UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C.  20549









FORM 10-Q


(Mark One)




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




For the quarterly period ended March 31, 2011




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




For the transition period from _____________ to ___________


Commission file number 001-34796




ZOO ENTERTAINMENT, INC.


(Exact name of Registrant as Specified in Its Charter)


Delaware

(State or other jurisdiction of incorporation or 
organization )
71-1033391

(I.R.S. Employer Identification No.)3805 Edwards Road, Suite 400

Cincinnati, OH

(Address of Principal Executive Offices)
45209



(Zip Code)(513) 824-8297

(Registrant’s telephone number, including area code)





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


Yes  x  No   ̈




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




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




Large Accelerated filer ̈

Non-accelerated filer ̈

(do not check if a smaller reporting company)
Accelerated filer ̈

Smaller reporting companyx





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 May 11, 2011, there were 6,814,556 shares of the Registrant’s common stock, par value $0.001 per share, issued and 6,801,553 shares outstanding.







ZOO ENTERTAINMENT, INC.




Table of Contents




PagePART I - FINANCIAL INFORMATIONItem 1.
Financial StatementsCondensed Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and December 31, 2010
F-3Condensed Consolidated Statements of Operations (Unaudited) for the Three Months Ended March 31, 2011 and 2010
F- 4Condensed Consolidated Statements of Cash Flows (Unaudited) for the Three Months Ended March 31, 2011 and 2010
F- 5Condensed Consolidated Statement of Stockholders’ Equity (Unaudited) for the Three Months Ended March 31, 2011
F- 6Notes to Condensed Consolidated Financial Statements
F- 7 - F-23Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
24Item 3.
Quantitative and Qualitative Disclosures About Market Risk
30Item 4T.
Controls and Procedures
30PART II - OTHER INFORMATIONItem 1.
Legal Proceedings
32Item 1A.
Risk Factors
32Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
32Item 3.
Defaults Upon Senior Securities
32Item 4.
(Removed and Reserved)
32Item 5.
Other Information
32Item 6.
Exhibits
33Signatures
34


2


PART I – FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS.





ZOO ENTERTAINMENT, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(In thousands, except share and per share amounts)




MARCH 31,


DECEMBER 31,2011


2010(Unaudited)ASSETSCurrent assets:Cash

$
441


$
379Accounts receivable and due from factor, net of allowances of $1,995 and $8,131 at March 31, 2011 and December 31, 2010, respectively


2,169



13,736Inventory, net


7,229



7,368Prepaid expenses and other current assets


609



820Product development costs, net


5,125



5,319Deferred tax assets


220



153Total current assets


15,793



27,775Fixed assets, net


243



264Intangible assets, net


3,481



3,900Other non-current assets


9



9Total assets

$
19,526


$
31,948LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:Accounts payable

$
5,180


$
4,806Financing arrangements


1,615



9,606Accrued expenses and other current liabilities


8,075



7,457Notes payable, current portion


160



160Total current liabilities


15,030



22,029Notes payable, non-current portion


30



60Deferred tax liabilities


220



153Total liabilities


15,280



22,242Commitments and ContingenciesStockholders’ Equity:Common stock, $.001 par value, 3,500,000,000 shares authorized:6,243,699 shares issued and 6,230,696 shares outstanding at March 31, 2011 and December 31, 2010


6



6Additional paid-in capital


73,442



73,336Accumulated deficit


(64,733
)


(59,167
)Treasury stock, at cost, 13,003 shares at March 31, 2011 and December 31, 2010


(4,469
)


(4,469
)Total stockholders’ equity


4,246



9,706Total liabilities and stockholders' equity

$
19,526


$
31,948





See accompanying notes to condensed consolidated financial statements.


F-3


ZOO ENTERTAINMENT, INC. AND SUBSIDIARIES


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(In thousands, except share and per share amounts)





THREE MONTHS ENDED

MARCH 31,2011


2010Revenue

$
3,781


$
16,662Cost of goods sold


4,691



12,930Gross (loss) profit


(910
)


3,732Operating expenses:General and administrative


2,199



1,605Selling and marketing


1,045



1,116Research and development


461



–Depreciation and amortization


453



504Total operating expenses


4,158



3,225(Loss) income from operations


(5,068
)


507Interest expense, net


(498
)


(477
)(Loss) income before income taxes


(5,566
)


30Income tax expense


–



(9
)Net (loss) income

$
(5,566
)

$
21(Loss) income per common share – basic and diluted:Net (loss) income per common share - basic

$
(0.92
)

$
0.02Net (loss) income per common share - diluted

$
(0.92
)

$
0.01Weighted average common shares outstanding – basic


6,067,488



1,098,947Weighted average common shares outstanding – diluted


6,067,488



2,873,225





See accompanying notes to condensed consolidated financial statements.


F-4


ZOO ENTERTAINMENT, INC. AND SUBSIDIARIES


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)





THREE MONTHS ENDED

MARCH 31,2011


2010Operating activities:Net (loss) income

$
(5,566
)

$
21Adjustments to reconcile net (loss) income from operations to net cash provided by (used in) operating activities:Depreciation and amortization


453



504Deferred income taxes


–



(288
)Stock-based compensation


106



246Other changes in assets and liabilities:Accounts receivable and due from factor, net


11,567



(756
)Inventory, net


139



(1,181
)Product development costs, net


194



(1,113
)Prepaid expenses and other current assets


211



1,087Accounts payable


374



60Accrued expenses and other liabilities


588



(1,687
)Net cash provided by (used in) operating activities


8,066



(3,107
)Investing activities:Purchase of fixed assets


(13
)


(79
)Net cash used in investing activities


(13
)


(79
)Financing activities:Net (repayments) borrowings in connection with financing facilities


(7,991
)


1,360Net cash (used in) provided by financing activities


(7,991
)


1,360Net increase (decrease) in cash


62



(1,826
)Cash at beginning of period


379



2,664Cash at end of period

$
441


$
838Supplemental schedule of non-cash investing and financing activities:Transfer of option liability to equity

$
–


$
403Supplemental data:Cash paid for interest

$
721


$
326Cash paid for income taxes

$
8


$
38





See accompanying notes to condensed consolidated financial statements.


F-5


ZOO ENTERTAINMENT, INC. AND SUBSIDIARIES


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY


FOR THE THREE MONTHS ENDED MARCH 31, 2011


(In thousands)





Common Stock








Treasury StockShares


Par Value


Additional

Paid-in Capital


Accumulated

Deficit


Shares


Cost


TotalBalance at December 31, 2010


6,244


$
6


$
73,336


$
(59,167
)


13


$
(4,469
)

$
9,706Stock-based compensation


–



–



106



–



–



–



106Net loss


–



–



–



(5,566
)


–



–



(5,566
)Balance at March 31, 2011


6,244


$
6


$
73,442


$
(64,733
)


13


$
(4,469
)

$
4,246





See accompanying notes to condensed consolidated financial statements.


F-6


Zoo Entertainment, Inc. And Subsidiaries


Notes to Condensed Consolidated Financial Statements





NOTE 1. DESCRIPTION OF ORGANIZATION





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





Zoo is a developer, publisher and distributor of interactive entertainment software for use on all major platforms including: Nintendo’s Wii, DS and 3DS; Sony’s PlayStation 3 (“PS3”); Microsoft’s Xbox 360 and its controller-free accessory, Kinect; Android mobile devices; and iOS devices including iPod Touch, iPad and iPhone. We also develop and publish downloadable games for “connected services” including mobile devices, Microsoft’s Xbox Live Arcade (“XBLA”), Sony’s PlayStation Network (“PSN”), Nintendo’s DsiWare, Facebook, and Steam, a platform for hosting and selling downloadable PC/Mac software. Zoo sells primarily to major retail chains and video game distributors.





The Company’s current overall business strategy has shifted with the changes taking place within the industry. The Company is gradually phasing out its retail business of family-oriented, often-branded console titles, and shifting its focus to digital downloadable content on platforms such as XBLA and PSN, as well as mobile gaming. Zoo’s digital business focuses on bringing fresh, innovative content to digital distribution channels, as well as mobile devices. Sourcing content from its newly-incorporated indiePub division is one way the Company acquires new intellectual property for development and publication for digital distribution.





On March 9, 2011, the Company incorporated  indiePub, Inc. in the State of Delaware as a wholly-owned subsidiary of Zoo Publishing, Inc.





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





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


F-7


NOTE 2. GOING CONCERN





These condensed 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 $64.7 million as of March 31, 2011. Although the Company generated positive cash flows from operating activities of approximately $8.1 million for the three months ended March 31, 2011, for the year ended December 31, 2010, the Company generated negative cash flows from operating activities of approximately $16.2 million, and for the year ended December 31, 2009, the Company generated negative cash flows from operating activities of approximately $5.5 million. As of March 31, 2011 and December 31, 2010, the Company’s working capital was approximately $763,000 and $5.7 million, respectively. Given the Company’s history of generating negative cash flows from operating activities, there is no assurance that it will be able to generate positive cash flows from operations. Due to the Company’s history of losses and negative cash flows from operating activities, the Company is unable to predict whether it will have sufficient cash from operations to meet its financial obligations for the next 12 months, which raises substantial doubt about the Company’s ability to continue as a going concern.





The Company’s ability to continue as a going concern is dependent on, among other factors, the following significant short-term actions: (i) its ability to generate cash flow from operations sufficient to maintain its daily business activities; (ii) its ability to reduce expenses and overhead and (iii) its ability to renegotiate certain obligations. Management’s active efforts in this regard include negotiations with certain vendors to satisfy cash obligations with non-cash assets or equity, reductions of headcount and overhead obligations, and the development of strategies to convert other non-cash assets into cash. There can be no assurance that all or any of these actions will meet with success.





The 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 (“GAAP”) and the interim financial statement rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the condensed consolidated financial statements. The condensed consolidated financial statements should be read in conjunction with the Company’s management discussion and analysis contained elsewhere herein and the consolidated financial statements for the year ended December 31, 2010 filed on April 15, 2011. The Company’s results for the three months ended March 31, 2011 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, Inc. and its wholly-owned subsidiaries, Zoo Publishing, Inc. (and its wholly-owned subsidiary, indiePub, Inc.) and Zoo Entertainment Europe Ltd. All intercompany accounts and transactions are eliminated in consolidation.





Use of Estimates





The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The estimates affecting the condensed consolidated financial statements that are particularly significant include the recoverability of product development costs, adequacy of allowances for returns, price concessions and doubtful accounts, lives and realization of intangibles, valuation of equity instruments and the valuation of inventories. Estimates are based on historical experience, where applicable or other assumptions that management believes are reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results may differ from those estimates under different assumptions or conditions.


F-8


Concentration of Credit Risk





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





If the financial condition and operations of the Company’s customers deteriorate, its risk of collection could increase substantially. A majority of the Company’s trade receivables are derived from sales to major retailers and distributors. The Company’s five largest ultimate customers accounted for approximately 71% (of which the following customers constituted balances greater than 10%:  customer A-24%, customer B-14%, customer C-14% and customer D-13%) and 87% (of which the following customers constituted balances greater than 10%: customer A-35%, customer B-24% and customer C-10%) of net revenue for the three months ended March 31, 2011 and 2010, respectively. These five largest customers accounted for 57% of the Company’s gross accounts receivable and due from factor as of March 31, 2011. The Company believes that the receivable balances from its customers do not represent a significant credit risk based on past collection experience. During the three months ended March 31, 2011 and 2010, the Company sold approximately $9.7 million and $4.2 million, respectively, of receivables to its factor with recourse. The factored receivables were approximately $2.9 million and $11.3 million of the Company’s gross accounts receivable and due from factor as of March 31, 2011 and December 31, 2010, respectively. The Company regularly reviews its outstanding receivables for potential bad debts and has had no history of significant write-offs due to bad debts.





Inventory





Inventory is stated at the lower of actual cost or market. Estimated product returns are included in the inventory balances and also recorded at the lower of actual cost or market.





Product Development Costs





The Company utilizes third party product developers and frequently enters into agreements with these developers that require it to make payments based on agreed upon milestone deliverable schedules for game design and enhancements. The Company receives the exclusive publishing and distribution rights to the finished game title as well as, in some cases, the underlying intellectual property rights for that game. The Company typically enters into these development agreements after it has completed the design concept for its products. The Company contracts with third party developers that have proven technology and the experience and ability to build the designed video game as conceived by the Company. As a result, technological feasibility is determined to have been achieved at the time in which the Company enters the agreement and it therefore capitalizes such payments as prepaid product development costs. On a product by product basis, the Company reduces prepaid product development costs and records amortization using the proportion of current year unit sales and revenues to the total unit sales and revenues expected to be recorded over the life of the title.





At each balance sheet date, or earlier if an indicator of impairment exists, the Company evaluates the recoverability of capitalized prepaid product development costs, development payments and any other unrecognized minimum commitments that have not been paid, using an undiscounted future cash flow analysis, and charge any amounts that are deemed unrecoverable to cost of goods sold if the product has already been released. If the product development process is discontinued prior to completion, any prepaid unrecoverable amounts are charged to research and development expense. During the three months ended March 31, 2011 and 2010, the Company wrote off approximately $461,000 and $0, respectively, of expense relating to costs incurred for the development of games that were abandoned during those periods. The Company uses various measures to estimate future revenues for its product titles, including past performance of similar titles and orders for titles prior to their release. For sequels, the performance of predecessor titles is also taken into consideration.





Prior to establishing technological feasibility, the Company expenses research and development costs as incurred.


F-9





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





Licenses and Royalties





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





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





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





Fixed Assets





Fixed assets, consisting primarily of office equipment and furniture and fixtures, are stated at cost. Major additions or improvements are capitalized, while repairs and maintenance are charged to expense. Property and equipment are depreciated on a straight-line basis over the estimated useful life of the assets. Office equipment and furniture and fixtures are depreciated over five years, computer equipment and software are generally depreciated over three years, and leasehold improvements are depreciated over the shorter of the related lease term or seven years. When depreciable assets are retired or sold, the cost and related allowances for depreciation are removed from the accounts and any gain or loss is recognized as a component of operating income or loss in the statement of operations.





Intangible Assets





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.


F-10


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





The Company reviews all long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, including assets to be disposed of by sale, whether previously held and used or newly acquired. The Company compares the carrying amount of the asset to the estimated undiscounted future cash flows expected to result from the use of the asset. If the carrying amount of the asset exceeds estimated expected undiscounted future cash flows, the Company records an impairment charge for the difference between the carrying amount of the asset and its fair value. The estimated fair value is generally measured by discounting expected future cash flows at the Company’s incremental borrowing rate or fair value, if available. As of December 31, 2010, the Company determined that certain intangible assets were impaired and recorded a charge of $9.9 million.





Revenue Recognition





The Company earns its revenue from the sale of interactive software titles developed by and/or licensed from third party developers. The Company recognizes such revenue upon the transfer of title and risk of loss to its customers. Accordingly, the Company recognizes revenue for software titles when there is (1) persuasive evidence that an arrangement with the customer exists, which is generally a customer purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable, (4) collection of the customer receivable is deemed probable, and (5) the Company does  not have any continuing obligations. The Company’s payment arrangements with customers typically provide net 30 and 60-day terms. Advances received from customers are reported on the condensed consolidated balance sheets as accrued expenses and other current liabilities until the Company meets its performance obligations, at which point it recognizes the revenue.





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





Allowances for Returns, Price Concessions and Other Items





The Company may accept returns and grant price concessions in connection with its publishing arrangements. Following reductions in the price of the Company’s products, price concessions may be granted that permit customers to take credits for unsold merchandise against amounts they owe the Company. The Company’s customers must satisfy certain conditions to allow them to return products or receive price concessions, including compliance with applicable payment terms and confirmation of field inventory levels. The Company also offers certain customers quarterly and/or annual rebates based upon achievement of certain pre-established sales levels of its products to such customers. The Company accounts for such volume rebates in the period in which they are earned by the customer.





Customers with whom the Company has distribution arrangements do not have the right to return titles or cancel firm orders. However, at times the Company will accept returns from its distribution customers to facilitate stock balancing, and will at times make accommodations to these distribution customers, including credits and returns, when demand for specific product titles fall below expectations.





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





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


F-11


Consideration Given to Customers and Received from Vendors and Vendor Concentrations





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





The Company receives various incentives from its manufacturers, including rebates based on a cumulative level of purchases. Such amounts are generally accounted for as a reduction in the price of the manufacturer’s product and included as a reduction of inventory or cost of goods sold.





The Company’s two largest vendors comprised approximately 41% and 31% of all purchases of inventory in the first three months of 2011. For the first three months of 2010, the Company’s two largest vendors for that period comprised approximately 73% and 3% of all purchases of inventory.





Equity-Based Compensation





The Company issued restricted common stock and options to purchase shares of common stock of the Company to certain members of management, employees and directors during the three months ended March 31, 2011 and 2010. Stock option grants vest over periods ranging from immediately to four years and expire within ten years of issuance. Stock options that vest in accordance with service conditions amortize over the applicable vesting period using the straight-line method.





The fair value of the options granted is estimated using the Black-Scholes option-pricing model. This model requires the input of assumptions regarding a number of complex and subjective variables that will usually have a significant impact on the fair value estimate. These variables include, but are not limited to, the volatility of the Company’s stock price and estimated exercise behavior. The Company used the current market price to determine the fair value of the stock price for the March 8, 2011 grant, and used the price of the Company’s equity raise in the fourth quarter of 2009 to determine the fair value of the stock price for the grant made on February 11, 2010. The following table summarizes the assumptions and variables used by the Company to compute the weighted average fair value of stock option grants:





Three Months

Ended March 31,2011


2010Risk-free interest rate


2.22
%


3.00
%Expected stock price volatility


60.0
%


60.0
%Expected term until exercise (years)


5



5Expected dividend yield

None


None





For the three months ended March 31, 2011 and 2010, the Company estimated the implied volatility for publicly traded options on its common shares as the expected volatility assumption required in the Black-Scholes option-pricing model. The selection of the implied volatility approach was based upon the historical volatility of companies with similar businesses and capitalization and the Company’s assessment that implied volatility is more representative of future stock price trends than historical volatility.





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


F-12


(Loss) Income Per Share





Basic (loss) income per share (“EPS”) is computed by dividing the net (loss) income applicable to common stockholders for the period by the weighted average number of shares of common stock outstanding during the same period. A 2010 restricted stock grant, of which 132,930 and 199,395 shares were unvested as of March 31, 2011 and March 31, 2010, respectively, was excluded from the basic EPS calculation. Diluted EPS is computed by dividing the net (loss) 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, except when the effect would be antidilutive. The number of additional shares is calculated by assuming that outstanding stock options and warrants with an exercise price less than the Company’s average stock price for the period were exercised, and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the reporting period. The Company incurred a loss for the three-month period ended March  31, 2011, therefore the dilutive net loss per share is the same as the basic net loss per share. For the three-month period ended March 31, 2010, 2,914 outstanding warrants and 4,321 outstanding stock options were excluded from the calculation of diluted net earnings per share, as their exercise price exceeded the average stock price for the period.





Income Taxes





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





In accordance with FASB Accounting Standards Codification Topic 740, the Company adopted the standard that clarifies the accounting and recognition for income tax positions taken or expected to be taken in the Company’s income tax returns. As a result of the implementation, the Company did not recognize any change in its tax liability. As of March 31, 2011, the Company believes it does not have any material unrecognized tax liabilities from tax positions taken during the current or any prior period. In addition, as of March 31, 2011, tax years 2007 through 2010 remain within the statute of limitations and are subject to examination by tax jurisdictions. The Company’s policy is to recognize any interest and penalties accrued on unrecognized tax benefits as part of income tax expense.





Fair Value Measurement





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





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


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


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





As of March 31, 2011 and December 31, 2010, the carrying value of cash, accounts receivable and due from factor, inventory, prepaid expenses, accounts payable, accrued expenses, due to factor, and advances from customers were reasonable estimates of the fair values because of their short-term maturity. The carrying value of financing arrangements and notes payable are reasonable estimates of fair value because interest rates closely approximate market rates.


F-13


Recently Issued Accounting Pronouncements





In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13, amending Accounting Standards Codification 605 related to revenue arrangements with multiple deliverables. Among other things, ASU 2009-13 provides guidance for entities in determining the accounting for multiple deliverable arrangements and establishes a hierarchy for determining the amount of revenue to allocate to the various deliverables. The amendments in ASU 2009-13 were effective for the Company beginning January 1, 2011, and did not have a material impact on the Company’s financial statements.





NOTE 4. INVENTORY, NET





Inventory consisted of:





(Amounts in Thousands)March 31,


December 31,2011


2010Finished products

$
4,049


$
3,166Parts & supplies


3,180



4,202Totals

$
7,229


$
7,368





Estimated product returns included in inventory at March 31, 2011 and December 31, 2010 were approximately $85,000 and $2.7 million, respectively.





NOTE 5. PREPAID EXPENSES AND OTHER CURRENT ASSETS





Prepaid expenses and other current assets consisted of:





(Amounts in Thousands)March 31,


December 31,2011


2010Vendor advances for inventory

$
76


$
68Prepaid royalties


288



271Income tax receivable


–



261Other


245



220Totals

$
609


$
820





NOTE 6. PRODUCT DEVELOPMENT COSTS, NET





The Company’s capitalized product development costs for the three months ended March 31, 2011 were as follows (amounts in thousands):





Product development costs, net - December 31, 2010

$
5,319New product development costs incurred


1,563Amortization and write-off of product development costs


(1,757
)Product development costs, net – March 31, 2011

$
5,125





Amortization of product development costs for the three months ended March 31, 2011 and 2010 was approximately $1.2 million and $1.0 million, respectively.





NOTE 7. INTANGIBLE ASSETS, NET





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


F-14





(Amounts in Thousands)March 31,

2011


December 31,

2010Estimated

Useful

Lives

(Years)


Gross

Carrying

Amount


Impairment

and

Accumulated

Amortization


Net

Book

Value


Net

Book

ValueContent

2


$
14,965


$
13,345


$
1,620


$
1,850Trademarks

5



1,510



652



858



903Customer relationships

2



2,749



1,746



1,003



1,147Total




$
19,224


$
15,743


$
3,481


$
3,900





Amortization expense related to intangible assets was approximately $420,000 and $480,000 for the three months ended March 31, 2011 and 2010, respectively.





The following table presents the estimated amortization of the Company’s current intangible assets for the next five years:





Year Ending December 31,

(Amounts in thousands)Balance of 2011(nine months)

$
1,2602012


1,6792013


1812014


1812015


180Total

$
3,481





NOTE 8. CREDIT AND FINANCING ARRANGEMENTS, ATARI AGREEMENT AND OTHER CUSTOMER ADVANCES





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





Purchase Order Financing





Zoo Publishing utilizes purchase order financing with Wells Fargo Bank, National Association (“Wells Fargo”) to fund the manufacturing of video game products. Under the terms of the Company’s agreement (the “Assignment Agreement”), the Company assigns purchase orders received from customers to Wells Fargo, and requests that Wells Fargo purchase the required materials to fulfill such purchase orders. Wells Fargo, which may accept or decline the assignment of specific purchase orders, retains the Company to manufacture, process and ship ordered goods, and pays the Company for its services upon Wells Fargo’s receipt of payment from the customers for such ordered goods. Upon payment in full of the purchase order invoice by the applicable customer to Wells Fargo, Wells Fargo re-assigns the applicable purchase order to the Company. 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 was for an initial term of 12 months, and continues thereafter for successive 12 month renewal terms unless either party terminates the Assignment Agreement by written notice to the other no later than 30 days prior to the end of the initial term or any renewal term. If the term of the Assignment Agreement is renewed for one or more 12 month terms, for each such 12 month term, the Company will pay to Wells Fargo a commitment fee, paid on the earlier of the anniversary of such renewal date or the date of termination of the Assignment Agreement. The initial and renewal commitment fees are subject to waiver if certain product volume requirements are met.


F-15


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





On April 6, 2011, Zoo Publishing, the Company and Wells Fargo entered into an amendment to the existing agreement. Pursuant to the amendment, the parties agreed to, among other things: (i) decrease the amount of funding available pursuant to the facility to $5,000,000; (ii) reduce the commitment fee to $200,000 for the next 12 months; and (iii) extend its term until April 5, 2012, subject to automatic renewal for successive 12 month terms unless either party terminates the agreement with written notice 30 days prior to the end of the initial term or any renewal term.





The amounts outstanding as of March 31, 2011 and December 31, 2010 were approximately $95,000 and $1.6 million, respectively, which is included in financing arrangements in the current liability section of the condensed consolidated balance sheets. The interest rate on advances is prime plus 2.0%, effective April 6, 2010; prior to that date the interest rate on advances was prime plus 4.0%. As of March 31, 2011 and 2010, the effective interest rate was 5.25% and 7.25%, respectively. The charges and interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and were approximately $49,000 and $203,000 for the periods ended March 31, 2011 and March 31, 2010, respectively. See Note 14 – Related Party Transactions, regarding guaranties of outstanding balances under the purchase order financing arrangement by current and former executive officers of the Company.





Receivable Financing





Zoo Publishing uses a factor to approve credit and to collect the proceeds from a portion of its sales. In August 2008, Zoo Publishing entered into a factoring and security agreement with Working Capital Solutions, Inc. (“WCS”), which utilizes existing accounts receivable in order to provide working capital to fund all aspects of the Company’s continuing business operations. The Company entered into a new factoring and security agreement with WCS on September 29, 2009 (the “Factoring Agreement”). Under the terms of the Factoring Agreement, the Company sells its receivables to WCS, with recourse. WCS, in its sole discretion, determines whether or not it will accept each receivable based upon the credit risk factor of each individual receivable or account. Once a receivable is accepted by WCS, WCS provides funding subject to the terms and conditions of the Factoring Agreement. The amount remitted to the Company by WCS equals the invoice amount of the receivable adjusted for any discounts or allowances provided to the account, less a reserve percentage (currently 30%) which is deposited into a reserve account established pursuant to the Factoring Agreement, less allowances and fees. In the event of default, valid payment dispute, breach of warranty, insolvency or bankruptcy on the part of the receivable account, WCS can require the receivable to be repurchased by the Company in accordance with the Factoring Agreement. The amounts to be paid by the Company to WCS for any accepted receivable include a factoring fee for each ten (10) day period the account is open. Since WCS acquires the receivables with recourse, the Company records the gross receivables including amounts due from its customers to WCS and it records a liability to WCS for funds advanced to the Company from WCS. During the three months ended March 31, 2011 and 2010, the Company sold approximately $9.7 million and $4.2 million, respectively, of receivables to WCS with recourse. At March 31, 2011 and December 31, 2010, accounts receivable and due from WCS included approximately $2.9 million and approximately $11.3 million, respectively, of amounts due from the Company’s customers to WCS. WCS had an advance outstanding to the Company of approximately $1.5 million and $8.0 million as of March 31, 2011 and December 31, 2010, respectively, which is included in financing arrangements in the current liability section of the respective condensed consolidated balance sheets. The interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and were approximately $449,000 and $123,000 for the three-month periods ended March 31, 2011 and 2010, respectively.


F-16




On April 1, 2010, Zoo Publishing, Zoo Games and the Company entered into a First Amendment to Factoring and Security Agreement (the “WCS Amendment”) with WCS which amended the Factoring Agreement to, among other things increase the maximum amount of funds available pursuant to the facility to $5,250,000. On October 1, 2010 Zoo Publishing, Zoo Games and the Company entered into a Second Amendment to Factoring and Security Agreement with WCS (the “WCS Second Amendment”) which further amended the Factoring Agreement to, among other things increase the maximum amount of funds available pursuant to the facility to $8,000,000. On November 30, 2010, Zoo Publishing, Zoo Games and the Company entered into a Third Amendment to Factoring and Security Agreement with WCS (the “WCS Third Agreement”) which further amended the Factoring Agreement to, among other things: (i) increase the reserve percentage from 25% to 30%; and (ii) reduce the factoring fee percentage for each ten (10) day period from 0.60% to 0.56%.





In connection with the Factoring Agreement and related amendments, Mark Seremet, President, Chief Executive Officer and a director of the Company and Zoo Games, and David Rosenbaum, the former President of  Zoo Publishing, entered into Guaranties with WCS, pursuant to which Messrs. Seremet and Rosenbaum agreed to guaranty the full and prompt payment and performance of the obligations under the Factoring Agreement. (See Note 14 - Related Party Transactions, for further information on such Guaranties.)





Atari Agreement





As a result of a fire in October 2008 that destroyed the Company’s inventory and impacted its cash flow from operations, the Company entered into an agreement with Atari, Inc. (“Atari”). This agreement became effective on October 24, 2008 and provided for Zoo Publishing to sell its products to Atari without recourse and Atari would resell the products to wholesalers and retailers that were acceptable to Atari in North America. The agreement initially expired on March 31, 2009, but was amended to extend the term for certain customers until June 30, 2010 and subsequently expired on June 30, 2010. This agreement provided for Atari to prepay to the Company for the cost of goods and pay the balance due within 15 days of shipping the product. Atari’s fees approximated 10% of the Company’s standard selling price and were recorded as a reduction in revenue. During the three months ended March 31, 2011 and 2010, the Company recorded approximately $0 and $8.3 million, respectively, of sales, net of the fee to Atari under this agreement. Atari took a reserve from the initial payment for potential customer sales allowances, returns and price protection that was analyzed and reviewed within a sixty day period to be liquidated no later than July 31, 2010. In addition, Atari was granted exclusive distribution rights for two of our products during 2009 and 2010. As of March 31, 2011 and December 31, 2010, the Company owed Atari approximately $1.7 million for cash received from customers that was owed to Atari. This amount is included in accrued expenses and other current liabilities on the Company’s condensed consolidated balance sheet.





NOTE 9. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES





Accrued expenses and other current liabilities consisted of:





(Amounts in Thousands)March 31,


December 31,2011


2010Obligations from content intangible assets fully impaired as of December 31, 2010

$
2,069


$
2,069Operating expenses


1,863



1,276Due to customers, including Atari


1,912



1,699Obligations arising from acquisitions (see Note 15)


620



620Royalties


1,551



1,523Interest


60



270Totals

$
8,075


$
7,457


F-17


NOTE 10. INCOME TAXES





The provision for income taxes is based on income recognized for financial statement purposes and includes the effects of temporary differences between such income and that recognized for tax return purposes. For the three months ended March 31, 2011, a federal income tax benefit recorded at a 34% rate against the Company’s loss for the period was offset fully by an increase in the Company’s valuation allowance against its deferred tax assets. Realization of the Company’s deferred tax assets is dependent upon the generation of future taxable income, the timing and amounts of which, if any, are uncertain. Based on the Company’s history of operating losses and the uncertainty surrounding the Company’s ability to generate future income, the Company was unable to conclude that it is more likely than not that the deferred tax assets will be realized. Accordingly, the Company has recorded a valuation allowance against substantially all of its deferred tax assets at March 31, 2011 and December 31, 2010.





The Company paid approximately $8,000 and $38,000 to various state jurisdictions for income taxes during the three months ended March 31, 2011 and 2010, respectively.





As of March 31, 2011, the Company had approximately $1.2 million of available capital loss carryforwards which expire in 2013. If the Company is able to utilize the carryforwards in the future, the tax benefit of the carryforwards will be applied to reduce future capital gains of the Company.





As of March 31, 2011, the Company has U.S. federal net operating loss (“NOL”) carryforwards of approximately $9.8 million. This amount includes approximately $1.6 million of acquired NOLs which cannot be immediately utilized as a result of statutory limitations. As a result of such statutory limitations, the Company will only be able to utilize approximately $160,000 of NOL and capital loss carryforwards per year. The federal NOL carryforwards will begin to expire in 2028. The Company has state NOL carryforwards of approximately $15.8 million which will be available to offset taxable state income during the carryforward period. The state NOL carryforwards will also begin to expire in 2028.





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





The Company has authorized 3,500,000,000 shares of common stock, par value $0.001, and 5,000,000 shares of preferred stock, par value $0.001 as of March 31, 2011. All references to common stock reflect the one-for-600 reverse stock split of the Company’s common stock, par value $.001 per share, that became effective May 10, 2010, and all historical information has been restated to reflect the reverse stock split.





Common Stock





As of March 31, 2011, there were 6,243,699 shares of common stock issued and 6,230,696 shares of common stock outstanding.





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





On February 11, 2010, the Board of Directors approved the issuance of 281,104 shares of restricted common stock to various members of the Board of Directors. The fair value of the restricted common stock grants was determined to be $397,000, based on the price of the Company’s equity raise in the fourth quarter of 2009 and a marketability discount. The Company expensed approximately $25,000 and $111,000 during the three-month periods ending March 31, 2011 and 2010, respectively. The remaining balance as of March 31, 2011 of approximately $187,000 will be expensed throughout the remaining vesting period of the restricted common stock grants until February 2013.





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





Non-vested shares at December 31, 2010


199,395Shares granted


–Shares vested


(66,465
)Non-vested shares at March 31, 2011


132,930


F-18


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





Preferred Stock





As of March 31, 2011 and December 31, 2010, there were no shares of Series A Preferred Stock or Series B Preferred Stock issued or outstanding.





Stock-based Compensation Arrangements





The Zoo Entertainment, Inc. 2007 Employee, Director and Consultant Stock Plan, as amended, (the “2007 Plan”) provides for the issuance of common shares  in connection with the issuance of incentive stock options (“ISOs”), non-qualified stock options (“NQSOs”), grants of common stock, or stock-based awards. Under the terms of the 2007 Plan, no more than 300,000 stock rights may be granted to any participant in any fiscal year. The Company’s Board of Directors determines eligibility. The exercise price of the options is to be not less than the fair market value of the underlying common stock at the grant date and in the case of ISOs granted to a 10% owner (as defined), the exercise price must be at least 110% of the fair market value of the underlying common stock at the grant date. Under the terms of the 2007 Plan, the options expire no later than ten years from the date of grant in the case of ISOs (five years in the case of ISOs granted to a 10% owner), as set forth in each option agreement in the case of NQSOs, or earlier in either case in the event a participant ceases to be an employee, director or consultant of the Company. The grants vest over periods ranging from immediately to four years.





On January 14, 2009, the Company’s Board of Directors approved and adopted an amendment to the 2007 Plan, which increased the number of shares of common stock that could be issued under the 2007 Plan from 1,667 shares to 6,667 shares, and increased the maximum number of shares of common stock with respect to which stock rights could be granted to any participant in any fiscal year from 417 shares to 1,250 shares. All other terms of the 2007 Plan remained in full force and effect. On February 11, 2010, the Company’s Board of Directors approved and adopted a second amendment to the 2007 Plan, which increased the number of shares of common stock that may be issued under the plan from 6,667 shares to 1,208,409 shares and increased the maximum number of shares of common stock with respect to which stock rights may be granted to any participant in any fiscal year from 1,250 shares to 300,000 shares. All other terms of the 2007 Plan remain in full force and effect.




F-19


As part of the November 2009 financing, Messrs. Seremet and Rosenbaum agreed to amend their respective letter agreements, pursuant to which, in consideration of each of their continued personal guaranties, the Company’s Board of Directors approved the issuance of an option to purchase restricted stock or other incentives intended to comply with Section 409A of the Internal Revenue Code, equal to a 6.25% ownership interest, to each of Mr. Seremet and Mr. Rosenbaum. Subject to the effectiveness of an amendment to the Company’s Certificate of Incorporation authorizing an increase in the number of authorized shares of the Company’s common stock and the one-for-600 reverse stock split, on February 11, 2010, the Company issued 337,636 options to purchase shares of common stock to each of Mr. Seremet and Mr. Rosenbaum in consideration for their continued personal guarantees. The Company performed a Black-Scholes valuation on the options and determined that the value of the arrangements on February 11, 2010 was $542,000. Of the $542,000, $403,000 was included as stock-based compensation expense in 2009 based on the value ascribed for the period from November 20, 2009 to December 31, 2009, and was included in accrued expenses in the December 31, 2009 consolidated balance sheet. The stock-based compensation expense recorded for the three months ended March 31, 2011 and 2010 was approximately $9,500 and $28,000, respectively. The remaining $6,300 of compensation expense related to the options as of March 31, 2011, will be expensed throughout the remaining vesting period of the options until May 2011.





On February 11, 2010, the Company granted options to purchase 585,645 shares of common stock to various employees, directors and consultants, outside of the 2007 Plan, at an exercise price of $2.46 per share. These shares were issued outside of the 2007 Plan, as there were insufficient shares in the 2007 Plan at the date of grant to allow such issuance.





On March 8, 2011, the Company granted options to purchase 42,138 shares of common stock to a newly-appointed director at an exercise price of $3.86 per share, pursuant to the 2007 Plan.





A summary of the status of the Company’s outstanding stock options as of March 31, 2011 and changes during the period is presented below:





Number of

Shares


Weighted

Average

Exercise

PriceOutstanding at December 31, 2010


1,300,838


$
4.54Granted


42,138



3.86Forfeited and expired


–



–Outstanding at March 31, 2011


1,342,976


$
4.52Options exercisable at March 31, 2011


831,488


$
5.41





The fair value of options granted during the first quarter of 2011 was approximately $84,000.





The following table summarizes information about outstanding stock options at March 31, 2011:


F-20





Options Outstanding


Options ExercisableRange of Exercise

Prices


Number

Outstanding


Weighted-
Average

Remaining

Contractual

Life

(Years)


Weighted-
Average

Exercise

Price


Number

Exercisable


Weighted-
Average

Exercise

Price$
1,548.00



273



7.5


$
1,548.00



273


$
1,548.00$
1,350.00



235



7.5


$
1,350.00



157


$
1,350.00$
912.00



2,438



7.5


$
912.00



2,438


$
912.00$
180.00



1,250



7.8


$
180.00



833


$
180.00$
5.50



60,000



9.4


$
5.50



4,000


$
5.50$
3.86



42,138



9.9


$
3.86



–


$
3.86$
2.46



561,370



8.9


$
2.46



243,053


$
2.46$
1.50



675,272



8.9


$
1.50



580,734


$
1.50$
1.50 to $1,548.00



1,342,976



8.9


$
4.52



831,488


$
5.41





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





Number

Outstanding


Weighted-
Average

Exercise

Price


Weighted-
Average

Remaining

Contractual Life

(Years)Non-vested shares at December 31, 2010


612,590


$
3.02



9.2Options granted


42,138


$
3.86



9.9Options vested


(143,240
)

$
3.06



8.9Options forfeited or expired


–


$
–



–Non-vested shares at March 31, 2011


511,488


$
3.08



9.0





As of March 31, 2011, there was approximately $387,000 of unrecognized compensation costs related to non-vested stock option awards, which is expected to be recognized over a remaining weighted-average vesting period of 1.4 years.





At March 31, 2011, there were 1,100,449 shares available for issuance under the 2007 Plan.





The intrinsic value of options outstanding at March 31, 2011 was approximately $2.6 million.





Warrants





As of March 31, 2011, there were 1,039,703 warrants outstanding with terms expiring in 2012 through 2014, all of which are currently exercisable.





A summary of the status of the Company’s outstanding warrants as of March 31, 2011 and changes during the period then ended are presented below:





Number of

Warrants


Weighted

Average

Exercise

PriceOutstanding at December 31, 2010


1,039,703


$
6.82Granted

–


–Exercised

–


–Outstanding at March 31, 2011


1,039,703


$
6.82Warrants exercisable at March 31, 2011


1,039,703


$
6.82





F-21





The following table summarizes information about outstanding warrants at March 31, 2011:





Warrants OutstandingRange of Exercise Prices


Number

Outstanding


Weighted-

Average

Remaining

Contractual

Life


Weighted-

Average

Exercise

Price$
1,704.00



2,383



2.3


$
1,704.00$
1,278.00



531



2.3


$
1,278.00$
180.00



12,777



3.4


$
180.00$
6.00



6,818



2.3


$
6.00$
0.01



1,017,194



3.7


$
0.01$
0.01 to $1,704.00



1,039,703



3.7


$
6.82





NOTE 12. INTEREST EXPENSE





(Amounts in Thousands)Three Months Ended March 31,2011


2010Interest on various notes

$
–


$
30Interest arising from amortization of warrants


–



121Interest on financing arrangements


498



326Interest expense

$
498


$
477





NOTE 13. LITIGATION





As previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, on or around March 2, 2011, Atari, Inc. (“Atari”) commenced an action in the United States District Court for the Southern District of New York against the Company alleging that the Company had breached a sales agreement, dated October 24, 2008, as amended, and a sales agreement entered into on or about June 15, 2010, to sell finished, packaged video games to Atari for its resale to wholesalers and retailers in the U.S., Mexico and Canada. On May 6, 2011, the Company entered into a Settlement Agreement with Atari whereby, in exchange for dismissing the complaint with prejudice if the terms of the Settlement Agreement are followed, the Company agreed to transfer to Atari full ownership of, and rights to sell and convey good title to certain units of video games listed therein. As of March 31, 2011, the Company had recorded all amounts related to this obligation in its financial statements (see Note 8).





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





NOTE 14. RELATED PARTY TRANSACTIONS





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


F-22


On October 1, 2010, the Company entered into an Amended and Restated Letter Agreement with each of Mark Seremet and David Rosenbaum, which among other things, the Company agreed to compensate each of Messrs. Seremet and Rosenbaum in consideration for each of their guarantees of the increased indebtedness incurred by the Company under the WCS Second Amendment, for so long as such guarantees and loan remain in full force and effect, an additional $25,000 on each of October 1, 2010, January 1, 2011, April 1, 2011 and July 1, 2011.





On May 16, 2011, the Company entered into the Amendment. Pursuant to the Amendment, the Company agreed to continue to pay Mr. Rosenbaum a monthly fee of $7,000 for so long as the Loan and guaranty from Wells Fargo continue to remain in full force and effect. In addition, the Company agreed to pay Mr. Rosenbaum $25,000 on each of May 31, 2011 and July 1, 2011 for so long as such guaranties and the Loan remain in full force and effect. The Company acknowledged that it would make a determination on or before August 31, 2011 whether it will continue to pay Mr. Rosenbaum such amount.





As part of the November 2009 financing, Messrs. Seremet and Rosenbaum agreed to amend their respective letter agreements, pursuant to which, in consideration of each of their continued personal guaranties, the Company’s Board of Directors approved the issuance of an option to purchase restricted stock or other incentives intended to comply with Section 409A of the Internal Revenue Code, equal to a 6.25% ownership interest, to each of Mr. Seremet and Mr. Rosenbaum. Subject to the effectiveness of an amendment to the Company’s Certificate of Incorporation authorizing an increase in the number of authorized shares of the Company’s common stock and the one-for-600 reverse stock split, on February 11, 2010, the Company issued 337,636 options to purchase shares of common stock to each of Mr. Seremet and Mr. Rosenbaum in consideration for their continued personal guarantees. The Company performed a Black-Scholes valuation on the options and determined that the value of the arrangements on February 11, 2010 was $542,000. Of the $542,000, $403,000 was included as stock-based compensation expense in 2009 based on the value ascribed for the period from November 20, 2009 to December 31, 2009, and was included in accrued expenses in the December 31, 2009 consolidated balance sheet. The stock-based compensation expense recorded for the three months ended March 31, 2011 and 2010 was approximately $9,500 and $28,000, respectively. The remaining $6,300 of compensation expense related to the options as of March 31, 2011, will be expensed throughout the remaining vesting period of the options until May 2011.





NOTE 15.              SUBSEQUENT EVENT





As previously disclosed in the Company’s Current Report on Form 8-K filed with the SEC on May 5, 2011, effective April 29, 2011, David Rosenbaum, former President of Zoo Publishing is no longer with the Company. In connection therewith, on May 16, 2011, the Company and Mr. Rosenbaum entered into a Separation Agreement and General Release (the “Release”), effective as of the eighth day following Mr. Rosenbaum’s execution without revocation of the Release. Pursuant to the Release, Mr. Rosenbaum’s option to purchase 337,636 shares of the Company’s common stock (the “Option”) will accelerate, vest fully and become exercisable as of April 29, 2011. The term of the Option was extended through April 30, 2018. The change in vesting provisions constituted a modification of a stock option award. Accordingly, the Company will revalue the option award and record any necessary additional expense from such modification during the second quarter of 2011. The Company has an outstanding obligation to Mr. Rosenbaum for $620,000 (see Note 9).  Such amount will be satisfied in the following manner.The Company and Mr. Rosenbaum agreed that the Company would pay Mr. Rosenbaum $270,000 in twenty-seven equal monthly installments with the first such installment payable on July 31, 2011, and on October 31, 2013, the Company will pay the remaining $350,000 either in a lump sum amount in cash or in shares having an aggregate fair market value of $350,000 in full payment of obligations owed to Mr. Rosenbaum by the Company pursuant to that certain Separation and Release Agreement, dated July 31, 2007, by and among the Company, Zoo Publishing and Mr. Rosenbaum. The Company and Mr. Rosenbaum each agreed to release each other of any continuing charges, complaints, damages or remedies between the parties.


F-23


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





The following discussion should be read in conjunction with, and is qualified in its entirety by, the financial statements and the notes thereto included in this report. In this discussion, the words “Company”, “we”, “our” and “us” refer to the Company and its operating subsidiaries, Zoo Games, Zoo Publishing, and indiePub, Inc. This discussion contains certain forward-looking statements that involve substantial risks, assumptions and uncertainties. When used in this report, the words “anticipate,” “believe,” “estimate,” “expect,” “may,” “should,” “could” and similar expressions as they relate to our management or us are intended to identify such forward-looking statements. Our actual results, performance or achievements could differ materially from those expressed in, or implied by, these forward-looking statements as a result of various factors, including, but not limited to, those presented under “Risk Factors” disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and elsewhere herein. Historical operating results are not necessarily indicative of the trends in operating results for any future period.





We are a developer, publisher, and distributor of interactive entertainment software for both retail and digital distribution channels. Our retail business complements our digital strategy, allowing us access to the growing market and popularity of user-generated content. Our disc-based retail software targets family-oriented mass-market consumers with retail prices ranging from $9.99 to $49.99 per title. Our entertainment software is developed for use on major consoles, handheld gaming devices, personal computers, tablets, and mobile smart-phone devices. We currently develop and/or publish or are in the process of developing and/or publishing video games that operate on platforms including Nintendo’s Wii, DS and 3DS, Sony’s PlayStation 3, Microsoft’s Xbox 360 and its controller-free accessory, Kinect, Android mobile devices and iOS devices including iPod Touch, iPad and iPhone. We also develop and publish downloadable games for “connected services” including mobile devices, Microsoft’s Xbox Live Arcade (XBLA), Sony’s PlayStation Network (PSN), Nintendo’s DsiWare, Facebook, and Steam, a platform for hosting and selling downloadable PC/Mac software.





On March 9, 2011, we incorporated our wholly-owned subsidiary, indiePub, Inc. in the State of Delaware. IndiePub fosters the independent gaming community by playing host to independent game developers and players and providing developers with the resources they need to collaborate, publish and create great games. We operate indiePub (www.indiepub.com), an innovative content creation site that is designed to capitalize on opportunities in the emerging and high-growth digital entertainment space by serving as a source for content for future development and eventual publication.





Our current overall business strategy has shifted with the changes we are seeing within the industry. We are gradually phasing out our retail business of family-oriented, often-branded, console titles, and shifting our focus to digital downloadable content on platforms such as XBLA and PSN, as well as mobile gaming. Our digital business focuses on bringing fresh, innovative content to digital distribution channels, as well as mobile devices. Sourcing content from indiePub is one way in which we acquire new intellectual property for development and publication for digital distribution.





Historically, some of our titles have been based on licenses of well-known properties such as Jeep, Hello Kitty, Bigfoot, Shawn Johnson, and Remington, and in other cases, based on our original intellectual property. Our games span a diverse range of categories, including sports, family, racing, game-show, strategy and action-adventure, among others. In addition, we have developed video game titles that were bundled with unique accessories such as fishing rods, bows, steering wheels and guns, which helped to differentiate our products and provide additional value to the consumer. Our focus was on high-quality products with great value while simultaneously putting downward pressure on our development expenditures and time to market.





Zoo Entertainment; Merger with Zoo Games





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





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


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On September 12, 2008, the Company, Merger Sub, Zoo Games and the stockholder representative completed the Merger. Effective as of the closing of the Merger, Zoo Games became our wholly-owned subsidiary. As a result thereof, the historical and current business operations of Zoo Games now comprise our principal business operations.





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





Zoo Games





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





Currently, we have determined that we operate in one segment in the United States.





Results of Operations





For the Three Months Ended March 31, 2011 as Compared to the Three Months Ended March 31, 2010





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





(Amounts in Thousands Except Per Share Data)

For the Three Months Ended March 31,2011


2010Revenue

$
3,781



100
%

$
16,662



100
%Cost of goods sold


4,691



124



12,930



78Gross (loss) profit


(910
)


(24
)


3,732



22Operating expenses:General and administrative


2,199



58



1,605



10Selling and marketing


1,045



28



1,116



6Research and development


461



12



–



–Depreciation and amortization


453



12



504



3Total operating expenses


4,158



110



3,225



19(Loss) income from operations


(5,068
)


(134
)


507



3Interest expense, net


(498
)


(13
)


(477
)


(3
)(Loss) income from operations before income taxes


(5,566
)


(147
)


30



0Income tax expense


–



–



(9
)


(0
)Net (loss) income

$
(5,566
)


(147
)%

$
21



0
%(Loss) income per common share - basic

$
(0.92
)





$
0.02(Loss) income per common share - diluted

$
(0.92
)





$
0.01


Net Revenues. Net revenues for the three months ended March 31, 2011 were approximately $3.8 million, a decrease of 77% from the revenues for the three months ended March 31, 2010 of approximately $16.7 million. Sales in both periods consist primarily of casual game sales in North America. The breakdown of gross sales by platform is as follows:


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Three Months Ended March 31,2011


2010Nintendo Wii


65
%


68
%Nintendo DS


11
%


32
%SONY PS3


12
%


0
%Microsoft Xbox 360


12
%


0
%





Sales of all software for Nintendo Wii and DS products decreased approximately17% from the first quarter of 2010 to 2011, according to The NPD Group, an independent global provider of consumer and retail market research information. Our two largest distributors during the 2010 year, who combined represented 43% of our sales for the first quarter of 2010, did not purchase any product in the three months ended March 31, 2011. The biggest sellers during the 2011 period were (i) Minute to Win It for the Nintendo Wii platform, (ii) Mayhem 3D for the SONY PS3 platform, and (iii) Mayhem 3D for the Microsoft Xbox 360 platform. The various Wii games bundled with our gun blaster, bow, rod and wheel peripherals accounted for approximately 34% of our revenue during the 2011 period and approximately 21% during the comparable 2010 period. The biggest sellers during the 2010 period were (i) Deal or No Deal on the Nintendo Wii platform, (ii) Deer Drive bundled with our gun blaster for the Nintendo Wii platform, and (iii) Dream Chronicles on the Nintendo DS platform. The 2011 period consisted of approximately 277,000 units sold in North America at an average gross price of $18.07, while the 2010 period consisted of approximately 1.53 million units sold in North America at an average gross price of $11.22. The average price increase resulted primarily from the sale of approximately 20,000 PS3 and 20,000 Xbox Mayhem 3D at a gross price of approximately $30.00 per unit in the 2011 period. Sales allowances provided to customers for returns, markdowns, price protection and other deductions were 25% of gross sales for the three months ended March 31, 2011, as compared to 4% of gross sales for the three months ended March 31, 2010. The increase was due primarily to large price protection allowances for certain products sold in the 2011 period.





Gross (Loss) Profit. Gross loss for the three months ended March 31, 2011 was approximately $(0.9) million, or (24%) of net revenue, while the gross profit for the three months ended March 31, 2010 was approximately $3.7 million, or 22% of net revenue. The costs included in 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 2011 sales were primarily catalogue product sold at a price slightly above the current value of the inventory, therefore generating minimal gross profit., The gross margin was further adversely affected by the accelerated amortization of approximately $1.1 million of product development costs and approximately $100,000 of royalty expense as a result of changes in estimated unit sales for certain ofour catalogue products, as well as an additional $200,000 inventory reserve recorded in the 2011 period.





General and Administrative Expenses. General and administrative expenses for the three months ended March 31, 2011 were approximately $2.2 million as compared to approximately $1.6 million for the comparable period in 2010. Non-cash stock-based compensation included in general and administrative expenses was approximately $106,000 and $246,000 for the three months ended March 31, 2011 and 2010, respectively. The department costs included in general and administrative expenses include executive, finance, legal, information technology, product development administration, warehouse operations and digital/indiePub initiatives. The increase in general and administrative expenses is due primarily to the increase in headcount from six employees in the 2010 period to nineteen employees in the 2011 period, resulting in an increase of approximately $350,000 of salaries and related expenses. In addition, there were six employees whose function’s classification shifted from selling and marketing in the 2010 period to general and administrative in the 2011 period, resulting in an increase of approximately $150,000 in general & administrative expenses from 2010 to 2011. The indiePub and digital initiative costs included in general and administrative expenses for the 2011 period were approximately $162,000.





Selling and Marketing Expenses. Selling and marketing expenses decreased from approximately $1.1 million for the three months ended March 31, 2010 to approximately $1.0 million for the three months ended March 31, 2011. However, these expenses did not decrease to the same extent as our net revenues as a significant portion of those costs are fixed in nature, such as payroll expenses . This decrease was offset by increased expense for prize winners of game contests held on our indiePub site of $250,000.


26




Research and Development.We incurred research and development expenses of approximately $461,000 during the first three months of 2011 to expense costs relating to the development of games that were abandoned during the period. There were no write-offs during the comparable 2010 period.





Depreciation and Amortization Expenses. Depreciation and amortization costs for the three months ended March 31, 2011 were approximately $453,000 compared to approximately $504,000 in the 2010 period. The amortization of intangible assets was $420,000 for the three months ended March 31, 2011, compared to approximately $481,000 for the three months ended March 31, 2010, due to the reduced intangible asset balance offset by the shortened lives of such assets. The balance relates to depreciation of fixed assets during each period.





Interest Expense. Interest expense for the three months ended March 31, 2011 was $498,000 as compared to $477,000 for the three months ended March 31, 2010. The 2011 period includes $449,000 of interest for the receivable factoring facility and $49,000 of interest for the purchase order financing facility. The 2010 period includes $123,000 of interest for the receivable factoring facility, $203,000 of interest for the purchase order financing facility, $30,000 for the Solutions 2 Go loan and $121,000 of non-cash interest relating to the warrants issued for the Solutions 2 Go exclusive distribution rights





Income Taxes. We recorded no income tax benefitfor the three months ended March 31, 2011 against our pre-tax loss of approximately $5.6 million. A federal income tax benefit calculated at a 34% rate was fully offset by an increase in our valuation allowance against our deferred tax assets, as we could conclude that it was more likely than not that the deferred tax assets would be realized. We recorded income tax expense of $9,000 for the three months ended March 31, 2010 against pre-tax income of approximately $30,000.





(Loss) Income Per Common Share. The basic and diluted loss per share for the three months ended March 31, 2011 was $(0.92) based on a weighted average shares outstanding for the period of approximately 6.1 million shares. The basic earnings per share for the three months ended March 31, 2010 was $0.02 based on weighted average shares outstanding for the period  of approximately 1.1 million, while the diluted earnings per share for the same period was $0.01 based on weighted average shares outstanding of approximately 2.9 million shares.





Liquidity and Capital Resources





We incurred a net loss of approximately $5.6 million for the three months ended March 31, 2011 and net income of approximately $21,000 for the three months ended March 31, 2010. Our principal sources of cash during both the 2011 and 2010 periods were the use of our purchase order and receivable financing arrangements, and cash generated from operations throughout the periods.





Net cash provided by operating activities for the three months ended March 31, 2011 was approximately $8.1 million, due primarily to a decrease in receivables and due from factor resulting from the collection of the December 31, 2010 receivables, offset by cash utilized for operating expenses during the quarter. Net cash used in operating activities for the three months ended March 31, 2010 was approximately $3.1 million, consisting primarily of the use of customer advances for product sales in the quarter, product development costs, building inventory for future sales and an increase in receivables as we became less dependent on prepayments from Atari.





Net cash used in investing activities for the three months ended March 31, 2011 was $13,000 and for the three months ended March 31, 2010 was $79,000, all for the purchase of fixed assets.





Net cash used in financing activities for the three months ended March 31, 2011 was approximately $8.0 million, consisting of net repayments of approximately $6.5 million on our receivable factoring facility and approximately $1.5 million on our purchase order financing facility. Net cash provided by financing activities for the three months ended March 31, 2010 was approximately $1.4 million, consisting of net borrowings on our financing facilities.


27





Factoring Facility





We have a factoring facility with Working Capital Solutions, Inc. (“WCS”), which utilizes existing accounts receivable in order to provide working capital to fund our continuing business operations. Under the terms of our factoring and security agreement (the “Factoring Agreement”), our receivables are sold to WCS, with recourse. WCS, in its sole discretion, determines whether or not it will accept each receivable based upon the credit risk factor of each individual receivable or account. Once a receivable is accepted by WCS, WCS provides funding, subject to the terms and conditions of the Factoring Agreement. The amount remitted to us by WCS equals the invoice amount of the receivable adjusted for any discounts or allowances provided to the account, less a reserve percentage (currently 30%). In the event of default, valid payment dispute, breach of warranty, insolvency or bankruptcy on the part of the receivable account, the factor can require the receivable to be repurchased by us in accordance with the Factoring Agreement. The amounts to be paid by us to WCS for any accepted receivable include a factoring fee of 0.56% (0.60% prior to November 30, 2010) for each ten (10) day period the account is open. During the three months ended March 31, 2011 and 2010, we sold approximately $9.7 million and $4.2 million, respectively, of receivables to WCS with recourse. At March 31, 2011 and December 31, 2010, accounts receivable and due from WCS included approximately $2.9 million and approximately $11.3 million, respectively, of amounts due from our customers to WCS. WCS had an advance outstanding to us of approximately $1.5 million and $8.0 million as of March 31, 2011 and December 31, 2010, respectively, which is included in financing arrangements in the current liability section of our condensed consolidated balance sheets. The interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and were approximately $449,000 and $123,000 for the three-month periods ended March 31, 2011 and 2010, respectively.





On April 1, 2010, we entered into a First Amendment to Factoring and Security Agreement (the “WCS Amendment”) with WCS, which amended the Factoring Agreement to, among other things increase the maximum amount of funds available pursuant to the facility to $5,250,000. On October 1, 2010, we entered into a Second Amendment to Factoring and Security Agreement with WCS (the “WCS Second Amendment”) which further amended the Factoring Agreement to, among other things, increase the maximum amount of funds available pursuant to the facility to $8,000,000. On November 30, 2010, we entered into a Third Amendment to Factoring and Security Agreement with WCS (the “WCS Third Agreement”) which further amended the Factoring Agreement to, among other things: (i) increase the reserve percentage from 25% to 30%; and (ii) reduce the factoring fee percentage for each ten (10) day period from 0.60% to 0.56%.





In connection with the Factoring Agreement and related amendments, Mark Seremet, President, Chief Executive Officer and a director of the Company and Zoo Games, and David Rosenbaum, the former President of Zoo Publishing, entered into Guaranties with WCS, pursuant to which Messrs. Seremet and Rosenbaum agreed to guaranty the full and prompt payment and performance of the obligations under the Factoring Agreement. In connection therewith, pursuant to an Amended and Restated Letter Agreement, dated as of October 1, 2010, with each of Mark Seremet and David Rosenbaum, the Company agreed to compensate each of Messrs. Seremet and Rosenbaum in consideration for each of their guaranties of the increased indebtedness incurred by the Company, for so long as such guaranties and loan remain in full force and effect, an additional $25,000 on each of October 1, 2010, January 1, 2011, April 1, 2011 and July 1, 2011.





Pursuant to that certain Letter Amendment dated as of May 16, 2011 by and between the Company and Mr. Rosenbaum which amended that certain Amended and Restated Letter Agreement dated as of October 1, 2010 (the “Amendment”), the Company agreed to pay Mr. Rosenbaum $25,000 on each of May 31, 2011 and July 1, 2011 for so long as such guaranty and the loan to WCS remain in full force and effect.





Purchase Order Facility




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




28





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





On April 6, 2011, we and Wells Fargo entered into an amendment to the existing agreement. Pursuant to the amendment, the parties agreed to, among other things: (i) decrease the amount of funding available pursuant to the facility to $5,000,000; (ii) reduce the commitment fee to $200,000 for the next 12 months; and (iii) extend its term until April 5, 2012, subject to automatic renewal for successive 12 month terms unless either party terminates the agreement with written notice 30 days prior to the end of the initial term or any renewal term.





The amounts outstanding as of March 31, 2011 and December 31, 2010 were approximately $95,000 and $1.6 million, respectively, which is included in financing arrangements in the current liability section of our condensed consolidated balance sheets. The interest rate on advances is prime plus 2.0%, effective April 6, 2010; prior to that date the interest rate on advances was prime plus 4.0%. As of March 31, 2011 and 2010, the effective interest rate was 5.25% and 7.25%, respectively. The charges and interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and were approximately $48,000 and $203,000 for the periods ended March 31, 2011 and March 31, 2010, respectively. See Note 14 – Related Party Transactions, regarding guaranties of outstanding balances under the purchase order financing arrangement by current and former executive officers of the Company.





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 us, 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.





Due to the losses we incurred since inception, we are unable to predict whether we will have sufficient cash from operations to meet our financial obligations for the next 12 months. Accordingly, the report of our independent registered public accounting firm on our consolidated financial statements for the fiscal year ended December 31, 2010 includes an explanatory paragraph raising substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent on, among other factors, the following significant short-term actions: (i) management’s ability to generate cash flow from operations sufficient to maintain our daily business activities; ; (ii) our ability to reduce expenses and overhead and (iii) our ability to renegotiate certain obligations. Management’s active efforts in this regard include negotiations with certain vendors to satisfy cash obligations with non-cash assets or equity, reductions of headcount and overhead obligations, and the development of strategies to convert other non-cash assets into cash. There can be no assurance that all or any of these actions will meet with success. We may be required to seek alternative or additional financing to maintain or expand our existing operations through the sale of our securities, an increase in our credit facilities, or otherwise, and there can be no assurance that we will secure financing, and if we are able to, that such financing will be on favorable terms to us or our stockholders. Our failure to obtain financing, if needed, could have a material adverse effect upon our business, financial conditions and results of operations.


29


Critical Accounting Policies and Estimates





There were no changes to our critical accounting policies and estimates since the year ended December 31, 2010. A complete description of our critical accounting policies and estimates can be found in our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission on April 15, 2011 and also in Note 3 to the unaudited condensed consolidated financial statements included in this quarterly report for the period ended March 31, 2011.





Recently Issued Accounting Pronouncements





In October 2009, the FASB issued ASU No. 2009-13, amending Accounting Standards Codification 605 related to revenue arrangements with multiple deliverables. Among other things, ASU 2009-13 provides guidance for entities in determining the accounting for multiple deliverable arrangements and establishes a hierarchy for determining the amount of revenue to allocate to the various deliverables. The amendments in ASU 2009-13 became effective for us beginning January 1, 2011 and implementation did not have a material impact on our financial statements.





Accounting Standards Updates Not Yet Effective





There are no ASUs that are effective after May 16, 2011 that are expected to have a significant effect on our consolidated financial position or results of operations.





Off-Balance Sheet Arrangements





As of March 31, 2011, we did 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 did not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases.





Fluctuations in Operating Results and Seasonality





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





ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





Not applicable as we are a smaller reporting company.





ITEM 4T. CONTROLS AND PROCEDURES.





Evaluation of Disclosure Controls and Procedures





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





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




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





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





Our management has determined that we have material weaknesses in our internal control over financial reporting related to: (i) 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 statement close process, (ii) an insufficient level of monitoring and oversight, (iii) ineffective controls over accounting for revenue recognition and allowances for returns and other items, (iv) insufficient analysis of certain key account balances at interim reporting cycles and (v) timely recognition of changes within the Company’s business plan and the related impact on the financial statements.





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





Due to resource constraints in 2010 and 2011, both monetary and time, we were not able to appropriately address these matters and we were unable to get to a level to fully remediate these material weaknesses. We will continue to reassess our accounting and finance staffing levels to determine and seek the appropriate accounting resources to be added to our staff to handle the existing workload, provide for a sufficient level of monitoring and oversight, implement effective controls over accounting for revenue recognition and allowances for returns and other items, provide for sufficient analysis of certain key account balances at interim reporting cycles and allow for the  timely evaluation and recognition of impact on the financial statements associated with changes to the Company’s business plan.





Changes in Controls and Procedures





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


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PART II - OTHER INFORMATION





ITEM  1. LEGAL PROCEEDINGS.





As previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and filed with the SEC on April 15, 2011, on or around March 2, 2011, Atari, Inc. (“Atari”) commenced an action in the United States District Court for the Southern District of New York against the Company alleging that the Company had breached a sales agreement, dated October 24, 2008, as amended, and a sales agreement entered into on or about June 15, 2010, to sell finished, packaged video games to Atari for its resale to wholesalers and retailers in the U.S., Mexico and Canada. On May 6, 2011, the Company entered into a Settlement Agreement with Atari whereby, in exchange for dismissing the complaint with prejudice if the terms of the Settlement Agreement are followed, the Company agreed to transfer to Atari full ownership of, and rights to sell and convey good title to certain units of video games listed therein.





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





ITEM 1A. RISK FACTORS.





There have been no material changes in our risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.





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





None.





ITEM 3. DEFAULTS UPON SENIOR SECURITIES.





None.





ITEM 4. (Removed and Reserved).





ITEM 5. OTHER INFORMATION.





As previously disclosed in the Company’s Current Report on Form 8-K filed with the SEC on May 5, 2011, effective April 29, 2011, David Rosenbaum, former President of Zoo Publishing is no longer with the Company. In connection therewith, on May 16, 2011, the Company and Mr. Rosenbaum entered into a Separation Agreement and General Release (the “Release”), effective as of the eighth day following Mr. Rosenbaum’s execution without revocation of the Release. Pursuant to the Release, Mr. Rosenbaum’s option to purchase 337,636 shares of the Company’s common stock (the “Option”) will accelerate, vest fully and become exercisable as of April 29, 2011. The term of the Option was extended through April 30, 2018. The Company and Mr. Rosenbaum agreed that the Company would pay Mr. Rosenbaum $270,000 in twenty-seven equal monthly installments with the first such installment payable on July 31, 2011, and on October 31, 2013, the Company will pay the remaining $350,000 either in a lump sum amount in cash or in shares having an aggregate fair market value of $350,000 in full payment of obligations owed to Mr. Rosenbaum by the Company pursuant to that certain Separation and Release Agreement, dated July 31, 2007, by and among the Company and Mr. Rosenbaum. The Company and Mr. Rosenbaum each agreed to release each other of any continuing charges, complaints, damages or remedies between the parties. The foregoing description of the Release does not purport to be complete and is qualified in its entirety by reference to the Release, a copy of which is attached hereto as Exhibit 10.1 and incorporated herein by reference.








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ITEM 6.  EXHIBITS.





10.1
Separation Agreement and General Release, dated as of May 16, 2011, by and between David Rosenbaum and Zoo Entertainment, Inc., Zoo Games, Inc. and Zoo Publishing, Inc.


10.2
Letter Amendment dated as of May 16, 2011, by and between David Rosenbaum and Zoo Entertainment, Inc.


31.1
Certification of Chief Executive Officer.


31.2
Certification of Chief Financial Officer.


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


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SIGNATURES





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





Dated: May 16, 2011


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


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EXHIBIT INDEX





10.1
Separation Agreement and General Release, dated as of May 16, 2011, by and between David Rosenbaum and Zoo Entertainment, Inc., Zoo Games, Inc. and Zoo Publishing, Inc.


10.2
Letter Amendment dated as of May 16, 2011, by and between David Rosenbaum and Zoo Entertainment, Inc.


31.1
Certification of Chief Executive Officer.


31.2
Certification of Chief Financial Officer.


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


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