zoo Publishing
acquisition. The balance relates to depreciation of fixed assets during the
period.





Interest
Expense





Interest
expense for the 2009 period was approximately $1.0 million as compared to
$592,000 for the 2008 period. The 2009 period includes $698,000 of non-cash
interest expense relating to the amortization on the Zoo Entertainment Notes,
$139,000 of interest relating to the Zoo Entertainment Notes and approximately
$163,000 of interest on the various promissory notes due to the sellers of Zoo
Publishing of which $133,000 is non-cash interest imputed at the then market
rate. The 2008 period includes $370,000 of interest on the various
promissory notes due to the sellers of Zoo Publishing of which $304,000 is
non-cash interest imputed at the then market rate.





Gain
on Legal Settlement





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


4





Income
Tax Benefit





We did
not record any income tax benefit for the three months ended June 30, 2009 as
compared to $1.1 million for the three months ended June 30, 2008. As of
December 31, 2008, we had already maximized the allowable amount of deferred
taxes, so no additional tax benefits could be recorded for the 2009
period.





Loss
from Discontinued Operations





During
the three months ended June 30, 2008, we generated a loss of approximately $1.9
million from four operating divisions which were subsequently discontinued, so
the net losses relating to those operations are recorded separately as a loss
from discontinued operations. The loss relating to Supervillain was
approximately $1.1 million, the loss relating to Zoo Digital was $677,000, the
loss relating to Repliqa was $25,000 and the loss relating to the on-line
concept was $48,000.





Earnings
(loss) per Share from Continuing Operations





The
earnings per share from continuing operations for the three months ended June
30, 2009 was $0.00, based on a weighted average shares outstanding for the
period of 35.2 million, vs. a loss per share from continuing operations of
$0.15, based on a weighted average shares outstanding of 19.4 million for the
three months ended June 30, 2008.





Six
Months Ended June 30, 2009 As Compared to the Six Months Ended June 30,
2008





Results
of Operations





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





(Amounts in Thousands Except Per Share Data)For the Six Months Ended June 302009
                            
                            
                            2008Revenue
                            
                            $
                            21,553
                            
                            
                            
                            
                            
                            
                            $
                            14,499Cost
      of goods sold
                            
                            
                            19,225
                            
                            
                            
                            89%
                            
                            
                            
                            13,213
                            
                            
                            
                            91%Gross
      profit
                            
                            
                            2,328
                            
                            
                            
                            11%
                            
                            
                            
                            1,286
                            
                            
                            
                            9%Operating
      expenses:General
      and administrative expenses
                            
                            
                            3,260
                            
                            
                            
                            15%
                            
                            
                            
                            3,399
                            
                            
                            
                            23%Selling
      and marketing expenses
                            
                            
                            1,525
                            
                            
                            
                            7%
                            
                            
                            
                            1,917
                            
                            
                            
                            13%Research
      and development expenses
                            
                            
                            370
                            
                            
                            
                            2%
                            
                            
                            
                            1,479
                            
                            
                            
                            10%Depreciation
      and amortization
                            
                            
                            869
                            
                            
                            
                            4%
                            
                            
                            
                            891
                            
                            
                            
                            6%Total
      operating expenses
                            
                            
                            6,024
                            
                            
                            
                            28%
                            
                            
                            
                            7,686
                            
                            
                            
                            53%Loss
      from operations
                            
                            
                            (3,696)
                            
                            
                            
                            (17)%
                            
                            
                            
                            (6,400)
                            
                            
                            
                            (44)%Interest
      expense, net
                            
                            
                            (2,033)
                            
                            
                            
                            (9)%
                            
                            
                            
                            (979)
                            
                            
                            
                            (7)%Gain
      on settlement
                            
                            
                            4,328
                            
                            
                            
                            20%
                            
                            
                            
                            -
                            
                            
                            
                            0%Loss
      from continuing operations before income tax benefit
                            
                            
                            (1,401)
                            
                            
                            
                            (7)%
                            
                            
                            
                            (7,379)
                            
                            
                            
                            (51)%Income
      tax benefit
                            
                            
                            -
                            
                            
                            
                            0%
                            
                            
                            
                            1,058
                            
                            
                            
                            7%Loss
      from continuing operations
                            
                            
                            (1,401)
                            
                            
                            
                            (7)%
                            
                            
                            
                            (6,321)
                            
                            
                            
                            (44)%Loss
      from discontinued operations
                            
                            
                            -
                            
                            
                            
                            0%
                            
                            
                            
                            (2,548)
                            
                            
                            
                            (18)%Net
      loss
                            
                            $
                            (1,401)
                            
                            
                            
                            (7)%
                            
                            
                            $
                            (8,869)
                            
                            
                            
                            (61)%Loss
      per share from continuing operations
                            
                            $
                            (0.04)
                            
                            
                            
                            
                            
                            
                            $
                            (0.35)





Net
Revenues





Net
revenues for the six months ended June 30, 2009 were approximately $21.6
million, an increase of approximately 49% over the sales for the six months
ended June 30, 2008 of approximately $14.5 million, all consisting of casual
game sales in North America. The sales in the 2009 period are recorded net
of the $2.4 million fee to Atari for the period; without this fee, the sales
increase from 2008 to 2009 would be 65%.  The breakdown of gross sales
by platform is:




Six Months Ended June 30,2009
                        
                        
                        2008Nintendo
      Wii
                        
                        
                        62
                        %
                        
                        
                        26
                        %Nintendo
      DS
                        
                        
                        33
                        %
                        
                        
                        68
                        %Nintendo
      GBA
                        
                        
                        0
                        %
                        
                        
                        3
                        %SONY
      PS2
                        
                        
                        2
                        %
                        
                        
                        1
                        %SONY
      PSP
                        
                        
                        0
                        %
                        
                        
                        2
                        %Microsoft
      Xbox
                        
                        
                        3
                        %
                        
                        
                        0
                        %


5


The
biggest sellers during the 2009 period were (i) M&M Kart Racing, (ii)
M&M Beach Party, and (iii) Deal or No Deal, all on the Nintendo Wii
platform. The biggest sellers during the 2008 period were (i) the compilation of
Battle Ship, Connect 4, Sorry & Trouble on the Nintendo DS platform, (ii)
the compilation of Clue, Perfection & Aggravation on the Nintendo DS
platform, and (iii) M&M Kart Racing on the Nintendo Wii platform. The
2009 period consisted of approximately 2.5 million units sold compared to
approximately 1.6 million units sold for the same period in 2008.





Gross
Profit





Gross
profit for the six months ended June 30, 2009 was approximately $2.3 million, or
11% of net revenue, while the gross profit for the six months ended June 30,
2008 was approximately $1.3 million, or 9% of net revenue. The costs included in
the cost of goods sold consist of manufacturing and packaging costs, royalties
due to licensors relating to the current period’s revenues and the amortization
of product development costs relating to the current period’s revenues. The
Atari sales agreement was in place during the entire 2009 period and Atari’s
fees recorded as a reduction in revenue during this period were approximately
$2.4 million as compared to $0 in the corresponding period in 2008. 
As part of our business plan to focus on higher margin games and more cost
effective product licenses, we opted to discontinue certain lower-margin
products in the 2009 period through the accelerated sale of such products at
lower than normal prices.  This resulted in a significant amount of
sales at very low margins, which along with royalty fees and amortization of
product development costs resulted in a low overall gross margin for the 2009
period.  The 2008 period included a close-out initiative for a license
that terminated during that period resulting in similar low overall margins for
the 2008 period.





General
and Administrative Expenses





General
and administrative expenses for the six months ended June 30 2009 were
approximately $3.3 million as compared to $3.4 million for the comparable period
in 2008. The decrease in costs from the 2008 period to the 2009 period
resulted primarily from a reduction in corporate salaries and related costs.
During the six months ended June 30, 2009 the Company incurred approximately
$120,000 in startup cost for its new European sales office.





Selling
and Marketing Expenses





Selling
and marketing expenses for the six months ended June 30, 2009 and 2008 were
approximately $1.5 million and $1.9 million, respectively.  These expenses
all relate to the sales of casual games in North America and consist primarily
of the salaries, commissions and related costs for Zoo Publishing. Due to the
Atari sales agreement in 2009, we incurred a lower percentage of distribution
costs in the 2009 period compared to the 2008 period.





Research
and Development Expenses





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





Depreciation
and Amortization Expenses





Depreciation
and amortization costs for the six months ended June 30, 2009 were $869,000 as
compared to $891,000 in the prior period. Both periods include $823,000
resulting from the amortization of intangibles acquired from the Zoo Publishing
acquisition. The balance relates to depreciation of fixed assets during the
period.





Interest
Expense





Interest
expense for the 2009 period was approximately $2.0 million as compared to
$979,000 for the 2008 period. The 2009 period includes approximately $1.4
million of non-cash interest expense relating to the amortization on the Zoo
Entertainment Notes, $279,000 of interest relating to the Zoo Entertainment
Notes and approximately $358,000 of interest on the various promissory notes due
to the sellers of Zoo Publishing of which $293,000 is non-cash interest imputed
at the then market rate.  The 2008 period includes $765,000 of
interest on the various promissory notes due to the sellers of Zoo Publishing of
which $608,000 is non-cash interest imputed at the then market
rate.


6


Gain
on Legal Settlement





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





Income
Tax Benefit





We did
not record any income tax benefit for the six months ended June 30, 2009. As of
December 31, 2008, we had already maximized the allowable amount of deferred
taxes, so no additional tax benefits could be recorded for the 2009
period. During the six months ended June 30, 2008, we recorded a tax
benefit of approximately $1.1 million.





Loss
from Discontinued Operations





During
the six months ended June 30, 2008, we incurred an aggregate of approximately
$2.5 million in losses from four operating divisions which were subsequently
discontinued, so the net losses relating to those operations are recorded
separately as a loss from discontinued operations.  The loss relating
to Supervillain was approximately $1.5 million, the loss relating to Zoo Digital
was $677,000, the loss relating to Repliqa was $219,000 and the loss relating to
the on-line concept was $122,000.





Loss
per Share from Continuing Operations





The loss
per share from continuing operations for the six months ended June 30, 2009 was
$0.04, based on a weighted average shares outstanding for the period of 35.6
million, vs. a loss per share from continuing operations of $0.35, based on a
weighted average shares outstanding of 18.0 million for six months ended June
30, 2008.





Liquidity
and Capital Resources





We
incurred a loss from continuing operations of approximately $1.4 million for the
six months ended June 30, 2009 and a net loss of approximately $6.3 million from
continuing operations for the six months ended June 30, 2008. Our principal
source of cash during the 2009 period was from the use of our purchase order
financing and cash generated from operations. Net cash provided from operating
activities for the six months ended June 30, 2009 was $562,000, while net cash
used in continuing operations for the six months ended June 30, 2008 was $4.8
million. The specifics of the Atari sales agreement, which was in effect
during the 2009 period, where Atari prepays the Company for the cost of
goods and pays the balance due within 15 days of shipping the product, resulted
in significant improvements for our cash provided from operations in the 2009
period, as compared to the 2008 period.





Zoo
Entertainment Notes





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


7





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





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





Zoo
Publishing Notes





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





As part
of the acquisition of Zoo Publishing, Zoo Games was required to pay $1,200,000
to an employee of Zoo Publishing.  Of that amount, as of June 30,
2009, Zoo Games paid $387,000; $193,000 is past due and $620,000 will be paid on
July 31, 2011, in cash or our common stock based on the fair market value of our
common stock as of July 31, 2011, at the election of Zoo Games.





Zoo
Publishing has additional debt outstanding which debt existed prior to Zoo
Games’ acquisition of that subsidiary. As of June 30, 2009, Zoo Publishing owes
approximately $310,000 as a result of the repurchase of certain stock
from a former stockholder. This amount is being repaid by its terms in monthly
increments of $10,000.


8


Zoo
Publishing also takes advances from our factor, Working Capital Solutions, Inc.,
which utilizes existing accounts receivable in order to provide working capital
to fund all aspects of our continuing business operations. Under the terms of
our factoring and security agreement, our receivables are sold to the factor,
with recourse. The factor, in its sole discretion, determines whether or not it
will accept each receivable based upon the credit risk factor of each individual
receivable or account. Once a receivable is accepted by the factor, the factor
provides funding, subject to the terms and conditions of the factoring and
security agreement. The amount remitted to us by the factor equals the invoice
amount of the receivable adjusted for any discounts or allowances provided to
the account, less 20% which is deposited into a reserve account established
pursuant to the agreement, less allowances and fees. In the event of default,
valid payment dispute, breach of warranty, insolvency or bankruptcy on the part
of the receivable account, the factor can require the receivable to be
repurchased by us in accordance with the agreement. The amounts to be paid by us
to the factor for any accepted receivable include a factoring fee of 0.6% for
each ten (10) day period the account is open. We have not used the factor
since we entered into the Atari agreement in October 2008 (see
below).





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





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





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





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


9


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





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





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





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





We
believe the existing cash and cash generated from operations will be sufficient
to meet our immediate operating requirements along with our current financial
arrangements. However, given our strategic plan, working capital requirements,
debt obligations, planned capital expenditures and potential future
acquisitions, we will need to raise additional capital within the short-term. We
also need to either raise enough capital to force conversion of the $11.2
million of Zoo Entertainment Notes, at face value, that mature on August 31,
2009 and September 26, 2009, as applicable, into equity or restructure the
maturing note obligations. We believe that we require at least an
additional $4 million to $10 million in financing in order to fund our operating
requirements and strategic plan for the following 12 months.





In
addition, should we be successful in raising capital, we may need to raise
additional capital to strengthen our cash position, facilitate expansion, pursue
strategic investments or to take advantage of business opportunities as they
arise.





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


10


Critical
Accounting Policies and Estimates





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





Recently
Issued Accounting Pronouncements





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





Off-Balance
Sheet Arrangements





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





Fluctuations
in Operating Results and Seasonality





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





ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Not
applicable as we are a smaller reporting company.





ITEM
4T.  CONTROLS AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





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





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





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





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


11





Changes
in Controls and Procedures





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


12


PART
II - OTHER INFORMATION





ITEM  1.  LEGAL
PROCEEDINGS





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





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., the claimant Revolution Partners, LLC was seeking money damages for a
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We settled this claim in June 2009 for $140,000,
$60,000 of which was paid as of June 30, 2009 and the balance of which is
included in accounts payable as of June 30, 2009, to be paid in four monthly
installments through October 2009.





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





ITEM
1A.  RISK FACTORS





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





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





Issuer
Purchases of Equity Securities





Period
                      
                      (a) Total Number of
                        Shares (or Units)
                        Purchased
                      
                      
                      (b)Average Price Paid
                        per Share (or Unit)
                      
                      
                      (c)
                        Total Number of
                        Shares (or Units)
                        Purchased as Part of
                        Publicly Announced
                        Plans or Programs
                      
                      
                      (d)
                        Maximum Number
                        (or Approximate
                        Dollar Value) of
                        Shares (or Units)
                        that May Yet Be
                        Purchased Under
                        the Plans or
                        ProgramsApril
      1, 2009- April30,
      2009
                      
                      -
                      
                      
                      -
                      
                      
                      -
                      
                      
                      -May
      1, 2009- May 31, 2009
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -June
      1, 2009- June 30, 2009
                      
                      5,563,950
                      (1)
                      
                      
                      
                      (1)
                      
                      
                      -
                      
                      
                      
                      -




13


(1)  On February
19, 2009, Susan Kain Jurgensen, Steven Newton, Mercy Gonzalez, Bruce Kain,
Wesley Kain, Raymond Pierce and Cristie Walsh filed a compliant against Zoo
Publishing, Zoo Games and Zoo in the Supreme Court of the State of New York, New
York County, alleging claims for breach of certain loan
agreements and employment agreements, intentional interference and
fraudulent transfer.  The complaint sought compensatory damages,
punitive damages and preliminary and permanent injunctive relief, among other
remedies.  On June 18, 2009, we reached a settlement whereby we agreed to
pay to the plaintiffs an aggregate of $560,000 in full satisfaction of the
disputed claims, without any admission of any liability of wrongdoing. In
connection with the settlement agreement, the plaintiffs returned to us an
aggregate of 5,563,950 shares of our common stock owned by the plaintiffs prior
to such date.





ITEM
3.  DEFAULTS UPON SENIOR SECURITIES





None.





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





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





ITEM
5.  OTHER INFORMATION





None.





ITEM
6.  EXHIBITS





10.1
                
                Amendment
      No. 2 to Senior Secured Convertible Note, dated as of June 26, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.2
                
                Letter
      Agreement, dated as of June 26, 2009, by and among Zoo Entertainment, Inc.
      and the holders of Notes set forth therein.10.3
                
                Amendment
      Number 3 to the October 24, 2008 Sales Agreement, dated as of June 15,
      2009, by and between Zoo Publishing, Inc. and Atari, Inc. †10.4
                
                Amendment
      No. 2 to License Agreement, dated as of May 20, 2009, by and among Zoo
      Publishing, Inc., Zoo Entertainment, Inc. and New World IP,
      LLC.10.5
                
                Employment
      Agreement, dated as of January 1, 2008, by and between Zoo Publishing,
      Inc. and David Rosenbaum.  *10.6
                
                Amendment
      No. 1 to Employment Agreement, dated as of July 1, 2008, by and between
      Zoo Publishing, Inc. and David Rosenbaum.  *10.7
                
                Amendment
      No. 2 to Employment Agreement, dated as of July 23, 2009, by and between
      Zoo Publishing, Inc. and David Rosenbaum.  *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.





*
Management compensation agreements


†
Confidential treatment as to certain portions requested


14





SIGNATURES




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





Dated
August 14, 2009




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





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




15




EXHIBIT
INDEX




10.1
              
              Amendment
      No. 2 to Senior Secured Convertible Note, dated as of June 26, 2009, by
      and among Zoo Entertainment, Inc. and the holders of Notes set forth
      therein.10.2
              
              Letter
      Agreement, dated as of June 26, 2009, by and among Zoo Entertainment, Inc.
      and the holders of Notes set forth therein.10.3
              
              Amendment
      Number 3 to the October 24, 2008 Sales Agreement, dated as of June 15,
      2009, by and between Zoo Publishing, Inc. and Atari, Inc. †10.4
              
              Amendment
      No. 2 to License Agreement, dated as of May 20, 2009, by and among Zoo
      Publishing, Inc., Zoo Entertainment, Inc. and New World IP,
      LLC.10.5
              
              Employment
      Agreement, dated as of January 1, 2008, by and between Zoo Publishing,
      Inc. and David Rosenbaum.  *10.6
              
              Amendment
      No. 1 to Employment Agreement, dated as of July 1, 2008, by and between
      Zoo Publishing, Inc. and David Rosenbaum.  *10.7
              
              Amendment
      No. 2 to Employment Agreement, dated as of July 23, 2009, by and between
      Zoo Publishing, Inc. and David Rosenbaum.  *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.





*
Management compensation agreements


†
Confidential treatment as to certain portions requested




16