UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





x
            ANNUAL
      REPORT UNDER SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
fiscal year ended December
31,
2008





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from __________________


Commission
file number 000-53475





CYBERDEFENDER
CORPORATION


(Name of
registrant in its charter)





California
              
              65-1205833(State
      or other jurisdiction of incorporation or organization)
              
              (I.R.S.
      Employer Identification No.)617 West 7thStreet, Suite 401, Los Angeles,
      California
              
              90017(Address
      of principal executive offices)
              
              (Zip
      Code)





Issuer’s
telephone number (213)
689-8631




Securities
registered pursuant to Section 12(b) of the Act: None





Securities
registered pursuant to Section 12(g) of the Act: Common Stock, no par
value





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  ̈ Yes
x
No





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  ̈ Yes
x
No





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act during the last 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 if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  ̈




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.





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




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


State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter. On June 30, 2008, the aggregate market value of the voting and
non-voting common equity held by non-affiliates was $12,551,026.





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date. As of March 27, 2009 the number of
shares of the registrant’s classes of common stock outstanding was
19,195,114.





List
hereunder the following documents if incorporated by reference and the Part of
the Form 10-K (eg., Part I, Part II, etc.) into which the document is
incorporated: (1) Any annual report to security holders; (2) Any proxy or
information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or
(c) under the Securities Act of 1933. The listed documents should be clearly
described for identification purposes.





CONTENTS




PageForward-Looking
      Statements
                      iPart
      1Item
      1
                      Business
                      1Item
      1A
                      Risk
      Factors
                      11Item
      1B
                      Unresolved
      Staff CommentsItem
      2
                      Properties
                      20Item
      3
                      Legal
      Proceedings
                      20Item
      4
                      Submission
      of Matters to a Vote of Security Holders
                      20Part
      IIItem
      5
                      Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                      20Item
      6
                      Selected
      Financial Data
                      22Item
      7
                      Management’s
      Discussion and Analysis of Financial Condition and Results Of
      Operations
                      22Item
      7A
                      Quantitative
      and Qualitative Disclosures About Market Risk
                      31Item
      8
                      Financial
      Statements and Supplementary Data
                      31Item
      9
                      Changes
      In and Disagreements With Accountants on Accounting
      and  Financial Disclosure
                      31Item
      9A
                      Controls
      and Procedures
                      32Item
      9B
                      Other
      Information
                      35Part
      IIIItem
      10
                      Directors,
      Executive Officers and Corporate Governance
                      35Item
      11
                      Executive
      Compensation
                      38Item
      12
                      Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                      42Item
      13
                      Certain
      Relationships and Related Transactions and Director
      Independence
                      43Item
      14
                      Principal
      Accountant Fees and Services
                      48








Part
      IVItem
      15
                Exhibits,
      Financial Statement Schedules
                49Signatures
      and CertificationsFinancial
      Statements
                F-1







Forward-Looking
Statements





This
report contains forward-looking statements throughout and in particular in the
discussion at Item 7 titled “Management’s Discussion and Analysis of Financial
Condition and Results of Operations”. These are statements regarding financial
and operating performance and results and other statements that are not
historical facts. The words “expect,” “project,” “estimate,” “believe,”
“anticipate,” “intend,” “plan,” “forecast,” and similar expressions are intended
to identify forward-looking statements. Certain important risks, including those
discussed in the risk factors set forth in Item 1A of this report, could cause
results to differ materially from those anticipated by some of the
forward-looking statements. Some, but not all, of these risks include, among
other things:





·
            our
      lack of capital and whether or not we will be able to raise capital when
      we need it;





·
            changes
      in local, state or federal regulations that will adversely affect our
      business;





·
            our
      ability to market and distribute or sell our
  products;




·
            whether
      we will continue to receive the services of certain officers and
      directors;





·
            our
      ability to protect our intellectual property and operate our business
      without infringing upon the intellectual property rights of others;
      and





·
            other
      uncertainties, all of which are difficult to predict and many of which are
      beyond our control.





We do not
intend to update forward-looking statements. You should refer to and carefully
review the information in future documents we file with the Securities and
Exchange Commission.


i


PART
I





Item
1. Business





We were
incorporated as Network Dynamics in California on August 29, 2003, and changed
our name to CyberDefender Corporation (“the Company”, “we”, “us” or “our” in
this report) on October 21, 2005. We are a provider of secure content management
(“SCM”) software. Our mission is to bring to market advanced solutions to
protect computer users against identity theft, Internet viruses, spyware and
related security threats. Individuals who use personal computers make up our
subscriber base, therefore we are not dependent on any single customer or on a
few major customers. While our product is available for downloading from our
website, which makes it available to anyone in the world, we do not have a
significant customer base outside of the United States.





Our
business was originally built around the sale of a single product, our
CyberDefender Anti-spyware. During the period from our founding through 2004,
our primary focus was on marketing and selling this product. In 2005, we
acquired certain assets from Unionway International, LLC, an entity controlled
by Mr. Bing Liu, one of our directors and a consultant. Among these assets was
software that formed the basis for our proprietary Collaborative Internet
Security Network, which we refer to as the “CISN” or the
“earlyNETWORKTM”.





On
November 20, 2006, we stopped engaging in new sales of our product,
CyberDefender Anti-Spyware 2006 (although we still continue to support the
product and will continue upgrading it), and we began providing a suite of
Internet security products called CyberDefender Early Detection Center V2.0,
which is also provided as CyberDefender FREE V2.0.





We offer
CyberDefender FREE V2.0 as a free download in an ad-supported version and
CyberDefender Early Detection Center V2.0, without ads, in exchange for the
payment of a licensing fee. There is no trial period and no monthly or annual
fee to pay for using CyberDefender FREE V2.0. Instead, we receive payment from
the advertisers, typically at the end of each month. Subscribers who choose
CyberDefender Early Detection Center pay for the license fees via credit card.
The annual subscription rate for this version of the security suite ranges from
$12.99 to $94.46, depending on the number of licenses bundled, the term of the
license and the marketing and distribution channels that we use. In addition to
our core products above, CyberDefender markets CyberDefender Registry Cleaner
V1.0, CyberDefenderCOMPLETE and CyberDefenderULTIMATE, CyberDefender Identity
Protection Service and MyIdentityDefender browser toolbar. We distribute our
software via the internet and on computer disk.





Once our
CyberDefender Early Detection Center V2.0 or CyberDefender FREE V2.0 suite of
security products is downloaded, the subscriber becomes a part of our
earlyNETWORKTM. We believe that the earlyNETWORKTM provides a unique approach to
updating personal computer security. We have developed the earlyNETWORKTM based
on certain technology principles commonly found in a peer-to-peer network
infrastructure. A peer-to-peer network does not have the notion of clients or
servers, but only equal peer nodes that simultaneously function as both
“clients” and “servers” to the other nodes on the network. Therefore, as system
demands increase, so does the system’s capacity. Our earlyNETWORKTM is designed
to reduce the lag time between the identification of a new security threat by
our Early Alert Center and notification to the personal computers that are part
of the earlyNETWORKTM. The peer-to-peer network infrastructure allows us to
provide a fluid, distributed system for alerts and updates, and to incorporate a
universal threat definition system. This approach is different and, we believe,
significantly faster than traditional Internet security companies that provide
manual, broadcast-updated threat management systems.


1


Our
earlyNETWORKTM is an adaptive network of machines that defends automatically
against a wide spectrum of software attacks and provides users with proprietary
automated processes that rapidly identify and quarantine both known and emerging
threats. Our customers obtain access to the earlyNETWORKTM by downloading and
installing our security suite (CyberDefender Early Detection Center V2.0 or
CyberDefender FREE V2.0) or the MyIdentidyDefender toolbar, discussed below. As
additional users are added to well-managed peer networks, the networks work
better. The same is true of our collaborative security network. With more
clients, threats are picked up faster and updates occur faster as well, because
users of our software find peers more easily than they could an update server.
Users of our software who cannot connect with other users will always be able to
fall back on the CyberDefender Alert Server which is the central source for
threat analysis and notification.





The
nature of current SCMs, which assume a single point of threat capture, a
cumbersome threat analysis system and an intermittent update system, creates a
“coverage gap” which can delay alerts on important new infectious attacks for 12
hours or more. However, our proprietary technology quickly distributes threat
updates to all computers that are part of the earlyNETWORKTM. Other SCMs send
updates in a scheduled batch. For example, our system for generating threat
reports, the Early Alert Center, first reported the Sasser.E virus at 11:52 p.m.
on May 7, 2004. This was one to two days before other SCM software vendors
announced their discoveries of the same virus. We believe we are the first to
provide threat updates in this manner.





Using the
earlyNETWORKTM infrastructure instead of relying on expensive bandwidth for mass
updates means that our updates are relayed securely throughout the earlyNETWORKTM
using each local user’s bandwidth. There is no need to wait for a scheduled
update – updates are simply sent to the entire network in approximately one hour
as opposed to 12 hours for a conventional network. The network responds quickly
to new threats because it enlists all the machines in the earlyNETWORKTM to act
as listening posts for new threats. Our solution works well with existing
security software and can operate as an additional layer of security on a
desktop.





Industry
Background





Secure
Content Management (SCM) Market





According
to a report issued by BCC Research, which was published in January 2006, the
global Internet security market is expected to rise at an average annual growth
rate (AAGR) of 16.0%, reaching $58 billion by 2010. The high growth rate is
attributed to a higher demand for strong security solutions in market verticals
such as government installations, financial services, and healthcare. Firewall
and content management currently account for a majority share of the market.
However, the increasing need to counter “zero-day” attacks, that is, viruses or
other exploits that take advantage of a newly discovered vulnerability in a
program or operating system before the software developer becomes aware of the
vulnerability or fixes it, along with the increasing popularity of
“defense-in-depth” strategies, wherein coordinated uses of multiple security
countermeasures are used to protect the integrity of information assets, will
bring unified threat management solutions to the forefront.




Currently,
the U.S. and Europe account for a major portion of the Internet security market.
However, the market for Internet security is expected to grow significantly in
the Asia Pacific regions, especially China and India. Increased e-commerce in
these regions and a simultaneously growing security consciousness is expected to
drive the market in these areas.





Three
specific product areas comprise SCM:





Antivirus software identifies
and/or eliminates harmful software and macros by scanning hard drives, email
attachments, disks, Web pages and other types of electronic traffic, for
example, instant messaging and short message service (“SMS”), for any known or
potential viruses, malicious code, trojans or spyware.


2


Web filtering software is used
to screen and exclude from access or availability Web pages that are deemed
objectionable or not business related. Web filtering is used by entities to
enforce corporate Internet use policies as well as by schools, universities and
home computer owners for parental controls.





Messaging security software is
used to monitor, filter and/or block messages from different messaging
applications, for example, e-mail, IM, SMS and P2P, containing spam,
confidential information and objectionable content. Messaging security is also
used by certain industries to enforce compliance with privacy
regulations.





SCM
Growth Drivers





Viruses, worms and spyware are serious
threats facing businesses and consumers today because these programs can be used
to steal personal information, enable identity theft, damage or destroy
information stored on a computer and cause damage to legitimate software,
network performance and productivity. These types of malicious programs are
introduced to computers in a number of ways, including, but not limited
to:





·
            poor
      browser security as most browsers today are full of security holes that
      are exploited by hackers and
criminals;





·
            growing
      use of the Internet and e-mail as a business tool and preferred
      communication channel;





·
            increased
      use of mobile devices to access key
data;





·
            continued
      rapid increases in spam as the majority of spam sent today originates from
      zombie machines remotely controlled by
spammers;




·
            explosive
      growth in spyware causing theft of confidential information, loss of
      employee productivity, consumption of large amounts of bandwidth, damage
      to desktops and a spike in help desk calls;
and





·
            flaws
      in operating systems that contribute to the wide range of current Internet
      security threats, particularly if users do not update their computers with
      patches.





As a
result of the foregoing factors, the SCM market developed and continues to
expand in order to respond to the ever-evolving threats presented by malicious
programs.





Current
Product Limitations





Many SCM
software vendors have attempted to solve Internet security problems with a
variety of software applications. Although many products exist today to address
such security issues, these solutions face many limitations, including the
following:





No Real-Time Security - Most
antivirus and antispyware software applications do not protect personal
computers against real-time threats. If new viruses or spyware exist on the
Internet but do not reside in risk definition databases, most personal computers
exposed to the threat will be infected. Typical virus protection software
requires frequent downloads and updates to work properly. If a user does not
download a patch timely, the user’s system may no longer be safe. By the time a
new virus is announced, it may already be too late to take action, and an
infection may have occurred. Also, new patches may take hours to install,
decreasing work productivity.





Inability to Catch all Viruses and
Malicious Content – Current threat analysis systems are not capable of
detecting all malicious codes. With current security networks, software alone
cannot detect unknown attacks – human involvement is required. Not only are
threats not detected, but threats that are detected are resolved untimely due to
intermittent update systems delaying user alerts.


3


Costly Updating - Most
antispyware and antivirus software providers use a client-server network
infrastructure to distribute new spyware and virus definitions. Such solutions
are expensive to maintain because they rely on intensive data centers and
networks to deliver updates, thereby using a significant amount of bandwidth,
which is expensive to obtain. Also, vendors cannot afford to send threat updates
continuously and therefore are slow to distribute them. In fact, many software
vendors provide updates on a scheduled basis, rather than as the updates are
needed. This may leave the PC vulnerable since threats propagate without a
schedule, and therefore a PC which was updated on Monday may be effectively
infected on Tuesday.





Every
consumer or business using any networked device needs to have some form of
Internet security. We provide consumers and business users with a platform of
products and services designed to protect against various types of security
attacks.





CyberDefender
Technology





Conventional
Internet security companies use a cumbersome manual process to identify new
threats, analyze threats in labs, and distribute threat updates to their user
base. These security companies have to broadcast updates to each personal
computer user individually in the network. Serious drawbacks to conventional
broadcast updates exist, including the following:





·
            The
      expense related to this process; the network cannot be updated in
      real-time, and instead is updated in batches spaced days
      apart.





·
            Because
      broadcasting servers are a single point of distribution, they are
      vulnerable to “flooding” attacks that prevent clients from getting the
      needed updates.





·
            A
      threat may block a client computer’s access to the broadcast server,
      disabling its ability to download an update for the
  threat.





We have
addressed these shortcomings by developing the earlyNETWORKTM to
detect, analyze and quarantine new security threats. The earlyNETWORKTM is not
a conventional peer-to-peer network because the Alert Server is a required
checkpoint for all client activities, thus assuring the integrity of the
network. The earlyNETWORKTM is a
controlled publishing network that leverages the power of distributed bandwidth.
Each client has a controlled role in relaying the threat updates to as many as
20 clients, thus allowing continuous release of threat updates.





Unusual
behavior is detected by a personal computer equipped with our CyberDefender
Internet security software. The potential threat may be anything from spam to a
virus. The program puts the potential threat on standby, and reports it to our
Early Alert Center’s Alert ServerTM. The Alert Server compares the threat to
existing threat definitions. If the Alert Server does not recognize the threat,
the threat is sent to our AppHunterTM for analysis.





AppHunter
is an automated system that manages the threat analysis process. First,
AppHunter tests the undefined threat on an isolated computer that is
automatically wiped clean after each test. Based on the behavior of the test
computer, AppHunter ranks the threat on a scale from one to ten. Rankings of
five and above are classified as infectious (viruses). Additionally, AppHunter
carries out a confidential set of proprietary verifications to ensure that the
threat itself is not an attempt to deceive or hack the network.





As there
is a wide set of possible attacks that do not qualify as viruses, our AppHunter
is supplemented by a team of human technicians who classify threats that rank
below 5 in severity. Threat definitions are added as quickly as possible to our
definition database, which is then updated to our users via our earlyNETWORKTM. We
continually make changes to our technology to make sure that we address as many
security concerns as possible.


4


We
believe that our earlyNETWORKTM may be
the only network today that distributes information securely between the
individual personal computer users who have installed our software, which we
have sometimes referred to as “peers” in this discussion.





Using our
peer-to-peer technology, our CyberDefender Alert Server notifies users of our
software who, in turn, notify up to 20 other users in an ever-widening circle.
This distributed notification process frees up the Alert Server to deal with
incoming alerts from clients that have encountered unexpected behavior, and
makes the network truly responsive and “in tune” with its users. Because the
cost of updating using the earlyNETWORKTM is very
small, Alert Server can send out updates as fast as threats are confirmed,
resulting in better security coverage. In general, from the time the first
client has picked up the new threat to the updating of the network, about an
hour passes. We believe that this process occurs roughly ten times faster than
the updating of any other competitive system.





Proprietary
Technology Overview





The
following is a description of our proprietary technologies:





1. Threat
Protection Network V1.0 / V2.0 (“TPN”)





Sophisticated
threat analysis platform which utilizes CyberDefenders proprietary threat
analysis engine and updating technology.





A patent
application covering this technology, serial number 11/234,531 was filed on
September 22, 2005.





2. Secure
Peer to Peer Network V1.2/V2.0





Dynamic
secure peer to peer network which utilizes cloud computing and various
proprietary security protocols in order to update PCs against new
threats.





A patent
application covering this technology, serial number 11/234,868, was filed on
September 22, 2005.





3.
CyberHunter V1.0





A
proprietary web crawling technology which identitifes and collects malware
information found on the web and reports it to the TPN.





4.
CyberDefender Early Detection Center V2.0





Windows
PC Internet security suite designed to protect consumers and small businesses
against viruses, spyware, spam and phishing attacks.





5. Web
Access Protection – CyberDefender MyIdentityDefender V1.0/V1.5





Proprietary
anti-phishing and web access protection technology designed for Windows Internet
Explorer and Windows FireFox browsers.





6.
CyberDefender Gladiator V1.0




A free
tool designed to remove specific malware files from Windows
PCs.


5


Future
Technology Projects





The
following products are currently in the planning or development stages. We
cannot guarantee that any of the following products will be successfully
developed and marketed.





1.
CyberDefender Real-time World Threat Map




A website
dedicated to informing subscribers about emerging threats worldwide. Threat data
will be provided by TPN. By utilizing Google Maps or other mapping technologies,
this platform will provide real time updates via web or wireless devices.
Targeted users will be ISPs and security professionals.





2.
CyberDefender Real-time Threat Feed




Scheduled
for release in 2010 this service will provide real-time threat data feeds to
other Internet security providers and ISPs.




3.
CyberDefender Reputation Management Platform V1.0





A
business and consumer reputation management system designed to inform and
protect online reputation. This product is scheduled for Alpha release in
2009.





4.
CyberDefender Mobile Security Platform


Scheduled
for Alpha release in 2010, this will be a consumer-based all-in-one security
suite for the Apple iPhone, Microsoft Windows mobile, Google Andriod and Nokia
Smartphone platforms which will allow them to utilize the power of TPN2 and
SPN2.





Products




CyberDefender
Early Detection Center V2.0





Early
Detection Center V2.0 is a Windows PC Internet security suite designed to
protect consumers against spyware, viruses, phishing attacks and spam.
CyberDefender Early Detection Center utilizes the earlyNETWORK and retails from
$12.99 to $49.99 per single PC user per year. Early subscription includes
unlimited threat definition updates.





CyberDefender
FREE V2.0





FREE V2.0
has the same technology features as the CyberDefender Early Detection Center
V2.0. This version is offered free to consumers and is supported by impeded
banner advertising. Users can upgrade to the non ad supported version
(CyberDefender Early Detection Center V2.0) for $12.99 to $49.99. Users will
receive unlimited updates as long as the product is available by
CyberDefender.





CyberDefender
Registry Cleaner V1.0





Registry
Cleaner V1.0 is Windows PC optimization software designed to improve performance
and speed up PC speed. CyberDefender Registry Cleaner V1.0 fixes common Windows
registry errors and is offered to consumers for $9.95 to $29.95 for 1 year
subscription. Users will receive unlimited updates during the 12 month
subscription.


6


CyberDefender
FamilyPak





The
FamilyPak offers the same technology as CyberDefender Early Detection Center
V2.0. Designed for families with multiple PCs or small businesses running
multiple PCs, it is offered at $29.95 to $49.95 per year for a 12 month
subscription.





MyIdentityDefender
V1.0





A free
Windows Internet Explorer browser plug in designed to protect users against
phishing attacks and dangerous websites, this product is offered for free and
generates revenue through an imbedded search engine powered by
InfoSpace.





CyberDefenderCOMPLETE





CyberDefenderCOMPLETE
provides live premium tech-on-call service which offers a one-time resolution
for any malware related PC problem. Service is offered from $99.95 to $149.99
per incident.





CyberDefenderULTIMATE





CyberDefenderULTIMATE
provides unlimited live premium tech-on-call service 24 hours per day and 7 days
per week for assistance with the resolution of any technology problem. The
service is offered for $199.99 to $299.99 per user per year.





CyberDefender
Identity Protection Service





This is
an identity protection service offering users basic ID protection features and a
$25,000 identity theft insurance policy. This product is offered at $9.95 to
$14.95 per month.





CyberDefender
Identity Protection Service with Credit Monitoring





This
version of the CyberDefender Identity Protection Services includes credit
monitoring. This product is offered at $19.95 to $29.95 per month.





Growth
Strategy





Our plan
is to continue to grow our business by continuing to purchase effective online
advertising and by recruiting new customers and renewing subscriptions from our
current customers. Approximately 50% of our customers renew their subscriptions
to our products year over year. We believe that as the number of our customers
grows, this renewal stream will be compounded.


By
optimizing price points and adding new products, we believe that we will achieve
a higher revenue per user per year and a higher lifetime value. We will continue
to optimize our advertising spending in order to achieve higher
profitability.





In
addition to the above, we believe that our recently signed contract with
Guthy-Renker, as detailed below, will help us market our product effectively
utilizing radio and television advertising. Considering the large scale of
available TV and radio media, we believe that this relationship with
Guthy-Renker could be very significant to CyberDefender.


7


On March
24, 2009 we entered into a Media and Marketing Services Agreement with GR Match,
LLC (“GRM”). Pursuant to the agreement, GRM will provide direct response media
campaigns, including radio and television direct response commercials, to
promote our products and services and will purchase media time on our behalf.
During the term of the agreement, which is to continue until August 31, 2010,
subject to certain rights of termination, GRM will be the exclusive provider of
all media purchasing and direct response production services. On August 22,
2009, assuming that the agreement has not been terminated, we will appoint a
representative of GRM to our board of directors. This director will continue to
serve throughout the term of the agreement and for so long as GRM owns shares of
our common stock or the right to purchase shares of our common stock which
constitute at least 5% of our issued and outstanding common stock.





We are to
provide a monthly budget to GRM for media placement. GRM will purchase the media
and invoice us for the cost plus 2.5% in overhead expenses incurred in
connection with providing the media placement services. As security for the
payment of the media costs and overhead, we have agreed to grant to GRM a
security interest and lien in any proceeds held in a merchant services account
we will establish with Lidle Merchant Services. The purpose of the merchant
services account is to collect the proceeds from sales made as a result of the
media campaigns. These sales will be made through websites we will establish
that will be exclusively used to receive and process orders of our products from
customers who respond to the media campaign (“direct response
websites”).





As
compensation for GRM’s services, we have agreed to issue a warrant for the
purchase of 1,000,000 shares of our common stock. The term of the warrant will
be 5 years and the exercise price will be $1.25 per share. This warrant will
have both cash and cashless exercise provisions. This warrant will replace a
warrant issued to GRM in November 2008. We will also issue to GRM a second 5
year warrant which will also be for the purchase of 1,000,000 shares of our
common stock at a price of $1.25 per share. This warrant may be exercised only
for cash. Finally, we have agreed to issue to GRM a 5 year warrant for the
purchase of 8,000,000 shares of our common stock at an exercise price of $1.25
per share. This warrant may be exercised only with cash. This warrant will be
subject to vesting as follows: for each $2 of media placement costs advanced by
GRM on our behalf, the right to purchase one share of our common stock will
vest. If GRM terminates the agreement due to a breach by us in our performance
or as a result of our discontinuance, dissolution, liquidation, winding up or
insolvency, or if we terminate the agreement for any reason, any unexpired and
unvested rights of GRM to purchase shares of our common stock pursuant to the
agreement will immediately vest.





If the
average closing price of our common stock as reported by Bloomberg LP for the 20
trading days preceeding January 1, 2010 is not at least $3.00 per share or if
our common stock is not publicly traded on any stock exchange or
over-the-counter market as of December 31, 2009, then we shall be required to
pay a monthly royalty to GRM. The royalty will be equal to 20% of gross renewal
revenue, which is defined as the aggregate gross revenue, net of refunds and
chargebacks, earned by us as a result of renewals and/or re-orders of our
products by our customers who both (i) became customers during the period
commencing on March 1, 2009 and ending upon the earlier of (A) the termination
date of the agreement or (B) the date following January 1, 2010 when the average
closing price of our common stock as reported by Bloomberg LP for the 20 trading
days preceding that date was at least $5.00 per share and (ii) initially
purchased any of our products from any direct response websites. Our obligation
to pay these royalties will survive the expiration of termination of the
agreement.





The
agreement may be terminated by either us or GRM in the following
events:





·
            if
      there is a breach or default in performance of any obligation, unless the
      breach or default is cured with 15 business days following receipt of
      written notice from the non-breaching
party;





·
            upon
      the discontinuance, dissolution, liquidation or winding up of the other
      party’s business or the insolvency of the other party;
  or





·
            by
      either party for any reason by giving the other party written notice of
      the termination at least 30 days prior to the effective date of
      termination.


8


After May
30, 2009, GRM may terminate the agreement upon 5 days written notice to us in
the event that the average media placement costs for any 3 consecutive months
during the term are less than $250,000 per month.





If we
breach our payment obligations under the agreement and fail to cure the breach
within 15 days after receiving notice from GRM, then the number of warrant
shares which would otherwise vest during the month of the delinquent payment
will automatically double and GRM will have the right to enforce its security
interest in the merchant services account. If we breach our payment obligation
more than 3 times, we will not be entitled to cure the breach and GRM will be
entitled to enforce its rights and remedies under the agreement.





If the
agreement is terminated by GRM prior to the expiration of the term because of
our breach, our discontinuance, dissolution, liquidation, winding up or
insolvency or because our average media placement costs for any 3 consecutive
months during the term are less than $250,000, or if we terminate the agreement
upon notice, then, if we propose to procure media purchasing services from a
third party which are similar to the services provided by GRM under the
agreement, we will notify GRM of the terms of such engagement. GRM will have a
period of 15 days to elect to provide the services on the same
terms.





Revenue
Model





We earn
revenues from the sale of our products. We license CyberDefender Early Detection
Center software for $12.99 to $49.99 for one year of service. This price
includes technical support related to the basic software installation, software
updates and definition updates. After one year of service, customers have the
option to renew the service. Users are notified when a subscription is due to
expire and what the cost will be to continue the subscription. In September
2007, we launched CyberDefenderULTIMATE and CyberDefenderCOMPLETE which we sell
for $99.95 to $299.99 per year. By promoting our newer products and increasing
the amount of money spent on advertising, the number of licenses sold, gross
sales and the average dollar per sale during the year ended December 31, 2008
increased significantly. In addition, we are also offering CyberDefender
Registry Cleaner and CyberDefender Identity Protection Service to all of the
customers who purchase CyberDefender Early Detection Center. The total number of
licenses sold for all products during the period increased from 1,043 in January
2008 to 25,086 in December 2008, gross sales receipts increased from $38,791 in
January 2008 to $1,265,459 in December 2008 and the average dollars per sale
increased from $37.19 in January 2008 to a high of $52.49 in October 2008 and an
average of approximately $49.00 per month from February through December 2008.
We expect this trend to continue, although we cannot guarantee that it will do
so.





We also
generate advertising revenue from CyberDefenderFREE 2.0 and MyIdentityDefender
V1.0. Since November 2006, we began generating revenue from advertising by
showing users of our CyberDefender FREE V2.0 software small banners inside the
user interface, showing text links to third party products and/or getting paid
by search engine companies whenever individuals use our MyIdentityDefender
Toolbar. Our goal is to maximize our advertising revenue by increasing the
number of CyberDefender FREE 2.0 and MyIdentityDefender toolbar users.
Individuals who use these free products also contribute to the earlyNETWORKTM since
they create additional “nodes” or peers, which allow for faster threat
updates.





On
occasion, we also offer to our software users, both paying and non-paying, other
subscription services such as identity theft protection and consumer credit
management.





Retail
Sales





In
September 2008, we signed an agreement with a marketing partner, Allianex
Corporation, which will give us an opportunity to sell our products through over
200,000 retail locations worldwide. We have not yet started delivering our
products via this retail channel and we anticipate finalizing the distribution
terms in 2009 which will allow us to start these deliveries.


9


Customers





Our
primary customers are consumers who use home computers that use the Windows
operating systems. Our customers reside primarily in the United States. The
number of our customers fluctuates due to the fact that, while we gain new
customers on a daily basis, existing customers can cancel or may not renew their
subscriptions.





Marketing
and Sales




We market
our products to computer users through the use of Internet marketing and our
e-commerce website. We plan to make our products available to customers through
channels that include retailers, distributors, direct marketers, Internet-based
resellers, original equipment manufacturers (OEMs), and Internet service
providers. In October 2008, we signed a contract with Maxtek Distributing Inc.
which is currently marketing our products through an online retailer,
NEWEGG.com. In addition, we have an ongoing contract with DDNI Corporation which
is currently in the process of launching our product through Lenovo Computers.
Current and future marketing opportunities include TV advertising, search engine
optimization, international marketing, co-marketing with distributors and
resellers, marketing through the use of a CyberDefender web browser security
toolbar and participation in trade and computer shows and user group
conferences.





Competition





Internet
security markets are competitive and subject to continuous technological
innovation. Our competitiveness depends on our ability to offer products that
meet customers’ needs on a timely basis. The principal competitive factors of
our products are time to market, quality, price, reputation, terms of sales,
customer support and breadth of product line.




Some of
our competitors include WebRoot Software, Sunbelt Software and Kaspersky Labs.
In addition, we may face potential competition from operating system providers
and network equipment and computer hardware manufacturers. These competitors may
provide various security solutions in their current and future products and may
limit our ability to penetrate these markets. These competitors have significant
advantages due to their ability to influence and control computing platforms and
security layers in which our products operate. At this time, we do not represent
a competitive presence in the SCM industry.





Intellectual
Property





Our
software is proprietary and we make every attempt to protect our software
technology by relying on a combination of copyright, patent, trade secret and
trademark laws and restrictions on disclosure.





On
September 22, 2005 we filed two applications with the US Patent and Trademark
Office for final patents. The application titles and serial numbers are “Threat
Protection Network” – Application No. 11/234,531 and “System for Distributing
Information Using a Secure Peer to Peer Network” – Application No.
11/234,868.





On
September 21, 2005 we submitted an application to the US Patent and Trademark
Office for the registration of our name, CyberDefender, on the principal
register. The mark was registered on the principal register on March 13, 2007 as
number 3217137. On November 19, 2008 we filed an application with the US Patent
and Trademark Office for registration of the mark, CyberDefender Registry
Cleaner, which is a mark used on our downloadable software program used to clean
and repair an operating system registry. We also own a registered mark
consisting of the @ symbol inside a star.





We may
also license intellectual property from third parties for use in our products
and, in the future, we may license our technology to third parties. We face a
number of risks relating to intellectual property, including unauthorized use
and copying of our software solutions. Litigation may be necessary to enforce
our intellectual property rights or to protect trade secrets or trademarks
rights.




10




Employees




We
currently employ 35 full time employees and 3 independent contractors. Our
employees are segmented by the following functions: executive management,
research and development, information technology, marketing and sales, customer
service and call center, and finance and administration.





Government
Regulation and Probability of Affecting Business





The
development of our products is generally not subject to government regulation.
However, laws and regulations that apply to Internet communications, commerce
and advertising are becoming more prevalent. These regulations could affect the
costs of communicating on the Internet and adversely affect the demand for our
products or otherwise harm our business, results of operations and financial
condition. The United States Congress has enacted Internet legislation regarding
children’s privacy, copyrights, sending of unsolicited commercial email and
spyware. Other laws and regulations may be adopted in the future. This
legislation could hinder growth in the use of the Internet generally and
decrease the acceptance of the Internet as a communications, commercial and
advertising medium.





In
addition, the growth and development of the market for Internet commerce may
prompt calls for more stringent consumer protection laws, such as laws against
identity theft, which may impose additional burdens on companies conducting
business over the Internet. While none of the current laws governing Internet
commerce has imposed significant burdens on us to date, in the future our
business, results of operations and financial condition could be materially and
adversely affected by the adoption or modification of laws or regulations
relating to the Internet, or the application of existing laws to the Internet or
Internet-based advertising.




Item
1A. Risk Factors




Our
operations and financial results are subject to various risks and uncertainties
that could adversely affect our business, financial condition, results of
operations, cash flows, and the trading price of our common stock. Discussion
about important operational risks that our business encounters can be found in
Item 1 and in Item 7 of this report, as well as in the discussion
below.





Risks
Related to Our Business





We
have been in business only since August 2003. Our limited operating history
makes evaluation of our business difficult.





We were
incorporated in the State of California as Network Dynamics in August 2003 and
have limited historical financial data upon which to base planned operating
expenses or to accurately forecast our future operating results. We have a
limited operating history which makes it difficult to evaluate our performance.
You must consider our prospects in light of the risks, expenses and difficulties
we face as an early stage company with a limited operating history. These risks
include uncertainty as to whether we will be able to:





·
            increase
      revenues from sales of our suite of Internet security
      products;





·
            successfully
      protect our earlyNetworkTM from all
      security attacks;





·
            successfully
      protect personal computers or networks against all Internet
      threats;


11


·
            respond
      effectively to competitive
pressures;





·
            protect
      our intellectual property rights;





·
            continue
      to develop and upgrade our technology;
and





·
            continue
      to renew our customers’ subscriptions to current and future
      products.





We
incurred net losses for our last three fiscal years. We are not certain that our
operations will ever be profitable.





We
incurred a net loss of $5,507,600 for the fiscal year ended December 31, 2006, a
net loss of $5,866,123 for the fiscal year ended December 31, 2007 and a net
loss of $11,251,772 for the fiscal year ended December 31, 2008. We can provide
no assurance as to when, or if, we will be profitable in the future. Even if we
achieve profitability, we may not be able to sustain it.





As
of December 31, 2008 we had approximately $779,000 in cash. In order to meet our
financial obligations and continue our business development for a period of 12
months, we will need an additional $2-5 million. We do not have a commitment for
this financing.





We have
no committed sources of additional capital. We have been funding our operations
and capital expenditures from limited cash flow from operations, our cash on
hand and the proceeds from the offerings of our debt and equity securities. As
of December 31, 2008 we had approximately $779,000 in cash. Aside from the
revenues we generate from our products, we will need approximately $2-5 million
in additional funds to continue our operations for the next 12 months, pursue
business opportunities (such as expansion of our marketing efforts and customer
service activities or the development of new products or services), react to
unforeseen difficulties or respond to competitive pressures. This does not
include funds we may need by September 12, 2009 to repay $729,679 in aggregate
principal amount of our 10% Secured Convertible Debentures and 10% Convertible
Debentures, or to repay $1,200,000 in aggregate principal amount of our 11 month
10% Convertible Debentures issued between November 13, 2008 and January 28,
2009, to the extent the same are not converted to common stock before such date.
We cannot assure you that any financing arrangements will be available in
amounts or on terms acceptable to us, if at all. If additional financing is not
available or is not available on acceptable terms, we may be unable to continue
our operations. If we choose to raise additional funds through the issuance of
equity securities, our existing equity security holders may experience
significant dilution of their ownership interests, and holders of the additional
equity securities may have rights senior to those of the holders of our common
stock. If we obtain additional financing by issuing debt securities, the terms
of these securities could restrict or prevent us from paying dividends and could
limit our flexibility in making business decisions.





We
may be unable to continue as a going concern.





Our
consolidated financial statements have been prepared on a going concern basis
which assumes that we will be able to realize our assets and discharge our
liabilities in the normal course of business for the foreseeable future. We have
generated a net loss of $11,251,772 and realized a negative cash flow from
operating activities of $1,080,302 for the year ended December 31, 2008. At this
date, we had negative working capital of $7,848,539. At December 31, 2008 we had
an accumulated deficit of $25,812,724. Stockholders deficit was $8,032,180 at
December 31, 2008.




Our
ability to continue as a going-concern is in substantial doubt as it is
dependent on a number of factors including, but not limited to, the receipt of
continued financial support from our investors, our ability to control and
possibly reduce our expenses, our ability to raise equity or debt financing as
we need it, and whether we will be able to use our securities to meet certain of
our liabilities as they become payable. The outcome of these matters is
dependent on factors outside of our control and cannot be predicted at this
time.


12


We
market our products through search engines (for example, Google, Yahoo! and
MSN), e-mail and banner advertising and affiliate marketing. If we fail to
market our products effectively, our sales could decline and our results of
operations would be adversely affected.





We market
our products and related services over the Internet, primarily through space
purchased from Internet-based marketers and search engines. Currently we drive
traffic to our website by spending approximately 92% of our advertising budget
on pay-per-click advertising on Google, Yahoo!, WebMetro and MSN. While the
amount that we spend on this advertising varies on a daily basis, in general
approximately 58% of our advertising budget is spent on pay-per-click
advertising through Google, 22% through Yahoo!, 7% through WebMetro and 5%
through MSN. If Internet advertising fails to perform as we anticipate, our
sales could decline and the cost of the advertising, per click, would increase.
This could have a material, adverse effect on our results of
operations.





We
face intense competition from other providers of Internet security software. If
we cannot offer consumers a reason to use our software instead of the software
marketed by our competitors, our business and the results of our operations will
be adversely affected.





We have
many competitors in the markets for our products. Our competitors include
software companies that offer products that directly compete with our products
or that bundle their software products with Internet security software offered
by another company. End-user customers may prefer purchasing Internet security
software that is manufactured by the same company that provides its other
software programs because of greater product breadth offered by the company,
perceived advantages in price, technical support, compatibility or other
issues.





Some of
our competitors include WebRoot Software, Kaspersky Labs and Sunbelt Software.
Many of our competitors, such as TrendMicro, McAfee and Norton have greater
brand name recognition and financial, technical, sales, marketing and other
resources than we do and consequently may have an ability to influence customers
to purchase their products rather than ours. Our future and existing competitors
could introduce products with superior features, scalability and functionality
at lower prices than our products and could also bundle existing or new products
with other more established products in order to compete with us. Our
competitors could also gain market share by acquiring or forming strategic
alliances with our other competitors. Finally, because new distribution methods
offered by the Internet and electronic commerce have removed many of the
barriers to entry historically faced by start-up companies in the software
industry, we may face additional sources of competition in the
future.




We
rely on the services of QResolve to provide tech-on-call services. If we were to
lose the services of QResolve, this portion of our business could be
disrupted.





For an annual fee,
CyberDefenderULTIMATETM provides year round tech-on-call services for any
software or hardware connected to a subscriber’s computer while
CyberDefenderCOMPLETETM provides one time anti-malware tech-on-call services for
a subscriber’s computer. These tech-on-call services are provided by QResolve, a
business partner. If we lose our working relationship with QResolve and are
unable to replace it with an equally competent tech-on-call service provider at
competitive pricing, or if the quality of QResolve’s services deteriorates for
any reason, our ability to service customers may suffer and our revenues from
CyberDefenderULTIMATETM and CyberDefenderCOMPLETETM could be adversely affected.
We would also be required to spend a significant amount of time and effort to
find and train a new service provider, which would take management’s attention
away from the day-to-day operations of our business.We could also be
required to file a legal action to recover money paid in advance for services
that were never provided. This could have a material adverse effect on our
business and results of operations.


13


If
we are unable to develop and maintain new and enhanced Internet security or
identity protection products and services to meet emerging industry standards,
our operating results could be adversely affected.





Our
future success depends on our ability to address the rapidly changing needs of
our customers by developing, acquiring and introducing new products, product
updates and services on a timely basis. For example, in September 2007, we
launched CyberDefenderULTIMATETM and CyberDefenderCOMPLETETM. These are enhanced
versions of our Internet security software. Also, in November 2008, we released
CyberDefender Registry CleanerTM. The CyberDefender Registry CleanerTM eliminates
clutter and junk that builds up within a computer's registry due to the
installation and removal of programs, deletion and creation of files and cached
records from Web surfing. The success of our business depends on our ability to
keep pace with technological developments and emerging industry standards. We
intend to commit a portion of our resources to developing new applications for
threat research and new security applications for Web 2.0 and social networking
environments. However, if we are unable to successfully develop such products or
if we develop these products but demand for them does not materialize or occurs
more slowly than we expect, we will have expended resources (such as personnel
and equipment) and capital without realizing sufficient revenue to recover these
costs, and our operating results could be adversely affected.





If
we fail to adapt our technologies to new Internet technologies, we could lose
customers and key technology partners. This would have a material adverse effect
on our revenues, our business and the results of our operations.





Internet
technology is constantly evolving to make the user's experience easier and more
comprehensive. Our products use Internet technologies. We must constantly
monitor new technologies and adapt our technologies to them as appropriate. If
we fail to keep our products compatible with the latest Internet technologies,
they may not perform adequately and we may lose not only our customers, but
those suppliers and partners whose Internet technologies support our products.
The loss of our customers or our suppliers and partners would have a material
adverse effect on our revenues, our business and the results of our
operations.





Because
of the constant development of new or improved products in the software
industry, we must continually update our products or create new products to keep
pace with the latest advances. While we do our best to test these products prior
to their release, they may nevertheless contain significant errors and failures,
which could adversely affect our operating results.





With the
introduction of Vista, the most recent operating system from Microsoft, and
constant changes in the software industry as new standards and processes emerge,
we are required to continually update our suite of Internet security products.
While we do our best to test these products prior to their release, due to the
speed with which we are required to release new or updated products to remain
competitive, they could be released with errors or they may fail altogether.
These errors or failures may put the users of our software at risk because their
computers will not be adequately protected against spyware, viruses, spam or
phishing attacks. We try to reduce this risk by constantly upgrading our
software and by working closely with the creators of the operating platforms,
particularly Microsoft, to make sure that our software works with the operating
platform. However, if our existing suite of Internet security products and our
future products fail to perform adequately or fail entirely, our operating
results could be adversely affected.





Our
ability to effectively recruit and retain qualified officers and directors could
be adversely affected if we experience difficulty in maintaining directors' and
officers' liability insurance.





We may be
unable to maintain insurance as a public company on terms affordable to us to
cover liability for claims made against our officers and directors. If we are
unable to adequately insure our officers and directors, we may not be able to
retain or recruit qualified officers and directors to manage our
business.




14




Loss
of any of our key management personnel, particularly Gary Guseinov, could
negatively impact our business and the value of our common stock.





Our
ability to execute our business strategy will depend on the skills, experience
and performance of key members of our management team. We depend heavily on the
services of Gary Guseinov, our Chief Executive Officer, Igor Barash, our Chief
Information Officer and Secretary, Kevin Harris, our Chief Financial Officer,
and Bing Liu, a director and formerly our Chief Software Architect. We believe
that the skills of Mr. Guseinov would be particularly difficult to replace. We
have long-term employment agreements with Gary Guseinov and Kevin Harris. We
have entered into an employment agreement with Mr. Barash, but it is “at-will”
and does not preclude him from leaving us. We have an independent contractor
agreement with Mr. Liu that ends on March 31, 2009. While Mr. Barash and Mr. Liu
continue to provide services to us, we have no guarantee that they will continue
to do so for any particular period of time.





If we
lose members of our key management personnel, we may be forced to expend
significant time and money in the pursuit of replacements, which could result in
both a delay in the implementation of our business plan and the diversion of
limited working capital. We cannot assure you that we will find satisfactory
replacements for these key management personnel at all, or on terms that are not
unduly expensive or burdensome to our company. We do not maintain key man
insurance policies on any of our key officers or employees.





To
date, our business has been developed assuming that laws and regulations that
apply to Internet communications and e-commerce will remain minimal. Changes in
government regulation and industry standards may adversely affect our business
and operating results.





We have
developed our business assuming that the current state of the laws and
regulations that apply to Internet communications, e-commerce and advertising
will remain minimal. At this time, complying with these laws and regulations is
not burdensome. However, as time exposes various problems created by Internet
communications and e-commerce, laws and regulations may become more prevalent.
These regulations may address issues such as user privacy, spyware, pricing,
intellectual property ownership and infringement, taxation, and quality of
products and services. This legislation could hinder growth in the use of the
Internet generally and decrease the acceptance of the Internet as a
communications, commercial and advertising medium. Changes in current
regulations or the addition of new regulations could affect the costs of
communicating on the Internet and adversely affect the demand for our products
or otherwise harm our business, results of operations and financial
condition.





Our business is
the development and distribution of software. If we do not
protect our proprietary information and prevent third parties from unauthorized
use of our technology, our business could be harmed.





We rely
on a combination of copyright, patent, trademark and trade secret laws,
confidentiality procedures, contractual provisions and other measures to protect
our proprietary information, especially our software codes. All of these
measures afford only limited protection. These measures may be invalidated,
circumvented or challenged, and others may develop technologies or processes
that are similar or superior to our technology. We may not have the proprietary
information controls and procedures in place that we need to protect our
proprietary information adequately. Despite our efforts to protect our
proprietary rights, unauthorized parties may attempt to copy our software or
obtain or use information that we regard as proprietary, which could harm our
business.


15


Third
parties claiming that we infringe their proprietary rights could cause us to
incur significant legal expenses and prevent us from selling our
products.





As the
number of products in the software industry increases and the functionality of
these products further overlap, we believe that we may become increasingly
subject to infringement claims, which could include patent, copyright and
trademark infringement claims. In addition, former employers of our former,
current or future employees may assert claims that such employees have
improperly disclosed to us the confidential or proprietary information of these
former employers. Any such claim, with or without merit, could:





·
            be
      time consuming to defend;





·
            result
      in costly litigation;





·
            divert
      management’s attention from our core
business;





·
            require
      us to stop selling, delay providing or redesign our product;
      and





·
            require
      us to pay monetary amounts as damages or for royalty or licensing
      arrangements.





Risks
Related to Ownership of Our Securities





The
holders of our 10% Secured Convertible Debentures have a security interest in
all of our assets. If we were to default in any of our obligations under these
secured debentures, the holders could foreclose on their security interest and
our securities could become worthless.





We have
outstanding $496,368 in aggregate principal amount of our 10% Secured
Convertible Debentures at the time of this filing. The payment of these secured
debentures is secured with all of our assets. If we were to default in any of
our obligations under these secured debentures, the holders of these securities
could foreclose the security interest, take our assets and sell or otherwise
dispose of them. If that were to happen, we may not be able to continue our
business and our securities would become worthless.





Holders
of our 10% Secured Convertible Debentures and unsecured 10% Convertible
Debentures have anti-dilution rights that are triggered by a disposition of our
common stock at a price per share that is lower than the applicable conversion
price of the debt securities or the volume weighted average price of our common
stock on the date of such disposition. These rights are not available to the
holders of our common stock. If future issuances of our common stock trigger the
anti-dilution rights, your investment in our common stock would be diluted to
the extent such convertible debentures are converted.





Holders
of $496,368 in aggregate principal amount of our 10% Secured Convertible
Debentures may convert the outstanding principal amount and accrued interest
thereon into common stock at a conversion price of $1.00per share. If all of our
10% Secured Convertible Debentures were converted into common stock, we would be
required to issue an additional 496,368 shares. In addition, we have issued
$440,784 in aggregate principal amount of our unsecured 10% Convertible
Debentures to satisfy unpaid interest and liquidated damages accrued on our 10%
Secured Convertible Debentures of which $233,311 remain outstanding as of the
date of this filing. The holders of our unsecured 10% Convertible Debentures
will have the right to convert the outstanding principal amount and accrued
interest thereon into common stock at a conversion price of $0.85 per share. If
all of our unsecured 10% Convertible Debentures were converted into common
stock, we would be required to issue approximately 274,484 additional shares.
If, during the time that any of our convertible debentures are outstanding, we
sell or grant any option to purchase (other than options issued pursuant to a
plan approved by our board of directors), or sell or grant any right to re-price
our securities, or otherwise dispose of or issue any common stock or common
stock equivalents entitling any person to acquire shares of our common stock at
a price per share that is lower than the applicable conversion price of the
debentures (which, for purposes of this discussion will be designated as the
“Base Conversion Price”) or that is higher than the Base Conversion Price but
lower than the volume weighted average price of the common stock on the date of
such disposition, then the conversion price of the debentures will be
reduced.


16


In the
first instance, the conversion price will be reduced to the Base Conversion
Price. In the second instance, the conversion price will be multiplied by a
fraction the denominator of which will be the number of shares of common stock
outstanding on the date of the issuance plus the number of additional shares of
common stock offered for purchase and the numerator of which will be the number
of shares of common stock outstanding on the date of such issuance plus the
number of shares which the aggregate offering price of the total number of
shares so offered would purchase at the daily volume weighted average
price.





A
reduction in the conversion price resulting from any of the foregoing would
allow our convertible debenture holders to receive more shares of common stock
than they would otherwise be entitled to receive. In that case, other holders of
our common stock would be diluted to a greater extent than they would be if no
adjustment to the conversion price were required.





Holders
of our 10% Convertible Promissory Notes have anti-dilution rights that are
triggered by a disposition of our common stock at a price per share that is
lower than the conversion price of such notes. These rights are not available to
the holders of our common stock. If future issuances of our common stock trigger
the anti-dilution rights, an investment in our common stock would be diluted to
the extent such convertible notes are converted.





Holders
of $1,200,000 in aggregate principal amount of our 10% Convertible Promissory
Notes may convert the outstanding principal amount and accrued interest thereon
into common stock at a conversion price of $1.25per share. If all of our
10% Convertible Promissory Notes were converted into common stock, we would be
required to issue an additional 960,000 shares. If, during the time that any of
our 10% Convertible Promissory Notes are outstanding, we sell or grant any
option to purchase (other than options issued to our employees, officers,
directors and consultants), or sell or grant any right to re-price our
securities, or otherwise dispose of or issue any common stock or common stock
equivalents entitling any person to acquire shares of our common stock at a
price per share that is lower than the conversion price of these notes (which,
for purposes of this discussion will be designated as the “Base Conversion
Price”), then the conversion price of the debentures will be reduced according
to the following weighted average formula: the conversion price will be
multiplied by a fraction the denominator of which will be the number of shares
of common stock outstanding on the date of the issuance plus the number of
additional shares of common stock offered for purchase and the numerator of
which will be the number of shares of common stock outstanding on the date of
such issuance plus the number of shares which the aggregate offering price of
the total number of shares so offered would purchase at the conversion price. A
reduction in the conversion price resulting from the foregoing would allow the
holders of our 10% Convertible Promissory Notes to receive more shares of common
stock than they would otherwise be entitled to receive. In that case, other
holders of our common stock would be diluted to a greater extent than they would
be if no adjustment to the conversion price were required.





Investors
who purchased units of our securities, consisting of common stock and warrants
to purchase common stock, from October 2007 through August 2008, have
anti-dilution rights with respect to the shares of common stock issued in the
unit offering. These rights are not available to other holders of our common
stock. If future issuances of our common stock trigger these anti-dilution
rights, holders of our common stock would have their investments
diluted.





The
security holders who purchased our units consisting of shares of our common
stock and warrants to purchase shares of our common stock have anti-dilution
rights. In the event that we sell common stock for less than $1.00 per share or
issue securities convertible into or exercisable for common stock at a
conversion price or exercise price less than $1.00 per share (a “Dilutive
Issuance”), then we are required to issue a number of additional shares of
common stock to each unit purchaser, without additional consideration. The
number of additional shares to be issued will be equal to the product of the
purchaser’s subscription amount multiplied by a fraction, the numerator of which
is the number of shares of common stock sold and issued at the closing of such
Dilutive Issuance plus the number of shares which the aggregate offering price
of the total number of shares of common stock sold and issued at the closing of
such Dilutive Issuance would purchase at $1.00 per share, and the denominator of
which is the number of shares of common stock issued and outstanding on the date
of such Dilutive Issuance plus the number of additional shares of common stock
sold and issued at the closing of such Dilutive Issuance. In this case, other
holders of our common stock would be diluted to a greater extent than they would
be if the anti-dilution provision were not triggered.


17


Our
common stock began to be quoted on the OTC Bulletin Board on August 2, 2007. We
cannot assure you that an active public trading market for our common stock will
develop or be sustained. Even if an active market develops, it may not be
possible to sell shares of our common stock in a timely manner.





While our
common stock began to be quoted on the OTC Bulletin Board on August 2, 2007, to
date an active trading market has not developed and we cannot guarantee you that
an active trading market will ever develop. This situation may be attributable
to a number of factors, including the fact that we are a small company that is
relatively unknown to stock analysts, stock brokers, institutional investors and
others in the investment community that generate or influence sales volume, and
that even if we came to the attention of such persons, they tend to be risk
averse and may be reluctant to follow a relatively unproven company such as ours
or purchase or recommend the purchase of our shares until such time as we became
more seasoned and viable. As a consequence, even though our common stock is
quoted on the OTC Bulletin Board, there may be periods of several days or more
when trading activity in our shares is minimal or nonexistent, as compared to a
seasoned issuer that has a large and steady volume of trading activity that will
generally support continuous sales without an adverse effect on share price.
Because an active trading market may not develop, it may not be possible to sell
shares of our common stock in a timely manner.





Our
common stock is considered a “penny stock”. The application of the “penny stock”
rules to our common stock could limit the trading and liquidity of the common
stock, adversely affect the market price of our common stock and increase
transaction costs to sell those shares.





Our
common stock is a “low-priced” security or “penny stock” under rules promulgated
under the Securities Exchange Act of 1934. In accordance with these rules,
broker-dealers participating in transactions in low-priced securities must first
deliver a risk disclosure document which describes the risks associated with
such stocks, the broker-dealer’s duties in selling the stock, the customer’s
rights and remedies and certain market and other information. Furthermore, the
broker-dealer must make a suitability determination approving the customer for
low-priced stock transactions based on the customer’s financial situation,
investment experience and objectives. Broker-dealers must also disclose these
restrictions in writing to the customer, obtain specific written consent from
the customer, and provide monthly account statements to the customer. The effect
of these restrictions will probably decrease the willingness of broker-dealers
to make a market in our common stock, will decrease liquidity of our common
stock and will increase transaction costs for sales and purchases of our common
stock as compared to other securities.





The
stock market in general and the market prices for penny stocks in particular,
have experienced volatility that often has been unrelated to the operating
performance of such companies. These broad fluctuations may be the result of
unscrupulous practices that may adversely affect the price of our stock,
regardless of our operating performance.





Shareholders
should be aware that, according to SEC Release No. 34-29093 dated April 17,
1991, the market for penny stocks has suffered in recent years from patterns of
fraud and abuse. Such patterns include (1) control of the market for the
security by one or a few broker-dealers that are often related to the promoter
or issuer; (2) manipulation of prices through prearranged matching of purchases
and sales and false and misleading press releases; (3) boiler room practices
involving high-pressure sales tactics and unrealistic price projections by
inexperienced sales persons; (4) excessive and undisclosed bid-ask differential
and markups by selling broker-dealers; and (5) the wholesale dumping of the same
securities by promoters and broker-dealers after prices have been manipulated to
a desired level, along with the resulting inevitable collapse of those prices
and with consequent investor losses. The occurrence of these patterns or
practices could increase the volatility of our share price. In the past,
plaintiffs have often initiated securities class action litigation against a
company following periods of volatility in the market price of its securities.
We may in the future be the target of similar litigation. Securities litigation
could result in substantial costs and liabilities and could divert management's
attention and resources.


18


Our executive
officers and directors, along with their friends and family, own or control
approximately 42% of our issued
and outstanding common stock, which may limit the ability of our non-management
shareholders, whether acting alone or together, to influence our management.
Additionally, this concentration of ownership could discourage or prevent a
potential takeover that might otherwise result in our shareholders receiving a
premium over the market price for our common stock.





Approximately
46% of the issued and outstanding shares of our common stock is owned and
controlled by a group of insiders, including current directors and executive
officers and their friends and family. Mr. Gary Guseinov, our Chief Executive
Officer and President, owns 38% of our issued and outstanding common stock. Such
concentrated control may adversely affect the price of our common stock. These
insiders may be able to control matters requiring approval by our shareholders,
including the election of directors, mergers or other business combinations.
Such concentrated control may also make it difficult for our shareholders to
receive a premium for their shares of our common stock in the event we merge
with a third party or enter into different transactions that require shareholder
approval. These provisions could also limit the price that investors might be
willing to pay in the future for shares of our common stock. Our non-management
shareholders may have no effective voice in our management.





We
do not expect to pay dividends for the foreseeable future, and we may never pay
dividends.





We
currently intend to retain any future earnings to support the development of our
business and do not anticipate paying cash dividends in the foreseeable future.
Our payment of any future dividends will be at the discretion of our board of
directors after taking into account various factors, including but not limited
to our financial condition, operating results, cash needs, growth plans and the
terms of any credit agreements that we may be a party to at the time. In
addition, our ability to pay dividends on our common stock may be limited by
California state law. Accordingly, investors must rely on sales of their common
stock after price appreciation, which may never occur, as the only way to
realize a return on their investment. Investors seeking cash dividends should
not purchase our common stock.





Limitations
on director and officer liability and our indemnification of officers and
directors may discourage shareholders from bringing suit against a
director.





Our
articles of incorporation and bylaws provide, with certain exceptions as
permitted by California law, that a director or officer shall not be personally
liable to us or our shareholders for breach of fiduciary duty as a director,
except for acts or omissions which involve intentional misconduct, fraud or
knowing violation of law, or unlawful payments of dividends. These provisions
may discourage shareholders from bringing suit against a director for breach of
fiduciary duty and may reduce the likelihood of derivative litigation brought by
shareholders on our behalf against a director. In addition, our articles of
incorporation and bylaws provide for mandatory indemnification of directors and
officers to the fullest extent permitted by California law.





Future
sales of our common stock could put downward selling pressure on our shares, and
adversely affect the stock price. There is a risk that this downward pressure
may make it impossible for an investor to sell his shares at any reasonable
price, if at all.





Future
sales of substantial amounts of our common stock in the public market, or the
perception that such sales could occur, could put downward selling pressure on
our shares, and adversely affect the market price of our common
stock.


19


Item
2. Properties





Our corporate office is located at 617
West 7th Street, Suite 401, Los Angeles, California. We hold the premises under
the terms of a lease that was signed on October 19, 2007. The monthly rent for
the initial 12 month period was $10,670, with increases of 3% per year
thereafter through 2013. Aside from the monthly rent, we are required to pay our
share of the “Common Operating Expenses”, which are all costs and expenses
(including property taxes) incurred by the landlord with respect to the
operation, maintenance, protection, repair and replacement of the building in
which the premises are located and the parcel of land on which the building is
located. We occupy approximately 4,742 square feet of office space, or
approximately 2.47% of the building.





During the 2008 fiscal year, we
determined that the premises described above would not be adequate for our needs
for the next 12 months. Subsequent to year end, we expanded into approximately
2,395 square feet of additional office space at our current location as we
negotiate expanded contiguous office space on the 9th floor
of the building.





Item
3. Legal Proceedings





On June
16, 2006, we were named as a defendant in a civil complaint filed with the
United States District Court, Central District of California. The action is
entitled, Wellbourne Limited,
a Seychelles corporation vs. 2Checkout.com Inc., a Delaware corporation; and
CyberDefender Corporation, a California Corporation. We recorded a
liability of $102,000 when the services were rendered. On March 14, 2007,
we entered into a settlement agreement with Wellbourne Limited. The terms of the
settlement agreement require us to pay Wellbourne Limited the sum of $55,000. At
December 31, 2007 we had paid $50,000 towards the settlement. At December 31,
2008, we owed no amounts on this claim.





On September 18, 2007, a former
employee of the Company alleged that the Company owed him approximately $50,000
in additional pay and demanded payment. The Company settled the lawsuit on June
3, 2008 and has complied with all of the payment terms as of December 31, 2008.
No amounts remain due at December 31, 2008.





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





Not applicable. No matters have been
submitted to a vote of security holders during the fourth quarter of our fiscal
year.





PART
II





Item
5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities





Market
Information





On August
2, 2007 our common stock was approved for quotation on the OTC Bulletin Board
under the symbol “CYDE”. As of March 27, 2009 we have 19,195,114 shares of
common stock issued and outstanding and we have approximately122 record holders
of our common stock. This does not include an indeterminate number of
shareholders whose shares are held by brokers in street name.




The
following table sets forth, for the periods indicated, the high and low bid
information per share of our common stock as reported by the OTC Bulletin Board.
These quotations reflect inter-dealer prices, without retail mark-up, mark-down
or commission and may not represent actual transactions.


20





PERIOD
                  
                  HIGH
                  
                  
                  LOWFiscal
      Year Ended December 31, 2008
                  First
      Quarter
                  
                  $
                  1.06
                  
                  
                  $
                  0.61Second
      Quarter
                  
                  $
                  2.00
                  
                  
                  $
                  0.63Third
      Quarter
                  
                  $
                  1.77
                  
                  
                  $
                  0.75Fourth
      Quarter
                  
                  $
                  1.40
                  
                  
                  $
                  0.70Fiscal
      Year Ended December 31, 2007
                  First
      Quarter
                  
                  
                  (1
                  )
                  
                  
                  (1
                  )Second
      Quarter
                  
                  
                  (1
                  )
                  
                  
                  (1
                  )Third
      Quarter
                  
                  $
                  0.90
                  
                  
                  $
                  0.90Fourth
      Quarter
                  
                  $
                  0.48
                  
                  
                  $
                  1.56


(1) Our
common stock did not trade during the first and second quarters of the 2007
fiscal year.  Our common stock began to trade on August 2,
2007.





Dividends





We
anticipate that any future earnings will be retained for the development of our
business and we do not anticipate paying any dividends on our common stock in
the foreseeable future.





Sales
of Unregistered Securities





For information relating to
unregistered securities that were sold during the three months ended December
31, 2008, please see our Current Report on Form 8-K, which was filed with the
Securities and Exchange Commission on November 18, 2008 and our Current Report
on Form 8-K, which was filed with the Securities and Exchange Commission on
December 5, 2008.





Securities
Authorized for Issuance under Equity Compensation Plans





Our Board
of Directors has adopted, and our shareholders have approved, two equity
incentive plans for directors, officers, consultants and
employees.  The CyberDefender Corporation 2005 Equity Incentive Plan
(sometimes referred to as the 2005 Stock Option Plan) was adopted by our
directors and approved by our shareholders on December 31, 2004 and includes
780,797 shares of our authorized common stock.  As of December 31,
2008 there were two awards covering a total of 276,107 shares of our common
stock outstanding under this plan.  The CyberDefender Corporation 2006
Equity Incentive Plan was adopted by our board of directors and approved by our
shareholders on October 30, 2006 and includes 1,175,000 shares of our authorized
common stock.  As of December 31, 2008 there were thirty-four awards
covering a total of 1,167,977 shares of our common stock outstanding under this
plan.


21





The following table illustrates
information about the securities issued from these plans:





Plan Category
                        
                        Number of securities to
                          be issued upon exercise
                          of outstanding options,
                          warrants and rights
                        
                        
                        Weighted average
                          exercise price of
                          outstanding options
                          warrants and rights
                        
                        
                        Number of securities
                          remaining available for
                          future issuance under the
                          equity compensation plan
                          (excluding securities
                          reflected in column (a)(a)
                        
                        
                        (b)
                        
                        
                        (c)Shareholder
      Approved(1)
                        
                        
                        1,444,084
                        
                        
                        $
                        0.83
                        
                        
                        
                        511,713Non-ShareholderApproved
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A


(1)
Includes the CyberDefender Corporation 2005 Equity Incentive Plan (also known as
the CyberDefender Corporation 2005 Stock Option Plan) and the CyberDefender
Corporation 2006 Equity Incentive Plan.





Item
6.  Selected Financial Data





The registrant is a smaller reporting
company and is not required to provide this information.





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





The
following discussion of our financial condition and results of operations should
be read in conjunction with our financial statements and the notes to those
statements included elsewhere in this report.  In addition to the
historical financial information, the following discussion and analysis contains
forward-looking statements that involve risks and uncertainties.  Our
actual results may differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including those set
forth under “Risk Factors” at Item 1A of this report.




Overview




We are a
provider of secure content management software based in Los Angeles,
California.  We develop and license security software.  Our
mission is to bring to market advanced solutions to protect computer users
against identity theft, Internet viruses, spyware and related security
threats.





We have
developed a Collaborative Internet Security Network, which we refer to as the
“CISN” or the “earlyNETWORKTM”, which is based on certain technology principles
commonly found in a peer-to-peer network infrastructure.  A
peer-to-peer network does not have the notion of clients or servers, but only
equal peer nodes that simultaneously function as both “clients” and “servers” to
the other nodes on the network.  This means that when a threat is
detected from a computer that is part of the earlyNETWORKTM, the threat is
relayed to our Early Alert Center.  The Early Alert Center tests,
grades and ranks the threat, automatically generates definition and signature
files based on the threat, and relays this information to the Alert Server, in
some cases after a human verification step.  The Alert Server will
relay the information it receives from the Early Alert Center to other machines
in the earlyNETWORKTM, and each machine that receives the information will, in
turn, relay it to other machines that are part of the
earlyNETWORKTM.  This protocol allows us to rapidly distribute alerts
and updates regarding potentially damaging viruses, e-mails and other threats to
members of the earlyNETWORKTM, without regard for the cost of the bandwidth
involved.  Because cost is not a factor, updates can be continuous,
making our approach significantly faster than the client/server protocols used
by traditional Internet security companies that provide manual broadcast-updated
threat management systems.  Computer users join the earlyNETWORKTM
simply by downloading and installing our software.


22





Historically,
our revenues were derived from subscriptions to our software.  We sold
one product, CyberDefender Anti-Spyware 2006, at a price of $39.99, which
included the initial download and one year of updates.  The license to
use the software was renewed annually, also at $39.99, with incentives for early
renewals.  On November 20, 2006 we stopped licensing this product to
new subscribers (although we continue to support and upgrade it for existing
users).  We now offer CyberDefender Early Detection Center V2.0 and
CyberDefender Free V2.0, as well as upgrades to these
products.  CyberDefender Early Detection Center V2.0 and CyberDefender
Free V2.0 are complete Internet security suites that protect home computer users
against spam, spyware, viruses and scams.  The software programs are
identical but are distributed in one of two ways.  If the subscriber
chooses the free version (CyberDefender Free V2.0), he will receive the software
with advertising banners in it.  If the subscriber does not wish to
receive the advertising, he may pay to purchase a license for CyberDefender
Early Detection Center V2.0.  The annual licensing fee can be as low
as $12.99 or as high as $49.99, depending on the marketing and distribution
channels that we use.





Additionally
on September 27, 2007, we announced the launch of CyberDefenderULTIMATETM and
CyberDefenderCOMPLETETM.  These are enhanced versions of our security
software.  For an annual fee, CyberDefenderULTIMATETM provides year
round support for any software or hardware connected to a subscriber’s computer
while CyberDefenderCOMPLETETM provides year-round unlimited anti-malware support
for a subscriber’s computer with a one time live technical support
call.  These new security suites also include 2 gigabytes of online
backup.  These products are sold for $99.99 to $299.99 per
year.  We also offer a free Internet security toolbar called
MyIdentityDefender (“MyID”).  MyID is free to use and generates
revenue through search advertising. On November 20, 2008, the Company
announced the launch of CyberDefender Registry CleanerTM.  The
CyberDefender Registry CleanerTM eliminates clutter and junk that builds up
within a computer's registry due to the installation and removal of programs,
deletion and creation of files and cached records from Web
surfing.  The annual subscription rate ranges from $9.95 to $29.95,
depending on the marketing or distribution channels we use.




In the
past, we acquired new users primarily with an online direct purchase
offer.  The offer, to scan a computer for spyware and then pay for
removal of the spyware found, was broadcast in e-mails, banners and search
ads.  We are now partnering with other businesses, such as those
providing search engine marketing services and distribution services, for the
purpose of generating new users of our software.  These new
partnerships will offer additional avenues for distribution of our products and
are mainly revenue sharing partnerships, whereby our partner retains a portion
of the revenue for every item sold.  This allows us to incrementally
increase revenue while not incurring additional marketing and advertising
expenses.





The
following table summarizes our revenue for the sale of our products during each
quarter of the two most recently completed fiscal years.  Sales
include renewals of our CyberDefender Anti-Spyware 2006 product, as well as
sales of our CyberDefender Early Detection Center V2.0, CyberDefenderULTIMATETM,
CyberDefenderCOMPLETETM and CyberDefender Registry CleanerTM
products and advertising revenue derived from our CyberDefender FREE V2.0
product and our MyID toolbar.




Quarter Ended
                              
                              Sales1-Mar-07
                              
                              $
                              666,13630-Jun-07
                              
                              $
                              628,44330-Sep-07
                              
                              $
                              544,95631-Dec-07
                              
                              $
                              380,619Fiscal
      Year 2007 Totals
                              
                              $
                              2,220,15431-Mar-08
                              
                              $
                              475,04630-Jun-08
                              
                              $
                              742,86230-Sep-08
                              
                              $
                              1,202,71531-Dec-08
                              
                              $
                              2,467,136Fiscal
      Year 2008 Totals
                              
                              $
                              4,887,759




23





CyberDefender
Early Detection Center V2.0 is typically offered to consumers on a trial basis
whereby the consumer downloads a limited version of the software from the
Internet.  Using the trial version, consumers scan their computer for
threats and then have the option to upgrade to a fully featured version of the
software for a fee.  Typically, the trial version is limited to a
simple security scan. Once upgraded, users are able to remove the threats from
their PCs.





CyberDefenderFREE
is offered to consumers at no cost.  CyberDefenderFREE generates
revenue through banner advertisements and upgrades.    There
is no trial period for using CyberDefender FREE V2.0 software.  Once a
subscriber downloads the software, it is his to keep and we receive payment from
the advertisers.  If the subscriber chooses, he may pay for an annual
subscription to CyberDefender Early Detection Center V2.0 without
advertising.  In this way, we will generate revenues from either the
advertiser or the subscriber.  This business model allows any computer
user to obtain protection against Internet threats, regardless of his ability to
pay.  We made this change because we believe that the advertising
revenue we may receive, in conjunction with the licensing fees we receive, could
be substantial.  We obtain the ads from ad networks, which are
plentiful.  Ad networks provide advertising for a website and share
advertiser revenue each time the website visitors click on the
ads.  During the month that the ads are displayed on a subscriber’s
computer, revenues will be earned from the ad networks each time an ad is shown
(per impression) or when an ad is clicked (per click) or for each action taken
by the subscriber after he clicks on the ad and visits to the advertiser’s
website (per action).





While we
were developing CyberDefender Early Detection Center/CyberDefender FREE 2.0, we
slowed down our efforts in marketing our CyberDefender Anti-Spyware 2006
software so that we could devote more of our financial resources to the
development of our new product.  The expense of turning our business
from a marketer of a single software product into a developer of a suite of
Internet security products exceeded our revenues.  During this period,
our new user marketing was restricted to experimental
activities.  Therefore, as and when we needed cash, we sold our
securities.  To date, we have received $5,120,000 from the sale of our
convertible debt securities, $800,000 from the sale of our 7.41% Original Issue
Discount Notes, $160,000 from the issuance of a note payable to a shareholder
and $1,810,000 from the sale of units consisting of our common stock and
warrants.





We are
continuing to roll-out our CyberDefender Early Detection Center
V2.0/CyberDefender FREE V2.0, CyberDefenderULTIMATETM, CyberDefenderCOMPLETETM and
CyberDefender Registry CleanerTM products and, to date, revenues we receive from
advertising or from those who license the products have not been adequate to
support our operations.  We expect that our expenses will continue to
exceed our revenues for at least the next three to six months.  We
currently have enough cash to fund our operations through June
2009.  In order to fund our operations beyond that date, we will be
required to borrow money or to find other sources of financing.  We do
not have any commitments for financing at this time and we cannot guarantee that
we will be able to find financing when we need it.  If we are unable
to find financing when we need it we may be required to curtail, or even to
cease, our operations.





Critical
Accounting Policies and Estimates





Our
discussion and analysis of our financial condition and results of operations is
based on our financial statements, which have been prepared in accordance with
accounting principles generally accepted in the U.S.  The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses for
each period.  The following represents a summary of our critical
accounting policies, defined as those policies that we believe are the most
important to the portrayal of our financial condition and results of operations
and that require management’s most difficult, subjective or complex judgments,
often as a result of the need to make estimates about the effects of matters
that are inherently uncertain.


24


Revenue
recognition.  We recognize revenue from the sale of software
licenses under the guidance of SOP No. 97-2, “Software Revenue Recognition,” as
amended by SOP No. 98-9, “Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions” and SEC Staff Accounting
Bulletin (“SAB”) 104.





Specifically,
we recognize revenues from our CyberDefender Anti-Spyware 2006, CyberDefender
Early Detection Center, CyberDefenderULTIMATETM, CyberDefenderCOMPLETETM and
CyberDefender Registry Cleaner products when all of the following conditions for
revenue recognition are met:





·
            persuasive
      evidence of an arrangement exists,





·
            the
      product or service has been
delivered,





·
            the
      fee is fixed or determinable, and





·
            collection
      of the resulting receivable is reasonably
  assured.





We
currently sell five products, CyberDefender Early Detection Center (“EDC”),
CyberDefenderULTIMATETM, CyberDefenderCOMPLETETM, CyberDefender Registry CleanerTM
and CyberDefender Identity Protection Service, over the Internet.  We
also offer a backup CD-ROM of the EDC software for an additional
fee.  CyberDefenderCOMPLETETM offers customers one-time technical
support and a license for EDC, while CyberDefenderULTIMATETM offers customers
unlimited technical support for a specified period and a license for
EDC.  Customers order the product and simultaneously provide their
credit card information to us.  Upon receipt of authorization from the
credit card issuer, we provide technical support if the customer purchased
CyberDefenderULTIMATETM or CyberDefenderCOMPLETETM and a license allowing the
customer to download EDC over the Internet.  As part of the sales
price, we provide renewable product support and content updates, which are
separate components of product licenses and sales.  Term licenses
allow customers to use our products and receive product support coverage and
content updates for a specified period, generally twelve months.  We
invoice for product support, content updates and term licenses at the beginning
of the term.  These revenues contain multiple element arrangements
where “vendor specific objective evidence” (“VSOE”) may not exist for one or
more of the elements.  EDC and CyberDefenderULTIMATETM are in substance
a subscription and the entire fee is deferred and is recognized ratably over the
term of the arrangement according to the guidance in SOP 97-2 paragraph
49.  Revenue is recognized immediately for the sale of the backup
CD-ROM, the license of CyberDefender Registry CleanerTM and for the portion of
the sale of CyberDefenderCOMPLETETM that relates to the one-time technical
support as we believe that VSOE of fair value exists for all elements
delivered.





We use a
third party service provider for the technical support services provided as part
of our CyberDefenderCOMPLETETM and CyberDefenderULTIMATETM
products.  The costs associated with this service are deferred and
expensed over the same period as the related revenue. We also use third parties
to sell our software and therefore we evaluate the criteria of Financial
Accounting Standards Board (“FASB”) Emerging Issues Task Force Issue No. 99-19,
“Reporting Revenue Gross as a Principal Versus Net as an Agent”, in determining
whether it is appropriate to record the gross amount of revenue and related
costs or the net amount earned as commissions.  We are the primary
obligor, are subject to inventory risk, have latitude in establishing prices and
selecting suppliers, establish product specifications, and have the risk of loss
as it relates to cargo losses.  Accordingly, our revenue is recorded
on a gross basis.





We use a
third party to process our product sales.  We pay a direct acquisition
cost to the processor for each completed sale.  These direct
acquisition costs are deferred and recognized ratably over the term of the
arrangement of the associated sale in accordance with FASB Technical Bulletin
90-1, “Accounting for Separately Priced Extended Warranty and Product
Maintenance Contracts.”  The third party processor refunds any direct
acquisition cost paid to it on any credit card chargeback or on any product that
is returned.  The refunds are matched against the associated
chargebacks and product returns.


25





Product
returns are generally received within 30 days of the original sale and are
charged against the associated sale upon receipt of the return.  A
chargeback occurs after a customer is automatically charged for a renewal
license and subsequently, within 30 days of renewal, decides not to continue
using the license or the credit card processed for renewal is no longer
valid.  The third party processor of renewal sales is usually notified
within 30 days by a customer that the customer no longer wishes to license our
product.  The third party processor reduces the amounts due to us as a
result of any chargebacks during the preceding 30 day period.  As a
result, a majority of chargebacks occur within 30 days of the rebilling event
and are recorded prior to closing the previous month’s accounting
records.  As stated in our revenue recognition policy, revenue is
deferred and recognized ratably over the term of the arrangement.




In
November 2006 we launched CyberDefender FREE 2.0, which is free to the
subscriber.  We earn revenue from advertising networks and search
engine providers that pay us for displaying the advertiser’s advertisements
inside the software and from search results generated by our
users.  Advertising revenue is recognized when earned.




Customers
are permitted to return our software products (CyberDefender Early Detection
Center and CyberDefender Registry CleanerTM) within 30 days from the date of
purchase.  During the fiscal years ended December 31, 2008 and
December 31, 2007, we did not accrue any sum for product returns or chargebacks
as such returns and chargebacks are identified within the first 30 days of sale
and are charged against our gross sales in the month that they
occur.  Our net revenue, including returns and chargebacks for each
period, are deferred and recognized ratably over a 12 month period according to
our revenue recognition policy.




Software Development
Costs.We account for
software development costs in accordance with Statement of Financial Accounting
Standards (“SFAS”) No. 86, “Computer Software to Be Sold, Leased, or Otherwise
Marketed.”  Such costs are expensed prior to achievement of
technological feasibility and thereafter are capitalized.  We have had
very limited software development costs incurred between the time the software
and its related enhancements have reached technological feasibility and its
general release to customers.  As a result, all software development
costs have been charged to product development.




Stock Based Compensation and Fair
Value of our Shares.We adopted SFAS
No. 123 (Revised 2004), Share Based Payment (“SFAS No. 123R”),
under the modified-prospective transition method on
January 1, 2006.  SFAS No. 123R requires companies to
measure and recognize the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair
value.  Share-based compensation recognized under the
modified-prospective transition method of SFAS No. 123R includes
share-based compensation based on the grant date fair value determined in
accordance with the original provisions of SFAS No. 123, “Accounting for
Stock-Based Compensation”, for all share-based payments granted prior to and not
yet vested as of January 1, 2006 and share-based compensation based on
the grant-date fair-value determined in accordance with SFAS No. 123R for
all share-based payments granted after January 1, 2006.




Contractual
Obligations





We are
committed under the following contractual obligations:





Payments Due By PeriodTotal
                      
                      
                      Less than 1
                        year
                      
                      
                      1 to 3 Years
                      
                      
                      3 to 5 Years
                      
                      
                      Over 5
                        YearsLong-term
      debt obligations
                      
                      $
                      3,287,754
                      
                      
                      $
                      3,287,754
                      
                      
                      $
                      —
                      
                      
                      $
                      —
                      
                      
                      $
                      —Capital
      lease obligations
                      
                      $
                      46,979
                      
                      
                      $
                      28,930
                      
                      
                      $
                      16,200
                      
                      
                      $
                      6,185
                      
                      
                      $
                      —Operating
      lease obligations
                      
                      $
                      710,918
                      
                      
                      $
                      166,185
                      
                      
                      $
                      333,548
                      
                      
                      $
                      211,183
                      
                      
                      $
                      —




26


Off-Balance
Sheet Arrangements





We do not
have off-balance sheet arrangements.  As part of our ongoing business,
we do not participate in transactions that generate relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, often established
for the purpose of facilitating off-balance sheet arrangements or other
contractually narrow or limited purposes.





Indemnities





During
the normal course of business, we have agreed to certain
indemnifications.  In the future, we may be required to make payments
in relation to these commitments.  These indemnities include
agreements with our officers and directors which may require us to indemnify
these individuals for liabilities arising by reason of the fact that they were
or are officers or directors.  The duration of these indemnities
varies and, in certain cases, is indefinite.  There is no limit on the
maximum potential future payments we could be obligated to make pursuant to
these indemnities.  We hedge some of the risk associated with these
potential obligations by carrying general liability
insurance.  Historically, we have not been obligated to make any
payments for these obligations and no liabilities have been recorded for these
indemnities in our financial statements.





Trends,
Events and Uncertainties





As
described above in the discussion of revenue recognition, we receive payment
upon the sale of our products and defer the revenue over the life of the license
agreement, which is generally one year.  We have disclosed in the
table below the total number of licenses sold (net of returns and chargebacks)
and gross dollar sales (net of returns and chargebacks) before deferral for the
12 month period covered by this report.





Total # of
                        Licenses
                      
                      
                      %
                        Change
                      
                      
                      Gross Sales $
                      
                      
                      %
                        Change
                      
                      
                      Avg. $
                        Sale
                      
                      
                      %
                        ChangeJanuary
      2008
                      
                      
                      1,043
                      
                      
                      
                      -
                      
                      
                      $
                      38,791
                      
                      
                      
                      -
                      
                      
                      $
                      37.19
                      
                      
                      
                      -February
      2008
                      
                      
                      1,695
                      
                      
                      
                      62.5
                      %
                      
                      $
                      67,040
                      
                      
                      
                      72.8
                      %
                      
                      $
                      39.55
                      
                      
                      
                      6.3
                      %March
      2008
                      
                      
                      2,761
                      
                      
                      
                      62.9
                      %
                      
                      $
                      110,190
                      
                      
                      
                      64.4
                      %
                      
                      $
                      39.91
                      
                      
                      
                      0.9
                      %April
      2008
                      
                      
                      4,811
                      
                      
                      
                      74.2
                      %
                      
                      $
                      225,306
                      
                      
                      
                      104.5
                      %
                      
                      $
                      46.83
                      
                      
                      
                      17.3
                      %May
      2008
                      
                      
                      7,503
                      
                      
                      
                      56.0
                      %
                      
                      $
                      352,269
                      
                      
                      
                      56.4
                      %
                      
                      $
                      46.95
                      
                      
                      
                      0.3
                      %June
      2008
                      
                      
                      8,634
                      
                      
                      
                      15.1
                      %
                      
                      $
                      403,970
                      
                      
                      
                      14.7
                      %
                      
                      $
                      46.79
                      
                      
                      
                      -0.3
                      %July
      2008
                      
                      
                      14,207
                      
                      
                      
                      64.5
                      %
                      
                      $
                      711,236
                      
                      
                      
                      76.1
                      %
                      
                      $
                      50.06
                      
                      
                      
                      7.0
                      %August
      2008
                      
                      
                      18,458
                      
                      
                      
                      29.9
                      %
                      
                      $
                      928,789
                      
                      
                      
                      30.6
                      %
                      
                      $
                      50.32
                      
                      
                      
                      0.5
                      %September
      2008
                      
                      
                      17,358
                      
                      
                      
                      -6.0
                      %
                      
                      $
                      866,509
                      
                      
                      
                      -6.7
                      %
                      
                      $
                      49.92
                      
                      
                      
                      -0.8
                      %October
      2008
                      
                      
                      18,908
                      
                      
                      
                      8.9
                      %
                      
                      $
                      992,526
                      
                      
                      
                      14.5
                      %
                      
                      $
                      52.49
                      
                      
                      
                      5.2
                      %November
      2008
                      
                      
                      28,663
                      
                      
                      
                      51.6
                      %
                      
                      $
                      1,342,556
                      
                      
                      
                      35.3
                      %
                      
                      $
                      46.84
                      
                      
                      
                      -10.8
                      %December
      2008
                      
                      
                      25,086
                      
                      
                      
                      -12.5
                      %
                      
                      $
                      1,265,459
                      
                      
                      
                      -5.7
                      %
                      
                      $
                      50.44
                      
                      
                      
                      7.7
                      %




The table
above indicates an upward trend in the number of licenses sold and the average
dollar sale through November 2008.  During the month of December, we
lowered our customer acquisitions costs/advertising spent by 14% from November
2008 in an effort to optimize our product offering and to increase overall gross
profit margins. The general upward trend is a result of our focus on promoting
our new products that were released in late 2007 and an increase in the amount
of money spent on advertising, as discussed below.  We cannot
guarantee that this upward trend will continue, even with increased spending on
advertising, or that the margins will remain beneficial to us.  The
table above does not include advertising revenue.


27





Other
trends, events and uncertainties that may impact our liquidity are included in
the discussion below.





RESULTS
OF OPERATIONS





Fiscal
Year Ended December 31, 2008 Compared to the Fiscal Year Ended December 31,
2007





Revenue





Total
revenue was $4,887,759 for the fiscal year ended December 31, 2008 as compared
to total revenue of $2,220,154 for the fiscal year ended December 31, 2007, an
increase of $2,667,605 or approximately 120%.  This increase in total
revenue was due primarily to the increase in new product sales. There was a
corresponding increase in advertising, as described below.





Cost
of Sales





Total cost of sales increased by
$587,326, or approximately 327%, to $767,115 during the fiscal year ended
December 31, 2008, as compared to $179,789 in incurred during the fiscal year
ended December 31, 2007. This increase is due primarily to the increase in sales
of our technical support service products and to the increase in sales of the
CD-ROMs that backup our EDC software.





Operating
Expenses





Total
operating expenses increased by $8,217,229, or approximately 185%, to
$12,668,742 during the fiscal year ended December 31, 2008, as compared to
$4,451,513 in operating expenses incurred during the fiscal year ended December
31, 2007.  Operating expenses include advertising, product
development, selling, general and administrative expense, the value of equity
issued for consulting services, and depreciation and amortization.  A
detailed explanation of the increase in operating expenses is provided in the
discussion below.





Advertising





Advertising
costs are comprised primarily of media and channel fees, including online
advertising and related functional resources.  Media and channel fees
fluctuate by channel and are higher for the direct online consumer market than
for the OEM, reseller and SMB markets.  Advertising expenses increased
by $6,491,598, or approximately1,056%, from $614,857 during the fiscal year
ended December 31, 2007 to $7,106,455 during the fiscal year ended December 31,
2008.  This increase was primarily due to the launch of our new
products and our decision to use advertising as a customer acquisition strategy.
During the fiscal year ended December 31, 2008 and 2007, four vendors accounted
for approximately 92% and 47% of our advertising expenses,
respectively.





Product
Development





Product
development expenses are primarily comprised of research and development costs
associated with the continued development of our products.  Product
development expenses decreased by $7,548, from $537,558 during the fiscal year
ended December 31, 2007 to $530,010 during the fiscal year ended December 31,
2008.





Selling,
General and Administrative





Selling,
general and administrative expenses are primarily comprised of salaries,
commissions, rent, stock based compensation and professional
fees.


28





Selling,
general and administrative expenses increased by $529,180, from $3,198,073
during the fiscal year ended December 31, 2007 to $3,727,253 during the fiscal
year ended December 31, 2008.  The increase is primarily attributable
to an increase in outside services of approximately $296,000, mainly public
relations and investor relations, an increase in legal expenses of approximately
$85,000 relating to the preparation of public filings and the consents and
waivers that were signed by holders of our 10% Secured Convertible Debentures,
and an increase of approximately $287,000 in credit card fees due to the
increase in sales.  These increases were partially offset by a
decrease in salaries of approximately $139,000 due to outsourcing.




Investor
relations and other related consulting
 
 Investor
relations and other related consulting increased by $788,545 from $477,071
during the fiscal year ended December 31, 2007 to $1,265,616 during the fiscal
year ended December 31, 2008. The increase is primarily related to an increased
amount of investor relations services in the current year.


Interest
expense





Interest
expense decreased by $401,493, from $2,887,827 in the fiscal year ended December
31, 2007 to $2,486,334 in the fiscal year ended December 31,
2008.  The decrease in interest expense was primarily due to a
decrease of approximately $252,000 in the amortization of deferred financing
costs and a decrease of approximately $149,000 in interest associated with our
debt which has decreased in the current year.





Public
company costs





We expect
to incur increased professional fees for audit, legal and investor relations
services, and for insurance costs as a result of being a public
company.  We also anticipate that we may be required to hire
additional accounting personnel as a public company.





Liquidity
and Capital Resources





In
November 2006 we changed our operating strategy by deciding to introduce a suite
of security products instead of just a single product.  Eventually, we
also changed the way in which our core product was offered to
consumers.  Rather than licensing the product and collecting a license
fee, we offered consumers a choice.  They could download the product
for free, so long as advertising by third parties was included in the
product.  Alternatively, consumers could purchase a license for the
product and the product would be free of advertising.  Our advertising
revenues are earned each time an ad is shown (per impression) or when an ad is
clicked (per click) or for each action taken by the consumer after he clicks on
the ad and visits to the advertiser’s website (per action).  This
change in our business resulted in a significant decrease in our revenues from
2006 to 2007 since we stopped selling our CyberDefender AntiSpyware 2006 product
while we developed and rolled-out our new products.  We launched two
of our new products in late 2007 and subsequently our revenues have been
increasing on a quarterly basis since January 2008, however our expenses still
exceed our revenues.





To help
with our cash flow, we occasionally sell our debt or equity
securities.  We currently have outstanding $1,929,679 in principal
amount of debt securities.  Of this amount, $496,368 represents the
outstanding principal amount of our 10% Secured Convertible
Debentures.  According to the terms of these debentures, we are to
make interest payments quarterly on January 1, April 1, July 1 and October 1
until September 2009, when the principal amount and all accrued but unpaid
interest will be due.  To date, holders of these debentures have
agreed to accept our securities as payment of the interest obligation, in lieu
of cash, but they are not required to do this and we have no assurance that they
will continue to do so.  We also sold a total of $1,200,000 in
principal amount of 10% Convertible Promissory Notes from November 2008 to
January 2009.  Unless converted into shares of our common stock,
principal and accrued interest will be due and payable in October to December
2009.


29





At
December 31, 2008, we had cash and cash equivalents totaling
$779,071.  In the fiscal year ended December 31, 2008, we generated
positive cash flows of $542,077.  Cash provided/(used) during the
fiscal year ended December 31, 2008 included:





Operating
Activities





Net cash
used in operating activities during the fiscal year ended December 31, 2008 was
primarily the result of our net loss of $11,251,772.  Net loss for the
fiscal year ended December 31, 2008 was adjusted for non-cash items such as
amortization of debt discount of $1,322,379, a loss on registration rights
agreement for the effect of partial liquidated damages of $216,540, compensation
expense for vested stock options of $252,943 amortization of deferred financing
fees of $702,061, shares issued for penalties and interest of $253,081, shares
and warrants issued for services of $2,266,783 and depreciation and amortization
of $39,408. Other changes in working capital accounts include an increase in
prepaid and other assets of $667,593, an increase in deferred charges of
$1,010,965, an increase in accounts payable and accrued expenses of $3,059,002
and an increase of $3,923,511 in deferred revenue resulting from higher new
customer and renewal sales.




Historically,
our primary source of operating cash flow is the collection of license fee
revenues from our customers and the timing of payments to our vendors and
service providers.  In 2008 and 2007, we did not make any significant
changes to our payment terms for our customers, which are generally credit card
based.





The
increase in cash related to accounts payable, accrued taxes and other
liabilities was $3,059,002.  Our operating cash flows, including
changes in accounts payable and accrued liabilities, are impacted by the timing
of payments to our vendors for accounts payable.  We typically pay our
vendors and service providers in accordance with invoice terms and
conditions.  The timing of cash payments in future periods will be
impacted by the nature of accounts payable arrangements.  In the
fiscal years ended December 31, 2008 and 2007, we did not make any significant
changes to the timing of payments to our vendors, although our financing
activities caused an increase in this category.





Our
working capital deficit at December 31, 2008, defined as current assets minus
current liabilities, was ($7.8) million as compared to a working capital deficit
of ($1.9) million at December 31, 2007.  The decrease in working
capital of approximately $5.9 million from December 31, 2007 to December 31,
2008 was primarily attributable to an increase in accounts payable and accrued
expenses of approximately $2,750,000, an increase in deferred revenue of
approximately $3,396,000 as a result of increased sales, an increase in the
current portion of notes payable of approximately $1,716,000, an increase in
cash of approximately $542,000, an increase in accounts receivable of
approximately $185,000, an increase in prepaid expenses and other assets of
approximately $667,000, an increase in deferred charges of approximately
$771,000 and a decrease in deferred financing costs of approximately
$273,000.





Investing
Activities





Net cash
used in investing activities during the fiscal year ended December 31, 2008 was
approximately $2,000, which was used for property and equipment
purchases.  We expect to continue to purchase property and equipment
in the normal course of our business.  The amount and timing of these
purchases and the related cash outflows in future periods is difficult to
predict and is dependent on a number of factors, including but not limited to
any increase in the number of our employees and changes in computer hardware and
software used in our business.  Net cash used in investing activities
during the fiscal year ended December 31, 2007 was approximately $5,000 and also
related to the purchase of property and equipment.


30





Financing
Activities





Cash
provided by financing activities during the fiscal year ended December 31, 2008
was primarily the result of issuances of notes payable totaling $954,300 and the
sale of stock net of offering costs totaling $1,042,743.  Cash used in
financing activities was primarily used for payment of notes payable totaling
$349,000 and payments on capital lease obligations.  Cash provided by
financing activities during the fiscal year ended December 31, 2007 was the
result of issuing notes payable totaling $800,000 and the sale of stock totaling
$654,500. Cash used in financing activities was primarily used for payments on
capital lease obligations.




We expect
to meet our obligations through June 2009.  However, we cannot predict
whether our current growth as a developer of a suite of Internet security
products will continue or what the effect on our business might be from the
competitive environment in which we operate.  We continue to manage
our operating costs and expect to continue to grow. We are currently attempting
to raise cash through the sale of our equity securities although there is no
guarantee that we will be successful in doing so.  To the extent it
becomes necessary to raise additional cash in the future, we will seek to raise
it through the sale of debt or equity securities, funding from joint-venture or
strategic partners, debt financing or short-term loans, or a combination of the
foregoing.  We may also seek to satisfy indebtedness without any cash
outlay through the private issuance of debt or equity securities.  We
currently do not have any binding commitments for, or readily available sources
of, additional financing.  We cannot provide any assurances that we
will be able to secure the additional cash or working capital we may require to
continue our operations, either now or in the future. If we are unable to secure
financing, we may be required to severely curtail, or even to cease, our
operations.





Our
consolidated financial statements have been prepared on a going concern basis
which assumes that we will be able to realize our assets and discharge our
liabilities in the normal course of business for the foreseeable
future.  We have generated a net loss of $11,251,772 and realized a
negative cash flow from operating activities of $1,080,302 for the year ended
December 31, 2008.  At this date, we had negative working capital of
$7,848,539.  At December 31, 2008 we had an accumulated deficit of
$25,812,724.  Stockholders deficit was $8,032,180 at December 31,
2008.





Our
ability to continue as a going-concern is in substantial doubt as it is
dependent on a number of factors including, but not limited to, the receipt of
continued financial support from our investors, our ability to control and
possibly reduce our expenses, our ability to raise equity or debt financing as
we need it, and whether we will be able to use our securities to meet certain of
our liabilities as they become payable.  The outcome of these matters
is dependent on factors outside of our control and cannot be predicted at this
time.





Other
than as discussed above, we know of no trends, events or uncertainties that are
reasonably likely to impact our future liquidity.





Item
7A.  Quantitative and Qualitative Disclosures About Market
Risk





The registrant is a smaller reporting
company and is not required to provide this information.





Item
8.  Financial Statements and Supplementary Data





The
financial statements and supplementary data required to be included in this Item
8 are set forth at page F-1 of this report.





Item
9.  Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure





Not applicable.


31





Item
9A. Controls and Procedures





Disclosure
Controls and Procedures





Regulations
under the Securities Exchange Act of 1934 (the “Exchange Act”) require public
companies to maintain “disclosure controls and procedures,” which are defined to
mean a company’s controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the Commission’s rules and forms.





We
conducted an evaluation, with the participation of our Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, as amended, or the Exchange Act, as of
December 31, 2008, to ensure that information required to be disclosed by us in
the reports filed or submitted by us under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Securities Exchange Commission’s rules and forms, including to ensure that
information required to be disclosed by us in the reports filed or submitted by
us under the Exchange Act is accumulated and communicated to our management,
including our principal executive and principal financial officers, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure.  Based on that evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that as of December 31, 2008,
our disclosure controls and procedures were not effective at the reasonable
assurance level due to the material weaknesses described below.





In light
of the material weaknesses described below, we performed additional analysis and
other post-closing procedures to ensure our financial statements were prepared
in accordance with generally accepted accounting
principles.  Accordingly, we believe that the financial statements
included in this report fairly present, in all material respects, our financial
condition, results of operations and cash flows for the periods
presented.





A
material weakness is a control deficiency (within the meaning of the Public
Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected.  Management has
identified the following three material weaknesses which have caused management
to conclude that, as of December 31, 2008, our disclosure controls and
procedures were not effective at the reasonable assurance level:





1.           We
do not have written documentation of our internal control policies and
procedures.  Written documentation of key internal controls over
financial reporting is a requirement of Section 404 of the Sarbanes-Oxley Act
which is applicable to us for the year ending December 31,
2008.  Management evaluated the impact of our failure to have written
documentation of our internal controls and procedures on our assessment of our
disclosure controls and procedures and has concluded that the control deficiency
that resulted represented a material weakness.





2.           We
do not have sufficient segregation of duties within accounting functions, which
is a basic internal control.  Due to our size and nature, segregation
of all conflicting duties may not always be possible and may not be economically
feasible.  However, to the extent possible, the initiation of
transactions, the custody of assets and the recording of transactions should be
performed by separate individuals.  Management evaluated the impact of
our failure to have segregation of duties on our assessment of our disclosure
controls and procedures and has concluded that the control deficiency that
resulted represented a material weakness.





3.           We
have had, and continue to have, a significant number of audit
adjustments.  Audit adjustments are the result of a failure of the
internal controls to prevent or detect misstatements of accounting
information.  The failure could be due to inadequate design of the
internal controls or to a misapplication or override of
controls.  Management evaluated the impact of our significant number
of audit adjustments and has concluded that the control deficiency that resulted
represented a material weakness.


32


To
address these material weaknesses, management performed additional analyses and
other procedures to ensure that the financial statements included herein fairly
present, in all material respects, our financial position, results of operations
and cash flows for the periods presented.





Remediation
of Material Weaknesses





We have
attempted to remediate the material weaknesses in our disclosure controls and
procedures identified above by working with our independent registered public
accounting firm and refining our internal procedures.  To date, we
have not been successful in reducing the number of audit adjustments, but will
continue our efforts in the coming fiscal year.





Management's
Report on Internal Control Over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting.  Internal control over financial
reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the
Securities Exchange Act of 1934 as a process designed by, or under the
supervision of, the company's principal executive and principal financial
officers and effected by the company's board of directors, management and other
personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with accounting principles generally accepted in the
United States of America and includes those policies and procedures
that:





-
            Pertain
      to the maintenance of records that in reasonable detail
      accurately and fairly reflect the transactions and dispositions of
      the assets of the company;





-
            Provide
      reasonable assurance that transactions are recorded as necessary
      to permit preparation of financial statements in accordance with
      accounting principles generally accepted in the United States of
      America and that receipts and expenditures of the company are being
      made only in accordance with authorizations of management and
      directors of the company; and





-
            Provide
      reasonable assurance regarding prevention or timely detection
      of unauthorized acquisition, use or disposition of the company's
      assets that could have a material effect on the financial
      statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.  All internal control
systems, no matter how well designed, have inherent
limitations.  Therefore, even those systems determined to be effective
can provide only reasonable assurance with respect to financial statement
preparation and presentation.  Because of the inherent limitations of
internal control, there is a risk that material misstatements may not be
prevented or detected on a timely basis by internal control over financial
reporting. However, these inherent limitations are known features of the
financial reporting process.  Therefore, it is possible to design into
the process safeguards to reduce, though not eliminate, this
risk.


33





As of
December 31, 2008, management assessed the effectiveness of our internal control
over financial reporting based on the criteria for effective internal control
over financial reporting established in Internal Control—Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
("COSO") and SEC guidance on conducting such assessments.  Based on
that evaluation, they concluded that, during the period covered by this report,
such internal controls and procedures were not effective to detect the
inappropriate application of US GAAP rules as more fully described
below.  This was due to deficiencies that existed in the design or
operation of our internal controls over financial reporting that adversely
affected our internal controls and that may be considered to be material
weaknesses.





The
matters involving internal controls and procedures that our management
considered to be material weaknesses under the standards of the Public Company
Accounting Oversight Board were: (1) lack of a functioning audit committee due
to a lack of a majority of independent members and a lack of a majority of
outside directors on our board of directors, resulting in ineffective oversight
in the establishment and monitoring of required internal controls and
procedures; (2) inadequate segregation of duties consistent with control
objectives; and (3) ineffective controls over period end financial disclosure
and reporting processes.  The aforementioned material weaknesses were
identified by our Chief Financial Officer in connection with the review of our
financial statements as of December 31, 2008.





Management
believes that the material weaknesses set forth in items (2) and (3) above did
not have an effect on our financial results.  However, management
believes that the lack of a functioning audit committee and the lack of a
majority of outside directors on our board of directors results in ineffective
oversight in the establishment and monitoring of required internal controls and
procedures, which could result in a material misstatement in our financial
statements in future periods.





This
annual report does not include an attestation report of the Company's registered
public accounting firm regarding internal control over financial
reporting.  Management's report was not subject to attestation by the
Company's registered public accounting firm pursuant to temporary rules of the
SEC that permit the Company to provide only the management's report in this
annual report.





Management's
Remediation Initiatives





In an
effort to remediate the identified material weaknesses and other deficiencies
and enhance our internal controls, we have initiated, or plan to initiate, the
following series of measures:





We will
create a position to segregate duties consistent with control objectives and
will increase our personnel resources and technical accounting expertise within
the accounting function when funds are available to us.  And, we plan
to appoint one or more outside directors to our board of directors who shall be
appointed to an audit committee resulting in a fully functioning audit committee
who will undertake the oversight in the establishment and monitoring of required
internal controls and procedures such as reviewing and approving estimates and
assumptions made by management when funds are available to us.





Management
believes that the appointment of one or more outside directors, who shall be
appointed to a fully functioning audit committee, will remedy the lack of a
functioning audit committee and a lack of a majority of outside directors on our
Board.





We
anticipate that these initiatives will be at least partially, if not fully,
implemented by December 31, 2009. Additionally, we plan to test our updated
controls and remediate our deficiencies by December 31, 2009.


34





Changes
in Internal Control over Financial Reporting





There
have been no changes in our internal control over financial reporting (as such
term is defined in Rules 13a-15(f) and 15d-15 (f) under the Exchange Act) during
the fourth quarter of 2008 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.





Item
9B. Other Information





Not
applicable




PART
III





Item
10. Directors, Executive Officers and Corporate Governance





The
following table identifies our current executive officers and
directors.







Name
                
                Age
                
                Position
      HeldGary
      Guseinov
                
                
                39
                
                Chief
      Executive Officer, and Chairman of the Board of
  DirectorsKevin
      Harris
                
                
                40
                
                Chief
      Financial Officer and DirectorIgor
      Barash
                
                
                38
                
                Chief
      Information Officer, Secretary and DirectorBing
      Liu
                
                
                49
                
                Director




There are
no family relationships between any two or more of our directors or executive
officers.  Our executive officers are appointed by our board of
directors and serve at the board’s discretion.  There is no
arrangement or understanding between any of our directors or executive officers
and any other person pursuant to which any director or officer was or is to be
selected as a director or officer, and there is no arrangement, plan or
understanding as to whether non-management shareholders will exercise their
voting rights to continue to elect the current board of
directors.  There are also no arrangements, agreements or
understandings to our knowledge between non-management shareholders that may
directly or indirectly participate in or influence the management of our
affairs.




None of
our directors or executive officers has, during the past five
years,




·
            had
      any bankruptcy petition filed by or against any business of which such
      person was a general partner or executive officer, either at the time of
      the bankruptcy or within two years prior to that
  time,




·
            been
      convicted in a criminal proceeding and none of our directors or executive
      officers is subject to a pending criminal
  proceeding,




·
            been
      subject to any order, judgment, or decree, not subsequently reversed,
      suspended or vacated, of any court of competent jurisdiction, permanently
      or temporarily enjoining, barring, suspending or otherwise limiting his
      involvement in any type of business, securities, futures, commodities or
      banking activities, or




·
            been
      found by a court of competent jurisdiction (in a civil action), the
      Securities and Exchange Commission or the Commodity Futures Trading
      Commission to have violated a federal or state securities or commodities
      law, and the judgment has not been reversed, suspended, or
      vacated.




35




Business
Experience





Gary
Guseinov is one of our co-founders and has served as our Chief Executive
Officer and Chairman of the Board of Directors since our inception in August of
2003.  Mr. Guseinov has over 12 years of start-up business experience
in the e-commerce sector in addition to direct marketing
expertise.  In 1994, Mr. Guseinov rapidly grew Digital Media Concepts,
a web development firm, by establishing business relationships with AT&T,
Pacific Bell and British Petroleum.  In 1998, Digital Media Concepts
merged with Synergy Ventures Inc., a marketing firm focusing on performance
based Internet advertising.  By 1999, Mr. Guseinov developed the first
Automated Media Planning System (“SynergyMPS”) and an email marketing platform
capable of delivering over 1 billion email messages per month.  While
at Synergy, Mr. Guseinov was responsible for acquiring such clients as Lucent
Technologies, Wells Fargo Bank, Citibank, Chase, New Century Financial, JD
Powers and Associates, Sears, GoToMyPC/Citrix and many other Fortune 1000
clients.  Under Mr. Guseinov’s management, Synergy was able to
generate over $2 billion in revenues for its clients.  Mr. Guseinov
earned his B.A. from the California State University at Northridge, School of
Social and Behavioral Sciences.





Kevin
Harris joined us as a financial consultant in October 2008 and became our
Chief Financial Officer in January 2009 and a director in March
2009.  Mr. Harris is a Certified Public Accountant in the State of
California with over fifteen years of financial, accounting and management
experience.  From April 2004 to December 31, 2008, Mr. Harris served
as the Chief Operating Officer of Statmon Technologies Corp., a publicly traded
company, where he was also a financial advisor from 2002-2004.  From
February 2001 to March 2004, Mr. Harris served as the Senior Vice President of
Finance for RKO Pictures, LLC.  Prior to RKO, he was the Vice
President – Finance and Controller for Pop.com, LLC, an Internet content joint
venture among DreamWorks SKG, Imagine Entertainment and Vulcan
Ventures.  From 1998 to 2000, Mr. Harris was the Director – Corporate
Financial Planning at Metro-Goldwyn-Mayer Studios, Inc.  From 1995 to
1998, Mr. Harris was the Head of Production Finance and Assistant Controller at
PolyGram Television where he oversaw all aspects of production finance,
accounting and financial planning.  From 1993 to 1995, Mr. Harris was
a Senior Auditor at KPMG Peat Marwick. Mr. Harris graduated with honors from the
California State University at San Bernardino, earning his Bachelor of Science
in Business Administration.  Mr. Harris serves as a board member and
treasurer of Lollipop Theater Network, a 501c(3) non-profit
organization.





Igor
Barash is one of our co-founders and has served as our Chief Information
Officer and as a director since our inception in August of 2003.  Mr.
Barash has over 10 years of senior level management experience with tier one
Internet service providers.  In 1997, Mr. Barash became one of the
first employees of Hostpro, a Los Angeles based ISP.  With his
extensive knowledge of the Internet based systems, servers, administration and
development, Hostpro grew to become one of the largest hosting service providers
in the world.  After Hostpro’s purchase by Micron PC, Mr. Barash took
a key roll in Micron’s Internet services business, including developing value
added features on enterprise level service models and participating as Micron’s
representative to Microsoft.  Later, Mr. Barash became the technical
due diligence leader during Micron’s procurement of other ISPs, and Mr. Barash
delivered assessments of all companies in contention to be purchased and
incorporated under the Micron umbrella.  In 1999, Mr. Barash was given
the task of restructuring and incorporating WorldWide Hosting in Boca Raton, an
acquisition he led.  Since January 2000, Mr. Barash has been operating
his own consulting firm, supplying high level IT solutions and management
services.  Mr. Barash earned his B.S. from the California State
University at Northridge, School of Computer Science.




36


Bing Liu
has served as our Chief Software Architect (first as an employee and now as an
independent contractor) from January 2005 and as a director since October
2006.  Mr. Liu has worked in the software technology field for over 22
years.  Mr. Liu started his technology career in the U.S. in
1989.  In 1991, Mr. Liu founded Unionway International Corporation and
developed the most popular Asian language software called
AsianSuite.  AsianSuite is used by Wal-Mart, the U.S. Army, the
Library of Congress and millions of consumers worldwide.  Mr. Liu also
worked as Senior Software Architect for CyberMedia Corporation.  While
at CyberMedia, Mr. Liu developed ActiveHelp technology, which was later
integrated into FirstAID and GuardDog – popular software marketed to Microsoft
Windows users.  In 1997, Mr. Liu was instrumental in selling
CyberMedia to McAfee for over $200 million.  In 2001, Mr. Liu founded
Cyber-Defender, an innovative Internet security company focusing on antivirus
technology.  Cyber-Defender’s technology is based on a sophisticated
secure adaptive peer network that we believe is far superior than any other
competitive product on the market.  In January 2005, we acquired the
software application Cyber-Defender.  Mr. Liu holds five different
software patents in the U.S.  Mr. Liu also holds a Masters and
Bachelors Degree in Computer Science from Tsinghua University, Beijing
China.





All
directors serve until the next annual meeting of common shareholders and until
their successor is elected and qualified by our common shareholders, or until
the earlier of their death, retirement, resignation or removal.





Compensation
of Directors





Directors
do not currently receive compensation for their services as directors nor are
they reimbursed for expenses incurred in attending board meetings.





Section
16(a) Beneficial Ownership Reporting Compliance





Section
16(a) of the Securities Exchange Act of 1934 requires executive officers,
directors and persons who own more than ten percent of a registered class of our
equity securities to file reports of ownership with the Securities and Exchange
Commission.  Executive officers, directors and more than 10%
shareholders are required by regulations to furnish us with copies of all
Section 16(a) reports they file.





To our
knowledge, based solely on review of the copies of such reports furnished to us
and written representations that no other reports were required, all of our
officers, directors and greater than 10% shareholders complied with all
applicable Section 16(a) filing requirements for the fiscal year ended December
31, 2008, with the exception of the following:  Mr. Bing Liu reported
on a Form 5 that he filed on February 18, 2009 that he had failed to report the
partial exercise of an option on December 24, 2008.  Mr. Liu exercised
the option to purchase 50,000 shares of common stock.  Mr. Liu also
disclosed on the Form 5 that he had been granted an option to purchase 12,500
shares of our common stock on August 1, 2008.





Code
of Ethics





We have
adopted a code of ethics that applies to all of our employees, including our
principal executive officer and principal financial officer.  We will
provide to any person, upon request and without charge, a copy of our Code of
Ethics.  Requests should be in writing and addressed to Mr. Gary
Guseinov, c/o CyberDefender Corporation, 617 West 7th Street,
Suite 401, Los Angeles, California 90017.





Corporate
Governance





Our board
of directors has not yet adopted procedures by which shareholders may recommend
nominees to the board of directors.


37


Item
11. Executive Compensation





Summary
of Compensation





The
following table reflects all compensation awarded to, earned by or paid to our
Chief Executive Officer, our two most highly compensated officers other than the
Chief Executive Officer and any other individuals who are no longer serving, but
who did serve, as an officer during the last two completed fiscal
years.




Summary
      Compensation TableName
      and principal position
              
              Year
              
              Salary
      ($)
              
              
              Bonus
                ($)
              
              
              Stock
                Awards
                ($)
              
              
              Option
                Awards
                ($)
              
              
              Non-
                Equity
                Incentive
                Plan
                Compen
                -sation
                ($)
              
              
              Nonquali-
                fied
                Deferred
                Compen-
                sation
                Earnings
                ($)
              
              
              All
      Other
                Compen-
                sation
      ($)
              
              
              Total
      ($)Gary
      Guseinov, Chief Executive Officer and President
              
              2008
              
              $
              225,000
              (1)
              
              $
              112,500
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              14,024
              
              
              $
              351,5242007
              
              $
              225,000
              (1)
              
              $
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              13,757
              
              
              $
              238,757Ivan
      Ivankovich, former Consulting Chief Financial Officer
              
              2008
              
              $
              12,000
              (2)
              
              
              0
              
              
              
              0
              
              
              $
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              12,0002007
              
              $
              132,000
              (2)
              
              
              0
              
              
              
              0
              
              
              $
              144,401
              (6)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              276,401Michael
      Barrett former Chief Financial Officer
              
              2008
              
              $
              55,000
              
              
              
              0
              
              
              
              0
              
              
              $
              58,650
              (7)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              113,6502007
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0Kevin
      Harris, Chief Financial Officer
              
              2008
              
              $
              13,750
              (3)
              
              
              0
              
              
              
              0
              
              
              $
              24,675
              (7)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              38,425Igor
      Barash, Chief Information Officer
              
              2008
              
              $
              137,500
              (4)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              3,255
              
              
              $
              140,7552007
              
              $
              135,000
              (4)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              3,201
              
              
              $
              138,201Bing
      Liu, Chief Software Architect
              
              2008
              
              $
              92,000
              (5)
              
              $
              12,000
              
              
              
              0
              
              
              $
              14,446
              (7)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              118,4462007
              
              $
              70,825
              (5)
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              $
              70,825


(1) From
March 19, 2005 through September 30, 2006, Mr. Guseinov’s base salary was
$285,000.  As of October 1, 2006, Mr. Guseinov’s base salary has been
set, pursuant to his employment agreement, at $225,000 per
year.  While Mr. Guseinov’s employment agreement requires a matching
contribution to a 401(k) plan in the amount of $2,500 per month and a life
insurance policy the premium of which is no more than $3,000 per year, we have
not provided either of these benefits to him.  In November 2006, in
order to conserve cash, Mr. Guseinov agreed to defer payment of one-half of his
base salary.  In 2007, compensation in the amount of $107,813 was
deferred and has been accrued for Mr. Guseinov’s benefit.  In 2008,
all deferred compensation from 2007 was paid to Mr. Guseinov.  In
addition, of the $112,500 accrued as a 2008 bonus, only $41,000 was paid during
2008 and the balance of $71,500 was accrued at December 31, 2008.


(2) Mr.
Ivankovich began providing consulting services to us on September 1,
2006.  Under the Consulting Agreement signed on that date, Mr.
Ivankovich agreed to provide services to us on a 40% basis in exchange for
$8,000 per month.  The Consulting Agreement was amended on October 30,
2006 and pursuant to the amendment, Mr. Ivankovich agreed to provide services to
us on a half-time basis in exchange for $11,000 per month.  In October
2007, we signed another amendment to Mr. Ivankovich’s Consulting Agreement,
pursuant to which we paid him $12,000 per month for his services.  Mr.
Ivankovich separated from service on January 31, 2008.


(3) Mr.
Harris rendered services to us during the 2008 fiscal year as a
consultant.  The salary paid to him during the 2008 fiscal year was
for the period that began on October 1, 2008. In 2009, he was appointed Chief
Financial Officer.


(4) From
March 19, 2005 through September 30, 2006, Mr. Barash’s base salary was
$145,000.  As of October 1, 2006, Mr. Barash’s base salary has been
set, pursuant to his employment agreement, at $135,000 per year.  In
November 2006, in order to conserve cash, Mr. Barash agreed to defer payment of
one-half of his base salary.  In 2007, compensation in the amount of
$73,125 was deferred and has been accrued for Mr. Barash’s
benefit.  In 2008, deferred compensation of $47,462 was paid to Mr.
Barash.


38





(5) From
January 2006 to September 2006, Mr. Liu’s annual salary was
$165,000.  In September 2006 Mr. Liu’s annual salary was increased to
$202,000.  In November 2006, in order to conserve cash, Mr. Liu agreed
to defer payment of one-half his base salary.  Mr. Liu resigned as an
employee in August 2007 and became an independent contractor
thereafter.  In 2007, compensation in the amount of $63,281 was
deferred and has been accrued for Mr. Liu’s benefit.  In 2008,
deferred compensation of $45,163 was paid to Mr. Liu.


(6) For
the assumptions used in calculating the value of this grant, please see Note 6
of our financial statements for the fiscal year ended December 31,
2007.


(7) For
the assumptions used in calculating the value of this grant, please see Note 6
of our financial statements for the fiscal year ended December 31,
2008.




Discussion
of Compensation





Our
compensation program consists of the following three components:





·
            base
      salary;





·
            bonuses;
      and





·
            awards
      of restricted stock or stock options from our 2005 Equity Incentive Plan
      and our Amended and Restated 2006 Equity Incentive
  Plan.





We
believe that a combination of cash and common stock or options will allow us to
attract and retain the services of the individuals who will help us achieve our
business objectives, thereby increasing value for our shareholders.





In
setting the compensation for our officers our board of directors, which is
currently comprised of Mr. Gary Guseinov, Mr. Igor Barash, Mr. Kevin Harris and
Mr. Bing Liu, looked primarily at the person’s responsibilities, at salaries
paid to others in businesses comparable to ours, at the person’s experience and
at our ability to replace the individual.  We expect the salaries of
our executive officers to remain relatively constant unless the person’s
responsibilities are materially changed.





Bonuses
are used to reward exceptional performance, either by the individual or by the
company.  Bonuses are discretionary.  There is no single
method of computing bonuses.  The board of directors may use any
criteria to determine the amount of a bonus.  A bonus of $112,500 was
accrued for Mr. Gary Guseinov and a bonus of $12,000 was accrued for Mr. Bing
Liu in 2008. No bonuses were paid in 2007.





In 2007
and 2008 we granted restricted stock or options to purchase our common stock to
Messrs. Liu, Ivankovich, Barrett and Harris.  We grant options or
restricted stock because we believe that share ownership by our employees is an
effective method to deliver superior shareholder returns by increasing the
alignment between the interests of our employees and our
shareholders.  No employee is required to own common stock in our
company.





The
following table sets forth certain information concerning stock option awards
granted to our executive officers and our directors.  With the
exception of Mr. Bing Liu, who partially exercised an option and purchased
50,000 shares of our common stock, no options were exercised by our executive
officers or directors during the last fiscal year.


39





OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-ENDOPTION
      AWARDS
                
                STOCK
      AWARDSName
                
                Number
      of
                  securities
                  underlying
                  unexercised
                  options
      (#)
                  Exercisable
                
                
                Number
      of
                  securities
                  underlying
                  unexercised
                  options
      (#)
                  Unexercis-
                  able
                
                
                Equity
                  Incentive
                  Plan
                  Awards:
                  Number
      of
                  Securities
                  underlying
                  unexercised
                  unearned
                  options
      (#)
                
                
                Option
                  exercise
                  price
      ($)
                
                Option
                  expiration
                  date
                
                Number
                  of
      shares
                  or
      units
                  of
      stock
                  that
      have
                  not
                  vested
                  (#)
                
                
                Market
                  value
      of
                  shares
      or
                  units
      of
                  stock
      that
                  have
      not
                  vested
                  ($)
                
                
                Equity
                  incentive
                  plan
                  awards:
                  number
                  of
                  unearned
                  shares,
                  units
      or
                  other
                  rights
                  thathave
                  not
                  vested
                  (#)
                
                
                Equity
                  incentive
                  plan
                  awards:
                  Market
                  or
      payout
                  value
      of
                  unearned
                  shares,
                  units
      or
                  other
                  rights
                  that
      have
                  not
                  vested
                  (#)Bing
      Liu
                
                
                276,107
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                0.0107
                
                12/31/2009
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Bing
      Liu
                
                
                335,777
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                12/31/2009
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Bing
      Liu
                
                
                12,500
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                08/01/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Igor
      Barash
                
                
                6,250
                
                
                
                -0-
                
                
                
                6,250
                
                
                $
                1.00
                
                12/11/2016
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Michael
      Barrett
                
                
                20,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                2/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Michael
      Barrett
                
                
                20,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                4/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Michael
      Barrett
                
                
                10,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.30
                
                8/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Michael
      Barrett
                
                
                10,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                10/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Michael
      Barrett
                
                
                2,500
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.20
                
                12/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-Kevin
      Harris
                
                
                20,000
                
                
                
                -0-
                
                
                
                -0-
                
                
                $
                1.00
                
                10/1/2018
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-
                
                
                
                -0-





Employment
Agreements, Termination of Employment and Change-in-Control
Arrangements





The
following discussions provide only a brief description of the documents
described below.  The discussions are qualified by the full text of
the agreements.





We entered into an employment agreement
with Mr. Gary Guseinov as of August 31, 2006.  The term of the
agreement is three years, however if the agreement is not terminated during that
period, then it will be renewed for a period of one year until terminated
pursuant to its terms.  Mr. Guseinov receives compensation of $225,000
per year and is reimbursed for business related expenses. Under the employment
agreement, we are required to match Mr. Guseinov’s monthly contribution to our
401(k) plan up to the sum of $2,500 per month and we have agreed to provide a
term life insurance policy with coverage in the face amount of $1,000,000, so
long as the premium for any such policy does not exceed the sum of $3,000 per
year, however, we do not currently, and we have not in the past, provided these
benefits.  We also agreed to obtain officers and directors liability
insurance with coverage of not less than $1,000,000, which we obtained in
November 2007.  Mr. Guseinov receives three weeks of paid vacation per
year.  We are entitled to terminate Mr. Guseinov’s employment upon a
change of control, upon Mr. Guseinov’s disability or for
cause.  Constructive termination is defined as a change in Mr.
Guseinov’s position, authority, duties, responsibilities or status, an adverse
change in his title, any reduction in his salary with which he does not agree
(unless such reduction is concurrent with and part of a company-wide reduction
for all employees), any breach by us of a material obligation to Mr. Guseinov
under this agreement, any requirement that Mr. Guseinov relocate to an office
that is outside of Los Angeles County, California or outside of a 30 mile radius
from his home, any termination of this agreement (other than as permitted by the
agreement) and the failure of Mr. Guseinov to be elected to the board of
directors.  Mr. Guseinov may terminate his employment upon 30 days
written notice to us or in the event that he is constructively
terminated.  If Mr. Guseinov’s employment is terminated for any reason
other than voluntarily by him or for cause, he is entitled to receive upon
termination all accrued but unpaid salary, earned and pro rata bonus
compensation, vested stock and stock options and post termination
benefits.  Post termination benefits are defined as Mr. Guseinov’s
right to receive his monthly base salary in effect at termination for a period
of one year following termination and to continue to receive coverage under our
health and dental insurance program (if any) for a period of six months
following his termination.  By signing the agreement, Mr. Guseinov
assigned and agreed to assign in the future, to us or to our nominees, all
intellectual property defined in the agreement as “Relevant Intellectual
Property”.


40




On September 1, 2003 we entered into an
employment agreement with Igor Barash, our Chief Information
Officer.  Mr. Barash is an “at-will” employee and we can terminate his
employment at any time.  As compensation for the services he renders
to us, Mr. Barash is paid the sum of $140,000 per year.  We reimburse
Mr. Barash for reasonable business expenses.  Currently, Mr. Barash is
entitled to 17 paid days of personal time and three sick days for each 12 months
of employment.




On August 30, 2007 and again on March
4, 2008 we entered into Independent Contractor Agreements with Mr. Bing Liu
pursuant to which Mr. Liu will continue to provide services to us as Chief
Software Architect.  Complete descriptions of these agreements are
included in the section of this report titled “Item 13. Certain Relationships
and Related Transactions”.




On
January 3, 2005 we entered into an Incentive Stock Option Agreement with Mr.
Liu.  Pursuant to this agreement, Mr. Liu was granted the right to
purchase 326,106 shares of our common stock at an exercise price of $0.0107 per
share.  The right to purchase the shares was originally subject to
vesting conditions, such as the length of Mr. Liu’s service and any sale of all
of our assets.  On August 30, 2007, Mr. Liu resigned as an employee
and began providing services to us as a consultant.  In accordance
with the terms of his consulting agreement, the right to purchase all of the
shares included in the Incentive Stock Option Agreement vested as of December
31, 2007.




We
entered into three Independent Contractor Agreements with Michael Barrett, our
former Chief Financial Officer.  Descriptions of these agreements are
included in the section of this report titled “Item 13 - Certain Relationships
and Related Transactions and Director Independence.”





During a
transition period from October 1, 2008 until his appointment as our Chief
Financial Officer, Mr. Kevin Harris served as a financial consultant to us,
assisting Mr. Michael Barrett, our former Chief Financial Officer.  In
addition to paying Mr. Harris $13,750 in cash compensation for his consulting
services during this transition period, we granted Mr. Harris a 10-year option
to purchase a total of 20,000 shares of our  common stock at an
exercise price of $1.00 per share.





On March
24, 2009 our board of directors approved an employment agreement with Kevin
Harris, our Chief Financial Officer and a director.  Pursuant to the
employment agreement, Mr. Harris will provide services to us as our Chief
Financial Officer through December 31, 2010, unless the employment agreement is
terminated earlier pursuant to its terms.  We will pay Mr. Harris
annual compensation at the rate of $190,000 per year for his
services.  We also agreed to grant to Mr. Harris options to purchase
300,000 shares of our common stock, as described below.





The right
to purchase 200,000 shares of common stock will vest as follows:  (i)
the right to purchase 25,000 shares of common stock vested immediately upon
execution of the employment agreement; (ii) the right to purchase 25,000 shares
of common stock will vest on April 1, 2009; and the right to purchase the
remaining 150,000 shares of common stock will vest in equal increments of 6,250
shares of common stock per month over a period of 24 months, starting with the
effective date of the employment agreement which is January 1,
2009.  The term of the option is 10 years and the exercise price is
$1.00 per share.





We have
also provided quarterly performance goals to be met by Mr. Harris during the
2009 fiscal year.  If he is successful in meeting these goals, he will
be able to earn a quarterly bonus consisting of $11,875 in cash and an option to
purchase an additional 25,000 shares of common stock.  This option
will also have a term of 10 years and an exercise price of $1.00 per
share.  The right to purchase the shares will vest in equal increments
over a period of 24 months.


41





The
performance goals to be met by Mr. Harris during the 2010 fiscal year will be
agreed to by us and Mr. Harris on or about January 1, 2010.





We have
also agreed to pay for health and dental insurance for Mr. Harris and his family
and to provide him with an automobile allowance of $750 per
month.  Mr. Harris will also receive 4 weeks paid
vacation.





Mr.
Harris may terminate his employment upon giving us 30 days written notice of his
termination.  We may terminate Mr. Harris’ employment for cause, in
the event that a disability (as defined in the employment agreement) renders him
unable to provide services to us and as a result of a Change of Control (as
defined in the employment agreement).  Mr. Harris’ employment may also
be terminated as a result of a “Constructive Termination” (as defined in the
employment agreement).  If his employment is terminated as a result of
a disability or Change of Control, or if we terminate his employment in our
discretion but without cause, Mr. Harris will receive his monthly base salary
for the lesser of 6 months or the remaining term of the employment agreement and
we will continue to pay the premiums for his health and dental insurance for a
period of 6 months (the “Post-Termination Benefits”).  If Mr. Harris’
employment is terminated as a result of a Constructive Termination that occurs
on or after July 1, 2009, all stock option grants and conditional grants (such
as the grant made in conjunction with the performance goals) will vest and Mr.
Harris will receive the Post Termination Benefits.  If Mr. Harris’
employment is terminated as a result of a Constructive Termination that occurs
prior to July 1, 2009, he will be entitled to receive 3 months salary as a
severance benefit.  If Mr. Harris’ employment is terminated as a
result of a Change of Control, aside from the Post-Termination Benefits, all
stock option grants and conditional grants will vest.  In the event of
termination for any reason, Mr. Harris will also be entitled to receive his
accrued but unpaid salary, earned bonus compensation, vested stock options and
vested benefits, such as accrued vacation pay.





Item
12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters





The
following tables set forth certain information regarding beneficial ownership of
our securities as of March 25, 2009 by (i) each person who is known by us to own
beneficially more than 5% of the outstanding shares of each class of our voting
securities, (ii) each of our directors and executive officers, and (iii) all of
our directors and executive officers as a group. Unless otherwise stated, the
address of our directors and executive officers is c/o CyberDefender
Corporation, 617 West 7th Street, Suite 401, Los Angeles, California
90017.




We have
determined beneficial ownership in accordance with the rules of the Securities
and Exchange Commission.  Under these rules, beneficial ownership
generally includes voting or investment power over securities. The number of
shares shown as beneficially owned in the tables below are calculated pursuant
to Rule 13d-3(d)(1) of the Securities Exchange Act of 1934.  Under
Rule 13d-3(d)(1), shares not outstanding that are subject to options, warrants,
rights or conversion privileges exercisable within 60 days are deemed
outstanding for the purpose of calculating the number and percentage owned by
such person, but not deemed outstanding for the purpose of calculating the
percentage owned by each other person listed.  Except as otherwise
indicated, we believe that the beneficial owners listed below, based on the
information furnished by these owners, have sole investment and voting power
with respect to the securities indicated as beneficially owned by them, subject
to applicable community property laws.  As of March 27, 2009, there
were 19,195,114 shares of common stock issued and outstanding.


42




Name of Director, Officer and
      Beneficial
                      Owner(1)
                    
                    Number
      of Shares of
                      Common
      Stock
                      Beneficially
      Owned
                    
                    
                    Percentage
      of
                      Common
      StockNamed Executive Officers and
      Directors:Gary
      Guseinov, Chief Executive Officer and director
                    
                    
                    6,467,376
                    
                    
                    
                    35.3
                    %Igor
      Barash, Chief Information Officer, Secretary and director
                    
                    
                    643,326
                    (2)
                    
                    
                    3.5
                    %Bing
      Liu, Chief Software Architect and director
                    
                    
                    1,466,227
                    (3)
                    
                    
                    7.7
                    %Michael
      Barrett, former Chief Financial Officer
                    
                    
                    62,500
                    (4)
                    
                    
                    0.3
                    %Kevin
      Harris, Chief Financial Officer
                    
                    
                    57,500
                    (5)
                    
                    
                    0.3
                    %ITU
      Ventures
                    
                    
                    1,819,382
                    (6)
                    
                    
                    9.6
                    %TOTAL
                    
                    
                    10,516,311
                    
                    
                    
                    56.7
                    %All
      officers and directors as a group (5 persons)
                    
                    
                    8,696,929
                    
                    
                    
                    46.8
                    %




(1) The
address for each of our officers and directors is 617 West 7th Street, Suite
401, Los Angeles, California 90017.


(2) This
number includes the vested portion of an option to purchase 12,500 shares of our
common stock that was approved by our board of directors on December 11,
2006.  The option exercise price is $1.00 per shares.  The
option was granted from our 2006 Equity Incentive Plan.


(3) This
number consists of 841,843 shares of common stock, an option to purchase 276,106
shares of our common stock that was granted from our 2005 Equity Incentive Plan,
an option to purchase 335,777 shares of our common stock that was approved by
our Board of Directors on November 2, 2006 and a option to purchase 12,500
shares of our common stock.  The option was granted from our 2006
Equity Incentive Plan.  The option exercise prices are $0.0107 per
share, $1.00 per share and $1.00 per share, respectively.


(4) Mr.
Barrett received an option to purchase 20,000 shares of our common stock on
March 31, 2008 that was approved by the board of directors on March 31, 2008.
Mr. Barrett received an option to purchase 20,000 shares of our common stock on
April 16, 2008. Mr. Barrett received an option to purchase 10,000 shares of our
common stock on August 1, 2008 that was approved by the board of directors on
August 6, 2008. Mr. Barrett received an option to purchase 10,000 shares of our
common stock on October 31, 2008. Mr. Barrett received an option to purchase
2,500 shares of our common stock on December 1, 2008.


(5)
Mr. Harris received an option to purchase 10,000 shares of our common stock on
October 1, 2008, an option to purchase 5,000 shares of our common stock on
November 1, 2008 and an option to purchase 5,000 shares of our common stock on
December 1, 2008.  In January 2009, Mr. Harris received an option to
purchase 200,000 shares of our common stock of which 37,500 had vested as of the
above date.  The option exercise prices are $1.00 per
share.


(6) This
number represents 1,252,475 shares of common stock and 566,907 shares of common
stock issuable upon the exercise of a common stock purchase
warrant.  The address of ITU Ventures is 1900 Avenue of the Stars,
Suite 2701, Los Angeles, California 90067.





Item
13. Certain Relationships and Related Transactions and Director
Independence





Using the
definition of “independent” as that term is defined under the rules of the
NASDAQ Capital Market, we have determined that none of our three directors will
qualify as an independent director.




Described
below are certain transactions or series of transactions between us and our
executive officers, directors and the beneficial owners of 5% or more of our
common stock, on an as converted basis, and certain persons affiliated with or
related to these persons, including family members, in which they had or will
have a direct or indirect material interest in an amount that exceeds the lesser
of $120,000 or 1% of the average of our total assets as of year-end for the last
two completed fiscal years, other than compensation arrangements that are
otherwise required to be described under “Executive
Compensation.”


43


On
January 3, 2005 we entered into an employment agreement with Mr. Bing Liu, our
Chief Software Architect, wherein we agreed to pay him an annual salary of
$100,000.  In December 2005 we increased Mr. Liu’s salary to
$165,000.  Mr. Liu’s annual salary was increased again in September
2006, and, until his resignation as an employee, he was paid the sum of $202,000
per year.  Pursuant to this agreement, Mr. Liu was entitled to receive
a bonus, calculated as two percent of the net revenue we earn from any invention
created by him during the course of his employment.  “Net revenue” was
defined as gross receipts less direct marketing and shipping costs less returns
and discounts.  Inventions created by Mr. Liu were defined as any and
all ideas, processes, trademarks, service marks, inventions, technology,
computer programs, original works of authorship, designs, formulas, discoveries,
patents, copyrights, and all improvements, rights, and claims related to the
foregoing that are conceived, developed, or reduced to practice by Mr. Liu alone
or with others that result from any work performed by him for us or in which our
equipment, supplies, facilities or trade secret information is
used.  This provision survived the termination of Mr. Liu’s
employment.  Pursuant to this agreement, we were required to reimburse
Mr. Liu for reasonable business expenses.  Mr. Liu agreed that
following termination of his employment, he would not take any action to induce
or influence any person who provides services to us to terminate his or her
employment nor will he attempt to employ any such person within six months of
the date that person’s employment with us terminated.  Mr. Liu agreed
to keep secret our confidential information during his employment and for a
period of one year following the termination of his employment.  This
agreement was terminated on August 30, 2007 when we entered into an independent
contractor agreement with Mr. Liu.  A discussion of this agreement is
included below.




On
September 1, 2006 Mr. Ivan Ivankovich signed an independent contractor agreement
with us for part-time financial management and reporting
services.  The term of the agreement was 90 days.  We were
entitled to terminate the agreement at any time by giving Mr. Ivankovich 10 days
written notice of termination or, upon a breach of the agreement, immediately by
giving written notice to Mr. Ivankovich.  Mr. Ivankovich was entitled
to terminate the agreement by giving us 30 days written notice of
termination.  Pursuant to this agreement, Mr. Ivankovich received
compensation in the amount of $8,000 per month through October 15,
2006.  The agreement was amended on October 15, 2006, January 12,
2007, April 24, 2007 and October 22, 2007.  Pursuant to the amendment
dated April 24, 2007, Mr. Ivankovich’s salary was set at $9,000 per month
through June 30, 2007, and on July 1, 2007 Mr. Ivankovich’s salary was increased
to $12,000 per month.  By signing the amendment dated October 22,
2007, we extended the term of the Independent Contractor Agreement through
January 31, 2008.  We also agreed to grant Mr. Ivankovich options to
purchase 40,000 shares of our common stock.  The right to purchase the
common stock vested in equal increments through January 31, 2008 with the right
to purchase an initial 10,000 shares vesting as of October 1,
2007.  In exchange for this compensation, Mr. Ivankovich provided
services to us for at least 20 hours per week.  The agreement expired
on January 31, 2008 without renewal.  Mr. Ivankovich no longer
provides services to us.




On
October 30, 2006 we entered into Indemnification Agreements with Mr. Guseinov,
Mr. Ivankovich, Mr. Liu and Mr. Barash, on November 6, 2007 we entered into an
Indemnification Agreement with Mr. John LaValle, a former director, and on March
24, 2009 we entered into an Indemnification Agreement with Kevin Harris, our
current Chief Financial Officer and a director, all of whom are sometimes
collectively referred to in this discussion as the “indemnified parties” or
individually referred to as an “indemnified party”.  The agreements
require us to provide indemnification for the indemnified parties for expenses
(including attorneys’ fees, expert fees, other professional fees and court
costs, and fees and expenses incurred in connection with any appeals), judgments
(including punitive and exemplary damages), penalties, fines and amounts paid in
settlement (if such settlement is approved in advance by us, which approval
shall not be unreasonably withheld) actually and reasonably incurred by the
indemnified parties in connection with any threatened, pending or completed
action or proceeding (including actions brought on our behalf, such as
shareholder derivative actions), whether civil, criminal, administrative or
investigative, to which he is or was a party, a witness or other
participant (or is threatened to be made a party, a witness or other
participant) by reason of the fact that he is or was a director, officer,
employee or agent of ours or of any of our subsidiaries.  The
indemnification covers any action or inaction on the part of the indemnified
party while he was an officer or director or by reason of the fact that he is or
was serving at our request as a director, officer, employee or agent of another
corporation, partnership, joint venture, trust or other
enterprise.  We must advance the costs of the fees and expenses within
20 days following the delivery of a written request from an indemnified
party.  The indemnified parties have agreed to promptly repay the advances
only if, and to the extent that, it is ultimately determined by the court (as to
which all rights of appeal therefrom have been exhausted or lapsed) that the
indemnified party is not entitled to the indemnity.  The indemnified
parties’ obligations to repay us for any such amounts are unsecured and no
interest will be charged thereon. We also agreed to indemnify the
indemnified parties to the fullest extent permitted by law, notwithstanding that
such indemnification is not specifically authorized by the other provisions of
the Indemnification Agreements, our articles of incorporation, our bylaws or by
statute.  In the event of any change, after the date of the Indemnification
Agreements, in any applicable law, statute or rule which expands the right of a
California corporation to indemnify a member of its board of directors or an
officer, such changes shall be within the purview of the indemnified parties’
rights and our obligations under the Indemnification Agreements.  In the
event of any change in any applicable law, statute or rule which narrows the
right of a California corporation to indemnify a member of its board of
directors or an officer, such changes, to the extent not otherwise required by
such law, statute or rule to be applied to the Indemnification
Agreements will have no effect on the rights and obligations of the
indemnified parties and the company under them.  The indemnification
provided by the Indemnification Agreements is not exclusive of any rights
to which the indemnified parties may be entitled under our articles of
incorporation, bylaws, any agreement, any vote of shareholders or disinterested
directors or the California Corporations Code.  The indemnification
provided under the Indemnification Agreements continues for any action taken or
not taken while an indemnified party serves in an indemnified capacity, even
though he may have ceased to serve in such capacity at the time of any action or
other covered proceeding.  If the indemnification provided for in the
Indemnification Agreement is unavailable to an indemnified party, in lieu of
indemnifying the indemnified party we will contribute to the amount incurred by
him, whether for judgments, fines, penalties, excise taxes, amounts paid or to
be paid in settlement and/or for expenses, in connection with any claim relating
to an indemnifiable event, in such proportion as is deemed fair and reasonable
by the court before which the action was brought.  We are not
obligated to provide indemnification pursuant to the terms of the
Indemnification Agreements


44




·
            for
      any acts or omissions or transactions from which a director may not be
      relieved of liability under the California General Corporation Law; or for
      breach by an indemnified party of any duty to us or our shareholders as to
      circumstances in which indemnity is expressly prohibited by
      Section 317 of the California General Corporation Law;
    or





·
            with
      respect to proceedings or claims initiated or brought voluntarily by an
      indemnified party not by way of defense, (except with respect to
      proceedings or claims brought to establish or enforce a right to
      indemnification) although such indemnification may be provided if our
      Board of Directors has approved the initiation or bringing of such
      proceeding or claim; or





·
            with
      respect to any proceeding instituted by the indemnified party to enforce
      or interpret the Indemnification Agreement, if a court of competent
      jurisdiction determines that each of the material assertions made by the
      indemnified party in such proceeding was not made in good faith or was
      frivolous; or





·
            for
      expenses or liabilities of any type whatsoever which have been paid
      directly to an indemnified party by an insurance carrier under a policy of
      directors’ and officers’ liability insurance maintained by us;
      or





·
            for
      expenses and the payment of profits arising from the purchase and sale by
      an indemnified party of securities in violation of Section 16(b) of
      the Securities Exchange Act of 1934, as amended, or any similar successor
      statute.




The
Indemnification Agreements are effective as of the date they were signed
and may apply to acts or omissions of the indemnified parties which occurred
prior to such date if the indemnified party was an officer, director, employee
or other agent of our company, or was serving at our request as a director,
officer, employee or agent of another corporation, partnership, joint venture,
trust or other enterprise, at the time such act or omission occurred.  All
of obligations under the Indemnification Agreements will continue as long as an
indemnified party is subject to any actual or possible matter which is the
subject of the Indemnification Agreement, notwithstanding an indemnified party’s
termination of service as an officer or director.


45




In
January 2007, we paid to International Equity Partners, a Nevada limited
liability company, a fee in the amount of $2,775 for use of property during a
trade show.  Mr. Guseinov is the manager of International Equity
Partners.





In
conjunction with his agreement to render services to us, we granted options to
Mr. Ivan Ivankovich, our former consulting Chief Financial
Officer.  The options were granted from our Amended and Restated 2006
Equity Incentive Plan.  The options permit Mr. Ivankovich to purchase
a total of 200,000 shares of our common stock at a price of $1.00 per
share.  With the exception of the right to purchase 30,000 shares,
which vested on July 19, 2007, the right to purchase the remaining shares of
common stock vested at the rate of 10,000 shares per month.  The
options have terms of 10 years.  The fair value for the initial option
grant of 40,000 shares was estimated at the date of grant using a Black-Scholes
option pricing model, as more fully described in Note 6 of our financial
statements for the fiscal year ended December 31, 2006.  The fair
value of the subsequent grant of 120,000 shares was estimated at the date of
grant using a Black-Scholes option pricing model with the following
weighted-average assumptions:  risk-free interest rate of 4.62%,
dividend yields of 0% and volatility factors of the expected market price of our
common shares of 128%.The fair value of the
grant of 40,000 shares made in October 2007 was also estimated using a
Black-Scholes option pricing model with the following weighted average
assumptions:  risk-free interest rate of 3.99%, dividend yields of 0%
and volatility factors of the expected market price of our common shares of
116%.





On August
30, 2007 Mr. Bing Liu, our Chief Software Architect, resigned as an employee and
began providing services to us as a consultant pursuant to a Consulting
Agreement entered into on the same day.  The term of the agreement was
six months, but the agreement could be terminated by either party upon 30 days
notice, or immediately if Mr. Liu failed to discharge his obligations under the
agreement.  Upon execution of the agreement we paid Mr. Liu the sum of
$7,500 and we agreed to pay him the sum of $4,000 per month in exchange for his
services.  We would reimburse Mr. Liu for expenses incurred by him in
rendering services under the agreement.  We also agreed that Mr. Liu
will have a period of 24 months to exercise any vested options, that one-half of
any options remaining unvested on December 31, 2007 will vest and that the
remaining unvested options will vest in equal increments over 34
months.  The agreement further states that if we failed to pay to Mr.
Liu any unpaid salary due to him by December 31, 2007, then any unvested options
would immediately vest.  Mr. Liu is currently owed $63,281 in unpaid
salary, which was not paid to him by December 31, 2007.  At the time
of this agreement, Mr. Liu has options to purchase a total of 661,884 shares of
our common stock, all of which are now vested.  Pursuant to the
agreement, Mr. Liu continued his duties as Chief Software Architect and agreed
to assist us with the recruiting of a Chief Technology Officer or Vice-President
of Software Development.  Mr. Liu continues to provide services to us
as a consultant and a member of our board of directors.





On March
4, 2008 we entered into a second Independent Contractor Agreement with Mr.
Liu.  The term of the agreement was five months, but the agreement
could be terminated by either party upon 30 days notice, or immediately if Mr.
Liu failed to discharge his obligations under the agreement.  We
agreed to pay Mr. Liu the sum of $8,000 per month in exchange for his services
and we agreed to reimburse Mr. Liu for expenses incurred by him in rendering
services under the agreement.





On August
1, 2008 we entered into a third Independent Contractor Agreement with Mr. Liu.
The term of the agreement was five months, but the agreement could be terminated
by either party upon 30 days notice, or immediately if Mr. Liu failed to
discharge his obligations under the agreement.  We agreed to pay Mr.
Liu the sum of $8,000 per month for the month of August and $9,000 per month for
the remaining term of the agreement in exchange for his services.  We
agreed to reimburse Mr. Liu for expenses incurred by him in rendering services
under the agreement.


46


From
time-to-time, Unionway International, LLC, an entity controlled by Mr. Liu,
provides software development services to us.  During the fiscal year
ended December 31, 2008, we paid Unionway International, LLC $92,000 for
software development services. We did not pay Unionway International LLC any
money during the 2007 fiscal year. Because Mr. Liu continues to act as our Chief
Software Architect and is a director, the negotiation of the compensation for
these services was not done “at arm’s length”. However, we believe that we
receive fair value in the services provided to us by Unionway International, LLC
and that if we were to pay an independent provider for the services, we would
pay approximately the same amount per month.





On
October 1, 2007 Mr. Guseinov loaned us the sum of $28,078.  The loan
did not accrue interest.  We repaid the loan on November 19,
2007.  No loan agreement or promissory note was signed in conjunction
with the loan.





On
February 4, 2008 our board of directors approved an independent contractor
agreement with Mr. Michael Barrett.  The term of the agreement was six
months.  Pursuant to the agreement, Mr. Barrett provided consulting
services to us as our Chief Financial Officer.  We agreed to pay Mr.
Barrett the sum of $6,000 per month for the months of February and March
2008.  Beginning on April 1, 2008, Mr. Barrett’s cash compensation was
reduced to $4,000 per month.  We also issued to Mr. Barrett an option
to purchase 20,000 shares of our common stock.  The right to purchase
10,000 shares vested on April 30, 2008.  The right to purchase the
remaining 10,000 shares of common stock vested at the end of the
term.  The fair value of the grant was estimated using a Black-Scholes
option pricing model with the following weighted average
assumptions:  expected term of 5 years, a risk-free interest rate of
2.48%, a dividend yield of 0%, volatility of 173% and a forfeiture rate of
4%.  On April 16, 2008, we granted to Mr. Barrett an option to
purchase 20,000 shares of common stock under the 2006 Plan, at a price of $1.00
per share with an estimated fair value of $17,269 using the Black-Scholes option
pricing model with the following assumptions: expected term of 5.1 years, a
risk-free interest rate of 2.84%, a dividend yield of 0%, volatility of 169% and
a forfeiture rate of 4%. On August 6, 2008 our board of directors approved a
second independent contractor agreement with Mr. Barrett.  Pursuant to
the agreement, Mr. Barrett continued to provide services to us as our Chief
Financial Officer through September 30, 2008.  We agreed to pay Mr.
Barrett at the rate of $6,000 per month for his services.  We also
agreed to grant to Mr. Barrett options to purchase 10,000 shares of our common
stock.  The right to purchase the common stock vested in equal
increments of 5,000 shares per month over the term of the
contract.  In exchange for this compensation, Mr. Barrett provided his
services to us for 10 to 15 hours per week.  The fair value of the
grant was estimated using a Black-Scholes option pricing model with the
following weighted average assumptions:  expected term of 5.1 years, a
risk-free interest rate of 3.24%, a dividend yield of 0%, volatility of 158% and
a forfeiture rate of 4%. On October 1, 2008, we extended Mr. Barrett’s agreement
through November 30, 2008 and we granted to Mr. Barrett an option to purchase
10,000 shares of common stock under the 2006 Plan, at a price of $1.00 per share
with an estimated fair value of $9,679 using the Black-Scholes option pricing
model with the following assumptions: expected term of 5.06 years, a risk-free
interest rate of 2.88%, a dividend yield of 0%, volatility of 153% and a
forfeiture rate of 4%. On December 1, 2008, we extended Mr. Barrett’s agreement
through December 15, 2008 and granted to Michael Barrett an option to purchase
2,500 shares of common stock under the 2006 Plan, at a price of $1.00 per share
with an estimated fair value of $2,748 using the Black-Scholes option pricing
model with the following assumptions: expected term of 5 years, a risk-free
interest rate of 1.71%, a dividend yield of 0%, volatility of 153% and a
forfeiture rate of 4%.





In March
2008, Mr. Guseinov pledged 750,000 shares of his common stock to Michael and
Casey DeBaecke in exchange for a loan of $160,000 made to us.  The
pledge was non-recourse to Mr. Guseinov in the event the collateral was
foreclosed upon due to our failure to pay the loan.  So long as there
was no event of default in connection with the loan, Mr. Guseinov could continue
to vote the shares at any annual or special meeting of the
shareholders.  The loan was due to be repaid on the earlier of two
months following execution of the loan document or two days following our
receipt of over $500,000 in new equity capital.  Additionally, we
issued warrants to purchase 40,000 shares of our common stock to the
lenders.  The warrants may be exercised at a price of $1.25 per share
for a period of 5 years.  The loan plus accrued interest was paid in
full on July 30, 2008.


47





On August
19, 2008 we entered into an Amended and Restated Consent and Waiver (the “August
Agreement”) with the holders of at least 75% of the outstanding principal amount
of our 10% Secured Convertible Debentures (the “Debenture
Holders”).  Pursuant to the August Agreement, the Debenture Holders
waived the requirement that we file a second registration statement (as required
by the Debentures and the Registration Rights Agreement signed in conjunction
therewith) and waived all liquidated damages that accrued after December 19,
2007 as a result of that breach.  Although the Debenture Holders did
not waive the liquidated damages that accrued prior to December 19, 2007, which
totaled $194,602.68, they waived the payment of the interest accrued on the
liquidated damages.  The August Agreement allowed us to pay the
liquidated damages, as well as the interest accrued on the Debentures which was
to be paid on January 1, 2008, with our securities.  Each holder was
permitted to choose to accept either shares of our common stock having an agreed
upon value of $0.85, or a debenture as payment.  The debenture accrues
interest at the rate of 10% per annum, has a maturity date 18 months from the
date of issuance, and may be converted to common stock at the rate of $0.85 per
share.





On
September 22, 2008 we entered into another Amended and Restated Consent and
Waiver (the “September Agreement”) with the Debenture Holders.  The
September Agreement allowed us to pay the interest accrued on the Debentures,
which was to be paid on April 1, July 1 and October 1, 2008 as well as accrued
late fees with our securities.  Each holder of a Debenture was
permitted to choose to accept either shares of our common stock having an agreed
upon value of $0.85 or a debenture.  The debenture accrues interest at
the rate of 10% per annum, has a maturity date 18 months from the date of
issuance, and may be converted to common stock at the rate of $0.85 per
share.





On
November 21, 2008, the Company entered into another Amended and Restated Consent
and Waiver (the “November Agreement”) with the Debenture Holders.  The
November agreement allowed us to sell up to $1,200,000 in aggregate principal
amount of our 10% Convertible Promissory Notes, due eleven months from the date
of issuance and convertible into shares of Common Stock at a conversion price of
$1.25 per share. In consideration of the Waiver and the consent provided by the
holders, we agreed to accelerate the maturity date of the 18 month 10%
convertible debentures to September 12, 2009 and we agreed and acknowledged that
the 2006 Warrant Shares and the shares of Common Stock underlying the 18 month
10% convertible debentures issued or issuable to each of the holders in payment
of interest and liquidated damages pursuant to prior consent and waiver
agreements shall carry “piggyback” registration rights.





Item
14. Principal Accounting Fees and Services





The
following table sets forth fees billed to us by AJ. Robbins, PC and by KMJ
Corbin & Company LLP during the fiscal years ended December 31, 2007 and
December 31, 2008 for: (i) services rendered for the audit of our annual
financial statements and the review of our quarterly financial statements, (ii)
services that were reasonably related to the performance of the audit or review
of our financial statements and that are not reported as Audit Fees, (iii)
services rendered in connection with tax compliance, tax advice and tax
planning, and (iv) all other fees for services rendered.





December 31, 2007
                      
                      
                      December 31, 2008(i)
                      
                      Audit
      Fees
                      
                      $
                      169,935
                      
                      
                      $
                      119,732(ii)
                      
                      Audit
      Related Fees
                      
                      $
                      0
                      
                      
                      $
                      0(iii)
                      
                      Tax
      Fees
                      
                      $
                      6,207
                      
                      
                      $
                      6,685(iv)
                      
                      All
      Other Fees
                      
                      $
                      51,090
                      
                      
                      $
                      0




48


PART
IV





Item
15. Exhibits, Financial Statement Schedules





3.1
              
              Articles
      of incorporation of the registrant, as amended (1)3.2
              
              Bylaws
      of the registrant, as amended (1)10.1
              
              2005
      Stock Incentive Plan (1)10.2
              
              Amended
      and Restated 2006 Equity Incentive Plan (1)10.3
              
              Securities
      purchase agreement between registrant and each purchaser identified on the
      signature pages thereof dated as of September 12, 2006
  (1)10.4
              
              Employment
      agreement between the registrant and Gary Guseinov dated August 31, 2006
      (1)**10.5
              
              Employment
      agreement between the registrant and Igor Barash dated September 1, 2003
      (1)**10.6
              
              Independent
      Contractor Agreement between the registrant and Bing Liu dated August 30,
      2007 (1)**10.7
              
              Independent
      Contractor Agreement between the registrant and Michael Barrett dated
      January 25, 2008 (3)**10.8
              
              Form
      of Securities Purchase Agreement dated September 12, 2006
    (1)10.9
              
              Form
      of 10% Secured Convertible Debenture dated September 12, 2006
      (1)10.10
              
              Form
      of Registration Rights Agreement dated September 12, 2006
    (1)10.11
              
              Form
      of Warrant dated September 12, 2006 (1)10.12
              
              Form
      of Security Agreement dated September 12, 2006 (1)10.13
              
              Form
      of Subsidiary Guarantee dated September 12, 2006 (1)10.14
              
              Form
      of Escrow Agreement dated September 12, 2006 (1)10.15
              
              Form
      of Lock Up Agreement dated September 12, 2006 (1)10.16
              
              Consulting
      Agreement with New Castle Consulting LLC dated February 12, 2008
      (4)10.17
              
              Consulting
      Agreement with Kulman IR LLC dated February 14, 2008
(4)10.18
              
              Agreement
      for Internet Advertising Agent Services date May 16, 2008 between the
      registrant and WebMetro (5)10.19
              
              Consulting
      Agreement with Frontier Capital Partners LLC dated July 15, 2008
      (6)10.20
              
              Form
      of Indemnification Agreement entered into between the registrant and Gary
      Guseinov, Riggs Eckelberry, Ivan Ivankovich, Bing Liu, Igor Barash and
      John LaValle (1)**10.21
              
              Engagement
      letter between the registrant and Oceana Partners LLC
  (1)10.22
              
              Agreement
      date July 11, 2006 between the registrant and ARC Investment Partners, LLC
      (1)10.23
              
              Form
      of Securities Purchase Agreement for the sale of Units (August 2008)
      (7)10.24
              
              Form
      of Warrant to Purchase Common Stock (August 2008) (7)10.25
              
              Agreement
      to Defer Piggyback Registration Rights dated September 12, 2006
      (1)10.26
              
              Form
      of Note Conversion and Warrant Lock-Up Agreement (1)10.27
              
              Amendment
      to Registration Rights Agreement dated October 11, 2006 between the
      registrant and the purchasers of the registrant’s 10% Secured Convertible
      Debentures (1)10.28
              
              Common
      Stock Purchase Warrant issued to Newview Finance L.L.C. dated November 10,
      2008 (8)10.29
              
              Settlement
      Agreement between the registrant and Patrick Hinojosa
  (9)10.30
              
              Consent
      and Waiver dated as of March 23, 2007 between the registrant and the
      holders of the 10% Convertible Debentures dated September 12, 2006
      (1)10.31
              
              Description
      of agreement relating to advances between the registrant and Gary Guseinov
      (1)**10.32
              
              Description
      of agreement relating to advances between the registrant and Igor Barash
      (1)**10.33
              
              Amendment
      No. 3 to Independent Contractor Agreement dated April 24, 2007 between the
      registrant and Ivan Ivankovich (1)**10.34
              
              Form
      of 7.41% Senior Secured Note (10)10.35
              
              Form
      of Registration Rights Agreement executed in conjunction with the sale of
      7.41% Senior Secured Notes (10)10.36
              
              Form
      of Amended and Restated Security Agreement executed in conjunction with
      the sale of 7.41% Senior Secured Notes (10)10.37
              
              Form
      of Securities Purchase Agreement executed in conjunction with the sale of
      7.41% Senior Secured Notes (10)10.38
              
              Form
      of Common Stock Purchase Warrant issued in conjunction with the sale of
      7.41% Senior Secured Notes
(10)




49





10.39
              
              Consent
      and Waiver dated as of September 21, 2007 between the registrant and the
      holders of the 10% Secured Convertible Debentures dated September 12, 2006
      (11)10.40
              
              Form
      of Securities Purchase Agreement executed in conjunction with the sale of
      Units beginning in October 2007 (3)10.41
              
              Form
      of Warrant to Purchase Common Stock executed in conjunction with the sale
      of Units beginning in October 2007 (3)10.42
              
              Lease
      Agreement dated October 19, 2007 between the registrant and 617 7th
      Street Associates, LLC (12)10.43
              
              Amendment
      No. 4 dated October 22, 2007 to Independent Contractor Agreement
      originally dated April 24, 2007 between the registrant and Ivan
      Ivankovich(13)**10.44
              
              Independent
      Contractor Agreement dated January 29, 2007 between the registrant and
      Michael Barrett(3)**10.45
              
              Form
      of Securities Purchase Agreement (November 25, 2008/December 5, 2008)
      (14)10.46
              
              Form
      of 10% Convertible Promissory Note (November 25, 2008/December 5, 2008)
      (14)10.47
              
              Form
      of Common Stock Purchase Warrant (November 25, 2008/December 5, 2008)
      (14)10.48
              
              Form
      of Registration Rights Agreement (November 25, 2008/December 5, 2008)
      (14)10.49
              
              Form
      of Subordination Agreement (November 25, 2008/December 5, 2008)
      (14)10.50
              
              Consent
      and Waiver Agreement dated November 21, 2008 between the registrant and
      the holders of the 10% Secured Convertible Debentures dated September 12,
      2006 (November 25, 2008/December 5, 2008) (14)10.51
              
              Amended
      and Restated Consent and Waiver dated August 19, 2008 between the
      registrant and the holders of the 10% Secured Convertible Debentures dated
      September 12, 2006 (15)10.52
              
              Consent
      and Waiver dated September 22, 2008 between the registrant and the holders
      of the 10% Secured Convertible Debentures dated September 12, 2006
      (15)10.53
              
              Warrant
      to Purchase Common Stock issued to Guthy-Renker Match
  LLC*10.54
              
              Employment
      Agreement between the registrant and Kevin Harris* **10.55
              
              Amendment
      to Lease Agreement dated January 30, 2009 between the registrant and 617
      7th
      Street Associates, LLC *10.56
              
              Media
      and Marketing Services Agreement with GR Match, LLC*23.1
              
              Consent
      of KMJ Corbin & Company LLP*31.1
              
              Certification
      Pursuant to Rule 13a-14(a) and 15d-14(a) (4)*31.2
              
              Certification
      Pursuant to Rule 13a-14(a) and 15d-14(a) (4)*32
              
              Certification
      Pursuant to Section 1350 of Title 18 of the United States
      Code*




*Filed
herewith.


**
Denotes an agreement with management.


(1)
Incorporated by reference from the registrant’s Registration Statement on Form
SB-2, file no. 333-138430, filed with the Securities and Exchange Commission on
November 3, 2006.


(2)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on August 31, 2007.


(3)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on February 8, 2008.


(4)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on March 5, 2008.


(5)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on June 5, 2008.


(6)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on July 22, 2008.


(7)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on September 3,
2008.


(8)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on November 18,
2008.


(9)
Incorporated by reference from the registrant’s Quarterly Report on Form 10-Q
filed with the Securities and Exchange Commission on August 14,
2008.  This document is the subject of a confidential treatment
request therefore portions of it have been redacted. A full copy of the document
has been filed separately with the Securities and Exchange
Commission.


50





(10)
Incorporated by reference from the registrant’s Annual Report on Form 10-K filed
with the Securities and Exchange Commission on April 15,
2008.


(11)Incorporated by reference
from the registrant’s Quarterly Report on Form 10-QSB filed with the Securities
and Exchange Commission on November 16, 2007.


(12)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on November 19, 2007.


(13)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on October 24,
2007.


(14)
Incorporated by reference from the registrant’s Current Report on Form 8-K filed
with the Securities and Exchange Commission on December 5,
2008.


(15)
Incorporated by reference from the registrant’s Quarterly Report on Form 10-Q
filed with the Securities and Exchange Commission on November 14,
2008.


51





SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) 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.





Date:  March
      31, 2009
                  CYBERDEFENDER
      CORPORATIONBy:
                  /s/
      Gary GuseinovGary
      GuseinovChief
      Executive OfficerBy:
                  /s/
      Kevin HarrisKevin
      HarrisChief
      Financial Officer





Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities indicated
below on this 31st day of March 2009.





SIGNATURE,
      TITLE/s/ Gary GuseinovGary
      GuseinovPresident,
      Chief Executive Officer, and Director/s/ Kevin HarrisKevin
      HarrisChief
      Financial Officer/s/ Igor BarashIgor
      BarashDirector/s/ Bing LiuBing
      LiuDirector




52





CYBERDEFENDER
CORPORATION


Table
of Contents




PageReport
      of Independent Registered Public Accounting Firm
                    F-2Balance
      Sheets – December 31, 2008 and 2007
                    F-3Statements
      of Operations - For the Years Ended December 31, 2008 and
    2007
                    F-4Statements
      of Stockholders’ Deficit - For the Years Ended December 31, 2008 and
      2007
                    F-5Statements
      of Cash Flows - For the Years Ended December 31, 2008 and
    2007
                    F-6Notes
      to the Financial Statements
                    F-8


F-1


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




Board of
Directors and Stockholders





Cyberdefender
Corporation




We have
audited the accompanying balance sheets of Cyberdefender Corporation (the
“Company”) as of December 31, 2008 and 2007 and the related statements of
operations, stockholders’ deficit and cash flows for the years then
ended.  These financial statements are the responsibility of the
Company’s management.  Our responsibility is to express an opinion on
these financial statements based on our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company has determined that it is not required to have, nor were we engaged to
perform, an audit of its internal control over financial reporting. Our audits
included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the
Company’s internal control over financial reporting.  Accordingly, we
express no such opinion.  An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Cyberdefender Corporation as of
December 31, 2008 and 2007 and the results of its operations and its cash
flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America.





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern.  As discussed in Note 1 to the
financial statements, the Company has recurring losses from operations, negative
working capital, an accumulated deficit and has not generated significant
revenues to cover costs to date.  These factors raise substantial
doubt about the Company’s ability to continue as a going
concern.  Management’s plans in regard to these matters are also
described in Note 1.  The financial statements do not include any
adjustments relating to the recoverability and classification of asset carrying
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern.




/s/  KMJ | Corbin & Company
      LLPKMJ
      | Corbin & Company
LLP




Costa
Mesa, California


March 31,
2009


F-2





CYBERDEFENDER
CORPORATION


BALANCE
SHEETS





December
      31,
                                                
                                                
                                                December
      31,2008
                                                
                                                
                                                2007ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                                                
                                                $
                                                779,071
                                                
                                                
                                                $
                                                236,995Accounts
      receivable, net of allowance for doubtful accounts of $0
                                                
                                                
                                                204,635
                                                
                                                
                                                
                                                19,053Deferred
      financing costs, current
                                                
                                                
                                                324,200
                                                
                                                
                                                
                                                596,917Prepaid
      expenses
                                                
                                                
                                                689,478
                                                
                                                
                                                
                                                21,885Deferred
      charges, current
                                                
                                                
                                                811,542
                                                
                                                
                                                
                                                40,560Total
      Current Assets
                                                
                                                
                                                2,808,926
                                                
                                                
                                                
                                                915,410PROPERTY
      AND EQUIPMENT, net
                                                
                                                
                                                94,883
                                                
                                                
                                                
                                                129,643DEFERRED
      FINANCING COSTS, net of current portion
                                                
                                                
                                                -
                                                
                                                
                                                
                                                331,146DEFERRED
      CHARGES, net of current portion
                                                
                                                
                                                239,983
                                                
                                                
                                                
                                                -OTHER
      ASSETS
                                                
                                                
                                                26,196
                                                
                                                
                                                
                                                26,097Total
      Assets
                                                
                                                $
                                                3,169,988
                                                
                                                
                                                $
                                                1,402,296LIABILITIES AND STOCKHOLDERS’
      DEFICITCURRENT
      LIABILITIES:Accounts
      payable
                                                
                                                $
                                                3,798,645
                                                
                                                
                                                $
                                                647,976Accrued
      expenses
                                                
                                                
                                                331,229
                                                
                                                
                                                
                                                619,805Accrued
      expenses - registration rights agreement
                                                
                                                
                                                53,745
                                                
                                                
                                                
                                                166,297Current
      portion of deferred revenue
                                                
                                                
                                                4,025,026
                                                
                                                
                                                
                                                629,442Notes
      payable, net of discount
                                                
                                                
                                                -
                                                
                                                
                                                
                                                705,298Current
      portion of convertible notes payable, net of discount
                                                
                                                
                                                2,421,529
                                                
                                                
                                                
                                                -Current
      portion of capital lease obligations
                                                
                                                
                                                27,291
                                                
                                                
                                                
                                                24,271Total
      Current Liabilities
                                                
                                                
                                                10,657,465
                                                
                                                
                                                
                                                2,793,089CONVERTIBLE
      NOTES PAYABLE, net of discount, less current portion
                                                
                                                
                                                -
                                                
                                                
                                                
                                                1,235,035DEFERRED
      REVENUE, less current portion
                                                
                                                
                                                527,927
                                                
                                                
                                                
                                                -CAPITAL
      LEASE OBLIGATIONS, less current portion
                                                
                                                
                                                16,776
                                                
                                                
                                                
                                                41,347Total
      Liabilities
                                                
                                                
                                                11,202,168
                                                
                                                
                                                
                                                4,069,471COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS’
      DEFICIT:Common
      stock, no par value; 50,000,000 shares authorized; 17,350,798 and
      13,994,597 shares issued and outstanding at December 31, 2008 and December
      31, 2007, respectively
                                                
                                                
                                                6,381,921
                                                
                                                
                                                
                                                4,788,349Additional
      paid-in capital
                                                
                                                
                                                11,398,623
                                                
                                                
                                                
                                                7,105,428Accumulated
      deficit
                                                
                                                
                                                (25,812,724
                                                )
                                                
                                                
                                                (14,560,952
                                                )Total
      Stockholders’ Deficit
                                                
                                                
                                                (8,032,180
                                                )
                                                
                                                
                                                (2,667,175
                                                )Total
      Liabilities and Stockholders’ Deficit
                                                
                                                $
                                                3,169,988
                                                
                                                
                                                $
                                                1,402,296





See
accompanying notes to financial statements


F-3





CYBERDEFENDER
CORPORATION


STATEMENTS
OF OPERATIONS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





2008
                                            
                                            
                                            2007REVENUES:Net
      sales
                                            
                                            $
                                            4,887,759
                                            
                                            
                                            $
                                            2,220,154COST
      OF SALES
                                            
                                            
                                            767,115
                                            
                                            
                                            
                                            179,789GROSS
      PROFIT
                                            
                                            
                                            4,120,644
                                            
                                            
                                            
                                            2,040,365OPERATING
      EXPENSES:Advertising
                                            
                                            
                                            7,106,455
                                            
                                            
                                            
                                            614,857Product
      development
                                            
                                            
                                            530,010
                                            
                                            
                                            
                                            537,558Selling,
      general and administrative
                                            
                                            
                                            3,727,253
                                            
                                            
                                            
                                            3,198,073Invester
      relations and other related consulting
                                            
                                            
                                            1,265,616
                                            
                                            
                                            
                                            477,071Depreciation
      and amortization
                                            
                                            
                                            39,408
                                            
                                            
                                            
                                            101,025Total
      Operating Expenses
                                            
                                            
                                            12,668,742
                                            
                                            
                                            
                                            4,928,584LOSS
      FROM OPERATIONS
                                            
                                            
                                            (8,548,098
                                            )
                                            
                                            
                                            (2,888,219
                                            )OTHER
      EXPENSE:Other
      expense
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (4,413
                                            )Loss
      on registration rights agreement
                                            
                                            
                                            (216,540
                                            )
                                            
                                            
                                            (84,864
                                            )Interest
      expense
                                            
                                            
                                            (2,486,334
                                            )
                                            
                                            
                                            (2,887,827
                                            )Total
      Other Expenses
                                            
                                            
                                            (2,702,874
                                            )
                                            
                                            
                                            (2,977,104
                                            )LOSS
      BEFORE INCOME TAX EXPENSE
                                            
                                            
                                            (11,250,972
                                            )
                                            
                                            
                                            (5,865,323
                                            )INCOME
      TAX EXPENSE
                                            
                                            
                                            800
                                            
                                            
                                            
                                            800NET
      LOSS
                                            
                                            $
                                            (11,251,772
                                            )
                                            
                                            $
                                            (5,866,123
                                            )Basic
      and fully diluted net loss per share
                                            
                                            $
                                            (0.72
                                            )
                                            
                                            $
                                            (0.47
                                            )Weighted
      Average Shares Outstanding:Basic
      and fully diluted
                                            
                                            
                                            15,562,790
                                            
                                            
                                            
                                            12,439,759





See
accompanying notes to financial statements


F-4





CYBERDEFENDER
CORPORATION


STATEMENTS
OF STOCKHOLDERS’ DEFICIT


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





AdditionalCommon Stock
                                    
                                    
                                    Paid-in
                                    
                                    
                                    AccumulatedShares
                                    
                                    
                                    Amount
                                    
                                    
                                    Capital
                                    
                                    
                                    Deficit
                                    
                                    
                                    TotalBalance
      at December 31, 2006
                                    
                                    
                                    12,173,914
                                    
                                    
                                    $
                                    3,561,821
                                    
                                    
                                    $
                                    5,027,228
                                    
                                    
                                    $
                                    (8,694,829
                                    )
                                    
                                    $
                                    (105,780
                                    )Value
      of warrants issued with debt
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    370,390
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    370,390Conversion
      of bridge notes
                                    
                                    
                                    460,000
                                    
                                    
                                    
                                    460,000
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    460,000Issuance
      of shares for penalties and interest
                                    
                                    
                                    418,683
                                    
                                    
                                    
                                    363,153
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    363,153Sale
      of shares with warrants attached, net of issuance costs of
      $45,815
                                    
                                    
                                    654,500
                                    
                                    
                                    
                                    218,252
                                    
                                    
                                    
                                    390,433
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    608,685Issuance
      of shares and warrantsfor
      services
                                    
                                    
                                    287,500
                                    
                                    
                                    
                                    185,123
                                    
                                    
                                    
                                    418,946
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    604,069Shares
      contributed to third party directly by officers and directors for
      financing costs
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    400,000
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    400,000Compensation
      expense on vested options
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    498,431
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    498,431Net
      loss
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    (5,866,123
                                    )
                                    
                                    
                                    (5,866,123
                                    )Balance
      at December 31, 2007
                                    
                                    
                                    13,994,597
                                    
                                    
                                    
                                    4,788,349
                                    
                                    
                                    
                                    7,105,428
                                    
                                    
                                    
                                    (14,560,952
                                    )
                                    
                                    
                                    (2,667,175
                                    )Sale
      of shares with warrants attached, net of cash issuance costs of
      $112,757
                                    
                                    
                                    1,155,500
                                    
                                    
                                    
                                    139,504
                                    
                                    
                                    
                                    903,239
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    1,042,743Issuance
      of shares and warrantsfor
      services
                                    
                                    
                                    300,000
                                    
                                    
                                    
                                    393,673
                                    
                                    
                                    
                                    1,873,110
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    2,266,783Issuance
      of shares for penalties and interest
                                    
                                    
                                    271,091
                                    
                                    
                                    
                                    253,081
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    253,081Value
      of warrants issued in association with debt
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    83,590
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    83,590Conversion
      of OID notes and accrued interest
                                    
                                    
                                    744,749
                                    
                                    
                                    
                                    125,096
                                    
                                    
                                    
                                    619,653
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    744,749Conversion
      of convertible notes and accrued interest
                                    
                                    
                                    796,876
                                    
                                    
                                    
                                    681,683
                                    
                                    
                                    
                                    115,193
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    796,876Value
      of warrants and  Beneficial conversion feature of convertible
      notes payable
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    445,467
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    445,467Cashless
      warrant exercise
                                    
                                    
                                    37,985
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Exercise
      of stock options
                                    
                                    
                                    50,000
                                    
                                    
                                    
                                    535
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    535Compensation
      expense on vested options
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    252,943
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    252,943Net
      loss
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    (11,251,772
                                    )
                                    
                                    
                                    (11,251,772
                                    )Balance
      at December 31, 2008
                                    
                                    
                                    17,350,798
                                    
                                    
                                    $
                                    6,381,921
                                    
                                    
                                    $
                                    11,398,623
                                    
                                    
                                    $
                                    (25,812,724
                                    )
                                    
                                    $
                                    (8,032,180
                                    )





See
accompanying notes to financial statements


F-5





CYBERDEFENDER
CORPORATION


STATEMENTS
OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





2008
                                              
                                              
                                              2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                                              
                                              $
                                              (11,251,772
                                              )
                                              
                                              $
                                              (5,866,123
                                              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Loss
      on registration rights agreement
                                              
                                              
                                              216,540
                                              
                                              
                                              
                                              84,864Amortization
      of debt discount
                                              
                                              
                                              1,322,379
                                              
                                              
                                              
                                              1,459,575Depreciation
      and amortization
                                              
                                              
                                              39,408
                                              
                                              
                                              
                                              101,025Compensation
      expense from vested stock options
                                              
                                              
                                              252,943
                                              
                                              
                                              
                                              498,431Amortization
      of deferred financing costs
                                              
                                              
                                              702,061
                                              
                                              
                                              
                                              1,032,089Shares
      issued for penalties and interest
                                              
                                              
                                              253,081
                                              
                                              
                                              
                                              363,153Shares
      and warrants issued for services
                                              
                                              
                                              2,266,783
                                              
                                              
                                              
                                              604,069Changes
      in operating assets and liabilities:Accounts
      receivable
                                              
                                              
                                              (185,582
                                              )
                                              
                                              
                                              (14,846
                                              )Prepaid
      and other assets
                                              
                                              
                                              (667,593
                                              )
                                              
                                              
                                              39,034Deferred
      charges
                                              
                                              
                                              (1,010,965
                                              )
                                              
                                              
                                              41,253Other
      assets
                                              
                                              
                                              (99
                                              )
                                              
                                              
                                              -Accounts
      payable and accrued expenses
                                              
                                              
                                              3,059,002
                                              
                                              
                                              
                                              269,999Deferred
      revenue
                                              
                                              
                                              3,923,511
                                              
                                              
                                              
                                              (356,941
                                              )Cash
      Flows Used In Operating Activities
                                              
                                              
                                              (1,080,303
                                              )
                                              
                                              
                                              (1,744,418
                                              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
                                              
                                              
                                              (2,286
                                              )
                                              
                                              
                                              (5,424
                                              )Cash
      Flows Used In Investing Activities
                                              
                                              
                                              (2,286
                                              )
                                              
                                              
                                              (5,424
                                              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from notes payable and convertible notes payable, net of
      commissions
                                              
                                              
                                              954,300
                                              
                                              
                                              
                                              800,000Principal
      payments on notes payable
                                              
                                              
                                              (349,000
                                              )
                                              
                                              
                                              -Principal
      payments on capital lease obligations
                                              
                                              
                                              (23,913
                                              )
                                              
                                              
                                              (17,344
                                              )Proceeds
      from exercise of stock options
                                              
                                              
                                              535
                                              
                                              
                                              
                                              -Proceeds
      from sale of stock, net of cash issuance costs
                                              
                                              
                                              1,042,743
                                              
                                              
                                              
                                              654,500Cash
      Flows Provided by Financing Activities
                                              
                                              
                                              1,624,665
                                              
                                              
                                              
                                              1,437,156NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                                              
                                              
                                              542,076
                                              
                                              
                                              
                                              (312,686
                                              )CASH
      AND CASH EQUIVALENTS, beginning of year
                                              
                                              
                                              236,995
                                              
                                              
                                              
                                              549,681CASH
      AND CASH EQUIVALENTS, end of year
                                              
                                              $
                                              779,071
                                              
                                              
                                              $
                                              236,995





See
accompanying notes to financial statements


F-6





CYBERDEFENDER
CORPORATION


STATEMENTS
OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007




2008
                      
                      
                      2007Supplemental
      disclosures of cash flow information:Income
      taxes paid
                      
                      $
                      39
                      
                      
                      $
                      18,211Cash
      paid for interest
                      
                      $
                      36,203
                      
                      
                      $
                      17,769Supplemental
      schedule of non-cash financing activities:Property
      and equipment acquired through capital lease obligation
                      
                      $
                      2,362
                      
                      
                      $
                      22,716Discount
      on notes payable
                      
                      $
                      83,590
                      
                      
                      $
                      370,390Warrants
      issued in connection with sale of stock
                      
                      $
                      903,239
                      
                      
                      $
                      436,248Conversion
      of notes payable and accrued interest to common stock and
      warrants
                      
                      $
                      1,541,625
                      
                      
                      $
                      460,000Warrants
      issued in connection with debt conversion
                      
                      $
                      445,467
                      
                      
                      $
                      —Convertible
      notes payable issued as payment for accrued interest and
      penalties
                      
                      $
                      440,784
                      
                      
                      $
                      —Deferred
      financing costs to be paid by issuance of stock
                      
                      $
                      —
                      
                      
                      $
                      400,000





See
accompanying notes to financial statements


F-7




CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
1 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES





Organization and
Business


The
Company, based in Los Angeles, California, is a provider of secure content
management software. The Company develops and licenses security software and
related services. The Company continues to bring to market advanced solutions to
combat and prevent online information theft, unwanted advertisements, spam,
Internet viruses, spyware and related computer threats.





Going Concern and
Management’s Plans


Historically,
the Company’s revenues were derived from subscriptions to CyberDefender
Anti-Spyware 2006, which included the initial download and one year of updates.
The license to use the software was renewed annually with incentives for early
renewals. The Company acquired new users with an online direct purchase offer.
The offer, toscan
a computer for spyware and then pay for removal of spyware, was broadcast in
emails, banners and search ads.





In
November 2006, the Company launched its new Internet security suite called
CyberDefender FREE 2.0 that is free to the subscriber. Revenues are earned from
advertising networks which pay the Company to display advertisements inside the
software. CyberDefender Early Detection Center is a version of the same
software, without the advertising, which is paid for by the subscriber. The
annual subscription rate during 2008 for the version without ads ranged from
$12.99 to $49.99, depending on the marketing or distribution channels used by
the Company.





On
September 27, 2007, the Company announced the launch of CyberDefenderULTIMATETM
and CyberDefenderCOMPLETETM.  These are enhanced versions of its
security software.  For an annual fee, CyberDefenderULTIMATETM provides
year round support for any software or hardware connected to a subscriber’s
computer while CyberDefenderCOMPLETETM provides a one-time fix to a customer’s
computer and a year-round unlimited anti-malware support for a subscriber’s
computer.  These new security suites also include 2 gigabytes of
online backup.  These products are sold for $99.95 to $299.99,
depending on the marketing or distribution channels used by the
Company.





On
November 20, 2008, the Company announced the launch of CyberDefender Registry
CleanerTM.  The CyberDefender Registry CleanerTM eliminates clutter and
junk that builds up within a computer's registry due to the installation and
removal of programs, deletion and creation of files and cached records from Web
surfing.  The annual subscription rate ranges from $19.99 to $29.98,
depending on the marketing or distribution channels used by the
Company.





The
Company’s financial statements have been presented on the basis that it is a
going concern, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. The Company has incurred net
losses of $11,251,772 and $5,866,123 during the years ended December 31, 2008
and 2007, respectively, and has negative working capital of $7,848,539 and an
accumulated deficit of $25,812,724 at December 31, 2008, which raises
substantial doubt about its ability to continue as a going concern. Until sales
of the products provide the Company with the revenue it needs to attain
profitability, the Company intends to continue to raise money for operating
capital through sales of its securities or by borrowing money.  From
inception through December 31, 2008, the Company has raised $6,080,000 from
debt financing and $1,810,000 from equity financing to develop software and to
build out a management team capable of delivering its products to market. The
Company’s ability to continue as a going concern is dependent upon its ability
to develop additional sources of capital. Management cannot assure that any
future financing arrangements will be available in amounts or on terms
acceptable to the Company. If additional future financing is not available or is
not available on acceptable terms, the Company may be unable to continue its
operations. The accompanying financial statements do not include any adjustments
that might result from the outcome of these uncertainties.





The
Company currently has no firm agreements with any third parties for any future
transactions and future financings.





Reclassification


To
conform to the current year's presentation, as a result of management's
continuing analysis of its operating activities, the Company reclassified
$179,789 related to amounts previously classified as operating expense to costs
of sales with no effect on previously reported net loss. In
addition, the Company reclassified $477,071 related to investor relations
and other related consulting from interest
expense.


F-8


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES (Continued)





Use of
Estimates


The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Significant estimates made by management are, among
others, realization of accounts receivables, recoverability of prepaid expense,
deferred charges and long-lived assets, value of shares and options/warrants
granted and valuation of deferred tax assets. Actual results could differ from
those estimates and assumptions.





Cash and Cash
Equivalents


Cash and
cash equivalents include cash on hand and investments with original maturities
of three months or less.





Property and
Equipment


Property
and equipment are recorded at cost. Expenditures for major additions and
improvements are capitalized and minor replacements, maintenance, and repairs
are charged to expense as incurred. When equipment is retired or otherwise
disposed of, the cost and accumulated depreciation are removed from the accounts
and any resulting gain or loss is included in the results of operations for the
respective period. Depreciation is provided over the estimated useful lives of
the related assets ranging from three to seven years, using the straight-line
method.




Equipment under Capital
Lease


The
Company leases certain of its furniture and other equipment under agreements
accounted for as capital leases. The assets and liabilities under capital lease
are recorded at the lesser of the present value of aggregate future minimum
lease payments, including estimated bargain purchase options, or the fair value
of the assets under lease. Assets under capital lease are depreciated using the
straight-line method over their estimated useful lives.





Fair Value of Financial
Instruments


Unless
otherwise specified, the Company believes the carrying value of financial
instruments approximates their fair value.





Revenue
Recognition


The
Company recognizes revenue from the sale of software licenses under the guidance
of  Statement of Position (“SOP”)  No. 97-2, “Software Revenue
Recognition,” as amended by SOP No. 98-9, “Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions” and SEC Staff
Accounting Bulletin (“SAB”) No. 101 “Revenue Recognition in Financial
Statements” as amended by SAB 104.





Specifically,
the Company recognizes revenues from its products when all of the following
conditions for revenue recognition are met:





i.
            
            persuasive
      evidence of an arrangement exists,ii.
            
            the
      product or service has been delivered,iii.
            
            the
      fee is fixed or determinable, andiv.
            
            collection
      of the resulting receivable is reasonably
  assured.





The
Company currently sells four products, CyberDefender Early Detection Center
(“EDC”), an antivirus and anti spyware software, CyberDefender Registry Cleaner,
CyberDefenderULTIMATETM and CyberDefenderCOMPLETETM, over the Internet. The
Company also offers a backup CD of the EDC software for an additional fee.
CyberDefenderCOMPLETETM offers customers one-time technical support and a license
for EDC, while CyberDefenderULTIMATETM offers customers unlimited technical
support for a specified period and a license for EDC. Customers order the
product and simultaneously provide their credit card information to the Company.
Upon receipt of authorization from the credit card issuer, the Company provides
technical support if the customer purchased CyberDefenderULTIMATETM or
CyberDefenderCOMPLETETM and licenses the customer to download EDC over the
Internet. As part of the sales price, the Company provides renewable product
support and content updates, which are separate components of product licenses
and sales. Term licenses allow customers to use the Company’s products and
receive product support coverage and content updates for a specified period,
generally twelve months. The Company invoices for product support, content
updates and term licenses at the beginning of the term. These revenues contain
multiple element arrangements where “vendor specific objective evidence”
(“VSOE”) may not exist for one or more of the elements. EDC and
CyberDefenderULTIMATETM are in substance a subscription and the entire fee is
deferred and is recognized ratably over the term of the arrangement according to
the guidance in SOP 97-2 paragraph 49. Revenue is recognized immediately for the
sale of the backup CD, CyberDefender Registry Cleaner and for the portion of the
sale of CyberDefenderCOMPLETETM that relates to the one-time technical support as
the Company believes that all of the elements necessary for revenue recognition
have occurred.





The
Company also uses third parties to sell its software and therefore evaluates the
criteria of Financial Accounting Standards Board ("FASB") Emerging Issues Task
Force ("EITF") Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus
Net as an Agent,” in determining whether it is appropriate to record the gross
amount of revenue and related costs or the net amount earned as commissions. The
Company is the primary obligor, is subject to inventory risk, has latitude in
establishing prices and selecting suppliers, establishes product specifications,
and has the risk of loss. Accordingly, the Company's revenue is recorded on a
gross basis.





The
Company also offers two products which are free to the subscriber, CyberDefender
FREE 2.0 and MyIdentityDefender Toolbar. Revenues are earned from advertising
networks which pay the Company to display advertisements inside the software or
through the toolbar search. Under the guidance of SAB 104, the Company
recognizes revenue from the advertising networks monthly based on a rate
determined either by the quantity of the ads displayed or the performance of the
ads based on the amount of times the ads are clicked by the user. Furthermore,
advertising revenue is recognized provided that no significant Company
obligations remain at the end of a period and collection of the resulting
receivable is probable. The Company’s obligations do not include guarantees of a
minimum number of impressions.


F-9




CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES (Continued)





Deferred
Charges


The
Company uses a third party to provide technical support services associated with
the CyberDefenderCOMPLETETM and CyberDefenderULTIMATETM products.  The
costs associated with this service are deferred and amortized against the
recognition of the related sales revenue.





In
addition, the Company uses a third party to process a portion of its product
renewal sales. The Company pays a direct acquisition fee to the processor for
each completed sale. These direct acquisition fees are deferred and recognized
ratably over the term of the arrangement of the associated sale in accordance
with FASB Technical Bulletin 90-1, “Accounting for Separately Priced Extended
Warranty and Product Maintenance Contracts.” The third party processor refunds
any direct acquisition fee on any credit card chargeback or on any product that
is returned. The refunds are matched against the associated chargebacks and
product returns.





Reserves for Product
Returns


The
Company’s policy with respect to product returns is defined in its End User
License Agreement (“EULA”), which states “...products purchased that are
downloadable are refundable within the first 30 days after the date of
purchase.” Product returns are generally received within 30 days of the original
sale and are charged against the associated sale upon receipt of the
return.  A chargeback occurs after a customer is automatically charged and
subsequently, within 30 days, decides not to continue using the license or the
credit card processed is no longer valid.  The Company’s third party
processor of sales is usually notified within 30 days by customers that they no
longer wish to license the Company’s product.  The third party processor
reduces the amounts due to the Company as a result of any chargeback during the
preceding 30 day period.  As a result, a majority of chargebacks occur
within 30 days of the sale event and are recorded prior to closing the previous
month’s accounting records.  The Company may voluntarily accept returns
from a customer. The returns are charged against revenues upon receipt. As of
December 31, 2008 and 2007, the Company had $0 accrued for customer returns and
chargebacks, based on historical returns.





Concentrations of
Risk


Revenues
are concentrated in the software industry which is highly competitive and
rapidly changing. 
Significant technological changes in the industry or customer requirements, or
the emergence of competitive products with new technologies or capabilities
could adversely affect operating results.





As of
December 31, 2008, all of our cash and cash equivalents were maintained at a
major financial institution in the United States. At times, deposits held with
the financial institution may exceed the amount of insurance provided on such
deposits. Generally, these deposits may be redeemed upon demand and, therefore,
are believed to bear low risk. Effective October 3, 2008, the Emergency Economic
Stabilization Act of 2008 raised the Federal Deposit Insurance Corporation
deposit coverage limits to $250,000 per owner from $100,000 per owner. This
program is currently available through December 31, 2009.  As of
December 31, 2008, the Company had a balance of approximately $799,000 in excess
of the FDIC limit.





Advertising
expenses are expensed as incurred and consist primarily of various forms of
media purchased from Internet-based marketers and search engines. For the years
ended December 31, 2008 and 2007, advertising expense amounted to $7,106,455 and
$614,857, respectively.  Advertising purchased from four vendors
accounted for 92% and 45% of the Company’s total advertising expense for the
years ended December 31, 2008 and 2007, respectively.





Income
Taxes


The
Company has adopted the liability method of accounting for income taxes pursuant
to Statement of Financial Accounting Standard (“SFAS”) No. 109, “Accounting for
Income Taxes.” Under SFAS No. 109, deferred income taxes are recorded to reflect
tax consequences on future years for the differences between the tax bases of
assets and liabilities and their financial reporting amounts at each year-end.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statements
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets, including tax loss and credit carryforwards, and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.





Deferred
income tax expense represents the change during the period in the deferred tax
assets and deferred tax liabilities. The components of the deferred tax assets
and liabilities are individually classified as current and non-current based on
their characteristics. Deferred tax assets are reduced by a valuation allowance
when, in the opinion of management, it is more likely than not that some portion
or all of the deferred tax assets will not be realized.





Effective
January 1, 2007, the Company adopted the provisions of Financial Accounting
Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes,” (“FIN 48”). FIN 48 prescribes recognition thresholds that must be
met before a tax position is recognized in the financial statements and provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosure, and transition. Under FIN 48, an entity may only
recognize or continue to recognize tax positions that meet a “more likely than
not” threshold. The Company did not make any adjustment to opening retained
earnings as a result of the implementation.




F-10


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES (Continued)





Income Taxes
(Continued)


Based on
its evaluation, the Company has concluded that there are no significant
uncertain tax positions requiring recognition in its financial statements. The
Company’s evaluation was performed for the tax years ended December 31,
2004 through 2008 for U.S. Federal Income Tax and for the tax years ending
December 31, 2003 through 2008 for the State of California Income
Tax.





The
Company does not have any unrecognized tax benefits as of December 31, 2008
that, if recognized, would affect the Company’s effective income tax
rate.





The
Company’s policy is to recognize interest and penalties related to income tax
issues as components of income tax expense. The Company did not recognize or
have any accrual for interest and penalties relating to income taxes as of
December 31, 2008.





Software Development
Costs


The
Company accounts for software development costs in accordance with SFAS No. 86,
“Computer Software to Be Sold, Leased, or Otherwise Marketed.” Such costs are
expensed prior to achievement of technological feasibility and thereafter are
capitalized. There have been very limited software development costs incurred
between the time the software and its related enhancements have reached
technological feasibility and its general release to customers. As a result, all
software development costs have been charged to product development expense. For
the years ended December 31, 2008 and 2007, product development costs were
$530,010 and $537,558, respectively.





Recently Issued Accounting
Pronouncements


The
Company has adopted all accounting pronouncements effective before December 31,
2008 which are applicable to the Company.





In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements.” This statement clarifies the definition of fair value,
establishes a framework for measuring fair value and expands the disclosures on
fair value measurements. SFAS No. 157 is effective for fiscal years
beginning after November 15, 2007.  FASB Staff Position
No. FAS 157-2 (“FSP 157-2”), “Effective Date of FASB Statement
No. 157,”was
issued in February 2008.  FSP 157-2 delays the effective date of
SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except
for items that are recognized or disclosed at fair value at least once a year,
to fiscal years beginning after November 15, 2008, and for interim periods
within those fiscal years. Effective January 1, 2008, the Company adopted
SFAS 157 for financial assets and liabilities recognized at fair value on a
recurring basis. The partial adoption of SFAS 157 for financial assets and
liabilities had no impact on the Company’s financial position, results of
operations or cash flows. Management does not expect the adoption of the FSP to
have a material impact on the Company’s financial statements.





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations”
(“SFAS 141R”). SFAS 141R establishes principles and requirements for
how an acquirer recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, any noncontrolling
interest in the acquiree and the goodwill acquired. SFAS 141R also
establishes disclosure requirements to enable the evaluation of the nature and
financial effects of the business combination. This statement is effective
for the Company beginning January 1, 2009. The Company does not
expect the adoption of this statement to have a material impact on the
Company's consolidated financial statements unless the Company enters
into business acquisitions in the future.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles.” SFAS 162 identifies the sources of accounting principles
and the framework for selecting the principles used in the preparation of
financial statements. SFAS No. 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.” Management does not currently expect the
adoption of SFAS No. 162 to have a material impact on the Company’s financial
statements.





In June
2008, the Emerging Issues Task Force of the FASB published EITF Issue 07-5
“Determining Whether an Instrument is Indexed to an Entity’s Own Stock” (“EITF
07-5”) to address concerns regarding the meaning of “indexed to an entity’s own
stock” contained in FASB Statement 133 “Accounting for Derivative Instruments
and Hedging Activities”.  This related to the determination of whether
a free-standing equity-linked instrument should be classified as equity or
debt.  If an instrument is classified as debt, it is valued at fair
value, and this value is re-measured on an ongoing basis, with changes recorded
in earnings in each reporting period.  EITF 07-5 is effective for
years beginning after December 15, 2008 and earlier adoption is not
permitted.  Although EITF 07-5 is effective for fiscal years beginning
after December 15, 2008, any outstanding instrument at the date of adoption will
require a retrospective application of the accounting through a cumulative
effect adjustment to retained earnings upon adoption.  The Company is
currently evaluating the impact of EITF 07-5 on its financial position and
results of operations.


F-11


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES (Continued)





Loss Per
Share


In
accordance with SFAS No. 128, “Earnings Per Share”, the basic loss per
common share is computed by dividing net loss available to common stockholders
by the weighted average number of common shares outstanding.  Diluted loss
per common share is computed similar to basic loss per common share except that
the denominator is increased to include the number of additional common shares
that would have been outstanding if the potential common shares had been issued
and if the additional common shares were dilutive. As of December 31, 2008 and
2007, there were 14,807,513 and 10,138,067 shares of potentially dilutive
securities outstanding, respectively. As the Company reported a net
loss, none of the potentially dilutive securities were included in the
calculation of diluted earnings per share since their effect would be
anti-dilutive for that reporting period.





Stock Based
Compensation


The
Company applies SFAS No. 123 (Revised 2004), “Share Based Payment”
(“SFAS No. 123R”), which requires companies to measure and recognize the
cost of employee services received in exchange for an award of equity
instruments based on the grant-date fair value. Share-based compensation
recognized under the modified-prospective transition method of SFAS
No. 123R includes share-based compensation based on the grant-date fair
value determined in accordance with the original provisions of SFAS
No. 123, “Accounting for Stock-Based Compensation,” for all share-based
payments granted prior to and not yet vested as of January 1, 2006 and
share-based compensation based on the grant-date fair value determined in
accordance with SFAS No. 123R for all share-based payments granted after
January 1, 2006. For non-employee stock based compensation, the
Company recognizes an expense in accordance with SFAS No. 123 and values
the equity securities based on the fair value of the security on the date of
grant. For stock-based awards the value is based on the market value of the
stock on the date of grant or the value of services, whichever is more readily
available. Stock option awards are valued using the Black-Scholes option-pricing
model.





The
Company accounts for equity instruments issued to consultants and vendors in
exchange for goods and services in accordance with the provisions of EITF Issue
No. 96-18, “Accounting for Equity Instruments that are Issued to Other than
Employees for Acquiring, or in Conjunction with Selling Goods or Services”, and
EITF Issue No. 00-18, “Accounting Recognition for Certain Transactions Involving
Equity Instruments Granted to Other than Employees”. The measurement date for
the fair value of the equity instruments issued is determined at the earlier of
(i) the date at which a commitment for performance by the consultant or vendor
is reached or (ii) the date at which the consultant or vendor’s performance is
complete. In the case of equity instruments issued to consultants, the fair
value of the equity instrument is recognized over the term of the consulting
agreement.





In
accordance with EITF Issue No. 00-18, an asset acquired in exchange for the
issuance of fully vested, non-forfeitable equity instruments should not be
presented or classified as an offset to equity on the grantor’s balance sheet
once the equity instrument is granted for accounting purposes. Accordingly, the
Company records the fair value of the fully vested, non-forfeitable common stock
issued for future consulting services as prepaid expense in its balance
sheet.





NOTE
2 – RESTRICTED CASH





Under a
credit card processing agreement with a financial institution the Company was
required to maintain a security reserve deposit as collateral.  The
amount of the deposit was at the discretion of the financial institution and as
of December 31, 2008 and 2007 was $15,000 and $8,592,
respectively.  This amount is included in prepaid expenses on the
accompanying balance sheets.





NOTE
3 – PROPERTY AND EQUIPMENT





Property
and equipment consists of the following:





December
      31,
                  
                  
                  December
      31,2008
                  
                  
                  2007Furniture
      and fixtures
                  
                  $
                  121,370
                  
                  
                  $
                  119,007Office
      equipment
                  
                  
                  88,294
                  
                  
                  
                  88,294Software
                  
                  
                  10,766
                  
                  
                  
                  8,481220,430
                  
                  
                  
                  215,782Less
      accumulated depreciation
                  
                  
                  (125,547
                  )
                  
                  
                  (86,139
                  )Net
      property and equipment
                  
                  $
                  94,883
                  
                  
                  $
                  129,643





NOTE
4 – INTANGIBLE





In
January 2005, the Company entered into an asset purchase agreement with Unionway
Int’l, LLC whereby the Company purchased certain assets of Unionway Int’l, LLC
that principally included the software application Cyber-DefenderTM and
associated rights for $200,000 through the issuance of a note payable. The
software technology purchased from Unionway Int’l, LLC is the core of the
Company’s existing product. The asset is being amortized over the expected life
of three years on a straight line basis. The amortization for the year ended
December 31, 2008 and 2007 is $0 and $66,667, respectively and the accumulated
amortization is $200,000 as of December 31, 2008 and 2007.


F-12


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
5 - INCOME TAXES





In July
2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No.109” ("FIN 48"), which
clarifies the accounting and disclosure for uncertainty in tax positions, as
defined.  FIN 48 seeks to reduce the diversity in practice associated
with certain aspects of the recognition and measurement related to accounting
for income taxes.  As of January 1, 2007, the Company became subject
to the provision of FIN 48.  The cumulative effect, if any, of
applying FIN 48 was to be reported as an adjustment to the opening balance of
retained earnings in the year of adoption.  The Company did not record
a cumulative effect adjustment upon the adoption of FIN 48.  As of
December 31, 2008, the Company has concluded that its income tax filing
positions will be sustained on audit and does not anticipate any adjustments
that will result in a material change to its financial
position.  Therefore, to date, no reserves for uncertain income tax
positions have been recorded pursuant to FIN 48.




The
Company is subject to taxation in the United States and the State of
California.  The Company is subject to examination for tax years 2005
forward by the United States and the tax years 2004 forward by
California.  The Company may be, due to unused net operating losses,
subject to examination for earlier years.




The
Company recognizes interest and/or penalties related to income tax matters in
income tax expense.  As of December 31, 2008 and 2007, the Company did
not recognize interest and/or penalties related to income tax
expense.




Deferred
income taxes reflect the tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting and income
tax purposes.  A valuation allowance is established when uncertainty
exists as to whether all or a portion of the net deferred tax assets will be
realized.




Components
of the net deferred tax asset as of December 31, 2008 and 2007 are approximately
as follows (in thousands):





December 31,2008
                    
                    
                    2007Deferred
      tax assetsNet
      operating loss carryforwards
                    
                    
                    5,183,635
                    
                    
                    
                    3,671,742Stock
      compensation expense
                    
                    
                    295,102
                    
                    
                    
                    241,328Accrued
      liabilities
                    
                    
                    59,925
                    
                    
                    
                    106,716Contingent
      liabilities
                    
                    
                    20,208
                    
                    
                    
                    62,528Accounts
      payable
                    
                    
                    18,800
                    
                    
                    
                    18,800AMT
      credit carryforwards
                    
                    
                    17,226
                    
                    
                    
                    17,226Charitable
      contribution carryforwards
                    
                    
                    9,400
                    
                    
                    
                    9,400Total
      gross deferred tax assets
                    
                    
                    5,604,296
                    
                    
                    
                    4,127,740Deferred
      tax liabilitiesDepreciation/amortization
                    
                    
                    (13,387
                    )
                    
                    
                    (17,252
                    )Deferred
      Royalty
                    
                    
                    (9,224
                    )
                    
                    
                    -Total
      gross deferred tax liabilites
                    
                    
                    (22,611
                    )
                    
                    
                    (17,252
                    )Net
      deferred tax asset (liability)
                    
                    
                    5,581,685
                    
                    
                    
                    4,110,488Less
      valuation allowance
                    
                    
                    (5,581,685
                    )
                    
                    
                    (4,110,488
                    )Net
      deferred tax assets
                    
                    
                    -
                    
                    
                    
                    -





The
Company’s effective income tax rate differs from the statutory federal income
tax rate as follows for the years ended December 31, 2008 and 2007:




December 31,2008
                      
                      
                      2007Federal
      tax benefit rate
                      
                      
                      (34.0
                      )%
                      
                      
                      (34.0
                      )%State
      tax benefit, net of federal benefit
                      
                      
                      (1.8
                      )%
                      
                      
                      (2.5
                      )%Debt
      Discount Amortization
                      
                      
                      3.9
                      %
                      
                      
                      8.5
                      %Investor
      Relations Consulting
                      
                      
                      5.6
                      %
                      
                      
                      0.0
                      %Warrants
      Issued for Services
                      
                      
                      7.3
                      %
                      
                      
                      0.0
                      %Other
                      
                      
                      6.1
                      %
                      
                      
                      0.1
                      %Valuation
      Allowance
                      
                      
                      12.9
                      %
                      
                      
                      27.9
                      %Effective
      income tax rate
                      
                      
                      0.00
                      %
                      
                      
                      0.00
                      %





As
required by SFAS No. 109, the change in the valuation allowance for the years
ended December 31, 2008 and 2007 was $1,471,197 and $1,641,158, respectively,
for income taxes.





At
December 31, 2008, the Company had federal and state net operating loss
carryforwards of $13,786,263 and $13,660,459 available, respectively, to reduce
future taxable income and which will expire at various dates beginning in
2015.




Pursuant
to Internal Revenue Code Sections 382 and 383, the use of the Company’s net
operating loss and credit carryforwards may be limited if a cumulative change in
ownership of more than 50% occurs within a three-year period.  The
annual limitation may result in the expiration of net operating losses and
credits before utilization.




The
Company has not completed a study to assess whether an ownership change has
occurred or whether there have been multiple ownership changes since the
Company's formation due to the complexity and cost associated with such a study,
and the fact that there may be additional such ownership changes in the future.
If the Company has experienced an ownership change at any time since its
formation, utilization of the NOL carryforwards would be subject to an annual
limitation under Section 382 of the Code, which is determined by first
multiplying the value of the Company's stock at the time of the ownership change
by the applicable long-term, tax-exempt rate, and then could be subject to
additional adjustments, as required. Any limitation may result in expiration of
a portion of the NOL carryforwards before utilization. Further, until a study is
completed and any limitation known, no amounts are being considered as an
uncertain tax position or disclosed as an unrecognized tax benefit under FIN 48.
Due to the existence of the valuation allowance, future changes in the Company's
unrecognized tax benefits will not impact its effective tax rate. Any
carryforwards that will expire prior to utilization as a result of such
limitations will be removed from deferred tax assets with a corresponding
reduction of the valuation allowance.




F-13





CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
6 – STOCKHOLDERS’ DEFICIT





Common
Stock


On August
15, 2007, the Company issued to Oceana Partners 50,000 shares of the Company’s
common stock in consideration for research coverage valued at $50,000 for a
twelve month period commencing August 1, 2007 thru July 31, 2008. The entire
$50,000 was recognized as selling, general and administrative costs in the
accompanying statement of operations for the year ended December 31, 2007. On
October 22, 2007, the Company entered into an agreement with Oceana Partners
pursuant to which the Company agreed to issue to Oceana Partners warrants to
purchase 400,000 shares of our common stock in exchange for research coverage
valued at $477,071 for services provided in 2007. The agreement was amended on
November 30, 2007. Pursuant to the amendment, the Company agreed to issue 37,500
shares of common stock to designees of Oceana Partners and to reduce the number
of shares of common stock covered by the warrants issued to Oceana Partners from
400,000 shares to 362,500 shares. The entire $477,071 was recognized
in investor relations and other related consulting in the accompanying
statement of operations for the year ended December 31, 2007.





On August
17, 2007, the Company issued to Richardson & Patel, its legal counsel,
100,000 shares of the Company’s common stock as payment for general corporate
legal services rendered that amounted to $23,578 that was recognized as selling,
general and administrative expense in the accompanying statement of operations
for the year ended December 31, 2007.





On
October 24, 2007, the Company issued to Richardson & Patel, its legal
counsel, 100,000 shares of the Company’s common stock as payment for general
corporate legal services rendered that amounted to $53,420 that was recognized
as selling, general and administrative expense in the accompanying statement of
operations for the year ended December 31, 2007.





On
October 18, 2007, the Company began an offering of units.  Each unit
consisted of 25,000 shares of common stock and a warrant to purchase 18,750
shares of common stock at an exercise price of $1.25 per share.  The
warrants have a term of five years.  Pursuant to the warrant
agreements, from and after the warrant issue date, in the event the Company
sells common stock for less than the then exercise price or issues securities
convertible into or exercisable for common stock at a conversion price or
exercise price less than the then exercise price (a “Dilutive Issuance”), then
the exercise price shall be multiplied by a fraction, the numerator of which is
the number of shares of common stock sold and issued at the closing of such
Dilutive Issuance plus the number of shares which the aggregate offering price
of the total number of shares of common stock sold and issued at the closing of
such Dilutive Issuance would purchase at the then exercise price, and the
denominator of which is the number of shares of common stock issued and
outstanding on the date of such Dilutive Issuance plus the number of additional
shares of common stock sold and issued at the closing of such Dilutive
Issuance.  The purchase price was $25,000 per unit.  During
the fourth quarter of 2007, the Company issued 654,500 shares and raised
$654,500 through this offering.  The 490,875 warrants issued in
connection with the units were valued at $436,248 using the Black-Scholes option
pricing model with the following assumptions: term of 5 years, a risk-free
interest rate of 4.52%, a dividend yield of 0% and volatility of
142%.  Issuance costs consisted of a 7% cash fee and 32,200 warrants
at $1.00 per share valued at $29,054 based on the following assumptions: term of
5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and
volatility of 142%. Issuance
costs of $45,815 as of December 31, 2007 were recorded in accrued expense on the
accompanying balance sheet.





During
February and March, 2008, the Company issued 175,000 shares and raised $175,000
through this offering.  The 131,250 warrants issued in connection with
the units were valued at $118,058 using the Black-Scholes option pricing model
with the following assumptions: term of 5 years, a risk-free interest rate of
4.52%, a dividend yield of 0% and volatility of 146-148%.  Issuance
costs consisted of a 7% cash fee and additional 8,750 warrants at $1.00 per
share valued at $7,895 based on the following assumptions: term of 5 years, a
risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of
146%.  In May 2008 the Company updated the agreement prospectively
with the placement agent to increase both the cash and warrant placement fees
from 7% to 9% as well as to provide to the placement agent a 2.5% cash expense
allowance.





During
June, 2008, the Company issued 400,000 shares of common stock and raised
$354,000, net of placement fees, through this offering.  The 300,000
warrants issued in connection with the units were valued at $271,438 using the
Black-Scholes option pricing model with the following assumptions: term of 5
years, a risk-free interest rate of 3.88%, a dividend yield of 0% and volatility
of 111%.  Issuance costs consisted of a 9% cash fee, 2.5% expense
allowance and 36,000 warrants at $1.00 per share valued at $38,761 based on the
following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a
dividend yield of 0% and volatility of 146%.





During
July and August, 2008, the Company issued 580,500 shares of common stock and
raised $513,743, net of placement fees, through this offering.  The
435,375 warrants issued in connection with the units were valued at $468,931
using the Black-Scholes option pricing model with the following assumptions:
term of 5 years, a risk-free interest rate of 3.88%, a dividend yield of 0% and
volatility of 110-116%.  Issuance costs consisted of a 9% cash fee,
2.5% expense allowance and 52,245 warrants at $1.00 per share valued at $44,812
based on the following assumptions: term of 5 years, a risk-free interest rate
of 3.88%, a dividend yield of 0% and volatility of 110-116%.





On
February 12, 2008, the Company entered into a consulting agreement with New
Castle Consulting.Pursuant
to this agreement, New Castle will provide investor relations services to the
Company for a period of 6 months in exchange for payment of $4,500, which was
made in conjunction with the execution of the agreement, a monthly fee of $4,500
the payment of which began in March 2008, the issuance of 100,000 shares of
restricted common stock valued at $100,000 and an indemnity.  As the
shares were unforfeitable upon issuance and there was no guarantee of future
benefit to be provided, the value of the shares was expensed upon issuance
to investor relations and other related
consulting expense.





On
February 14, 2008, the Company entered into a consulting agreement with Kulman
IR.  Pursuant to this agreement, Kulman will provide investor
relations services to us for a period of 12 months in exchange for a monthly fee
of $3,500, the issuance of 100,000 shares of restricted common stock valued at
$100,000, the payment of pre-approved expenses incurred by Kulman in discharging
its obligations under the agreement and cross-indemnities.  In regards
to the stock that was issued, 50,000 shares vested immediately, 25,000 shares
vested on August 7, 2008 and the remaining 25,000 shares were to vest on October
7, 2008.  During August 2008, the Company terminated the agreement and
cancelled the 25,000 unvested shares.  As there was no guarantee of
future benefit to be provided, the value of the vested shares of $100,000 was
expensed in 2008 to investor relations and other related
consulting.





On July
15, 2008, the Company entered into a consulting agreement with Frontier Capital
Partners L.L.C. (“Frontier”) pursuant to which Frontier agreed to provide
investor relations and other business advisory services. The agreement term was
3 months, but the agreement could be terminated by either party upon 5 days
written notice. The agreement also includes provisions allowing immediate
termination in the event of dissolution, bankruptcy or insolvency and for cause.
The Company agreed to issue to Frontier 125,000 shares of its restricted common
stock as compensation for these services. 75,000 of these shares, valued at
$81,000, were issued immediately (upon execution of the agreement) and are
deemed to be a non-refundable retainer. The remaining 50,000 shares, valued at
$63,000, were issued 46 days after execution of the agreement. As the shares
were unforfeitable upon issuance and there was no guarantee of future benefit to
be provided, the value of the shares was expensed in 2008 to investor relations
and other related consulting.





On August
14, 2008, a holder of warrants to purchase 98,121 shares of common stock of the
Company at a price of $1.01 per share exercised the warrants under Section 3(c)
of the warrant document which allows for cashless exercise of the
warrants.  As a result, the Company issued 37,985 shares of its common
stock.





See Note
7 for additional shares issued during the year ended December 31, 2008 related
to the convertible notes payable.


F-14


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
6 – STOCKHOLDERS’ DEFICIT (Continued)





Stock
warrants




On
November 11, 2008, the Company entered into a consulting agreement with Newview
Consulting L.L.C. (“Newview”) Pursuant to this agreement, Newview will provide
investor relations services for a period of 6 months in exchange for warrants to
purchase 2,250,000 shares of common stock at a price of $1.25 per share. 900,000
warrants vested immediately with an estimated fair value of $716,997 using the
Black-Scholes pricing model, and 270,000 warrants vest on the 1st of each
month beginning December 1, 2008 and ending April 1, 2009.  The
270,000 warrants that vested on December 1, 2008 had an estimated fair value of
$204,619 using the Black Scholes pricing model.  These warrants have
been expensed to investor relations and other related consulting services.
Either party may terminate the agreement with fifteen days written
notice.  At December 31, 2008, 1,080,000 warrants are unvested and
forfeitable.




On
October 30, 2008, the Company executed a letter of intent with a subsidiary of
Guthy-Renker (“GRM”) to create, market and distribute direct response
advertisements to sell the Company’s product.  GRM is responsible for
creating, financing, producing, testing and evaluating a radio commercial to
market the Company’s products in exchange for $50,000 and fully vested,
non-forfeitable warrants to purchase 1,000,000 shares of common stock at a price
of $1.25 per share with an estimated fair value of $951,495 using the
Black-Scholes pricing model.  The fair value of these warrants has
been capitalized at the time of issuance and will be expensed over the five
month expected term of service. For the
year ended December 31, 2008, the Company has expensed $380,598 to selling,
general and administrative expense.The letter also allows the parties
the option to elect to have GRM create television commercials to market the
Company’s product in exchange for additional warrants to purchase 1,000,000
shares of common stock at a price of $1.25 per share. Subsequent
to December 31, 2008, the Company has entered into a Media and Marketing
Services Agreement with GRM as more fully disclosed in Note
12.




The
following represents a summary of the warrants outstanding at December 31,
2008 and 2007 and changes during the years then ended:




Year
      EndedDecember
      31, 2008
                                                                                                  
                                                                                                  
                                                                                                  December
      31, 2007WeightedAverage
                                                                                                  
                                                                                                  
                                                                                                  Aggregate
                                                                                                  
                                                                                                  
                                                                                                  Number
                                                                                                  
                                                                                                  
                                                                                                  Average
                                                                                                  
                                                                                                  
                                                                                                  AggregateExercise
                                                                                                  
                                                                                                  
                                                                                                  Intrinsic
                                                                                                  
                                                                                                  
                                                                                                  of
                                                                                                  
                                                                                                  
                                                                                                  Exercise
                                                                                                  
                                                                                                  
                                                                                                  IntrinsicWarrants
                                                                                                  
                                                                                                  
                                                                                                  Price
                                                                                                  
                                                                                                  
                                                                                                  Value
                                                                                                  
                                                                                                  
                                                                                                  Warrants
                                                                                                  
                                                                                                  
                                                                                                  Prices
                                                                                                  
                                                                                                  
                                                                                                  ValueOutstanding
      and exercisable, beginning of year
                                                                                                  
                                                                                                  
                                                                                                  5,741,306
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.05
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  4,337,931
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.05Issued
                                                                                                  
                                                                                                  
                                                                                                  5,386,705
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.24
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  1,403,375
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.21Expired/forfeited
                                                                                                  
                                                                                                  
                                                                                                  —
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —Exercised
                                                                                                  
                                                                                                  
                                                                                                  (98,121
                                                                                                  )
                                                                                                  
                                                                                                  $
                                                                                                  1.01
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —Outstanding,
      end of year
                                                                                                  
                                                                                                  
                                                                                                  11,029,890
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.14
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  5,741,306
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.05Exercisable,
      end of year
                                                                                                  
                                                                                                  
                                                                                                  9,949,890
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.13
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  5,741,306
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  1.05
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  —Weighted
      average fair value of warrants issued and exercisable
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  0.84
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  
                                                                                                  $
                                                                                                  0.99





The
following table summarizes information about warrants outstanding at
December 31, 2008:





WeightedAverageNumber
      of
                  
                  RemainingWarrant
                  
                  ContractualExercise
      Price
                  
                  Shares
                  
                  Life
      (Years)$ 1.00
                  
                  
                  3,806,600
                  
                  
                  
                  2.82$ 1.01
                  
                  
                  779,432
                  
                  
                  
                  6.94$ 1.20
                  
                  
                  400,000
                  
                  
                  
                  3.50$ 1.25
                  
                  
                  6,043,858
                  
                  
                  
                  4.6611,029,890


The
outstanding warrants at December 31, 2008 are held by consultants and other
service providers, stockholders, and former note-holders.


F-15


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
6 – STOCKHOLDERS’ DEFICIT (Continued)





Stock
options


In
January 2005, the Company adopted the CyberDefender Corporation 2005 Stock
Option Plan (sometimes called the CyberDefender Corporation 2005 Equity
Incentive Plan and referred to herein as the “2005 Plan”), which consists of
equity programs that provide for the granting of Incentive Stock Options or
Nonstatutory Stock Options, the issuance of stock appreciation rights, stock
purchase rights and awards of stock. Under the terms of the 2005 Plan, the
exercise price of options granted may be equal to, greater than or less than the
fair market value on the date of grant, the options have a maximum term of ten
years and generally vest over a period of service or
attainment of specified performance objectives. The maximum aggregate amount of
options that may be granted from the 2005 Plan is 931,734
shares.





On
October 30, 2006, the Company adopted the Amended and Restated 2006 Equity
Incentive Plan (“2006 Plan”) that provides for the granting of Incentive Stock
Options or Nonstatutory Stock Options, the issuance of stock appreciation
rights, stock purchase rights and awards of stock. Under the terms of the 2006
Plan, the exercise price of options granted may be equal to, greater than
or less than the fair market value on the date of grant, the options may have a
maximum term of ten years and generally vest over a period of service or
attainment of specified performance objectives. The maximum aggregate amount of
stock based awards that may be granted from the 2006 Plan is 1,375,000
shares.





On March
31, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial
Officer, an option to purchase 20,000 shares of common stock under the 2006
Plan, at a price of $1.00 per share with an estimated fair value of $17,344
using the Black-Scholes option pricing model with the following assumptions:
expected term of 5.1 years, a risk-free interest rate of 4.62%, a dividend yield
of 0%, volatility of 128% and a forfeiture rate of 4%.





On April
16, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial
Officer, an option to purchase 20,000 shares of common stock under the 2006
Plan, at a price of $1.00 per share with an estimated fair value of $17,269
using the Black-Scholes option pricing model with the following assumptions:
expected term of 5.1 years, a risk-free interest rate of 2.84%, a dividend yield
of 0%, volatility of 169% and a forfeiture rate of 4%.





On April
16, 2008, the Company granted to Steve Astere, a consultant, an option to
purchase 15,700 shares of common stock under the 2006 Plan, at a price of $1.25
per share with an estimated fair value of $9,115 using the Black-Scholes option
pricing model with the following assumptions: expected term of 2.50 years, a
risk-free interest rate of 2.09%, a dividend yield of 0%, volatility of 118% and
a forfeiture rate of 0%.





On April
16, 2008, the Company granted to Tawab Rahmani, a consultant, an option to
purchase 75,000 shares of common stock under the 2006 Plan, at a price of $1.00
per share with an estimated fair value of $46,380 using the Black-Scholes option
pricing model with the following assumptions: expected term of 2.50 years, a
risk-free interest rate of 2.09%, a dividend yield of 0%, volatility of 118% and
a forfeiture rate of 0%.





On April
16, 2008, the Company granted to Sean Whiteley, a consultant, an option to
purchase 40,000 shares of common stock under the 2006 Plan, at a price of $1.00
per share with an estimated fair value of $27,131 using the Black-Scholes option
pricing model with the following assumptions: expected term of 3.25 years, a
risk-free interest rate of 2.28%, a dividend yield of 0%, volatility of 118% and
a forfeiture rate of 0%.





In June
2008, the Company granted to employees, options to purchase 160,000 shares of
common stock under the 2006 Plan, at prices ranging from $1.01 to $1.10 per
share with an estimated fair value of $167,319 using the Black-Scholes option
pricing model with the following assumptions: expected term of 6.1 years, a
risk-free interest rate of 3.54% to 3.84%, a dividend yield of 0%, volatility of
166-167% and a forfeiture rate of 4% to 20%.





On August
6, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial
Officer, an option to purchase 10,000 shares of common stock under the 2006
Plan, at a price of $1.30 per share with an estimated fair value of $12,094
using the Black-Scholes option pricing model with the following assumptions:
expected term of 5.1 years, a risk-free interest rate of 3.24%, a dividend yield
of 0%, volatility of 158% and a forfeiture rate of 4%.





In August
and September 2008, the Company granted to employees, options to purchase 75,000
shares of common stock under the 2006 Plan, at prices ranging from $1.07 to
$1.44 per share with an estimated fair value of $89,826 using the Black-Scholes
option pricing model with the following assumptions: expected term of 5-6 years,
a risk-free interest rate of 2.88% to 3.23%, a dividend yield of 0%, volatility
of 157-161% and a forfeiture rate of 20%.





On August
1, 2008, the Company granted to Bing Liu, a consultant and member of the
Company’s Board of Directors, an option to purchase 12,500 shares of common
stock under the 2006 Plan, at a price of $1.00 per share with an estimated fair
value of $14,541 using the Black-Scholes option pricing model with the following
assumptions: expected term of 5.1 years, a risk-free interest rate of 3.25%, a
dividend yield of 0%, volatility of 158% and a forfeiture rate of
4%.





On
October 1, 2008, the Company granted to Michael Barrett, the Company’s Chief
Financial Officer, an option to purchase 10,000 shares of common stock under the
2006 Plan, at a price of $1.00 per share with an estimated fair value of $10,083
using the Black-Scholes option pricing model with the following assumptions:
expected term of 5.1 years, a risk-free interest rate of 2.88%, a dividend yield
of 0%, volatility of 153% and a forfeiture rate of 4%.





On
October 1, 2008, the Company granted to Kevin Harris, a consultant, an option to
purchase 35,000 shares of common stock under the 2006 Plan, at a price of $1.00
per share with an estimated fair value of $35,319 using the Black-Scholes option
pricing model with the following assumptions: expected term of 5.1 years, a
risk-free interest rate of 2.89%, a dividend yield of 0%, volatility of 153% and
a forfeiture rate of 4%.





On
December 1, 2008, the Company granted to Michael Barrett, the Company’s Chief
Financial Officer, an option to purchase 2,500 shares of common stock under the
2006 Plan, at a price of $1.00 per share with an estimated fair value of $2,748
using the Black-Scholes option pricing model with the following assumptions:
expected term of 5.0 years, a risk-free interest rate of 1.71%, a dividend yield
of 0%, volatility of 153% and a forfeiture rate of 4%.





In
October and December 2008, the Company granted to employees, options to purchase
27,500 shares of common stock under the 2006 Plan, at prices ranging from $1.20
to $1.28 per share with an estimated fair value of $31,401 using the
Black-Scholes option pricing model with the following assumptions: expected
terms of 6.0 years, a risk-free interest rate of 1.53% to 3.02%, a dividend
yield of 0%, volatility of 154-157% and forfeiture rates of
0-20%.


F-16


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
6 – STOCKHOLDERS’ DEFICIT (Continued)





A summary
of stock option activity for the 2005 Plan and 2006 Plan is as
follows:





Year
      EndedDecember
      31, 2008
                                          
                                          
                                          December
      31, 2007Weighted
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          WeightedWeighted
                                          
                                          
                                          
                                          
                                          
                                          Average
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          Weighted
                                          
                                          
                                          AverageNumber
                                          
                                          
                                          Average
                                          
                                          
                                          Remaining
                                          
                                          
                                          Aggregate
                                          
                                          
                                          Number
                                          
                                          
                                          Average
                                          
                                          
                                          Remaining
                                          
                                          
                                          AggregateOf
                                          
                                          
                                          Exercise
                                          
                                          
                                          Contractual
                                          
                                          
                                          Intrinsic
                                          
                                          
                                          of
                                          
                                          
                                          Exercise
                                          
                                          
                                          Contractual
                                          
                                          
                                          InstrinsicOptions
                                          
                                          
                                          Price
                                          
                                          
                                          Term
                                          
                                          
                                          Value
                                          
                                          
                                          Options
                                          
                                          
                                          Prices
                                          
                                          
                                          Term
                                          
                                          
                                          ValueOutstanding,
      beginning of year
                                          
                                          
                                          1,316,384
                                          
                                          
                                          $
                                          0.75
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          1,441,613
                                          
                                          
                                          $
                                          0.
      75Granted
                                          
                                          
                                          503,200
                                          
                                          
                                          $
                                          1.09
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          350,500
                                          
                                          
                                          $
                                          1.06Exercised
                                          
                                          
                                          (50,000
                                          )
                                          
                                          $
                                          0.01
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Cancelled
                                          
                                          
                                          (325,500
                                          )
                                          
                                          $
                                          1.05
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          (475,729
                                          )
                                          
                                          $
                                          0.98Outstanding,
      end of year
                                          
                                          
                                          1,444,084
                                          
                                          
                                          $
                                          0.83
                                          
                                          
                                          
                                          7.66
                                          
                                          
                                          
                                          649,905
                                          
                                          
                                          
                                          1,316,384
                                          
                                          
                                          $
                                          0.75
                                          
                                          
                                          
                                          8.52
                                          
                                          
                                          
                                          732,532Vested
      and expected to vest in the future at December 31, 2008
                                          
                                          
                                          1,355,037
                                          
                                          
                                          $
                                          0.81
                                          
                                          
                                          
                                          7.55
                                          
                                          
                                          
                                          635,011
                                          
                                          
                                          
                                          1,244,633
                                          
                                          
                                          $
                                          0.73
                                          
                                          
                                          
                                          8.47
                                          
                                          
                                          
                                          712,730Exercisable,
      end of year
                                          
                                          
                                          1,080,662
                                          
                                          
                                          $
                                          0.73
                                          
                                          
                                          
                                          7.25
                                          
                                          
                                          
                                          582,098
                                          
                                          
                                          
                                          1,087,717
                                          
                                          
                                          $
                                          0.68
                                          
                                          
                                          
                                          8.37
                                          
                                          
                                          
                                          672,930





The
weighted-average grant date fair value of options granted during the years ended
December 31, 2008 and 2007 was $0.96 and $0.93 per option share,
respectively.




As of
December 31, 2008 and 2007, 274,375 and 228,667 of the options granted are
not vested with an estimated remaining value of $52,913 and $164,219,
respectively. At
December 31, 2008 and 2007, the remaining value of non vested options granted is
expected to be recognized over the weighted average vesting period of 2.95 and
2.77 years, respectively.




The
Company recorded compensation expense associated with the issuance and
vesting of stock options of $252,943 and $498,431 for the years ended
December 31, 2008 and 2007, respectively.





During
the year ended December 31, 2008, 50,000 of employee stock options were
exercised for total proceeds to the Company of $535.  No options were
exercised during the year ended December 31, 2007.





NOTE
7 – CONVERTIBLE NOTES PAYABLE





On
September 12, 2006, the Company entered into a Securities Purchase Agreement
with 13 accredited investors pursuant to which it sold 10% secured convertible
debentures (the “Debentures”) in the aggregate principal amount of $3,243,378
and common stock purchase warrants to purchase an aggregate of 3,243,378 shares
of the Company’s common stock at $1.00 per share (the “Base Conversion Price”)
that also included a registration rights agreement. The debenture holders have
the right to convert the Debentures into 3,243,378 shares of common stock.
The Debentures mature on September 12, 2009 and bear interest at the rate of 10%
per year, payable quarterly.  If, during the time that the Debentures
are outstanding, the Company sells or grants any option to purchase (other than
options issued pursuant to a plan approved by our board of directors), or sells
or grants any right to reprice its securities, or otherwise disposes of or
issues any common stock or common stock equivalents entitling any person to
acquire shares of the Company’s common stock at a price per share that is lower
than the conversion price of the debentures or that is higher than the Base
Conversion Price but lower than the daily volume weighted average price of the
common stock, then the conversion price of the Debentures will be reduced. As of
December 31, 2008, the conversion price of the Debentures has not been
reduced.





Under the
terms of the agreement, the Company is obligated to register for resale at least
130% of the shares of its common stock issuable upon the conversion of the
Debentures and the exercise of the common stock purchase warrants. However, the
agreement also prohibits the Company from registering shares of common stock on
a registration statement that total more than one-half of the issued and
outstanding shares of common stock, reduced by 10,000 shares.





If a
registration statement was not filed within 30 days of the sale of the
Debentures, or was not effective 120 days from the date of the sale
of  the Debentures, which was January 10, 2007, or if the Company did
not respond to an SEC request for information during the registration period
within 10 days of notice, the Company was required to pay to each holder of its
Debentures an amount in cash, as partial liquidated damages and not as a
penalty, equal to 1.5% of the aggregate subscription amount paid by each holder.
The Company, (1) will not be liable for liquidated damages with respect to any
warrants or warrant shares, (2) in no event will the Company be liable for
liquidated damages in excess of 1.5% of the aggregate subscription amount of the
holders in any 30-day period, and (3) the maximum aggregate liquidated damages
payable to a holder is 18% of the aggregate subscription amount paid by such
holder up to a maximum aggregate liquidated damages of 18% of the total amount
of the secured convertible debentures, or $583,808. If the Company fails to pay
any partial liquidated damages in full within seven days after the date payable,
the Company will pay interest at a rate of 18% per annum to the holder, accruing
daily from the date such partial liquidated damages are due until such amounts,
plus all such interest, are paid in full. The partial liquidated damages apply
on a daily pro-rata basis for any portion of a month.





Pursuant
to Amendments No. 1 and No. 2 to the Registration Rights Agreement, the holders
of the Company’s Debentures agreed to extend the filing date of the registration
statement to November 3, 2006, and agreed to waive their rights to enforce the
liquidated damages clause for the initial filing of the registration statement.
The Company did not meet the 10 day response period for responding to an SEC
request for additional information nor did the Company meet the target
registration statement effectiveness date of January 10, 2007. The holders did
not agree to waive the liquidated damages that accrued due to the Company’s
failure to meet the 10 day period for responding to an SEC request for
additional information nor have the holders agreed to waive the liquidated
damages that accrued due to the Company’s failure to have the registration
statement declared effective by January 10, 2007.





In
accordance with FASB Staff Position Emerging Issues Task Force (“FSP EITF”)
00-19-02, “Accounting for Registration PaymentArrangements,” the
Company believed, at the time the Debentures were issued, that it was probable
that it would be in violation of certain filing provisions within the
Registration Rights Agreement and recorded $111,897 as adiscount to the
Debentures.  At December 31, 2006, the Company estimated its
liquidated damages to be $225,415 and therefore recorded an additional expense
of $113,518 in loss on registration rights agreement in the statement of
operations.  On March 23, 2007 the Company entered into a Consent and
Waiver agreement as more fully described below that determined the actual
liquidated damages to be $169,917 calculated through March 23, 2007 and covering
the period through April 30, 2007, resulting in a $55,498 decrease to the
liability.


F-17


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
7 – CONVERTIBLE NOTES PAYABLE (Continued)




The
Company was also required to make an interest payment to the Debenture holders
on April 1, 2007.  The Consent and Waiver allowed the Company to make
the April 1 interest payment and pay the liquidated damages in one of two ways
to be chosen by each holder. For payment of the Debenture holder’s pro rata
portion of the April 1 interest payment, the Debenture holder could choose to
increase the principal amount of his Debenture by his pro-rata share of the
accrued interest amount or accept shares of the Company’s common stock valued at
$0.85 per share for this purpose. For payment of the Debenture holders pro rata
portion of the liquidated damages, each Debenture holder has the same choice,
that is, either to increase his Debenture by the pro rata liquidated damages
amount or accept shares of the Company’s common stock valued at $0.85 per share
for this purpose. If all the Debenture holders were to choose to accept shares
of the Company’s common stock in payment of the April 1 interest payment and the
liquidated damages, the Company could be required to issue up to a total of
566,336 shares of the Company’s common stock. The Consent and Waiver allowed the
Company to issue these shares without triggering the anti-dilution rights
included in the original offering documents.  The Company issued
180,187 shares in November and December 2007 as partial payment for these
liquidated damages valued at $153,167.  At December 31, 2007, $16,750
of these damages remained in accrued expenses – registration rights
agreement.  The Company issued 15,407 shares in January and February
2008 as partial payment for these liquidated damages valued at
$13,097.  At December 31, 2008, $3,657 of these damages remained in
accrued expenses – registration rights agreement.  The Company issued
190,090 shares in November and December 2007 as partial payment for the April 1,
2007 interest payment of $161,580.  At December 31, 2007, $17,179
remained in accrued interest.  The Company issued 15,669 shares in
January and February 2008 as partial payment for the April 1 interest payments
of $13,319.  At December 31, 2008, $3,860 remained in accrued
interest.





The
Consent and Waiver allowed the Company to issue to Oceana Partners, LLC, without
triggering the anti-dilution rights, 50,000 shares of common stock in
consideration for research coverage for a 12-month period.





The
Company did not meet the April 30, 2007 date for its registration statement to
be declared effective by the SEC. The registration statement became effective on
July 19, 2007. As a result, the Company incurred additional liquidated damages
for the period May 1 through July 19, 2007 of $132,726.  On September
21, 2007 the Company received from the holders of the Debentures a second
Consent and Waiver. The holders of the Debentures agreed to accept shares of the
Company’s common stock at $0.85 per share instead of cash as payment
for the interest due on July 1, 2007 and October 1, 2007 and for damages
incurred under the Registration Rights Agreement. The Company issued 135,063
shares in February 2008 as partial payment for these liquidated damages valued
at $106,518.  At December 31, 2008, $26,213 of these damages remained
in accrued expenses – registration rights agreement.  The Company
issued 94,952 shares in February 2008 as partial payment for the July 1 and
October 1, 2007 interest payments of $110,147.  At December 31, 2008,
$32,504 remained in accrued interest.





The
Company did not meet the August 18, 2007 date to file a second registration
statement. As a result, the Company incurred additional liquidated damages for
the period August 18 through December 19, 2007 of $194,603.  The
Company received from the holders of the Debentures a third Consent and Waiver,
dated February 13, 2008 and amended on August 19, 2008. The third Consent and
Waiver waived the requirement included in the Debentures and the Registration
Rights Agreement that the Company file a second registration statement, waived
the liquidated damages that accrued from and after December 19, 2007 and waived
the payment of any interest that would have accrued on the liquidated damages.
The holders of the Debentures agreed to accept either additional debentures or
shares of the Company’s common stock at $0.85 per share instead of
cash as payment for the interest due on January 1, 2008 and as payment of the
liquidated damages accrued prior to December 19, 2007 under the Registration
Rights Agreement. In August 2008, a holder of the 10% Secured Convertible
Debentures converted $6,000 of accrued liquidated damages into 6,000 shares of
common stock as more fully described below. In September 2008, the Company
issued $64,422 in additional debentures as payment of liquidated damages, which
included $4,422 of penalty interest, and $26,868 in additional debentures as
payment for quarterly interest due on January 1, 2008, which included $1,868 of
penalty interest. The additional debentures had a term of 18 months and are
convertible at $0.85 per share.  During October and December 2008, the
Company issued $349,494 in additional debentures as payment of liquidated
damages, quarterly interest, and penalty interest.  These additional
debentures also have a term of 18 months and are convertible at $0.85 per share.
The Company issued 3,750 shares in December 2008 as partial payment for these
liquidated damages valued at $3,750.  At December 31, 2008, $4,732
remained in accrued expenses – registration rights agreement and $1,972 remained
in accrued interest.





According
to the terms of the Debentures, the Company is to make interest payments
quarterly on January 1, April 1, July 1 and October 1 until September 2009, when
the principal amount and all accrued but unpaid interest will be
due.  To date, holders of the Debentures have agreed to accept the
Company’s securities as payment of the interest obligation, in lieu of
cash.  The Company failed to make the interest payments that were due
on April 1, and July 1, 2008, totaling $139,169. On September 22, 2008 the
Company received from the holders of the Debentures a fourth Consent and Waiver
of defaults of the Debentures. The holders of the Debentures agreed to accept
either additional debentures or shares of the Company’s common stock at
$0.85 per share instead of cash as payment for the interest due on
April 1, July 1, and October 1, 2008, totaling $205,740.  In August
2008, certain holders of the Debentures converted $8,694 of accrued interest
into 8,694 shares of common stock as more fully described below. During October
and December 2008, the Company issued $349,494 in additional debentures as
payment of liquidated damages, quarterly interest, and penalty
interest.  The additional debentures have a term of 18 months and are
convertible at $0.85 per share. The Company issued 6,250 shares in December 2008
as partial payment for interest valued at $6,250.  At December 31,
2008, $5,915 remained in accrued interest.





The
Company recorded $65,696 in accrued interest as of December 31, 2008 for the
January 1, 2009 interest payment.





The
holders of certain shares and warrants for the purchase of common stock issued
in conjunction with the sale of the Company’s previously issued Secured
Convertible Promissory Notes from November 2005 through March 2006, which were
converted on September 12, 2006, also have certain registration rights. These
holders agreed to defer their rights to require registration of their securities
on the registration statement the Company filed; however, they have maintained
the rights to piggyback on future registration statements filed by the
Company.





The
Company has accounted for the Debentures according to Statement of Financial
Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and
Hedging Activities,” EITF 00-19 “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock,” FSP EITF
00-19-2, EITF 98-5 “Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios” and EITF 00-27 “Application
of Issue No. 98-5 to Certain Convertible Instruments.” The Company has accounted
for the registration rights arrangement under the guidance of FSP EITF 00-19-2
and the warrants as permanent equity under the guidance of SFAS No. 133 and
EITF 00-19. The value of the Debentures was allocated between the Debentures,
the registration rights arrangement and the warrants, including the beneficial
conversion feature, which amounted to $63,689, $111,897 and $3,067,792,
respectively. The discount of $3,179,689 related to the registration rights
arrangement and the warrants, including the beneficial conversion feature, is
being amortized over the term of the Debentures. The Company amortized
$1,071,060 and $1,316,925 to interest expense for the years ended December 31,
2008 and 2007. The remaining unamortized warrant and beneficial conversion
feature value is recorded as a discount on the Debentures on the accompanying
balance sheet.


F-18


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
7 – CONVERTIBLE NOTES PAYABLE (Continued)





In
addition, as part of the transaction, the Company paid $217,000, issued
1,000,515 shares of common stock in November 2006 valued at $1,000,515 and
issued 217,000 unit purchase options with each unit consisting of 1 share of
common stock and a warrant to purchase 1 share of common stock for $1.00 per
share in November 2006. The unit purchase options were valued at $374,531 using
the Black-Scholes option pricing model with the following assumptions: term of 5
years, a risk-free interest rate of 4.62%, a dividend yield of 0%, and
volatility of 128%. These costs, totaling $1,592,046, are being amortized over
the term of the Debentures.  The Company recorded amortization of
$535,448 and $658,789 to interest expense during the years ended December 31,
2008 and 2007 related to the Debentures. The unamortized amount is recorded as
part of the deferred financing costs in the accompanying balance
sheets.





In
November and December 2007, certain holders of the Debentures converted $460,000
of principal and $48,406 of accrued interest into 508,406 shares of common stock
at $1.00 per share. The unamortized discount of $253,481 on the converted notes
was recorded as interest expense at the time of the conversion.





In August
2008, certain holders of the Debentures converted $300,000 of principal and
$15,468 of accrued interest, accrued liquidated damages and penalty interest
into 315,468 shares of common stock at $1.00 per share and 86,601 warrants to
purchase shares of the Company’s common stock at $1.25 per share.  The
unamortized discount of $103,310 on the converted notes was recorded as interest
expense at the time of the conversion.





In
November and December 2008, certain holders of the Debentures converted $481,408
of principal into 481,408 shares of common stock at $1.00 per
share.  The unamortized discount of $121,673 on the converted notes
was recorded as interest expense at the time of the conversion.





On
November 21, 2008, the Company entered into a fifth Consent and Waiver agreement
whereby the holders of the Debentures agreed to allow the Company to sell up to
$1,200,000 in aggregate principal amount of the Company’s 10% Convertible
Promissory Notes, due eleven months from the date of issuance and convertible
into shares of Common Stock at a conversion price of $1.25 per share. In
consideration of the Waiver and the consent provided by the holders, the Company
agreed to accelerate the maturity date of the 18 month 10% convertible
debentures to September 12, 2009 and the Company agreed and acknowledged that
the 2006 Warrant Shares and the shares of Common Stock underlying the 18 month
10% convertible debentures issued or issuable to each of the holders in payment
of interest and liquidated damages pursuant to prior consent and waiver
agreements shall carry “piggyback” registration rights.





Per the
Consent and Waiver discussed above, in November and December, 2008 the Company
entered into a Securities Purchase Agreement, that also included registration
rights, with certain accredited investors to which it sold 10% Convertible
Promissory Notes in the aggregate principal amount of $845,000, which may be
converted at the price of $1.25 per share (subject to adjustment as discussed
below) into an aggregate of 676,000 shares of common stock.  In
conjunction with the sale of the 10% Convertible Promissory Notes, the Company
issued common stock purchase warrants to purchase an aggregate of 338,000 shares
of common stock at $1.25 per share.





If,
during the time that the 10% Convertible Promissory Notes are outstanding, we
sell or grant any option to purchase (other than options issued to our
employees, officers, directors or consultants), or sell or grant any right to
re-price our securities, or otherwise dispose of or issue any common stock or
common stock equivalents entitling any person to acquire shares of our common
stock at a price per share that is lower than the conversion price of these
notes (which, for purposes of this discussion will be designated as the “Base
Conversion Price”), then the conversion price of the 10% Convertible Promissory
Notes will be reduced according to the following weighted average
formula:  the conversion price will be multiplied by a fraction of the
denominator of which will be the number of shares of common stock outstanding on
the date of the issuance plus the number of additional shares of common stock
offered for purchase and the numerator of which will be the number of shares of
common stock outstanding on the date of such issuance plus the number of shares
which the aggregate offering price of the total number of shares so offered
would purchase at the conversion price.  A reduction in the conversion
price resulting from the foregoing would allow holders of our 10% Convertible
Promissory Notes to receive more than 676,000 shares of our common stock upon
conversion of the outstanding principal amount.  In that case, an
investment in our common stock would be diluted to a greater extent than it
would be if no adjustment to the conversion price were required to be
made.





The value
of the 10% Convertible Promissory Notes was allocated between the Debentures and
the warrants, including the beneficial conversion feature, which amounted to
$399,533 and $445,467, respectively. The discount of $445,467 related to the
warrants, including the beneficial conversion feature, is being amortized over
the term of the 10% Convertible Promissory Notes. The Company amortized $56,525
to interest expense for the year ended December 31, 2008. The remaining
unamortized warrant and beneficial conversion feature value is recorded as a
discount on the 10% Convertible Promissory Notes on the accompanying balance
sheet. At December 31, 2008, $6,885 of interest has been accrued on these
notes.





In
addition, as part of the transaction, the Company paid $50,700 and issued common
stock purchase warrants to purchase an aggregate of 50,700 shares of common
stock at $1.25 per share. The warrants were valued at $47,498 using the
Black-Scholes option pricing model with the following assumptions: term of 5
years, a risk-free interest rate of 3.81%, a dividend yield of 0%, and
volatility of 99-103%. These costs, totaling $98,198, are being amortized over
the term of the 10% Convertible Promissory Notes.  The Company
recorded amortization of $12,603 to interest expense during the year ended
December 31, 2008. The unamortized amount is recorded as part of the deferred
financing costs in the accompanying balance sheets.





Convertible
notes payable consist of the following:





December
      31, 2008
                        
                        
                        December
      31, 200710%
      debentures outstanding
                        
                        $
                        3,287,754
                        
                        
                        $
                        2,783,378Unamortized
      discount on debentures
                        
                        
                        (866,225
                        )
                        
                        
                        (1,548,343
                        )Convertible
      notes payable, net
                        
                        $
                        2,421,529
                        
                        
                        $
                        1,235,035




At
December 31, 2008, all debt is shown as current as it is due before December 31,
2009.


F-19


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
8 – NOTES PAYABLE





7.41% Senior Secured
Original Issue Discount Notes


In April
and May 2007, the Company sold $405,000 in face amount of its 7.41% Senior
Secured Original Issue Discount Notes (“7.41% Notes”) and warrants to purchase
187,500 shares of the Company’s common stock for a purchase price of $375,000.
The 7.41% Notes are due one year from issuance with interest at 7.41% payable at
maturity. One warrant to purchase 5 shares of the Company’s common stock was
issued for every $10 of purchase price paid. The warrants may be exercised at a
price of $1.20 per share for a period of 5 years beginning nine months after
issuance of the warrant.  Pursuant to the warrant agreements, if the
Company issues common stock or common stock equivalents at a price lower than
the warrant exercise price (the “Base Share Price”), then the warrant exercise
price will be reduced to equal the Base Share Price and the number of warrant
shares issuable will be increased so that the aggregate exercise price, after
taking into account the decrease, will be equal to the aggregate exercise price
prior to the adjustment.  As of December 31, 2008, the exercise price
per share of the warrants has not been reduced as a result of the issuance of
any of the Company’s common stock or common stock equivalents. The Company has
accounted for the debentures according to SFAS 133, EITF 00-19, EITF 98-5 and
EITF 00-27. The Company has accounted for the warrants as permanent equity under
the guidance of SFAS 133 and EITF 00-19. The value of the 7.41% Notes was
allocated between the original issue discount (“OID”), the warrants and the
debentures which amounted to $30,000, $112,229 and $262,771, respectively. The
discount related to the OID and warrants of $142,229 will be amortized over the
one year term of the 7.41% Notes. The warrants issued in connection with the
7.41% Notes were valued using the Black-Scholes option pricing model with
the following assumptions: term of 5 years, a risk-free interest rate of 4.69%,
a dividend yield of 0% and volatility of 124%.





In August
2007, the Company sold $297,000 in face amount of the 7.41% Notes and warrants
to purchase 137,500 shares of the Company’s common stock for a purchase price of
$275,000. The value of the 7.41% Notes was allocated between the OID, the
warrants and the debentures which amounted to $22,000, $86,020 and $188,980,
respectively. The discount related to the OID and the warrants of $108,020 will
be amortized over the term of the 7.41% Notes. The warrants issued in connection
with the 7.41% Notes were valued using the Black-Scholes option pricing
model with the following assumptions: term of 5 years, a risk-free interest rate
of 4.60%, a dividend yield of 0% and volatility of 134%.





In
October 2007, the Company sold $162,000 in face amount of the 7.41% Notes and
warrants to purchase 75,000 shares of the Company’s common stock for a purchase
price of $150,000.  The value of the 7.41% Notes was allocated between
the OID, the warrants and the debentures which amounted to $12,000, $44,103
and $105,897, respectively. The discount related to the OID and the warrants of
$56,103 will be amortized over the term of the 7.41% Notes. The warrants issued
in connection with the 7.41% Notes were valued using the Black-Scholes
option pricing model with the following assumptions: term of 5 years, a
risk-free interest rate of 4.50%, a dividend yield of 0% and volatility of
116%.





The
Company recorded $158,702 and $147,650 of interest expense related to the
amortization of the discount related to the 7.41% Notes and warrants for the
years ended December 31, 2008 and 2007, respectively.





As part
of the March 23, 2007 Consent and Waiver, as described above in Note 7, the
holders of the Debentures agreed to allow the Company to sell the $864,000 face
amount of 7.41% Notes in exchange for warrants to purchase 150,000 shares of the
Company’s common stock at an exercise price of $1.00 per share. The warrants
were valued at $128,038 using the Black-Scholes option pricing model with the
following assumption: term of 5 years, a risk-free interest rate of 4.52%, a
dividend yield of 0% and volatility of 124%. These costs were recorded as
deferred financing costs and will be amortized over the term of the 7.41% Notes.
As part of the issuance of the 7.41% Notes certain officers of the Company
transferred to Oceana Partners and Carlin Capital 400,000 shares of common stock
valued at $1.00 per share. The value of $400,000 was recorded as deferred
financing cost and will be amortized over the term of the 7.41%
Notes.  The transfer of shares from the officers was recorded in
additional paid-in capital.





The
Company recorded amortization of deferred financing costs of $154,011 and
$374,027 to interest expense related to the 7.41% Notes during the years ended
December 31, 2008 and 2007, respectively.





Pursuant
to the Registration Rights Agreement the Company signed in connection with the
offering of the 7.41% Notes, the Company was required to register 125% of the
number of shares underlying the related Warrants. The Company was required to
file a registration statement for this purpose within 180 days following the
date that the units were sold, and the Company would be in default of the
Registration Rights Agreement if it failed to file the registration statement
within 30 days following the expiration of the 180 day period. The Company
obtained a Consent and Waiver from the holders of the 7.41% Notes in relation to
the liquidated damages under the Registration Rights Agreement.  As
more fully described below the Company issued 19,616 shares for payment of
$19,616 of liquidated damages.  As of December 31, 2008 and 2007,
respectively the Company has recorded $19,143 and $16,821 in accrued expenses –
registration rights agreement.





On June
23, 2008, certain holders of the 7.41% Notes converted their notes in the face
amount of $216,000 plus accrued interest of $19,101 into 235,101 shares of the
Company’s common stock and warrants to purchase 190,498 shares of the Company’s
common stock at an exercise price of $1.25 per share.  As the
Company’s negotiated conversion was at a price per share identical to the units
described in Note 7, no gain or loss was recorded upon the
conversion.




On August
6, 2008, certain holders of the 7.41% Notes converted their notes in the face
amount of $459,000 plus accrued interest of $31,032 and penalties of $19,616
into 509,648 shares of the Company’s common stock and warrants to purchase
368,059 shares of the Company’s common stock at an exercise price of $1.25 per
share.  As the
Company’s negotiated conversion was at a price per share identical to the units
described in Note 7, no gain or loss was recorded upon the conversion.
The Company issued 67,027 warrants to purchase shares of common stock at $1.00
per share for a term of five years, valued at $81,723 per the Black Scholes
pricing model, to the placement agent for this conversion.


F-20


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
8 – NOTES PAYABLE (Continued)





During
the year ended December 31, 2008, the Company repaid the 7.41% Notes in the face
amount of $189,000 and accrued interest on those notes of $17,196.  At
December 31, 2008 all of the 7.41% Notes were converted or paid in
full.





7.41%
Notes payable consist of the following:


December
      31, 2008
                        
                        
                        December
      31, 20077.41%
      notes outstanding
                        
                        $
                        -
                        
                        
                        $
                        864,000Unamortized
      discount on notes
                        
                        
                        -
                        
                        
                        
                        (158,702
                        )7.41%
      notes payable, net
                        
                        $
                        -
                        
                        
                        $
                        705,298




Note Payable to
Shareholder


In March
2008, Gary Guseinov pledged 750,000 shares of his common stock in CyberDefender
Corporation to Michael and Casey DeBaecke in exchange for a loan of $160,000,
bearing interest at the rate of 18% per annum, made to the
Company.  The pledge was non-recourse to Mr. Guseinov in the event the
collateral was foreclosed upon due to the Company’s failure to pay the
loan.  So long as there was no event of default in connection with the
loan, Mr. Guseinov could continue to vote the shares at any annual or special
meeting of the shareholders.  The loan was due to be repaid on the
earlier of two months from execution of the loan document or two days following
the Company’s receipt of over $500,000 in new equity
capital.  Additionally, the Company issued warrants to purchase 40,000
shares of the Company’s stock to the lenders.  The warrants may be
exercised at a price of $1.25 per share for a period of 5 years.  The
discount related to the warrants of $36,092 was amortized over the term of the
note. The warrants issued in connection with the note were valued using the
Black-Scholes option pricing model with the following assumptions: term of 5
years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility
of 148%. The Company recorded amortization of $36,092 to interest expense during
the year ended December 31, 2008. The loan plus accrued interest was paid in
full and the pledge cancelled on July 30, 2008.





NOTE
9 - CAPITAL LEASE OBLIGATIONS





The
Company leases certain furniture and other equipment under leases with a bargain
purchase option through November 2012 at implicit rates ranging from 11.1% to
12.4%. The following is a schedule by fiscal years of the future minimum lease
payments under this capital lease together with the present value of the net
minimum lease payments at December 31, 2008:





2009
                          
                          $
                          28,9302010
                          
                          
                          9,4472011
                          
                          
                          6,7532012
                          
                          
                          6,185Total
      minimum lease payments
                          
                          
                          51,315Less
      amount representing interest
                          
                          
                          (7,248
                          )Present
      value of minimum capitalized payments
                          
                          
                          44,067Less
      current portion
                          
                          
                          (27,291
                          )Long-term
      capital lease obligations
                          
                          $
                          16,776





Property
and equipment included $105,924 and $103,562 and accumulated depreciation
included $49,623 and $31,002 acquired through capital leases as of December 31,
2008 and 2007, respectively. Depreciation expense of $18,621 and $13,608 is
included in the total depreciation expense for the years ended December 31, 2008
and 2007. Interest expense under the lease was $6,775 and $6,881 for the years
ended December 31, 2008 and 2007, respectively





NOTE
10 - RELATED PARTY TRANSACTIONS





Unionway
International, LLC, an entity controlled by Bing Liu, a former officer, provides
software development services to the Company. During the years ended December
31, 2008 and 2007, the Company paid Unionway International, LLC $92,000 and $0,
respectively. The Company continues to contract for the use of such services as
of the date of this filing.





The
Company had amounts due to two officers as of December 31, 2007 totaling
$22,165. This amount is included in accounts payable in the accompanying balance
sheet as of December 31, 2007 and was paid in 2008.





On
October 1, 2007, our Chief Executive Officer, Gary Guseinov, provided the
Company with a short-term loan in the amount of $28,078. The loan was repaid on
November 19, 2007.





On
November 5, 2007, the Company entered into a promissory note agreement with
Chris Carlin, the Company’s financial advisor, whereby Mr. Carlin loaned the
Company $35,000 at an interest rate of 7% per annum. The principal and accrued
interest was repaid prior to December 31, 2007.





In March
2008, Gary Guseinov pledged 750,000 shares of his common stock in CyberDefender
Corporation to Michael and Casey DeBaecke in exchange for a loan of $160,000
made to the Company.  The pledge was non-recourse to Mr. Guseinov in
the event the collateral was foreclosed upon due to the Company’s failure to pay
the loan.  So long as there was no event of default in connection with
the loan, Mr. Guseinov could continue to vote the shares at any annual or
special meeting of the shareholders.  The loan plus accrued interest
was paid in full and the pledge cancelled on July 30, 2008.


F-21





CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
11 - COMMITMENTS AND CONTINGENCIES





Operating
Leases


The
Company's primary offices are in Los Angeles, California where it entered into a
lease on October 19, 2007 which commenced on March 24, 2008 for approximately
4,742 rentable square feet of office space which began upon completion of the
tenant improvements with a term of sixty-two months. The base rent is $10,670
per month for year one with 3% annual increases. The lease includes an abatement
of the first two months rent as long as the Company abides by all the terms and
conditions of the lease and if no event of default occurs. In the event the
Company fails to abide by all the terms and conditions of the lease or an event
of default occurs the Company shall reimburse the landlord for the abated rent
along with interest. Aside from the monthly rent, the Company is required to pay
its share of common operating expenses.





Previously,
the Company had entered into a lease for office space beginning September 1,
2004 and terminating August 31, 2007. The base rent was $10,619 per month for
2007.





As of
December 31, 2008, the Company's future minimum lease payments required under
the operating leases with initial or remaining terms in excess of one year are
as follows:





Years
      Ending December 31,2009
                    
                    $
                    166,1852010
                    
                    
                    166,0982011
                    
                    
                    167,4502012
                    
                    
                    150,4222013
                    
                    
                    60,764Total
                    
                    $
                    710,919





Total
rent expense for the years ended December 31, 2008 and 2007 was $111,026 and
$150,139, respectively, in selling, general and administrative
expense.





Employment
Agreements


On August
31, 2006, the Company entered into an employment agreement with Gary Guseinov
pursuant to which Mr. Guseinov will act as Chief Executive Officer. The
agreement is for three years and unless terminated within that period will renew
for successive one year periods until terminated. Mr. Guseinov receives
compensation of $225,000 per year and is entitled to participate in any bonus
compensation plan the Company adopts from time to time, so long as any such
bonus does not exceed more than 50% of his base salary for any 12-month
period.





On
November 23, 2005, the Company entered into an employment agreement with Igor
Barash pursuant to which Mr. Barash acts as Chief Information Officer. The
agreement is “at will” and can be terminated at any time. Mr. Barash receives
compensation of $140,000 per year.





On
November 30, 2006, the Company entered into temporary deferred salary
arrangements with Mr. Guseinov, Mr. Liu and Mr. Barash in which they agreed to
defer 50% of their salary each pay period. This arrangement can be terminated by
resolution of the Company’s Board of Directors. The Company has accrued $36,281
and $268,658 of deferred compensation as of December 31, 2008 and
2007.





Litigation





In the
ordinary course of business, the Company may face various claims brought by
third parties and the Company may, from time to time, make claims or take legal
actions to assert its rights, including intellectual property rights as well as
claims relating to employment and the safety or efficacy of its products. Any of
these claims could subject the Company to costly litigation and, while the
Company generally believes that it has adequate insurance to cover many
different types of liabilities, the Company’s insurance carriers may deny
coverage or the Company’s policy limits may be inadequate to fully satisfy any
damage awards or settlements. If this were to happen, the payment of any such
awards could have a material adverse effect on the Company’s operations, cash
flows and financial position. Additionally, any such claims, whether or not
successful, could damage the Company’s reputation and business. Management
believes the outcome of currently pending claims and lawsuits will not likely
have a material effect on the Company’s operations or financial
position.




Guarantees and
Indemnities


During
the normal course of business, the Company has made certain indemnities and
guarantees under which it may be required to make payments in relation to
certain transactions. These indemnities include certain agreements with the
Company’s officers, under which the Company may be required to indemnify such
person for liabilities arising out of their employment relationship. The
duration of these indemnities and guarantees varies and, in certain cases, is
indefinite. The majority of these indemnities and guarantees do not provide for
any limitation of the maximum potential future payments the Company could be
obligated to make. The Company hedges some of the risk associated with these
potential obligations by carrying general liability insurance. Historically, the
Company has not been obligated to make significant payments for these
obligations and no liabilities have been recorded for these indemnities and
guarantees in the accompanying statement of financial position.




On
October 30, 2006, the Company entered into Indemnification Agreements with Mr.
Guseinov, Mr. Ivankovich, the former Chief Financial Officer, Mr. Liu and Mr.
Barash, on November 6, 2007 the Company entered into an Indemnification
Agreement with Mr. John LaValle, a former director, and on February 1, 2008 the
Company entered into an Indemnification Agreement with Mr. Michael Barrett, all
of whom are sometimes collectively referred to in this discussion as the
“indemnified parties” or individually referred to as an “indemnified
party.”  The agreements require the Company to provide indemnification
for the indemnified parties for expenses (including attorneys’ fees, expert
fees, other professional fees and court costs, and fees and expenses incurred in
connection with any appeals), judgments (including punitive and exemplary
damages), penalties, fines and amounts paid in settlement (if such settlement is
approved in advance by the Company, which approval shall not be unreasonably
withheld) actually and reasonably incurred by the indemnified parties in
connection with any threatened, pending or completed action or proceeding
(including actions brought on the Company’s behalf, such as shareholder
derivative actions), whether civil, criminal, administrative or investigative,
to which he is or was a party, a witness or other participant (or is threatened
to be made a party, a witness or other participant) by reason of the fact that
he is or was a director, officer, employee or agent of the Company or any of its
subsidiaries.  The indemnification covers any action or inaction on
the part of the indemnified party while he was an officer or director or by
reason of the fact that he is or was serving at the Company’s request as a
director, officer, employee or agent of another corporation, partnership, joint
venture, trust or other enterprise.  In the event of any change, after
the date of the Indemnification Agreements, in any applicable law, statute or
rule which expands the right of a California corporation to indemnify a member
of its board of directors or an officer, such changes shall be within the
purview of the indemnified parties’ rights and the Company’s obligations under
the Indemnification Agreements.





The
Indemnification Agreements are effective as of the date they were signed and may
apply to acts or omissions of the indemnified parties which occurred prior to
such date if the indemnified party was an officer, director, employee or other
agent of the Company, or was serving at the Company’s request as a director,
officer, employee or agent of another corporation, partnership, joint venture,
trust or other enterprise, at the time such act or omission
occurred.  All obligations under the Indemnification Agreements will
continue as long as an indemnified party is subject to any actual or possible
matter which is the subject of the Indemnification Agreement, notwithstanding an
indemnified party’s termination of service as an officer or
director.


F-22


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
12 – SUBSEQUENT EVENTS





Subsequent
to December 31, 2008, the Company appointed Kevin R. Harris, age 40, as its new
Chief Financial Officer and member of the Board of Directors.  The
Company and Mr. Harris also agreed in principle to enter into a 2-year
employment agreement and Indemnification Agreement whereby the Company will pay
Mr. Harris an annual salary of $190,000 plus a car allowance of $750 per month
and grant to Mr. Harris additional 10-year options to purchase 200,000 shares of
common stock at an exercise price of $1.00 per share, vesting as follows: 25,000
of the option shares will vest upon grant; 25,000 of the option shares will vest
three months after the grant date; and the balance of 150,000 option shares will
vest in equal monthly increments over the term of the agreement.





On
January 1, 2009, the Company entered into a consulting agreement with Unionway
International, LLC an entity controlled by Mr. Bing Liu, for consulting
services. The agreement has a term of three months.  The agreement
provides compensation of $9,000 for January 2009 and $4,500 per month for each
of February and March 2009.  In addition, Mr. Liu has been granted
10-year options to purchase a total of 18,000 shares of common stock at an
exercise price of $1.00 per share vesting over the term of the
agreement.  During the term of the agreement, Mr. Liu was paid a
one-time bonus of $18,000 related to 2008 achievements.





On
January 17, 2009, the Company entered into a consulting agreement with Michael
Barrett for consulting services relating to financial management and
reporting.  The agreement had a term of two months and contemplated
that Mr. Barrett would provide the Company with approximately 10 hours of
services per week.  The Company will compensate Mr. Barrett at the
rate of $110 per hour and has granted an option to purchase 2,500 shares of
common stock at an exercise price of $1.25 per share and a warrant to purchase
2,500 shares of common stock with a term of five years at an exercise price of
$1.25 per share, per month for the term of the agreement.  The Options
are to expire one year from the termination of the agreement.





On
January 30, 2009, the Company entered into a one year lease with its current
landlord for approximately 2,395 rentable square feet of additional office
space.  The Company is negotiating to occupy approximately 16,000
square feet in the building to accommodate growth and the landlord has agreed to
abate the rent of this additional office space while the parties are in active
negotiations about this possible expansion.





In
January and February 2009, the Company granted to employees, options to purchase
a total of 18,500 shares of common stock under the 2006 Plan and the 2005 Plan
at a price of $1.25 per share.





In
January 2009, the Company completed the sale and issuance of
the  Company’s 10% Convertible Promissory Notes as described in
footnote 7 above.  Accordingly, the Company received additional gross
proceeds of $355,000 and
issued warrants to purchase 142,000 shares of common stock with a term of five
years at an exercise price of $1.25 per sharepursuant to the Offering,
and paid its placement agent a total of $21,300 in commissions and issued to its
placement agent a five-year warrant to purchase an additional 21,300 shares of
the Company’s common stock, at an exercise price of $1.25 per
share.





In
January 2009, certain holders of the 10% Secured Convertible Debentures
converted $50,000 of principal into 50,000 shares of common stock at $1.00 per
share.





In
February 2009, certain holders of the 10% Secured Convertible Debentures
converted $601,439 of principal into 601,439 shares of common stock at $1.00 per
share.  In addition, those same holders converted $207,473 of
principal amount and accrued interest of certain other debentures received in
2008 into 244,086 shares of common stock at $0.85 per share.





In
February 2009, the Company issued 94,628 shares of restricted common stock
valued at $1.10 per share to a vendor as settlement for past services
rendered.





In March
2009, certain holders of the 10% Secured Convertible Debentures converted
$854,163 of principal into 854,163 shares of common stock at $1.00 per
share.





On March
24, 2009, the Company entered into a Media and Marketing Services Agreement with
GR Match, LLC (“GRM”).  Pursuant to the agreement, GRM will provide
direct response media campaigns, including radio and television direct response
commercials, to promote the Company’s products and services and will purchase
media time on the Company’s behalf.  During the term of the agreement,
which is to continue until August 31, 2010, subject to certain rights of
termination, GRM will be the exclusive provider of all media purchasing and
direct response production services.  On August 22, 2009, assuming
that the agreement has not been terminated, the Company will appoint a
representative of GRM to the Company’s board of directors.  This
director will continue to serve throughout the term of the agreement and for so
long as GRM owns shares of the Company’s common stock or the right to purchase
shares of the Company’s common stock which constitute at least 5% of the
Company’s issued and outstanding common stock.
 
 The
Company is to provide a monthly budget to GRM for media
placement.  GRM will purchase the media and invoice the Company for
the cost plus 2.5% in overhead expenses incurred in connection with providing
the media placement services.  As security for the payment of the
media costs and overhead, the Company has agreed to grant to GRM a security
interest and lien in any proceeds held in a merchant services account the
Company will establish with Lidle Merchant Services.  The purpose of
the merchant services account is to collect the proceeds from sales made as a
result of the media campaigns.  These sales will be made through
websites the Company will establish that will be exclusively used to receive and
process orders of the Company’s  products from customers who respond
to the media campaign (“direct response websites”).


F-23


CYBERDEFENDER
CORPORATION


NOTES
TO FINANCIAL STATEMENTS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





NOTE
12 – SUBSEQUENT EVENTS (continued)





As
compensation for GRM’s services, the Company has agreed to issue a warrant for
the purchase of 1,000,000 shares of the Company’s common stock.  The
term of the warrant will be 5 years and the exercise price will be $1.25 per
share.  This warrant will have both cash and cashless exercise
provisions.  This warrant will replace a warrant issued to GRM in
November 2008.  The Company will also issue to GRM a second 5 year
warrant which will also be for the purchase of 1,000,000 shares of the Company’s
common stock at a price of $1.25 per share.  This warrant may be
exercised only for cash.  Finally, the Company has agreed to issue to
GRM a 5 year warrant for the purchase of 8,000,000 shares of the Company’s
common stock at an exercise price of $1.25 per share.  This warrant
may be exercised only with cash.  This warrant will be subject to
vesting as follows:  for each $2 of media placement costs advanced by
GRM on the Company’s behalf, the right to purchase one share of the Company’s
common stock will vest.  If GRM terminates the agreement due to a
breach by the Company in the Company’s performance or as a result of the
Company’s discontinuance, dissolution, liquidation, winding up or insolvency, or
if the Company terminates the agreement for any reason, any unexpired and
unvested rights of GRM to purchase shares of the Company’s common stock pursuant
to the agreement will immediately vest.
 
 If the
average closing price of the Company’s common stock as reported by Bloomberg LP
for the 20 trading days preceeding January 1, 2010 is not at least $3.00 per
share or if the Company’s common stock is not publicly traded on any stock
exchange or over-the-counter market as of December 31, 2009, then the Company
shall be required to pay a monthly royalty to GRM.  The royalty will
be equal to 20% of gross renewal revenue, which is defined as the aggregate
gross revenue, net of refunds and chargebacks, earned by the Company as a result
of renewals and/or re-orders of the Company’s products by the Company’s
customers who both (i) became customers during the period commencing on March 1,
2009 and ending upon the earlier of (A) the termination date of the agreement or
(B) the date following January 1, 2010 when the average closing price of the
Company’s common stock as reported by Bloomberg LP for the 20 trading days
preceding that date was at least $5.00 per share and (ii) initially purchased
any of the Company’s products from any direct response websites.  The
Company’s obligation to pay these royalties will survive the expiration of
termination of the agreement.
 
 The
agreement may be terminated by either the Company or GRM in the following
events:
 
 ·
                if there is a
      breach or default in performance of any obligation, unless the breach or
      default is cured with 15 business days following receipt of written notice
      from the non-breaching party;
 
 ·
                upon the
      discontinuance, dissolution, liquidation or winding up of the other
      party’s business or the insolvency of the other party;
  or
 
 ·
                by either party for
      any reason by giving the other party written notice of the termination at
      least 30 days prior to the effective date of
  termination.
 
 After May
30, 2009, GRM may terminate the agreement upon 5 days written notice to the
Company in the event that the average media placement costs for any 3
consecutive months during the term are less than $250,000 per
month.
 
 If the
Company breaches its payment obligations under the agreement and fails to cure
the breach within 15 days after receiving notice from GRM, then the number of
warrant shares which would otherwise vest during the month of the delinquent
payment will automatically double and GRM will have the right to enforce its
security interest in the merchant services account.  If the Company
breaches its payment obligation more than 3 times, the Company will not be
entitled to cure the breach and GRM will be entitled to enforce its rights and
remedies under the agreement.
 
 If the
agreement is terminated by GRM prior to the expiration of the term because of
the Company’s breach, its discontinuance, dissolution, liquidation, winding up
or insolvency or because the Company’s average media placement costs for any 3
consecutive months during the term are less than $250,000, or if the Company
terminates the agreement upon notice, then, if the Company proposes to procure
media purchasing services from a third party which are similar to the services
provided by GRM under the agreement, the Company will notify GRM of the terms of
such engagement.  GRM will have a period of 15 days to elect to
provide the services on the same terms.


F-24