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, 2009





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


For the
transition period from _____________ to ___________


Commission
file number   333-124829





ZOO
ENTERTAINMENT, INC.


(Exact
name of Registrant as Specified in Its Charter)


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





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





Indicate
by check mark whether the Registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.   Yes   x  No    ̈





Indicate by check mark whether the
Registrant has submitted electronically and posted on its corporate Web site, if
any, every Interactive Data File required to be submitted and posted pursuant to
Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12
months (or for such shorter period that the registrant was required to submit
and post such files). YesoNoo





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




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





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







ZOO
ENTERTAINMENT, INC.




Table
of Contents





PART I - FINANCIAL
INFORMATION




PageItem
      1.
                          
                          Financial
      StatementsCondensed
      Consolidated Balance Sheets as of March 31, 2009 (Unaudited) and December
      31, 2008
                          F-1Condensed
      Consolidated Statements of Operations (Unaudited) for the Three Months
      Ended March 31, 2009 and 2008
                          F-2Condensed
      Consolidated Statements of Cash Flows (Unaudited) for the Three Months
      Ended March 31, 2009 and 2008
                          F-3Condensed
      Consolidated Statement of Stockholders’ Equity (Unaudited) for the Three
      Months Ended March 31, 2009
                          F-4Notes
      to Condensed Consolidated Financial Statements
                          F-5Item
      2.
                          
                          Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                          1Item
      3.
                          
                          Quantitative
      and Qualitative Disclosure About Market Risk
                          9Item
      4T.
                          
                          Controls
      and Procedures
                          9




PART II - OTHER
INFORMATION


Item
      1.
                
                Legal
      Proceedings
                10Item
      1A.
                
                Risk
      Factors
                10Item
      2.
                
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                10Item
      3.
                
                Defaults
      Upon Senior Securities
                10Item
      4.
                
                Submission
      of Matters to a Vote of Security Holders
                10Item
      5.
                
                Other
      Information
                11Item
      6.
                
                Exhibits
                11Signatures
                12











Zoo
Entertainment, Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


(in
$000s except share and per share amounts)





March
      31, 2009
                    
                    
                    December
      31, 2008 *(unaudited)ASSETSCurrent
      AssetsCash
                    
                    $
                    468
                    
                    
                    $
                    849Accounts
      receivable, net of allowances for returns and discounts of $915 and
      $1,160
                    
                    
                    1,296
                    
                    
                    
                    1,832Inventory
                    
                    
                    2,144
                    
                    
                    
                    3,120Prepaid
      expenses and other current assets
                    
                    
                    2,290
                    
                    
                    
                    2,124Product
      development costs, net
                    
                    
                    5,709
                    
                    
                    
                    5,338Deferred
      tax asset
                    
                    
                    581
                    
                    
                    
                    688Total
      Current Assets
                    
                    
                    12,488
                    
                    
                    
                    13,951Fixed
      assets, net
                    
                    
                    194
                    
                    
                    
                    214Goodwill
                    
                    
                    14,704
                    
                    
                    
                    14,704Intangible
      assets, net
                    
                    
                    14,335
                    
                    
                    
                    14,747Total
      Assets
                    
                    $
                    41,721
                    
                    
                    $
                    43,616LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable
                    
                    $
                    6,435
                    
                    
                    $
                    5,709Financing
      arrangements
                    
                    
                    -
                    
                    
                    
                    849Accrued
      expenses and other current liabilities
                    
                    
                    4,170
                    
                    
                    
                    5,167Notes
      payable, net of discount of $94 and $145 - current
      portion
                    
                    
                    1,738
                    
                    
                    
                    1,803Convertible
      notes payable, net of discount of $878 and $1,576
                    
                    
                    10,272
                    
                    
                    
                    9,574Total
      Current Liabilities
                    
                    
                    22,615
                    
                    
                    
                    23,102Notes
      payable, net of discount of $797 and $885 - non current
      portion
                    
                    
                    1,852
                    
                    
                    
                    1,772Deferred
      tax liability
                    
                    
                    581
                    
                    
                    
                    688Other
      long-term liabilities
                    
                    
                    620
                    
                    
                    
                    620Total
      Liabilities
                    
                    
                    25,668
                    
                    
                    
                    26,182Commitments
      and ContingenciesStockholders'
      EquityPreferred
      Stock, par value $0.001, 5,000,000 shares authorized, none issued and
      outstanding
                    
                    
                    -
                    
                    
                    
                    -Common
      Stock, par value $0.001, 75,000,000 shares authorized, 38,243,937
      issued and outstanding
                    
                    
                    38
                    
                    
                    
                    38Additional
      Paid-in-capital
                    
                    
                    52,714
                    
                    
                    
                    52,692Accumulated
      deficit
                    
                    
                    (33,343
                    )
                    
                    
                    (31,940
                    )Treasury
      Stock, at cost 2,237,376 shares
                    
                    
                    (3,356
                    )
                    
                    
                    (3,356
                    )Total
      Stockholders' Equity
                    
                    
                    16,053
                    
                    
                    
                    17,434Total
      Liabilities and Stockholders' Equity
                    
                    $
                    41,721
                    
                    
                    $
                    43,616





*  Derived
from audited financials





See
accompanying notes to condensed consolidated financial
statements


F-1





Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Operations


For
the Three Months Ended March 31, 2009 and 2008


(in
$000s except per share amounts)





Three
      Months Ended March 31,2009
                          
                          
                          2008Revenue
                          
                          $
                          13,884
                          
                          
                          $
                          9,029Cost
      of goods sold
                          
                          
                          11,483
                          
                          
                          
                          8,807Gross
      profit
                          
                          
                          2,401
                          
                          
                          
                          222Operating
      expenses:General
      and administrative expenses
                          
                          
                          1,394
                          
                          
                          
                          1,119Selling
      and marketing expenses
                          
                          
                          863
                          
                          
                          
                          864Research
      and development expenses
                          
                          
                          80
                          
                          
                          
                          894Depreciation
      and amortization
                          
                          
                          434
                          
                          
                          
                          448Total
      Operating expenses
                          
                          
                          2,771
                          
                          
                          
                          3,325Loss
      from operations
                          
                          
                          (370
                          )
                          
                          
                          (3,103
                          )Interest
      expense, net
                          
                          
                          (1,033
                          )
                          
                          
                          (387
                          )Loss
      from continuing operations before income tax benefit
                          
                          
                          (1,403
                          )
                          
                          
                          (3,490
                          )Income
      tax benefit
                          
                          
                          -
                          
                          
                          
                          -Loss
      from continuing operations
                          
                          
                          (1,403
                          )
                          
                          
                          (3,490
                          )Loss
      from discontinued operations
                          
                          
                          -
                          
                          
                          
                          (687
                          )Net
      loss
                          
                          $
                          (1,403
                          )
                          
                          $
                          (4,177
                          )Loss per share - basic and
      diluted:Continuing
      operations
                          
                          $
                          (0.04
                          )
                          
                          $
                          (0.21
                          )Discontinued
      operations
                          
                          
                          -
                          
                          
                          
                          (0.04
                          )Net
      loss
                          
                          $
                          (0.04
                          )
                          
                          $
                          (0.26
                          )Weighted
      average shares outstanding - basic and diluted
                          
                          
                          38,243,937
                          
                          
                          
                          16,314,950





See
accompanying notes to condensed consolidated financial
statements


F-2





Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statements of Cash Flow


For
the Three Months Ended March 31, 2009 and March 31, 2008


(in
$000s)





Three
      Months Ended March 31,2009
                
                
                2008Operating
      Activities:Net
      loss
                
                $
                (1,403
                )
                
                $
                (4,177
                )Loss
      from discontinued operations
                
                
                -
                
                
                
                (687
                )Net
      loss from continuing operations
                
                
                (1,403
                )
                
                
                (3,490
                )Adjustments
      to reconcile net loss from continuing operations to net cash provided by
      (used in) operating activities:Depreciation
      and amortization
                
                
                434
                
                
                
                448Amortization
      of deferred debt discount
                
                
                858
                
                
                
                304Stock-based
      compensation
                
                
                22
                
                
                
                140Other
      changes in assets and liabilities, net
                
                
                559
                
                
                
                (2,032
                )Net
      cash provided by (used in) continuing operations
                
                
                470
                
                
                
                (4,630
                )Net
      cash used in discontinued operations
                
                
                -
                
                
                
                (28
                )Net
      cash provided by (used in) operating activities
                
                
                470
                
                
                
                (4,658
                )Investing
      activities:Purchases
      of fixed assets
                
                
                (2
                )
                
                
                (39
                )Financing
      activities:Proceeds
      from sale of equity securities
                
                
                -
                
                
                
                4,635Net
      (repayments) borrowings in connection with financing
      facilities
                
                
                (849
                )
                
                
                69Net
      cash (used in) provided by financing activities
                
                
                (849
                )
                
                
                4,704(Decrease)
      increase in cash
                
                
                (381
                )
                
                
                7Cash
      at beginning of period
                
                
                849
                
                
                
                137Cash
      at end of period
                
                $
                468
                
                
                $
                144





See
accompanying notes to condensed consolidated financial
statements


F-3





Zoo
Entertainment, Inc. and Subsidiaries


Unaudited
Condensed Consolidated Statement of Stockholders' Equity


For
the Three Months Ended March 31, 2009


(in
000s)





Preferred
      Stock
                  
                  
                  Common
      Stock
                  
                  
                  Additional
                  
                  
                  
                  
                  
                  Treasury
      StockShares
                  
                  
                  Par
      value
                  
                  
                  Shares
                  
                  
                  Par
                    Value
                  
                  
                  Paid-in-
                    Capital
                  
                  
                  AccumulatedDeficit
                  
                  
                  Shares
                  
                  
                  Cost
                  
                  
                  TotalBalance
      December 31, 2008
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  38,244
                  
                  
                  
                  38
                  
                  
                  
                  52,692
                  
                  
                  
                  (31,940
                  )
                  
                  
                  2,237
                  
                  
                  
                  (3,356
                  )
                  
                  
                  17,434Stock-based
      compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  22
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  22Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,403
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,403
                  )Balance
      March 31, 2009
                  
                  
                  -
                  
                  
                  $
                  -
                  
                  
                  
                  38,244
                  
                  
                  $
                  38
                  
                  
                  $
                  52,714
                  
                  
                  $
                  (33,343
                  )
                  
                  
                  2,237
                  
                  
                  $
                  (3,356
                  )
                  
                  $
                  16,053





See
accompanying notes to condensed consolidated financial
statements


F-4





ZOO
ENTERTAINMENT, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




1.
DESCRIPTION OF ORGANIZATION AND REVERSE MERGER




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




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





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


F-5


Zoo
Games, a Delaware corporation, is a New York City-based developer, publisher and
distributor of interactive entertainment software for use on all major platforms
including Nintendo’s Wii and DS, Sony’s PSP and PlayStation 3, Microsoft’s Xbox
360, and personal computers (PCs). Zoo Games sells primarily to major retail
chains and video game distributors. Zoo Games began business in March 2007,
acquired the assets of Supervillain Studios, Inc. (“SVS”) on June 13, 2007,
acquired the stock of Zoo Publishing, Inc. (“Zoo Publishing”) on December 18,
2007 and acquired the stock of Zoo Digital Publishing Limited (“Zoo Digital”) on
April 4, 2008. The consolidated financial statements include the results of
their operations from their respective acquisition dates. We also acquired an
interest in Cyoob, Inc., also known as Repliqa (“Repliqa”), on June 28, 2007.
During January 2008, Zoo Games’ board of directors made a determination to
discontinue its involvement with the operations of Repliqa. During September
2008, Zoo Games sold SVS back to its original owners.  In November
2008, Zoo Games sold Zoo Digital back to its original
owners.  Repliqa, SVS and Zoo Digital have been reflected as
discontinued operations for all periods presented.





Currently,
the Company has determined that it operates in one business segment in North
America, as described above, which includes the operations of Zoo
Publishing.





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




2.
GOING CONCERN





These
consolidated financial statements have been prepared assuming the Company
will continue as a going concern. The Company has incurred losses since
inception, resulting in an accumulated deficit of approximately $33.3
million and a working capital deficiency of approximately $10.1 million at
March 31, 2009. For the three months ended March 31, 2009 the Company generated
$470,000 of cash flow from operations, but for the year ended December 31, 2008,
the Company generated negative cash flows from operations of approximately $12.1
million. Further losses are anticipated in the development of its business
raising substantial doubt about the Company's ability to continue as a going
concern. In addition, the Company has various notes maturing between July and
September 2009 with a total face value of approximately $12.3
million.  The Company has been in discussions with the debt holders to
either convert a portion or the entirety of the debt to equity or extend or
amend the terms of the debt.   Its ability to continue as a going
concern is dependent upon the ability of the Company to generate cash flow from
operations sufficient to maintain its daily business activities as well as
acquiring financing from outside sources through the sale of equity or debt
instruments as well as restructuring its maturing note obligations. While
management has plans to seek financing through additional sales of such
instruments, there is no assurance that such financing can be obtained. These
condensed consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded assets, or the
amounts of and classification of liabilities that might be necessary as a result
of this uncertainty.




3.
BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES




Principles of Consolidation
and Interim Financial Information





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


F-6





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




Use of
Estimates




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





Concentration of Credit
Risk





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





If the
financial condition and operations of our customers deteriorate, our risk of
collection could increase substantially. A majority of our trade receivables are
derived from sales to major retailers and distributors. In October 2008, we
entered into an agreement with Atari, Inc. where sales from October 24, 2008
through March 31, 2009 for all customers that Atari deemed acceptable would be
through Atari and Atari would prepay us for the cost of goods and they would
bear the credit risk from the ultimate customer.  This agreement was
subsequently amended twice to include sales through May 31, 2009. As of March
31, 2009, Atari had prepaid us approximately $727,000 which is included in
customer advances in the accrued expenses and other current liabilities in the
condensed consolidated balance sheet and the receivable due from Atari was
approximately $1.3 million, before allowances, which is included in accounts
receivable in the condensed consolidated balance sheet.  Our five
largest ultimate customers for the three months ended March 31, 2009 accounted
for approximately 85% of the gross revenue for the period.  We believe
that the receivable balances from Atari and our ultimate customers do not
represent a significant credit risk based on past collection experience. There
were no receivables from our factor included in our gross accounts receivable as
of March 31, 2009 and December 31, 2008. We regularly review our outstanding
receivables for potential bad debts and have had no history of significant
write-offs due to bad debts.


F-7





Inventory





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





Product Development
Costs





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





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





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





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





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


F-8


Prior to
establishing technological feasibility, we expense research and development
costs as incurred. During the three months ended March 31, 2009 and 2008, we
wrote-off $80,000 and $894,000, respectively, of expense relating to costs
incurred for the development of games that were abandoned during those
periods.  Those costs are included in the Statement of Operations
under research and development expenses.




Licenses and
Royalties




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




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




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





Goodwill and Intangible
Assets





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




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


F-9





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





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




Revenue
Recognition





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





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





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




Allowances for Returns,
Price Concessions and Other Allowances





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




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





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


F-10


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





Consideration Given to
Customers and Received from Vendors





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





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





Equity-based
Compensation





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




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





For the Three
      MonthsEnded March 31,2009
                    
                    
                    2008Risk-free
      interest rate
                    
                    
                    1.36
                    %
                    
                    
                    3.45
                    %Expected
      stock price volatility
                    
                    
                    70.0
                    %
                    
                    
                    45.0
                    %Expected
      term until exercise (years)
                    
                    
                    5
                    
                    
                    
                    5Dividends
                    
                    None
                    
                    
                    None


F-11


For the
three months ended March 31, 2009 and 2008, we estimated the implied
volatility for publicly traded options on our common shares as the expected
volatility assumption required in the Black-Scholes option-pricing
model.  The selection of the implied volatility approach was based
upon the historical volatility of companies with similar businesses and
capitalization and our assessment that implied volatility is more representative
of future stock price trends than historical volatility.




Earnings (Loss) per
Share




Basic
earnings (loss) per share ("EPS") is computed by dividing the net loss
applicable to common stockholders for the period by the weighted average number
of shares of common stock outstanding during the same period. Diluted EPS is
computed by dividing the net income applicable to common stockholders for the
period by the weighted average number of shares of common stock outstanding and
common stock equivalents, which includes warrants and options outstanding during
the same period. Since the inclusion of the 6,502,159 warrants and 3,086,552
options outstanding as of March 31, 2009 and the 1,414,316 warrants and 243,040
options outstanding as of March 31, 2008 are anti-dilutive because of losses,
the dilutive loss per share is the same as the basic loss per
share.





Income
Taxes




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




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





Fair Market Value of
Financial Instruments





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


F-12





Recently Issued Accounting
Pronouncements





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




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





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




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





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


F-13





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





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





4.
DISCONTINUED OPERATIONS





The loss
from discontinued operations for the three months ended March 31, 2008 is
summarized as follows:


(amounts in $000s)Supervillain
                  
                  $
                  (419
                  )Repliqa
                  
                  
                  (194
                  )On-line
      concept
                  
                  
                  (74
                  )Loss
      from discontinued operations
                  
                  $
                  (687
                  )





The
revenues from the discontinued operations were $203,000 for the three months
ended March 31, 2008.





5.
INVENTORY




Inventory
consisted of:





(amounts
      in $000s)March
      31,
                      
                      
                      December
      31,2009
                      
                      
                      2008Finished
      products
                      
                      $
                      2,011
                      
                      
                      $
                      2,939Parts
      and supplies
                      
                      
                      133
                      
                      
                      
                      181Inventory
                      
                      $
                      2,144
                      
                      
                      $
                      3,120




F-14





Estimated
product returns included in Inventory at March 31, 2009 and December 31, 2008
were $304,000 and $337,000, respectively.




6.
PREPAID EXPENSES AND OTHER CURRENT ASSETS




Prepaid
expense and other current assets consisted of:




(amounts
      in $000s)March
      31, 2009
                      
                      
                      December
      31, 2008Vendor
      advances for inventory
                      
                      $
                      814
                      
                      
                      $
                      555Prepaid
      royalties
                      
                      
                      1,158
                      
                      
                      
                      1,072Income
      taxes receivable
                      
                      
                      55
                      
                      
                      
                      55Other
      prepaid expenses
                      
                      
                      263
                      
                      
                      
                      442Prepaid
      expenses and other current assets
                      
                      $
                      2,290
                      
                      
                      $
                      2,124




7.
PRODUCT DEVELOPMENT COSTS




Details
of our capitalized product development costs were as follows:





(amounts
      in $000s)March
      31, 2009
                              
                              
                              December
      31, 2008Product
      development costs, internallydeveloped,
      net of amortization
                              
                              $
                              102
                              
                              
                              $
                              170Product
      development costs, externallydeveloped,
      net of amortization
                              
                              
                              5,607
                              
                              
                              
                              5,168Product
      development costs
                              
                              $
                              5,709
                              
                              
                              $
                              5,338




F-15




8.
INTANGIBLE ASSETS, NET




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





(amounts in $000s)March 31, 2009
                          
                          
                          December
                            31, 2008EstimatedUseful
                          
                          GrossLives
                          
                          Carrying
                          
                          
                          Accumulated
                          
                          
                          Net Book
                          
                          
                          Net Book(Years)
                          
                          Amount
                          
                          
                          Amortization
                          
                          
                          Value
                          
                          
                          ValueContent
                          10
                          
                          $
                          12,202
                          
                          
                          $
                          1,576
                          
                          
                          $
                          10,626
                          
                          
                          $
                          10,931Trademarks
                          10
                          
                          
                          1,510
                          
                          
                          
                          195
                          
                          
                          
                          1,315
                          
                          
                          
                          1,353Customer
      relationships
                          10
                          
                          
                          2,749
                          
                          
                          
                          355
                          
                          
                          
                          2,394
                          
                          
                          
                          2,463Total
      Intangible Assets
                          
                          
                          $
                          16,461
                          
                          
                          $
                          2,126
                          
                          
                          $
                          14,335
                          
                          
                          $
                          14,747




Amortization
expense related to intangible assets for the three months ended March 31, 2009
and 2008 was $412,000 for both periods.





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




(amounts
      in $000s)Year
      ending Dec. 31,Balance
      of 2009
                          
                          $
                          1,2342010
                          
                          
                          1,6462011
                          
                          
                          1,6462012
                          
                          
                          1,6462013
                          
                          
                          1,646Thereafter
                          
                          
                          6,517Total
                          
                          $
                          14,335





F-16





9.
CREDIT AND FINANCING ARRANGEMENTS AND ATARI AGREEMENT




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




The
Company and Zoo Publishing entered into a purchase order financing agreement
with Transcap Trade Finance, LLC (“Transcap”) on December 19, 2007. This
agreement made the Company a party to a Master Purchase Order Assignment
Agreement dated August 20, 2001 pursuant to which Transcap agreed to provide
purchase order financing to or for the benefit of Zoo Publishing. Total advances
under the factoring arrangement include letters of credit for purchase order
financing and is limited to $10.0 million. The amounts outstanding as of
March 31, 2009 and December 31, 2008 were $0 and $855,000, respectively. The
interest rate is prime plus 4.0% on outstanding advances. As of March 31, 2009
and December 31, 2008, the effective interest rates were 7.25%.  The
charges and interest expense on the advances are included in the cost of goods
sold in the accompanying condensed consolidated statement of
operations.




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





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





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


F-17





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





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





As a
result of a fire in October 2008 that destroyed our inventory and impacted our
cash flow from operations, we entered into an agreement with Atari, Inc.
(“Atari”). This agreement became effective on October 24, 2008 and provided for
Zoo Publishing to sell its products to Atari without recourse and Atari will
resell the products to wholesalers and retailers that are acceptable to Atari in
North America. The agreement initially expired on March 31, 2009, but was
amended twice to extend the term until May 31, 2009.  This agreement
provided for Atari to prepay to the Company for the cost of goods and pay the
balance due within 15 days of shipping the product.  Atari’s fees
approximate 10% of our standard selling price and they have been recorded as a
reduction in revenue.  During the three months ended March 31, 2009,
we recorded approximately $15.7 million of net sales to Atari.  Atari
takes a reserve from the initial payment for potential customer sales
allowances, returns and price protection that is analyzed and reviewed within a
sixty day period to be liquidated no later than July 31, 2009.  As of
March 31, 2009 and December 31, 2008, Atari had prepaid the Company $727,000 and
approximately $1.8 million, respectively, for goods not yet shipped which is
recorded as customer advances in accrued expenses and other current
liabilities.  Also, as of March 31, 2009 and December 31, 2008, Atari
owed the Company approximately $1.3 million and $1.8 million, respectively,
before allowances, for goods already shipped which is recorded in accounts
receivable.





10.
ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES




Accrued
expenses and other current liabilities consisted of:


F-18





(amounts
      in $000s)March
      31, 2009
                        
                        
                        December
      31, 2008Customer
      advances ($727 in 2009 and $1,828 in 2008 is from Atari)
                        
                        $
                        898
                        
                        
                        $
                        1,828Due
      to customers
                        
                        
                        269
                        
                        
                        
                        710Obligation
      arising from Zoo Publishing acquisition
                        
                        
                        213
                        
                        
                        
                        254Obligations
      relating to Cyoob acquisition
                        
                        
                        100
                        
                        
                        
                        100Obligations
      to compensate current and former employees
                        
                        
                        710
                        
                        
                        
                        720Royalty
                        
                        
                        119
                        
                        
                        
                        252Operating
      expenses
                        
                        
                        1,366
                        
                        
                        
                        982Interest
                        
                        
                        495
                        
                        
                        
                        321Total
                        
                        $
                        4,170
                        
                        
                        $
                        5,167




11.
NOTES PAYABLE




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




(amounts
      in $000’s)March
      31,
                            2009
                          
                          
                          December
      31,
                            2008Note DescriptionZoo
      Entertainment convertible notes, net of discounts attributable to the
      warrant value of $878 and $1,576
                          
                          $
                          10,272
                          
                          
                          $
                          9,5743.9% Zoo
      Publishing notes, net of discount of $891 and $1,030
                          
                          
                          2,676
                          
                          
                          
                          2,5362.95%
      note due June 2012 assumed from Zoo Publishing acquisition
                          
                          
                          340
                          
                          
                          
                          3708.25%
      Wachovia demand note assumed from Zoo Publishing
      acquisition
                          
                          
                          -
                          
                          
                          
                          45Note
      assumed from Zoo Publishing acquisition, 12% interest
                          
                          
                          -
                          
                          
                          
                          25Employee
      loans, payable on demand
                          
                          
                          331
                          
                          
                          
                          331Zoo
      Publishing employee loans at 4% interest
                          
                          
                          243
                          
                          
                          
                          268Total
                          
                          
                          13,862
                          
                          
                          
                          13,149Current
      portion
                          
                          
                          12,010
                          
                          
                          
                          11,377Non-current
      portion
                          
                          $
                          1,852
                          
                          
                          $
                          1,772




F-19


The face
amounts of the notes payable as of March 31, 2009 are due as
follows:


(amounts in $000s)Year
      Ending December
                          
                          Amount
      DueBalance
      of 2009
                          
                          $
                          12,9522010
                          
                          
                          2,2322011
                          
                          
                          4362012
                          
                          
                          10Total
                          
                          $
                          15,630




Zoo Entertainment
Notes




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




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


F-20




The total
principal amount of all of the notes described above is approximately $11.2
million, $9.8 million of which was incurred prior to the date of the reverse
merger. The warrants issued with all the notes were valued at approximately $5.9
million by the Company and an independent valuation firm. We used the income and
market valuation approaches to derive the Company’s business enterprise value
and then used the Black-Scholes option-pricing model, applying discounts for
illiquidity and dilution, to calculate the value of the warrants.  The
total deferred debt discount of $5.9 million is amortized over the one year life
of the notes. Prior to September 12, 2008, 4,545,455 warrants were exercised and
the interest expense related to the discount of these warrants was accelerated.
As of September 12, 2008, the deferred debt discount of the existing notes was
approximately $2.4 million and the net value of the notes recorded as of
September 12, 2008 was approximately $7.8 million. On September 26, 2008, we
issued $1.0 million of the notes and 909,090 of the warrants which were valued
at $527,000 using consistent valuation methodologies as those used for all the
previously issued notes. As of March 31, 2009, the net deferred debt discount of
all the notes is $878,000 and the net value of the notes recorded as of March
31, 2009 is approximately $10.3 million.





Zoo Publishing
Notes





In
connection with the acquisition of Zoo Publishing, the Company issued various
promissory notes (“Zoo Publishing Note”) in an aggregate of approximately $6.8
million. Approximately $1.8 million of principal was payable at the earlier of
the Company’s completion of another round of financing or by December 2008 with
the $5.0 million balance to be paid in two installments pursuant to the “Zoo
Publishing Note”. The first installment of $2.5 million of principal together
with accrued interest at the rate of 3.9% per annum would be due on the earlier
of June 18, 2009 and the date on which the Company consummates a round of equity
financing of $40.0 million or more. The balance of the Zoo Publishing Note
(including accrued interest) would be payable December 18, 2010. In connection
with the aforementioned note, the Company recorded a debt discount of
approximately $2.3 million. For the three months ended March 31, 2009,
amortization of deferred debt discount and interest expense were $35,000 and
$160,000, respectively. For the three months ended March 31, 2008, amortization
of deferred debt discount and interest expense were $66,000 and $304,000,
respectively.  In July 2008, the $6.8 million of notes were
restructured and approximately $3.2 million of this debt was converted to common
stock of the Company based on fair value and of the remaining $3.6 million,
approximately $1.1 million is due September 18, 2009, $113,000 is due September
18, 2010, $2.0 million is due December 18, 2010 and approximately $316,000 is
due July 31, 2011.




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





·
            $200,000
      demand note with 12.0% percent interest per annum, callable in 6 months,
      minimum guaranteed interest per renewal is $ 12,000. The note is
      guaranteed by the Zoo Publishing President.  The note was
      totally paid off by March 31, 2009.





·
            Zoo
      Publishing purchased treasury stock from a former employee in December
      2006 for the amount of $650,000. The balance on the note as of March 31,
      2009 was $340,000; $120,000 is classified as current and $220,000 is
      classified as long-term. The payments are due monthly and the amount of
      the payment is $10,000 per
month.


F-21


12.
INCOME TAXES





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





The
components of income tax benefit for the three months ended March 31, 2009 are
as follows (in $000s):





Current:Federal
                          
                          $
                          -State
                          
                          
                          77Total
      Current
                          
                          
                          77Deferred:Federal
                          
                          
                          -State
                          
                          
                          (77
                          )Total
      Deferred
                          
                          
                          (77
                          )Total
                          
                          $
                          -


No income
taxes were paid during the three months ended March 31, 2009.





The
reconciliation of income tax benefit computed at the U.S. statutory tax rates to
income tax benefit for the three months ended March 31, 2009
is:


F-22





Tax
      at U.S. federal income tax rates
                        
                        
                        (34.0
                        )%State
      taxes, net of federal income tax benefit
                        
                        
                        (12.1
                        )Valuation
      allowance
                        
                        
                        34.4Nondeductible
      expenses and other
                        
                        
                        11.70.0
                        %





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the
Company's deferred tax assets and liabilities as of March 31, 2009 are as
follows (in $000's):





Deferred tax assets:
                                    
                                    Current
                                    
                                    
                                    Long-termNet
      operating loss carryforwards
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    6,200Capital
      loss carryforwards
                                    
                                    
                                    -
                                    
                                    
                                    
                                    515Allowance
      for doubtful accounts
                                    
                                    
                                    451
                                    
                                    
                                    
                                    -Bonus
      and other accruals
                                    
                                    
                                    708
                                    
                                    
                                    
                                    111Interest
      on convertible notes
                                    
                                    
                                    -
                                    
                                    
                                    
                                    136Non-qualified
      options
                                    
                                    
                                    -
                                    
                                    
                                    
                                    401Gross
      deferred tax assets
                                    
                                    
                                    1,159
                                    
                                    
                                    
                                    7,363Valuation
      allowance
                                    
                                    
                                    (330
                                    )
                                    
                                    
                                    (2,095
                                    )Net
      deferred tax assets
                                    
                                    
                                    829
                                    
                                    
                                    
                                    5,268Deferred
      tax liabilities:Property
      and equipment
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (23
                                    )Intangibles
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (5,668
                                    )Discount
      on notes
                                    
                                    
                                    (248
                                    )
                                    
                                    
                                    (158
                                    )Total
      deferred tax liabilities
                                    
                                    
                                    (248
                                    )
                                    
                                    
                                    (5,849
                                    )Net
      deferred tax asset (liability)
                                    
                                    $
                                    581
                                    
                                    
                                    $
                                    (581
                                    )




F-23





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





As of
March 31, 2009, the Company has U.S. federal net operating loss (NOL)
carryforwards of approximately $13.4 million which will be available to offset
taxable U.S. income during the carryforward period and are expected to be fully
realized. The federal NOL will begin to expire in 2023. The Company has various
state net operating loss carryforwards of approximately $15.3 million which will
be available to offset taxable state income during the carryforward period. The
state NOL will also begin to expire in 2023.  The tax benefit of these
items is reflected in the above table of deferred tax assets and
liabilities.





13.
STOCKHOLDERS’ EQUITY AND STOCK-BASED COMPENSATION ARRANGEMENTS




Common
Stock





The
Company has authorized 75,000,000 shares of common stock, par value $0.001, and
5,000,000 preferred shares, par value $0.001. As of March 31, 2009, there were
38,243,937 shares of common stock issued.




Options





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





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





On
January 14, 2009, the Company granted Mr. Seremet an option to purchase 750,000
shares of the Company’s common stock at an exercise price of $0.30 per share,
pursuant to the Company’s 2007 Plan, as amended. There were no other options
issued during the three months ended March 31, 2009.


F-24





As of
March 31, 2009, there was approximately $230,000 of unrecognized compensation
cost related to non-vested stock option awards, which is expected to be
recognized over a remaining weighted-average vesting period of 2.5 - 2.8
years.





The
intrinsic value of options outstanding at March 31, 2009 is $0.





Warrants





As of
March 31, 2009, there were 6,502,159 warrants outstanding. All are currently
exercisable and have a five-year life.





There were no warrants issued in the
three months ended March 31, 2009.





14.
INTEREST, NET




(amounts
      in $000s)Three
      Months Ended  March 31,2009
                    
                    
                    2008Interest
      arising from amortization of debt discount
                    
                    $
                    858
                    
                    
                    $
                    304Interest
      on various notes
                    
                    
                    175
                    
                    
                    
                    87Less:
      Interest income
                    
                    
                    -
                    
                    
                    
                    (4
                    )Interest
      expense, net
                    
                    $
                    1,033
                    
                    
                    $
                    387




F-25




15.
SUPPLEMENTAL CASH FLOW INFORMATION




Supplemental
cash flow information for the three months ended March 31, 2009 and 2008 is as
follows:




(amounts
      in $000s)Three
      Months Ended March 31,2009
                        
                        
                        2008Changes in other assets and
      liabilitiesAccounts
      receivable
                        
                        $
                        536
                        
                        
                        
                        (1,335
                        )Inventory
                        
                        
                        976
                        
                        
                        
                        (963
                        )Prepaid
      expenses and other current assets
                        
                        
                        (166)
                        )
                        
                        
                        244Product
      development costs
                        
                        
                        (371
                        )
                        
                        
                        967Accounts
      payable
                        
                        
                        726
                        
                        
                        
                        1,018Accrued
      expenses and other current liabilities
                        
                        
                        (1,142
                        )
                        
                        
                        (1,963
                        )Net
      changes in other assets and liabilities
                        
                        $
                        559
                        
                        
                        
                        (2,032
                        )Cash
      paid during the period for interest
                        
                        $
                        -
                        
                        
                        $
                        -Cash
      paid during the period for taxes
                        
                        $
                        -
                        
                        
                        
                        -Non
      Cash Investing and Financing Activities:
                        
                        $
                        -
                        
                        
                        $
                        -





16.
LITIGATION





On February
19, 2009, Susan Kain Jurgensen, Steven Newton, Mercy Gonzalez, Bruce Kain,
Wesley Kain, Raymond Piece and Christie Walsh filed a compliant against Zoo
Publishing, Zoo Games and Zoo in the Supreme Court of the State of New York, New
York County, index number 09 / 102381 alleging claims
for breach of certain loan agreements and employment
agreements, intentional interference and fraudulent transfer. 
The complaint seeks compensatory damages, punitive damages and preliminary
and permanent injunctive relief, among other remedies.  An answer is due on
May 25, 2009.  We believe we have meritorious defenses and intend to
vigorously defend the matter.





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., pending in the Boston, Massachusetts office of JAMS Alternative Dispute
Resolution, the claimant Revolution Partners, LLC is seeking money damages for a
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We have denied all material allegations and are
vigorously defending the matter.  At this time, discovery is ongoing. 
The matter is scheduled for trial before an arbitrator in July
2009.





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


F-26


17.  RELATED PARTY
TRANSACTIONS





We leased
office space in New York from 575 Broadway Associates, LLC, a company owned
principally by one of our principal investors, from April 2007 to October 2008.
We paid rent expense of $0 and $69,000 during the three months ended March 31,
2009 and 2008, respectively, to this related party.





Certain
Zoo Publishing employees loaned the Company an aggregate of up to $765,000 in
2008 on a short-tem basis. The employees are paid interest at 4% per annum and
all amounts are expected to be repaid in full. (See Note 11.)





18.
SUBSEQUENT EVENTS





On May 1,
2009, Zoo Publishing entered into Amendment Number Two to the sales agreement
with Atari, dated as of October 24, 2008, extending the term of the agreement
through May 31, 2009.





Also on May 1, 2009, Zoo Publishing,
the Company and New World IP, LLC (“Licensor”) entered into a License Agreement
(the “License Agreement”), pursuant to which the Licensor granted to Zoo
Publishing all of the Licensor’s rights in and to certain of its computer video
games (the “Games”) as set forth in the License Agreement.  In
consideration thereof, Zoo Publishing agreed to pay to Licensor a minimum
royalty of $2.6 million, paid $75,000 quarterly for the first two years and the
unpaid balance due May 1, 2011.  The minimum royalty is offset at a
royalty rate of 3.75% of gross cash received by us for the exploitation of the
Games, in accordance with the License Agreement, which payments are due within
45 days of the end of each calendar quarter during which such royalties are
received.  The Company agreed to guarantee Zoo Publishing’s prompt
payment to Licensor of such royalties and any other amounts due under the
License Agreement.  At any time prior to April 1, 2011, Zoo Publishing
has the option to purchase all rights in and to the Games.  At any
time after April 1, 2011, Licensor has the right to sell all rights in and
to the Games to Zoo Publishing. Within one month of the date of the License
Agreement, Zoo Publishing shall reimburse Licensor in the amount of $42,398 for
certain fees and expenses incurred by Licensor on behalf of Zoo
Publishing.  Additionally, Zoo Publishing agreed to pay or reimburse,
as the case may be, Licensor for all fees, costs, expenses, claims and
indemnification obligations incurred by Licensor in connection with Licensor’s
acquisition of the Games.  The License Agreement may be terminated by
either party in the event that the other party is in breach of its obligations
thereunder and such breach is not cured within the specified period, becomes
insolvent or bankrupt or subject to a petition for bankruptcy, or makes an
assignment of all or substantially all of its assets for the benefit of
creditors.  Either party may terminate the License Agreement with
respect to any particular Game in the event Licensor loses the right to exploit
such Game.





On April
3, 2009, David Rosenbaum, the Senior Vice President of Sales of Zoo Publishing,
was appointed as President of Zoo Publishing.





On May 1,
2009, Robert S. Ellin resigned as Chief Executive Officer and President of the
Company, in order for the Company to appoint Mark Seremet as Chief Executive
Officer and President of the Company.  Mr. Ellin will continue to
serve as a director of the Company.  On May 1, 2009, the Company’s
board of directors appointed Mark Seremet as Chief Executive Officer and
President of the Company.





On May 1,
2009, Charles Bentz resigned as Chief Financial Officer of the Company, in order
for the Company to appoint David Fremed as Chief Financial Officer of the
Company.  On May 1, 2009, the Company’s board of directors appointed
David Fremed as Chief Financial Officer of the Company.


F-27





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 in April 2009 a guaranty with Wells
Fargo, Bank, National Association 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 “Guaranty” and “Loan”, respectively), the
Company agreed to compensate Mr. Seremet in the amount of $10,000 per month, and
Mr. Rosenbaum in the amount of $7,000 per month, for so long as the executive
remains employed while the Guaranty and Loan remain in full force and
effect.  If the Guaranty is not released by the end of the month
following termination of employment the monthly fee shall be doubled for each
month thereafter until the Guaranty is removed.




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


F-28




Item 2.
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.





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





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




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





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





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




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


1





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





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





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





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




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





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




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





The
financial statements of Zoo Games include operations of each division from the
date that they were acquired.  The results for Supervillain and
Repliqa are included in discontinued operations for the three months ended March
31, 2008.


2


Results
of Operations





For
the three months ended March 31, 2009 as compared to the three months ended
March 31, 2008





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 $000s except per share data)For The Three Months Ended March
      31,2009
                                                            
                                                            
                                                            2008Revenue
                                                            
                                                            $
                                                            13,884
                                                            
                                                            
                                                            
                                                            100
                                                            %
                                                            
                                                            $
                                                            9,029
                                                            
                                                            
                                                            
                                                            100
                                                            %Cost
      of goods sold
                                                            
                                                            
                                                            11,483
                                                            
                                                            
                                                            
                                                            83
                                                            %
                                                            
                                                            
                                                            8,807
                                                            
                                                            
                                                            
                                                            98
                                                            %Gross
      profit
                                                            
                                                            
                                                            2,401
                                                            
                                                            
                                                            
                                                            17
                                                            %
                                                            
                                                            
                                                            222
                                                            
                                                            
                                                            
                                                            2
                                                            %Operating
      expenses:General
      and administrative expenses
                                                            
                                                            
                                                            1,394
                                                            
                                                            
                                                            
                                                            10
                                                            %
                                                            
                                                            
                                                            1,119
                                                            
                                                            
                                                            
                                                            12
                                                            %Selling
      and marketing expenses
                                                            
                                                            
                                                            863
                                                            
                                                            
                                                            
                                                            6
                                                            %
                                                            
                                                            
                                                            864
                                                            
                                                            
                                                            
                                                            10
                                                            %Research
      and development expenses
                                                            
                                                            
                                                            80
                                                            
                                                            
                                                            
                                                            1
                                                            %
                                                            
                                                            
                                                            894
                                                            
                                                            
                                                            
                                                            10
                                                            %Depreciation
      and amortization
                                                            
                                                            
                                                            434
                                                            
                                                            
                                                            
                                                            3
                                                            %
                                                            
                                                            
                                                            448
                                                            
                                                            
                                                            
                                                            5
                                                            %Total
      Operating expenses
                                                            
                                                            
                                                            2,771
                                                            
                                                            
                                                            
                                                            20
                                                            %
                                                            
                                                            
                                                            3,325
                                                            
                                                            
                                                            
                                                            37
                                                            %Loss
      from operations
                                                            
                                                            
                                                            (370
                                                            )
                                                            
                                                            
                                                            (3
                                                            )%
                                                            
                                                            
                                                            (3,103
                                                            )
                                                            
                                                            
                                                            (34
                                                            )%Interest
      (expense) income, net
                                                            
                                                            
                                                            (1,033
                                                            )
                                                            
                                                            
                                                            (7
                                                            )%
                                                            
                                                            
                                                            (387
                                                            )
                                                            
                                                            
                                                            (4
                                                            )%Loss
      from continuing operations before benefit for income taxes
                                                            
                                                            
                                                            (1,403
                                                            )
                                                            
                                                            
                                                            (10
                                                            )%
                                                            
                                                            
                                                            (3,490
                                                            )
                                                            
                                                            
                                                            (39
                                                            )%Income
      tax benefit
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -Loss
      from continuing operations
                                                            
                                                            
                                                            (1,403
                                                            )
                                                            
                                                            
                                                            (10
                                                            )%
                                                            
                                                            
                                                            (3,490
                                                            )
                                                            
                                                            
                                                            (39
                                                            )%Loss
      from discontinued operations
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            (687
                                                            )
                                                            
                                                            
                                                            (8
                                                            )%Net
      loss
                                                            
                                                            $
                                                            (1,403
                                                            )
                                                            
                                                            
                                                            (10
                                                            )%
                                                            
                                                            $
                                                            (4,177
                                                            )
                                                            
                                                            
                                                            (46
                                                            )%Loss
      per share from continuing operations
                                                            
                                                            $
                                                            (0.04
                                                            )
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            $
                                                            (0.21
                                                            )




3




Net Revenues. Net revenues
for the three months ended March 31, 2009 were approximately $13.9 million,
while the sales for the three months ended March 31, 2008 were approximately
$9.0 million, all consisting of casual game sales in North
America.  The breakdown of gross sales by platform is:





Three
      Months Ended March 31,2009
                  
                  
                  2008Nintendo
      Wii
                  
                  
                  64
                  %
                  
                  
                  22
                  %Nintendo
      DS
                  
                  
                  32
                  %
                  
                  
                  72
                  %Nintendo
      GBA
                  
                  
                  0
                  %
                  
                  
                  5
                  %SONY
      PS2
                  
                  
                  2
                  %
                  
                  
                  0
                  %SONY
      PSP
                  
                  
                  0
                  %
                  
                  
                  1
                  %Microsoft
      Xbox
                  
                  
                  2
                  %
                  
                  
                  0
                  %




The
biggest sellers during the 2009 period were (i) Deal or No Deal, (ii) M&M
Kart Racing, and (iii) Calvin Tucker’s Redneck Jam, all on the Nintendo Wii
platform. The biggest sellers during the 2008 period were (i) the compilation of
Battle Ship, Connect 4, Sorry & Trouble on the Nintendo DS platform, (ii)
the compilation of Clue, Perfection & Aggravation on the Nintendo DS
platform, and (iii) Showtime Championship Boxing on the Nintendo Wii
platform.  The 2009 period consisted of approximately 1.5 million
units sold at an average gross price of $10.04, while the 2008 period consisted
of approximately 1.1 million units sold at an average gross price of
$9.21.





Gross Profit.Gross profit
for the three months ended March 31, 2009 was approximately $2.4 million, or 17%
of net revenue, while the gross profit for the three months ended March 31, 2008
was approximately $222,000, or 2% of net revenue. The costs included in the cost
of goods sold consist of manufacturing and packaging costs, royalties due to
licensors relating to the current period’s revenues and the amortization of
product development costs relating to the current period’s revenues. The Atari
sales agreement was in place during the entire 2009 period and Atari’s fees
recorded as a reduction in revenue during this period were approximately $1.6
million.  The 2008 period had a significant amount of sales at very
low margins, which along with royalty fees and amortization of product
development costs resulted in a very low gross margin for the 2008
period.





General and Administrative Expenses.General and administrative expenses for the three months ended March 31,
2009 were approximately $1.4 million as compared to $1.1 million for the
comparable period in 2008.  The increase in costs from the 2008 period
to the 2009 period resulted primarily from additional professional fees incurred
during the 2009 period, partially offset by a reduction in corporate salaries
and related costs.





Selling and Marketing Expenses.Selling and marketing expenses for the three months ended March 31, 2009
and 2008 remained constant at approximately $863,000.  These expenses
all relate to the sales of casual games in North America and consist primarily
of the salaries, commissions and related costs for Zoo Publishing.





Research and Development Expenses.Research and development expenses for the three months ended March 31,
2009 were approximately $80,000 as compared to $894,000 for the three months
ended March 31, 2008. The 2009 expense resulted from discontinuing one video
game project during the period while the 2008 expense resulted from two video
game projects being discontinued during the period.





Depreciation and Amortization
Expenses.Depreciation and amortization costs for the three months ended
March 31, 2009 were $434,000 as compared to $448,000 in the prior period. Both
periods include $412,000 resulting from the amortization of intangibles acquired
from the Zoo Publishing acquisition. The balance relates to depreciation of
fixed assets during the period.





Interest Expense.Interest expense for the 2009 period was approximately $1.0 million as
compared to $387,000 for the 2008 period. The 2009 period includes $698,000 of
non-cash interest expense relating to the amortization on the Zoo Entertainment
Notes, $135,000 of interest relating to the Zoo Entertainment Notes and
approximately $195,000 of interest on the various promissory notes due to the
sellers of Zoo Publishing of which $160,000 is non-cash interest imputed at the
then market rate.  The 2008 period includes $370,000 of interest on
the various promissory notes due to the sellers of Zoo Publishing of which
$304,000 is non-cash interest imputed at the then market
rate.


4


Income Tax Benefit.We
did not record any income tax benefit for the three months ended March 31, 2009
or for the three months ended March 31, 2008. As of December 31, 2008, we had
already maximized the allowable amount of deferred taxes, so no additional tax
benefits could be recorded for the 2009 period.  During the three
months ended March 31, 2008, we were operating as a limited liability company,
so all tax benefits passed to the members and no tax benefits were recorded on
the Company’s financial statements.





Loss from Discontinued
Operations.  During the three months ended March 31, 2008, we
incurred an aggregate of $687,000 in losses from three operating divisions that
were subsequently discontinued, so the net losses relating to those operations
are recorded separately as a loss from discontinued operations.  The
loss relating to Supervillain was $419,000, the loss relating to Repliqa was
$194,000 and the loss relating to the on-line concept was $74,000.





Loss Per Share from Continuing
Operations.The loss per share from continuing operations for
the three months ended March 31, 2009 was $0.04, based on a weighted average
shares outstanding for the period of 38.2 million, vs. a loss per share from
continuing operations of $0.21, based on a weighted average shares outstanding
of 16.3 million for the three months ended March 31, 2008.




Liquidity
and Capital Resources





We
incurred a loss from continuing operations of approximately $1.4 million for the
three months ended March 31, 2009 and a net loss of approximately $3.5 million
from continuing operations for the three months ended March 31, 2008. Our
principal source of cash during the 2009 period was from the use of our purchase
order financing and cash generated from operations. Net cash provided from
operating activities for the three months ended March 31, 2009 was $470,000,
while net cash used in operations for the three months ended March 31, 2008 was
$4.6 million.  The specifics of the Atari sales agreement, which was
in effect during the 2009 period, where Atari  prepays the Company for
the cost of goods and pays the balance due within 15 days of shipping the
product, resulted in significant improvements for our cash provided from
operations in the 2009 period, as compared to the 2008 period.





Zoo
Entertainment Notes





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




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


5




Zoo
Publishing





In
connection with Zoo Games’ acquisition of Zoo Publishing, there is an
outstanding 3.9% promissory note for the benefit of the former shareholders of
Zoo Publishing in the aggregate principal amount of $2,957,500. Of that amount,
$1,137,500 of the principal plus accrued and unpaid interest must be paid on or
before September 18, 2009 and the remaining $1,820,000 plus accrued and unpaid
interest must be paid on or before December 18, 2010. As part of that
acquisition transaction, Zoo Games also has a remaining obligation to two
employees of Zoo Publishing in connection with that acquisition transaction. Zoo
Games is required to pay one of those individuals $1,200,000. Of that amount,
Zoo Games paid $327,000 in 2008, $253,000 is past due and $620,000 will be paid
on July 31, 2011, in cash or our common stock based on the fair market value of
our common stock as of July 31, 2011, at the election of Zoo Games. Zoo Games is
required to pay the other individual an aggregate of $608,400. Of that amount,
$292,500 is due on December 18, 2010 and $315,900 will be paid on July 31, 2011,
in cash or our common stock based on the fair market value of our common stock
as of July 31, 2011, at the election of Zoo Games.





Zoo
Publishing has additional debt outstanding which debt existed prior to Zoo
Games’ acquisition of that subsidiary.  As of March 31, 2009, Zoo
Publishing owes an aggregate of approximately $912,000 to various
individuals.  Of this amount, $340,000 is owed as a result of the
repurchase of certain stock from a former stockholder.  This amount is
being repaid by its terms in monthly increments of $10,000.





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





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




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


6


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





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





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





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


7


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




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





We
believe the existing cash and cash generated from operations will be sufficient
to meet our immediate operating requirements along with our current financial
arrangements. However, given our strategic plan, working capital requirements,
debt obligations, planned capital expenditures and potential future
acquisitions, we will need to raise additional capital within the short-term. We
also need to either raise enough capital to force conversion of the $11.2
million of Zoo Entertainment Notes, at face value, that mature between July and
September 2009 into equity or restructure the maturing note
obligations.  We believe that we require at least an additional $5
million to $10 million in financing in order to fund our operating requirements
and strategic plan for the following 12 months. However, there can be no
assurances that we will be able to secure any such financing on favorable terms,
if at all. If we do not secure such financing on a timely basis, it may have a
material adverse effect on our financial condition.





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





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





Critical
Accounting Policies and Estimates





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




Recently
Issued Accounting Pronouncements





See Note
3 to the unaudited condensed consolidated financial statements included in this
quarterly report for the period ended March 31, 2009.


8


Off-Balance
Sheet Arrangements




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




Fluctuations
in Operating Results and Seasonality




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




Item
3. Quantitative and
Qualitative Disclosures about Market Risk.





Not
applicable as we are a smaller reporting company.





Item
4T. Controls and
Procedures.




Evaluation
of disclosure controls and procedures.


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




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





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





We are
committed to appropriately addressing this matter in 2009 and we will reassess
our accounting and finance staffing levels to determine and seek the appropriate
accounting resources to be added to the team to handle the existing
workload.




Changes
in controls and procedures.


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


9


PART II - OTHER
INFORMATION





Item
1. Legal Proceedings





On February
19, 2009, Susan Kain Jurgensen, Steven Newton, Mercy Gonzalez, Bruce Kain,
Wesley Kain, Raymond Piece and Christie Walsh filed a compliant against Zoo
Publishing., Zoo Games and Zoo in the Supreme Court of the State of New York,
New York County, index number 09 / 102381 alleging claims
for breach of certain loan agreements and employment
agreements, intentional interference and fraudulent transfer. 
The complaint seeks compensatory damages, punitive damages and preliminary
and permanent injunctive relief, among other remedies.  An answer is due on
May 25, 2009.  We believe we have meritorious defenses and intend to
vigorously defend the matter.





In
connection with an action brought by Revolution Partners, LLC against Zoo Games,
Inc., pending in the Boston, Massachusetts office of JAMS Alternative Dispute
Resolution, the claimant Revolution Partners, LLC is seeking money damages for a
claimed investment banking or finder’s fee purportedly earned in connection with
a reverse merger transaction and related financing that we entered into in the
third quarter of 2008. We have denied all material allegations and are
vigorously defending the matter.  At this time, discovery is ongoing. 
The matter is scheduled for trial before an arbitrator in July
2009.





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





Item
1A. Risk Factors.





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




Item
2. Unregistered Sales of Equity Securities and Use of Proceeds.





On
January 14, 2009, the Company granted to Mark Seremet, a director, President and
Chief Executive Officer of the Company, an option to purchase 750,000 shares of
the Company’s common stock at an exercise price of $0.30 per share (the
“Options”), pursuant to the Company’s 2007 Employee, Director and Consultant
Stock Plan, as amended. The Options were granted in connection with Mr. Seremet
entering into an employment agreement with Zoo Games, pursuant to which Mr.
Seremet became Chief Executive Officer of Zoo Games.  The Options have
a ten-year term and vest as follows: Options to purchase 250,000 shares will
vest on January 14, 2010, Options to purchase 250,000 shares will vest on
January 14, 2011 and Options to purchase the remaining 250,000 shares will vest
on January 14, 2012. The Options were granted pursuant to the exemption from
registration permitted under Rule 506 of Regulation D of the Securities Act of
1933, as amended.





Item 3.  Defaults Upon Senior
Securities.





None.





Item
4. Submission of Matters to a Vote of Security Holders.





None.


10


Item
5. Other Information.





None.





Item
6. Exhibits.





10.1
              
              License
      Agreement, by and among Zoo Entertainment, Inc., Zoo Publishing, Inc. and
      New World IP, LLC, dated as of May 1, 2009. †31.1
              
              Certification of Chief Executive
      Officer Pursuant to Section 302 of the Sarbanes-Oxley Act and Rule
      13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
      †31.2
              
              Certification of Financial
      Officer Pursuant to Section 302 of the Sarbanes-Oxley Act and Rule
      13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
      †32.1
              
              Certification
      of Trailer Bridge, Inc.’s Chief Executive Officer and Chief Financial
      Officer Pursuant to 18 U.S.C. Section 1350 (as adopted by Section 906
      of the Sarbanes-Oxley Act of 2002).†





†
Filed herewith


11


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.




Zoo
      Entertainment, Inc.May
      20, 2009
                By:
                /s/ Mark SeremetMark
      Seremet
                  President
      and Chief Executive Officer
                  (Principal
      Executive Officer)





May
      20, 2009
                By:
                /s/ David FremedDavid
      Fremed
                  Chief
      Financial Officer
                  (Principal
      Financial Officer)


12