##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q (Mark One) þ
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended September 30, 2004 or o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from     to Commission File Number: 0-29583 Loudeye Corp.  Delaware
(State or other jurisdiction of
incorporation or organization)
    
    91-1908833
(I.R.S. Employer Identification No.)
 1130 Rainier Avenue South, Seattle, WA 98144
(Address of principal executive offices) (Zip Code)
206-832-4000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2) Yes o No þ Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. Common
    
    81,913,373(Class)
    
    (Outstanding at November 10, 2004)




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Loudeye Corp. Form 10-Q Quarterly Report
For the Quarter Ended September 30, 2004 TABLE OF CONTENTS  
 PagePART I. Financial Information (unaudited)Item 1 Financial StatementsCondensed Consolidated Balance Sheets
    
    
    3Condensed Consolidated Statements of Operations
    
    
    4Condensed Consolidated Statement of Stockholders Equity
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    23Item 3 Quantitative and Qualitative Disclosures About Market Risk
    
    
    51Item 4 Controls and Procedures
    
    
    52PART II. Other InformationItem 1 Legal Proceedings
    
    
    54Item 4 Submission of Matters to a Vote of Security Holders
    
    
    54Item 6 Exhibits and Reports on Form 8-K
    
    
    54EXHIBIT 2.1EXHIBIT 3.1EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 10.4EXHIBIT 10.5EXHIBIT 10.6EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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##### Table of Contents



LOUDEYE CORP. AND SUBSIDIARIES 
   September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCash and cash equivalents
    
    $
    9,435
    
    
    $
    12,480Marketable securities
    
    
    15,296
    
    
    
    9,460Accounts receivable, net of allowances of $231
and $235 respectively
    
    
    6,443
    
    
    
    1,781Prepaids and other
    
    
    1,293
    
    
    
    345Assets held for sale
    
    
    
    
    
    
    363Total current assets
    
    
    32,467
    
    
    
    24,429Restricted investments
    
    
    305
    
    
    
    316Property and equipment, net
    
    
    5,113
    
    
    
    1,123Goodwill
    
    
    38,101
    
    
    
    Intangible assets, net
    
    
    3,886
    
    
    
    86Assets held for sale
    
    
    
    
    
    
    730Other assets, net
    
    
    249
    
    
    
    360Total assets
    
    $
    80,121
    
    
    $
    27,044LIABILITIES AND STOCKHOLDERS EQUITYAccounts payable
    
    $
    5,842
    
    
    $
    1,229Line of credit
    
    
    
    
    
    
    1,285Accrued compensation and benefits
    
    
    686
    
    
    
    378Other accrued expenses
    
    
    3,800
    
    
    
    1,155Accrued special charges
    
    
    871
    
    
    
    1,670Accrued acquisition consideration
    
    
    11,007
    
    
    
    Deferred revenue
    
    
    3,884
    
    
    
    485Current portion of long-term debt
    
    
    1,249
    
    
    
    1,348Liabilities related to assets held for sale
    
    
    
    
    
    
    98Total current liabilities
    
    
    27,339
    
    
    
    7,648Deferred revenue
    
    
    1,577
    
    
    
    228Common stock payable related to acquisition
    
    
    3,208
    
    
    
    Accrued acquisition consideration, net of current portion
    
    
    3,812
    
    
    
    Long-term debt, net of current portion
    
    
    1,250
    
    
    
    2,135Total liabilities
    
    
    37,186
    
    
    
    10,011Commitments and contingenciesSTOCKHOLDERS EQUITYPreferred stock, $0.001 par value, 5,000 shares authorized,
none outstanding
    
    
    
    
    
    
    Common stock, additional paid-in capital and warrants; for common
stock $0.001 par value, 150,000 shares
authorized; 79,702 shares issued and outstanding
in 2004, 56,974 issued and outstanding in 2003
    
    
    247,384
    
    
    
    210,134Deferred stock compensation
    
    
    (159
    )
    
    
    (214
    )Accumulated deficit
    
    
    (203,646
    )
    
    
    (192,887
    )Accumulated other comprehensive income (loss)
    
    
    (644
    )
    
    
    Total stockholders equity
    
    
    42,935
    
    
    
    17,033Total liabilities and stockholders equity
    
    $
    80,121
    
    
    $
    27,044
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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##### Table of Contents



LOUDEYE CORP. AND SUBSIDIARIES 
   Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003REVENUES
    
    $
    5,080
    
    
    $
    2,811
    
    
    $
    10,202
    
    
    $
    9,024COST OF REVENUES(1)
    
    
    3,480
    
    
    
    1,562
    
    
    
    6,725
    
    
    
    5,788Gross profit
    
    
    1,600
    
    
    
    1,249
    
    
    
    3,477
    
    
    
    3,236OPERATING EXPENSESResearch and development (1)
    
    
    1,325
    
    
    
    399
    
    
    
    2,668
    
    
    
    1,368Sales and marketing (1)
    
    
    1,478
    
    
    
    486
    
    
    
    2,949
    
    
    
    2,867General and administrative (1)
    
    
    3,798
    
    
    
    1,614
    
    
    
    7,990
    
    
    
    6,106Amortization of intangibles and other assets
    
    
    325
    
    
    
    157
    
    
    
    591
    
    
    
    943Stock-based compensation (1)
    
    
    21
    
    
    
    723
    
    
    
    186
    
    
    
    954Special charges  goodwill impairments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,307Special charges  other
    
    
    350
    
    
    
    
    
    
    
    300
    
    
    
    3,130Total operating expenses
    
    
    7,297
    
    
    
    3,379
    
    
    
    14,684
    
    
    
    20,675OPERATING LOSS
    
    
    (5,697
    )
    
    
    (2,130
    )
    
    
    (11,207
    )
    
    
    (17,439
    )OTHER INCOME (EXPENSE), netInterest income
    
    
    139
    
    
    
    75
    
    
    
    325
    
    
    
    262Interest expense
    
    
    (46
    )
    
    
    (83
    )
    
    
    (176
    )
    
    
    (180
    )Increase in fair value of common stock warrants
    
    
    
    
    
    
    (222
    )
    
    
    
    
    
    
    (222
    )Gain on sale of media restoration business
    
    
    273
    
    
    
    
    
    
    
    113
    
    
    
    Other, net
    
    
    
    
    
    
    20
    
    
    
    186
    
    
    
    119Total other income (expense)
    
    
    366
    
    
    
    (210
    )
    
    
    448
    
    
    
    (21
    )NET LOSS
    
    $
    (5,331
    )
    
    $
    (2,340
    )
    
    $
    (10,759
    )
    
    $
    (17,460
    )Net loss per share  basic and diluted
    
    $
    (0.07
    )
    
    $
    (0.05
    )
    
    $
    (0.15
    )
    
    $
    (0.37
    )Weighted average shares  basic and diluted
    
    
    79,285
    
    
    
    50,401
    
    
    
    71,149
    
    
    
    47,659
 (1) Stock-based compensation, consisting of amortization of deferred
stock-based compensation and the fair value of options issued to non-employees
for services rendered, is allocated as follows: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Cost of revenues
    
    $
    44
    
    
    $
    37
    
    
    $
    82
    
    
    $
    44Research and development
    
    
    19
    
    
    
    27
    
    
    
    70
    
    
    
    32Sales and marketing
    
    
    (5
    )
    
    
    26
    
    
    
    45
    
    
    
    38General and administrative
    
    
    7
    
    
    
    671
    
    
    
    71
    
    
    
    884
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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LOUDEYE CORP. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY  Common Stock and
    
    
    
    
    
    
    
    
    
    AccumulatedAdditional Paid-in Capital
    
    Deferred
    
    
    
    
    
    Other
    
    TotalStock-based
    
    Accumulated
    
    Comprehensive
    
    Stockholders'Shares
    
    Amount
    
    Compensation
    
    Deficit
    
    Income (Loss)
    
    EquityBALANCES, December 31, 2003
    
    
    56,974
    
    
    $
    210,134
    
    
    $
    (214
    )
    
    $
    (192,887
    )
    
    $
    
    
    
    $
    17,033Stock option exercises
    
    
    499
    
    
    
    222
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    222Shares issued in private placement
    
    
    10,811
    
    
    
    18,839
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,839Shares issued for acquisitions
    
    
    11,418
    
    
    
    17,975
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,975Deferred stock-based compensation
    
    
    
    
    
    
    331
    
    
    
    (331
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred stock-based compensation,
net of cancellations
    
    
    
    
    
    
    (139
    )
    
    
    386
    
    
    
    
    
    
    
    
    
    
    
    247Stock-based compensation
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3
    )Issuance of common stock warrant
    
    
    
    
    
    
    25
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25Unrealized loss on marketable securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (63
    )
    
    
    (63
    )Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (581
    )
    
    
    (581
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,759
    )
    
    
    
    
    
    
    (10,759
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11,403
    )BALANCES, September 30, 2004
    
    
    79,702
    
    
    $
    247,384
    
    
    $
    (159
    )
    
    $
    (203,646
    )
    
    $
    (644
    )
    
    $
    42,935
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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LOUDEYE CORP. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  Nine months endedSeptember 30,2004
    
    2003OPERATING ACTIVITIESNet loss
    
    $
    (10,759
    )
    
    $
    (17,460
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    2,063
    
    
    
    2,023Special charges (credits) and other non cash items
    
    
    (67
    )
    
    
    6,568Stock-based compensation
    
    
    244
    
    
    
    998Foreign currency transaction adjustment
    
    
    (183
    )
    
    
    Increase in fair value of common stock warrants
    
    
    
    
    
    
    222Changes in operating assets and liabilities, net of amounts acquired in purchases
of businesses:Accounts receivable
    
    
    (3,048
    )
    
    
    (48
    )Prepaid expenses and other assets
    
    
    (4
    )
    
    
    1,073Accounts payable
    
    
    837
    
    
    
    8Accrued compensation, benefits and other expenses
    
    
    (659
    )
    
    
    (266
    )Accrued special charges
    
    
    (749
    )
    
    
    (1,420
    )Deferred revenue
    
    
    2,534
    
    
    
    935Assets and liabilities held for sale
    
    
    
    
    
    
    341Net cash used in operating activities
    
    
    (9,791
    )
    
    
    (7,026
    )INVESTING ACTIVITIESPurchases of property and equipment
    
    
    (4,412
    )
    
    
    (53
    )Proceeds from sales of property and equipment
    
    
    
    
    
    
    183Cash paid for acquisition of businesses and technology, net
    
    
    (555
    )
    
    
    (82
    )Assets and liabilities held for sale
    
    
    996
    
    
    
    Payments received on loans made to related party and related interest
    
    
    
    
    
    
    1,187Purchases of marketable securities
    
    
    (16,046
    )
    
    
    (7,850
    )Sales of marketable securities
    
    
    10,211
    
    
    
    6,321Net cash used in investing activities
    
    
    (9,806
    )
    
    
    (294
    )FINANCING ACTIVITIESProceeds from sale of stock and exercise of stock options
    
    
    222
    
    
    
    1,838Proceeds from private equity financing, net
    
    
    18,934
    
    
    
    11,568Proceeds from line of credit
    
    
    
    
    
    
    3,727Principal payments on long-term debt, line of credit and capital lease obligations
    
    
    (2,280
    )
    
    
    (3,269
    )Repurchase of common stock
    
    
    
    
    
    
    (426
    )Net cash provided by financing activities
    
    
    16,876
    
    
    
    13,438Effect of foreign currency translation on cash
    
    
    (324
    )
    
    
    Net increase (decrease) in cash and cash equivalents
    
    
    (3,045
    )
    
    
    6,118Cash and cash equivalents, beginning of period
    
    
    12,480
    
    
    
    1,780Cash and cash equivalents, end of period
    
    $
    9,435
    
    
    $
    7,898
 The accompanying notes are an integral part of these consolidated financial statements. 6




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LOUDEYE CORP. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 September 30, 2004
 (Unaudited)
 1. ORGANIZATION and RISKS Loudeye Loudeye Corp. (Loudeye) provides digital media services and media
restoration services. Loudeye is headquartered in Seattle, Washington and has
offices in the United States, the United Kingdom, France, Germany and Italy. As discussed in Note 5, on June 22, 2004, Loudeye acquired On Demand
Distribution Limited (OD2), a privately held digital music provider based in
Europe. As discussed in Note 5, under the terms of the OD2 transaction,
Loudeye is obligated to pay an additional £9.6 million (approximately $17.3
million based on exchange rates as of September 30, 2004) in deferred
consideration through November 30, 2005, to OD2s shareholders, plus additional
contingent consideration of up to £10.0 million (approximately $18.0 million
based on exchange rates as of September 30, 2004) if OD2 achieves certain
financial performance targets during the period through November 30, 2006. The
payments are to be made in British pounds, and accordingly, Loudeye is exposed
to risks with changes in the prevailing exchange rate. Any decrease in the
value of the U.S. dollar against the British pound will cause a proportional
increase in the amount of the future consideration Loudeye must pay to the
former OD2 shareholders. Loudeye may elect to pay amounts due to OD2s
shareholders in shares of Loudeyes common stock. However, in accordance with
the rules of the NASDAQ Stock Market, approval of Loudeyes stockholders
(excluding shares issued in connection with the OD2 transaction) will be
required prior to any election to satisfy these payments in shares. Loudeye
has scheduled a special stockholder meeting for December 8, 2004, seeking
approval of its stockholders for issuance of shares of common stock to satisfy
the deferred and contingent consideration obligations. Such approval cannot be
assured. If stockholder approval is not obtained, Loudeye would not be able to
pay the additional amounts due related to the OD2 transaction in 2005 unless it
obtains additional funds through an equity or debt financing transaction. In
addition, as a result of Loudeyes acquisition of OD2, Loudeye will be required
to provide additional funding to support OD2s ongoing operations. There can
be no assurance that Loudeyes cash balances after December 31, 2004 will be
sufficient to sustain its operations in 2005 and to fund the ongoing operations
of OD2. Loudeye has incurred net losses and negative cash flows from operations
since inception and has an accumulated deficit of $203.6 million at September
30, 2004. Loudeyes operating expenses have increased as a result of the OD2
acquisition. Historically, Loudeye has funded its operations through equity
transactions, leases and debt. However, there can be no assurance that
Loudeyes cash balances after December 31, 2004 will be sufficient to sustain
its operations until profitable operations and positive cash flows are
achieved. Accordingly, Loudeye may require additional capital or debt financing
subsequent to December 31, 2004 to fund its operations and the amounts due in
2005 related to the OD2 transaction. There can be no assurance that additional
capital or debt will be available to Loudeye on acceptable terms, or at all.
If Loudeye lacks necessary cash or debt financing capacity during 2005, Loudeye
may not only be unable to pay the scheduled OD2 transaction amounts in 2005 but
might also have to delay or abandon some or all of its development plans or
otherwise forego market opportunities. Loudeyes inability to execute on its
strategy could result in increased expenses and decreased revenues, either or
both of which could seriously harm Loudeyes business, results of operations
and financial condition subsequent to December 31, 2004. Loudeye segregates its business in two business segments, digital media
services and media restoration services. As discussed in Note 6, Loudeye
completed the sale of its media restoration services business in May 2004. The
consolidated financial statements at December 31, 2003, and the
unaudited interim condensed consolidated financial statements at
September 30, 2004, do not include
any adjustments that may result from the outcome of the aforementioned
uncertainties. Risks Loudeye is subject to a number of risks similar to other companies in a
comparable stage of development, including, but not limited to, reliance on key
personnel, successful marketing of its services in emerging markets,
competition from other companies with greater technical, financial, management
and marketing resources, successful development of new services, the
enhancement of existing services and the ability to secure adequate financing
to support future operations. 7




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Assuming Loudeyes stockholders approve the issuance of additional shares
to OD2 stockholders to pay future required payments, Loudeye believes that its
existing cash, cash equivalents, and short-term investments will be sufficient
to fund its operations and meet its working capital and capital expenditure
requirements for the next twelve months. If Loudeyes stockholders do not approve such
issuances. Loudeye will be required to satisfy such amounts in cash, which
would likely cause a significant strain on Loudeyes cash resources, Loudeye
may need to obtain additional equity or debt financing and Loudeye may have
difficulty pursuing its business objectives. Since Loudeye has incurred net
losses since inception, Loudeye has relied on sales of equity securities,
proceeds from the exercises of stock options and warrants and borrowings under
its credit facilities to fund its working capital needs. Such capital may not
be available in the future if it is needed. The availability of such capital
will depend on a number of factors, some of which are outside Loudeyes
control. These include general market conditions, conditions in the private
equity and public markets, the then-current market price of Loudeyes common
stock and Loudeyes historical financial performance and future prospects. Basis of Consolidation The consolidated financial statements include the accounts of Loudeye and
its subsidiaries. All significant intercompany transactions and balances have
been eliminated in consolidation. Loudeye has included the results of
operations of acquired entities from the date of acquisition (see Note 5). Unaudited Interim Financial Information The interim condensed consolidated financial statements are unaudited and
have been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles in the United States have been condensed or omitted
pursuant to such rules and regulations. These condensed consolidated financial
statements should be read in conjunction with the audited consolidated
financial statements and notes thereto included in Loudeyes Annual Report on
Form 10-K as filed with the Securities and Exchange Commission on March 22,
2004. The interim financial information included herein reflects all
adjustments (consisting only of normal recurring adjustments) that are, in the
opinion of management, necessary for a fair presentation of the results for
interim periods. The unaudited results of operations for the three and nine
months ended September 30, 2004 and 2003 are not necessarily indicative of the
results to be expected for the full years. Use of Estimates The preparation of the financial statements in conformity with generally
accepted accounting principles in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the 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. Actual results could differ from those estimates. Managements assessments of the impairment of property and equipment,
goodwill and intangible assets are sensitive accounting estimates that could
result in additional impairment charges in the near term. Factors that impact
these estimates include, but are not limited to, possible changes in business
plans and declining financial results. Management evaluates the potential loss exposure on various claims and
lawsuits arising in the normal course of business. An accrual is made if the
amount of a particular claim or lawsuit is probable and reasonably estimable. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents Loudeye considers all highly liquid investments with a remaining maturity
of three months or less at the date of acquisition to be cash equivalents. Cash
and cash equivalents consist of demand deposits and money market accounts
maintained with financial institutions and certain other investment grade
instruments, which at times exceed federally insured limits. Loudeye has not
experienced any losses on its cash and cash equivalents. Marketable Securities Loudeye has invested amounts in investment-grade government obligations,
institutional money market funds and other obligations with FDIC insured U.S.
banks. Marketable securities are accounted for as available for sale.
Marketable securities are classified in current assets as they are considered
by management as available to support current operations. Available for sale
marketable securities are carried at fair value, with unrealized gains and
losses reported as a separate component of stockholders 8




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##### Table of Contents



equity. Realized gains and losses are included in investment income. The cost
of securities sold is based upon the specific identification method. Restricted Investments Loudeye has approximately $305,000 of short-term investments which are
utilized as collateral for certain irrevocable standby letters of credit.
Accordingly, these investments are classified as restricted
investments in the accompanying condensed
consolidated balance sheets. These securities all mature within one year and
reported amounts approximate fair value due to the relatively short maturities
of these investments. These investments are related to standby letters of
credit required for certain lease agreements which expire in October 2005.
Accordingly, the restricted investments have been classified in long-term
assets in the accompanying consolidated balance sheets. Fair Value of Financial Instruments and Concentrations of Credit Risk Financial instruments that potentially subject Loudeye to concentrations
of credit risk consist of cash and cash equivalents, marketable securities, and
long-term obligations. Fair values of cash and cash equivalents approximate
their carrying value due to the short period of time to maturity. Marketable
securities are reported at their market value. The carrying value of Loudeyes
line of credit and long-term obligations approximate fair value because the
interest rates of the obligations are variable. Loudeye is exposed to credit risk because it extends credit to its
customers. Loudeye performs initial and ongoing evaluations of its customers
financial condition and generally extends credit on open account, requiring
collateral as deemed necessary. Loudeye had sales to certain significant customers, as a percentage of
revenues, as follows: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Microsoft Corporation
    
    
    17
    %
    
    
    4
    %
    
    
    14
    %
    
    
    6
    %Sony Corporation
    
    
    11
    %
    
    
    0
    %
    
    
    7
    %
    
    
    0
    %The
Coca-Cola Company
    
    
    2
    %
    
    
    12
    %
    
    
    2
    %
    
    
    11
    %30
    %
    
    
    16
    %
    
    
    23
    %
    
    
    17
    %
 Revenues from Microsoft Corporation and Sony Corporation were reported in
the digital media services segment and revenues from The Coca-Cola Company were
reported primarily in the media restoration services segment, which Loudeye
ceased providing with the sale of that business in January 2004. Impairment of Long-lived Assets Loudeye assesses the recoverability of long-lived assets whenever events
or changes in business circumstances indicate that the carrying value of an
asset may not be recoverable. An impairment loss is considered when the sum of
the expected undiscounted future net cash flows over the remaining useful life
is less than the carrying amount of the asset. Goodwill and Intangible Assets Loudeye accounts for goodwill and intangible assets in accordance with
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (FAS 142). Under FAS 142, goodwill and intangible assets
deemed to have indefinite lives
are not amortized, but are subject to, at a minimum, annual impairment tests.
Loudeye completes its annual impairment test as of November 30 of each year. As
disclosed in Note 5, Loudeye has recorded goodwill and intangible assets in
connection with its acquisition of Overpeer, Inc. in March 2004 and OD2 in June
2004. Foreign Currencies For operations outside the U.S. that prepare financial statements in
currencies other than U.S. dollars, the financial statements are translated
into U.S. dollars. Results of operations and cash flows are translated at
average rates of exchange prevailing during the period. Assets and liabilities
are translated at end of period exchange rates, except for equity transactions
and advances not expected to be repaid in the foreseeable future, which are
translated at historical cost. The effects of exchange rate fluctuation on
translating 9




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##### Table of Contents



foreign currency assets and liabilities into U.S. dollars are
accumulated as a separate component in other comprehensive income (loss). Revenue Recognition Loudeye recognizes revenue in accordance with Staff Accounting Bulletin
(SAB) No. 101, Revenue Recognition in Financial Statements, (SAB 101) as
amended by Staff Accounting Bulletin No. 104 (SAB 104), and Emerging Issues
Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. Loudeye recognizes revenue associated with the license of
software in accordance with Statement of Position 97-2, Software Revenue
Recognition (SOP 97-2), as amended by SOP 98-4, SOP 98-9 and related
interpretations and Technical Practice Aids. Loudeye recognizes revenues from encoding services, digital music samples
services, digital distribution services, Internet radio services, live and
on-demand webcasting services, software licensing, content protection services,
and media restoration services. Loudeye recognizes these revenues when
persuasive evidence of an arrangement exists, the product and/or service has
been delivered, the price is fixed or determinable and collectibility is
probable. In arrangements that include rights to multiple products and/or services,
Loudeye allocates the total arrangement consideration among each of the
deliverables using the residual method, under which revenue is allocated to
undelivered elements based on verifiable and objective evidence of the fair
value of the undelivered elements. Multiple element arrangements may consist of
implementation services, development services, encoding services, digital music
samples services, digital distribution services, Internet radio services, and
on-demand webcasting services. Verifiable and objective evidence is based upon
the price charged when an element is sold separately. Under the provisions of SOP 97-2, in software arrangements that involve
rights to multiple products and services, Loudeye allocates the total
arrangement consideration among each of the deliverables using the residual
method, under which revenue is allocated to the undelivered elements based on
vendor-specific objective evidence of the fair value of such undelivered
elements. Elements included in multiple element arrangements consist of
software, intellectual property, implementation services, maintenance and
consulting services. Vendor-specific objective evidence is based on the price
charged when an element is sold separately or, in the case of an element not
sold separately, the price established by management, if it is probable that
the price, once established, will not change before market introduction. Deferred revenue arises from payments received or services rendered and
billed in advance of the culmination of the earnings process. Deferred revenue
expected to be realized within the next twelve months is classified as current. Encoding services consist of the conversion of audio and video content
into digital media formats. Sales of encoding services are generally under
nonrefundable time and materials or per unit contracts. Under the provisions of
SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenues as
the encoding services are rendered and Loudeye has no continuing involvement in
the goods and services delivered, which is generally the date the finished
media is shipped to the customer. Digital music samples services are provided to customers using Loudeyes
proprietary streaming media software, tools, and processes. Music samples are
streamed files containing selected portions, or samples, of a full music track
and are typically 30 to 60 seconds in length. Customer billings are based on
the volume of data streamed at rates agreed upon in the customer contract,
subject to a nonrefundable monthly minimum fee. Under the provisions of SAB
101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenue in the
period in which the samples are delivered. Digital distribution services consist primarily of rights clearing
services, ringtune services and the hosting of digital media content for
Loudeyes customers for download by the end user. Customer billings for digital
distribution services are generally based on a
combination of a fixed monthly fee and a transactional fee per download. Under
the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye
recognizes revenue in the period in which the services are provided. Similar to the digital music samples services, Internet radio and video
services are provided to customers using Loudeyes proprietary media software,
tools and processes. Internet radio and video services can consist of the
rebroadcasting over the Internet of a customers over-the-air radio
programming. Services provided may also include playlist selection and
programming services for online radio channels and may include related video
content, such as music videos. Under the provisions of SAB 101, as amended by
SAB 104, and EITF 00-21, revenue from the sale of Internet radio and video
services is recognized on a monthly basis as the services are provided and
customers are typically billed monthly in arrears. 10




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Webcasting services are provided to customers using Loudeyes proprietary
streaming media software, tools and processes. Services for live webcast events
may be sold separately or combined with on-demand webcasting services in which
Loudeye may host an archive of the webcast event for future use on an on-demand
basis. In addition, on-demand webcasting services are often sold separately
without the live event component. As a result, Loudeye has verifiable and
objective evidence of the fair value for both the live and on-demand services.
Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye
recognizes revenue for live webcasting in the period in which the webcast event
occurs. Revenue for on-demand webcasting services are deferred and recognized
ratably over the period in which the services are provided. Customer billings
are typically based on the volume of data streamed at rates agreed upon in the
customer contract or a set monthly fee. Content protection services consist primarily of anti-piracy, data mining
and content promotion solutions related to peer-to-peer file sharing networks.
Customer billings for content protection services are generally based on a
fixed monthly fee, but may also contain a volume-based component and, for
content promotion services, a fee based on customer sales volume. Under the
provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye
recognizes revenue in the period in which the services are provided. Media restoration services consisted of services provided by Loudeyes
VidiPax subsidiary to restore and upgrade old or damaged archives of
traditional media. Under the provisions of SAB 101, as amended by SAB 104, and
EITF 00-21, Loudeye recognizes revenues as these services are rendered and
Loudeye has no continuing involvement in the goods and services delivered,
which generally is the date the finished media is shipped to the customer. As
discussed in Note 6, Loudeye completed the sale of its VidiPax business in May
2004 pursuant to an agreement dated October 31, 2003. Stock-based Compensation Loudeye accounts for stock-based employee compensation plans under the
recognition and measurement principles of Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issues to Employees (APB 25), as
interpreted by Financial Accounting Standards Board Interpretation No. 44,
Accounting for Certain Transactions Involving Stock Compensation, an
Interpretation of APB 25 (FIN 44), and related interpretations. Under APB 25,
compensation expense is based on the difference between the exercise price of
employee stock options granted and the fair value of Loudeyes common stock at
the date of grant. Deferred compensation, if any, is amortized over the vesting
period of the related options, which is three to four years. Equity instruments issued to non-employees are accounted for in accordance
with the provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (FAS 123) and Emerging Issues Task
Force Issue No. 96-18, Accounting for Equity Investments that are Issued to
Other than Employees for Acquiring or in Conjunction with Selling Goods or
Services (EITF 96-18), and related interpretations. Stock-based compensation for the quarter ended September 30, 2004 totalled
$65,000, of which $44,000 is included in cost of revenues, consisting of the
amortization of deferred stock compensation. Stock-based compensation was
$761,000 for the quarter ended September 30, 2003, of which $37,000 is included
in cost of revenues, consisting of the amortization of deferred stock
compensation of $139,000 and variable stock-based compensation expense of
$55,000 accounted for under APB 25, and stock-based compensation expense of
$567,000 accounted for under FAS 123 related to options granted to a member of
Loudeyes board of directors for consulting services. Stock-based compensation for the nine months ended September 30, 2004
totalled $268,000, of which $82,000 is included in cost of revenues, consisting
of the amortization of deferred stock compensation of $247,000, stock-based
compensation expense of $39,000, including $14,000 related to options granted
to a consultant, and a credit of $18,000 for variable stock compensation
related to stock options that were repriced in 2001. Stock-based compensation
was $998,000 for the nine months ended September 30, 2003, of which $44,000 is
included in cost of revenues, consisting of the amortization of deferred stock
compensation of $225,000, variable stock-based compensation expense of $55,000
accounted for under APB 25, stock issued to former employees as severance and
termination benefits of $30,000, and stock-based compensation expense of
$668,000 accounted for under FAS 123 related to options granted to a member of
Loudeyes board of directors for consulting services. 11




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The following table illustrates the effect on net loss and net loss per
share if Loudeye had applied the fair value recognition provisions of FAS 123
to stock-based employee compensation (in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (5,331
    )
    
    $
    (2,340
    )
    
    $
    (10,759
    )
    
    $
    (17,460
    )Add: stock-based employee compensation
expense under APB 25 included in reported
net loss
    
    
    65
    
    
    
    194
    
    
    
    268
    
    
    
    280Deduct: total stock-based employee
compensation expense determined under
fair value method for all awards
    
    
    (1,035
    )
    
    
    (533
    )
    
    
    (2,355
    )
    
    
    (548
    )Pro forma net loss
    
    $
    (6,301
    )
    
    $
    (2,679
    )
    
    $
    (12,846
    )
    
    $
    (17,728
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.07
    )
    
    $
    (0.05
    )
    
    $
    (0.15
    )
    
    $
    (0.37
    )Basic and diluted  pro forma
    
    $
    (0.08
    )
    
    $
    (0.05
    )
    
    $
    (0.18
    )
    
    $
    (0.37
    )
 To determine compensation expense under FAS 123, Loudeye used the following
assumptions: 2004
    
    2003Risk-free interest rates
    
    
    2.33-5.71
    %
    
    
    2.68-5.71
    %Expected lives
    
    3 years
    
    5 yearsExpected dividend yields
    
    
    0
    %
    
    
    0
    %Expected volatility
    
    
    115
    %
    
    
    136
    %
 Comprehensive Loss Comprehensive
loss is comprised of net loss and other comprehensive
income (loss), net. Other comprehensive income (loss), net includes
unrealized gains losses on
foreign exchange and unrealized gains and losses on marketable securities. For
the three months ended September 30, 2004, other comprehensive
income (loss), net totaled $5.7 million. There was an unrealized gain on marketable securities of
$20,000 and a foreign currency translation adjustment of $380,000 in the third
quarter 2004. For the three and nine month periods ended
September 30, 2003,
other than net loss, there were no items that impacted other comprehensive
income (loss), net. Reclassifications Certain information reported in previous periods has been reclassified to
conform to the current period presentation. These reclassifications had no
impact on previously reported net loss, stockholders equity or cash flows. 12




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3. SPECIAL CHARGES Loudeye has recorded special charges related to corporate
restructurings, facilities consolidations and the impairment of assets in
accordance with its long-lived asset policy (see Note 2). The following table
summarizes such charges recorded in the consolidated statements of operations
(in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Goodwill impairment
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    5,307Intangible assets impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    685Property and equipment impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    601Employee severance and termination benefits
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    501Facilities related charges
    
    
    350
    
    
    
    
    
    
    
    300
    
    
    
    465Other restructuring charges
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    878$
    350
    
    
    $
    
    
    
    $
    300
    
    
    $
    8,437
 The following table summarizes the activity in accrued special charges
during the nine months ended September 30, 2004 (in thousands): Facilities- relatedchargesBalance, December 31, 2003
    
    $
    1,670Additional accruals
    
    
    350Payments
    
    
    (1,099
    )Adjustments
    
    
    (50
    )Balance, September 30, 2004
    
    $
    871
 During the fourth quarter 2002, management committed to a plan to exit
certain of Loudeyes leased facilities, including Loudeyes unoccupied facility
at 414 Olive Way, Seattle, Washington. Under the provisions of EITF 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity, Loudeye recorded the estimated lease termination
costs in accrued special charges. As discussed in Note 9, the landlord of
Loudeyes unoccupied facility at 414 Olive Way, Seattle, Washington filed suit
against Loudeye in April 2003 for breach of its lease. In January 2004, the
Court entered a judgment in favor of the plaintiff for rents due through
January 2004 of $438,000, which Loudeye had accrued in a prior period and paid
in the first quarter 2004. On November 12, 2004, Loudeye settled this suit. As
of December 31, 2003, and June 30, 2004, Loudeye had recorded in accrued
special charges an estimate of the additional amount that Loudeye may
ultimately be required to pay with respect to the litigation matter. As a
result of the settlement, Loudeye has increased its estimate of the additional
amount which it may ultimately be required to pay by $350,000. Loudeye has
reflected this amount as special charges  other on its condensed
consolidated statement of operations. On November 4, 2004, Loudeye issued
preliminary financial results for the quarter ended September 30, 2004, which
reported a net loss of $5.0 million, or $0.06 per share. As a result of the
increased accrual, Loudeyes net loss for the quarter ended September 30, 2004,
increased to $5.3 million, or $0.07 per share. The total amount paid by
Loudeye to settle this suit will be $1.7 million, consisting of $1.0 million
previously paid by Loudeye under a letter of credit, deposits
previously paid and pursuant to the January
2004
Court judgment, and $720,000 of new cash consideration, $360,000 of which
Loudeye paid on November 12, 2004 and the remainder of which is payable in
January 2005. At December 31, 2003, Loudeye had accrued special charges under the
provisions of FAS No. 146, Accounting for Costs Associated with Exit or
Disposal Activities (FAS 146) related to its VidiPax facility in New York, New
York. The lease agreement was originally entered into in December 2002 and
Loudeye had never occupied the facility. During 2003, Loudeye informed the
landlord of its decision to release its rights under the lease agreement and
had been in ongoing discussions with the landlord to negotiate a lease
termination agreement. Accordingly, under the requirements of FAS 146, Loudeye
had accrued $562,000 of accrued special charges through the third quarter 2003
representing the estimated fair value of future rental payments, net of
estimated sublease rentals and related costs with respect to the termination of
this lease. In December 2003, Loudeye accrued an additional 13




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$150,000, for a
total accrual of $712,000, to adjust its estimate of the fair value of the
liability based on further negotiations with the landlord. In February 2004,
Loudeye entered into a lease settlement agreement with the landlord pursuant to
which Loudeye paid the landlord $450,000 and allowed the landlord to retain its
security deposit of $212,000, for a total settlement of $662,000. The $50,000
difference between the amount recorded in accrued special charges and the final
settlement amount has been reflected as a credit to special charges
during the first quarter 2004 in the consolidated statement of operations. In February 2003, Loudeyes Chairman and Chief Executive Officer, John T.
Baker, resigned and Loudeye engaged Regent Pacific Management Corporation to
provide management services to Loudeye. In March 2003, Regent Pacific resigned
from the engagement and Jeffrey M. Cavins was elected President and Chief
Executive Officer. These events are described more fully in Loudeyes Annual
Report on Form 10-K for the year ended December 31, 2003. During and subsequent
to Regent Pacifics engagement, Loudeye undertook a strategic and operational
analysis of its business and product lines. This analysis resulted in the
development of a new strategic and operational plan, under which Loudeye
restructured itself to focus on its core competencies in digital media services
and on core strategic customers and markets for its enterprise communications
services. A revised corporate forecast was developed in connection with this
plan. The revised forecast also considered that Loudeye had learned that
revenue from a significant customer in its Media Restoration Services segment
would be less than originally anticipated. Using the revised forecast, Loudeye
performed a reassessment of the carrying value of all of its assets, both
tangible and intangible. The revised forecast demonstrated that certain
tangible and intangible assets related to its media restoration services and
enterprise communications services businesses were impaired, as the projected
undiscounted discernible cash flows did not exceed the carrying value of the
assets over their estimated useful lives. The fair values of each of these
assets were estimated using primarily a discounted cash flow method. The fair
value of goodwill was estimated under the two-step process required by FAS 142.
The estimated fair values of each of the assets were then compared to their
carrying values to measure the impairments. As a result of this analysis,
Loudeye recorded impairment charges for goodwill, intangible assets, and
property and equipment related to its enterprise communication services and
media restoration services businesses of $5.3 million, $685,000, and $601,000,
respectively, during the first quarter 2003. In addition to the impairment charges above, Loudeye recorded severance
and termination benefits of $204,000 associated with a reduction in force
announced in March 2003 of approximately 35% of its consolidated staffing.
Loudeye also recorded $297,000 of severance and termination benefits with
respect to certain changes in senior management in the first quarter 2003.
Loudeye incurred costs of approximately $465,000 related to the termination of
certain facilities leases in connection with its facilities consolidation. The
other restructuring charges of $878,000 represent fees and costs paid to Regent
Pacific Management Corporation with respect to interim management services
provided to Loudeye in connection with its management and operational
restructuring. 4. NET LOSS PER SHARE Basic earnings per share is computed by dividing net loss by the weighted
average number of shares of common stock outstanding during the period. Diluted
earnings per share is computed by dividing net loss by the weighted average
number of common and dilutive common equivalent shares outstanding during the
period. Common equivalent shares consist of shares of common stock issuable
upon the exercise of stock options and warrants (using the treasury stock
method). For all periods presented, common equivalent shares are excluded from
the calculation because their effect is antidilutive as a result of Loudeyes
net losses. The dilutive effect of approximately 1,041,000 warrants and
options to purchase approximately 13,025,000 shares are excluded for the three
and nine-month periods ended September 30, 2004 because such warrants and
options were anti-dilutive; therefore, there is no difference in the
calculation between basic and diluted per share amounts. The dilutive effect
of approximately 1,100,000 warrants and options to purchase approximately
7,221,000 shares are excluded for the three and nine-month periods ended
September 30, 2003 because such warrants and options were anti-dilutive;
therefore, there is no difference in the calculation between basic and diluted
per share amounts. There were no shares subject to repurchase at September 30, 2004. Loudeye
had 300 shares outstanding that were subject to repurchase at September 30,
2003, which shares have been removed from the calculation of weighted average
shares outstanding for purposes of determining basic and diluted net loss per
share. 14




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The following table presents a reconciliation of shares used to calculate
basic and diluted earnings per share (in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares outstanding
    
    
    79,285
    
    
    
    50,401
    
    
    
    71,149
    
    
    
    47,660Weighting of shares subject to repurchase
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1
    )Weighted average shares used to calculate
basic and diluted earnings per share
    
    
    79,285
    
    
    
    50,401
    
    
    
    71,149
    
    
    
    47,659
 5. ACQUISITIONS On Demand Distribution Limited On June 22, 2004, Loudeye commenced a tender offer to acquire 100% of the
outstanding shares of On Demand Distribution Limited (OD2), a privately held
digital music provider based in Europe. Loudeye acquired 93% of the shares of
OD2 upon commencement of the tender offer. As of August 17, 2004 Loudeye
acquired the remaining 7% of OD2s shares on the same terms from the remaining
shareholders of OD2. This acquisition supports Loudeyes commitment to
providing global services by broadening its reach and capabilities into key
geographic regions including Europe, the second largest music market in the
world, and Australia. In addition, the acquisition expands Loudeyes content
management and anti-piracy content protection services into Europe and will
enable Loudeye to leverage OD2s reach to expand its business into new markets.
The unaudited consolidated statement of operations of Loudeye for the nine
month period ended September 30, 2004, includes the results of operations of
OD2 effective from June 22, 2004 to September 30, 2004. The consideration for the transaction consisted of the following elements:  
    
    Loudeye issued 9,065,919 shares of its common stock on June 22, 2004,
and 599,259 shares of its common stock on August 25, 2004 to existing OD2 shareholders and
option holders.
    
    Loudeye expects to issue up to 2,212,302 additional shares of its
common stock, representing shares to be issued to OD2 option holders
issuable upon exercise of OD2 options assumed by Loudeye.
    
    Certain of OD2s principal shareholders agreed to have an aggregate of
15% of the total consideration payable in the transaction held in
escrow by Loudeye for 18 months to satisfy claims Loudeye may have
with respect to breaches of representations, warranties and covenants,
indemnification claims and working capital adjustments. As of
September 30, 2004, Loudeye had issued and placed in escrow 2,072,369
shares of its common stock to 17 former OD2 shareholders who had
tendered their shares of OD2 stock as of that date. Loudeye is
obligated to issue and place into escrow an additional 20,131 shares
of its common stock to one individual upon exercise of options held by
such individual.
    
    Loudeye paid approximately $900,000 in cash to retire certain
liabilities as of September 30, 2004, and it is obligated to pay an
additional $1.0 million to retire additional liabilities.
    
    Loudeye is obligated to pay an additional £8.3 million (approximately
$14.8 million based on exchange rates as of September 30, 2004),
excluding the 15% additional consideration to be held in escrow (as
discussed below), through November 30, 2005, to OD2s shareholders, as
follows: 
    
    On November 30, 2004, approximately £1.1 million or $1.9 million;
    
    On January 31, 2005, approximately £4.0 million or $7.2 million;
    
    On May 31, 2005, approximately £1.1 million or $1.9 million; and
    
    On November 30, 2005, approximately £2.1 million or $3.8 million. 15




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##### Table of Contents




    
    15% of the total additional consideration that Loudeye is required to
pay to the OD2 shareholders through November 30, 2005, or
approximately $2.6 million, will be placed into escrow along with the
escrow shares.
    
    Loudeye is obligated to pay an additional contingent consideration of
up to £10.0 million (approximately $18.0 million based on exchange
rates as of September 30, 2004), which amount has not been adjusted
for the 15% holdback in escrow, if OD2 achieves
certain financial performance targets during the period through
November 30, 2006. Loudeye
issued promissory notes in aggregate principal amount of
£1.9 million (approximately $3.4 million based on
exchange rates as of September 30, 2004) to ten of OD2s former
shareholders. Loudeyes obligations under these notes are included
within the £8.3 million (approximately $14.8 million
based on exchange rates as of September 30, 2004) of accrued
acquisition consideration and within the approximately
$2.6 million of additional consideration to be paid
into escrow described above. The notes bear interest at 5% per annum
and are repayable in unequal installments on December 30, 2004
and on January 31, May 31 and November 30, 2005 (which
installments are proportional to the amounts of deferred
consideration we are required to pay on November 30, 2004 and on
January 31, May 31 and November 30, 2005). Interest
expense for the quarter ended September 30, 2004 was
approximately $11,000. Aggregate interest expense over the terms of
the notes will be included in interest expense and will be
approximately £60,000 (approximately $108,000 based on exchange
rates as of September 30, 2004). If Loudeye obtains the approval
of our stockholders to pay our future obligations to OD2s former
shareholders in shares of Loudeyes common stock, Loudeye may satisfy
its payment obligations under the notes by issuing shares of its
common stock to the noteholders. The number of shares which Loudeye
would be required to issue will be determined based on the volume
weighted average share price of Loudeyes common stock for a
specified period prior to issuance. The escrow shares and the 15%, or approximately $2.6 million, of
additional consideration described above are not recorded as liabilities and
the value of the shares held in escrow and the 15% additional consideration was
not included in determining the cost of acquiring OD2 as of September 30, 2004,
since the resolution of the escrow shares and 15% additional consideration is
still pending. Loudeye will reflect the escrow shares as outstanding and the
liability relating to the 15% additional consideration as accrued and record
the value of both as additional costs of acquiring OD2 upon the earlier of the
expiration of the 18 month escrow period (to the extent
such shares and additional consideration are released from escrow) or when Loudeye believes beyond a
reasonable doubt that it will not state a claim pursuant to the terms of the
escrow. The
number of shares issued and to be issued upon exercise of options of 13,949,849 constituted
approximately 19.9% of Loudeyes outstanding shares of common stock at the
commencement of the tender offer. Based on managements internal analysis, excluding the impact of the
escrow shares and 15% additional consideration discussed above, as of September
30, 2004 Loudeye has preliminarily recorded $35.7 million of net assets in
connection with the transaction consisting of upfront stock consideration,
including the assumption of OD2 options, deferred consideration, cash
obligations to retire certain liabilities, and Loudeyes transaction related
expenses. As of June 22, 2004, the initial purchase price excluded minority
interest related to the acquisition and included preliminary estimates of
certain transaction consideration. Because OD2 had a deficit in net worth at
acquisition, the 7% minority interest that Loudeye had not yet
acquired was not reflected in Loudeyes consolidated
balance sheet at June 30, 2004. As of August 17, 2004, Loudeye subsequently
acquired the remaining 7% of OD2s shares and adjusted certain transaction
consideration based upon current information. The initial purchase price can
be summarized at June 22, 2004 and September 30, 2004 as follows (amounts in
thousands): June 22, 2004
    
    Sept. 30, 2004Transaction related expenses
    
    $
    1,527
    
    
    $
    1,527Cash paid at closing
    
    
    900
    
    
    
    900Cash due on certain liabilities assumed
    
    
    1,878
    
    
    
    978Accrued acquisition consideration
    
    
    13,654
    
    
    
    15,104Common stock payable related to acquisition
    
    
    2,596
    
    
    
    3,208Common stock issued in connection with acquisition
    
    
    13,146
    
    
    
    14,015$
    33,701
    
    
    $
    35,732
 The accrued acquisition consideration recorded in Loudeyes financial
statements as of September 30, 2004, has been adjusted to reflect the foreign
currency exchange rate at September 30, 2004, and a foreign currency transaction
gain of $0 and $183,000 was recorded in other income in the accompanying
consolidated statement of operations for the three and nine month
periods ended
September 30, 2004. Under the terms of the offer, future cash consideration is payable in
British currency (pounds), and accordingly the corresponding U.S. dollar
amounts set forth above may vary with fluctuations in the prevailing exchange
rate. All future payments are payable in cash or, at Loudeyes election and if
approved by stockholders representing a majority of Loudeyes outstanding
shares (excluding shares issued in connection with the transaction), in shares of Loudeye common stock, the number of which will be
determined based on Loudeyes volume weighted average share price for a
specified period prior to issuance. OD2 shareholders may also elect to receive
promissory notes in lieu of any cash 16




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payments that Loudeye may be required to make. Loudeye has also agreed to
reserve approximately 2 million shares for stock option grants under its 2000
Stock Option Plan to employees of OD2 for future services. Loudeye has agreed to file a registration statement covering the resale of
the initial shares issued. The registration statement has not yet been
filed. Loudeye accounted for the acquisition in accordance with Statement of
Financial Accounting Standards No. 141, Business Combinations. In accordance
with EITF Issue No. 99-12, Determination of the Measurement Date for the
Market Price of Acquirer Securities Issued in a Purchase Business Combination,
for purposes of estimating the value of the OD2 purchase consideration, the
fair value of the Loudeye common stock to be issued for the acquisition of OD2
was determined to be $1.45 per share based on the average closing price of
Loudeyes common stock over the two day periods before and after June 22, 2004,
the date the acquisition was announced, multiplied by the Loudeye shares issued
based upon the exchange ratio set forth in the merger agreement. The fair value
of options assumed is deemed to be equivalent to the value of the underlying
Loudeye shares into which such options are exercisable given the nominal strike
price of such options. In accordance with FAS No. 52,
Foreign Currency Translation, and as a result of currency
fluctuation between the U.S. dollar and British pound since the
June 22, 2004 acquisition date, Loudeye adjusted the accrued
acquisition consideration recorded in Loudeyes unaudited
interim condensed consolidated balance sheet and recorded a foreign
currency transaction gain of $0 and $183,000 in other income in the
accompanying unaudited interim condensed consolidated statement of
operations for the three and nine month periods ended
September 30, 2004. The following table summarizes as of June 22, 2004 and September 30, 2004,
the preliminary estimated fair values of the assets acquired and liabilities
assumed, along with the preliminary estimated useful lives of property and
equipment and intangible assets, based upon managements internal analysis,
which have been recorded in Loudeyes digital media services segment (in
thousands): Purchase Price Allocation
    
    UsefulJune 22, 2004
    
    Sept. 30, 2004
    
    LifeCurrent assets
    
    $
    2,700
    
    
    $
    2,700Property and equipment
    
    
    629
    
    
    
    629
    
    
    1-3 yearsGoodwill
    
    
    33,598
    
    
    
    35,629Acquired technology
    
    
    2,970
    
    
    
    2,970
    
    
    3 yearsCurrent liabilities
    
    
    (6,196
    )
    
    
    (6,196
    )Total purchase price allocation
    
    $
    33,701
    
    
    $
    35,732
 The purchase price allocation set forth above is preliminary and subject
to change in future periods pending the completion of an independent valuation
report. Loudeye is currently in the process of finalizing its assessment of the
fair value of the net assets acquired. The preliminary allocation of the
purchase price to tangible and intangible assets, as well as the related
amortization expense, may change materially as a result of the completion of
Loudeyes evaluation of the fair value of the net assets acquired. The weighted average amortization period of amortizable intangibles
acquired is estimated to be three (3) years. The goodwill recorded is not
expected to be amortizable for income tax purposes. The goodwill associated
with OD2 will be included in Loudeyes digital media services segment. Overpeer, Inc. In March 2004, Loudeye completed the acquisition of Overpeer, Inc.
(Overpeer), a privately held company based in New York. Pursuant to the
Agreement and Plan of Merger and Reorganization (Merger Agreement), among
Loudeye, Privateer Acquisition Corp., a wholly owned subsidiary of Loudeye,
Overpeer and certain of Overpeers stockholders. Privateer Acquisition Corp.
was merged with and into Overpeer, with Overpeer continuing as the surviving
company and a wholly-owned subsidiary of Loudeye (the Merger). As a result of
the Merger, all of the outstanding capital stock of Overpeer was exchanged for
a total of 1,752,772 shares of Loudeyes common stock. The number of shares
issued in the Merger was calculated by dividing $4.0 million by the volume
weighted average closing share price of Loudeyes common stock on each of the
thirty consecutive trading days preceding the closing of the Merger, or $2.2821
per share. Of the shares issued in the Merger, 262,916 will be held in escrow
for one year and will be available during that time to satisfy indemnity claims
under the Merger Agreement. Loudeye filed a registration statement in March
2004 for the resale of the securities issued to the Overpeer shareholders,
which registration statement was declared effective on May 26, 2004. Overpeer is a provider of digital media data mining, anti-piracy and
promotional solutions, which are complimentary to Loudeyes current and planned
future digital media solutions. The acquisition is intended to allow Loudeye to
provide a more complete suite of digital media solutions to its customers. 17




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Loudeye accounted for the acquisition in accordance with Statement of
Financial Accounting Standards No. 141, Business Combinations. In accordance
with EITF Issue No. 99-12, Determination of the Measurement Date for the
Market Price of Acquirer Securities Issued in a Purchase Business Combination,
the fair value of the shares issued was determined to be $2.26 per share based
on the closing price of Loudeyes common stock on February 29, 2004, which was
the date on which the number of shares issued could be determined. Overpeers
operating results have been included in the accompanying consolidated
statements of operations effective beginning in March 2004. The following table
summarizes the estimated fair values of the assets acquired and liabilities
assumed, along with the estimated useful lives of property and equipment and
intangible assets, which have been recorded in Loudeyes digital media services
segment (in thousands): PurchasePriceAllocation
    
    Useful lifeCurrent assets
    
    $
    277Property and equipment
    
    
    278
    
    
    1-3 yearsGoodwill
    
    
    2,434Trademark
    
    
    42
    
    
    IndefiniteAcquired technology
    
    
    682
    
    
    5 yearsCustomer relationships
    
    
    317
    
    
    7 yearsNon-compete agreements
    
    
    373
    
    
    3 yearsOther long-term assets
    
    
    8Current liabilities
    
    
    (321
    )Total purchase price allocation
    
    $
    4,090
 The purchase price allocation set forth above includes acquisition costs
of $129,000. Pro forma financial information The following table presents the unaudited pro forma results of Loudeye
for the three and nine months ended September 30, 2004 and 2003 assuming
Loudeye had acquired OD2 and Overpeer at the beginning of each period (in
thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Total revenues
    
    $
    5,080
    
    
    $
    4,165
    
    
    $
    14,428
    
    
    $
    11,956Net loss
    
    
    (5,331
    )
    
    
    (3,853
    )
    
    
    (17,689
    )
    
    
    (23,280
    )Basic and diluted net loss per share
    
    $
    (0.07
    )
    
    $
    (0.08
    )
    
    $
    (0.25
    )
    
    $
    (0.49
    )
 6. SALE OF MEDIA RESTORATION BUSINESS On January 30, 2004 (Transfer Date), Loudeyes wholly-owned media
restoration services subsidiary, VMRLE Co., Inc. (formerly VidiPax, Inc.),
transferred substantially all of its assets and certain liabilities to a
company controlled by the former general manager of VMRLE Co., Inc. pursuant to
an asset purchase agreement signed on October 31, 2003 and amended on January
30, 2004. The total purchase price of $1.2 million was placed in escrow when
the asset purchase agreement was signed. Based on the January 30, 2004
amendment, $900,000 of the $1.2 million purchase price was to be released from
escrow upon the assignment to the purchaser of contracts with the General
Services Administration of the United States (GSA Contracts). If the GSA
Contracts were not assigned within a certain time period after the Transfer
Date, the purchaser had the option to unwind the transfer and reclaim the $1.2
million held in escrow. Accordingly, the assets and liabilities transferred
were recorded on the consolidated balance sheet as assets and liabilities
transferred under contractual arrangement at their carrying value as of the
Transfer Date. As of December 31, 18




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2003, these assets and liabilities were classified as held for sale. At March
31, 2004, these assets and liabilities were classified as net assets
transferred under contractual arrangement. On May 17, 2004, (Accounting
Closing Date), the GSA Contracts were assigned to the purchaser, resulting in
the subsequent release of the $900,000 from escrow to VMRLE Co., Inc. For the
period from the Transfer Date to the Accounting Closing Date, VMRLE Co., Inc.
continued to be the contracting party with the GSA. The media restoration
services provided under the GSA Contracts during that period were provided by
the purchaser as agent for VMRLE Co., Inc. and the purchaser retained the
profits or losses earned from such services. Because VMRLE Co. continued to be
the primary obligor under the GSA Contracts until their assignment, revenues
and costs of revenues in the consolidated statement of operations of Loudeye
reflect the revenues and cost of revenues from services provided under the GSA
Contracts totalling $213,000 for the period from the Transfer Date through the
Accounting Closing Date, of which $95,000 was recorded as revenue and cost of
revenues in the first quarter 2004 and $118,000 was recorded as revenue and
cost of revenues in the second quarter 2004. All other revenues and costs of
VMRLE Co., Inc.s operations have been appropriately excluded from Loudeyes
statement of operations subsequent to the Transfer Date. The difference between
the $900,000 proceeds received from escrow and the carrying value of the assets
and liabilities transferred as of the Accounting Closing Date is $160,000 and
was recorded as a loss on the sale of net assets transferred under contractual
arrangement in the second quarter 2004. With the GSA Contracts assigned to the purchaser, the remaining $300,000
of the $1.2 million originally held in escrow was released during third quarter
2004 upon the execution of an agreement relating to certain rights associated
with certain equipment owned by a third party and was recorded as a gain of
$273,000 during the third quarter 2004. Loudeye may receive up to an additional $500,000 based on the purchaser
achieving certain performance targets over a period of two years from the
Transfer Date. At transfer, Loudeye also entered into a co-marketing and
reseller agreement with the purchaser pursuant to which Loudeye will sell, for
a fee, media restoration services on behalf of the purchaser for a two-year
period. The co-marketing and earn-out provisions constitute continuing
involvement by Loudeye under Statement of Financial Accounting
Standards No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (FAS 144). Consequently, VMRLE Co. Inc. has not been
reported as a discontinued operation. 7. PRIVATE EQUITY FINANCING In February 2004, Loudeye sold 10,810,811 shares of common stock at $1.85
per share to a limited number of accredited investors. The gross proceeds
received from the financing were $20.0 million. Loudeye paid a placement fee
equal to 5% of the gross proceeds. The net proceeds of the offering, after
commissions and expenses, will be used for working capital and general
corporate purposes, including expansion of Loudeyes business-to-business
digital music solutions in the U.S. and internationally. Loudeye filed a
registration statement in March 2004 covering the resale of the shares sold in
the financing and the registration statement was declared effective by the SEC
on May 26, 2004. 19




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##### Table of Contents



8. SEGMENT INFORMATION Loudeye operates in two business segments, Digital Media Services and
Media Restoration Services. As described in Note 6, Loudeye transferred the
assets and certain liabilities of its media restoration services business on
January 30, 2004, and completed the sale on May 17, 2004. The following
information summarizes Loudeyes segments (in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003RevenuesDigital media services
    
    $
    5,080
    
    
    $
    2,407
    
    
    $
    9,905
    
    
    $
    7,566Media restoration services
    
    
    
    
    
    
    404
    
    
    
    297
    
    
    
    1,458Total revenue
    
    $
    5,080
    
    
    $
    2,811
    
    
    $
    10,202
    
    
    $
    9,024Net income (loss)Digital media services
    
    $
    (5,604
    )
    
    $
    (2,010
    )
    
    $
    (10,822
    )
    
    $
    (16,086
    )Media restoration services
    
    
    273
    
    
    
    (330
    )
    
    
    63
    
    
    
    (1,374
    )Total net loss
    
    $
    (5,331
    )
    
    $
    (2,340
    )
    
    $
    (10,759
    )
    
    $
    (17,460
    )Total assetsDigital media services
    
    $
    80,121
    
    
    $
    24,859
    
    
    $
    80,121
    
    
    $
    24,859Media restoration services
    
    
    
    
    
    
    1,251
    
    
    
    
    
    
    
    1,251Total assets
    
    $
    80,121
    
    
    $
    26,110
    
    
    $
    80,121
    
    
    $
    26,110
 9. CONTINGENCIES Legal Proceedings On September 10, 2004, Loudeye was served in a patent infringement lawsuit
brought by Altnet, Inc, and others against Loudeye, its Overpeer subsidiary,
Marc Morgenstern, one of our executive officers, the Recording Industry
Association of America and others. The complaint, filed in federal district
court in Los Angeles, California, involves two patents that appear to cover
file identifiers for use in accessing, identifying and/or sharing files over
peer-to-peer networks. The complaint alleges that the anti-piracy solutions
offered by Loudeyes Overpeer subsidiary infringe the patents in question. The
complaint does not state a specific damage amount. On November 1, 2004,
Loudeye filed a motion to dismiss the complaint. Loudeye has indicated it
intends to defend itself, Overpeer and Mr. Morgenstern vigorously against the
allegations contained in the complaint. At present, Loudeye cannot assess the
probability of an unfavorable outcome or the magnitude of any such outcome. In February 2003, Loudeye entered into an agreement with Regent Pacific
Management Corporation pursuant to which Regent Pacific would provide
management services. The agreement was for a term of 26 weeks, with an option
to renegotiate certain terms of the agreement after 13 weeks, and was
terminable by either party under certain circumstances. Under the agreement,
Loudeye paid certain cash fees to Regent Pacific. In addition, Regent Pacific
was to receive stock options to purchase up to 4,000,000 shares of Loudeye
common stock based on Regent Pacifics length of service. These options were to
be granted at various times throughout their engagement at exercise prices
based on the closing market price on each grant date. In March 2003, Regent
Pacific resigned from the engagement. In July 2003, Regent Pacific filed suit
against Loudeye in the Superior Court of California in San Francisco County for
breach of the agreement. In this complaint, Regent Pacific is seeking
unspecified damages and specific performance of the alleged obligation to grant
the stock options due to them under the contract. Loudeye answered the
complaint in September 2003 denying all allegations and asserting
counterclaims. In March 2004, the court granted Loudeyes motion to transfer
the case to the United States District Court for the Western District of
Washington. Loudeye intends to defend vigorously this action and to pursue
vigorously its counterclaims. The likelihood of loss is not considered probable
and the amount of loss, if any, is not estimable at this time. Between January 11 and December 6, 2001 class action complaints were filed
in the United States District Court for the Southern District of New York.
These actions were filed against 310 issuers (including Loudeye), 55
underwriters and numerous individuals including certain of Loudeyes former
officers and directors. The various complaints were filed purportedly on behalf
of a class of persons who purchased Loudeye common stock during the time period
between March 15 and December 6, 2000. The complaints allege violations of the
Securities Act of 1933 and the Securities Exchange Act of 1934, primarily based
on allegations that Loudeyes underwriters received undisclosed compensation in
connection with its initial public offering and that the underwriters entered
into undisclosed arrangements with some investors that were designed to distort
and/or inflate the market price for its common stock in the aftermarket. These
actions were consolidated for pre-trial purposes. No specific amount of damages
has been claimed. Loudeye and the individual defendants have demanded to be
indemnified by underwriter defendants pursuant to the underwriting agreement
entered into at the time of the initial public offering. Presently all claims
against the former officers have been withdrawn without prejudice. 20




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The Court suggested that the parties select six test cases to determine
class-action eligibility. Loudeye is not a party to any of the test cases. In
June 2003, a proposed settlement was structured between plaintiffs, issuer
defendants, issuer officers and directors named as defendants, and issuers
insurance companies. This proposed settlement provides, among other matters,
that:  
    
    issuer defendants and related individual defendants will be released
from the litigation without any liability other than certain expenses
incurred to date in connection with the litigation;
    
    issuer defendants insurers will guarantee $1.0 billion in recoveries by plaintiff class members;
    
    issuer defendants will assign certain claims against underwriter defendants to the plaintiff class members; and
    
    issuer defendants will have the opportunity to recover certain
litigation-related expenses if plaintiffs recover more than $5.0 billion
from underwriter defendants. Loudeyes board of directors approved the proposed settlement in August 2003.
On June 25, 2004, the plaintiffs filed a motion for preliminary approval of the
settlement with the Court, which was accompanied by a brief filed by the issuer
defendants in support of the plaintiffs motion. The Court requested that any
objections to preliminary approval of the settlement be submitted by July 14,
2004, and the underwriter defendants formally objected to the settlement. The
plaintiffs and issuer defendants separately filed replies to underwriter
defendants objections to the settlement on August 4, 2004. On October 13, 2004
the Court issued an order granting plaintiffs September 2, 2003 motion for
class certification in each of the six test cases. There can be no assurance
that this proposed settlement would be approved and implemented in its current
form, or at all. Loudeyes management does not anticipate that the Company
will be required to pay any amounts under this settlement. In April 2003, the landlord of Loudeyes former facility at 414 Olive Way,
Seattle, Washington filed suit against Loudeye in the Superior Court of
Washington, King County, for breach of its lease and is seeking damages of $2.0
million. In January 2004, the court entered a judgment in favor of the landlord
for rents due through January 2004 of $438,000, which Loudeye had accrued in a
prior period and paid in the first quarter 2004. On November 12, 2004, Loudeye
settled this suit. As of December 31, 2003, and June 30, 2004, Loudeye had
recorded in accrued special charges an estimate of the additional amount that
Loudeye may ultimately be required to pay with respect to the litigation
matter. As a result of the settlement, Loudeye increased the additional amount
which it will be required to pay by $350,000. Loudeye has reflected this
amount as special charges  other on its condensed consolidated
statement of operations. On November 4, 2004, Loudeye issued preliminary
financial results for the quarter ended September 30, 2004, which reported a
net loss of $5.0 million, or $0.06 per share. As a result of the increased
accrual, Loudeyes net loss for the quarter ended September 30, 2004, increased
to $5.3 million, or $0.07 per share. The total amount paid by Loudeye to
settle this suit will be $1.7 million, consisting of $1.0 million previously
paid by Loudeye under a letter of credit, deposits previously paid and pursuant to the January 2004 Court
judgment, and $720,000 of new cash consideration, $360,000 of which Loudeye
paid on November 12, 2004 and the remainder of which is payable in January
2005. Loudeye becomes involved from time to time in various other claims and
lawsuits incidental to the ordinary course of its operations, including
contract and lease disputes and complaints alleging employment discrimination.
Loudeye believes that the outcome of any such pending claims or proceedings
individually or in the aggregate, will not have a material adverse effect upon
its business or financial condition, cash flows, or results of operations. Indemnifications In the normal course of business, Loudeye indemnifies other parties,
including business partners, lessors and parties to other transactions with
Loudeye. Loudeye has agreed to hold the other parties harmless against losses
arising from a breach of representation or covenants, or out of intellectual
property infringement or other claims made by third parties. These agreements
may limit the time within which an indemnification claim can be made. In
addition, Loudeye has entered into indemnification agreements with its
directors, executive officers and certain other officers and Loudeyes amended
bylaws contain similar indemnification obligations to Loudeyes officers and
directors. For all agreements entered into after December 31, 2002, the fair
value of potential claims has not been recorded in Loudeyes financial
statements because they are not material. 10. SUBSEQUENT EVENTS In October 2004, Loudeye was notified by Silicon Valley Bank that it had
failed to comply with certain financial covenants required by the loan
agreement. Loudeye was subsequently notified that it had cured the default
within the cure period by establishing a certificate of deposit in the amount
of $2.2 million, which was equal to the outstanding loan balance as of that
date. 21




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##### Table of Contents



On November 5, 2004, Loudeye issued a warrant to purchase 180,000 shares
of its common stock, par value $0.001 per share, to an individual for services
rendered. The exercise price per share is $1.13. The warrant has a two year
term and expires on November 5, 2006. As discussed in Note 9, in April 2003, the landlord of Loudeyes former
facility at 414 Olive Way, Seattle, Washington filed suit for breach of its
lease and is seeking damages of $2.0 million. On November 12, 2004, Loudeye
settled this suit. As of December 31, 2003, and June 30, 2004, Loudeye had
recorded in accrued special charges an estimate of the additional amount that
Loudeye may ultimately be required to pay with respect to the litigation
matter. As a result of the settlement, Loudeye has increased the amount which
it will ultimately be required to pay by $350,000. Loudeye has reflected this
amount as special charges  other on its condensed consolidated
statement of operations. On November 4, 2004, Loudeye issued preliminary
financial results for the quarter ended September 30, 2004, which reported a
net loss of $5.0 million, or $0.06 per share. As a result of the increased
accrual, Loudeyes net loss for the quarter ended September 30, 2004, increased
to $5.3 million, or $0.07 per share. The total amount paid by Loudeye to
settle this suit will be $1.7 million, consisting of $1.0 million previously
paid by Loudeye under a letter of credit, deposits previously paid and pursuant to the January 2004 Court
judgment, and $720,000 of new cash consideration, $360,000 of which Loudeye
paid on November 12, 2004 and the remainder of which is payable in January
2005. 22




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ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements The following discussion of our financial condition and results of
operations contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, and are made under the safe harbor
provisions thereof. Forward-looking statements include, but are not limited to,
statements about our digital media products and services and commercialization
goals and expectations, potential market opportunities, integration of OD2 and
Overpeer, and other statements that are not historical facts. Words such as
may, will, should, expect, plan, anticipate, intend, believe,
estimate, predict, potential or continue, and the negative of terms
like these or other comparable terminology may identify forward-looking
statements, but the absence of these words does not mean that a statement is
not forward-looking. These forward-looking statements are only predictions and
actual events or results may differ materially from those projected. Specific
factors that could cause actual results to differ materially from those
projected include, but are not limited to the Risk Factors set forth below in
this Managements Discussion and Analysis of Financial Condition and Results
of Operations. You should not unduly rely on these forward-looking statements, which
speak only as of the date of this quarterly report. We undertake no obligation
to publicly revise any forward-looking statement after the date of this
quarterly report to reflect circumstances or events occurring after the date of
this quarterly report or to conform the statement to actual results or changes
in our expectations. You should, however, review the factors, risks and other
information we provide in the reports we file from time to time with the SEC. This discussion is intended to provide an analysis of significant trends
and material changes in our financial position and operating results of our
business during the three and nine month periods ended September 30, 2004
compared with the corresponding periods in 2003. Overview Loudeye is a worldwide leader in business-to-business digital media
solutions that facilitate the distribution, promotion and sale of digital media
content for media and entertainment, retail, wireless and enterprise customers.
Our services enable our customers to outsource the management, distribution and
sale of audio and video digital media content over the Internet and other
electronic networks. Our proprietary consumer-facing applications and
e-commerce platform, combined with technical infrastructure and back-end
solutions, comprise an end-to-end solution, from core digital media services,
such as the hosting, storage, encoding, management and protection of media
assets for content owners, to turn-key, fully-outsourced digital media
distribution and promotional services, such as private-labelled digital music
download stores, wireless music services, streaming Internet radio and music
sample services. Our outsourced solutions can increase time-to-market while
reducing the complexity and cost of deployment compared with internal
solutions, and they enable our customers to provide branded digital media
offerings to their users while supporting a variety of digital media
technologies and consumer business models. The Loudeye Solution During 2003 and the first six months of 2004, we provided our services via
two primary business segments, Digital Media Services and Media Restoration
Services. In January 2004, we transferred substantially all of the assets of
our media restoration services subsidiary, VidiPax, Inc., to a company
controlled by VidiPaxs general manager. In May 2004, we completed the sale of
this media restoration services business. While we will have ongoing rights to
co-market and resell media restoration services for two years after the sale,
we anticipate media restoration services will represent an insignificant
portion of our revenues and operations for the remainder of 2004 and beyond. Digital Media Services.We provide a full service business-to-business
digital media solution that allows our customers to deploy, rapidly and cost
effectively, their own privately branded digital media service. Our solution is
the culmination of our significant investments in our systems and
infrastructure. Some of the key features of our solution include:  
    
    Web enabled architecture;
    
    Archive of nearly 5.0 million music tracks in uncompressed, digital master format;
    
    Highly scalable and reliable operations;
    
    Support for multiple media players and digital media formats;
    
    Support for multiple transmission speeds, or bit rates; and
    
    Extensive, transferable content rights and experience working with major and independent record labels. Media Restoration Services.Our media restoration services segment has
performed services to restore and migrate legacy media archives to current
media formats. We recognized revenues as services were rendered and we had no
continuing involvement in the goods and services delivered, which generally was
the date the finished media was shipped to the customer. Acquisition of OD2 In June 2004, we acquired On Demand Distribution Limited (OD2), one of the
largest digital music providers in Europe, creating what we believe is the
worlds largest business-to-business focused digital media company, providing
outsourced digital media solutions to many of the worlds digital media
businesses. The combined company now serves more than 200 customers in 15
countries, adding European customers such as The Coca-Cola Company,
Microsoft Corporations MSN, MTV Networks (a division of Viacom
International), Virgin Megastores ( a division of the Virgin
Group), HMV Group plc and other retailers, Internet
portals and Internet service providers, telecommunications companies and
commercial radio stations throughout Europe and Australia. This acquisition
supports our commitment to providing global services by broadening our reach
and capabilities into key geographic regions including Europe, the second
largest music market in the world, and Australia. In addition, this acquisition
expands our content management and anti-piracy content protection services into
Europe and will enable us to leverage OD2s reach to expand our business into
new markets. More information on the terms of the acquisition is provided below
under Liquidity and Capital ResourcesAcquisition of On Demand Distribution
Limited. 23




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##### Table of Contents



Liquidity and Capital Resources As of September 30, 2004, we had approximately $5.1 million of working
capital and $24.7 million of cash and cash equivalents, and marketable
securities. These funds reflect net proceeds of $18.9 million from our sale of
common stock in a private placement in February 2004. In addition, $305,000 of
restricted cash is held in investment accounts that serve as collateral for
standby letters of credit for certain of our capital lease and other
obligations. Loudeye acquired OD2 on June 22, 2004. Under the terms of the OD2
transaction, Loudeye is obligated to pay an additional £9.6 million
(approximately $17.3 million based on exchange rates as of September 30, 2004)
through November 30, 2005, to OD2s shareholders, plus additional contingent
consideration of up to £10.0 million (approximately $18.0 million based on
exchange rates as of September 30, 2004) if OD2 achieves certain financial
performance targets during the period through November 30, 2006. The payments
are to be made in British pounds, and accordingly, Loudeye is exposed to risks
with changes in the prevailing exchange rate. Any decrease in the value of the
U.S. dollar against the British pound will cause a proportional increase in the
amount of the future consideration Loudeye must pay to the former OD2
shareholders. Loudeye may elect to pay amounts due to OD2s shareholders in
shares of Loudeyes common stock. However, in accordance with the rules of the
NASDAQ Stock Market, approval of Loudeyes stockholders (excluding shares
issued in connection with the OD2 transaction) will be required prior to any
election to satisfy these payments in shares. Such approval cannot be assured.
If stockholder approval is not obtained, Loudeye would not be able to pay the
additional amounts due related to the OD2 transaction in 2005 unless it obtains
additional funds through an equity or debt financing transaction. Loudeye has incurred net losses and negative cash flows from operations
since inception and has an accumulated deficit of $203.6 million at September
30, 2004. Loudeyes operating expenses have increased as a result of the OD2
acquisition. Historically, Loudeye has funded its operations through equity
transactions, leases and debt. However, there can be no assurance that
Loudeyes cash balances after December 31, 2004 will be sufficient to sustain
its operations until profitable operations and positive cash flows are
achieved. Accordingly, Loudeye may require additional capital or debt financing
subsequent to December 31, 2004 to fund its operations and the amounts due in
2005 related to the OD2 transaction. There can be no assurance that additional
capital or debt will be available to Loudeye on acceptable terms, or at all.
If Loudeye lacks necessary cash or debt financing capacity during 2005, Loudeye
may not only be unable to pay the scheduled OD2 consideration amounts in 2005
but might also have to delay or abandon some or all of its development plans or
otherwise forego market opportunities. Loudeyes inability to execute on its
strategy could result in increased expenses and decreased revenues, either or
both of which could seriously harm Loudeyes business, results of operations
and financial condition subsequent to December 31, 2004. Net cash used in operating activities was $9.8 million for first nine
months of 2004. Cash used in operating activities resulted primarily from a net
loss of $10.8 million, offset partially by non-cash charges for depreciation
and amortization and stock-based compensation aggregating $2.3 million, an
increase in deferred revenue of $2.5 million and an increase in other assets
and liabilities of approximately $3.6 million. Net cash used in investing activities was $9.8 million in the first nine
months of 2004, consisting principally of the net purchases of short-term
investments of $5.8 million to invest a portion of the proceeds from our
private equity financing in February 2004 and purchases of property and
equipment of $4.4 million, consisting principally of equipment to upgrade the
storage and access systems for our digital music archive and investments in
capital equipment for our Overpeer anti-piracy service offering. In addition,
net cash of approximately $555,000 was used related to our acquisitions of OD2
and Overpeer. Net cash provided by financing activities was $16.9 million for the first
nine months of 2004, consisting primarily of net proceeds from the private equity
financing in February 2004 of $18.9 million, and proceeds
from the exercise of stock options of $222,000, offset partially by principal
payments on our debt and capital lease obligations of $1.0 million and the
repayment in full of our line of credit for $1.3 million. We are subject to various debt covenants and other restrictions, including
the requirement for early payments upon the occurrence of certain events,
including sales or transfers of ownership or control. If we violate these
covenants or restrictions, our lenders could require repayment of outstanding
borrowings and our credit rating and access to other financing could be
adversely affected. 24




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##### Table of Contents



In October 2004, we were notified by Silicon Valley Bank that we had
failed to comply with certain financial covenants required by the loan
agreement. We were subsequently notified that we had cured the default within
the cure period by establishing a certificate of deposit in the
amount of $2.2 million, which was equal to the outstanding loan balance as of that
date. If the certificate of deposit is outstanding as of
December 31, 2004, we will reflect it as restricted cash on our
December 31, 2004 balance sheet. Acquisition of On Demand Distribution Limited The discussion below includes information that is not based on accounting
principals generally accepted in the United States, or GAAP. To supplement our
consolidated financial statements and information below that is presented on a
GAAP basis, we have included this non-GAAP pro forma information, including
the table below indicating the allocation of the purchase price we will have
paid for OD2 including all shares and cash consideration
held or to be held in escrow. Reconciliations of the non-GAAP information are
included below. We believe these pro forma presentations enhance overall
understanding of the total consideration we will pay for our
acquisition of OD2, in particular with respect to
the approximately 2.1 million escrow shares that we have
issued and the 15%, or approximately $2.6 million, of additional consideration
that we are required to pay, which are not reflected from an accounting
perspective, and is used by management for that purpose. Although management
believes the above non-GAAP information enhances a readers understanding of
the OD2 acquisition, this non-GAAP information does not reflect GAAP

accounting for the acquisition as of September 30, 2004. Accordingly, readers
should consider this pro forma information together with the GAAP information
above, rather than as an alternative to GAAP basis financial measures. In June 2004, we commenced a tender offer to acquire 100% of the
outstanding shares of OD2, a privately held digital music provider based in
Europe. We acquired 93% of the shares of OD2 upon commencement of the tender
offer. As of August 17, 2004, we had acquired the remaining 7% of OD2s shares
on the same terms from the remaining shareholders of OD2. The consideration for the transaction consisted of the following elements:  
    
    From a financial accounting perspective, we issued 9,065,919 shares of our common stock
on June 22, 2004 and 599,259 shares of our common stock on August 25, 2004 to existing OD2 shareholders
and option holders. On a pro forma basis, as of September 30, 2004, we issued a total
of 11,737,547 shares of our common stock, which includes 2,072,369 shares held in
escrow described further below.
    
    We expect to issue up to 2,212,302 additional shares of our common stock, representing shares to
be issued to OD2 option holders issuable upon exercise of OD2 options which we assumed.
    
    Certain of OD2s principal shareholders agreed to have an aggregate of 15% of the total
consideration payable in the transaction held in escrow by us for 18 months to satisfy
claims we may have with respect to breaches of representations, warranties and
covenants, indemnification claims and working capital adjustments. As of September 30,
2004, we had issued and placed in escrow 2,072,369 shares of our common stock to 17
former OD2 shareholders who had tendered their shares of OD2 stock as of that date. We
are obligated to issue and place into escrow an additional 20,131 shares of our common
stock to one individual upon his tendering his outstanding shares of OD2 stock.
    
    We paid approximately $900,000 in cash to retire certain liabilities as of September
30, 2004, and are obligated to pay an additional $1.0 million to retire additional
liabilities.
    
    From a financial accounting perspective we are obligated to pay an additional £8.3 million (approximately $14.8 million based
on exchange rates as of September 30, 2004), through
November 30, 2005. On a pro forma basis, the full amount of the
additional consideration we are obligated to pay totals
£9.6 million (approximately $17.3 million based on
exchange rates as of September 30, 2004). The table below
compares additional cash consideration to be paid to OD2 shareholders as reflected in
our financial statements to the amount management believes we will be required to pay,
which includes minority interest and the 15% additional consideration to be paid into
escrow. Amounts reflected in financialstatements, which excludesminority interest and amountsto be held in escrow(approximate, amounts in
    
    Full consideration payablePayment Date
    
    millions)
    
    (approximate, amounts in millions)November 20, 2004
    
    £1.1, or $1.9
    
    £1.2, or $2.2January 31, 2005
    
    £4.0, or $7.2
    
    £4.7, or $8.4May 31, 2005
    
    £1.1, or $1.9
    
    £1.2, or $2.2November 30, 2005
    
    £2.1, or $3.8
    
    £2.5, or $4.5Total
    
    £8.3, or $14.8
    
    £9.6, or $17.3
  
    
    15% of the total additional consideration that we are required to pay to the OD2
shareholders through November 30, 2005, or approximately $2.6 million, will be placed
into escrow along with the escrow shares.
    
    We are obligated to pay an additional contingent consideration of up to £10.0 million
(approximately $18.0 million based on exchange rates as of
September 30, 2004) if OD2 achieves certain financial performance targets during the
period through November 30, 2006. We
issued promissory notes in aggregate principal amount of
£1.9 million (approximately $3.4 million based on
exchange rates as of September 30, 2004) to ten of OD2s
former shareholders. Our obligations under these notes are included
within the £8.3 million (approximately $14.8 million
based on exchange rates as of September 30, 2004) of accrued
acquisition consideration and within the approximately
$2.6 million of additional consideration to be paid into escrow
described above. The notes bear interest at 5% per annum and are
repayable in unequal installments on December 30, 2004 and on
January 31, May 31 and November 30, 2005 (which
installments are proportional to the amounts of deferred consideration
we are required to pay on November 30, 2004 and on
January 31, May 31 and November 30, 2005). Interest
expense for the quarter ended September 30, 2004 was
approximately $11,000. Aggregate interest expense over the terms of
the notes will be included in interest expense and will be
approximately £60,000 (approximately $108,000 based on exchange
rates as of September 30, 2004). If we obtain the approval of
our stockholders to pay our future obligations to OD2s former
shareholders in shares of our common stock, we may satisfy our
payment obligations under the notes by issuing shares of our common
stock to the noteholders. The number of shares which we would be required to issue will be determined based on our volume weighted average share price for a specified period prior to issuance. From a financial accounting perspective, the escrow shares and the 15%, or
approximately $2.6 million, of additional consideration described above are not
recorded as liabilities and the value of the shares held in escrow and the 15%
additional consideration was not included in determining the cost of acquiring
OD2 as of June 30, 2004, or September 30, 2004, since the resolution of the
escrow shares and 15% additional consideration is still pending. We will
reflect the escrow shares as outstanding and the liability relating to the 15%
additional consideration as accrued and record the value of both as additional
costs of acquiring OD2 upon the earlier of the expiration of the 18 month
escrow period or when management believes beyond a reasonable doubt that we
will not state a claim pursuant to the terms of the escrow. The number of shares issued and to be issued upon exercise of options of 13,949,849 constituted
approximately 19.9% of Loudeyes outstanding shares of common stock at the
commencement of the tender offer. Based on managements internal analysis, excluding the impact of the
escrow shares and 15% additional consideration discussed above, as of September
30, 2004 we have preliminarily recorded $35.7 million of net assets in
connection with the transaction consisting of upfront stock consideration,
including the assumption of OD2 options, deferred consideration, cash
obligations to retire certain liabilities, and our transaction related
expenses. As of June 22, 2004, the initial purchase price excluded the 7% minority
interest related to the acquisition and included preliminary estimates of
certain transaction consideration. As of August 17, 2004, we subsequently
acquired the remaining 7% of OD2s shares and adjusted certain transaction
consideration based upon current information. The initial purchase price can
be summarized at June 22, 2004 and September 30, 2004 as follows (amounts in
thousands): June 22, 2004
    
    Sept. 30, 2004Transaction related expenses
    
    $
    1,527
    
    
    $
    1,527Cash paid at closing
    
    
    900
    
    
    
    900Cash due on certain liabilities assumed
    
    
    1,878
    
    
    
    978Accrued acquisition consideration
    
    
    13,654
    
    
    
    15,104Common stock payable related to acquisition
    
    
    2,596
    
    
    
    3,208Common stock issued in connection with
acquisition
    
    
    13,146
    
    
    
    14,015$
    33,701
    
    
    $
    35,732
 In
accordance with FAS No. 52, Foreign Currency
Translation, and as a result of currency fluctuation between the
U.S. dollar and British pound since the June 22, 2004
acquisition date, we adjusted the accrued acquisition consideration
recorded in our unaudited interim condensed balance sheet and recorded
a foreign currency transaction gain of $0 and $183,000 in other
income in the accompanying unaudited interim condensed consolidated
statement of operations for the three and nine month periods ended
September 30, 2004. In addition to the $35.7 million purchase price recorded at September 30, 2004, if  
    
    the 2,072,369 shares of common stock held in escrow by us were treated as outstanding,  
    
    the 15% of additional escrow consideration to be paid by us were treated as a liability, and  
    
    net liabilities assumed of $2.8 million were reflected as an additional component of consideration, then the acquisition price
would have been approximately $45.0 million, including the
shares and additional consideration paid into escrow. The initial purchase
consideration would be summarized as follows (amounts in thousands): Assumption of certain liabilities
    
    $
    1,878Net liabilities assumed
    
    
    3,572Upfront stock consideration
    
    
    14,015Stock to be issued upon exercise of options
    
    
    3,208Stock consideration placed in escrow
    
    
    3,005Accrued acquisition consideration
    
    
    15,104Accrued acquisition consideration in escrow
    
    
    2,664Transaction related expenses
    
    
    1,527$
    44,973
 Under the terms of the offer, future cash consideration is payable in
British pounds, and accordingly the corresponding U.S. dollar amounts set forth
above may vary with fluctuations in the prevailing exchange rate. All future
payments are payable in cash or, at our election and if approved by
stockholders representing a majority of our outstanding shares (excluding
shares issued in connection with the transaction), in shares of
our common stock, the number of which will be determined based on our volume
weighted average share price for a specified period prior to issuance. OD2
shareholders may also elect to receive promissory notes in lieu of any cash
payments that we may be required to make. We have also agreed to reserve 2
million shares for stock option grants under our 2000 Stock Option Plan to
employees of OD2 for future services. We
have agreed to file a registration statement covering the resale of
the initial shares issued by us. The registration statement has not
yet been filed. In accordance with the rules of the Nasdaq Stock Market, approval of our
stockholders (excluding shares issued in connection with the OD2 transaction)
will be required prior to any election by us to satisfy the additional £9.6
million deferred payments, or up to £10.0 million in contingent payments, using
shares of our common stock. If our stockholders do not approve such issuances,
we will be required to satisfy such amounts in cash, which would likely cause a
significant strain on our cash resources. In addition, the number of shares we
must issue should we elect to pay these amounts in shares will vary based upon
the volume weighted average share price for a specified period prior to
issuance. Because the pricing formula averages historical prices of our stock
over periods of one to six months, the formula could result in an effective
value for the shares which differs from the market value at the time of
issuance. In the event of a decline in our stock price, or in the event the
pricing formula results in a price substantially below market price at the time
of payment, our board of directors could decide to pay certain amounts in cash
rather than subject our stockholders to the dilution of lower-valued stock
payments. Such a decision could also cause a significant strain on our cash
resources. Assuming our stockholders approve the issuance of additional shares to OD2
stockholders to pay future required payments, we believe that our existing
cash, cash equivalents, and short-term investments will be sufficient to fund
our operations and meet our working capital and capital expenditure
requirements for the next twelve months. If our stockholders do not approve
such issuances, we will be required to satisfy such amounts in cash, which
would likely cause a significant strain on our cash resources, we may need to
obtain additional equity or debt financing and we may have difficulty pursuing
our business objectives. Since we have incurred net losses since inception, we
have relied on sales of equity securities, proceeds from the exercises of stock
options and warrants and borrowings under our credit facilities to fund our
working capital needs. Such capital may not be available in the future if it is
needed. The availability of such capital will depend on a number of factors,
some of which are outside our control. These include general market conditions,
conditions in the private equity and public markets, the then-current market
price of our common stock, and our historical financial performance and future
prospects. Our ability to raise capital could also be affected by any of the
risks affecting our business discussed below under the heading Factors That
May Affect Our Business, Future Operating Results and Financial Condition. 25




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##### Table of Contents



Consolidated Results of Operations Percentage comparisons have been omitted within the following table where
they are not considered meaningful. Three months
    
    
    
    
    
    
    
    
    
    Nine monthsended September 30,
    
    Variance
    
    ended September 30,
    
    Variance2004
    
    2003
    
    $
    
    %
    
    2004
    
    2003
    
    $
    
    %RevenueDigital media servicesEncoding services
    
    $
    1,389
    
    
    $
    825
    
    
    $
    564
    
    
    
    68
    %
    
    $
    2,871
    
    
    $
    1,771
    
    
    $
    1,100
    
    
    
    62
    %Samples services
    
    
    335
    
    
    
    408
    
    
    
    (73
    )
    
    
    (18
    %)
    
    
    1,235
    
    
    
    1,320
    
    
    
    (85
    )
    
    
    (6
    %)Internet radio and hosting services
    
    
    43
    
    
    
    180
    
    
    
    (137
    )
    
    
    (76
    %)
    
    
    266
    
    
    
    740
    
    
    
    (474
    )
    
    
    (64
    %)Webcasting
    
    
    470
    
    
    
    911
    
    
    
    (441
    )
    
    
    (48
    %)
    
    
    1,682
    
    
    
    3,652
    
    
    
    (1,970
    )
    
    
    (54
    %)Digital distribution services
    
    
    1,902
    
    
    
    83
    
    
    
    1,819
    
    
    
    2192
    %
    
    
    2,210
    
    
    
    83
    
    
    
    2,127
    
    
    
    2563
    %Content protection services
    
    
    941
    
    
    
    
    
    
    
    941
    
    
    
    
    
    
    
    1,641
    
    
    
    
    
    
    
    1,6415,080
    
    
    
    2,407
    
    
    
    2,673
    
    
    
    111
    %
    
    
    9,905
    
    
    
    7,566
    
    
    
    2,339
    
    
    
    31
    %Media restoration services
    
    
    
    
    
    
    404
    
    
    
    (404
    )
    
    
    (100
    %)
    
    
    297
    
    
    
    1,458
    
    
    
    (1,161
    )
    
    
    (80
    %)Consolidated
    
    
    5,080
    
    
    
    2,811
    
    
    
    2,269
    
    
    
    81
    %
    
    
    10,202
    
    
    
    9,024
    
    
    
    1,178
    
    
    
    13
    %Cost of revenuesDigital media services
    
    
    3,480
    
    
    
    1,191
    
    
    
    2,289
    
    
    
    192
    %
    
    
    6,441
    
    
    
    4,491
    
    
    
    1,950
    
    
    
    43
    %Media restoration services
    
    
    
    
    
    
    371
    
    
    
    (371
    )
    
    
    (100
    %)
    
    
    284
    
    
    
    1,297
    
    
    
    (1,013
    )
    
    
    (78
    %)Consolidated
    
    
    3,480
    
    
    
    1,562
    
    
    
    1,918
    
    
    
    123
    %
    
    
    6,725
    
    
    
    5,788
    
    
    
    937
    
    
    
    16
    %Operating expensesResearch and development
    
    
    1,325
    
    
    
    399
    
    
    
    926
    
    
    
    232
    %
    
    
    2,668
    
    
    
    1,368
    
    
    
    1,300
    
    
    
    95
    %Sales and marketing
    
    
    1,478
    
    
    
    486
    
    
    
    992
    
    
    
    204
    %
    
    
    2,949
    
    
    
    2,867
    
    
    
    82
    
    
    
    3
    %General and administrative
    
    
    3,798
    
    
    
    1,614
    
    
    
    2,184
    
    
    
    135
    %
    
    
    7,990
    
    
    
    6,106
    
    
    
    1,884
    
    
    
    31
    %Amortization of intangibles and other assets
    
    
    325
    
    
    
    157
    
    
    
    168
    
    
    
    107
    %
    
    
    591
    
    
    
    943
    
    
    
    (352
    )
    
    
    (37
    %)Stock-based compensation
    
    
    21
    
    
    
    723
    
    
    
    (702
    )
    
    
    (97
    %)
    
    
    186
    
    
    
    954
    
    
    
    (768
    )
    
    
    (81
    %)Special charges  goodwill impairments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,307
    
    
    
    (5,307
    )
    
    
    (100
    %)Special charges  other
    
    
    350
    
    
    
    
    
    
    
    350
    
    
    
    
    
    
    
    300
    
    
    
    3,130
    
    
    
    (2,830
    )
    
    
    (90
    %)Consolidated
    
    
    7,297
    
    
    
    3,379
    
    
    
    3,918
    
    
    
    116
    %
    
    
    14,684
    
    
    
    20,675
    
    
    
    (5,991
    )
    
    
    (29
    %)Interest income
    
    
    139
    
    
    
    75
    
    
    
    64
    
    
    
    85
    %
    
    
    325
    
    
    
    262
    
    
    
    63
    
    
    
    24
    %Interest expense
    
    
    (46
    )
    
    
    (83
    )
    
    
    37
    
    
    
    (45
    %)
    
    
    (176
    )
    
    
    (180
    )
    
    
    4
    
    
    
    (2
    %)Increase in fair value of common stock warrants
    
    
    
    
    
    
    (222
    )
    
    
    222
    
    
    
    (100
    %)
    
    
    
    
    
    
    (222
    )
    
    
    222
    
    
    
    (100
    %)Gain (loss) on sale of media restoration business
    
    
    273
    
    
    
    
    
    
    
    273
    
    
    
    
    
    
    
    113
    
    
    
    
    
    
    
    113Other income (expense), net
    
    
    
    
    
    
    20
    
    
    
    (20
    )
    
    
    (100
    %)
    
    
    186
    
    
    
    119
    
    
    
    67
    
    
    
    56
    %Net lossDigital media services
    
    
    (5,604
    )
    
    
    (2,010
    )
    
    
    (3,594
    )
    
    
    179
    %
    
    
    (10,822
    )
    
    
    (16,086
    )
    
    
    5,264
    
    
    
    (33
    %)Media restoration services
    
    
    273
    
    
    
    (330
    )
    
    
    603
    
    
    
    (183
    %)
    
    
    63
    
    
    
    (1,374
    )
    
    
    1,437
    
    
    
    (105
    %)Consolidated
    
    $
    (5,331
    )
    
    $
    (2,340
    )
    
    $
    (2,991
    )
    
    
    128
    %
    
    $
    (10,759
    )
    
    $
    (17,460
    )
    
    $
    6,701
    
    
    
    (38
    %)
 Three and Nine Months
Ended September 30, 2004 compared to 2003 Revenues.  Revenues increased primarily due to the inclusion of a full quarter of
revenues from our OD2 acquisition which was completed in late June of 2004.
Revenues from digital distribution services consist principally of digital
download and subscription services, primarily from our acquisition of OD2 in
the second quarter, as well as existing ringtunes and rights clearing service
offerings. We began providing these services following our restructuring in the
first quarter 2003, and there were minimal revenues in the prior year quarter.
Our product and service mix changed significantly over the course of 2003 after
we restructured our management team and operations and changed our strategic
direction at the end of the first quarter 2003. We shifted marketing emphasis
away from webcasting and more toward other digital media services, primarily
digital distribution services, as well as content protection services. Revenues from encoding services, samples services, and internet radio and
hosting services generally fluctuate based on the volume of content delivered
(for encoding services) and volume of content streamed (for samples and radio
and hosting services). Such volume is driven primarily by our customers
content needs and the level of activity on their websites. Consequently, a
certain amount of fluctuation in these revenue sources is common. In the second
and third quarters there was increased demand from our customers for encoding
services, primarily for the delivery of digital music, as our customers focused
on launching digital music services. Our current webcasting services are
focused on customer relationships that provide higher margins. As a result,
revenue from webcasting services decreased significantly for the third quarter
2004 compared to the third quarter 2003. 26




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##### Table of Contents



Content protection services are provided by our Overpeer subsidiary which
we acquired in March 2004. Accordingly, there were no revenues from such
services in the 2003 period. Revenues for content protection services result
from service fees based on the number of titles protected and the level of
protection requested. There were no media restoration services revenues for the third quarter
2004 due to the transfer of our media restoration business on January 30, 2004
and completion of sale in May 2004 as discussed in Note 6 to the
unaudited interim condensed consolidated
financial statements. Revenues and cost of revenues from our media
restoration subsidiary totalling $213,000 are included in the
unaudited interim condensed consolidated statement of operations
through May 17, 2004, because our media restoration subsidiary continued to be
the primary obligor under certain contracts with the General Services
Administration of the United States until their
assignment on consummation of sale of the subsidiary on May 17, 2004. Cost
of Revenues.     Cost of revenues includes the cost of production, including personnel, an
allocated portion of facilities and equipment, and other supporting functions
related to the delivery of our digital media and media restoration services. We
implemented cost reduction initiatives related to our restructuring in March
2003; however, in 2004 we began to expand our digital media services production
work force in order to meet the demands of anticipated growth and new
initiatives. In addition, costs associated with the delivery of digital media
services revenue from our acquisitions of OD2 and Overpeer contributed to the
increase in digital media services cost of revenue compared to the prior year
quarter. We expect cost of revenues related to our digital media services to
increase over the remainder of 2004 compared to the prior year periods. As discussed above, there were no media restoration services cost of
revenues for the third quarter 2004 due to the transfer of our media
restoration business on January 30, 2004 and completion of sale in May 2004.
Because our media restoration subsidiary continued to be the primary obligor
under certain contracts with the GSA until their assignment on May 17, 2004,
revenues and costs of revenues in the consolidated statement of operations of
Loudeye reflect the cost of revenues from services provided under the GSA
Contracts, totalling $213,000 in the first nine months of 2004. The cost of
revenue entirely offset the associated revenue. Depreciation included in cost of revenues increased to approximately $1.1
million in the first nine months of 2004 from $688,000 in the first nine months
of 2003. This increase is due primarily to our acquisition of OD2. In addition,
we purchased $1.5 million in equipment in the first quarter 2004 to upgrade the
storage and access systems for our digital music archive, as well as additional
equipment expenditures in the second quarter 2004 related to our content
protection services offering. We expect depreciation included in cost of
revenues for the fourth quarter 2004 to approximate levels in the third quarter
2004. Research and Development.     Research and development expenses increased for the three and nine months
ended September 30, 2004 as compared with the three and nine-month periods in
the prior year. Research and development expenses include labor and other
related costs of the continued development and support of our digital media
services. We expect research and development expense in the fourth quarter 2004
to approximate levels in the third quarter 2004. Sales and Marketing.     Sales and marketing expenses consist primarily of salaries, commissions,
product branding costs, advertising, public relations costs, trade show
expenses, and cost of marketing collateral. Sales and marketing expenses for
the first nine months of 2004 were flat compared to the same period in 2003,
reflecting cost reduction initiatives implemented in 2003, somewhat offset by
increases resulting from our acquisitions of Overpeer in March 2004 and OD2 in
June 2004. We expect sales and marketing expenses in the fourth
quarter 2004 to approximate levels in the third quarter 2004. General and Administrative.     General and administrative expenses consist primarily of rent, facilities
and information technology charges, salaries, legal expenses, investor
relations costs and other costs associated with being a public company. This
increase was primarily the result of our acquisition of Overpeer in March 2004
and of OD2 in June 2004. We anticipate that general and administrative expenses
for the remainder of 2004 will approximate levels in the prior year periods as
we complete the integration of our acquisitions of OD2 and 27




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##### Table of Contents



Overpeer, and as we increase our personnel and other resources to support our
growth. In addition, we will continue to incur additional professional fees in
order to comply with the new requirements under the Sarbanes-Oxley Act of 2002. Amortization
of Intangible and Other Assets. Amortization of intangible and other assets includes amortization of
identified intangible assets related to acquisitions. We recorded impairment
charges in the first quarter 2003 relating to our restructuring, which resulted
in lower amortization charges starting with the second quarter 2003. The trend
of lower quarterly amortization charges continued through the third quarter
2004. However, during the second quarter 2004 we incurred additional
amortization expense related to our acquisitions of Overpeer and OD2. We
expect amortization expense for the remainder of 2004 to remain flat compared
to the third quarter 2004. Stock-Based
Compensation. Stock-based compensation for the quarter ended September 30, 2004 totalled
$65,000, of which $44,000 is included in cost of revenues, consisting of the
amortization of deferred stock compensation. Stock-based compensation was
$761,000 for the quarter ended September 30, 2003, of which $37,000 is included
in cost of revenues, consisting of the amortization of deferred stock
compensation of $139,000 and variable stock-based compensation expense of
$55,000 accounted for under APB 25, and stock-based compensation expense of
$567,000 accounted for under FAS 123 related to options granted to a member of
Loudeyes board of directors for consulting services. Stock-based compensation for the nine months ended September 30, 2004
totalled $268,000, of which $82,000 is included in cost of revenues, consisting
of the amortization of deferred stock compensation of $247,000, stock-based
compensation expense of $39,000, including $14,000 related to options granted
to a consultant, and a credit of $18,000 for variable stock compensation
related to stock options that were repriced in 2001. Stock-based compensation
was $998,000 for the nine months ended September 30, 2003, of which $44,000 is
included in cost of revenues, consisting of the amortization of deferred stock
compensation of $225,000, variable stock-based compensation expense of $55,000
accounted for under APB 25, stock issued to former employees as severance and
termination benefits of $30,000, and stock-based compensation expense of
$668,000 accounted for under FAS 123 related to options granted to a member of
Loudeyes board of directors for consulting services. Investment
Income. Investment income consists of interest income and realized gains and
losses on sales of our marketable securities. The increase was due primarily to
higher average investment balance resulting from the proceeds received from the
private equity financings completed in August 2003 and February 2004. We expect
interest income will decrease moderately for the remainder of 2004 due to lower
average investment balances resulting from our utilization of cash. Interest
Expense. Interest expense relates to our debt instruments, consisting of our line
of credit, term loan and capital lease obligations. The increase was due
primarily to higher average debt balances in 2004 resulting from borrowings
under the $3.0 million term loan facility that we put in place at the end of
2003. Other
Income (Expense). Other income primarily consists of foreign currency transaction gains on the accrued
acquisition consideration related to our acquisition of OD2 in June 2004. 28




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Critical Accounting Policies and Estimates The SEC has defined a companys critical accounting policies as the ones
that are the most important to the portrayal of the companys financial
condition and results of operations, and those which require the company to
make its most complex or subjective 31




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decisions or assessments. Our critical accounting policies and estimates
include revenue recognition, the estimates used in determining the
recoverability of goodwill and other intangible assets, exit costs, the amount
of litigation accruals, and the amount of the allowance for income taxes. For
a detailed discussion of our critical accounting policies and estimates, please
refer to our Annual Report on Form 10-K for the year ended December 31, 2003.
There have been no material changes in the application of our critical
accounting policies and estimates subsequent to that report. We have discussed
the development and selection of these critical accounting estimates with the
Audit Committee of our board of directors. The preparation of financial statements in conformity with generally
accepted accounting principles 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. Actual results could differ from those estimates. Contractual Obligations The following table provides aggregated information about our contractual
obligations as of September 30, 2004 (in thousands). Payments Due by PeriodLess Than
    
    
    
    
    
    
    
    
    
    AfterTotal
    
    1 Year
    
    1-3 years
    
    4-5 years
    
    5 yearsContractual ObligationsLong-term debt and capital leases (1)
    
    $
    2,532
    
    
    $
    1,253
    
    
    $
    1,279
    
    
    $
    
    
    
    $
    Operating leases
    
    
    2,192
    
    
    
    1,182
    
    
    
    854
    
    
    
    156
    
    
    
    Bandwidth and co-location purchase
obligations (2)
    
    
    244
    
    
    
    244
    
    
    
    
    
    
    
    
    
    
    
    Common stock payable related to acquisition
    
    
    3,208
    
    
    
    3,208
    
    
    
    
    
    
    
    
    
    
    
    Accrued acquisition consideration (3)
    
    
    14,819
    
    
    
    11,007
    
    
    
    3,812Total contractual obligations
    
    $
    22,995
    
    
    $
    16,894
    
    
    $
    5,945
    
    
    $
    156
    
    
    $
    
  (1)
    
    Capital lease obligations represent the total minimum future obligations.(2)
    
    Many of the contracts underlying these obligations contain renewal provisions, generally for a period of one year. In addition, amounts payable under these contracts may vary based on the volume of data transferred. The amounts in the table represent the base fee amount. We also have contracts for bandwidth and colocation services that run on a month-to-month basis and for which there are no unconditional obligations. Monthly amounts due under the month-to-month contracts are approximately $123,000 and have been excluded from the table above.(3)
    
    The tabular information presented above excludes the following items:  
    
    15% additional consideration of approximately
$2.6 million relating to our acquisition of OD2.
    
    Up to approximately $18.0 million relating to our
acquisition of OD2, payable upon the achievement of certain performance targets during the period ended November 30, 2006. Off-Balance Sheet Arrangements In the normal course of business, we indemnify other parties, including
business partners, lessors and parties to other transactions with us. We have
agreed to hold the other parties harmless against losses arising from a breach
of representation or covenants, or out of intellectual property infringement or
other claims made by third parties. These agreements may limit the time within
which an indemnification claim can be made. In addition, we have entered into
indemnification agreements with certain of our officers and directors and our
amended and restated certificate of incorporation and amended bylaws contain
similar indemnification obligations to our officers and directors. For all
agreements entered into after December 31, 2002, the fair value of potential
claims has not been recorded in our financial statements because they are not
material. 32




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##### Table of Contents



Legal Proceedings On September 10, 2004, we were served in a patent infringement lawsuit
brought by Altnet, Inc, and others against Loudeye, its Overpeer subsidiary,
Marc Morgenstern, one of our executive officers, the Recording Industry
Association of America and others. The complaint, filed in federal district
court in Los Angeles, California, involves two patents that appear to cover
file identifiers for use in accessing, identifying and/or sharing files over
peer-to-peer networks. The complaint alleges that the anti-piracy solutions
offered by Loudeyes Overpeer subsidiary infringe the patents in question. The
complaint does not state a specific damage amount. On November 1, 2004,
Loudeye, Overpeer and Mr. Morgenstern filed a motion to dismiss the complaint.
We have indicated that we intend to defend ourselves, Overpeer and Mr.
Morgenstern vigorously against the allegations contained in the complaint. At
present, we cannot assess the probability of an unfavorable outcome or the
magnitude of any such outcome. In February 2003, we entered into an agreement with Regent Pacific
Management Corporation pursuant to which Regent Pacific would provide
management services. The agreement was for a term of 26 weeks, with an option
to renegotiate certain terms of the agreement after 13 weeks, and was
terminable by either party under certain circumstances. Under the agreement, we
paid certain cash fees to Regent Pacific. In addition, Regent Pacific was to
receive stock options to purchase up to 4,000,000 shares of Loudeye common
stock based on Regent Pacifics length of service. These options were to be
granted at various times throughout their engagement at exercise prices based
on the closing market price on each grant date. In March 2003, Regent Pacific
resigned from the engagement. In July 2003, Regent Pacific filed suit against
us in the Superior Court of California in San Francisco County for breach of
the agreement. In this complaint, Regent Pacific is seeking unspecified damages
and specific performance of the alleged obligation to grant the stock options
due to them under the contract. We answered the complaint in September 2003
denying all allegations and asserting counterclaims. In March 2004, the court
granted our motion to transfer the case to the United States District Court for
the Western District of Washington. We intend to defend vigorously this action
and to pursue vigorously our counterclaims. We do not consider the likelihood
of loss is to be probable and the amount of loss, if any, is not estimable at
this time. Between January 11 and December 6, 2001 class action complaints were filed
in the United States District Court for the Southern District of New York.
These actions were filed against 310 issuers (including us), 55 underwriters
and numerous individuals including certain of our former officers and
directors. The various complaints were filed purportedly on behalf of a class
of persons who purchased our common stock during the time period between March
15 and December 6, 2000. The complaints allege violations of the Securities Act
of 1933 and the Securities Exchange Act of 1934, primarily based on allegations
that our underwriters received undisclosed compensation in connection with our
initial public offering and that the underwriters entered into undisclosed
arrangements with some investors that were designed to distort and/or inflate
the market price for our common stock in the aftermarket. These actions were
consolidated for pre-trial purposes. No specific amount of damages has been
claimed. We and the individual defendants have demanded to be indemnified by
underwriter defendants pursuant to the underwriting agreement entered into at
the time of the initial public offering. Presently all claims against the
former officers have been withdrawn without prejudice. The Court suggested
that the parties select six test cases to determine class-action eligibility.
We are not a party to any of the test cases. In June 2003, a proposed
settlement was structured between plaintiffs, issuer defendants, issuer
officers and directors named as defendants, and issuers insurance companies.
This proposed settlement provides, among other matters, that:  
    
    issuer defendants and related individual defendants will be released
from the litigation without any liability other than certain expenses
incurred to date in connection with the litigation;
    
    issuer defendants insurers will guarantee $1.0 billion in recoveries by plaintiff class members;
    
    issuer defendants will assign certain claims against underwriter defendants to the plaintiff class members; and
    
    issuer defendants will have the opportunity to recover certain
litigation-related expenses if plaintiffs recover more than $5.0 billion
from underwriter defendants. Our board of directors approved the proposed settlement in August 2003. On
June 25, 2004, the plaintiffs filed a motion for preliminary approval of the
settlement with the Court, which was accompanied by a brief filed by the issuer
defendants in support of the plaintiffs motion. The Court requested that any
objections to preliminary approval of the settlement be submitted by July 14,
2004, and the underwriter defendants formally objected to the settlement. The
plaintiffs and issuer defendants separately filed replies to underwriter
defendants objections to the settlement on August 4, 2004. On October 13, 2004
the Court issued an order granting plaintiffs September 2, 2003 motion for
class certification in each of the six test cases. We cannot assure that this
proposed settlement will be approved and implemented in its current form, or at
all. Management does not anticipate that we will be required to pay any amounts
under this settlement. 33




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In April 2003, the landlord of our former facility at 414 Olive Way,
Seattle, Washington filed suit against us in the Superior Court of Washington,
King County, for breach of our lease and seeking damages of $2.0 million. In
January 2004, the court entered a judgment in favor of the landlord for rents
due through January 2004 of $438,000, which we had accrued in a prior period
and paid in the first quarter 2004. On November 12, 2004, we settled this suit.
As of December 31, 2003, and June 30, 2004, we had recorded in accrued special
charges an estimate of the additional amount that Loudeye may ultimately be
required to pay with respect to the litigation matter. As a result of the
settlement, we have increased the additional amount which we will be required to pay by $350,000. We have reflected this amount
as special charges  other on its condensed consolidated statement of
operations. On November 4, 2004, we issued preliminary financial results for
the quarter ended September 30, 2004, which reported a net loss of $5.0
million, or $0.06 per share. As a result of the increased accrual, our net
loss for the quarter ended September 30, 2004, increased to $5.3 million, or
$0.07 per share. The total amount paid by us to settle this suit will be $1.7
million, consisting of $1.0 million previously paid by us under a letter of
credit, deposits previously paid and pursuant to the January 2004 Court judgment, and $720,000 of new
cash consideration, $360,000 of which we paid on November 12, 2004 and the
remainder of which is payable in January 2005. We are involved from time to time in various other claims and lawsuits
incidental to the ordinary course of our operations, including contract and
lease disputes and complaints alleging employment discrimination. We believe
that the outcome of any such pending claims or proceedings individually or in
the aggregate, will not have a material adverse effect upon our business or
financial condition, cash flows, or results of operations. Factors That May Affect Our Business, Future Operating Results and Financial
Condition Risks Related to Our Business We have a history of losses on a quarterly and annual basis and we may
experience greater losses from operations than we currently anticipate. As of September 30, 2004, we had an accumulated deficit of $203.6 million.
We have incurred net losses from inception, and we expect to continue to incur
net losses in future periods. We expect to continue to suffer losses in the
interim. We will need to generate additional revenues or reduce expenditures
to be profitable in the future and we may not generate sufficient revenues to
be profitable on either a quarterly or annual basis in the future. Even if we
ultimately do achieve profitability, we may not be able to sustain or increase
profitability on a quarterly or annual basis. Our quarterly and annual financial results will continue to fluctuate
making it difficult to forecast our operating results. Our quarterly and annual operating results have fluctuated in the past and
we expect our revenues and operating results may vary significantly from
quarter to quarter and year to year due to a number of factors, many of which
are beyond our control, including:  
    
    Market acceptance of our turn-key application level services;
    
    Variability in demand for our digital media services and applications;
    
    Market acceptance of digital media and components offered by us and our competitors;
    
    Ability of our customers and ourselves to procure necessary intellectual property rights for digital media content;
    
    Willingness of our customers to enter into longer-term volume or
recurring revenue digital media and applications service agreements and
purchase orders in light of the economic and legal uncertainties related
to their business models;
    
    Governmental regulations affecting use of the Internet, including
regulations concerning intellectual property rights and security
measures; or
    
    Competition from other companies entering our markets. Our limited operating history, unproven business model and significant
acquisitions and dispositions of businesses, in particular our acquisition of
OD2 in June 2004, further contribute to the difficulty of making meaningful
quarterly comparisons and forecasts. Our current and future levels of operating
expenses and capital expenditures are based largely on our growth plans and
estimates of expected future revenues. These expenditure levels are, to a large
extent, fixed in the short term and our sales cycle can be lengthy. 34




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Thus, we may not be able to adjust spending or generate new revenue
sources in a timely manner to compensate for any shortfall in revenues, and any
significant shortfall in revenues relative to planned expenditures could have
an immediate adverse effect on our business and results of operations. If our
operating results fall below the expectations of securities analysts and
investors in some future periods, our stock price could decline significantly. We may need to raise additional capital in the future to execute on our
current business plan. As of September 30, 2004, we had approximately $24.7 million of cash and
cash equivalents and marketable securities and $305,000 of restricted
investments. Based on our current projections, our existing cash reserves may
not be sufficient to fund operating and other expenses under our current
business plan until projected profitability. As a result, to execute on our
current business plan, we may need to secure additional financing. In the event
additional financing is required, we may not be able to obtain such financing
on acceptable terms, or at all. If adequate funds are not available or are not
available on acceptable terms, we may need to sell assets or reduce
expenditures, or both, and we may not be able to pursue our business
objectives. This inability could seriously harm our business, results of
operations and financial condition. We must integrate our recent acquisition of OD2. We have not completed
integrating OD2s operations and integration could cause significant diversions
of management time and resources. We completed the acquisition of OD2 in June 2004. Our business, financial
condition and results of operations could be materially adversely affected if
we are unable to integrate the operations of OD2 in a timely manner. Our
ability to integrate OD2s operations will depend, in part, on our ability to
overcome or address:  
    
    The difficulties of assimilating the operations and personnel of OD2
and realizing anticipated operational and cost efficiencies without
disruption to the ongoing business;
    
    Product development challenges, including combining two development platforms for our digital music stores;
    
    Operational difficulties, including maintaining customer satisfaction while migrating to a single development platform;
    
    Different management styles and prerogatives; and
    
    Challenges associated with expanding to international operations, including language, currency and cultural differences. If we are unsuccessful in these integration efforts, the anticipated benefits
of the OD2 transaction may not be realized. If this occurs, our operations and
financial position could be materially adversely affected. We are required to pay additional consideration in connection with our
acquisition of OD2, which can be paid with shares of our common stock only with
approval of our stockholders. If we do not obtain stockholder approval, we
would not be able to pay, in their entirety, the additional amounts due related
to the OD2 transaction in 2005 unless we obtain additional funds through an
equity or debt financing transaction. We have agreed to pay to the former shareholders of OD2 an additional £9.6
million (approximately $17.3 million based on exchange rates as
of September 30,
2004) in deferred payments, and up to £10.0 million (approximately $18.0
million based on exchange rates as of September 30, 2004) in contingent
payments. All future payments described above are payable in cash or, at our
election, in shares of our common stock, the number of which will be determined
based on our volume weighted average share price for a specified period prior
to issuance. In accordance with the rules of the Nasdaq Stock Market, approval
of our stockholders (excluding shares issued in connection with the OD2
transaction) will be required prior to any election by us to satisfy these
payments in shares. A special meeting of our stockholders to consider the
proposal to authorize issuance of shares to pay the deferred and contingent
payments is scheduled for December 8, 2004. If our stockholders do not approve
such issuances, we would not be able to pay, in their entirety, the additional
amounts due related to the OD2 transaction in 2005 unless we obtain additional
funds through an equity or debt financing transaction. We cannot assure that
additional capital or debt will be available to us on acceptable terms, or at
all. If we lack necessary cash or debt financing capacity during 2005, we may
not only be unable to pay, in their entirety, the scheduled OD2 transaction
amounts in 2005 but might also have to delay or abandon some or all of our
development plans or otherwise forego market opportunities. Our inability to
execute on our strategy could result in increased expenses and decreased
revenues, either or both of which could seriously harm our business, results of
operations and financial condition subsequent to December 31, 2004. 35




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If our stockholders approve our issuance of common stock to pay additional
consideration in connection with our acquisition of OD2 and we elect to pay
such additional consideration with shares of our common stock, the number of
shares we would issue in lieu of cash will vary based on the market value of
our stock and could result in significant dilution to our stockholders. The number of shares we must issue should we elect to pay the deferred
consideration and, if any, contingent consideration amounts due to the former
OD2 shareholders in shares will vary based upon the volume weighted average
share price for a specified period prior to issuance, and any such issuance
will have a dilutive effect on the holders of our common stock prior to such
issuance. The number of shares to be issued to satisfy the additional £9.6
million (approximately $17.3 million based on exchange rates as of September
30, 2004) in deferred payment obligations will be based upon the volume
weighted average share price of our common stock on the Nasdaq SmallCap Market
for the 30-day period prior to November 30, 2004, May 31, 2005 and November 30,
2005, in the case of the deferred payments due on those dates, and for the
90-day period prior to January 31, 2005 in the case of the deferred payment due
on such date. The number of shares to be issued to satisfy the £10.0 million
(approximately $18.0 million based on exchange rates as of September 30, 2004)
in contingent payments obligations, if any, will be based upon the volume
weighted average share price of our common stock during the six-month period
ending on the last day of the corresponding earnout period (i.e., November 30,
2004, May 31, 2005, November 30, 2005, and November 30, 2006). The lower the volume weighted average share price during the applicable
measurement period or the greater the effective dollar/British pound exchange
rate, the more shares of common stock that would be required to be issued and
the greater the dilutive effect on existing stockholders. For example, assuming
a volume weighted average closing price of $1.08 per share (the closing price
per share of our common stock on September 30, 2004) and an exchange rate of
$1.809 per British pound sterling (the exchange rate as of September 30, 2004)
in effect for each applicable measurement period, if our board determines to
satisfy our obligations to make deferred payments and contingent payments by
issuing shares of our common stock, we would issue approximately 16.0 million
shares to cover all deferred payments, and an additional
approximately 16.7 million shares to cover all contingent payments if we were required to make the
maximum amount of contingent payments payable to the former OD2 shareholders.
For further illustration, based on 81,774,334 shares of our common stock
outstanding as of September 30, 2004, and assuming no further intervening
issuances of our common stock, the 16.0 million shares issuable to cover the
deferred payments would represent 16.4 percent of our currently outstanding
common stock following issuance and the 16.7 million shares issuable to cover
the contingent payments would represent 17.0 percent of our currently
outstanding common stock following issuance. The tables below demonstrate in
tabular format the number of shares we would be required to issue to satisfy
all of our deferred payment obligations and our maximum potential contingent
payment obligation of £10.0 million assuming the specific volume weighted
average closing prices of our common stock and the specific dollar/British
pound exchange rates set forth in each table. Deferred Payments (£9.6 million) Volume WeightedAverage Closing
    
    Exchange RatePrice of Loudeye
    
    $1.44/£
    
    $1.53/£
    
    $1.62/£
    
    
    
    
    
    $1.98/£
    
    $2.07/£
    
    $2.16/£Common Stock
    
    (20%)
    
    (15%)
    
    (10%)
    
    $1.7994/£
    
    (+10%)
    
    (+15%)
    
    (+20%)Shares to be Issued (in millions)$0.27(75%)
    
    
    51.2
    
    
    
    54.4
    
    
    
    57.6
    
    
    
    64.0
    
    
    
    70.4
    
    
    
    73.6
    
    
    
    76.8$0.54(50%)
    
    
    25.6
    
    
    
    27.2
    
    
    
    28.8
    
    
    
    32.0
    
    
    
    35.2
    
    
    
    36.8
    
    
    
    38.4$0.81(25%)
    
    
    17.1
    
    
    
    18.1
    
    
    
    19.2
    
    
    
    21.3
    
    
    
    23.5
    
    
    
    24.5
    
    
    
    25.6$1.08
    
    
    12.8
    
    
    
    13.6
    
    
    
    14.4
    
    
    
    16.0
    
    
    
    17.6
    
    
    
    18.4
    
    
    
    19.2$1.35(+25%)
    
    
    10.2
    
    
    
    10.9
    
    
    
    11.5
    
    
    
    12.8
    
    
    
    14.1
    
    
    
    14.7
    
    
    
    15.4$1.62(+50%)
    
    
    8.5
    
    
    
    9.1
    
    
    
    9.6
    
    
    
    10.7
    
    
    
    11.7
    
    
    
    12.3
    
    
    
    12.8$1.89(+75%)
    
    
    7.3
    
    
    
    7.8
    
    
    
    8.2
    
    
    
    9.1
    
    
    
    10.1
    
    
    
    10.5
    
    
    
    11.0
 36




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Contingent Payments (Up to £10.0 million) Volume WeightedAverage Closing
    
    Exchange RatePrice of Loudeye
    
    $1.44/£
    
    $1.53/£
    
    $1.62/£
    
    
    
    
    
    $1.98/£
    
    $2.07/£
    
    $2.16/£Common Stock
    
    (20%)
    
    (15%)
    
    (10%)
    
    $1.7994/£
    
    (+10%)
    
    (+15%)
    
    (+20%)Shares to be Issued (in millions)$0.27(75%)
    
    
    53.3
    
    
    
    56.7
    
    
    
    60.0
    
    
    
    66.6
    
    
    
    73.3
    
    
    
    76.7
    
    
    
    80.0$0.54(50%)
    
    
    26.7
    
    
    
    28.3
    
    
    
    30.0
    
    
    
    33.3
    
    
    
    36.7
    
    
    
    38.3
    
    
    
    40.0$0.81(25%)
    
    
    17.8
    
    
    
    18.9
    
    
    
    20.0
    
    
    
    22.2
    
    
    
    24.4
    
    
    
    25.6
    
    
    
    26.7$1.08
    
    
    13.3
    
    
    
    14.2
    
    
    
    15.0
    
    
    
    16.7
    
    
    
    18.3
    
    
    
    19.2
    
    
    
    20.0$1.35(+25%)
    
    
    10.7
    
    
    
    11.3
    
    
    
    12.0
    
    
    
    13.3
    
    
    
    14.7
    
    
    
    15.3
    
    
    
    16.0$1.62(+50%)
    
    
    8.9
    
    
    
    9.4
    
    
    
    10.0
    
    
    
    11.1
    
    
    
    12.2
    
    
    
    12.8
    
    
    
    13.3$1.89(+75%)
    
    
    7.6
    
    
    
    8.1
    
    
    
    8.6
    
    
    
    9.5
    
    
    
    10.5
    
    
    
    11.0
    
    
    
    11.4
 We are subject to exchange rate risk in connection with up to £19.6
million in deferred and contingent payments payable to former OD2 shareholder,
and in connection with our international operations. We are obligated to pay an additional £9.6 million (approximately $17.3
million based on exchange rates as of September 30, 2004) through November 30,
2005, to OD2s shareholders, plus additional contingent consideration of up to
£10.0 million (approximately $18.0 million based on exchange rates as of
September 30, 2004) if OD2 achieves certain financial performance targets
during the period through November 30, 2006. The payments are to be made in
British pounds, and accordingly, we are exposed to risks with changes in the
prevailing exchange rate. We may hedge this risk. If we do not hedge against
exchange rate risk, any decrease in the value of the U.S. dollar against the
British pound will cause a proportional increase in the amount of the future
consideration we must pay to the former OD2 shareholders. To the extent we are
required to or elect to pay these amounts in cash, the obligations could put
significant strains on our cash resources. To the extent we elect to pay these
amounts in shares, we could be forced to issue additional shares due to a
decline in the U.S. dollar, which would cause further dilution to our
stockholders. In addition, the results of operations of OD2 are exposed to foreign
exchange rate fluctuations as the financial results of this subsidiary are
translated from the local currency to U.S. dollars upon consolidation. Because
of the significance of the operations of OD2 to our consolidated operations, as
exchange rates vary, net sales and other operating results, when translated,
may differ materially from our prior performance and our expectations. In
addition, because of the significance of our overseas operations, we could also
be significantly affected by weak economic conditions in foreign markets that
could reduce demand for our products and further negatively impact the results
of our operations in a material and adverse manner. As a result of these market
risks, the price of our stock could decline significantly and rapidly. We may engage in hedging activities. As foreign currency exchange rates
vary, the fluctuations in revenues and expenses may materially impact the
financial statements upon consolidation. A weaker U.S. dollar would result in
an increase to revenues and expenses upon consolidation, and a stronger U.S.
dollar would result in a decrease to revenues and expenses upon consolidation. We may need to make additional future acquisitions to remain competitive.
The process of identifying, acquiring and integrating these future acquisitions
may have a material adverse effect on our operating results. We have completed a number of acquisitions during the past three fiscal
years, and we expect to continue to pursue strategic acquisitions in the
future. In March 2004, we completed the acquisition of Overpeer and in June
2004 we completed the acquisition of OD2. Integrating the Overpeer and OD2
acquisitions and completing any potential future acquisitions could cause
significant diversions of management time and resources. In the past, we have
divested acquired assets, partially as a result of failure of an acquired
companys business to integrate fully with ours, as with the media restoration
business of our former Vidipax subsidiary that we acquired in June 2000 and
divested in early 2004. Our business, financial condition and results of
operations could be materially adversely affected if we are unable to integrate
the operations of current or future acquired companies or joint ventures. Our ability to integrate operations of acquired companies will depend, in
part, on our ability to overcome or address:  
    
    The difficulties of assimilating the operations and personnel of the
acquired companies and the potential disruption of our ongoing business;
    
    Operational difficulties, including the need to attract and retain
qualified personnel and the need to attract customers and advertisers;
    
    The difficulties of maintaining uniform standards, controls,
procedures and policies; 37




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
    
    The need to incorporate successfully the acquired or shared
technology or content and rights into our products and services; and
    
    The potential impairment of relationships with employees and
customers as a result of any integration of new management personnel or
reduction of personnel. In addition, completing acquisitions could require use of a significant
amount of our available cash. Furthermore, financing for future acquisitions
may not be available on favorable terms, if at all. If we identify an
appropriate acquisition candidate for any of our businesses, we may not be able
to negotiate the terms of the acquisition successfully, finance the acquisition
or integrate the acquired business, products, technologies or employees into
our existing business and operations. Future acquisitions may not be
well-received by the investment community, which may cause our stock price to
fall. We cannot ensure that we will be able to identify or complete any
acquisition in the future. If we acquire businesses, new products or technologies in the future, we
may be required to amortize significant amounts of identifiable intangible
assets and we may record significant amounts of goodwill that will be subject
to at least annual testing for impairment. For example, we recorded in the
first quarter 2003 impairments of $5.3 million, $685,000 and $601,000 to
goodwill, intangible assets, and property and equipment related to our
enterprise communication services and media restoration services business. A
significant portion of those impairments related to assets acquired in our
acquisition of TT Holding Corp. in November 2002. If we consummate one or more
significant future acquisitions in which the consideration consists of stock or
other securities, our existing stockholders ownership could be diluted
significantly. If we were to proceed with one or more significant future
acquisitions in which the consideration included cash, we could be required to
use a substantial portion of our available cash. The anticipated benefits of
any acquisition may not be realized. If any of the negative events occur, our
operations and financial position could be materially adversely affected. We have restructured our business and if we are unsuccessful in executing
on our revised business strategy, our business, results of operations and
financial condition could be seriously harmed. We have recently shifted our business plan to offering full-service
business-to-business digital media solutions which we have only recently begun to deliver. You should consider our prospects
in executing on our revised business strategy in light of the risk, expenses
and difficulties we may encounter as an early stage company in the new and
rapidly evolving market segments we serve. As a result of such risks, expenses
and difficulties, we may not be successful in:  
    
    Establishing and maintaining broad market acceptance of our products
and services and converting that acceptance into direct and indirect
sources of revenue;
    
    Establishing and maintaining our brand name;
    
    Successfully developing new products, product features and services
on a timely basis and increasing the functionality and features of
existing products and services;
    
    Successfully responding to our current competition including,
competition from emerging technologies and solutions;
    
    Developing and maintaining strategic relationships to enhance the
distribution, features, content and utility of our products and
services; and
    
    Attracting, training and retaining qualified sales, technical and
customer support personnel. We might not be successful in implementing our business strategy in a
cost-effective manner, if at all, and the implementation may require
significant additional expenditures on our part. The capital requirements of
our business strategy combined with the expectation that we will incur net
losses in future periods could have a serious adverse impact on our business,
results of operations and financial position. Our capital requirements may vary
materially from those currently planned if, for example, we incur unforeseen
capital expenditures, unforeseen operating expenses or make investments to
maintain our competitive position. If we lack necessary capital, we may have to
delay or abandon some or all of our development plans or otherwise forego
market opportunities. Our inability to execute on our strategy could result in
increased expenses and decreased revenues, either or both of which could
seriously harm our business, results of operations and financial condition. 38




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Our success is dependent on the cooperation, performance and retention of
our executive officers and key employees. Our business and operations are substantially dependent on the performance
of our executive officers and key employees, in particular our chief executive
officer and chief financial officer who have worked
together for only a relatively short period of time. We do not maintain key
person life insurance on any of our executive officers. The loss of one or
several key employees could seriously harm our business. Any reorganization or
reduction in the size of our employee base could harm our ability to attract
and retain other valuable employees critical to the success of our business. Our music content licenses are generally for limited terms. If we are
unable to reach agreement with recorded music companies to renew our licenses
prior to expiration of our existing agreements, especially with the four major
recorded music companies, portions of our services could be interrupted and our
business and results of operations could be harmed. We have digital music download licenses from all four major recorded music
companies, EMI Music Marketing, Sony BMG Music Entertainment, UMG Recordings,
and Warner Music Group, and numerous independent record labels, and in each
case our license grants are for finite terms and require the consent of the
label to renew. If we are unsuccessful in securing renewals of these label
license agreements before expiration of existing agreements, our digital media
services with respect to any one or a number of the labels content could be
interrupted, and our business and results of operations could be harmed. Our music content licenses could result in operational complexity that may
divert resources or make our business more expensive to conduct. The large number of licenses that we need to maintain in order to expand
our music-related services creates operational difficulties in connection with
tracking the rights that we have acquired and the complex structures under
which we have royalty obligations. In addition, in some circumstances, we are
responsible for tracking and remitting royalties to professional rights
organizations, such as ASCAP, BMI or SESAC, both in the U.S. and abroad, which
adds to the complexity of the royalty structure in which we operate. Our
licensing agreements typically allow the third party to audit our royalty
tracking and payment mechanisms to ensure that we are accurately reporting and
paying royalties owed. If we are unable to accurately track amounts that we
must pay to the numerous parties with whom we have licenses in connection with
each delivery of digital music services or if we do not deliver the appropriate
payment in a timely fashion, we may risk financial penalties and/or termination
of licenses. We rely on strategic relationships to promote our services and for access
to licensed technology; if we fail to maintain or enhance these relationships,
our ability to serve our customers and develop new services and applications
could be harmed. Our ability to provide our services to users of multiple technologies and
platforms depends significantly on our ability to develop and maintain our
strategic relationships with key streaming media technology companies and
content providers. We rely on these relationships for licensed technology and
content. We also rely on relationships with major recorded music companies for
our music content licensing strategy. Obtaining comprehensive music content
licenses is challenging, as doing so may require us to obtain copyright
licenses with various third parties in the fragmented recorded music and
publishing industries. These copyrights often address differing activities
related to the delivery of digital media, including reproduction and
performance, some of which may require separate licensing arrangements from
various rights holders such as publishers, artists and record labels. The
effort to obtain the necessary rights by such third parties is often
significant, and could disrupt, delay, or prevent us from executing our
business plans. Because of the large number of potential parties from which we
must obtain licenses, we may never be able to obtain a sufficient number of
licenses to allow us to provide services that will meet our customers
expectations. Due to the evolving nature of our industry, we will need to develop
additional relationships to adapt to changing technologies and standards and to
work with newly emerging companies with whom we do not have pre-existing
relationships. We cannot be certain that we will be successful in developing
new relationships or that our partners will view these relationships as
significant to their own business or that they will continue their commitment
to us in the future. If we are unable to maintain or enhance these
relationships, we may have difficulty strengthening our technology development
and increasing the adoption of our brand and services. Competition may decrease our market share, revenues, and gross margins. We face intense and increasing competition in the global digital media
services market. If we do not compete effectively or if we experience reduced
market share from increased competition, our business will be harmed. In
addition, the more successful we are in the emerging market for digital media
services, the more competitors are likely to emerge. We believe that the
principal competitive factors in our market include: 39




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
    
    Ability to offer a private branded solution;
    
    Service functionality, quality and performance;
    
    Ease of use, reliability, scalability and security of services;
    
    Establishing a significant base of customers and distribution partners;
    
    Ability to introduce new services to the market in a timely manner;
    
    Customer service and support;
    
    Attracting third-party web developers; and
    
    Pricing. Competition in our core business-to business digital media services comes
primarily from in-house efforts by our potential customers, but also comes from
companies such as MusicNet and Liquid Digital. Competitors for our anti-piracy
services business include MediaDefender and Media Sentry. In addition, our
customers for digital media distribution services face competition from other
providers of digital distribution services to customers including Apple
Computer Inc.s iTunes, Roxio Inc.s Napster, RealNetworks
Inc.s Rhapsody,
MusicNet, Inc. and Sony Connect Inc. Many of our competitors have
substantially more capital, longer operating histories, greater brand
recognition, larger customer bases and significantly greater financial,
technical and marketing resources than we do. These competitors may also engage
in more extensive development of their technologies, adopt more aggressive
pricing policies and establish more comprehensive marketing and advertising
campaigns than we can. Our competitors may develop products and service
offerings that we do not offer or that are more sophisticated or more cost
effective than our own. For these and other reasons, our competitors products
and services may achieve greater acceptance in the marketplace than our own,
limiting our ability to gain market share and customer loyalty and to generate
sufficient revenues to achieve a profitable level of operations. Our failure to
adequately address any of the above factors could harm our business and
operating results. We face competition from free peer-to-peer services such as eDonkey,
KaZaA and Morpheus, from emerging paid online music services delivered
electronically, and from traditional retail music distributors. The online music services of our customers face significant competition
from free peer-to-peer services, such as MetaMachine
Inc.s eDonkey, Sharman
Network Inc.s KaZaA, StreamCast Networks, Inc.s Morpheus, Grokster, Ltd. and
a variety of other similar services that allow computer users to connect with
each other and to copy many types of program files, including music and other
media, from one anothers hard drives, all without securing licenses from
content providers. The legal status of these free services is uncertain,
because although some courts have found that these services violate copyright
laws, other services such as Grokster have been found to not violate any
copyright laws. Additionally, enforcement efforts against those in violation
have not effectively shut down these services, and there can be no assurance
that these services will ever be shut down. The ongoing presence of these
free services substantially impairs the marketability of legitimate services,
regardless of the ultimate resolution of their legal status. Because digital recorded music formats, such as MP3, do not always contain
mechanisms for tracking the source or ownership of digital recordings, users
are able to download and distribute unauthorized or pirated copies of
copyrighted recorded music over the Internet. This piracy is a significant
concern to record companies and artists, and is a primary reason many record
companies and artists are reluctant to digitally deliver their recorded music
over the Internet. As long as pirated recordings are available, many consumers
will choose free pirated recordings rather than paying for legitimate
recordings. Accordingly, if this issue is not addressed, our business might be
harmed. We depend on a limited number of customers for a majority of our revenues
so the loss of, or delay in payment from, one or a small number of customers
could have a significant impact on our revenues and operating results. A limited number of customers have accounted for a majority of our
revenues and may continue to do so for the foreseeable future. During the nine
months ended September 30, 2004, Microsoft Corporation accounted for 14% of our
revenues. During 2003, The Coca-Cola Company accounted for approximately 11% of
our revenues and Microsoft Corporation accounted for 6% of our revenues. A
significant portion of our revenues from The Coca-Cola Company related to media
restoration services which we ceased providing with our sale of that business
in early 2004. We believe that a small number of customers may continue to
account for a 40




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significant percentage of our revenues for the foreseeable future. Due to
high revenue concentration among a limited number of customers, the
cancellation, reduction or delay of a large customer order or our failure to
complete or deliver a project on a timely basis during a given quarter is
likely to significantly reduce revenues. In addition, if any significant
customer fails to pay amounts it owes us, or does not pay those amounts on
time, our revenues and operating results could suffer. If we are unsuccessful
in increasing and broadening our customer base, our business could be harmed. If we do not continue to add customers for our services, our revenues and
business will be harmed. In order to achieve return on our investments in new products and
services, we must continue to add new customers while minimizing the rate of
loss of existing customers. If our other marketing and promotional activities
fail to add new customers at a rate significantly higher than our rate of loss,
our business will suffer. In addition, if the costs of such marketing and
promotional activities increase in order to add new customers, our margins and
operating results will suffer. Our business will suffer if we do not anticipate and meet specific
customer requirements or respond to technological change. The market for digital media services is characterized by rapid
technological change, frequent new product introductions and changes in
customer requirements, some of which are unique or on a customer by customer
basis. We may be unable to respond quickly or effectively to these developments
or requirements. Our future success will depend to a substantial degree on our
ability to offer services that incorporate leading technology, address the
increasingly sophisticated, varied or individual needs of our current and
prospective customers and respond to technological advances and emerging
industry standards and practices on a timely and cost-effective basis. You
should be aware that:  
    
    Our technology or systems may become obsolete upon the introduction
of alternative technologies;
    
    We may not have sufficient resources to develop or acquire new
technologies or the ability to introduce new services capable of
competing with future technologies or service offerings; and
    
    The price of our services is likely to decline as rapidly as the cost
of any competitive alternatives. The development of new or enhanced services through technology development
activities is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may experience design,
manufacturing, marketing and other difficulties that could delay or prevent the
development, introduction or marketing of new services and enhancements. In
addition, our inability to effectively manage the transition from older
services to newer services could cause disruptions to customer orders and harm
our business and prospects. Average selling prices of our products and services may decrease, which
may harm our gross margins. The average selling prices of our products and services may be lower than
expected as a result of competitive pricing pressures, promotional programs and
customers who negotiate price reductions in exchange for longer term purchase
commitments or otherwise. The pricing of services sold to our customers depends
on the duration of the agreement, the specific requirements of the order,
purchase volumes, the sales and service support and other contractual
agreements. We have experienced and expect to continue to experience pricing
pressure and anticipate that the average selling prices and gross margins for
our products will decrease over product life cycles. We may not be successful
in developing and introducing on a timely basis new products with enhanced
features that can be sold at higher gross margins. We may be liable or alleged to be liable to third parties for music,
software, and other content that we encode, distribute, or make available on to
our customers. We may be liable or alleged to be liable to third parties for the content
that we encode, distribute or make available to our customers:  
    
    If the content or the performance of our services violates third
party copyright, trademark, or other intellectual property rights;
    
    If our customers violate the intellectual property rights of others
by providing content to us or by having us perform digital media
services; or 41




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
    
    If content that we encode or otherwise handle for our customers is
deemed obscene, indecent, or defamatory. Any alleged liability could harm our business by damaging our reputation,
requiring us to incur legal costs in defense, exposing us to awards of damages
and costs and diverting managements attention which could have an adverse
effect on our business, results of operations and financial condition. Our
customers for encoding services generally agree to hold us harmless from claims
arising from their failure to have the right to encode the content given to us
for that purpose. However, customers may contest this responsibility or not
have sufficient resources to defend claims and we have limited insurance
coverage for claims of this nature. Because we host, stream and Webcast audio and video content on or from our
Website and on other Websites for customers and provide services related to
digital media content, we face potential liability or alleged liability for
negligence, infringement of copyright, patent, or trademark rights, defamation,
indecency and other claims based on the nature and content of the materials we
host. Claims of this nature have been brought, and sometimes successfully
prosecuted, against content distributors. In addition, we could be exposed to
liability with respect to the unauthorized duplication of content or
unauthorized use of other parties proprietary technology. Any imposition of
liability that is not covered by insurance or is in excess of insurance
coverage or any alleged liability could harm our business. We cannot provide assurance that third parties will not claim infringement
by us with respect to past, current, or future technologies. The music industry
in particular has recently been the focus of infringement claims. We expect
that participants in our markets will be increasingly subject to infringement
claims as the number of services and competitors in our industry segment grows.
In addition, these risks are difficult to quantify in light of the continuously
evolving nature of laws and regulations governing the Internet. Any claim
relating to proprietary rights, whether meritorious or not, could be
time-consuming, result in costly litigation, cause service upgrade delays or
require us to enter into royalty or licensing agreements, and we can not assure
you that we will have adequate insurance coverage or that royalty or licensing
agreements will be available on terms acceptable to us or at all. We cannot be certain that we will be able to protect our intellectual
property, and we may be found to infringe on proprietary rights of others,
which could harm our business. Our intellectual property is important to our business, and we seek to
protect our intellectual property through copyrights, trademarks, patents,
trade secrets, confidentiality provisions in our customer, supplier and
strategic relationship agreements, nondisclosure agreements with third parties,
and invention assignment agreements with our employees and contractors. We
cannot assure you that measures we take to protect our intellectual property
will be successful or that third parties will not develop alternative solutions
that do not infringe upon our intellectual property. In addition, we could be subject to intellectual property infringement
claims by others. Potential customers may be deterred from distributing content
over the Internet for fear of infringement claims. The music industry in
particular has recently been the focus of heightened concern with respect to
copyright infringement and other misappropriation claims, and the outcome of
developing legal standards in that industry is expected to affect music, video
and other content being distributed over the Internet. If, as a result,
potential customers forego distributing traditional media content over the
Internet, demand for our digital media services and applications could be
reduced which would harm our business. The music industry in the U.S. is
generally regarded as extremely litigious in nature compared to other
industries and we could become engaged in litigation with others in the music
industry. Claims against us, and any resultant litigation, should they occur in
regard to any of our digital media services and applications, could subject us
to significant liability for damages including treble damages for willful
infringement. In addition, even if we prevail, litigation could be
time-consuming and expensive to defend and could result in the diversion of our
time and attention. Any claims from third parties may also result in
limitations on our ability to use the intellectual property subject to these
claims. Further, we plan to offer our digital media services and applications
to customers worldwide including customers in foreign countries that may offer
less protection for our intellectual property than the United States. Our
failure to protect against misappropriation of our intellectual property, or
claims that we are infringing the intellectual property of third parties could
have a negative effect on our business, revenues, financial condition and
results of operations. We must enhance our existing digital media services and applications, and
develop and introduce new services and applications to remain competitive in
that segment. Any failure to do so in a timely manner will cause our results of
operations in that segment to suffer. The market for digital media service solutions is characterized by rapidly
changing technologies and short product life cycles. These market
characteristics are heightened by the emerging nature of the Internet and the
continuing trend of companies from many industries to offer Internet-based
applications and services. The widespread adoption of the new Internet,
networking, streaming 42




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media, or telecommunications technologies or other technological changes
could require us to incur substantial expenditures to modify or adapt our
operating practices or infrastructure. Our future success will depend in large
part upon our ability to:  
    
    Identify and respond to emerging technological trends in the market;
    
    Enhance our products by adding innovative features that differentiate
our digital media services and applications from those of our
competitors;
    
    Acquire and license leading technologies;
    
    Bring digital media services and applications to market and scale our
business and operations on a timely basis at competitive prices; and
    
    Respond effectively to new technological changes or new product
announcements by others. We will not be competitive unless we continually introduce new services
and applications or enhancements to existing services and applications that
meet evolving industry standards and customer needs. In the future, we may not
be able to address effectively the compatibility and interoperability issues
that arise as a result of technological changes and evolving industry
standards. The technical innovations required for us to remain competitive are
inherently complex, require long development schedules and are dependent in
some cases on sole source suppliers. We will be required to continue to invest
in research and development in order to attempt to maintain and enhance our
existing technologies and products, but we may not have the funds available to
do so. Even if we have sufficient funds, these investments may not serve the
needs of customers or be compatible with changing technological requirements or
standards. Most development expenses must be incurred before the technical
feasibility or commercial viability of new or enhanced services and
applications can be ascertained. Revenue from future services and applications
or enhancements to services and applications may not be sufficient to recover
the associated development costs. The technology underlying our services and applications is complex and may
contain unknown defects that could harm our reputation, result in product
liability or decrease market acceptance of our services and applications. The technology underlying our digital media services and applications is
complex and includes software that is internally developed and software
licensed from third parties. These software products may contain errors or
defects, particularly when first introduced or when new versions or
enhancements are released. We may not discover software defects that affect our
current or new services and applications or enhancements until after they are
sold. Furthermore, because our digital media services are designed to work in
conjunction with various platforms and applications, we are susceptible to
errors or defects in third-party applications that can result in a lower
quality product for our customers. Because our customers depend on us for
digital media management, any interruptions could:  
    
    Damage our reputation;
    
    Cause our customers to initiate product liability suits against us;
    
    Increase our product development resources;
    
    Cause us to lose sales; and
    
    Delay market acceptance of our digital media services and applications. We do not possess product liability insurance, and our errors and
omissions coverage is not likely to be sufficient to cover our complete
liability exposure. Our network is subject to security and stability risks that could harm our
business and reputation and expose us to litigation or liability. Online commerce and communications depend on the ability to transmit
confidential information and licensed intellectual property securely over
private and public networks. Any compromise of our ability to transmit such
information and data securely or reliably, and any costs associated with
preventing or eliminating such problems, could harm our business. Our systems
and operations are susceptible to, and could be damaged or interrupted by a
number of security and stability risks, including: outages caused by fire, 43




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flood, power loss, telecommunications failure, Internet breakdown,
earthquake and similar events. We do not have complete redundancy in our
webcasting facilities and therefore any damage or destruction to these would
significantly harm our webcasting business. Our systems are also subject to
human error, security breaches, power losses, computer viruses, break-ins,
denial of service attacks, sabotage, intentional acts of vandalism and
tampering designed to disrupt our computer systems, Websites and network
communications. A sudden and significant increase in traffic on our Websites
could strain the capacity of the software, hardware and telecommunications
systems that we deploy or use. This could lead to slower response times or
system failures. Our operations also depend on receipt of timely feeds from our content
providers, and any failure or delay in the transmission or receipt of such
feeds could disrupt our operations. We also depend on Web browsers, ISPs and
online service providers to provide access over the Internet to our product and
service offerings. Many of these providers have experienced significant outages
or interruptions in the past, and could experience outages, delays and other
difficulties due to system failures unrelated to our systems. These types of
interruptions could continue or increase in the future. The occurrence of any of these or similar events could damage our
business, hurt our ability to distribute products and services and collect
revenue, threaten the proprietary or confidential nature of our technology,
harm our reputation, and expose us to litigation or liability. We may be
required to expend significant capital or other resources to protect against
the threat of security breaches, hacker attacks or system malfunctions or to
alleviate problems caused by such breaches, attacks or failures. Our services are complex and are deployed in complex environments and
therefore may have errors or defects that could seriously harm our business. Our services are highly complex and are designed to be deployed in and
across numerous large complex networks. Our digital distribution activities are
managed by sophisticated software and computer systems. From time to time, we
have needed to correct errors and defects. In addition, we must continually
develop and update these systems over time as our business and business needs
grow and change and these systems may not adequately reflect the current needs
of our business. We may encounter delays in developing these systems, and the
systems may contain undetected errors and defects that could cause system
failures. Any system error or failure that causes interruption in availability
of products or content or an increase in response time could result in a loss
of potential or existing business services customers, users, advertisers or
content providers. If we suffer sustained or repeated interruptions, our
products, services and Websites could be less attractive to such entities or
individuals and our business could be harmed. Our transmission capacity is not entirely in our control, as we rely in
part on transmission capacity provided by third parties. Insufficient
transmission capacity could result in interruptions in our services and loss of
revenues. Significant portions of our business are dependent on providing customers
with efficient and reliable services to enable customers to broadcast content
to large audiences on a live or on-demand basis. Our operations are dependent
in part upon transmission capacity provided by third-party telecommunications
network providers. Any failure of such network providers to provide the
capacity we require may result in a reduction in, or interruption of, service
to our customers. If we do not have access to third-party transmission
capacity, we could lose customers and if we are unable to obtain such capacity
on terms commercially acceptable to us, our business and operating results
could suffer. We
have identified material weaknesses in our internal control
over financial reporting. Our audit committee was advised by PricewaterhouseCoopers LLP, or PwC, our
independent registered public accounting firm for the period from June 6, 2002
through August 31, 2004, that during their review of our unaudited interim
financial statements for the quarter ended June 30, 2004 they had identified
material weaknesses, as defined in Public Company Accounting Oversight Board
Standard No. 2, in our internal control over financial reporting. These matters
are:  
    
    Insufficiently skilled personnel compounded by a lack of human
resources and expected near-term significant turnover with Loudeyes
accounting and financial function. Also, Loudeye must improve controls
surrounding adequate monitoring and oversight of the work performed by
accounting and financial reporting personnel.
    
    Insufficient analysis, documentation and review of the selection and
application of generally accepted accounting principles to significant
non-routine transactions, including the preparation of financial
statement disclosures relating thereto. 44




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These material
weaknesses result in deficiencies in the processes,
procedures and competencies within our accounting and financial reporting
function and contributed to post-closing adjustments and delays in the
completion and filing of our June 30, 2004 Form 10-Q. Although we are
undertaking a number of initiatives to address these material weaknesses, the
existence of a material weakness is an indication that there is more than a
remote likelihood that a material misstatement of our financial statements will
not be prevented or detected in the current or any future period. In
addition, we may in the future identify further material weaknesses or
significant deficiencies in our internal control over financial reporting that
we have not discovered to date. Our operations could be harmed by factors including political instability,
natural disasters, fluctuations in currency exchange rates and changes in
regulations that govern international transactions. We sell our products worldwide. As a result of our acquisition of OD2, we
have substantial operations in the United Kingdom, France, Germany and Italy.
The risks inherent in international trade may reduce our international sales
and harm our business and the businesses of our customers and our suppliers.
These risks include:  
    
    Changes in tariff regulations;
    
    Political instability, war, terrorism and other political risks;
    
    Foreign currency exchange rate fluctuations;
    
    Establishing and maintaining relationships with local distributors and dealers;
    
    Lengthy shipping times and accounts receivable payment cycles;
    
    Import and export licensing requirements;
    
    Compliance with a variety of foreign laws and regulations, including
unexpected changes in taxation and regulatory requirements;
    
    Greater difficulty in safeguarding intellectual property than in the U.S.;
    
    Challenges caused by distance, language and cultural differences;
    
    Potentially adverse tax consequences;
    
    Difficulty in staffing and managing geographically diverse operations; and
    
    Higher costs associated with doing business internationally. These and other risks may preclude or curtail international sales or increase
the relative price of our products compared to those of local competitors in
other countries, reducing the demand for our products. Our business and operations may be especially subject to the risks of
earthquakes and other natural catastrophes. Our U.S. computer and communications infrastructure is located at a single
leased facility in Seattle, Washington, an area that is at heightened risk of
earthquake and volcanic events. We do not have fully redundant systems, and we
may not have adequate business interruption insurance to compensate us for
losses that may occur from a system outage. Despite our efforts, our network
infrastructure and systems could be subject to service interruptions or damage
and any resulting interruption of services could harm our business, operating
results and reputation. Risks Related to Our Industry Digital media distribution services in general are new and rapidly
evolving and may not prove to be viable business models. Digital media distribution services are a relatively new business model
for delivering digital media over electronic mediums, including the Internet.
It is too early to predict whether consumers will accept online music services
in significant numbers and 45




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accordingly whether the services will be financially viable. If digital
media distribution services do not prove to be popular with consumers, or if
these services cannot sustain any such popularity, our business and prospects
would be harmed. We must provide digital rights management solutions that are acceptable to
both content providers and consumers. We must also provide digital rights management solutions and other
security mechanisms in order to address concerns of content providers and
artists, and we cannot be certain that we can develop, license or acquire such
solutions, or that content licensors or consumers will accept them. Consumers
may be unwilling to accept the use of digital rights management technologies
that limit their use of content, especially with large amounts of free content
readily available. No assurance can be given that such solutions will be
available to us upon reasonable terms, if at all. If we are unable to acquire
these solutions on reasonable or any terms, or if customers are unwilling to
accept these solutions, our business and prospects could be harmed. Our industry is experiencing consolidation that may intensify competition. The Internet and digital media services industries are undergoing
substantial change that has resulted in increasing consolidation and a
proliferation of strategic transactions. Many companies in these industries
have failed or are being acquired by larger entities. As a result, we are
increasingly competing with larger competitors which have substantially greater
resources than we do. We expect this consolidation and strategic partnering to
continue. Acquisitions or strategic relationships could harm us in a number of
ways. For example:  
    
    Competitors could acquire or enter into relationships with companies
with which we have strategic relationships and discontinue our
relationship, resulting in the loss of distribution opportunities for
our products and services or the loss of certain enhancements or
value-added features to our products and services;
    
    Competitors could obtain exclusive access to desirable multimedia
content and prevent that content from being available in certain
formats, thus impairing our content selection and our ability to attract
customers;
    
    Suppliers of important or emerging technologies could be acquired by
a competitor or other company which could prevent us from being able to
utilize such technologies in our offerings, and disadvantage our
offerings relative to those of competitors;
    
    A competitor could be acquired by a party with significant resources
and experience that could increase the ability of the competitor to
compete with our products and services; and
    
    Other companies with related interests could combine to form new,
formidable competition, which could preclude us from obtaining access to
certain markets or content; or which could significantly change the
market for our products and services. Any of these results could put us at a competitive disadvantage that could
cause us to lose customers, revenue and market share. They could also force us
to expend greater resources to meet the competitive threat, which could also
harm our operating results. Our business could be harmed by a lack of availability of popular content. Our digital media services business is affected by the release of hit
music titles, which can create cyclical trends in sales distinctive to the
music industry. It is not possible to determine the timing of these cycles or
the future availability of hit titles. Hit products are important because they
generate consumer interest. We depend upon the music content providers to
continue to produce hit products. To the extent that new hits are not
available, or not available at prices attractive to consumers, our sales and
margins may be adversely affected. The growth of our business depends on the increased use of the Internet
and wireless networks for communications, electronic commerce and advertising. The growth of our business depends on the continued growth of the Internet
and wireless networks as a medium for media consumption, communications,
electronic commerce and advertising. Our business will be harmed if such usage
does not continue to grow, particularly as a source of media information and
entertainment and as a vehicle for commerce in goods and services. Our success
also depends on the efforts of third parties to develop the infrastructure and
complementary products and services necessary to maintain and expand the
Internet and wireless networks as viable commercial channels, and identifying
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models for digital media-based businesses. We believe that other
Internet-related issues, such as security, privacy, reliability, cost, speed,
ease of use and access, quality of service, and necessary increases in
bandwidth availability and access on an affordable basis, remain largely
unresolved and may affect the amount and type of business that is conducted
over such mediums, and may adversely affect our ability to sell our products
and services and ultimately impact our business results and prospects. If usage of the Internet and wireless networks grows, the respective
infrastructure may not be able to support the demands placed on them by such
growth, specifically the demands of delivering high-quality media content. As a
result, the performance and reliability of such mediums may decline. In
addition, the Internet and wireless networks have experienced interruptions in
service as a result of outages, system attacks and other delays occurring
throughout the relevant network infrastructure. If these outages, attacks or
delays occur frequently or on a broad scale in the future, overall usage, as
well as the usage of our products and services could grow more slowly or
decline. If broadband technologies do not become widely available or widely
adopted, our online media distribution services may not achieve broad market
acceptance, and our business may be harmed. We believe that increased Internet use and especially the increased use of
media over the Internet may depend on the availability of greater bandwidth or
data transmission speeds (also known as broadband transmission). If broadband
technologies do not become widely available or widely adopted, our online media
distribution services may not achieve broad market acceptance and our business
and prospects could be harmed. Congestion over the Internet and data loss may
interrupt audio and video streams, resulting in unsatisfying user experiences.
The success of digital media distribution over the Internet depends on the
continued rollout of broadband access to consumers on an affordable basis. To
date, we believe that broadband technologies have been adopted at a slower rate
than expected, which we believe has delayed broader-based adoption of the
Internet as a media distribution medium. Our business and prospects may be
harmed if the rate of adoption does not increase. More consumers are utilizing non-PC devices to access digital content, and
we may not be successful in developing versions of our products and services
that will gain widespread adoption by users of such devices. In the coming years, the number of individuals who access digital content
through devices other than a personal computer, such as personal digital
assistants, cellular telephones, television set-top devices, game consoles and
Internet appliances, may increase dramatically. Manufacturers of these types of
products are increasingly investing in media-related applications, but these
devices are in an early stage of development and business models are new and
unproven. If we are unable to offer our services on these alternative non-PC
devices, we may fail to capture a sufficient share of an increasingly important
portion of the market for digital media services or our costs may increase
significantly. Government regulation could adversely affect our business prospects. Few existing laws or regulations specifically apply to the Internet, other
than laws and regulations generally applicable to businesses. Certain U.S.
export controls and import controls of other countries, including controls on
the use of encryption technologies, may apply to our products. Many laws and
regulations, however, are pending and may be adopted in the United States,
European countries, and other countries, and in states, provinces and local
jurisdictions, with respect to the Internet. These laws may relate to many
areas that impact our business, including content issues (such as obscenity,
indecency and defamation), copyright and other intellectual property rights,
digital rights management, encryption, caching of content by server products,
personal privacy, taxation, e-mail, sweepstakes, promotions, network and
information security and the convergence of traditional communication services
with Internet communications, including the future availability of broadband
transmission capability and wireless networks. These types of regulations are
likely to differ between countries and other political and geographic
divisions. Other countries and political organizations are likely to impose or
favor more and different regulation than that which has been proposed in the
United States, thus furthering the complexity of regulation. In addition, state
and local governments may impose regulations in addition to, inconsistent with,
or stricter than federal regulations. The adoption of such laws or regulations,
and uncertainties associated with their validity, interpretation, applicability
and enforcement, may affect the available distribution channels for and costs
associated with our products and services, and may affect the growth of the
Internet. Such laws or regulations may harm our business. Our products and
services may also become subject to investigation and regulation of foreign
data protection and e-commerce authorities, including those in the European
Union. Such activities could result in additional product and distribution
costs for us in order to comply with such regulation. There is uncertainty regarding how existing laws governing issues such as
property ownership, copyright and other intellectual property issues, digital
rights management, taxation, gambling, security, illegal or obscene content,
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media, and personal privacy and data protection apply to the Internet. The
vast majority of such laws was adopted before the advent of the Internet and
related technologies and does not address the unique issues associated with the

Internet and related technologies. Most of the laws that relate to the Internet
have not yet been interpreted. In addition to potential legislation from local,
state and federal governments, labor guild agreements and other laws and
regulations that impose fees, royalties or unanticipated payments regarding the
distribution of media over the Internet may directly or indirectly affect our
business. While we and our customers may be directly affected by such
agreements, we are not a party to such agreements and have little ability to
influence the degree such agreements favor or disfavor Internet distribution or
our business models. Changes to or the interpretation of these laws and the
entry into such industry agreements could:  
    
    Limit the growth of the Internet;
    
    Create uncertainty in the marketplace that could reduce demand for our products and services;
    
    Increase our cost of doing business;
    
    Expose us to increased litigation risk, substantial defense costs and
significant liabilities associated with content available on our
Websites or distributed or accessed through our products or services,
with our provision of products and services, and with the features or
performance of our products and Websites;
    
    Lead to increased product development costs or otherwise harm our
business; or
    
    Decrease the rate of growth of our user base and limit our ability to
effectively communicate with and market to our user base. The Digital Millennium Copyright Act, or DMCA, includes statutory licenses
for the performance of sound recordings and for the making of recordings to
facilitate transmissions. Under these statutory licenses, we and our broadcast
customers may be required to pay licensing fees for digital sound recordings we
deliver in original and archived programming and through retransmissions of
radio broadcasts. The DMCA does not specify the rate and terms of the licenses,
which are determined by arbitration proceedings, known as CARP proceedings,
supervised by the United States Copyright Office. Past CARP proceedings have
resulted in proposed rates for statutory webcasting that were significantly in
excess of rates requested by webcasters. CARP proceedings relating to music
subscription and non-subscription services offering music programming that
qualify for various licenses under U.S. copyright law are pending. We cannot
predict the outcome of these CARP proceedings and may elect instead to directly
license music content for our subscription and/or non-subscription services,
either alone or in concert with other affected companies. Such licenses may apply only to music performed in the United States, and
the availability of corresponding licenses for international performances is
unclear. Therefore, our ability to find rights holders and negotiate
appropriate licenses is uncertain. Many of our customers may be affected by
these rates, which may negatively affect our revenue. Several CARP proceedings
are pending for subscription music services and services that deliver digital
downloads of music, and the outcome of these CARPs will also likely affect our
business in ways that we cannot predict. Depending on the rates and terms
adopted for the statutory licenses, our business could be harmed both by
increasing our own cost of doing business, as well as by increasing the cost of
doing business for our customers. We anticipate future CARPs relating to music
subscription delivery services, which may also adversely affect the online
distribution of music. The Child Online Privacy Protection Act imposes liability on persons
collecting personal information from children under the age of 13. The Child
Online Protection Act imposes civil and criminal penalties on persons
distributing material harmful to minors over the Internet to persons under the
age of 17. The manner in which these Acts may be interpreted and enforced
cannot be fully determined. For example, while the Supreme Court recently
upheld an injunction of the enforcement of the Child Online Protection Act
because it likely violates the First Amendment of the US Constitution, it is
possible that the courts will ultimately find the act enforceable. If the Child
Online Protection Act is ultimately found to be unenforceable it is possible
that Congress would enact new legislation aimed at preventing the distribution
of materials that might be harmful to minors. If it is determined that we fail
to conform to any such law we could face fines or civil penalties. There are a large number of legislative proposals before the United States
Congress and various state legislatures regarding intellectual property,
digital rights management, copy protection requirements, privacy, email
marketing and security issues related to our business. It is not possible to
predict whether or when such legislation may be adopted, and certain proposals,
if adopted, could 48




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materially and adversely affect our business through a decrease in user
registration and revenue, and influence how and whether we can communicate with
our customers. We may be subject to market risk and legal liability in connection with
the data collection capabilities of our products and services. Many of our products are interactive applications that by their very
nature require communication between a client and server to operate. To provide
better consumer experiences and to operate effectively, our products send
information to servers. Many of the services we provide also require that a
user provide certain information to us. We post an extensive privacy policy
concerning the collection, use and disclosure of user data involved in
interactions between our client and server products. Any failure by us to
comply with our posted privacy policy and existing or new legislation regarding
privacy issues could impact the market for our products and services, subject
us to litigation and harm our business. Risks Related to Our Common Stock Our future capital-raising activities could involve the issuance of equity
securities, which would dilute your investment and could result in a decline in
the trading price of our common stock. We may sell securities in the public or private equity markets if and when
conditions are favorable, even if we do not have an immediate need for
additional capital at that time. Raising funds through the issuance of equity
securities will dilute the ownership of our existing stockholders. Furthermore,
we may enter into financing transactions at prices that represent a substantial
discount to the market price of our common stock. A negative reaction by
investors and securities analysts to any discounted sale of our equity
securities could result in a decline in the trading price of our common stock. We have identified material weaknesses in
our internal controls over financial reporting which will likely result in an adverse opinion
on internal controls being issued by our auditors in connection with their annual
attestation process. This could have a negative impact on our stock
price. Section 404 of
the Sarbanes-Oxley Act of 2002 requires our auditors to audit both the design and operating effectiveness of our
internal controls and managements assessment of the design and the effectiveness of its internal controls. We
have identified two material weaknesses in our internal controls over
financial reporting as of June 30 and
September 30, 2004. It is unlikely that we will be able to remediate these material weaknesses in sufficient
time to permit testing of our documentation and remediation efforts relating to these material weaknesses. If
we are unable to remediate the weaknesses in a manner that permits testing of the effectiveness of these
remediation efforts, our auditors could be required to issue an adverse opinion on our internal controls. An
adverse opinion on our internal controls could have a negative impact on our stock price. Because opinions on
internal controls have not been required in the past, it is uncertain what impact an adverse opinion would have
upon our stock price. Some provisions of our amended and restated certificate of incorporation
and amended bylaws and of Delaware law may deter takeover attempts, which may
limit the opportunity of our stockholders to sell their shares at a favorable
price. Some of the provisions of our amended and restated certificate of
incorporation and amended bylaws could make it more difficult for a third party
to acquire us, even if doing so might be beneficial to our stockholders by
providing them with the opportunity to sell their shares possibly at a premium
over the then market price. For example, our board of directors is divided into three classes. At each
annual meeting of stockholders, the terms of approximately one-third of the
directors will expire, and new directors will be elected to serve for three
years. It will take at least two annual meetings to effect a change in control
of our board of directors because a majority of the directors cannot be elected
at a single meeting, which may discourage hostile takeover bids. In addition, our amended and restated certificate of incorporation
authorizes the board of directors to issue up to 5,000,000 shares of preferred
stock. The preferred stock may be issued in one or more series, the terms of
which may be determined at the time of issuance by our board of directors
without further action by the stockholders. These terms may include voting
rights including the right to vote as a series on particular matters,
preferences as to dividends and liquidation, conversion rights, redemption
rights and sinking fund provisions. No shares of preferred stock are currently
outstanding and we have no present plans for the issuance of any preferred
stock. The issuance of any preferred stock, however, could diminish the rights
of holders of our common stock, and therefore could reduce the value of our
common stock. In addition, specific rights granted to future holders of
preferred stock could be used to restrict our ability to merge with, or sell
assets to, a third party. The ability of our board of directors to issue
preferred stock could make it more difficult, delay, discourage, prevent or
make it more costly to acquire or effect a change in control, thereby
preserving the current stockholders control. Our amended bylaws contain provisions that require stockholders to act
only at a duly-called meeting and make it difficult for any person other than
management to introduce business at a duly-called meeting by requiring such
other person to follow certain notice procedures. Finally, we are also subject to Section 203 of the Delaware General
Corporation Law which, subject to certain exceptions, prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years following the date that the stockholder
became an interested stockholder. The preceding provisions of our certificate
of incorporation and bylaws, as well as Section 203 of the Delaware General
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proposals, delay or prevent a change of control and prevent changes in our
management, even if such things would be in the best interests of our
stockholders. Securities analysts may not continue to cover our common stock or may
issue negative reports, and this may have a negative impact on our common
stocks market price. There is no guarantee that securities analysts will continue to cover our
common stock. If securities analysts do not cover our common stock, the lack of
research coverage may adversely affect our common stocks market price. The
trading market for our common stock relies in part on the research and reports
that industry or financial analysts publish about our business or us. If one or
more of the analysts who cover us downgrades our stock, our stock price may
decline rapidly. If one or more of these analysts ceases coverage of our
company, we could lose visibility in the market, which in turn could cause our
stock price to decline. In addition, recently adopted rules mandated by the
Sarbanes-Oxley Act of 2002, and a global settlement reached between the SEC,
other regulatory analysts and a number of investment banks in April 2003, may
lead to a number of fundamental changes in how analysts are reviewed and
compensated. In particular, many investment banking firms will now be required
to contract with independent financial analysts for their stock research. It
may be difficult for companies with smaller market capitalizations, such as our
company, to attract independent financial analysts that will cover our common
stock, which could have a negative effect on our market price. Market fluctuations and volatility could cause the trading price of our
common stock to decline and limit our ability to raise capital. Our common stock trades on the Nasdaq SmallCap Market. Our common stock
has experienced extreme price and volume fluctuations to date. In the future,
the market price and trading volume of our common stock could be subject to
significant fluctuations due to general market conditions and in response to
quarter-to-quarter variations in:  
    
    Our anticipated or actual operating results;
    
    Developments concerning our technologies and market offerings;
    
    Technological innovations or setbacks by us or our competitors;
    
    Conditions in the digital media and Internet markets;
    
    Announcements of merger or acquisition transactions; and
    
    Other events or factors and general economic and market conditions. In the past, securities class action litigation has been brought against
companies that experienced volatility in the trading price of their securities.
Market fluctuations in the price of our common stock could also adversely
affect our ability to sell equity securities at a price we deem appropriate. Future sales of our common stock or the perception that future sales could
occur, may adversely affect our common stock price. If a large number of shares of our common stock are sold in the open
market or if there is a perception that such sales could occur, the trading
price of our common stock could decline materially. In addition, the sale of
these shares, or possibility of such sale, could impair our ability to raise
capital through the sale of additional shares of common stock. As of September 30, 2004, we had on file with the SEC effective
registration statements for a total of approximately 30 million shares for
resale by selling stockholders, representing approximately 36.7% of our common
stock then outstanding. The selling stockholders under effective registration
statements will be permitted to sell their registered shares in the open market
from time to time without advance notice to us or to the market and without
limitations on volume. We are obligated to file a registration statement covering the resale of
13,949,849 shares issued or issuable by us in our acquisition of OD2. We also
are obligated to register any additional shares we may issue to satisfy up to
£19.6 million (approximately $35.3 million based on exchange rates as of
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Sales of shares pursuant to exercisable options and warrants could also
lead to subsequent sales of the shares in the public market. These sales,
together with sales of shares by the selling stockholders, could depress the
market price of our stock by creating an excess in supply of shares for sale.
Availability of these shares for sale in the public market could also impair
our ability to raise capital by selling equity securities. If our stock price trades below $1.00 per share for an extended period of
time we may be delisted from the Nasdaq SmallCap Market Recently, our common stock has traded at prices below $1.00 per share. If
our stock price trades below $1.00 per share for an extended period, it may be
delisted from the Nasdaq SmallCap Market, which would have an adverse effect on
our business and on the trading of our common stock. In order to maintain
compliance with Nasdaq SmallCap listing standards, we may consider several
strategies, including without limitation a reverse stock split. We cannot
predict what effect a reverse stock split would have on the market price of our
common stock or our ability to maintain compliance with the listing standards
of the Nasdaq SmallCap market. If a delisting of our common stock were to
occur, our common stock would trade on the OTC Bulletin Board or in the pink
sheets maintained by the National Quotation Bureau, Inc. Such alternatives
are generally considered to be less efficient markets, and our stock price, as
well as the liquidity of our common stock, may be adversely impacted as a
result. Recently enacted and proposed changes in securities laws and regulations
will increase our costs. The Sarbanes-Oxley Act of 2002 along with other recent and proposed rules
from the Securities and Exchange Commission and Nasdaq require changes in our
corporate governance, public disclosure and compliance practices. Many of these
new requirements will increase our legal and financial compliance costs, and
make some corporate actions more difficult, such as proposing new or amendments
to stock option plans, which now require shareholder approval. These
developments could make it more difficult and more expensive for us to obtain
director and officer liability insurance, and we may be required to accept
reduced coverage or incur substantially higher costs to obtain coverage. These
developments also could make it more difficult for us to attract and retain
qualified executive officers and qualified members of our board of directors,
particularly to serve on our audit committee. If proposed accounting regulations that require companies to expense stock
options are adopted, our earnings will decrease and our stock price may
decline. A number of publicly-traded companies have recently announced that they
will begin expensing stock option grants to employees. In addition, the
Financial Accounting Standards Board (FASB) has indicated that possible rule
changes requiring expensing of stock options will be adopted in December 2004,
with an effective date beginning in third quarter 2005. Currently, we include
such expenses on a pro forma basis in the notes to our annual financial
statements in accordance with accounting principles generally accepted in the
United States, but do not include stock option expense for employee options in
our reported financial statements. If accounting standards are changed to
require us to expense stock options, our reported earnings will decrease
significantly and our stock price could decline. 
 Item 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our financial results could be affected by factors such as changes in
interest rates, changes in foreign exchange rates and fluctuations in the stock
market. As a substantial percentage of our sales are currently made in U.S.
dollars, a strengthening of the dollar could make our services less competitive
in foreign markets. We presently do not use derivative instruments to hedge our
risks. We are obligated to pay £9.6 million (approximately $17.3 million based on
exchange rates as of September 30, 2004) through November 30, 2005, to OD2s
shareholders. We are also obligated to pay additional contingent consideration
of up to £10.0 million (approximately $18.0 million based on exchange rates as
of September 30, 2004) if OD2 achieves certain financial performance targets
during the period through November 30, 2006. The payments are to be made in
British pounds, and accordingly, we are exposed to risks with changes in the
prevailing exchange rate. We may hedge this risk. If we do not hedge against
exchange rate risk, any decrease in the value of the U.S. dollar against the
British pound will cause a proportional increase in the amount of the future
consideration we must pay to the former OD2 shareholders. In addition, the results of operations of OD2 are exposed to foreign
exchange rate fluctuations as the financial results of this subsidiary are
translated from the local currency to U.S. dollars upon consolidation. Because
of the significance of the operations of OD2 to our consolidated operations, as
exchange rates vary, revenues and other operating results, when translated, may
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materially from our prior performance and our expectations. In addition,
because of the significance of our international operations, we could also be
significantly affected by weak economic conditions in foreign markets that
could reduce demand for our products and further negatively impact the results
of our operations in a material and adverse manner. As a result of these market
risks, the price of our stock could decline significantly and rapidly. We currently do not engage in any hedging activities. As foreign currency
exchange rates vary, the fluctuations in revenues and expenses may materially
impact the financial statements upon consolidation. A weaker U.S. dollar would
result in an increase to revenues and expenses upon consolidation, and a
stronger U.S. dollar would result in a decrease to revenues and expenses upon
consolidation. Our interest income is sensitive to changes in the general level of U.S.
interest rates. Based on our cash and investment balances of $24.8 million at
September 30, 2004, a one percent change in interest rates would cause a change
in interest income of $248,000 per year. Due to the investment grade level of
our investments, we anticipate no material market risk exposure. In addition,
interest on our term loan is based on the prime rate. Based on the $2.3 million
balance outstanding at September 30, 2004, a one percent increase in the prime
rate would increase our interest expense by $225,000 per year. We invest in investment-grade government obligations, institutional money
market funds and other obligations with FDIC insured U.S. banks. Our primary
investment focus is to preserve capital and earn a market rate of return on our
investments. We do not speculate nor invest in publicly traded equity
securities and, therefore, do not believe that our capital is subject to
significant market risk. 
 Item 4: CONTROLS AND PROCEDURES We maintain a set of disclosure controls and procedures designed to ensure
that information required to be disclosed by us in the reports filed under the
Securities Exchange Act, is recorded, processed, summarized and reported within
the time periods specified by the SECs rules and forms. Disclosure controls
are also designed with the objective of ensuring that this information is
accumulated and communicated to our management, including our chief executive
officer and chief financial officer, as appropriate to allow timely decisions
regarding required disclosure. Our audit committee was advised by PricewaterhouseCoopers LLP, or PwC, our
independent registered public accounting firm for the period from June 6, 2002
through August 31, 2004, that during their performance of review procedures
related to Loudeyes unaudited interim financial statements for the quarter
ended June 30, 2004 PwC identified two material weaknesses in our internal
controls over financial reporting, as defined in Public Company Accounting
Oversight Board, or PCAOB, Standard No. 2. As used by the PCAOB, a material
weakness is a significant deficiency, or a combination of significant
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. The material weaknesses identified by PwC were as
follows:  
    
    Insufficiently skilled personnel compounded by a lack of human
resources and expected near-term significant turnover within our
accounting and financial reporting function. Also, we must improve
controls surrounding adequate monitoring and oversight of the work
performed by accounting and financial reporting personnel.
    
    Insufficient analysis, documentation and review of the selection and
application of generally accepted accounting principles to significant
non-routine transactions, including the preparation of financial
statement disclosures relating thereto. As required by SEC Rule 13a-15(b), management conducted an evaluation with
the participation of our chief executive officer and our chief financial
officer, of the effectiveness of the design and operation of our disclosure
controls and procedures. Based upon the foregoing, our chief executive officer
and chief financial officer concluded that our disclosure controls and
procedures were not effective at a reasonable assurance level as of September
30, 2004. Management has assigned a high priority to the short-term and long-term
improvement of our internal control over financial reporting. Specific
initiatives with respect to our disclosure controls and procedures and actions
to address the material weaknesses described above that we will undertake
through December 31, 2004, include the following among others:  
    
    Our first priority has been to hire additional qualified staff for our
finance and accounting departments. We have engaged two outside
recruiting firms to assist us in our search for qualified accounting
and finance personnel. Three individuals (including a
director-financial planning and analysis, a director-financial
reporting and an assistant controller) joined
our finance and accounting staff on October 4, 2004. Each of these
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accounting

experience, including experience working with companies subject to the
reporting requirements of the Securities Exchange Act of 1934, as
amended. To further augment our accounting and finance departments, we
hired two additional individuals on November 1, 2004, and our goal is
to hire one to two additional qualified individuals during the fourth
quarter 2004. We anticipate that the integration process for our
newly-hired individuals will continue into the first quarter 2005.
Once our hiring process is completed, our accounting staff will
consist of significantly more qualified accounting and finance
personnel than was the case during the period that the material
weaknesses were identified.
    
    We continue to review and revise a number of our disclosure and
accounting policies and procedures, including internal employee
training, to strengthen and establish greater uniformity in their
application. We began implementing revised policies and procedures and
training with respect thereto beginning in October 2004, coinciding
with the start date of the additional personnel for our finance and
accounting departments that we have hired. Our training programs are
focused on our newly hired and continuing finance and accounting
personnel, as well as other employees within our organization. These
training programs are being designed to emphasize the duties and
responsibilities of employees with respect to internal controls over
financial reporting and disclosure controls and procedures.
Specifically, our training programs include training regarding
segregation of duties, contract approval processes and documentation,
document retention policies and identification and treatment of public
company disclosure matters.
    
    In May 2004, we engaged an outside consulting firm to advise us on
internal control matters. Together with our outside consultants, we
have established a multiple-phase remediation process. These phases
include risk assessment and planning, control documentation, control
gap remediation, information technology audit, identification of key
controls, test plan development and testing and development of a
monitoring plan. At present, we have substantially completed the risk
assessment and planning and we are in the process of updating our control documentation. In
September 2004, we began designing a plan to improve our staffing,
documentation and segregation of duties functions within our finance
and accounting departments. This process continued into November 2004.
Our goal is to complete the remaining phases of the documentation and
remediation process with our outside consultants by the end of 2004.
We will begin implementation of testing and monitoring of these controls and
procedures, in particular as implemented among our new staff within
the finance and accounting department, in the first quarter 2005.
    
    During the fourth quarter 2004, we will continue our internal control
review process to remediate the internal control material weaknesses
identified above by PwC. The steps identified above, including the hiring of additional qualified
accounting and finance personnel, are designed in part to ensure that our
accounting with respect to any significant non-routine transactions is in
accordance with generally accepted accounting principles. Management and our
audit committee intend to closely monitor the implementation of our remediation
plan and are prepared to take additional measures where necessary to ensure
that we have the necessary resources in place to account for significant
non-routine transactions, which measures may include hiring additional
permanent employees, establishing additional training programs and/or engaging
outside expert consultants. Management estimates that we will incur additional costs in connection
with our remediation efforts including recruiting costs, outside advisor fees,
incremental personnel costs, interim personnel costs and severance. Management
estimates that these costs will amount to approximately $750,000 through the
end of the first quarter 2005, including approximately $175,000 of severance
costs. Although we have undertaken the foregoing initiatives, the existence of a
material weakness is an indication that there is more than a remote likelihood
that a material misstatement of our financial statements will not be prevented
or detected in a future period. In addition, we cannot assure you that we will
not in the future identify further material weaknesses or significant
deficiencies in our internal control over financial reporting that we have not
discovered to date. We are taking steps to address the material weaknesses
identified by PwC and to refine our internal controls and procedures to meet
the internal control reporting requirements of Section 404 of the
Sarbanes-Oxley Act and the rules adopted thereunder. The effectiveness of the
steps we have taken to date and the steps we are still in the process of
completing is subject to continued management review, as well as audit
committee oversight, and we may make additional changes to our internal
controls and procedures. Other than the foregoing initiatives, since the date
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evaluation, there have been no material changes in our disclosure controls and
procedures, including our internal controls over financial reporting, that have
materially affected, or are reasonably likely to materially affect, our
disclosure controls and procedures, including our internal controls over
financial reporting. 
 PART II. OTHER INFORMATION 
 ITEM 1: LEGAL PROCEEDINGS See Note 9 to the consolidated unaudited financial statements for
information concerning legal proceedings. We become involved from time to time in various other claims and lawsuits
incidental to the ordinary course of our operations, including such matters as
contract and lease disputes and complaints alleging employment discrimination.
We believe that it is likely that the outcome of any such pending claims or
proceedings individually or in the aggregate, will not have a material adverse
effect upon our business or financial condition, results of operations, or cash
flows. 
 ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS We held an annual meeting of our stockholders on July 22, 2004. Of the
69,955,166 shares outstanding as of the record date for the annual meeting,
57,295,684 shares, or 81.9% of the total shares eligible to vote at the annual
meeting, were represented in person or by proxy.  1)
    
    At the annual meeting, James R. Kuster and Johan C. Liedgren were each elected to serve as Class 1
members of our board of directors, each to hold office for a three-year term or until his successor is
elected and qualified. Each of the incumbent Class 1 directors who stood for reelection was elected
with the following voting results: Nominee
    
    Votes For
    
    Votes WithheldJames R. Kuster
    
    
    55,838,382
    
    
    
    1,457,302Johan C. Liedgren
    
    
    56,363,574
    
    
    
    932,110
  2)
    
    A proposal to amend the 2000 Stock Option Plan, or Plan, to increase the total authorized shares under
the Plan to 17,416,137, passed with the following results: Votes For
    
    Votes Against
    
    Abstain
    
    Broker Non Votes18,423,794
    
    
    9,060,693
    
    
    
    60,133
    
    
    
    29,751,064
  3)
    
    A proposal to increase our authorized number of shares of common stock, par value $0.001 per share,
from 100,000,000 to 150,000,000, passed with the following results: Votes For
    
    Votes Against
    
    Abstain
    
    Broker Non Votes56,168,388
    
    
    1,094,787
    
    
    
    32,509
    
    
    

0
 
 ITEM 6: EXHIBITS 2.1
    
    Form of Promissory Note issued to
certain former shareholders of On Demand Distribution Limited3.1
    
    Certificate of Amendment to the
Amended and Restated Certificate of Incorporation of Loudeye Corp. as
filed with the Secretary of State of the State of Delaware on May 29,
200410.1
    
    2000 Stock Option Plan, as amended
June 4, 200410.2
    
    On Demand Distribution Limited
Employee Share Option Plan10.3
    
    Form of Option Exchange Agreement
for executive former optionees of On Demand Distribution Limited,
including Charles Grimsdale10.4
    
    Form of Option Exchange Agreement
for non-executive former optionees of On Demand Distribution Limited10.5
    
    Directors Service Agreement dated
June 31, 2004, between Charles Grimsdale and On Demand
Distribution Limited10.6
    
    Offer Letter dated February 18,
2004, between Marc Morgenstern and Loudeye Corp.31.1
    
    Certification of Jeffrey M. Cavins, President and Chief Executive
Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of Lawrence J. Madden, Executive Vice President and
Chief Financial Officer of Loudeye Corp., Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
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32.1
    
    Certification of Jeffrey M. Cavins, President and Chief Executive
Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Lawrence J. Madden, Executive Vice President and
Chief Financial Officer of Loudeye Corp., Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of Seattle, State of
Washington, November 15, 2004. LOUDEYE CORP.BY:
    
    /s/ Jeffrey M. CavinsJeffrey M. CavinsPresident and Chief Executive OfficerPrincipal Executive Officer)BY:
    
    /s/ Lawrence J. MaddenLawrence J. MaddenExecutive Vice President and Chief Financial officer(Principal Financial and Accounting Officer)
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EXHIBIT INDEX Exhibit No.
    
    Description2.1
    
    Form of Promissory Note issued to
certain former shareholders of On Demand Distribution Limited3.1
    
    Certificate of Amendment to the
Amended and Restated Certificate of Incorporation of Loudeye Corp. as
filed with the Secretary of State of the State of Delaware on May 29,
200410.1
    
    2000 Stock Option Plan, as amended
June 4, 200410.2
    
    On Demand Distribution Limited
Employee Share Option Plan10.3
    
    Form of Option Exchange Agreement
for executive former optionees of On Demand Distribution Limited,
including Charles Grimsdale10.4
    
    Form of Option Exchange Agreement
for non-executive former optionees of On Demand Distribution Limited10.5
    
    Directors Service Agreement
dated June 21, 2004, between Charles Grimsdale and On Demand
Distribution Limited10.6
    
    Offer Letter dated February 18,
2004, between Marc Morgenstern and Loudeye Corp.31.1
    
    Certification of Jeffrey M. Cavins, President and Chief
Executive Officer of Loudeye Corp., Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Lawrence J. Madden, Executive Vice President
and Chief Financial Officer of Loudeye Corp., Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of Jeffrey M. Cavins, President and Chief
Executive Officer of Loudeye Corp., Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 200232.2
    
    Certification of Lawrence J. Madden, Executive Vice President
and Chief Financial Officer of Loudeye Corp., Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
 57