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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 June 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
    
    91-1908833(State or other jurisdiction of
incorporation or organization)
    
    (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
    
    81,118,743(Class)
    
    (Outstanding at August 27, 2004)




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Loudeye Corp. Form 10-Q Quarterly Report
For the Quarter Ended June 30, 2004 TABLE OF CONTENTS PagePART I.
    
    Financial Information (unaudited)Item 1
    
    Financial StatementsConsolidated Balance Sheets
    
    
    3Consolidated Statements of Operations
    
    
    5Consolidated Statement of Stockholders' Equity
    
    
    6Consolidated Statements of Cash Flows
    
    
    7Notes to Consolidated Financial Statements
    
    
    8Item 2
    
    Management's Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    51Item 4
    
    Controls and Procedures
    
    
    52PART II.
    
    Other InformationItem 1
    
    Legal Proceedings
    
    
    53Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    54Item 3
    
    Defaults Upon Senior Securities
    
    
    56Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    56Item 5
    
    Other Information
    
    
    56Item 6
    
    Exhibits and Reports on Form 8-K
    
    
    56EXHIBIT 10.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  -2-




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PART I  FINANCIAL INFORMATION 
 ITEM I. FINANCIAL STATEMENTS LOUDEYE CORP. 
 CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts) June 30,
    
    December 31,2004
    
    2003ASSETSCash and cash equivalents
    
    $
    13,397
    
    
    $
    12,480Marketable securities
    
    
    18,746
    
    
    
    9,460Accounts receivable, net of allowances of $161 and
$235
    
    
    4,659
    
    
    
    1,781Prepaid expenses and other
    
    
    1,118
    
    
    
    345Assets held for sale
    
    
    
    
    
    
    363Restricted
investments
    
    
    11
    
    
    
    Total current assets
    
    
    37,931
    
    
    
    24,429Restricted investments
    
    
    305
    
    
    
    316Property and equipment, net
    
    
    3,903
    
    
    
    1,123Goodwill
    
    
    35,584
    
    
    
    Intangible assets, net
    
    
    4,218
    
    
    
    86Assets held for sale
    
    
    
    
    
    
    730Other assets, net
    
    
    250
    
    
    
    360Total assets
    
    $
    82,191
    
    
    $
    27,044LIABILITIES AND STOCKHOLDERS EQUITYAccounts payable
    
    $
    6,514
    
    
    $
    1,229Line of credit
    
    
    
    
    
    
    1,285Accrued compensation and benefits
    
    
    437
    
    
    
    378Other accrued expenses
    
    
    5,361
    
    
    
    1,155Accrued special charges
    
    
    521
    
    
    
    1,670Accrued acquisition consideration
    
    
    10,076
    
    
    
    Deferred revenue
    
    
    1,983
    
    
    
    485Current portion of long-term debt
    
    
    1,281
    
    
    
    1,348Liabilities related to assets held for sale
    
    
    
    
    
    
    98Total current liabilities
    
    
    26,173
    
    
    
    7,648Deferred revenue
    
    
    757
    
    
    
    228Common stock payable related to acquisition
    
    
    2,596
    
    
    
    Accrued acquisition consideration, net of current
portion
    
    
    3,395
    
    
    
    Long-term debt, net of current portion
    
    
    1,540
    
    
    
    2,135Total liabilities
    
    
    34,461
    
    
    
    10,011Commitments and contingencies
 -3-




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STOCKHOLDERS 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, 100,000
shares authorized; 79,030 shares issued and
outstanding in 2004 and 56,974 issued and outstanding
in 2003
    
    
    246,569
    
    
    
    210,134Deferred stock-based compensation
    
    
    (239
    )
    
    
    (214
    )Accumulated deficit
    
    
    (198,315
    )
    
    
    (192,887
    )Accumulated
other comprehensive income (loss)
    
    
    (285
    )
    
    
    Total stockholders equity
    
    
    47,730
    
    
    
    17,033Total liabilities and
stockholders equity
    
    $
    82,191
    
    
    $
    27,044
 The accompanying notes are an integral part of these consolidated financial statements. -4-




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003REVENUES
    
    $
    3,131
    
    
    $
    2,903
    
    
    $
    5,122
    
    
    $
    6,213COST OF REVENUESOther cost of revenues
    
    
    1,800
    
    
    
    1,678
    
    
    
    3,207
    
    
    
    4,219Non-cash stock-based compensation
    
    
    19
    
    
    
    4
    
    
    
    38
    
    
    
    7Total cost of revenues
    
    
    1,819
    
    
    
    1,682
    
    
    
    3,245
    
    
    
    4,226Gross profit
    
    
    1,312
    
    
    
    1,221
    
    
    
    1,877
    
    
    
    1,987OPERATING EXPENSESResearch and development (1)
    
    
    753
    
    
    
    392
    
    
    
    1,343
    
    
    
    969Sales and marketing (1)
    
    
    836
    
    
    
    835
    
    
    
    1,471
    
    
    
    2,381General and administrative (1)
    
    
    2,232
    
    
    
    1,740
    
    
    
    4,192
    
    
    
    4,492Amortization of intangibles and other assets
    
    
    126
    
    
    
    260
    
    
    
    266
    
    
    
    786Stock-based compensation (1)
    
    
    43
    
    
    
    191
    
    
    
    165
    
    
    
    231Gain on sale of property and equipment
    
    
    
    
    
    
    (96
    )
    
    
    
    
    
    
    (96
    )Special charges  goodwill impairments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,307Special charges (credits)  other
    
    
    
    
    
    
    
    
    
    
    (50
    )
    
    
    3,130Total operating expenses
    
    
    3,990
    
    
    
    3,322
    
    
    
    7,387
    
    
    
    17,200OPERATING LOSS
    
    
    (2,678
    )
    
    
    (2,101
    )
    
    
    (5,510
    )
    
    
    (15,213
    )OTHER INCOME (EXPENSE)Investment income
    
    
    107
    
    
    
    101
    
    
    
    186
    
    
    
    187Interest expense
    
    
    (59
    )
    
    
    (48
    )
    
    
    (130
    )
    
    
    (97
    )Loss on sale of media restoration business
    
    
    (160
    )
    
    
    
    
    
    
    (160
    )
    
    
    Other
    
    
    183
    
    
    
    (14
    )
    
    
    186
    
    
    
    3Total other income (expense)
    
    
    (71
    )
    
    
    39
    
    
    
    (82
    )
    
    
    93NET LOSS
    
    $
    (2,607
    )
    
    $
    (2,062
    )
    
    $
    (5,428
    )
    
    $
    (15,120
    )Basic and diluted net loss per share
    
    $
    (0.04
    )
    
    $
    (0.04
    )
    
    $
    (0.08
    )
    
    $
    (0.33
    )Weighted average shares  basic and diluted
    
    
    70,700
    
    
    
    45,931
    
    
    
    67,013
    
    
    
    46,215(1) Stock-based compensation charges have been excluded from the following expense categories:Research and development
    
    $
    24
    
    
    $
    2
    
    
    $
    51
    
    
    $
    5Sales and marketing
    
    
    18
    
    
    
    6
    
    
    
    50
    
    
    
    12General and administrative
    
    
    1
    
    
    
    183
    
    
    
    64
    
    
    
    214$
    43
    
    
    $
    191
    
    
    $
    165
    
    
    $
    231
 The accompanying notes are an integral part of these consolidated financial statements. -5-




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
(Unaudited, in thousands) Common Stock, AdditionalPaid-in Capital and Warrants
    
    DeferredStock-based
    
    
    
    
    
    Accumulated OtherComprehensive
    
    Total Stockholders'Shares
    
    Amount
    
    Compensation
    
    Accumulated Deficit
    
    Income (Loss)(1)
    
    EquityBALANCES, December 31, 2003
    
    
    56,974
    
    
    $
    210,134
    
    
    $
    (214
    )
    
    $
    (192,887
    )
    
    $
    
    
    
    $
    17,033Stock option exercises
    
    
    427
    
    
    
    195
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    195Shares issued in private placement
    
    
    10,811
    
    
    
    18,839
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,839Shares issued for acquisitions
    
    
    10,818
    
    
    
    17,146
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,146Deferred stock compensation
    
    
    
    
    
    
    
    
    
    
    307
    
    
    
    
    
    
    
    
    
    
    
    307Amortization of deferred stock
compensation, net of cancellations
    
    
    
    
    
    
    233
    
    
    
    (332
    )
    
    
    
    
    
    
    
    
    
    
    (99
    )Stock-based compensation
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3
    )Issuance of common stock warrant
    
    
    
    
    
    
    25
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25Unrealized loss on marketable securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (84
    )
    
    
    (84
    )Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (201
    )
    
    
    (201
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,428
    )
    
    
    
    
    
    
    (5,428
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,713
    )BALANCES, June 30, 2004
    
    
    79,030
    
    
    $
    246,569
    
    
    $
    (239
    )
    
    $
    (198,315
    )
    
    $
    (285
    )
    
    $
    47,730
    The accompanying notes are an integral part of these consolidated financial statements. -6-




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands) Six Months Ended June 30,2004
    
    2003OPERATING ACTIVITIESNet loss
    
    $
    (5,428
    )
    
    $
    (15,120
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    1,041
    
    
    
    1,598Special charges (credits) and other non cash items
    
    
    (110
    )
    
    
    6,573Stock-based compensation
    
    
    203
    
    
    
    238Foreign
currency transaction adjustment
    
    
    (183
    )
    
    
    Changes in operating assets and liabilities, net
of amounts acquired in purchases of businesses:Accounts receivable
    
    
    (1,264
    )
    
    
    (125
    )Prepaid expenses and other assets
    
    
    224
    
    
    
    947Accounts payable
    
    
    1,509
    
    
    
    416Accrued compensation, benefits and other expenses
    
    
    653
    
    
    
    (150
    )Accrued special charges
    
    
    (1,099
    )
    
    
    (1,358
    )Deposits and deferred revenue
    
    
    (187
    )
    
    
    1,063Net cash used in operating activities
    
    
    (4,641
    )
    
    
    (5,918
    )INVESTING ACTIVITIESPurchases of property and equipment
    
    
    (2,551
    )
    
    
    (50
    )Proceeds
from sales of property and equipment
    
    
    
    
    
    
    164Cash paid for acquisition of business and technology, net
    
    
    (774
    )
    
    
    (82
    )Assets and liabilities transferred under contractual arrangement
and held for sale
    
    
    906
    
    
    
    109Payments received on loans made to related parties
    
    
    
    
    
    
    1,113Purchases of marketable securities
    
    
    (16,046
    )
    
    
    Sales of marketable securities
    
    
    6,760
    
    
    
    5,820Net cash (used in) provided by investing activities
    
    
    (11,705
    )
    
    
    7,074FINANCING ACTIVITIESProceeds from sale of stock and exercise of stock options
    
    
    195
    
    
    
    475Proceeds from private equity financing, net
    
    
    18,934
    
    
    
    Proceeds from line of credit
    
    
    
    
    
    
    2,500Principal payments on long-term debt, line of credit
and capital lease obligations
    
    
    (1,947
    )
    
    
    (436
    )Repurchase of common stock
    
    
    
    
    
    
    (426
    )Net cash provided by financing activities
    
    
    17,182
    
    
    
    2,113Effect of foreign currency translation on cash
    
    
    81
    
    
    
    Net increase (decrease) in cash and cash equivalents
    
    
    917
    
    
    
    3,269Cash and cash equivalents, beginning of period
    
    
    12,480
    
    
    
    1,780Cash and cash equivalents, end of period
    
    $
    13,397
    
    
    $
    5,049Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    108
    
    
    $
    37Assets acquired under capital lease obligations
    
    $
    
    
    
    $
    112Issuance of common stock for acquisitions of businesses
    
    $
    17,146
    
    
    $
    Issuance of common stock warrants
    
    $
    25
    
    
    $
    
 The accompanying notes are an integral part of these consolidated financial statements. -7-




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS LOUDEYE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2004
(Unaudited) 1. ORGANIZATION and RISKS The Company Loudeye Corp. (the Company or Loudeye) provides digital media services
and media restoration services. The Company is headquartered in Seattle,
Washington and has offices in the United States, the United Kingdom, France,
Germany and Italy. The Company segregates its business in two business
segments, digital media services and media restoration services. As discussed
in Note 5, on June 22, 2004, the Company acquired On Demand Distribution
Limited (OD2), a privately held digital music provider based in Europe. As
discussed in Note 6, the Company completed the sale of its media restoration services business in May 2004. Risks The Company 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 an emerging market,
competition from other companies with greater technical, financial, management
and marketing resources, successful development of new services, successful
integration of acquired businesses and technology, the enhancement of existing
services and the ability to secure adequate financing to support future
operations. Assuming the Companys stockholders approve the issuance of additional
shares to OD2 stockholders to pay future required payments, the Company
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 year. If the Companys
stockholders do not approve such issuances, the Company will be required to
satisfy such amounts in cash, which would likely cause a significant strain on
the Companys cash resources, the Company may need to obtain additional equity
or debt financing and the Company may have difficulty pursuing its business
objectives. Since the Company has incurred net losses since inception, the
Company has relied on sales of equity securities, proceeds from the exercises
of stock options and warrants and borrowings under its 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 the Companys control. These
include general market conditions, conditions in the private equity and public
markets, the then-current market price of the Companys common stock and the
Companys historical financial performance and future prospects. Basis of Consolidation The consolidated financial statements include the accounts of the Company
and its subsidiaries. All significant intercompany transactions and balances
have been eliminated in consolidation. Unaudited Interim Financial Data The interim 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 have been condensed or omitted pursuant to such rules and
regulations. These consolidated financial statements should be read in
conjunction with the audited consolidated financial statements and notes
thereto included in the Company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 six months ended June 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 accounting
principles generally accepted 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. -8-




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2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents The Company 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.
The Company has not experienced any losses on its cash and cash equivalents. Marketable Securities The Company 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
equity. Realized gains and losses are included in investment income. The cost
of securities sold is based upon the specific identification method. Restricted Investments The Company has approximately $316,000 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
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 July
2004 and October 2005.
Accordingly, the restricted investments have been classified in
short-term and long-term
assets in the accompanying consolidated balance sheets. Fair Value of Financial Instruments and Concentrations of Credit Risk Financial instruments that potentially subject the Company 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 the Companys line of credit and long-term obligations approximate fair
value because the interest rates of the obligations are variable. The Company is exposed to credit risk because it extends credit to its
customers. The Company performs initial and ongoing evaluations of its
customers financial condition and generally extends credit on open account,
requiring collateral as deemed necessary. The Company had sales to certain significant customers, as a percentage of
revenues, as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Microsoft Corporation
    
    
    13
    %
    
    
    6
    %
    
    
    10
    %
    
    
    7
    %The Coca-Cola Company
    
    
    1
    %
    
    
    9
    %
    
    
    2
    %
    
    
    11
    %14
    %
    
    
    15
    %
    
    
    12
    %
    
    
    18
    %
 Revenues from Microsoft 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. Impairment of Long-lived Assets The Company 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 -9-




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The Company 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. The Company completes its annual impairment
test as of November 30 of each year. As disclosed in Note 5, the Company has
recorded goodwill and intangible assets in connection with its acquisition of
Overpeer, Inc. in March 2004 and OD2 in June 2004. Revenue Recognition The Company 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. The Company 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. The Company 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. The Company recognizes these
revenues when persuasive evidence of an arrangement exists, the product and/or
service has been delivered, the price is fixed and determinable and
collectibility is reasonably assured. In arrangements that include rights to multiple products and/or services,
the Company 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, the Company 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 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, the Company recognizes revenues
as the encoding services are rendered and the Company has no continuing
involvement in the goods and services delivered, which is the date the finished
media is shipped to the customer. Digital music samples services are provided to customers using the
Company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, the Company 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 the
Company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 fee per download. Under the provisions of SAB
101, as amended by SAB 104, and EITF 00-21, the Company 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 the Company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 -10-




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##### Table of Contents



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. Webcasting services are provided to customers using the Company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 the Company 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, the
Company 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, the Company 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, the Company
recognizes revenue in the period in which the services are provided. Media restoration services consisted of services provided by our 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, the
Company recognizes revenues as these services are rendered and the Company 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, the Company completed the sale of
its VidiPax business in May 2004 pursuant to an agreement dated October 31,
2003. Stock-based Compensation The Company 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 the Company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 June 30, 2004 totaled
$62,000, consisting of the amortization of deferred stock compensation of
$68,000, of which $19,000 is included in cost of revenues, and a credit of
$6,000 for variable stock compensation related to stock options that were
repriced in 2001. Stock-based compensation was $195,000 for the quarter ended
June 30, 2003, of which $4,000 is included in cost of revenues, consisting of
the amortization of deferred stock compensation of $44,000, stock issued to
former employees as severance and termination benefits of $30,000, and options
with an estimated fair value, accounted for under FAS 123, of $121,000 granted
to a member of the Companys board of directors for consulting services. Stock-based compensation for the six months ended June 30, 2004 totaled
$203,000, consisting of the amortization of deferred stock compensation of
$207,000, of which $38,000 is included in cost of revenues, stock-based
compensation expense of $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 $238,000 for the six
months ended June 30, 2003, of which $7,000 is included in cost of revenues,
consisting of the amortization of deferred stock compensation of $87,000, stock
issued to former employees as severance and termination benefits of $30,000,
and options with an estimated fair value, accounted for under FAS 123, of
$121,000 granted to a member of the Companys board of directors for consulting
services. The following table illustrates the effect on net loss and net loss per
share if the Company had applied the fair value recognition provisions of FAS
123 to stock-based employee compensation (in thousands): -11-




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##### Table of Contents



Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (2,607
    )
    
    $
    (2,062
    )
    
    $
    (5,428
    )
    
    $
    (15,120
    )Add: stock-based employee
compensation expense under APB
25 included in reported net loss
    
    
    62
    
    
    
    44
    
    
    
    203
    
    
    
    87Deduct: total stock-based
employee compensation expense
determined under fair value
method for all awards
    
    
    (852
    )
    
    
    (226
    )
    
    
    (1,320
    )
    
    
    (15
    )Pro forma net loss
    
    $
    (3,397
    )
    
    $
    (2,244
    )
    
    $
    (6,545
    )
    
    
    (15,048
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.04
    )
    
    $
    (0.04
    )
    
    $
    (0.08
    )
    
    $
    (0.33
    )Basic and diluted  pro-forma
    
    $
    (0.05
    )
    
    $
    (0.05
    )
    
    $
    (0.10
    )
    
    $
    (0.33
    )
 To determine compensation expense under FAS 123, the Company used the following
assumptions: 2004
    
    2003
    
    Risk-free interest rates
    
    
    2.33 - 5.71
    %
    
    
    2.68 - 5.71
    %
    
    Expected lives
    
    3 years
    
    5 years
    
    Expected dividend yields
    
    
    0
    %
    
    
    0
    %
    
    Expected volatility
    
    
    115
    %
    
    
    136
    %
 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. 3. SPECIAL CHARGES The Company 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
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Goodwill impairment
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    5,307Intangible assets impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    685Property and equipment impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    601Employee severance and termination
benefits
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    501Facilities related charges (credits)
    
    
    
    
    
    
    
    
    
    
    (50
    )
    
    
    465Other restructuring charges
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    878$
    
    
    
    $
    
    
    
    $
    (50
    )
    
    $
    8,437
 The following table summarizes the activity in accrued special charges during
the six months ended June 30, 2004 (in thousands): -12-




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##### Table of Contents



Facilities RelatedChargesBalance, December 31, 2003
    
    $
    1,670Additional accruals
    
    
    Payments
    
    
    (1,099
    )Adjustments
    
    
    (50
    )Balance, June 30, 2004
    
    $
    521
 During the fourth quarter 2002, management committed to a plan to exit
certain of the Companys leased facilities, including the Company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, the Company recorded the estimated lease
termination costs in accrued special charges. As discussed in Note 9, the
landlord of the Companys unoccupied facility at 414 Olive Way, Seattle,
Washington filed suit against the Company 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 the Company had accrued
in a prior period and paid in the first quarter 2004. At December 31, 2003, the Company had accrued special charges under the
provisions of Statement of Financial Accounting Standards 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 the Company had never occupied the facility.
During 2003, the Company 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, the Company 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, the Company
accrued an additional $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, the Company entered into a lease settlement
agreement with the landlord pursuant to which the Company 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, the Companys Chairman and Chief Executive Officer, John
T. Baker, resigned and the Company engaged Regent Pacific Management
Corporation to provide management services to the Company. 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
the Companys Annual Report on Form 10-K for the year ended December 31, 2003.
During and subsequent to Regent Pacifics engagement, the Company 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 the Company 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 the
Company had learned that revenue from a significant customer in its Media
Restoration Services segment would be less than originally anticipated. Using
the revised forecast, the Company 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, the Company 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, the Company 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. The Company also recorded $297,000 of severance and termination
benefits with respect to certain changes in senior management in the first
quarter 2003. The Company 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 -13-




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##### Table of Contents



Corporation with respect to interim management services provided to the
Company 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 the
Companys net losses. The Company has excluded the following numbers of shares
using this method (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Options
    
    
    9,727
    
    
    
    8,050
    
    
    
    9,727
    
    
    
    8,050Warrants
    
    
    1,041
    
    
    
    295
    
    
    
    1,041
    
    
    
    29510,768
    
    
    
    8,345
    
    
    
    10,768
    
    
    
    8,345
 5. ACQUISITIONS On Demand Distribution Limited On June 22, 2004, the Company 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. The Company acquired 93% of the
shares of OD2 upon commencement of the tender offer. The Company expects to
acquire the remaining 7% of OD2s shares on the same terms by October 2004 from
shareholders of OD2 that subsequently accept the offer or pursuant to
compulsory sweep-along provisions provided for under English law. This
acquisition supports the Company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 the Companys content management and
anti-piracy content protection services into Europe and will enable the Company
to leverage OD2s reach to expand its business
into new markets. The unaudited consolidated statement of operations of
Loudeye for the period ended June 30, 2004, includes the results of operations
of OD2 for the nine days from June 22, 2004 to June 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, to existing OD2 shareholders and option holders, which amount
includes shares issuable upon exercise of OD2 options to be assumed
by Loudeye.
    
    Loudeye expects to issue up to 2,811,712 additional
shares of its common stock, representing minority interest and shares
to be issued to OD2 shareholders who had
accepted the tender offer as of June 30, 2004, but to whom shares of
common stock had not yet been issued. Minority interest includes
shares that will be issued to
existing OD2 shareholders and option holders, including
shares issuable upon exercise of OD2 options to be 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 the Company for
18 months to satisfy claims the Company may have with respect to breaches of representations,
warranties and covenants, indemnification claims and working capital
adjustments.  As of June 22, 2004, the Company
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.  The Company is obligated to issue and
place into escrow an additional 20,131 shares of its common stock to one individual upon his tendering
his outstanding shares of OD2 stock.
    
    Loudeye will pay approximately $2.8 million in cash to retire certain
liabilities.
    
    Loudeye is obligated to pay an additional £7.8
million (approximately $13.5 million based on exchange rates as
of June 30,
2004), excluding minority interest and 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
£1.0 million or $1.7 million;
    
    On January 31, 2005, approximately
£3.8 million or $6.7 million;
    
    On May 31, 2005, approximately £1.0 million or
$1.7 million; and
    
    On November 30, 2005, approximately
£2.0 million or $3.4 million. -14-




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
    
    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 (excluding minority interest), 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
June 30, 2004) without adjustment for minority interest or 15%
holdback in escrow if OD2 achieves certain financial performance targets during the
period through November 30, 2006. 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,
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 or when Loudeye believes beyond a reasonable doubt that it
will not state a claim pursuant to the terms of the escrow. The maximum number of shares to be issued of approximately 13,950,000
constituted approximately 19.9% of Loudeyes outstanding shares of common stock
at the commencement of the tender offer. Certain OD2 employee option holders
may elect to exercise their options and accept the offer, in which case they
will receive the same consideration as other OD2 shareholders. Alternatively,
Loudeye will assume the unexercised OD2 options, which will then become
exercisable for Loudeye common stock based on a predetermined exchange rate. Based
on managements internal analysis, excluding the impact of minority interest which has not yet been recorded
as noted below and the escrow shares and 15% additional consideration discussed above, the Company has preliminarily
recorded $33.7 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 the Companys transaction related expenses. As
of June 22, 2004, the
initial
purchase price can be summarized as follows (amounts in thousands): Transaction related expenses
    
    $
    1,527Cash paid at closing
    
    
    900Cash due on certain liabilities assumed
    
    
    1,878Accrued
acquisition consideration
    
    
    13,654Common stock payable related to acquisition
    
    
    2,596Common stock issued in connection with acquisition
    
    
    13,146$
    33,701
 The accrued acquisition
consideration recorded in the Companys financial statements as
of June 30, 2004, has been
adjusted for the foreign currency exchange rate at June 30, 2004
and a foreign currency transaction gain
of $183,000 was recorded in other income in the accompanying consolidated statement
of operations for the three and six month periods ended June 30, 2004. Because
OD2 had a deficit in net worth at acquisition, minority interest has not been reflected in the Companys consolidated balance sheet. 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 to the extent such shares are required to be excluded by the rules
of the Nasdaq Stock Market), 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 payments that Loudeye may be
required to make. Loudeye has also agreed to reserve 2 million shares for
stock option grants under its 2000 Stock Option Plan to employees of OD2 for
future services. -15-




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##### Table of Contents



Loudeye has agreed to file a registration statement covering the resale of
the initial shares issued by it by the later of (i) August 6, 2004, (ii) 15
calendar days following the date it acquires all remaining OD2 shares, or (iii)
10 business days following receipt of certain OD2 financial statements required
to be filed by Loudeye on Form 8-K. The registration statement has not yet
been filed. The Company 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 the
Company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 during the
nine day period from June 22, 2004, to June 30, 2004, the
Company recorded a $183,000 foreign currency transaction gain in
other income in the accompanying consolidated statement of operations
for the three and six month periods ending June 30, 2004. The
following table summarizes as of June 22, 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 the Companys digital media services segment (in
thousands): Purchase Price Allocation
    
    Useful lifeCurrent assets
    
    $
    2,700Property and equipment
    
    
    629
    
    
    1  3 yearsGoodwill
    
    
    33,598Acquired technology
    
    
    2,970
    
    
    3 yearsCurrent liabilities
    
    
    (6,196
    )Total
purchase price allocation
    
    $
    33,701
 The purchase price allocation set forth above is preliminary and subject to change in future periods
pending the completion of an independent valuation report. The Company 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 the Company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 the Companys digital media services segment. Overpeer, Inc. In March 2004, the Company 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 the Company,
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 the Company (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 $4,000,000 by
the volume weighted average closing sales 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. 262,916 of the shares issued in the Merger will
be held in escrow for one year and will be available during that time to
satisfy indemnity claims under the Merger Agreement. The Company filed a -16-




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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 the
Company to provide a more complete suite of digital media solutions to its
customers. The Company 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 the Company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 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, which have been recorded
in the Companys digital media services segment (in thousands): Purchase Price Allocation
    
    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
    
    $
    4,090
 The purchase price allocation set forth above includes acquisition costs of
$129,000 and is preliminary and subject to change in future periods pending the
completion of an independent valuation report. Pro
forma financial information The following table presents the unaudited pro forma results of the
Company for the three and six months ended June 30, 2004 and 2003 assuming the
Company had acquired OD2 and Overpeer at the beginning of each period (in
thousands): Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Total revenues
    
    $
    4,981
    
    
    $
    4,153
    
    
    $
    8,722
    
    
    $
    8,461Net loss
    
    
    (6,261
    )
    
    
    (6,941
    )
    
    
    (11,227
    )
    
    
    (22,649
    )Basic and diluted net loss per share
    
    
    (0.09
    )
    
    
    (0.15
    )
    
    
    (0.17
    )
    
    
    (0.49
    )
 6. SALE OF MEDIA RESTORATION BUSINESS On January 30, 2004 (Transfer Date), the Company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, 2003, these assets and liabilities were
classified as held for sale. At March 31, 2004, these assets and liabilities
were classified as net -17-




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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 from services provided under the GSA
Contracts totaling $213,000 for the period from the Transfer Date through the
Accounting Closing Date, of which $95,000 was recorded as revenue in the first
quarter 2004 and $118,000 was recorded as revenue in the second quarter 2004.
All other revenues and costs of VMRLE Co., Inc.s operations have been
appropriately excluded from the Company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 is 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 will be released upon the
execution of an agreement relating to certain rights associated with certain
equipment owned by a third party. If such agreement is not executed by October
31, 2004, the purchaser may reclaim the $300,000 held in escrow. Due to this
uncertainty, the $300,000 will be recorded as a gain at the time the agreement
is executed. The Company 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, the Company also entered into a co-marketing
and reseller agreement with the purchaser pursuant to which the Company 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 the Company under FAS 144. Consequently, VMRLE Co.
Inc. has not been reported as a discontinued operation. 7. PRIVATE EQUITY FINANCING In February 2004, the Company 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 $20,000,000. The Company 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 the Companys business-to-business
digital music solutions in the U.S. and internationally. The Company 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. 8. SEGMENT INFORMATION The Company operates in two business segments, Digital Media Services and
Media Restoration Services. As described in Note 6, the Company 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 the Companys segments (in thousands): -18-




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Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003RevenuesDigital media services
    
    $
    3,013
    
    
    $
    2,499
    
    
    $
    4,825
    
    
    $
    5,159Media restoration services
    
    
    118
    
    
    
    404
    
    
    
    297
    
    
    
    1,054$
    3,131
    
    
    $
    2,903
    
    
    $
    5,122
    
    
    $
    6,213Net LossDigital media services
    
    $
    (2,450
    )
    
    $
    (1,727
    )
    
    $
    (5,218
    )
    
    $
    (14,076
    )Media restoration services
    
    
    (157
    )
    
    
    (335
    )
    
    
    (210
    )
    
    
    (1,044
    )$
    (2,607
    )
    
    $
    (2,062
    )
    
    $
    (5,428
    )
    
    $
    (15,120
    )
 June 30, 2004
    
    December 31, 2003Total AssetsDigital media services
    
    $
    82,191
    
    
    $
    25,829Media restoration services
    
    
    
    
    
    
    1,215$
    82,191
    
    
    $
    27,044
 9. CONTINGENCIES In July and August 2001, four substantially similar class action
complaints were filed in the Untied States District Court for the Southern
District of New York against the Company and certain of its former officers and
directors, as well as against certain underwriters who handled its initial
public offering of common stock in March 2000. The various complaints were
filed purportedly on behalf of a class of persons who purchased the Companys
common stock during the time period beginning on March 15, 2000 and ending on
December 6, 2000. The complaints together allege violations of the Securities
Act of 1933 and the Securities Exchange Act of 1934, primarily based on the
allegation that there was undisclosed compensation received by the Companys
underwriters in connection with its initial public offering and the allegation
that the underwriters entered into undisclosed arrangements with some investors
that were designed to distort and/or inflate the market price for the Companys
common stock in the aftermarket following the initial public offering. These
actions have all been consolidated before the same judge for pretrial purposes.
No specific amount of damages has been claimed. The Company and the
individual defendants have demanded to be indemnified by the 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. In June 2003, a proposed settlement of
this litigation was structured between the plaintiffs, the issuer defendants,
the issuer officers and directors named as defendants, and the issuers
insurance companies. The proposed settlement provides that the
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, the issuer defendants insurers will
guarantee $1.0 billion in recoveries by plaintiff class members, the issuer
defendants will assign certain claims against the underwriter defendants to the
plaintiff class members, and the issuer defendants will have the opportunity to
recover certain litigation-related expenses if the plaintiffs recover more than
$5.0 billion from the underwriter defendants. The Company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 the underwriter defendants
objections to the settlement on August 4, 2004. There can be no assurance that
this proposed settlement would be approved and implemented in its current form,
or at all. Management does not anticipate that the Company will be required to
pay any amounts under this settlement. In February 2003, the Company 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,
the Company 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 the Company 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. The
Company answered the complaint in September 2003 denying all allegations and
asserting counterclaims. In March 2004, the court granted the Companys -19-




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motion to transfer the case to the United States District Court for the
Western District of Washington. The Company 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 In April 2003, the
landlord of the Companys former facility at 414
Olive Way, Seattle, Washington filed suit against the Company 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 the
Company had accrued in a prior period and paid in the first quarter 2004. The
Court reserved the other issues in the suit, including mitigation, interest and
attorneys fees, for trial. The Company appealed the judgment which is now
in the process of being vacated by stipulation. As part of the
stipulation, the trial date has been extended to Spring 2005. Management believes that meritorious
defenses to some portions of the claims
made in the suit exist. The Company continues to vigorously defend
this suit while exploring opportunities to reach a settlement with the
plaintiff. As of December 31, 2003
and June 30, 2004, the Company has recorded in accrued special charges an
estimate of the additional amounts the Company may ultimately be required to
pay with respect to this matter. The Company 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.
The Company 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. In the normal course of business, the Company indemnifies other parties,
including business partners, lessors and parties to other transactions with the
Company. The Company 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, the Company has entered into indemnification agreements
with certain of its officers and directors and the Companys by-laws contain
similar indemnification obligations to the Companys officers and directors.
For all agreements entered into after December 31, 2002, the fair value of
potential claims has not been recorded in the Companys financial statements because they are not material. 10.  SUBSEQUENT
EVENTS On
August 24, 2004, the Company received a notice from the Nasdaq
Listing Qualifications staff indicating that the Company has failed
to timely file its quarterly report on Form 10-Q for the period ended
June 30, 2004, as required by Nasdaq Marketplace
Rule 4310(c)(14). This delisting notification is standard
procedure when a Nasdaq listed company fails to complete a required
filing in a timely manner. On August 30, 2004, to ensure it remains
listed until it can file this Quarterly Report and regain compliance
with all applicable listing standards, Loudeye filed an appeal of the delisting notification to the NASDAQ
Listings Qualifications Panel. The filing of this appeal will prevent
the delisting of Loudeyes securities until Loudeye regains compliance
with all applicable listing standards through the filing of its
Quarterly Report or, should that not occur, pending the Panels decision. -20-




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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
the 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. Overview We are an innovative business-to-business provider of services that
facilitate the distribution and promotion of digital media content to media and
entertainment, retail and enterprise customers. Our services enable our
customers to outsource the management and distribution of audio and video
digital media content over the Internet and on other digital distribution
platforms. Our technical infrastructure and back-end solutions, combined with
our proprietary applications, comprise an end-to-end solution, from basic
digital media services, such as the hosting, storage, encoding, management and
protection of media assets for content owners, to complex, fully-outsourced
digital media distribution and promotional services, such as private-labeled
digital music download stores and streaming Internet radio and music sample
services. Our solutions reduce the complexity and cost of internal solutions,
and enable our customers to provide branded digital media offerings to their
users while supporting a variety of digital media technologies and consumer
business models. 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 Coca Cola (UK), MSN (Pan-Europe),
MTV (Pan-Europe), Virgin Megastores (UK), HMV (UK) 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. The unaudited
consolidated statement of operations of Loudeye for the period ended June 30,
2004, includes the results of operations of OD2 for the nine days from June 22,
2004, to June 30, 2004. More information on the terms of the acquisition is
provided below under Liquidity and Capital ResourcesAcquisition of On Demand
Distribution Limited. The Loudeye Solution During the first and second quarters 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 -21-




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the sale, we anticipate media restoration services will represent an
insignificant portion of our revenue 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. Although our customers may choose any combination of services we offer, our
management views our solutions in three tiers of service. These tiers are
summarized as follows: Tier 1:
    
    These services consist primarily of content management, encoding and
fulfillment, and metadata services. Revenues from these services tend to
consist of repeat business. Tier 1 services
currently account for a substantial portion of our digital media services
revenue. However, over the next several years we expect the proportion of
revenues from Tier 1 services to decline relative to revenues from Tier 2
and Tier 3 services.Sales of our Tier 1 digital media services are generally under
nonrefundable time and materials or per unit contracts. Under these
contracts, we recognize revenues as services are rendered and we have no
continuing involvement in the goods and services delivered, which
generally is the date the finished media is shipped to the customer.Tier 2:
    
    These services consist primarily of hosted media and delivery, rights
administration and settlement and anti-piracy content protection services.
Revenues from these services tend to consist of recurring business and
may include scalable economics. Revenues for Tier 2 services may include
monthly minimum fees, setup and license fees, professional services fees,
ongoing maintenance fees and a share of our customers transactional
revenues.We sell our music samples service in application service provider
(ASP) arrangements. We are required to host the applications and the
customer does not have the ability to have the application hosted by
another entity without an additional charge. Billings are generally made
based upon volumes of data delivered or minutes of content streamed, and
revenue is recognized as the services are delivered.Our enhanced enterprise communication services include highly
scalable, live and on-demand audio and video webcasting services,
supported by proprietary applications such as synchronized streaming slide
presentation capabilities. Revenue from live webcasts is recognized when
the webcasts are delivered. Revenue from on-demand webcasts is recognized
over the period of time they are made available.Tier 3:
    
    These services consist primarily of custom application development,
ASP services, commerce engine, analytics and full operational outsourcing.
Our principal Tier 3 service offering, the Loudeye Digital MusicStoreTM,
offers a turnkey digital music solution for businesses to launch their own
branded music store and service. Revenues from Tier 3 services consist of
recurring business and may include setup and licensing fees, professional
services fees, ongoing maintenance fees and a share of our customers
transactional revenues. We expect that over the next several years Tier 3
services will account for an increasing percentage of our total revenues.
 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. Highlights of Second Quarter 2004 -22-




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Our second quarter 2004 represents a continuation of the business and
strategic initiatives implemented in 2003 and the first quarter 2004.
Highlights include: Digital Media Solutions Initiatives:  
    
    We made significant investments in the Overpeer anti-piracy content
protection service offering including doubling its capacity, expanding
capabilities and adding dedicated sales staff. Since the acquisition of
Overpeer in March 2004, we have added additional customer contracts
representing major content owners from the music, film/video, game and
software industries.
    
    We have expanded IndieSource, an extension of our music label program
that enables companies that build a digital music business to license
hundreds of thousands of non-major label, independent music tracks from
around the world through a single program. We have signed several
independent labels to the program, including Saregama, Indias largest
music company, and Naxos, the leading independent classical music
catalog.
    
    We acquired OD2, one of the largest digital music providers in
Europe. 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. Organization:  
    
    We expanded our management team with the hiring of Charles Grimsdale,
president and managing director of our international business operations
through the acquisition of OD2, and the hiring of Lee Kirby, executive
vice president of professional and customer services. Highlights of Operating Results: The following is a summary description of our operating results for the
three months ended June 30, 2004. A more detailed discussion of our operating
results is included below under the heading Results of Operations. Our second quarter 2004 revenues were $3.1 million, compared to $2.9
million in the prior year quarter. The results for the 2004 quarter include an
increase of $368,000 in revenue from our existing core digital media services
business, $545,000 of revenue from anti-piracy services, and $177,000 of
revenue attributable to our acquisition of OD2 on June 22, 2004. These
increases were offset by a decrease in our webcasting business resulting from a
restructuring in 2003 (representing $571,000 of the decrease) and the
completion of the sale of our substantially all of the business of our VidiPax
subsidiary in May 2004 (representing $286,000 of the decrease). We
reported a net loss of $2.6 million or $0.04 per share in the second
quarter 2004, compared to a net loss of $2.1 million or $0.04 per share in the
prior year quarter. The increase in net loss primarily reflects additional
research and development expense related to the Loudeye Digital MusicStoreTM
product, and increased selling, general and administrative expense related to
our acquisitions of Overpeer and OD2. Results of Operations Three Months Ended June 30, 2004 and 2003 Revenues.Revenues totaled $3.1 million and $2.9 million for the second
quarter 2004 and 2003 and consisted of the following (in thousands): -23-




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Three Months Ended June 30$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Encoding services
    
    $
    1,138
    
    
    $
    573
    
    
    $
    565
    
    
    
    99
    %Samples service
    
    
    426
    
    
    
    454
    
    
    
    (28
    )
    
    
    (6
    %)Internet radio and hosting services
    
    
    61
    
    
    
    263
    
    
    
    (202
    )
    
    
    (77
    %)Webcasting
    
    
    638
    
    
    
    1,209
    
    
    
    (571
    )
    
    
    (47
    %)Digital distribution services
    
    
    205
    
    
    
    
    
    
    
    205
    
    
    
    Content protection services
    
    
    545
    
    
    
    
    
    
    
    545
    
    
    
    Media restoration services
    
    
    118
    
    
    
    404
    
    
    
    (286
    )
    
    
    (71
    %)Total revenue
    
    $
    3,131
    
    
    $
    2,903
    
    
    $
    228
    
    
    
    8
    %
 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 digital media services, primarily
digital music solutions, as well as anti-piracy 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
quarter 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 second quarter 2004
compared to the second quarter 2003. 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, but there were no revenues in the prior year
quarter. 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. Media restoration services revenue for the second quarter 2004 does not
include a full three months of revenue 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 consolidated financial statements. Because our media
restoration subsidiary continued to be the primary obligor under certain
contracts with the General Services Administration of the United States (GSA
Contracts) until their assignment on May 17, 2004, revenues and costs of
revenues in the consolidated statement of operations of Loudeye reflect the
revenues from services provided under the GSA Contracts totaling $118,000 in
the second quarter 2004. Media restoration services revenues in future periods
are expected to be insignificant. Cost of Revenues.Cost of revenues increased to $1.8 million for the
second quarter 2004 from $1.7 million for the second quarter 2003. Cost of
revenues remained consistent at 58% of revenue in 2004 and 2003, and consisted
of the following (in thousands): Three Months Ended June 30,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Digital media services
    
    $
    1,701
    
    
    $
    1,257
    
    
    $
    444
    
    
    
    35
    %Media restoration services
    
    
    118
    
    
    
    425
    
    
    
    (307
    )
    
    
    (72
    )%Total cost of revenues
    
    $
    1,819
    
    
    $
    1,682
    
    
    $
    137
    
    
    
    8
    %
 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. -24-




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As discussed above, media restoration services cost of revenue for the
second quarter 2004 does not include a full three months of costs 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 revenues from services provided under the
GSA Contracts, totaling $118,000 in the second quarter 2004. The cost of
revenue entirely offset the associated revenue. Depreciation included in cost of revenues increased to approximately
$365,000 in the 2004 period from $240,000 in the 2003 period. This increase is
due primarily to equipment purchased in the first quarter 2004 of $1.5 million
to upgrade the storage and access systems for our digital music archive, as
well as additional equipment expenditures in the second quarter 2004 related to
our content protection services offering. As a result of these items, as well
as our acquisition of OD2, we expect depreciation included in cost of revenues
to increase moderately in the remainder of 2004 compared to the prior year
periods. Operating Expenses.Our operating expenses were as follows for the second
quarter 2004 and 2003 (in thousands): Three Months Ended June 30,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Research and development
    
    $
    753
    
    
    $
    392
    
    
    $
    361
    
    
    
    92
    %Sales and marketing
    
    
    836
    
    
    
    835
    
    
    
    1
    
    
    
    0
    %General and administrative
    
    
    2,232
    
    
    
    1,740
    
    
    
    492
    
    
    
    28
    %Amortization of intangibles and other assets
    
    
    126
    
    
    
    260
    
    
    
    (134
    )
    
    
    (52
    %)Stock-based compensation
    
    
    43
    
    
    
    191
    
    
    
    (148
    )
    
    
    (77
    %)Gain on sale of property and equipment
    
    
    
    
    
    
    (96
    )
    
    
    96
    
    
    
    (100
    %)Total operating expenses
    
    $
    3,990
    
    
    $
    3,322
    
    
    $
    668
    
    
    
    20
    %
 Research and Development.Research and development expenses totaled
$753,000 and $392,000 for the second quarter of 2004 and 2003. 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 to increase through the remainder of 2004 compared to the
prior year periods as we invest in the development of our digital media service
offerings, particularly our Loudeye Digital MusicStore product, as well as our
content protection services, and as we complete the integration of our
acquisitions of OD2 and Overpeer. Sales and Marketing.Sales and marketing expenses totaled $836,000 and
$835,000 for the second quarter of 2004 and 2003. 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 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 to increase
through the remainder of 2004 compared to the prior year periods as we expand
our sales force and marketing personnel to market and sell our new Tier 3
application level products and services and as we complete the integration of
our acquisitions of OD2 and Overpeer. General and Administrative.General and administrative expenses increased
to $2.2 million in the second quarter 2004 from $1.7 million in the second
quarter 2003. 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 acquisitions of
Overpeer in March 2004 and OD2 in June 2004. We anticipate that general and
administrative expenses for the remainder of 2004 will increase compared to the
prior year periods as we complete the integration of our acquisitions of OD2
and 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 totaled $126,000 and $260,000 for the second quarter of 2004
and 2003, and 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 second quarter 2004. However, during the second quarter 2004 we incurred additional
amortization expense related to our acquisitions of Overpeer and OD2, and
expect that amortization expense for the remainder of 2004 will increase
compared to the prior quarter periods. -25-




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##### Table of Contents



Stock-Based Compensation.Stock-based compensation included in operating
expenses for the second quarter 2004 totaled $43,000, consisting of the
amortization of deferred stock compensation of $49,000, somewhat offset by a
credit of $6,000 for variable stock compensation related to stock options that
were repriced in 2001. Stock-based compensation included in operating expenses
was $191,000 for the second quarter 2003, consisting of the amortization of
deferred stock compensation of $40,000, stock granted to former employees of
$30,000 and options granted to a member of our board of directors for
consulting services of $121,000. The increase in amortization of deferred
stock-based compensation is due to options granted to employees at below fair
value in July 2003 and February 2004. Investment Income.Investment income consists of interest income and
realized gains and losses on sales of our investments. Investment income
totaled approximately $107,000 and $101,000 for the second quarter of 2004 and 2003. 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.
Interest expense totaled $59,000 and $48,000 for the second quarter of 2004 and
2003. The increase was due primarily to higher average debt balances in 2004
resulting from borrowings under the $3 million term loan facility that we put
in place at the end of 2003. Other
Income (Expense). Other income consists of foreign currency
transaction gains on the accrued
acquisition consideration related to our acquisition of OD2 in June
2004. Six Months Ended June 30, 2004 and 2003 Revenues.Revenues totaled $5.1 million and $6.2 million for the first six
months of 2004 and 2003 and consisted of the following (in thousands): Six Months Ended June 30$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Encoding services
    
    $
    1,482
    
    
    $
    956
    
    
    $
    526
    
    
    
    55
    %Samples service
    
    
    900
    
    
    
    913
    
    
    
    (13
    )
    
    
    (1
    %)Internet radio and hosting services
    
    
    223
    
    
    
    743
    
    
    
    (520
    )
    
    
    (70
    %)Webcasting
    
    
    1,212
    
    
    
    2,547
    
    
    
    (1,335
    )
    
    
    (52
    %)Digital distribution services
    
    
    308
    
    
    
    
    
    
    
    308
    
    
    
    Content protection services
    
    
    700
    
    
    
    
    
    
    
    700
    
    
    
    Media restoration services
    
    
    297
    
    
    
    1,054
    
    
    
    (757
    )
    
    
    (72
    %)Total revenue
    
    $
    5,122
    
    
    $
    6,213
    
    
    $
    (1,091
    )
    
    
    (18
    %)
 Our product 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 digital media services, primarily digital
music solutions, as well as anti-piracy 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
quarter 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 first six months of
2004 compared to the first six months of 2003. 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, but there were no revenues during the first six
months of 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 corresponding period in 2003. Media restoration services revenue for the first six months of 2004 does
not include a full six months of revenue due to the transfer of our media
restoration business on January 30, 2004 and completion of the sale in May 2004
as discussed in Note 6 to the consolidated financial statements. Revenue in
the first six months of 2004 includes $84,000 from operations in January prior
to the transfer of substantially all of the business of our VidiPax subsidiary
to the purchaser of our media restoration subsidiary. Because our media
restoration subsidiary continued to be the primary obligor under certain
contracts with the General Services Administration of the United States GSA
Contracts until their assignment on May 17, 2004, revenues and costs of
revenues in the consolidated statement of operations of Loudeye reflect the
revenues from services provided under the GSA Contracts, totaling $213,000 in
the first six months of 2004. Media restoration services revenues in future
periods are expected to be insignificant. Cost of Revenues.Cost of revenues decreased to $3.2 million for the first
six months of 2004 from $4.2 million for the first six months of 2003. Cost of
revenues decreased from 68% of revenue in 2003 to 63% of revenue in 2004, and
consisted of the following (in thousands): Six Months Ended June 30,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Digital media services
    
    $
    2,961
    
    
    $
    3,300
    
    
    
    ($339
    )
    
    
    (10
    %)Media restoration services
    
    
    284
    
    
    
    926
    
    
    
    ($642
    )
    
    
    (69
    %)Total cost of revenues
    
    $
    3,245
    
    
    $
    4,226
    
    
    
    ($981
    )
    
    
    (23
    %)
 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, and as a result, cost of revenue in the first quarter 2004 were less than
the first quarter 2003. However, in the second quarter 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 an increase in digital media services cost of revenue
during the second quarter 2004 compared to the prior year period. Accordingly,
we expect cost of revenues related to our digital media services to increase
over the remainder of 2004 compared to the prior year periods. Media restoration services cost of revenue for the first six months of
2004 includes $71,000 for operations in January 2004 prior to the transfer of
substantially all of the business of our VidiPax subsidiary 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 revenues from
services provided under the GSA Contracts totaling $213,000 in the second
quarter 2004. From the January 30, 2004, date of transfer of the VidiPax
assets, the cost of revenue entirely offset the associated revenue. Depreciation included in cost of revenues increased to approximately
$657,000 in 2004 from $456,000 in 2003. This increase is due primarily to
equipment purchased in the first quarter 2004 of $1.5 million to upgrade the
storage and access systems for our digital music archive, as well as additional
equipment expenditures in the second quarter 2004 related to our content
protection services offering. As a result of these items, as well as our
acquisition of OD2, we expect depreciation included in cost of revenues to
increase moderately in 2004 compared to the prior year periods. Operating Expenses.Our operating expenses were as follows for the first
six months of 2004 and 2003 (in thousands): Six Months Ended June 30,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Research and development
    
    $
    1,343
    
    
    $
    969
    
    
    $
    374
    
    
    
    39
    %Sales and marketing
    
    
    1,471
    
    
    
    2,381
    
    
    
    (910
    )
    
    
    (38
    %)General and administrative
    
    
    4,192
    
    
    
    4,492
    
    
    
    (300
    )
    
    
    (7
    %)Amortization of intangibles and other assets
    
    
    266
    
    
    
    786
    
    
    
    (520
    )
    
    
    (66
    %)
 -27-




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Six Months Ended June 30,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Stock-based compensation
    
    
    165
    
    
    
    231
    
    
    
    (66
    )
    
    
    (29
    %)Gain on sale of property and equipment
    
    
    
    
    
    
    (96
    )
    
    
    96
    
    
    
    (100
    %)Special charges  goodwill impairments
    
    
    
    
    
    
    5,307
    
    
    
    (5,307
    )
    
    
    (100
    %)Special charges  other
    
    
    (50
    )
    
    
    3,130
    
    
    
    (3,180
    )
    
    
    (102
    %)Total operating expenses
    
    $
    7,387
    
    
    $
    17,200
    
    
    $
    (9,813
    )
    
    
    (57
    %)
 Research and Development.Research and development expenses totaled $1.3
million and $969,000 for the first six months of 2004 and 2003. 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 to increase through the remainder of 2004 compared to the
prior year periods as we invest in the development of our digital media service
offerings, particularly our Loudeye Digital MusicStore product, and as we
complete the integration of our acquisitions of OD2 and Overpeer. Sales
and Marketing.Sales and marketing expenses totaled
$1.5 million and $2.4
million for the first six months of 2004 and 2003. Sales and marketing expenses
consist primarily of salaries, commissions, product branding costs,
advertising, public relations costs, trade show expenses, and cost of marketing
collateral. The decrease in sales and marketing expenses compared to the same
period in 2003 reflects cost reduction initiatives implemented in 2003,
somewhat offset by increases resulting from our acquisitions of Overpeer in
March of 2004 and OD2 in June of 2004. We expect sales and marketing expenses
to increase through the remainder of 2004 compared to the prior year periods as
we expand our sales force and marketing personnel to market and sell our new
Tier 3 application level products and services and as we complete the
integration of our acquisitions of OD2 and Overpeer. General and Administrative.General and administrative expenses decreased
to $4.2 million in the first six months of 2004 from $4.5 million in the first
six months of 2003. 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 decrease was due to the decrease in personnel related to our
reductions in force in the first quarter 2003, and related cost reduction
initiatives. The decrease was somewhat offset by an increase in the second
quarter 2004 primarily as the result of our acquisitions of Overpeer in March
2004 and OD2 in June 2004. We anticipate that general and administrative
expenses for the remainder of 2004 will increase compared to the prior year
periods as we increase our personnel and other resources to support our growth.
In addition, we will 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 totaled $266,000 and $786,000 for the first six months of 2004
and 2003, and includes amortization of identified intangible assets related to
acquisitions. The decrease was due to the impairment charges recorded in the
first quarter 2003, which resulted in lower amortization charges starting with
the second quarter 2003. During the second quarter 2004 we incurred additional
amortization expense related to our acquisitions of Overpeer and OD2, and
expect that amortization expense for the remainder of 2004 will increase
compared to the prior year periods. Stock-Based Compensation.Stock-based compensation included in operating
expenses for the first six months of 2004 totaled $165,000, consisting of the
amortization of deferred stock compensation of $169,000, stock-based
compensation expense of $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 included in operating
expenses was $231,000 for the first six months of 2003, consisting of the
amortization of deferred stock compensation of $80,000, stock granted to former
employees of $30,000, and options granted to a member of our board of directors
for consulting services of $121,000. The increase in amortization of deferred
stock-based compensation is due to options granted to employees at below fair
value in July 2003 and February 2004. Special Charges.We have recorded special charges related to corporate
restructurings, facilities consolidations and the impairment of assets in
accordance with our long-lived asset policy. Following is a summary of special
charges for the first six months of 2004 and 2003 (in thousands): 2004
    
    2003Goodwill impairment
    
    $
    
    
    
    $
    5,307Intangible and other asset impairments
    
    
    
    
    
    
    685Property and equipment impairments
    
    
    
    
    
    
    601Facilities related charges (credits)
    
    
    (50
    )
    
    
    465Employee severance and termination benefits
    
    
    
    
    
    
    501Other restructuring charges
    
    
    
    
    
    
    878$
    (50
    )
    
    $
    8,437
 -28-




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In February 2004, we entered into a lease settlement agreement with the
landlord or our VidiPax facility in New York, New York, pursuant to which we
paid $450,000 and allowed the landlord to retain its security deposit of
$212,000, for a total settlement of $662,000. This total settlement was $50,000
less than we had recorded in accrued special charges at December 31, 2003.
Accordingly, this $50,000 difference has been reflected as a credit to special
charges in the consolidated statement of operations. Impairments during the
first quarter 2003 are explained in Note 3 to the consolidated financial
statements. Investment Income.Investment income consists of interest income and
realized gains and losses on sales of our investments. Investment income
totaled $186,000 and $187,000 for the first six months of 2004 and 2003. 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.
Interest expense totaled $130,000 and $97,000 for the first six months of 2004
and 2003. The increase was due primarily to higher average debt balances in
2004 resulting from borrowings under the $3 million term loan facility that we
put in place at the end of 2003. Other
Income (Expense).Other income consists primarily of foreign
currency transaction gains on the accrued acquisition consideration
related to our acquisition of OD2 in June 2004. Liquidity and Capital Resources As of June 30, 2004, we had approximately $32.5 million of cash and cash
equivalents, marketable securities, and restricted investments. These funds
reflect net proceeds of $18.9 million from our sale of common stock in a
private placement in February 2004. Of these funds, $316,000 is held in
investment accounts that serve as collateral for standby letters of credit for
certain of our capital lease and other obligations. Net
cash used in operating activities was $4.6 million for first six
months of 2004. Cash used in operating activities resulted primarily from a
net loss of $5.4 million and payments of accrued special charges of $1.1
million, offset partially by non-cash charges for depreciation and amortization
and stock-based compensation aggregating $1.2 million, collection of proceeds
from the sale of our media restoration subsidiary of $900,000 and an increase
in other assets and liabilities of approximately $935,000. The payment of
accrued special charges relates to the settlement of our lease obligation with
respect to our VidiPax facility in New York, New York and payment of a judgment
related to an unoccupied facility in Seattle, Washington as described in Note 3
to the consolidated financial statements. Net
cash used in investing activities was $11.7 million in the first six
months of 2004, consisting principally of the net purchases of short-term
investments of $9.3 million to invest a portion of the proceeds from our
private equity financing in February 2004 and purchases of property and
equipment of $2.6 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,
$900,000 cash was used related to our acquisition of OD2. Net cash provided by financing activities was $17.2 million for the first
six months of 2004, consisting primarily of proceeds from the private equity
financing in February 2004 of $18.9 million, as described below, and proceeds
from the exercise of stock options of $195,000, offset partially by principal
payments on our debt and capital lease obligations of $662,000 and the
repayment in full of our line of credit for $1.3 million. 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 minority interest and 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 our
expenses in acquiring OD2, in particular with respect to
minority interest and 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 June 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, to existing OD2 shareholders and option holders, which amount
includes shares issuable upon exercise of OD2 options to be assumed
by Loudeye. On a pro forma basis, we issued 11,138,288 shares of our
common stock on June 22, 2004, which includes 2,072,369 shares held in escrow described
further below.
 -29-




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##### Table of Contents




    
    We expect to issue up to 2,811,712 additional
shares of our common stock, representing minority interest and shares
to be issued to OD2 shareholders who had accepted the tender offer as
of June 30, 2004, but to whom shares of common stock had not yet
been issued. On
a pro forma basis, we are required to issue all 2,811,712 shares as a result
of all OD2 shareholders having tendered their shares as of August 17,
2004.
    
    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 June 22, 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 will pay approximately $2.8 million in cash to retire certain
liabilities.
    
    We are obligated to pay an additional £7.8 million
(approximately $13.5 million based on exchange rates as of
June 22, 2004), through
November 30, 2005. 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
    
    
    £1.0, or $1.7
    
    
    
    £1.2, or $2.2January 31,
2005
    
    
    £3.8, or $6.7
    
    
    
    £4.7, or $8.6May 31,
2005
    
    
    £1.0, or $1.7
    
    
    
    £1.2, or $2.2November 30,
2005
    
    
    £2.0, or $3.4
    
    
    
    £2.5, or $4.5Total
    
    
    £7.8, or $13.5
    
    
    
    £9.6, or $17.5
  
    
    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 (excluding minority interest), 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
June 30, 2004) including minority interest, if OD2 achieves certain financial performance targets during the
period through November 30, 2006. 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,
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 maximum number of shares to be issued of approximately 13,950,000
constituted approximately 19.9% of Loudeyes outstanding shares of common stock
at the commencement of the tender offer. Certain OD2 employee option holders
may elect to exercise their options and accept the offer, in which case they
will receive the same consideration as other OD2 shareholders. Alternatively,
Loudeye will assume the unexercised OD2 options, which will then become
exercisable for Loudeye common stock based on a predetermined exchange rate. Based
on managements internal analysis, excluding
the impact of minority interest and the escrow shares and 15%
additional consideration discussed above, we have preliminarily
recorded $33.7 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 can be
summarized as follows (amounts in thousands): Transaction
related expenses
    
    $
    1,527Cash paid at
closing
    
    
    900Cash due on
certain liabilities assumed
    
    
    1,878Accrued
acquisition consideration
    
    
    13,654Common stock
payable related to acquisition
    
    
    2,596Common stock
issued in connection with acquisition
    
    
    13,146$
    33,701
 -30-




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The accrued acquisition consideration
recorded in our financial statements as of June 30, 2004, has been
adjusted for the foreign currency exchange rate at June 30, 2004
and therefore accrued acquisition consideration in the table above is $183,000
greater than as reflected on our balance sheet as of June 30, 2004. In
addition to the $33.5 million purchase price recorded at June 30,
2004, if      we had acquired 100% of the OD2 stock at the date of
purchase, resulting in no minority interest,      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 $44.9
million as a result of the inclusion of the fair value of the
minority interest and the shares and additional consideration paid into
escrow and the initial purchase consideration would be
summarized as follows (amounts in thousands): Assumption of certain liabilities
    
    $
    2,776Net liabilities assumed
    
    
    2,868Upfront stock consideration
    
    
    17,193Stock
consideration placed in escrow
    
    
    3,034Accrued acquisition consideration
    
    
    14,899Accrued acquisition
consideration in escrow
    
    
    2,629Transaction related expenses
    
    
    1,527$
    44,926
 Certain OD2
employee option holders may make an election whether to exercise their options
and accept the offer, in which case they will receive the same consideration as
other OD2 shareholders, or to exchange their options for similar options issued
by us. -31-




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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 to the extent such shares are
required to be excluded by the rules of the Nasdaq Stock Market), 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 by the later of (i) August 6, 2004, (ii) 15
calendar days following the date it acquires all remaining OD2 shares, or (iii)
10 business days following receipt of certain OD2 financial statements required
to be filed by Loudeye on Form 8-K. 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 year. 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.

-32-



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Critical Accounting Policies and Estimates We have identified the most critical accounting policies and estimates
used in the preparation of our financial statements by considering accounting
policies and estimates that involve the most complex or subjective decisions or
assessments. Revenue recognition.We recognize revenue in accordance with Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as
amended by Staff Accounting Bulletin No. 104, and EITF 00-21. We recognize
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. We recognize revenues from encoding services, digital music samples
services, digital distribution services, Internet radio services, live and
on-demand webcasting services, software licensing, peer-to-peer services and
media restoration services. We recognize these revenues when persuasive
evidence of an arrangement exists, the product and/or service has been
delivered, the price is fixed and determinable, and collectibility is
reasonably assured. In arrangements that include rights to multiple products and/or services,
we allocate 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
live and on-demand webcasting services. Verifiable 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, we allocate 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 in advance of the
culmination of the earnings process. Deferred revenue expected to be realized
within the next twelve months is classified as current liability Long-lived assets.Management periodically evaluates the recoverability
of our long-lived assets in accordance with SFAS No. 144. When doing so,
management is required evaluate the recoverability of an assets (or group of
assets) carrying value through estimates of undiscounted future cash flows. If
the assets are deemed impaired, the assets are written down to estimated fair
value. Estimates of fair value may differ from the actual amount that could be
realized if we were to sell our assets. Managements assessments of the impairment of property and equipment 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, market price of our common
stock and declining financial results. Net long-term assets subject to
impairment review in the future totaled $8.1 million at June 30, 2004. We will
continue to review the carrying value of our long-lived assets and goodwill for
impairments. Future adverse developments in our business may result in
additional charges. Goodwill and Intangible Assets.We account 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. We complete our annual impairment test as of November 30 of each year. As disclosed in Note 7,
we have recorded goodwill and intangible assets in connection with our
acquisitions of Overpeer, Inc. in March 2004 and OD2 in June 2004. Exit costs.We have followed the provisions of EITF 94-3 to record the
costs associated with exit activities through December 31, 2002 and FAS 146 for
exit activities after December 31, 2002. Management is required to make its
best estimates of exit costs such as remaining lease obligations and/or
termination fees, these estimates may be different than the actual amounts that
will be paid under existing lease arrangements. Future adverse changes in our
business could result in additional exit activities and charges. -33-




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Litigation.We become involved from time to time in various 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 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. Income tax valuation allowance.Deferred tax assets and liabilities are
determined based on the differences between the financial statement and tax
bases of assets and liabilities using the enacted tax rates in effect for the
periods in which the differences are expected to reverse. The Companys net
deferred tax asset has been reduced by a full valuation allowance based upon
managements determination that it is more likely than not that the net
deferred tax asset will not be realized. Contractual Obligations The following table provides aggregated information about our contractual
obligations as of June 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)
    
    $
    2,821
    
    
    $
    1,281
    
    
    $
    1,540
    
    
    $
    
    
    
    $
    Operating leases
    
    
    2,494
    
    
    
    1,807
    
    
    
    687
    
    
    
    
    
    
    
    Bandwidth and co-location purchase obligations (2)
    
    
    361
    
    
    
    339
    
    
    
    22
    
    
    
    
    
    
    
    Common stock
payable related to acquisition
    
    
    2,596
    
    
    
    2,596
    
    
    
    
    
    
    
    
    
    
    
    Accrued
acquisition consideration (3)
    
    
    13,471
    
    
    
    10,076
    
    
    
    3,395
    
    
    
    
    
    
    
    Total contractual obligations
    
    $
    21,743
    
    
    $
    16,099
    
    
    $
    5,644
    
    
    $
    
    
    
    $
    
   (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 co-location 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 $37,000 and have been excluded from the table above.(3)
    
    The tabular information presented above excludes the
following items: 
    
    7.3% minority interest in accrued acquisition
consideration of approximately $1.3 million.
    
    15% additional consideration of approximately
$2.6 million.
    
    Up to approximately $18.0 million 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. -34-




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Legal Proceedings In July and August 2001, four substantially similar class action
complaints were filed in the Untied States District Court for the Southern
District of New York against us and certain of our former officers and
directors, as well as against certain underwriters who handled our initial
public offering of common stock in March 2000. The various complaints were
filed purportedly on behalf of a class of persons who purchased our common
stock during the time period beginning on March 15, 2000, and ending on
December 6, 2000. The complaints together allege violations of the Securities
Act of 1933 and the Securities Exchange Act of 1934, primarily based on the
allegation that there was undisclosed compensation received by our underwriters
in connection with our initial public offering and the allegation 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 following the initial public offering. These actions have
all been consolidated before the same judge for pretrial purposes. No specific
amount of damages has been claimed. We and the individual defendants have
demanded to be indemnified by the 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. In June 2003, a proposed settlement of this litigation was
structured between the plaintiffs, the issuer defendants, the issuer officers
and directors named as defendants, and the issuers insurance companies. The
proposed settlement provides that the 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, the issuer defendants insurers will guarantee $1.0 billion in
recoveries by plaintiff class members, the issuer defendants will assign
certain claims against the underwriter defendants to the plaintiff class
members, and the issuer defendants will have the opportunity to recover certain
litigation-related expenses if the plaintiffs recover more than $5.0 billion
from the 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 the underwriter defendants objections
to the settlement on August 4, 2004. There can be no assurance that this
proposed settlement would 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. 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 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. The Court reserved the other issues in the
suit, including mitigation, interest and attorneys fees, for trial. The
Company appealed the judgment which is now in the process of being
vacated by stipulation. As part of the stipulation, the trial date
has been extended to Spring 2005. Management believes that
meritorious defenses to some portions of the claims made in the suit
exist. We continue to vigorously defend this suit while exploring
opportunities to reach a settlement with the plaintiff. As of
December 31, 2003 and June 30, 2004, we have recorded in accrued special
charges an estimate of the additional amounts we may ultimately be required to
pay with respect to this matter. 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. -35-




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Factors That May Affect Our Business, Future Operating Results and Financial
Condition Risks of 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 June 30, 2004, we had an accumulated deficit of $198.3 million. We
have incurred net losses from inception, and we expect to continue to incur net
losses in future periods. If our revenues grow slower than anticipated, we may
not achieve a pro forma net profit by the middle of 2005 as previously
forecasted and we may continue to suffer substantial losses. We will need to
generate significant additional revenues 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 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. 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 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, referred to as Tier 3 services,
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; -36-




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      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. We may have to pay up to £19.6 million in 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. The number of shares we
would issue in lieu of cash will vary based on the market value of our stock. We
have agreed to pay to the former shareholders of OD2 an additional
£9.6 million (approximately $17.5 million based on
exchange rates as of June 22, 2004) in deferred payments, and up
to £10.0 million (approximately $18.3 million based on
exchange rates as of June 22,
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. 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. 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 from one to six months,
the formula could result in an effective value for the shares that 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
may 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, and we may have difficulty
pursuing our business objectives. 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 $17.5
million based on exchange rates as of June 22, 2004) through November 30, 2005,
to OD2s shareholders, plus additional contingent consideration
of up to £10.0 million (approximately $18.3 million
based on exchange rates as of June 22,
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 -37-




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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 US dollar would result in an
increase to revenues and expenses upon consolidation, and a stronger US dollar
would result in a decrease to revenues and expenses upon consolidation. We must integrate our recent acquisitions of On Demand Distribution
Limited And Overpeer, Inc. and we may need to make additional future
acquisitions to remain competitive. The process of identifying, acquiring and
integrating these and 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, Inc. and in
June 2004 we completed the acquisition of On Demand Distribution Limited (OD2). Integrating the Overpeer and OD2 acquisitions and completing any potential
future acquisitions could cause significant diversions of management time and
resources. Our business, financial condition and results of operations could
be materially adversely affected if we are unable to integrate the operations
of the acquired companies or joint ventures. Our ability to integrate the
operations of the 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;       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 our
first quarter of fiscal 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. -38-




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We may need to raise additional capital in the future, and if we are
unable to secure adequate funds on terms acceptable to us, we may be unable to
execute our business plan. As of June 30, 2004, we had approximately $32.5 million in cash and cash
equivalents, marketable securities, and restricted investments. If our
existing cash reserves prove insufficient to fund operating and other expenses,
we may find it necessary to secure additional financing, sell assets or reduce
expenditures. 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 not be able to
pursue our business objectives. This inability could seriously harm our
business, results of operations and financial condition. Our success is dependent on the performance and retention of our executive
officers and key employees. In particular, we must recruit and retain
personnel in our accounting function. Our business and operations are substantially dependent on the performance
of our executive officers and key employees who have worked together for only a
relatively short period of time. In addition, we must recruit for
positions in our accounting function in light of recent significant
turnover in that department. 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 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 royalty structures
under which we must pay. In addition, 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 the royalties owed. If we are
unable to accurately track the numerous parties that we must pay in connection
with each delivery of digital music services and deliver the appropriate
payment in a timely fashion, we may risk penalties up to and including
termination of certain 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 recording labels 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 music recording 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 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:       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. -39-




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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 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 KaZaA, Morpheus, Grokster 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 have been found to not violate any copyright laws,
particularly in the case of Grokster. Additionally, enforcement efforts against
those in violation have not effectively shut down these services, and there can
be no assurance that these -40-




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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
first six months of 2004, one customer accounted for 10% of our revenues.
During 2003, one customer accounted for approximately 11% of
our revenues and another customer accounted for 5% of our revenues. We
believe that a small number of customers may continue to account for a
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. -41-




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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       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 -42-




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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 assure you 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 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: -43-




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      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,
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 -44-




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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 received notice of material weaknesses in our internal control
over financial reporting from our independent accountants. As a result, we may
be unable to obtain the attestation of the adequacy of our internal controls
over financial reporting as required by Section 404 of the Sarbanes-Oxley Act
of 2002. Our
audit committee was advised by PricewaterhouseCoopers LLP, or PwC, our
independent registered public accounting firm for the period from June 6, 2002
through the date of this quarterly report on Form 10-Q, 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 the
Companys accounting and financial function. Also, the Company 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. 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. We are in the process of restructuring our accounting and reporting
function and recruiting appropriate personnel. If we are unable to hire
appropriate personnel in a timely manner, we may not be able to expeditiously
remediate these material weaknesses. The
independent registered public accounting firm auditing our financial statements must attest
to and report on managements assessment of the design and operational
effectiveness of our internal control over financial reporting as of December
31, 2004, the end of our current fiscal year. Although we intend to conduct a
rigorous review of our internal control over financial reporting to help
achieve compliance with the Section 404 requirements, if our independent
registered public accounting firm is not satisfied with our internal
control over financial reporting or with the level at which it is documented,
designed, operated or reviewed, they may decline to attest to managements
assessment or may issue a qualified report identifying either a significant
deficiency or a material weakness in our internal controls. This could result
in significant additional expenditures responding to the Section 404 internal
control audit, a diversion of management attention and potentially an adverse
reaction to our common stock in the financial markets. 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; -45-




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      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.; and       Difficulty in staffing and managing geographically diverse operations. 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 Online music distribution services in general are new and rapidly evolving
and may not prove to be viable business models. Online music distribution services are a relatively new business model for
delivering digital media over the Internet. It is too early to predict whether
consumers will accept in significant numbers, online music services and
accordingly whether the services will be financially viable. If online music
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; -46-




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      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
for communications, electronic commerce and advertising. The growth of our business depends on the continued growth of the Internet
as a medium for media consumption, communications, electronic commerce and
advertising. Our business will be harmed if Internet 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 as a viable
commercial medium, and identifying additional viable revenue 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 the Internet, and may adversely affect our
ability to sell our products and services and ultimately impact our business
results and prospects. If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by such growth, specifically the demands of
delivering high-quality media content. As a result, the performance and
reliability of the Internet may decline. In addition, Websites have experienced
interruptions in service as a result of outages, system attacks and other
delays occurring throughout the Internet network infrastructure. If these
outages, attacks or delays occur frequently or on a broad scale in the future,
Internet usage, as well as the usage of our products, services and Websites,
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 -47-




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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,
retransmission of 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 (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 -48-




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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 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 Internet 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. 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. -49-




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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
Corporation Law, could discourage potential acquisition 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; -50-




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      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 August 12, 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 37% 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. In addition, we have agreed to file a registration statement covering the
resale of up to 13,950,000 shares issued or issuable by us in our acquisition
of OD2 by the later of (i) August 6, 2004, (ii) 15 calendar days following the
date we acquire all remaining OD2 shares, or (iii) 10 business days following
receipt of certain OD2 financial statements required to be filed by us with the
SEC on Form 8-K. We are also obligated to register any additional shares we
issue to satisfy up to £19.6 million (approximately $35.8 million based on
exchange rates as of June 22, 2004) of deferred and contingent payment
obligations. 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 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 may be adopted in the near future.
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 $17.5 million based on
exchange rates as of June 22, 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 $18.3 million based on exchange rates as
of June 22, 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. -51-




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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 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 US dollar would
result in an increase to revenues and expenses upon consolidation, and a
stronger US 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 $32.5 million at
June 30, 2004, a one percent change in interest rates would cause a change in
interest income of $325,000 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
$2.8 million balance outstanding at June 30, 2004, a one percent increase in the
prime rate would increase our interest expense by $28,000 per year. We invest in investment-grade government obligations, institutional money
market funds and other obligations with FDIC insured US 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. Based upon their evaluation as of the end of the period covered by this
report, our chief executive officer and chief financial officer concluded that,
if we are able to successfully address the material weaknesses in our internal
accounting controls as discussed below, our disclosure controls and procedures
are effective to ensure that information required to be included in our
periodic SEC filings is recorded, processed, summarized, and reported within
the time periods specified in the SEC rules and forms. 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, as defined in
Public Company Accounting Oversight Board Standard No. 2, in our internal
control over financial reporting 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. 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. We have assigned a high priority to the short-term and long-term
improvement of our internal control over financial reporting. Actions to
address the material weaknesses described above that we will undertake, or have
undertaken, include the following among others:  
    
    We periodically review staffing of our accounting and financial
reporting functions to ensure appropriate staffing and supervision of
those functions. In March 2004 we hired a new chief financial officer.
In May 2004, based on an evaluation of our existing accounting
resources, management developed a plan to restructure the accounting
and financial reporting function. This plan includes both the addition
of new resources and the replacement of certain existing resources. At
that time, we began recruiting efforts for various positions within our
accounting department. In July 2004, and after details of the
restructuring plan became known to members of our accounting staff,
four individuals in our accounting department announced their intention
to leave. Three of these individuals have agreed to remain with
Loudeye in their current capacity through September 30, 2004,
and we may negotiate longer periods with one or more of these
individuals. We are continuing the recruitment process to hire appropriate
replacements.
    
    During the third quarter of 2004, we will continue our internal
control review process to remediate the internal control material
weaknesses identified above by PwC. In May 2004 we engaged an outside
consulting firm to advise us on internal control matters and will
utilize these advisors to assist in our process of remediation. -52-




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Other
than regarding the material weaknesses discussed above, there have been
no changes in our internal control over financial reporting during
the period covered by this report that significantly affect our
control environment. In addition to the matters discussed above, the independent registered
public accounting firm responsible for the audit of Loudeyes financial
statements as of and for the year ending December 31, 2004 must attest to and
issue a report on managements assessment of the design and operational
effectiveness of our internal control over financial reporting. Although we intend to conduct a
rigorous review of our internal control over financial reporting to help
achieve compliance with the Section 404 requirements of the Sarbanes-Oxley Act,
if our independent registered public accounting firm is not satisfied
with our internal control over financial reporting or with the level at which
it is documented, designed, operated or reviewed, they may decline to attest to
managements assessment or may issue a qualified report identifying either a
significant deficiency or a material weakness in our internal controls. This
could result in significant additional expenditures responding to the Section
404 internal control audit, a diversion of management attention and potentially
an adverse reaction to our common stock in the financial markets. Limitations of Disclosure Controls and Procedures. Our management, including our chief executive officer and chief financial
officer, does not expect that our disclosure controls or internal control over
financial reporting will prevent all errors or all instances of fraud. A
control system, no matter how well designed and operated, can provide only
reasonable, not absolute, assurance that the control systems objectives will
be met. Further, the design of a control system must reflect the fact that
there are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within our company have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Controls can also be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the controls. The design of any system of controls is based in part upon
certain assumptions about the likelihood of future events, and any design may
not succeed in achieving its stated goals under all potential future
conditions. Over time, controls may become inadequate because of changes in
conditions or deterioration in the degree of compliance with policies or
procedures. Because of the inherent limitation of a cost-effective control
system, misstatements due to error or fraud may occur and not be detected. 
 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. -53-




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ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 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 minority interest and all shares and cash consideration
held or to be held in escrow. Reconciliations of the non-GAAP
information contained in this table are included below. We believe these
pro forma presentations enhance overall understanding of our
expenses in acquiring OD2, in particular with respect to
minority interest and the approximately 2.1 million escrow
shares that we have issued and the approximately $2.6 million of
additional escrow 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 June 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, to existing OD2 shareholders and option holders, which amount
includes shares issuable upon exercise of OD2 options to be assumed
by Loudeye. On a pro forma basis, we issued 11,138,288 shares of our
common stock on June 22, 2004, which includes 2,072,369 shares held in escrow described
further below.
    
    We expect to issue up to 2,811,712 additional
shares of our common stock, representing minority interest and shares
to be issued to OD2 Shareholders, also had accepted the tender offer
as of June 30, 2004, but to whom shares of common stock had not
yet been issued. On
a pro forma basis, we are required to issue these shares as a result
of all OD2 shareholders having tendered their shares as of August 17,
2004.
    
    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 June 22, 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 will pay approximately $2.8 million in cash to retire certain
liabilities.
    
    We are obligated to pay an additional £7.8 million (approximately $13.5 million based on exchange rates as
of June 22,
2004), through November 30, 2005. 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
    
    
    £1.0, or $1.7
    
    

    £1.2, or $2.2January 31,
2005
    
    
    £3.8, or $6.7
    
    

    £4.7, or $8.6May 31,
2005
    
    
    £1.0, or $1.7
    
    

    £1.2, or $2.2November 30,
2005
    
    
    £2.0, or $3.4
    
    

    £2.5, or $4.5Total
    
    
    £7.8, or $13.5
    
    

    £9.6, or $17.5
 -54-




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
    
    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 (excluding minority interest), 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
June 30, 2004) without adjustment for minority interest or 15%
holdback in escrow, if OD2 achieves certain financial performance targets during the
period through November 30, 2006. From
a financial accounting perspective, the escrow shares and the 15%, or
approximately $2.6 million, of additional consideration
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,
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 maximum number of shares to be issued of approximately 13,950,000
constituted approximately 19.9% of Loudeyes outstanding shares of common stock
at the commencement of the tender offer. Certain OD2 employee option holders
may elect to exercise their options and accept the offer, in which case they
will receive the same consideration as other OD2 shareholders. Alternatively,
Loudeye will assume the unexercised OD2 options, which will then become
exercisable for Loudeye common stock based on a predetermined exchange rate. Based
on managements internal analysis, excluding
the impact of minority interest and the escrow shares and 15%
additional consideration discussed above, we have preliminarily
recorded $33.7 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 can be
summarized as follows (amounts in thousands): Transaction
related expenses
    
    $
    1,527Cash paid at
closing
    
    
    900Cash due on
certain liabilities assumed
    
    
    1,878Accrued acquisition
consideration
    
    
    13,654Common stock
payable related to acquisition
    
    
    2,596Common stock
issued in connection with acquisition
    
    
    13,146$
    33,701
 The accrued acquisition
consideration recorded in our financial statements as of
June 30, 2004, has been adjusted for the foreign currency exchange rate
at June 30, 2004
and therefore accrued acquisition consideration in the table above is $183,000 greater
than as reflected on our balance sheet as of June 30, 2004. In
addition to the $33.5 million purchase price recorded at June 30,
2004, if      we had acquired 100% of the OD2 stock at the date of
purchase, resulting in no minority interest,      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 $44.9
million as a result of the inclusion of the fair value of the
minority interest and the shares and additional consideration paid into
escrow and the initial purchase consideration would be
summarized as follows (amounts in thousands): Assumption of certain liabilities
    
    $
    2,776Net liabilities assumed
    
    
    2,868Upfront stock consideration
    
    
    17,193Stock
consideration placed in escrow
    
    
    3,034Accrued acquisition consideration
    
    
    14,899Accrued acquisition
consideration in escrow
    
    
    2,629Transaction related expenses
    
    
    1,527$
    44,926 Certain OD2
employee option holders may make an election whether to exercise their options
and accept the offer, in which case they will receive the same consideration as
other OD2 shareholders, or to exchange their options for similar options issued
by us. -55-




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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 to the extent such shares are
required to be excluded by the rules of the Nasdaq Stock Market), 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 by the later of (i) August 6, 2004, (ii) 15
calendar days following the date it acquires all remaining OD2 shares, or (iii)
10 business days following receipt of certain OD2 financial statements required
to be filed by Loudeye on Form 8-K. 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. The securities issued in the acquisition were offered and sold to OD2s
former shareholders without registration under the Securities Act of 1933 in
reliance upon the exemption provided by Regulation S and Section 4(2) of the
Securities Act. Such securities may not be offered or sold in the United
States in the absence of an effective registration statement or an exemption
from the registration requirements under the Securities Act. We have agreed to
file a registration statement covering the resale of the initial shares issued
by it by the later of (i) August 6, 2004, (ii) 15 calendar days following the
date it acquires all remaining OD2 shares, or (iii) 10 business days following
receipt of certain OD2 financial statements required to be filed by Loudeye on
Form 8-K. The registration statement has not yet been filed. 
 ITEM 3: DEFAULTS UPON SENIOR SECURITIES None. 
 ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 
 ITEM 5: OTHER INFORMATION None. 
 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K (a)
    
    Exhibits.2.1(1)
    
    Recommended Offer by Loudeye Corp. for On Demand Distribution
Limited dated June 22, 2004 (including form of Registration Rights
Agreement).2.2(1)
    
    Deed Poll of Warranty and Indemnity dated June 22, 200410.1
    
    Employment agreement dated May 10, 2004 between Lee Kirby and Loudeye
Corp., filed herewith.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
   (1)
    
    Incorporated by reference to Loudeye Corp.s Form 8-K filed on
June 22, 2004.  (b)
    
    Reports on Form 8-KOn April 29, 2004, we furnished a Report on Form 8-K containing disclosure
for Item 12.On May 28, 2004, we furnished a Report on Form 8-K containing disclosure
in Item 9.On June 22, 2004, we filed a Report on Form 8-K containing disclosure in
Items 2 and 7. -56-




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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, August 31, 2004. LOUDEYE CORP.BY:
    
    /s/ Jeffrey M. CavinsJeffrey M. CavinsPresident and Chief Executive Officer(Principal Executive Officer)BY:
    
    /s/ Lawrence J. MaddenLawrence J. MaddenExecutive Vice President and Chief Financial officer(Principal Financial and Accounting Officer)
 -57-




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EXHIBIT INDEX Exhibit No.
    
    Description2.1(1)
    
    Recommended Offer by Loudeye Corp. for On Demand Distribution
Limited dated June 22, 2004 (including form of Registration Rights
Agreement).2.2(1)
    
    Deed Poll of Warranty and Indemnity dated June 22, 200410.1
    
    Employment agreement dated May 10, 2004 between Lee Kirby and Loudeye
Corp., filed herewith.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
   (1)
    
    Incorporated by reference to Loudeye Corp.s Form 8-K filed on
June 22, 2004. -58-