**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**Washington,
D.C. 20549**


________________




**FORM
10-K**


________________





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





**For
the fiscal year ended December 31, 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 000-27065**





**APTIMUS,
INC.**


**(Exact
name of registrant as specified in its charter)**





**Washington**
    **91-1809146****(Jurisdiction
      of incorporation)**
    **(I.R.S.
      Employer Identification No.)**





**100
Spear Street**


**Suite
1115**


**San
Francisco, CA 98105**


**(Address
of principal executive offices)**





**Registrant's
telephone number: (415) 896-2123**





**Securities
registered pursuant to Section 12(b) of the Act:**





**Title
      of each class**
    **Name
      of each exchange**
      **on
      which registered****None**
    **N/A**





**Securities
registered pursuant to Section 12(g) of the Act:**





**Common
Stock, no par value**


**(Title
of Class)**





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




1





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o




Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes o No x




The
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold on the OTCBB as of the last business day of the registrant’s most
recently completed second fiscal quarter, which was June 30, 2004:
$19,168,613.




The
number of shares of the registrant's Common Stock outstanding as of March 25,
2005 was 6,043,613.




**DOCUMENTS
INCORPORATED BY REFERENCE**




Portions
of the definitive Proxy Statement to be delivered to shareholders in connection
with the Annual Meeting of Shareholders to be held on June 8, 2005 are
incorporated by reference into Part III.









2


****


**FORWARD
LOOKING STATEMENTS**









Certain
statements in this Annual Report constitute forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements can often be identified by terminology such as may,
will, should, expect, plan, intend, expect, anticipate, believe, estimate,
predict, potential or continue, the negative of such terms or other comparable
terminology. Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance
or achievements of Aptimus, Inc. ("Aptimus", "we", "us" or the "Company"), or
developments in the Company's industry, to differ materially from the
anticipated results, performance or achievements expressed or implied by such
forward-looking statements. Important factors currently known to management that
could cause actual results to differ materially from those in forward-looking
statements include, without limitation, fluctuation of the Company's operating
results, the ability of the Company to compete successfully, the ability of the
Company to maintain current client and publisher relationships and attract new
ones, the sufficiency of remaining cash and short-term investments to fund
ongoing operations and the ability to integrate acquired companies. For
additional factors that may cause actual results to differ materially from those
contemplated by such forward-looking statements, please see the risks and
uncertainties described under "Business — Risk Factors" in Part I of this Annual
Report. Certain of the forward-looking statements contained in this Report are
identified with cross-references to this section and/or to specific risks
identified under "Business — Risk Factors."




**PART
I**




**Item
1:** ***Business***




**Overview**




We are a
results-based advertising network that distributes advertisements for direct
marketing advertisers across a network of third-party web sites and
company-owned and licensed email lists. Advertisers pay us only for the results
that we deliver through one of four pricing models - (i) cost per click, (ii)
cost per lead, (iii) cost per acquisition or (iv) cost per impression. We then
share a portion of the amounts we bill to our advertiser clients with publishers
and email list owners on whose web properties and email lists we distribute the
advertisements. In addition, we occasionally pay web site owners either a fixed
fee for each completed user transaction or a fee for each impression of an
advertisement served on the web site.




At the
core of the Aptimus Network is a database configuration and software platform
used in conjunction with a direct marketing approach for which we have filed a
non-provisional business method patent application called Dynamic Revenue
OptimizationTM(DRO). DRO determines through computer-based logic, on a real-time
basis, which advertisements in our system, using the yield of both response
history and value, should be reflected for prominent promotion on each
individual web site placement and in each email sent to consumers. The outcome
of this approach is that we generate superior user response and revenue
potential for that specific web site or email placement and a targeted result
for our advertiser clients.




**Company
History**




Aptimus
began in 1994 as the FreeShop division of Online Interactive, Inc. This division
was spun-off from Online Interactive, Inc. in 1997 as FreeShop International,
Inc., and later became FreeShop.com, Inc. FreeShop was an online direct
marketing web site connecting marketers and consumers in an innovative new
approach made possible by the Internet. The concept was to take advantage of the
Internet’s ability to quickly link advertisers and individual consumers to
increase the efficacy of direct marketing campaigns by allowing consumers to
pick and choose the promotional offers they actually wanted from direct
marketers. This site-centric approach led to our growth through our initial
public offering in 1999 and into 2000. The core of our business model was the
lead generation business, a decades-old two-step marketing process where
marketers offer a free trial, sample or information as a first step in the
process of acquiring a new customer. By the year 2000, our lead generation
business was surrounded by advertising and sponsorship opportunities, which
eventually grew to 65% of our revenues in the second quarter of 2000.




3





During
the year 2000, funding for Internet companies slowed and stock prices generally
declined. Lack of funding, combined with an increased focus among Internet
companies on profitability over revenue growth objectives, resulted in reduced
marketing spending by Internet companies, most notably in the second half of
2000. This drop in spending had significant repercussions throughout the
industry and materially affected our advertising and sponsorship
businesses.




While we
faced major challenges in 2000 and our results suffered, we maintained our
aggressive posture and focused on what we know best - online direct marketing.
Toward that end, beginning in June 2000, we undertook an evaluation of all
aspects of how we do business. Through this effort, we made a number of
determinations and commitments that formed the basis of our strategy going
forward.





• We
determined that revenue streams from advertising and sponsorship opportunities
were declining quickly and would not likely return to their earlier levels for
some time to come. Those revenue streams were critical to making rapid growth
via our site-centric approach possible, given the high marketing and
infrastructure costs of growing a web site audience.





• We
determined that our response-based advertising business remained viable, since
direct marketing in general continued to prosper, most direct marketers
recognized the importance of the Internet as a key part of their distribution
mix, and the core of our traditional direct marketer client base remained in
place.





• We
determined that all major sites throughout the industry would be feeling the
same impacts on advertising spending, and thus would be seeking alternative
revenue-generation opportunities such as results-based pricing (where fees are
paid on a per-lead or other results basis).





• We
determined that our direct marketing clients could be served even better by our
placement of their offers in relevant context through other companies’ web sites
and email channels, without Aptimus spending the significant resources required
to continue to maintain and grow our own web site audiences.




As a
result of these determinations, we made a shift to a network strategy beginning
in the Summer of 2000, placing direct marketing clients’ offers in contextually
relevant locations on publisher web sites throughout the Internet. Consistent
with this new strategy, in October 2000, we renamed our company Aptimus, Inc.,
and named our network the Aptimus Network.




From the
summer of 2000 to the summer of 2001, we laid the foundation for our new network
business model, and also reevaluated and changed all aspects of our company in
the process. We exited the web site business and terminated most of the
contracts that were tied to our web site business. We also reduced our staff
from a high of 215 to 28 at the end of 2001 primarily through restructuring
plans implemented in February of 2001 and June of 2001. In addition, in November
2001, we completed a major issuer tender offer, acquiring 9,230,228 shares of
our outstanding common stock, or approximately 69.87% of our outstanding shares
as of November 15, 2001, at a price per share of $0.48. The tender offer was
designed to provide liquidity to shareholders who wished to sell their
investment in us at a slight premium to market. In addition, management believed
that the then current share price discounted the long-term value of our stock
and, therefore, a buy-back would also be beneficial to remaining
shareholders.




As of the
summer of 2001, we completed our transition to a network business.




4


****


**Industry
Background**




*Direct
Marketing*




Advertising
expenditures can be broadly defined as either brand or direct marketing. Brand
advertising is intended to generate brand name awareness and create a specific
image for a particular company, product or service. Direct marketing involves
any communication to a consumer intended to generate a specific response or
action, generally a purchase of a product or service.




*Traditional
Direct Marketing*




Traditional
direct marketing media include direct mail, telemarketing, newspaper, magazine,
radio and television advertising. Although traditional direct marketing is
effective and widely used, it presents a number of challenges for marketers and
consumers alike. Traditional direct marketers generally lack specific and timely
information on a particular consumer’s immediate interests. Given the costs
associated with traditional direct marketing, which typically include printing,
data processing, postage, assembly, labor, telecommunications, and facilities,
as well as the recent introduction of the FTC’s “do not call” registry, low
response rates can make the process inefficient.




*Online
Direct Marketing*




Online
direct marketing media include banner advertisements, interstitials,
advertorials, text-links, pop-ups, targeted email solicitations search and web
site sponsorships. We believe that online direct marketing is more efficient
than traditional direct marketing because online offers avoid expenses
associated with physical advertising such as production costs, mailing expenses,
and personnel expenses associated with individual telemarketing calls, while
allowing offers to be tailored to the interests of specific demographic groups
drawn to particular web sites. Further, user data input capabilities enable
easier and faster customer response. In addition, online direct
marketing:




·
    allows
      direct marketers to communicate directly with customers by email;




·
    facilitates
      instantaneous data and feedback on marketing campaigns;




·
    provides
      direct marketers with multiple performance-based payment models;
      and




·
    enables
      highly customized marketing campaigns.




Even with
these advantages, direct marketers face challenges in realizing the full
potential of the Internet as a marketing medium. With millions of web sites,
only a fraction of which have significant audiences, it is difficult for
marketers to decide where to spend their marketing budgets. Even leading brand
name marketers who build their own web sites must find ways to attract a
sizeable audience. In addition, financial hurdles presented by rapidly evolving
technologies such as updating archaic computer and legacy data entry systems,
may impede conventional direct marketers from successfully extending their
activities to the Internet. Also, a number of new applications, such as programs
that block pop-up ads have recently emerged and are becoming more widely used.
Similarly, there is evolving popular dissatisfaction with some of the more
intrusive methods of online advertising, such as pop-ups and unsolicited email.
These technologies, together with evolving consumer sentiment, may diminish the
value of placing online advertisements, particularly in the pop-up and email
format, and discourage online advertising in general. Finally, federal and state
laws have been implemented or are being implemented that would limit the use of
email advertising and the collection of personal data that has previously been
used to help target offers. For example, the Controlling The Assault of
Non-Solicited Pornography and Marketing Act of 2003, popularly described as the
CAN SPAM Act, has placed strict limitations on how and to whom commercial email
solicitations can be delivered. As a result, the number of consumers to whom
direct marketers can legitimately communicate by email has been significantly
reduced.




5





In
addition, we have experienced temporary or permanent blockages of our email
advertisements by ISPs and private networks in the past and may experience such
blockages in the future. And as of August 2003, we have voluntarily stopped
sending emails to subscribers of Hotmail and MSN as we work to secure an
agreement with Microsoft and its third-party validation service provider,
Ironport, to allow our emails to reach their subscribers unimpeded. These ISPs
collectively represent approximately 12.8 million individual users in our
aggregate email database of approximately 39 million individual users. Efforts
by ISPs and private networks to limit or restrict a material portion of our
emails, if successful, could result in lower revenues to the Company and cause
our business to suffer.




**The
Aptimus Solution**




We have
developed an effective performance-based advertising network. The Aptimus
Network generates orders for marketers by presenting their offers across a
network of web site publishers and email lists that we believe encompass a broad
demographic of users from sites focused on personal finance, electronics and
technology, health and fitness to sites devoted to games and trivia, hobbies,
news and online community. At the same time, the Aptimus Network provides
incremental revenue benefits to its web site publishers, enabling revenue
generation for its key formats, while saving the publisher the risk and cost of
supporting additional internal advertising sales and information technology
personnel. Our revenues per thousand page impressions or CPM, a standard
measurement of value for Internet-based companies, for the year ended December
31, 2004 averaged $377 for our core placements within a transaction process and
$20 for our other, non-transaction related placements. Moreover, our real-time
data validation capabilities filter the data users input and reject orders
containing information that appears to be invalid so that we only deliver orders
to our advertising clients that have been prescreened for data quality. For the
year ended December 31, 2004 and 2003, user leads from our top five largest
website publishers accounted for 45.7% and 41.0% of our total revenues,
respectively. Of the top five publishers in the year ended December 31, 2004,
one accounted for 23.7% of revenues.




Marketers
pay only for the results they achieve on a cost per click, cost per lead,
percentage of revenue, cost per acquisition, or cost per impression basis, as
well as combinations of those models. As a result, marketers can refine their
offers and payment models to achieve their specific objectives.




The
Aptimus Network is focused primarily on advertising placements at the points of
various transactional activities on web sites where consumers are more active
and, thus, more likely to respond to offers from marketers. Key formats include
cross-marketing promotions at the point of registration, log-in, download or
other transactional activities on web sites. The Aptimus Network also includes
other online advertising formats and email marketing campaigns.




*Dynamic
Revenue Optimization* *TM*




At the
core of the Aptimus Network is a proprietary database configuration and software
platform supporting a direct marketing approach for which we have filed a
non-provisional business method patent application called Dynamic Revenue
OptimizationTM, which automatically determines through computer-based logic on a
real-time basis the offers from among the total offers in our rotation, in terms
of response history and value, for promotion on each publisher’s web site and in
each email sent. The technology is designed to optimize results for our
advertiser clients by presenting offers that we believe are most likely to be of
interest to specific customers, while maximizing revenues for our publishers and
us. The system can target offers on a real time basis based on any information
the user has submitted in the transaction process where our offer page is
located. For example, male users on a particular publisher’s site may have a
different response history to our offers than the site’s female visitors. Our
system can tailor the offer mix displayed on the site depending on items such as
the gender of the user to assure the highest response rate possible. Other
useful targeting variables include age and physical address among others.




6





Our
Dynamic Revenue Optimization system measures every offer in every ad position on
a revenue generation basis. Then, the offers that generate the greatest revenues
for that specific position automatically receive more exposure there, while
lower performing offers receive less exposure. The analytics are continuously
updated to quickly identify the performance of new offers and to adjust and
improve the performance of every placement.




Revenues
for each offer are determined based on response rate to each offer in each
position multiplied by the fee for that response, whether the advertiser is
paying a fee per click, a fee per lead, a fee per acquisition or based on any
other measurable outcome. This approach is more flexible than other
response-based systems that usually focus on one payment model exclusively, such
as the cost per click approach of paid search networks.




Because
Dynamic Revenue Optimization depends on consumer response as a central factor,
the system automatically improves the targeting of each offer based on consumer
behavior, emphasizing the offers that have generated the highest level of
response in each location for that category of offer, target consumer and web
site. This aspect of our algorithm ensures that offers are placed in front of a
receptive audience. But consumer response is only one factor in determining
offer placement. Dynamic Revenue Optimization also factors in the price per
result paid by each advertiser. Offers are thus prioritized based on revenue
received by us in combination with consumer response to the offers. For example,
if two offers each generate 100 orders per 1,000 impressions and one advertiser
is paying $1 per order and the other advertiser is paying $2 per order, Dynamic
Revenue Optimization will emphasize the offer paying $2 per order. Similarly, if
between these two offers, the first receives 30 orders and the second receives
100 orders each per 1,000 impressions, and the first pays $10.00 per order and
the second $2.00 per order, Dynamic Revenue Optimization will emphasis the
first, higher paying offer even though it gets a fraction of the orders the
second offer receives per 1,000 impressions. This is so because the higher
paying offer generates more total revenue per 1,000 impressions than the lower
paying offer. This dynamic creates a competitive environment where advertisers
have an incentive to pay us higher fees and to create the most compelling offer
in order to ensure priority placement of their offer along with creating offers
of high interest to consumers.




*Benefits
to Consumers*




We
present our offers from leading brands to consumers, allowing consumers to
easily select and respond to the offers that are of greatest interest to them.
Because the Aptimus Network prioritizes offers in each location based on actual
response behavior in that location, consumers are more likely to find offers of
unique interest and value to them since they are likely to have interests in
common with others who have come to the same location. In addition, we present
our offers in brief, easy to read text that is accompanied by an HTML image of
the advertised product or service. While we can support the placement of many
offers on a page, we have found that users prefer and respond best if presented
with relatively few offers on a page. And consistent with our desire to maintain
a user-friendly process, our offer pages are intuitive and easy to navigate and
users are not forced or required to order something before proceeding to the
next step in the transaction process.




*Benefits
to Advertisers*




We
benefit advertisers by offering a flexible, cost effective way to acquire new
customers online. The Aptimus Network presents their offers across a selection
of web site publishers, and our Dynamic Revenue Optimization approach
automatically attempts to determine where the most responsive customers are
likely to be for each offer. Advertisers pay us solely based on the results
achieved for them, on a cost per click, cost per lead, cost per order, or other
payment model that makes the most sense for them. Thus, advertisers can test new
marketing programs with us with little to no risk, and with the potential for
high volume results for the best performing offers.




7


**


*Benefits
to Publishers*




We work
closely with publishers to identify key areas of their web sites that have the
most profit potential, and then dynamically serve targeted offers into those
placements on an ongoing basis. Publishers share in the results achieved, and we
do all of the work to manage the placements, advertiser sales, order taking,
optimization, billing, etc.




The
transaction-related positions on our publishers’ web sites that we prefer are
different than the targeted positions of other ad networks. The Aptimus Network
generates attractive revenues while keeping consumers at the publisher’s web
site, rather than clicking them away to the web site of a sponsoring advertiser,
which is disruptive to the consumer’s experience and counter to the publisher’s
interests.




**Strategy**




Our
objective is to be the performance-based advertising network on the Internet
preferred by advertisers and web site publishers alike. We intend to achieve
this objective by the following key strategies:




*Grow
Web Site Publisher Base*




We intend
to continue to grow our web site distribution network as our primary emphasis in
2004 and beyond, now that we have an established technology platform and a
growing base of advertiser clients with both continuing and campaign-based
customer acquisition goals. We believe our Dynamic Revenue Optimization system
enables us to generate higher revenues than through random placement of offers.
Our main emphasis is to increase the number of website publisher impressions
throughout our network. Our key target distribution publishers are large web
site properties with significant volumes of transactional activities such as
registrations, log-ins, downloads, auction bids, and other processes where users
are performing a transactional activity of some form. We are also seeking major
brand distribution publishers in key vertical interest categories to continue to
attract more and new types of major brand clients. These types of clients have
products and services that appeal to a broad demographic market, have large
advertising budgets, have historically relied on traditional print and
electronic distribution channels to advertise and acquire new customers, and are
interested in extending their customer acquisition efforts to direct, measurable
online marketing programs.




*Expand
Client Base*




We
believe that we provide advertisers with a cost-effective alternative to
traditional direct marketing and, as a result, we have a significant opportunity
to increase the number of direct marketing clients we serve. In particular, we
are seeing more national consumer brand companies seeking Internet-based direct
marketing vehicles, and we plan to initiate new relationships and expand our
existing relationships with these companies. We continue to focus our sales
staff on broadening relationships with existing advertiser clients and acquiring
new advertiser clients. We plan to continue to expand and refine the services we
offer to our clients, including:




·
    enhanced
      marketing programs,




·
    new
      methods of presenting offers, and




·
    expanded
      data-gathering options.




We intend
to achieve these objectives by a combination of inquiry and research to
determine evolving advertiser and publisher needs, placement opportunities and
user interests and then focusing our development resources and efforts on
solutions that will support the desired service extensions and enhancements.
Finally, we also offer our services to advertising and direct marketing agencies
as a solution for their client companies to access consumers on the
Internet.




8


**


*Increase
Revenues*




Our
Dynamic Revenue Optimization platform is designed to increase revenues through
an algorithmic approach. As discussed, the algorithm ranks offers based on two
independent factors: (i) the number of responses (what we call “orders”)
the offer receives, and (ii) the revenues received by us per response. As
one or both of these factors increase, the algorithm places the offer
incrementally more prominently versus offers not ranked as highly by the
algorithm. Over time, as we continue to add new clients and competitive offers,
our system should automatically increase our revenues from others based on the
revenue optimizing function of our algorithm. In addition, clients have an
incentive to make their offers more attractive to consumers and increase the
fees they pay to us per order, as the revenue results for their offer will be a
key factor in determining the exposure of their offer. We also offer marketers
tools to dynamically test new offer formats and versions, such as different
graphics or text, to improve the response rate to their preferred offer in the
Aptimus Network.




**Sales
and Marketing**




*Client
Base Development*




We sell
our solutions to advertiser clients primarily through a sales and marketing
organization comprised of Aptimus employed sales staff based in our San
Francisco office. As part of our strategy to increase our client base, we intend
to expand our sales force and client account management teams on an as needed
basis. In addition, we work extensively with advertising agencies, which often
act as “offer aggregators” bringing multiple new clients and offers to us
simultaneously. Relationships with key advertising agencies have enabled us to
expand our base of clients and offers more rapidly, without having to expand our
internal sales team as quickly or as much as might otherwise be required. We
consider our relationships with the agencies we work with to be good. However,
use of agencies also can mean that we are paid a lower fee for the leads we
generate than if we were to source the offers directly from the advertisers.
This is so because the advertisers pay an agency fee to the agencies, which is
calculated as a percentage of the total fee payable for the leads we deliver,
and which have the effect of reducing the fee we get paid by the sum the
advertiser must pay the agency. In addition, use of an agency as an intermediary
between the advertiser and us inhibits or prevents the development of direct
personal relationships with the advertiser. In the absence of direct personal
relationships the potential for account retention and expansion can be limited
or eliminated entirely. Finally, our policy is to not sign contracts with
agencies that prohibit or restrict our ability to contract directly with the
advertisers we source through them or to contract with other agencies to source
the same offers from the same advertisers as we source through the first agency.
There are no agency contracts currently in place with such limitations.




*Publisher*  *Base
Development*




We have a
dedicated business development team who target and offer web sites the
opportunity to participate in the Aptimus Network. Since our preferred
transaction-oriented placements are not the more traditional banner and
skyscraper placements sought by other ad networks, we have learned that the
publisher sales process can take weeks or even months to complete from initial
contact to the date our offers are live on the publisher’s site. Our business
development employees work closely with our publishers and potential publishers
to determine the most advantageous offer placements and presentation formats,
often monetizing previously untapped content and traffic. Our technology
platform continually and dynamically analyzes consumer response to offers
presented on each publisher web site in order to optimize results on each of
those sites. We also experiment with multiple overall presentation formats and
placements in an attempt to enhance revenues for our publishers.




**Operations
and Technology**




We have
implemented a broad array of offer presentation, dynamic optimization, customer
service, transaction processing and reporting systems using both proprietary and
licensed technologies. The Aptimus Network resides on a proprietary platform
that is flexible, reliable and scalable. The proprietary elements of our
platform we have developed over the past four years include our database
configurations, our data models and the software code we have written that
retrieves, analyzes and assigns random values to user, offer and placement
information, and distributes offers based on that analysis and random
valuation. **** Together
we term this combination of proprietary software code, data modeling and
database architecture our offer rotation engine and the resulting process
Dynamic Revenue Optimization. We believe that our system can support millions of
consumers and large numbers of advertiser clients and web site distribution
publishers. Our proprietary network has been developed using both data and
process engineering approaches to ensure a comprehensive and reliable
architecture. We have filed a non-provisional patent application with the US
Patent and Trademark Office that covers our proprietary offer rotation engine as
a whole as well as its various unique component parts. However, the proprietary
elements of our platform will remain proprietary whether or not the US Patent
and Trademark Office accepts our application and issues the requested business
method patent. The Aptimus Network technology has been created with four
foundation goals in mind:




9


*Flexibility:* The
network is built entirely in Java, HTML, and XML, and is intended to run across
all platforms and networks.




*Compatibility:* To
support the network, we have designed our offer presentation formats to scale
easily across publisher web sites with a minimum of technical integration
required. Since our platform is based on standard open-source code, we have, to
date, not encountered any systems incompatibility issues with our clients or
publishers. Our offer page is extremely easy for our publishers to implement.
Our engineers provide them with a line of code, which typically takes less than
an hour for them to fully integrate into their system.




*Reliability:* We have
conducted millions of paid transactions, such as leads, and clicks, across our
network of publisher sites with a negligible failure rate. All our data
transfers are conducted according to industry-standard security protocols,
including Secure Sockets Layer (SSL). In the past three years, we have never
encountered an outage exceeding three hours. However, in the event of a
longer-term outage in the future, our system is designed to cache incoming data,
which can then be processed when our system functionality is
restored.




*Scalability:* All of
our technologies are designed for rapid, complete deployment across a large
number of distribution publishers. With our single point implementation process,
new offers are built quickly and efficiently and go live simultaneously across
all our network placements. We have to date not encountered any challenges or
limitations to our ability to scale our technology infrastructure to meet the
demands of our growing network. We believe that we can support up to five times
the current traffic.




The
Aptimus Network technology has been designed to evolve with the business and the
Internet marketplace.




**Competition**




While we
believe that our Dynamic Revenue Optimization technology offers us a significant
advantage over any potential competition in the transaction-based environments
we prefer, we nonetheless face competition from other online advertising and
direct marketing networks for client advertising budgets. Other online
advertising networks and performance based marketing providers that advertisers
might work with include ValueClick, Google, CoolSavings, MaxWorldwide,
aQuantive, AskJeeves, FindWhat and Advertising.com. Except for Advertising.com,
which represented 20.2% of our revenue in the year ended December 31, 2004 none
of the foregoing entities and no other entity that we would consider a
competitor accounted for more than a two
percent of our total revenue at any time. Advertising.com is a continuity
client. If Advertising.com were to develop a viable offer rotation solution that
competed for placement in the transaction-based environments we prefer, our
value as a distribution channel for Advertising.com and the advertisers we
source through it that we could not then source either directly or through
another agency would diminish or even be eliminated. Finally, we provide
Advertising.com with a portion of the consumer information derived from some
orders. If Advertising.com chooses to develop a consumer database and establish
an email distribution business, they would, in the future, compete with our
email distribution lists and the distribution lists that we manage.




10





We also
compete indirectly for Internet advertising revenues in general with large Web
publishers and Web portals, such as America Online, Microsoft Network, and
Yahoo!, all of which would also be strong distribution publishers for the
Aptimus Network.




**Seasonality**




We are
subject to seasonal and cyclical fluctuations from both the Clients and
Publishers within our network. Web site Publishers are less likely to initiate
our network solution into their transaction based processes during their busiest
revenue periods. The fourth quarter of each year will typically be the busiest
period for most of our targeted publishers. Additionally, on the client side of
our network, continuity-type advertisers generally increase their customer
acquisition efforts in the third quarter and early fourth quarter more than at
any other time of the year. Campaign clients generally increase their
expenditures on advertising in the third and fourth quarters of their fiscal
year, which typically end either on December 31 or June 30 of each calendar
year. Further, in the United States Internet user traffic typically subsides
during the summer months. Expenditures by advertisers also tend to reflect
overall economic conditions as well as individual budgeting and buying patterns
of advertisers.




**Intellectual
Property**




We regard
our copyrights, service marks, trademarks, pending patents, trade secrets,
proprietary technology and similar intellectual property as critical to our
success, and we rely on trademark, patent and copyright law, trade secret
protection and confidentiality and license agreements with our employees,
customers, independent contractors, publishers and others to protect our
intellectual property rights. We have registrations of the trademark “Aptimus”
and the Centaur design in the United States, both of which will expire in 2013
if we do not renew them prior to that time. We have registrations for the
trademark “Aptimus” in Australia, Canada, China, and New Zealand, which will
respectively expire in 2010, 2019, 2012 and 2007 if we do not renew them prior
to their respective expiration dates. And we have a pending registration of the
trademark “Aptimus” in the European Union. We also have a pending
non-provisional business method patent application in the United States and
under the Patent Cooperation Treaty for protection in the PCT member states that
covers our proprietary offer rotation engine as a whole as well as its various
unique component parts. Our intellectual property rights have broad application
across all of our business activities.




We have
registered a number of domain names, including aptimus.com among others.
Internet regulatory bodies regulate domain names. The regulation of domain names
in the United States and in foreign countries is subject to change in the
future. Regulatory bodies could establish additional top-level domains, appoint
additional domain name registrars or modify the requirements for holding domain
names. The relationship between regulations governing domain names and laws
protecting trademarks and similar intellectual property rights is unclear.
Therefore, we could be unable to prevent third parties from acquiring domain
names that infringe on or otherwise decrease the value of our trademarks and
other proprietary rights.




We may be
required to obtain licenses from others to refine, develop, market and deliver
new services. We may be unable to obtain any such license on commercially
reasonable terms, if at all, or guarantee that rights granted by any licenses
will be valid and enforceable. We currently hold perpetual licenses to “off the
shelf” software programs developed and distributed by the following vendors:
Oracle, Veritas, eGain, Embarcadero, Dell, Sun, Hitachi, Cisco, Foundry, Network
Associates and Microsoft. We will be entitled to periodic updates to such
programs provided we continue to pay yearly maintenance fees for each. Except
for our Microsoft Office application where we do not feel paying for annual
maintenance services is necessary or useful, we are currently paying yearly
maintenance fees for all of the software programs that we currently use and have
no current plans to cease paying such yearly maintenance fees. However, if we do
elect to cease making such maintenance payments for a particular program, we may
no longer be entitled to receive future updates, if any, to that software issued
by the copyright holder, nor will we be entitled to free technical support
service in the event the need for such support arises.




11


****


**Financial
Information About Geographic Areas**




For the
years ended December 31, 2004, 2003, and 2002 revenues attributable to the
United States have been $14.0 million, $4.6 million, and $2.8 million, or 100%,
100%, and 97%, respectively. For the past three fiscal years all long-lived
assets of the Company have been located in the United States.




**Employees**




As of
February 28, 2005, we had a total of 34 employees. The current employee mix
includes 20 in sales and marketing, 9 in technology and development, and 5 in
finance and administration. Unions represent none of our employees. We consider
relations with our employees to be good.




**RISKS
RELATED TO OUR BUSINESS**






***We
generate substantially all of our revenue from advertising, and the reduction in
spending by or loss of advertisers or publishers could materially reduce our
revenues.***




We derive
substantially all of our revenues from fees paid by our advertiser clients for
results-based advertisements displayed on our publishers’ web sites and in
company-distributed emails. Our advertiser clients, publishers and email list
owners can generally terminate their contracts with us at any time on sixty (60)
days prior notice or less. Advertisers will not continue to do business with us
if their investment in advertising with us does not generate sales leads and,
ultimately, customers, or if we fail to deliver their advertisements in an
appropriate and effective manner. Publishers and email list owners will not
renew their contracts with us if we fail to generate revenue from the
advertisements we place on their sites and in our emails. If we are unable to
remain competitive and provide value to our advertisers, publishers and list
owners, they may stop placing advertisements with us, allowing us to display
advertisements on their web sites, or using their email lists to distribute
emails, which would adversely affect our revenues.




***A
limited number of advertisers accounted for a significant percentage of our
revenues in 2004 and the loss of one or more of these advertisers could cause
our revenues to decline.***




For the
year ended December 31, 2004, revenues from our two largest advertiser clients
accounted for 32.4% of our total revenues. For the year ended December 31, 2004
our largest client, Advertising.com, accounted for 20.2% of our total revenue
and our second largest advertising client, Quinstreet, accounted for 12.2% of
our revenue. We anticipate that a limited number of clients collectively will
continue to account for a significant portion of our revenues for the
foreseeable future. **** Key
factors in maintaining our relationships with these clients include our
performance on individual campaigns, the quality of the results we generate for
these clients, and the relationships of our sales employees with client
personnel. To the extent that our performance does not meet client expectations,
or the reputation of our data quality or relationships with one or more major
clients are impaired such that they reduce or eliminate use of our services, our
revenues could decline significantly and our operating results could be
adversely affected.





12





One of
these clients, Advertising.com, is an advertising network with whom we also
compete for advertisers. We maintain short-term, renewable contracts that
Advertising.com may at some point elect not to renew. In addition to the factors
noted above, circumstances that may cause Advertising.com not to renew its
contracts with us include a desire by Advertising.com not to contract directly
with a competitor. In addition, Advertising.com has recently been acquired by
AOL, another firm that we view as a competitor. Finally, we provide
Advertising.com with a portion of the consumer information derived from some
orders. If Advertising.com chooses to develop a consumer database and establish
an email distribution business, they would, in the future, compete with our
email distribution lists and the distribution lists that we manage. We can give
no assurance that we can maintain this relationship in the future. If
Advertising.com elects not to renew its contracts with us, our revenues could
decline and our operating results could be adversely affected.




***A
limited number of publishers accounted for a significant percentage of our user
leads in 2004 and the loss of one or more of these publishers could cause our
revenues to decline.***




For the
year ended December 31, 2004, user leads from our top five largest website
publishers accounted for 45.7% of our total revenue, with the top two publishers
accounting for 23.7% and 7.2% of revenues, respectively. We anticipate that a
limited number of publishers collectively will continue to account for a
significant portion of our lead volume for the foreseeable future. **** Key
factors in maintaining our relationships with these distributors include the
performance of our individual placements on their respective sites, the total
revenues we generate for each of these publishers, and the relationships of our
business development employees with publisher personnel. Of this group of
publishers, all but one can terminate its contract with us at any time on sixty-
(60-) days prior notice or less. The other publisher has a contract with an
auto-renewing, one-year term. To the extent that our performance does not meet
publisher expectations, or that the publishers source alternative, higher paying
advertising placements from competitive third-party networks or directly from
advertisers such that they reduce or eliminate use of our services, our lead
volume and, in turn, our revenues could decline significantly and our operating
results could be adversely affected.




***We
face intense and growing competition, which could result in price reductions,
reduced operating margins and loss of market share.***




The
market for Internet advertising and related services is highly competitive. If
we fail to compete effectively against other Internet advertising service
companies, we could lose advertising clients or publishers and our revenues
could decline **.** We expect
competition to continue to increase because there are no significant barriers to
entry. Our principal competitors include other on-line companies that provide
advertisers with results-based advertising services, including advertising
networks such as Google, aQuantive, CoolSavings, Advertising.com and ValueClick.
In addition, we compete with large interactive media companies with strong brand
recognition, such as AOL, Microsoft and Yahoo!, that sell advertising inventory
directly to advertisers. We also compete with traditional advertising media,
such as direct mail, television, radio, cable and print, for a share of
advertisers’ total advertising budgets.





Many
current and potential competitors have advantages over us, such as longer
operating histories, greater name recognition, larger client bases, greater
access to advertising space on high-traffic web sites, and significantly greater
financial, technical, marketing and human resources. These companies can use
their experience and resources against us in a variety of competitive ways,
including by making acquisitions, investing more aggressively in research and
development and competing more aggressively for advertisers and publishers
through increased marketing or other promotions. In addition, existing or future
competitors may develop or offer services that provide significant performance,
price, creative or other advantages over those offered by us.





Current
and potential competitors may merge or establish cooperative relationships among
themselves or with third parties to improve the ability of their products and
services to address the needs of our clients and publishers and prospective
clients and publishers. As a result, new competitors may emerge that may rapidly
acquire significant market share as well as place significant downward pressure
on the pricing of our services.





13





In
addition, current and potential clients and publishers have or may establish
products and services that are competitive with ours, or that better serve their
own internal needs or the needs of others. For example, two of our competitors
for advertisers, Advertising.com and ValueClick, are also clients of ours. As a
result, current clients and publishers may choose to terminate their contracts
with us and potential clients and publishers may choose not to contract for our
products and services or to contract with one of our competitors.





If we
fail to compete successfully, we could have difficulties attracting and
retaining advertising clients and publishers, which may decrease our revenues
and adversely affect our operating results. Increased competition may also
result in price reductions that cannot be offset by cost reductions resulting in
substantial decreases in operating income.




***Our
revenues would decline or stagnate if the market for results-based Internet
marketing services fails to grow.***




Our
services are offered to advertisers using results-based pricing models. The
market for results-based Internet advertising has only recently developed, and
the viability and profitability of this market is unproven. If advertisers
conclude that results-based marketing services are not profitable or fail to
achieve their customer acquisition goals, the Internet advertising market could
move away from these services, and our revenues could decline or
stagnate.




***We
depend on interactive publishers for inventory to display our clients’
advertising, and any decline in the supply of advertising inventory available
through our network could cause our revenues to decline.***




Most of
the web sites, search engines, and email list owners on whose pages, and before
whose users, our advertising is displayed are not bound by long-term contracts
that ensure us a consistent supply of advertising inventory. We generate a
significant portion of our revenues from the advertising inventory provided by a
limited number of publishers. In many instances, publishers can change the
amount of inventory they make available to us at any time. In addition,
publishers may place reasonable restrictions on our use of their advertising
inventory. These restrictions may prohibit advertisements from specific
advertisers or specific industries, or restrict the use of certain creative
content or format. If a publisher decides not to make inventory available to us,
or decides to increase the cost, or places significant restrictions on the use
of such inventory, we may not be able to replace this with inventory from other
publishers that satisfy our requirements in a timely and cost-effective manner.
As a result, we may be unable to place advertisements in high value positions
and advertisers may be dissuaded from using our services. In addition, we may
find it necessary to pay a substantially larger fee to publishers to maintain
advertising inventory. If this happens, our revenues could decline or our cost
of acquiring inventory may increase.




***We
have a short operating history as an advertising network business and a
relatively new business model in an emerging and rapidly evolving market. This
makes it difficult to evaluate our future prospects and may increase the risk of
your investment.***




We first
derived revenue from our advertising network business in late 2000. However, our
advertising revenues were not 100% attributable to our results-based advertising
network model until the second quarter of 2002. We introduced our current
technology platform on which our model is based in June of 2002. Furthermore,
the balance between our network publisher and email distribution channels has
changed significantly in the past years reflecting both the public’s negative
perception of commercial email solicitation, as well as our concerted efforts to
expand our network of web site publishers during this period. As a result, we
have relatively little operating history as a results-based advertising network
business for you to evaluate in assessing our future prospects. Also, we derive
substantially all of our revenues from online advertising, which is an immature
industry that has undergone rapid and dramatic changes in its short history. You
must consider our business and prospects in light of the risks and difficulties
we will encounter with a relatively immature business model in a new and rapidly
evolving market. As a result, management may need to devote substantial time and
effort to refining our business model. Such efforts may distract them from other
aspects of our business such as growing the publisher base or attracting more
advertising clients. In addition, due to the changes in our business model, our
historic financial statements provide very limited guidance as to the current
structure of our business; particularly the financial statements predating the
second half of 2002.




14


******


***New
technologies could block or filter our ads, which could reduce the effectiveness
of our services and lead to a loss of customers.***




Technologies
may be developed that can block the display of our ads. We derive substantially
all of our revenues from fees paid to us by advertisers in connection with the
display of ads on web pages and emails. Any ad-blocking technology could
severely restrict the number for advertisements that we are able to place before
consumers resulting in a reduction in the attractiveness of our services to
advertisers. If advertisers determine that our services are not providing
substantial value, we may suffer a loss of clients. As a result, ad-blocking
technology could, in the future, substantially decrease the number of ads we
place resulting in a decrease in our revenues.




***We
have to keep up with rapid technological change to continue offering our
advertising clients competitive services or we may lose clients and be unable to
compete.***




Our
future success will depend on our ability to continue delivering our advertising
clients and publishers competitive results-based Internet marketing services. In
order to do so, we will need to adapt to rapidly changing technologies, to adapt
our services to evolving industry standards and to improve the performance of
our services. Our failure to adapt to such changes would likely lead to a loss
of clients or a substantial reduction in the fees we are able to charge versus
competitors who have more rapidly adopted improved technology. Any loss of
clients or reduction of fees would adversely impact our revenue. In addition,
the widespread adoption of new Internet technologies or other technological
changes could require substantial expenditures to modify or adapt our services
or infrastructure. If we are unable to pass all or part of these costs on to our
clients, our margins and, therefore, profitability will be reduced.




***Because
our advertiser client and publisher contracts generally can be cancelled by the
client or publisher with little or no notice or penalty, the termination of one
or more large contracts could result in an immediate decline in our revenues.***




We derive
substantially all of our revenues from marketing services under short-term
insertion order contracts with advertising clients and web site publishers,
approximately 75% of which may be cancelled upon sixty (60) days or less notice.
In addition, these contracts generally do not contain penalty provisions for
cancellation before the end of the contract term. The short contract terms in
general reflect the limited timelines, budgets and customer acquisition goals of
specific advertising campaigns and are consistent with industry practice. The
non-renewal, re-negotiation, cancellation or deferral of large contracts such as
our contract with Advertising.com or a number of contracts that in the aggregate
account for a significant amount of revenues, could cause an immediate and
significant decline in our revenues and harm our business.




***If
our advertisers, publishers or we fail to comply with regulations governing
consumer privacy, we could face substantial liability and incur significant
litigation and other costs.***




Our
collection, maintenance and use of information regarding Internet users could
result in lawsuits or government inquiries. These actions may include those
related to U.S. federal and state legislation limiting the ability of companies
like ours to collect, receive and use information regarding Internet users and
to distribute commercial emails. In addition, we cannot assure you that our
advertiser clients, web site publishers and email list owners are currently in
compliance, or will remain in compliance, with their own privacy policies,
regulations governing data collection or consumer privacy or other applicable
legal requirements. We may be held liable if our clients use our technology or
the data we collect on their behalf, or they collect in a process initiated by
us, in a manner that is not in compliance with applicable laws or regulations or
their own stated privacy policies. Alternatively, we may be held liable if our
email list owners have collected the data we use under license in violation of
applicable laws or regulations. Litigation and regulatory inquiries are often
expensive and time-consuming and their outcome is uncertain. Any involvement by
us in any of these matters may require us to:





15




·
    spend
      significant amounts on our legal defense;




·
    divert
      the attention of senior management from other aspects of our business;




·
    defer
      or cancel new product or service launches as a result of these claims or
      proceedings; and




·
    make
      changes to our present and planned products or services.




As a
result of any of the foregoing, our revenues may decrease and our expenses may
increase substantially.




***Changes
in government regulation or industry standards applicable to the Internet could
decrease the demand for our services and increase our costs of doing business.***




Our
business is subject to existing laws and regulations that have been applied to
Internet communications, commerce and advertising. New laws and regulations may
restrict specific Internet activities, and existing laws and regulations may be
applied to Internet activities, either of which could increase our costs of
doing business over the Internet and adversely affect the demand for our
advertising services. In the United States, federal and state laws already apply
or may be applied in the future to areas, including commercial email, children’s
privacy, copyrights, taxation, user privacy, search engines, Internet tracking
technologies, direct marketing, data security, pricing, sweepstakes, promotions,
intellectual property ownership and infringement, trade secrets, export of
encryption technology, acceptable content and quality of goods and services.





The
European Union has adopted directives that may limit our ability to collect and
use information regarding Internet users in Europe if we ever elect to expand
our operations to Europe. The effectiveness of our Dynamic Revenue Optimization
algorithm and database configuration could be limited by any regulation
restricting the collection or use of information regarding Internet users.
Furthermore, due to the global nature of the Internet, it is possible that,
although our transmissions originate in particular states, governments of other
states or foreign countries might attempt to regulate our transmissions or levy
sales or other taxes relating to our activities. In addition, the growth and
development of the market for Internet commerce may prompt calls for more
stringent consumer protection laws, both in the United States and abroad, that
may impose additional burdens on companies conducting business over the
Internet. Such legislation, if adopted, could hinder the growth in the use of
the Internet generally and decrease the acceptance of the Internet as a
communications, commercial and advertising medium.





In
addition to government regulation, privacy advocacy groups and the technology
and direct marketing industries may consider various new, additional or
different self-regulatory standards applicable to the Internet. Governments,
trade associations and industry self-regulatory groups may enact more burdensome
laws, regulations and guidelines, including consumer privacy laws, affecting our
clients, publishers and us, which could harm our business by increasing
compliance costs or limiting the scope of our business.




16


******


***We
have a history of losses and we have an accumulated deficit of $60.9
million.***




We
incurred net losses of $17.9 million, or more than 9.5 times the amount of our
revenues, for the year ended December 31, 2001, $5.5 million, or more than 1.9
times the amount of our revenues, for the year ended December 31, 2002, and $1.5
million, or one-third the amount of our revenues for the year ended December 31,
2003. As of December 31, 2004, our accumulated deficit was $60.9 million. Even
though we have achieved profitability for a fiscal year, we may be unable to
sustain profitability on a quarterly or annual basis in the future. It is
possible that our revenues will grow more slowly than we anticipate or that
operating expenses will exceed our expectations.




***We
may need additional financing at some point in the future, without which we may
be required to restrict or discontinue our
operations.***




We
anticipate that our available cash resources will be sufficient to meet our
currently anticipated capital expenditures and working capital requirements
indefinitely. In the event our cash from operations does not meet or exceed our
capital expenditure and working capital requirements, we may need to raise
additional funds to continue operation. In addition, we may need to raise
additional funds to develop or enhance our services or products, fund expansion,
respond to competitive pressures or acquire businesses or technologies.
Unanticipated expenses, poor financial results or unanticipated opportunities
that require financial commitments could give rise to earlier financing
requirements. If we raise additional funds through the issuance of equity or
convertible debt securities, the percentage ownership of our existing
shareholders would be reduced, and these securities might have rights,
preferences or privileges senior to those of our common stock. Additional
financing may not be available on terms favorable to the Company, or at all. If
adequate funds are not available or are not available on acceptable terms, our
ability to fund our expansion, take advantage of business opportunities, develop
or enhance services or products or otherwise respond to competitive pressures
would be significantly limited, and we might need to significantly restrict or
discontinue our operations.




***Our
quarterly operating results are uncertain and may fluctuate significantly, which
could negatively affect the value of our share price.***




Our
operating results have varied significantly from quarter to quarter in the past
and may continue to fluctuate. For example, during the year ended December 31,
2004, the percentage of annual revenues attributable to the first, second, third
and fourth quarters were 12.9%, 21.3%, 31.7% and 34.1%, respectively.




Our
limited operating history under our new business model also makes it difficult
to ascertain the effects of seasonality and cyclicality on our business. You
should not rely on period-to-period comparisons of our operating results as an
indication of our future performance. Factors that may affect our quarterly
operating results include the following:




·
    the
      addition of new clients, publishers or email list owners or the loss of
      existing clients, publishers or email list owners;




·
    the
      addition of new services or the limitation or loss of existing services;




·
    changes
      in demand and pricing for our services;




·
    changes
      in the volume, cost and quality of publisher and email database inventory
      available to us;




·
    the
      timing and amount of sales and marketing expenses incurred to attract new
      advertisers, publishers and list owners;




17




·
    seasonal
      spending and budget cycles for “continuity” advertisers’ — those
      advertisers who contract with us year round;




·
    product
      development, marketing and budgetary plans and cycles for “campaign”
      advertisers — those advertisers who periodically contract with us as an
      online component of the advertisers’ broader product-specific customer
      acquisition programs involving multiple media platforms;




·
    changes
      in our pricing policies, the pricing policies of our competitors or the
      pricing of Internet advertising generally;




·
    changes
      in governmental regulation of the Internet itself or advertising on the
      Internet;




·
    changes
      in the health of the overall economy;




·
    timing
      differences at the end of each quarter between our payments to publishers
      and list owners and our collection of related revenues from advertisers;
      and




·
    predicted
      or unpredicted costs related to operations and corporate activities.




Because
our business continues to change and evolve, our historical operating results
may not be useful in predicting our future operating results. In addition,
advertising spending has historically been cyclical in nature, reflecting
overall economic conditions as well as budgeting and customer acquisition
patterns. For example, in 1999 and 2000, advertisers spent heavily on Internet
advertising. This was followed by a lengthy downturn in Internet ad spending. We
also shifted the focus of our business from being web site-based to
network-based during this period, which caused our revenues to decline below the
expectations of securities analysts and investors as a web site-based business.
Furthermore, spending by some advertisers tends to be seasonal, with larger
portions of their ad budgets dedicated to customer acquisition efforts in the
third and fourth quarters of the calendar year. We anticipate that cyclicality
and seasonality of our business will continue in the future causing our
operating results to fluctuate.





For these
reasons, comparing our operating results on a period-to-period basis may not be
meaningful, and you should not rely on past results as an indication of future
performance. Quarterly and annual expenses as a percentage of revenues may be
significantly different from historical or projected rates. These lower
operating results may cause a decrease in our stock price.




***We
may be liable for content in the advertisements we deliver for our clients
resulting in unanticipated legal costs.***




We may be
liable to third parties for content in the advertising we deliver if the
artwork, text or other content involved violates copyrights, trademarks or other
third-party intellectual property rights or if the content is defamatory.
Although substantially all of our contracts include both warranties from our
advertisers that they have the right to use and license any copyrights,
trademarks or other intellectual property included in an advertisement and
indemnities from our advertisers in the event of a breach of such warranties, a
third party may still file a claim against us. Any claims by third parties
against us could be time-consuming, could result in costly litigation and
adverse judgments. Such expenses would increase our costs of doing business and
reduce our net income per share. In addition, we may find it necessary to limit
our exposure to such risks by accepting fewer or more restricted advertisements
leading to loss of revenue.




18


******


***If
we cannot maintain our licenses with data owners, our email volumes will decline
resulting lower revenues.***




We
distribute promotional offers by means of email to lists of names owned by the
Company or managed by the Company under license from third-party list owners. We
face competition from other providers of list management services. If we are
unsuccessful in maintaining our current license agreements with data list
owners, our email-based order volumes will likely decrease. As a consequence,
our ability to generate revenues from the email portion of our business would
likely decline.




Furthermore,
as we expand the distribution component of our results-based advertising network
we intend to continue focusing the bulk of our energies on adding new web site
publishers. Thus, while the number of third-party email lists under management
has remained stable and may actually increase slightly in the future, we expect
that this revenue stream’s contribution to our overall revenues will continue to
shrink on a percentage basis.




***The
loss of the services of any of our executive officers or key personnel would
likely cause our business to suffer.***




Our
future success depends to a significant extent on the efforts and abilities of
our senior management, particularly Timothy C. Choate, our President and Chief
Executive Officer, John Wade, our Chief Financial Officer, Dave Davis, our
Secretary, General Counsel and Vice President of Business Development, Lance
Nelson, our Vice President of Technology, and Ron Allen, our Controller. The
loss of the services of any of these individuals could result in harm to key
client or publisher relationships, loss of key information, expertise or
know-how and unanticipated recruitment and training costs. Circumstances that
may lead to a loss of such individuals include his recruitment and hiring by an
entity inside or outside the industry, his voluntary termination of employment
to pursue alternative career or personal opportunities, and the illness or death
of the individual or a member of his immediate family. We may be unable to
attract, motivate and retain other key employees in the future. We have, in the
past, and may in the future, experienced difficulty in hiring qualified
personnel. We do not have employment agreements with any of our key personnel,
nor do we have key-person insurance for any of our employees. The loss of the
services of our senior management or other key employees could make it more
difficult to successfully operate our business and pursue our business
goals.




***Acquisitions
could result in operating difficulties, dilution and other harmful consequences.***




We have
limited experience acquiring companies. The companies we have acquired have been
small. We have evaluated in the past, and may in the future evaluate, potential
strategic transactions. Any of these transactions could be material to our
financial condition and results of operations. In addition, the process of
integrating an acquired company, business or technology may create unforeseen
operating difficulties and expenditures and may not provide the benefits
anticipated. The areas where we may face risks include ***:***





·
    difficulties
      integrating operations, personnel, technologies, products and information
      systems of acquired businesses;




·
    potential
      loss of key employees of acquired businesses;




·
    adverse
      effects on our results of operations from acquisition-related charges and
      amortization of goodwill and purchased
technology;




·
    increased
      fixed costs, which could affect profitability;




·
    inability
      to maintain the key business relationships and the reputations of acquired
      businesses;




19




·
    potential
      dilution to current shareholders from the issuance of additional equity
      securities;




·
    inability
      to maintain our standards, controls, procedures and
    policies;




·
    responsibility
      for liabilities of companies we acquire; and




·
    diversion
      of management’s attention from other business
concerns.




Also, the
anticipated benefit of an acquisition may not materialize. Future acquisitions
could result in the incurrence of debt or write-offs of goodwill. For example,
our acquisition of XmarksTheSpot.com, Inc. in late 2000, was completed for $1.5
million in cash, the issuance of 349,202 shares of additional common stock, and
the assumption of $300,000 in outstanding liabilities. The acquisition also
caused the consumption of our Chief Executive Officer’s, Chief Financial
Officer’s and General Counsel’s attention at a time of mounting external
challenges for the company. Subsequently, during 2001, $1.7 million of
intangible assets recorded related to this acquisition were written
off.




Incurring
any of the stated difficulties could result in increased costs and decreased
revenue. Future acquisitions may require us to obtain additional equity or debt
financing, which may not be available on favorable terms or at all.




***Since
our stock price is volatile, your ability to sell shares of our stock held by
you at a profit may be impaired, and we may become subject to securities
litigation that is expensive and could result in a diversion of
resources.***




The
market price of our common stock has fluctuated in the past and is likely to
continue to be highly volatile. Factors affecting the stability of our stock
price include the limited number of shares held by holders who are not deemed
company “insiders” (i.e. executive management, directors and holders of in
excess of 10% of the issued and outstanding shares of common stock), the limited
trading volume of our common stock on the Nasdaq National Market, the limited
size of the public market for our common stock, and speculative buying and
selling of our common stock. In addition, as of December 31, 2004, our employees
and outside directors held vested options to purchase a total of 1,150,046
shares of our common stock. Significant sales of our common stock by a
significant number of our employees and directors as a result of option
exercises, may adversely impact the price of our common stock. As a result, it
may be difficult to sell shares of our common stock at a profit. Furthermore,
securities class action litigation has often been brought against companies that
experience volatility in the market price of their securities. Litigation
brought against us could result in substantial costs to us in defending against
the lawsuit and a diversion of management’s attention that could result in
higher expenses and lower revenue, which may, in turn, further diminish the
value of your investment.




***Our
chief executive officer holds a substantial portion of our stock, which could
limit your ability to influence the outcome of key transactions, including
changes of control.***




As of
December 31, 2004, Mr. Choate beneficially owned approximately 23.0% of our
issued and outstanding common stock. As a result, the ability of our other
shareholders to influence matters requiring approval by our shareholders,
including the election of directors and the approval of mergers or similar
transactions, could be limited.




***Our
articles of incorporation, bylaws, change in control agreements and the
Washington Business Corporation Act contain anti-takeover provisions that could
discourage or prevent a takeover, even if an acquisition would be beneficial to
our shareholders.***




Provisions
of our amended and restated articles of incorporation, our bylaws, change in
control agreements we have entered into with certain of our executive officers,
and our Shareholder Rights Plan, which provides for the dilutive issuance of
shares in the event of a hostile takeover bid or similar transaction, could make
it more difficult for a third party to acquire us, even if doing so would be
beneficial to our shareholders. These provisions include:




20




·
    authorizing
      the issuance of “blank check” preferred stock that could be issued by our
      board of directors, without shareholder approval, to increase the number
      of outstanding shares or change the balance of voting control and thwart a
      takeover attempt;




·
    prohibiting
      cumulative voting in the election of directors, which would otherwise
      allow less than a majority of shareholders to elect directors;




·
    declaration
      of a dividend distribution of preferred share purchase rights and adoption
      of a Rights Plan in March 2002, which would discourage a change of control
      attempt without the approval of the Board of Directors;
  and




·
    under
      change in control agreements between the company and each of Messrs.
      Choate, Wade, Davis and Nelson, in the event of a sale or merger of the
      company that results in the termination of the executive’s employment, the
      executive will receive a severance payment equal to eight months of his
      base salary (Messrs. Wade, Davis and Nelson) or one-year of his base
      salary (Mr. Choate). As of December 31, 2004, the aggregate total of such
      severance payments equals $520,333. In addition, 100% of the unvested
      portion of any stock options held by the individual executive at the time
      of his termination will automatically vest and become
      exercisable.




Chapter
23B.19 of the Washington Business Corporation Act imposes restrictions on
transactions between corporations and significant shareholders unless such
transactions are approved by a majority of the corporation’s board of directors
prior to the time that such shareholders acquire 10% or more of the outstanding
stock. In addition, under the terms of our stock option plan a change of control
will trigger accelerated vesting of options unless the acquiring company assumes
the options or grants comparable options. These factors may discourage, delay or
prevent a change in control which certain shareholders may favor.




***An
increase in the number of orders on our network may strain our systems or those
of our third-party service providers, and we are vulnerable to system
malfunctions or failures.***




Any
serious or repeated problems with the performance of our network could lead to
the dissatisfaction of consumers, our clients or our publishers. The order
volume on our network is expected to increase over time as we seek to expand our
client, consumer and publisher base. The proprietary and third-party systems
that support our network must be able to accommodate an increased volume of
traffic. Although we believe our systems and those of our third-party hosting
service providers in their current configuration can accommodate at least five
times current order volumes, our network has, in the past, experienced slow
response times and brief outages. Slow response times and outages can be caused
by technical problems with our Internet service providers, denial of service
attacks, network router, firewall or switch failures, database server failures,
storage area network failures, and natural disasters. Except for a four-hour
system failure caused by a computer hardware malfunction at our Internet service
provider in early 2004, we have not experienced any system failures or slow
downs exceeding two hours in length. We may experience similar problems in the
future that could interrupt traffic on our network and lead to the loss of fees.
In addition, if we experience a high volume of interruptions, advertisers may
choose to use other providers, leading to a decrease in revenue.




Substantially
all of our contracts specifically exclude liability resulting from computer
hardware or software failures, third-party systems malfunctions and Internet
connectivity failure. Furthermore, we do not guarantee system availability or
“up time” in any of our contracts. However, a third party may still file a claim
against us. Any claims by third parties against us could be time-consuming,
could result in costly litigation and adverse judgments and could require us to
modify or upgrade our operating systems and infrastructure.




21


***In
the future we may need to increase the capacity of our operating systems and
infrastructure to grow our business.***





We may
need in the future to improve and upgrade our operating systems and
infrastructure in order to support the growth of our operations. Without such
improvements, our operations might suffer from slow delivery times, unreliable
service levels or insufficient capacity, any of which could negatively affect
our reputation and ability to attract and retain advertising clients and
publishers. We may be unable to expand our systems in a timely fashion, which
could limit our ability to grow. In addition, the expansion of our systems and
infrastructure will require us to commit financial, operational and technical
resources before the volume of business the upgraded systems and infrastructure
are designed to handle materializes. There can be no assurance that the volume
of business will, in fact, increase. If we improve and upgrade our systems and
the volume of our business does not increase to support the costs, our margins
may decrease or disappear entirely.




***If
our users request products and services directly from our clients instead of
requesting the product or service from us, our revenues may
decline.***




Our
clients, list owners and/or publishers may offer the same free, trial or
promotional products or services on their own web sites or email programs that
we offer via our advertising network and email programs. Users may choose to
request products or services directly from our clients, list owners and/or
publishers instead of requesting the product or service through us. Our
publisher agreements generally include a non-solicitation clause that prohibits
our publishers from soliciting the co-registration business of our advertising
clients directly while the publisher is under contract with us. However, our
client agreements do not contain any restrictions on the client’s ability to
solicit users directly or through other publishers or offer networks. If this
happens, our revenues could decline or fail to grow and our profitability could
be adversely affected.




***If
third-party Internet service providers place limitations or restrictions on
commercial email addressed to their subscribers, our business could
suffer.***




We
distribute commercial email to company-owned and licensed lists of individual
Internet users, some of whom are members of private networks, such as the
internal network of a private enterprise or governmental unit, or subscribers of
third-party Internet service providers or ISPs such as AOL, Yahoo! and MSN.
These ISPs have the ability to limit, restrict or otherwise filter the emails
delivered to their subscribers. ISP’s or private networks may choose to restrict
or block our emails to their subscribers if they believe we are sending
commercial email solicitations in violation of federal, state or local laws or
regulations or the ISP’s or network’s own internal guidelines and controls,
because they wish to limit commercial messages reaching their users or for other
reasons. No claims or proceedings have ever been asserted against us under
applicable federal, state or local laws concerning our email practices and we
have never been held liable for violating any such laws. However, we have
experienced temporary or permanent blockages by ISP’s and private networks in
the past and may experience such blockages in the future. For example, Yahoo has
periodically placed a temporary block on mailings from one of our lists, and
Earthlink, USA.net and Juno have blocked our mailings on a permanent basis.
Together these temporary or permanent blocks have affected approximately 2.1
million names in our aggregate email database of approximately 39 million names.
Any failure to reach agreements with these ISPs to allow our emails to reach
their subscribers unimpeded could limit the growth of our email lists and,
therefore, revenue. The only ISPs of consequence to whom we have voluntarily
stopped mailing are Hotmail and MSN, to which we stopped mailing in August 2003
and which together represent approximately 12.8 million names in our aggregate
database. The reason we elected to cease mailing to Hotmail and MSN users was
that mailing to the database was no longer cost effective due to a high bounce
rate and the fact the user base was generally unresponsive. Our discussions with
Microsoft and a third-party email validation service provider, Ironport, to
clear our lists for mailing to Hotmail and MSN users have proven inconclusive to
date, and we do not expect to agree on acceptable terms to resume mailing in the
near future and possibly ever. Out of an aggregate email database of
approximately 39 million names, we do not mail to approximately 26 million names
either due to ISP blocks or voluntary action on our part. Efforts by ISPs and
private networks to limit or restrict a material portion of our emails, if
successful, could result in lower revenues to the Company and profitability
could be adversely affected.




22


******


***We
may need to incur litigation expenses in order to defend our intellectual
property rights, and might nevertheless be unable to adequately protect these
rights.***




We may
need to engage in costly litigation to enforce our intellectual property rights,
to protect our trade secrets or to determine the validity and scope of the
intellectual property rights of others. We can give no assurance that our
efforts to prevent misappropriation or infringement of our intellectual property
will be successful. An adverse determination in any litigation of this type
could require us to make significant changes to the structure and operation of
our services and features or to license alternative technology from another
party. Implementation of any of these alternatives could be costly and
time-consuming and may not be successful. Any intellectual property litigation
would likely result in substantial costs and diversion of resources and
management attention.




Our
success largely depends on our trademarks, including “Aptimus,” and internally
developed technologies, including our opt-in serving business method, which
includes computer-driven offer rotation and implementation, consumer order
collection, consumer order processing and lead generation, that we seek to
protect through a combination of patent, trademark, copyright and trade secret
laws. Protection of our proprietary business method and trademarks is crucial as
we attempt to build our proprietary advantage, brand name and reputation.
Despite actions we take to protect our intellectual property rights, it may be
possible for third parties to copy or otherwise obtain and use our intellectual
property without authorization or to develop similar intellectual property
independently. In addition, legal standards relating to the validity,
enforceability and scope of protection of intellectual property rights in
Internet-related businesses are uncertain and still evolving. In the event that
our pending non-provisional business method patent application is granted, we
may experience difficulty entering this patent. The scope of business method
patent and the activities that may be deemed to infringe on such patent is not
as clearly defined as device patent rights. As a result, we may face additional
difficulty enforcing such rights if granted. Although we are not currently
engaged in any lawsuits for the purpose of defending our intellectual property
rights, we may need to engage in such litigation in the future. Moreover, we may
be unable to maintain the value of our intellectual property rights in the
future.




***We
could become involved in costly and time-consuming disputes regarding the
validity and enforceability of recently issued or pending
patents.***




The
Internet, including the market for e-commerce and online advertising, direct
marketing and promotion, is characterized by a rapidly evolving legal landscape.
A variety of patents relating to the market have been recently issued. Other
patent applications may be pending and yet other patent applications may be
forthcoming. We have a pending non-provisional business method patent
application before the United States Patent and Trademark Office and have made
appropriate filings with certain foreign regulatory bodies preserving our patent
rights in their jurisdictions, which we intend to prosecute. The patent
application has been submitted to secure patent rights to our opt-in serving
business method, which includes computer-driven, randomized offer rotation and
implementation, consumer order collection, consumer order processing and lead
generation. We intend to vigorously prosecute the patent application process,
which may entail substantial expense and management attention.




We are
not presently engaged in any patent-related disputes, nor have we ever been
accused of infringing another’s patent rights. However, we may incur substantial
expense and management attention may be diverted if litigation ever does occur.
Moreover, whether or not claims against us have merit, we may be required to
enter into license agreements or be subject to injunctive or other equitable
relief, either of which would result in unexpected expenses that would affect
our profitability or management distraction that would reduce the time
management can devote to operational issues.




23


******


***We
may face litigation and liability for information displayed on our network or
delivered in an email.***




We may be
subjected to claims for defamation, negligence, copyright or trademark
infringement and various other claims relating to the nature and content of
materials we publish on our offer distribution network or distribute by email.
These types of claims have been brought, sometimes successfully, against online
services in the past. We could also face claims based on the content that is
accessible from our network through links to other web sites. In addition, we
may be subject to litigation based on laws and regulations concerning commercial
email. Any litigation arising from these claims would likely result in
substantial costs and diversion of resources and management attention, and an
unsuccessful defense to one or more such claims could result in material damages
and/or injunctive or other equitable relief. We have no insurance coverage for
these types of claims. Moreover, any claim that successfully limited or entirely
prevented our current commercial email activities would result in lower revenues
to the Company and adversely affect our profitability.




***Security
and privacy breaches could subject us to litigation and liability and deter
consumers from using our network.***




While we
employ security measures typical of our industry, including encryption
technology, we could be subject to litigation and liability if third parties
penetrate our network security or otherwise misappropriate our users’ personal
or credit card information. This liability could include claims for unauthorized
purchases with credit card information, impersonation or other similar fraud
claims. It could also include claims for other misuses of personal information,
such as for unauthorized marketing purposes. In addition, the Federal Trade
Commission and other federal and state agencies have investigated various
Internet companies in connection with their use of personal information. We
could be subject to investigations and enforcement actions by these or other
agencies. In addition, we license on a very limited basis customer names and
street addresses to third parties. Although we provide an opportunity for our
customers to remove their names from our user list, we nevertheless may receive
complaints from customers for these license arrangements.




The need
to transmit confidential information securely has been a significant barrier to
electronic commerce and communications over the Internet. Any compromise of
security could deter people from using the Internet in general or, specifically,
from using the Internet to conduct transactions that involve transmitting
confidential information, such as purchases of goods or services. Many marketers
seek to offer their products and services on our distribution network because
they want to encourage people to use the Internet to purchase their goods or
services. Internet security concerns could frustrate these efforts. Also, our
relationships with consumers may be adversely affected if the security measures
we use to protect their personal information prove to be ineffective. We cannot
predict whether events or developments will result in a compromise or breach of
the technology we use to protect customers’ personal information. We have no
insurance coverage for these types of claims. In addition to direct losses from
claims, if consumers are leery of using our system, we may not be able to
attract advertisers to our network leading to a decline in
revenues.




Furthermore,
our computer servers or those of our third-party service providers, if any, may
be vulnerable to computer viruses, physical or electronic break-ins and similar
disruptions. We may need to expend significant additional capital and other
resources to protect against a security breach or to alleviate problems caused
by any such breaches. We may be unable to prevent or remedy all security
breaches. If any of these breaches occur, we could lose marketing clients,
distribution publishers and visitors to our distribution network resulting in a
decline in revenues and, ultimately, profitability.




***Failure
to timely collect amounts due pursuant to outstanding accounts receivable would
have a negative impact on our cash position.***




Pursuant
to our arrangements with our publishers, we make payments for leads generated on
their web sites representing up to 100% of the total amount due prior to
collecting fees from our advertising clients with respect to such fees. In the
event that we are unable to collect payments due from a substantial number of
our advertising clients in a reasonable time frame, we may be unable to make
payments when due to our publisher or to other creditors and we may need to seek
short-term financing or other financing means. Any failure to collect amounts
due in a timely manner would adversely affect our cash position and increase our
costs of operating to the extent we are required to borrow funds to cover any
shortfalls.




24


******


***Consolidation
among Internet publishers may result in a reduction in available inventory for
ad placement and may increase the pricing power of publishers resulting in
increased operating expenses.***




While we
believe that the number of websites available for ad placement will continue to
grow, many of the higher traffic sites have experienced consolidation over the
past few years. If significant consolidation of attractive sites continues to
occur, we may face additional difficulties in obtaining high value placements
for our clients as a result of increased competition for limited space. If we
are unable to provide high value placement to our clients, they may choose to
use the services of a competitor, resulting in lower revenue. In addition, large
publishers may have additional pricing power with respect to ad placement on
their sites requiring increased expenditures without the guaranty of a
concomitant increase in revenue. Any such occurrence would negatively impact
profitability.




***If
we are unable to use data derived from our clients’ advertising campaigns, our
email list may not grow as anticipated or at all.***




Client
advertising campaigns provide a primary vehicle for identifying new leads for
our email list mailings. We collect user email addresses in the process of
taking orders on behalf of our advertising clients. Those addresses, which under
the terms of our client contract are property we jointly own with the client,
are then added to our in-house email database, and used to send periodic
commercial email solicitations. In the event that we are unable to collect,
retain and utilize data from advertising campaigns as a result of preferences of
our advertising clients, new legislation governing the use of information
gathered over the Internet or consumer preferences, we may be unable to grow or
even maintain the current size of our email list. Stagnation or reduction in the
size of our email list would and limit or reduce the revenue generated from this
activity.




***We
may not achieve the levels of revenues anticipated if our Dynamic Revenue
Optimization system does not function as anticipated.***




Our
Dynamic Revenue Optimization system is designed to measure every offer in every
ad position on a revenue generation basis. Then, the offers with greater
revenues for that specific position should automatically receive more exposure
there, while lower performing offers receive less exposure. If the Dynamic
Revenue Optimization system performs as expected, the analytics should be
continuously updated to quickly identify the performance of new offers and to
adjust and improve the performance of every placement. Revenues per offer are
determined based on response rate to each offer in each position multiplied by
the fee for that response, whether the advertiser is paying a fee per click, a
fee per lead, a fee per acquisition or based on any other measurable outcome. In
the event that the Dynamic Revenue Optimization system fails to properly place
advertisements as anticipated or otherwise does not function as anticipated, our
revenue may not achieve anticipated levels and our profitability may
suffer.




***In
the event that we suffer a catastrophic data loss, our ability to effectively
utilize the Dynamic Revenue Optimization system and provide email list
information would be compromised resulting in decreased
revenue.***




Our
Dynamic Revenue Optimization system relies on historical data regarding consumer
response to offers to adjust placement of ads in an attempt to maximize revenue
generated. In the event that we suffer a catastrophic loss of data due to a
failure of storage devices, or otherwise, the effectiveness of the Dynamic
Revenue Optimization system would be substantially reduced until we are able to
recapture the lost data. In addition, if we lose consumer email addresses as a
result of such event, our ability to provide advertisements to our owned and
licensed email lists would be substantially compromised. Finally, if we lose
consumer data prior to providing it to advertising clients, we will be unable to
collect fees with respect to such lost leads. Any such event would result in an
interruption in our activities and a loss of revenue.




25


****


**RISKS
RELATED TO OUR INDUSTRY**




***If
the acceptance of online advertising and online direct marketing does not
increase, our business will suffer.***




The
demand for online marketing may not develop to a level sufficient to support our
continued operations or may develop more slowly than we expect. We derive all of
our revenues from contracts with advertiser clients under which we provide
online marketing services through our offer distribution network and our
commercial email programs. The Internet has not existed long enough as a
marketing medium to demonstrate its effectiveness relative to traditional
marketing methods. Advertisers that have historically relied on traditional
marketing methods may be reluctant or slow to adopt online marketing. Many
advertisers have limited or no experience using the Internet as a marketing
medium. In addition, advertisers that have invested substantial resources in
traditional methods of marketing may be reluctant to reallocate these resources
to online marketing. Those companies that have invested a significant portion of
their marketing budgets in online marketing may decide after a time to return to
more traditional methods if they find that online marketing is a less effective
method of promoting their products and services than traditional marketing
methods. Moreover, the Internet-based companies that have adopted online
marketing methods may themselves develop more slowly than anticipated or not at
all. This, in turn, may result in slower growth in demand for the online direct
marketing services of the type we provide.




We do not
know if accepted industry standards for measuring the effectiveness of online
marketing, particularly of the cost per action model most commonly used by us,
will develop. An absence of accepted standards for measuring effectiveness could
discourage companies from committing significant resources to online marketing.
Moreover, advertisers may determine that the cost per action pricing model is
less effective in achieving, or entirely fails to achieve, their marketing
objectives. If the market for Internet advertising fails to continue to develop,
develops more slowly than we expect, or rejects our primary cost per action
pricing model, our ability to place offers and generate revenues could be
harmed.




***If
we are unable to adapt to rapid changes in the online marketing industry, our
revenues and profitability will suffer.***




Online
marketing is characterized by rapidly changing technologies, frequent new
product and service introductions, short development cycles and evolving
industry standards. We may incur substantial costs to modify our services or
infrastructure to adapt to these changes and to maintain and improve the
performance, features and reliability of our services. We may be unable to
successfully develop new services on a timely basis or achieve and maintain
market acceptance. In the event our efforts are unsuccessful, we may be unable
to recover the costs of such upgrades and, as a result, our profitability may
suffer.




***We
face risks from potential government regulation and other legal uncertainties
relating to the Internet.***




Laws and
regulations that apply to Internet communications, commerce, commercial email
and advertising are becoming more prevalent. The adoption of such laws could
create uncertainty in use of the Internet and reduce the demand for our
services, or impair our ability to provide our services to clients. Congress has
enacted legislation regarding children’s privacy on the Internet. In addition,
the federal Assault of Non-Solicited Pornography and Marketing Act of 2003 (the
“CAN SPAM Act”), which regulates commercial email practices in the United
States, was signed into law in December 2003. Additional laws and regulations
may be proposed or adopted with respect to the Internet covering issues such as
user privacy, freedom of expression, pricing, content and quality of products
and services, taxation, advertising, intellectual property rights and
information security. Passage of the CAN SPAM Act, which preempts state laws
regulating commercial email, certainly has eliminated some uncertainty in
respect to our commercial email practices caused by the various, often
conflicting state laws. However, it’s too early to tell what effect, if any, the
Act will have on our business. The passage of legislation regarding user privacy
or direct marketing on the Internet may reduce demand for our services or limit
our ability to provide customer information to marketers. Furthermore, the
growth of electronic commerce may prompt calls for more stringent consumer
protection laws. For example, the European Union has adopted a directive
addressing data privacy that may result in limits on the collection and use of
consumer information. The adoption of consumer protection laws that apply to
online marketing could create uncertainty in Internet usage and reduce the
demand for our services, or impair our ability to provide those services to
clients.




26





In
addition, we are not certain how our business may be affected by the application
of existing laws governing issues such as property ownership, copyrights,
encryption and other intellectual property issues, taxation, libel, obscenity
and export or import matters. It is possible that future applications of these
laws to our business could reduce demand for our services or increase the cost
of doing business as a result of litigation costs or increased service delivery
costs.




Our
services are available on the Internet in many states and foreign countries, and
these states or foreign countries may claim that we are required to qualify to
do business in their jurisdictions. Currently, we are qualified to do business
only in Washington and California. Our failure to qualify in other jurisdictions
if we were required to do so could subject us to taxes and penalties and could
restrict our ability to enforce contracts in those jurisdictions.




**Item
2:** ***Properties***




We
currently occupy 4,200 square feet in a leased facility in Seattle, Washington
and 4,451 square feet in a leased facility in San Francisco, California. The
current lease in Seattle expires in May 2009, and the current lease in San
Francisco expires in December 2007. The leased facilities are adequate for our
needs.




**Item
3:** ***Legal
Proceedings***




We are
not engaged in any material litigation at this time.




**Item
4:** ***Submission
of Matters to a Vote of Security Holders***




No
matters were submitted for a vote of our shareholders during the fourth quarter
of 2004.


****


27


****


**PART
II**




**Item
5:** ***Market
For Our Common Equity And Related Stockholder Matters***




**Price
Range of Common Stock**




Our
Common Stock was quoted on the Nasdaq National Market under the symbol “FSHP”
from our initial public offering on September 27, 1999 through October 23, 2000.
From October 24, 2000 through September 30, 2002, the Common Stock was quoted on
the Nasdaq National Market under the symbol “APTM.” From October 1, 2002 to
March 6, 2003, the Common Stock was quoted on the Nasdaq Small-Cap Market under
the symbol “APTM.” From March 7, 2003 through March 16, 2005, the Common Stock
was traded on the OTCBB under the symbol “APTM.” As of March 17, 2005, the
Common Stock began trading on the Nasdaq national market under the symbol
“APTM.” Prior to September 27, 1999, there was no public market for our common
stock. The following table shows the high and low closing sale prices for our
common stock as reported on the Nasdaq National Market, the Nasdaq Small-Cap
Market and the OTCBB for the periods indicated:




****
    
    **High**
    
    **Low****Year Ended December 31,
      2002**First
      quarter
    
    $
    2.25
    
    $
    0.50Second
      quarter
    
    $
    2.00
    
    $
    1.05Third
      quarter
    
    $
    1.45
    
    $
    0.66Fourth
      quarter
    
    $
    0.86
    
    $
    0.48**Year Ended
      December 31, 2003**First
      quarter
    
    $
    0.65
    
    $
    0.28Second
      quarter
    
    $
    0.60
    
    $
    0.31Third
      quarter
    
    $
    1.10
    
    $
    0.40Fourth
      quarter
    
    $
    5.45
    
    $
    0.60**Year
      Ended December 31, 2004**First
      quarter
    
    $
    5.88
    
    $
    4.00****Second
      quarter
    
    $
    7.50
    
    $
    5.30Third
      quarter
    
    $
    17.68
    
    $
    5.50****Fourth
      quarter
    
    $
    27.45
    
    $
    16.76




As of
March 25, 2005 **,** there
were approximately 129 holders of record of the Common Stock and 6,043,613
shares of the Common Stock outstanding. The holders of record is calculated
excluding individual participants in securities positions listings. The closing
price of our shares on March 25, 2005, was $18.15.




We have
never paid cash dividends on the Common Stock and do not intend to pay cash
dividends on the Common Stock in the foreseeable future. Our board of directors
intends to retain any earnings to provide funds for the operation and expansion
of our business.




**Recent
Sales of Unregistered Securities**




None.





28




**Item
6** ***:
Selected Financial Data***




The
following selected financial data are qualified in their entirety by reference
to, and you should read them in conjunction with, our financial statements and
the notes thereto and “Management’s Discussion and Analysis of Financial
Condition and Results of Operations” appearing elsewhere in this annual report.
The statement of operations data presented below for the years ended December
31, 2001, 2002, 2003 and 2004, and the selected balance sheet data at December
31, 2001, 2002, 2003 and 2004, are derived from Aptimus’ financial statements
that have been audited by Moss Adams LLP, independent auditors. The statement of
operations data presented below for the year ended December 31, 2000, and the
selected balance sheet data at December 31, 2000, are derived from Aptimus’
financial statements that have been audited by PriceWaterhouseCoopers LLP,
independent auditors, and are not included in this annual report.




**Aptimus,
      Inc.****Year
      Ended December 31,****2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004****Statement
      of Operations Data:**Revenues
    
    $
    16,873
    
    $
    1,874
    
    $
    2,915
    
    $
    4,571
    
    $
    13,993Operating
      expenses:Cost
      of revenues
    
    
    —
    
    
    321
    
    
    1,013
    
    
    1,436
    
    
    6,262Sales
      and marketing
    
    
    30,116
    
    
    6,210
    
    
    1,974
    
    
    1,289
    
    
    2,316Connectivity
      and network costs
    
    
    2,068
    
    
    1,784
    
    
    1,312
    
    
    1,023
    
    
    812Research
      and development
    
    
    2,553
    
    
    1,640
    
    
    559
    
    
    527
    
    
    615General
      and administrative
    
    
    3,149
    
    
    2,757
    
    
    1,695
    
    
    1,422
    
    
    1,564Depreciation
      and amortization
    
    
    2,419
    
    
    2,268
    
    
    1,305
    
    
    315
    
    
    255Lease
      renegotiation costs and abandonmentof
      leasehold improvements
    
    
    —
    
    
    —
    
    
    478
    
    
    —
    
    
    —Loss
      (gain) on disposal of long-term assets
    
    
    (3
    )
    
    142
    
    
    105
    
    
    37
    
    
    1Restructuring
      costs
    
    
    —
    
    
    4,998
    
    
    —
    
    
    —
    
    
    —Total
      operating expenses
    
    
    40,302
    
    
    20,120
    
    
    8,441
    
    
    6,049
    
    
    11,825Operating
      income (loss)
    
    
    (23,429
    )
    
    (18,246
    )
    
    (5,526
    )
    
    (1,478
    )
    
    2,168Interest
      expense
    
    
    114
    
    
    155
    
    
    24
    
    
    41
    
    
    35Interest
      income
    
    
    2,439
    
    
    720
    
    
    46
    
    
    8
    
    
    33Impairment
      of long-term investment
    
    
    —
    
    
    197
    
    
    —
    
    
    —
    
    
    40Net
      income (loss)
    
    $
    (21,104
    )
    $
    (17,878
    )
    $
    (5,504
    )
    $
    (1,511
    )
    $
    2,126Earnings
      (loss) per share:Basic
    
    $
    (1.36
    )
    $
    (1.44
    )
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.38Diluted
    
    $
    (1.36
    )
    $
    (1.44
    )
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.30Weighted
      average shares outstanding:Basic
    
    
    15,567
    
    
    12,400
    
    
    4,073
    
    
    4,333
    
    
    5,630DilutedDiluted
    
    
    15,567
    
    
    12,400
    
    
    4,073
    
    
    4,333
    
    
    7,182





29




****
    
    **As
      of December 31,******
    
    **2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004****Balance
      Sheet Data:**Cash
      and cash equivalents
    
    $
    12,854
    
    $
    3,651
    
    $
    667
    
    $
    2,368
    
    $
    3,610Working
      capital (deficiency)
    
    
    23,032
    
    
    4,387
    
    
    698
    
    
    2,457
    
    
    4,591Total
      assets
    
    
    35,532
    
    
    7,510
    
    
    1,941
    
    
    3,975
    
    
    7,206Current
      Liabilities
    
    
    4,720
    
    
    798
    
    
    709
    
    
    996
    
    
    2,006Long-term
      obligations, less current portion
    
    
    944
    
    
    68
    
    
    —
    
    
    267
    
    
    —Total
      shareholders’ equity
    
    
    29,868
    
    
    6,644
    
    
    1,232
    
    
    2,712
    
    
    5,200




30





**Item
7:** ***Management’s
Discussion And Analysis Of Financial Conditions And Results Of
Operations***




**Overview**




We are a
results-based advertising network that distributes advertisements for direct
marketing advertisers across a network of third-party web sites and
company-owned and licensed email lists. For advertisers, the Aptimus Network
offers an Internet-based distribution channel to present their advertisements to
users on web sites and email lists. Advertisers pay us only for the results that
we deliver. We then share a portion of the amounts we bill our advertiser
clients with the third-party web site owners or “publishers” and email list
owners on whose web properties and email lists we distribute the advertisements.
While this “revenue share” approach is our primary payment model, we will as an
alternative occasionally pay web site owners either a fixed fee for each
completed user transaction or a fee for each impression of an advertisement
served on the web site. Historically, fixed fee arrangements with our publishers
have accounted for less than 3% of our overall publisher fees. Because fixed fee
arrangements have an inherent risk of distribution costs exceeding the ultimate
revenue generated, we will continue to structure substantially all of our
distribution contracts on a revenue share basis.




Advertisers
generally pay us based on one of the following approaches:




·
    when
      a user opens an advertisement served by Aptimus with a “click” of the
      cursor on the user’s computer screen (a “cost per click” pricing model);




·
    when
      a user opens an advertisement served by Aptimus, expresses his or her
      interest in the advertisement by providing certain information desired by
      the advertiser such as the user’s name and email address, and then submits
      that information to Aptimus or the advertiser directly by “clicking” the
      submit button on the computer screen (a “cost per lead” pricing model);




·
    when
      a user opens an advertisement and orders the advertised product or service
      by providing the desired information such as a name, postal address and
      payment, and then submits the order to Aptimus or the advertiser directly
      by “clicking” the submit button on the computer screen (a “cost per
      acquisition” or “percentage of revenue” pricing model);




·
    when
      an advertisement is displayed on a user’s computer screen (a “cost per
      impression” pricing model); or




·
    any
      combination of the pricing models described
above.




As a
result, advertisers can refine their offers and payment models to achieve their
specific objectives. For web site publishers and email list owners, we believe
the Aptimus Network generates high revenues for publishers or email list owners
while promoting offers from recognized brand advertisers in graphical formats
that complement the publishers’ sites and add value for their customers. Our
most effective placement on publishers’ websites is at the point of a
transaction where we host the offer page and the user initiates an action to
view the page. Transaction-oriented web site placements are thus the focus of
our model. We define a transaction as a registration, download or other active
participation point on a publisher website.




At the
core of the Aptimus Network is a database configuration and software platform
and direct marketing approach for which we have filed a non-provisional business
method patent application called Dynamic Revenue OptimizationTM. This system is
designed to determine the advertisements in our system for promotion on each
individual web site and in each email sent that the system estimates may
generate the greatest user response and revenue potential for that specific web
site or email placement. This estimation is made using computer-based logic on a
real-time basis incorporating response history and value of the advertisements
in our system. The purpose of the system is to enhance results for our
advertiser clients by presenting the offers in our database that are more likely
to be of interest to specific customers, which enhancing revenues for our
publishers and us.




31





Our lead
quality control efforts include real-time validation of postal address, email
address and telephone number so that only leads with valid data are passed along
to our clients. Our primary offer presentation formats include cross-marketing
promotions at the point of registration or other transactional activity on web
sites, online advertising programs, and email marketing campaigns. As the
network aspects of our business have experienced more rapid growth than our
email marketing campaigns, the percentage contribution of email to our overall
revenues has declined to approximately 16% of overall revenue as of the end of
2004. Because our focus has shifted away from email marketing toward our network
approach, we anticipate that network growth will continue while the revenue from
email campaigns will remain close to current 2004 levels subject to some
quarterly positive and negative fluctuations. We anticipate email will gradually
contribute lower percentages of revenue for the foreseeable future as network
revenues are expected to increase.




The
growth of our email marketing campaigns also may be limited by the effect of
ISPs limiting access to their networks. For example, Yahoo has periodically
placed a temporary block on mailings from one of our lists, and Earthlink,
USA.net and Juno have blocked our mailings on a permanent basis. Together these
temporary or permanent blocks have affected approximately 2.1 million names in
our aggregate email database of approximately 39 million names. In addition, we
have voluntarily stopped or limited sending emails to subscribers of certain
ISPs as we work to secure agreements with them to allow our emails to reach
their subscribers unimpeded. The only significant ISPs to whom we have
voluntarily stopped mailing are Hotmail and MSN, to which we stopped mailing in
August 2003 and which together represent approximately 12.8 million names in our
aggregate database. The reason we elected to cease mailing to Hotmail and MSN
users was that mailing to the database was no longer cost effective due to a
high bounce rate and the fact the user base was generally unresponsive. Our
discussions with Microsoft and a third-party email validation service provider,
Ironport, to clear our lists for mailing to Hotmail and MSN users have proven
inconclusive to date, and we do not expect to agree in the near future and
possibly ever on acceptable terms to resume mailing. Out of an aggregate email
database of approximately 39 million names, we do not mail to approximately 26
million names either due to ISP blocks or voluntary action on our part. Our
advertisements typically appear on a dedicated offer page where no other
advertisements or editorial content is presented. The number of advertisements
displayed on the page ranges from one to as many as twenty or more. They can
appear in a single column or in two columns and the method of selecting
advertisements can either be in a check box or a yes/no button format. All of
these elements are variables that we can change on the fly. We have found that
different publisher web sites will generate different results with the same
offer format. Our ability to test offer formats on a publisher-by-publisher
basis allows us to present the optimally performing format in terms of user
response and value for each individual publisher in our network.




We
believe that users are more inclined to respond to our clients’ advertisements
in an environment where they are engaged in some form of transaction, the logic
being a consumer is more likely to take the additional action of responding to
an ad when he or she is in a transaction frame of mind. We thus strive to have
our offers displayed in environments on our publishers’ web sites where
consumers are taking some form of action. Actions can include when a user
registers to be included in a web site community or to receive a newsletter,
when a user logs in to a site where he or she is already registered, when a user
downloads a software program or other product, and when a user completes an
online survey. In identifying potential publisher sites to contract with, a key
consideration for us is the number of registrations, log ins, downloads or other
form of user transactions taking place on the site. The more user transactions,
the more desirable that publisher is for inclusion in our network.




Given the
importance transacting consumers are to our business, a key focus of ours has
been expanding the number of publishers in our network. To this end, we have
added seven employees to our business development team since early December
2003. They are solely dedicated to identifying publishers for potential
inclusion in our network, engaging those publishers in negotiations and
contracting with them on mutually acceptable terms. Prior to hiring our first
fully dedicated business development employee in December 2003, our business
development efforts were performed on a part-time basis by Tim Choate, our CEO,
and Dave Davis, our General Counsel. Because we remain at an early stage in the
focused development of our distribution network, our lead volumes are
concentrated among a limited number of top performing publishers. For the years
ended December 31, 2003 and 2004, user leads from our top five largest website
publishers accounted for 41.0% and 45.7% of our total revenues, respectively.
For the year ended December 31, 2004, user leads from the top two publishers
accounting for 23.7% and 7.2% of revenues, respectively. The concentration of
revenue among our five largest website publishers increased as a result of the
fact revenues generated from website publisher derived leads increased as a
percentage of our total overall revenues during the same period by approximately
28%. While our goal is to expand the number of publishers and reduce the
concentration of revenue from any one publisher, we anticipate that a limited
number of publishers collectively will continue to account for a significant
portion of our lead volume for the foreseeable future.




32





Over the
past three years, accounts receivable has increased and the allowance for
doubtful accounts has remained relatively consistent. This trend results from
the recovery from the economic downturn that occurred in 2001. We do not expect
to see this trend continue but rather expect our overall reserve balance will
stabilize around 4-7% range as the economy stabilizes.




The
limited three-year history of the business, together with the evolving nature of
results-based online advertising in general, makes it difficult to identify
business metrics other than total revenue and profitability that will prove
useful if consistently applied over the long term. For example, identifying the
number of new publisher sites added to our network in a quarter can be
confusing. Because impressions play an important role in our performance, the
addition of ten publishers each with relatively few impressions may not be as
meaningful to the company as the addition of one publisher with high impression
volumes. Similarly, identifying the total number of impressions can be
confusing, since we have found that depending on the site and the placement
within that site revenues per impression can vary widely. The type of impression
makes a difference in performance of each impression. For example, a pop-up
advertising impression that appears at the end of a user visit to a publisher’s
site may occur with high frequency, but is likely to generate a limited number
of orders and thus lower average revenue for the company. On the other hand,
transaction-based impressions - where an advertisement is displayed in the
middle of a registration process for example - may be fewer in number, but they
usually generate higher average revenues.




Identifying
average revenue for each lead or other paid action on a quarterly basis is
likely to be confusing as well. Lead fees our clients pay vary widely based on
the specific offer and offer requirements. Also, our Dynamic Revenue
Optimization system is designed to maximize revenues per impression regardless
of the payment model a client uses, basing its calculations on the combination
of the responses an offer generates in each placement and the value of those
responses. A popular offer with a lower lead fee can achieve greater exposure
than less popular offers with higher lead fees. Therefore, we do not find our
average lead fee a useful indicator of the health or prospects of the
business.




Our most
effective placement on publishers’ websites is at the point of a transaction
where we host an offer page that is included as an intermediate step in the
user-initiated transaction process. We define a transaction as a registration,
download or other active participation point on a publisher website. We consider
these transaction-oriented web site placements our core placements, and they are
thus the focus of our model and are referred to in this Registration Statement
as our “core placements”. Our offers also appear in other formats where we
either do not host the offer page or the page that we do host is not included as
an intermediate step in a transaction process. These other formats, which are
collectively referred to in this Registration Statement as “other placements”,
include pop-ups and pop-unders, log-ins, thank you pages, and non-hosted pages
with unrelated editorial and advertising content. They do not include banners,
skyscrapers and other, similar ad units, which to date we have elected not to
support with our Dynamic Revenue Optimization system. The overall performance of
these other placements has been widely variable historically, yet the supply of
impressions in these other formats on a publisher’s site can be substantial.




33





Our
website publishers measure our performance by comparing the revenue per thousand
impression results to other available revenue generating solutions. An
impression occurs each time an offer is displayed on a user’s computer screen.
While we do not use average revenue per impression or per lead in evaluating the
performance of our business, website publishers do use this metric in comparing
various advertising options. Publishers can source advertisements directly from
advertisers and agencies, they can contract with advertising networks like our
network to satisfy their advertising requirements or they can do a combination
of both. Almost exclusively publishers use revenue per impression when comparing
the relative benefits of these various options. In addition, because of its
value as a marketing tool to the publisher base, industry analysts find revenue
per impression data useful. We thus have regularly provided data on average
revenues per impression in our public filings, intend to do so in the future and
discuss average revenues per impression in our Results of Operations
below.




However,
the most important, consistent and reliable business metrics management
considers in determining the health of the business are revenues and net profit
(loss).




For the
years ended December 31, 2002, 2003, and 2004 our ten largest clients accounted
for 44.6%, 61.7% and 63.9% of our revenues, respectively. No single client
accounted for more than 10% of revenues in the year ended December 31, 2002.
Proctor & Gamble and Advertising.com accounted for 13.6% and 10.1%,
respectively, of revenues during the year ended December 31, 2003.
Advertising.com and Quinstreet accounted for 20.2% and 12.3%, respectively, of
revenues during the year ended December 31, 2004.




Over the
past year we have sought to work with larger clients with bigger ad budgets.
This has resulted in the percentage of our revenues derived from our 10 largest
clients remaining relatively high. This has also resulted in an increase of the
percentage of revenue provided by Advertising.com. The overall percentage of
revenue related to Advertising.com increased from 10.1% in 2003 to 20.2% in
2004. As we look to do more business with other agencies it is expected that
Advertising.com will account for a less significant portion of our revenues in
the future. However, we expect our revenues to be composed of a similar mix of
large and small advertiser clients in the immediate future.




In March
2005, the Company completed a $6 million private placement investment with seven
accredited investors. The Company sold the accredited investors 351,083 shares
of unregistered Aptimus, Inc. common stock at a price of $17.09 per share. In
connection with this sale warrants for an additional 95,494 shares of common
stock at a strike price of $20.22 were also issued to the
investors.




In March
2005, shares of our common stock (APTM) were re-listed on the Nasdaq National
Market Exchange.




**Results
of Operations**




**Year
Ended December 31, 2004 Compared to Year Ended December 31,
2003**




*Revenues.* We derive
our revenues primarily from response-based advertising contracts. Leads are
obtained through promoting our clients’ offers across our Aptimus Network of web
site publishers and opt-in email lists. Revenues generated through network
publishers and opt-in email list owners are recorded on a gross basis in
accordance with Emerging Issues Task Force Issue Number 99-19 (EITF 99-19). Fees
paid to network publishers and opt-in email list owners related to these
revenues are shown as Cost of revenues on the Statement of
Operations.




34




Revenue
      (In
      thousands, except percentages)
    
    2003
    
    2004
    
    Percentage
      ChangeYear
      ended December 31,
    
    $
    4,571
    
    $
    13,993
    
    
    206.1
    %





Year
      Ended December 31,Revenue
      Per Thousand Impression (CPM)
      (In
      thousands, except percentages and CPM data)
    
    2003
    
    2004
    
    Percentage
      Increase (Decrease)Core
      placement CPM
    
    $
    266.06
    
    $
    377.02
    
    
    41.7
    %Core
      placement page impressions
    
    
    3,172
    
    
    23,373
    
    
    636.9
    %Other
      placement CPM
    
    $
    14.08
    
    $
    20.24
    
    
    43.8
    %Other
      placement page impressions
    
    
    117,000
    
    
    133,737
    
    
    14.5
    %





The
increase in revenue is primarily due to expansion of our Aptimus Network,
including the addition of new web site distribution publishers thereby
increasing our page impressions and corresponding user transactions, and the
expansion of our advertiser client base. A primary focus for the company in 2004
was to continue expanding the number of publishers in our Network, thereby
increasing the number of placements, both core and other, and corresponding page
impressions. We source our results based leads from two primary network sources
- web sites and email lists. For the year ended December 31, 2003, leads derived
from email list sources accounted for $2.1 million or 45% of our overall revenue
compared to $2.3 million or 16% for the year ended December 31, 2004.





For the
year ended December 31, 2004, our average revenue per thousand impressions for
our core placements increased to $377 per thousand impressions compared to $266
for the comparable period in 2003. Our average revenue per thousand impressions
for our other placements for the year ended December 31, 2004 increased to $20
from $14 for the comparable period in 2003. The number of page impressions for
core placements and other placements for the year ending December 31, 2004
increased to 23.4 million and 133.7 million, respectively, compared to 3.2
million and 117 million, respectively, for the comparable period in 2004. The
increase in page impressions was the result of adding more publishers to the
Aptimus Network and adding additional placements within existing publisher
websites. In addition, the average revenue per thousand impressions for our core
placements increased as a result of further refinements to our Dynamic Revenue
Optimization technology and a higher performing offer mix. The average revenue
per thousand impressions for our other placements increased slightly also as a
result of further refinements to our Dynamic Revenue Optimization technology and
a higher performing offer mix. While we expect our revenues from lead generation
sourced via our email lists to remain at close to current revenue levels in
future periods subject to quarterly positive and negative fluctuations, we
anticipate their contribution as a percentage of total revenues will continue to
decline as we focus all our efforts in respect to offer distribution on
expansion of our network of website publishers. We expect the revenue per
thousand impressions of our core placements to be consistent with current levels
over the long term while it might fluctuate quarter-to-quarter depending on the
mix of publishers in our network and placements within those publishers. We
expect over the long term the revenue per thousand impressions of our other
placements will fluctuate to an even greater degree depending on the placements
within our network and the mix of offers in our system. It is expected that
revenues will continue to grow as we increase our client and publisher network,
although the growth rate in 2005 is expected to be lower than that experienced
in 2004. Our plan is to continue to expand our network with new distribution
publishers and client offers.





*Cost
of revenues* . Cost of
revenues consists of fees to web site publishers and email list owners
participating in our network.




35




(In
      thousands, except percentages)
    
    2003
    
    %
      of
      revenue
    
    2004
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      Ended December 31,
    
    $
    1,436
    
    
    31.4
    %
    
    6,262
    
    
    44.8
    %
    
    336.1
    %





Cost of
revenues have increased primarily as a result of the increase in total revenue.
Cost of revenues have increased on a percentage of revenue basis, as a result of
the growth in web site network revenues outpacing the growth of our email based
revenues. The effective rate at which we share revenues for email based revenue
is lower than that of web site network based revenues as a result of our
ownership of a large portion of the names mailed and that we deduct the cost of
delivering the emails before calculating the fees due publishers for email based
revenues. Cost of revenues is expected to increase further as a percentage of
revenues as revenues increase and is expected to normalize at around 47% of
revenues for the year ended December 31, 2005.





*Sales
and Marketing.* Sales and
marketing expenses consist primarily of marketing and operational personnel
costs, bad debts, and outside sales costs.





(In
      thousands, except percentages)
    
    2003
    
    %
      of
      revenue
    
    2004
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      Ended December 31,
    
    $
    1,288
    
    
    28.2
    %
    $
    2,316
    
    
    16.6
    %
    
    79.8
    %





The
increase in sales and marketing expenses was a result of hiring of additional
personnel, increases in sales commissions due to increased sales, accrual of a
net income based bonus pool for the year, and increases in bad debt expense.
These items accounted for 53.0%, 29.0% 10.0% and 9.8% of the increase in
expense, respectively. The majority of the new employees in sales and marketing
were in the business development department, which focuses on signing up new
publishers. Bad debts increased due to an increase in the reserve and the
write-off of approximately $60,000 in accounts during the year. Sales and
marketing costs are expected to increase further as revenues increase and as
additional advertising is done to attract new publishers. However, sales and
marketing expense is not expected to increase as a percentage of
revenues.





*Connectivity
and Network Costs.* Connectivity and network costs consist of expenses associated with the
maintenance and usage of our network as well as email delivery costs. Such costs
include Internet connection charges, hosting facility costs, email delivery
costs and personnel costs.





(In
      thousands, except percentages)
    
    2003
    
    %
      of
      revenue
    
    2004
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      Ended December 31,
    
    $
    1,023
    
    
    22.4
    %
    $
    812
    
    
    5.8
    %
    
    (20.6
    )%





This
decrease was primarily the result of decreases in connectivity and email
delivery costs, which were offset by increases in labor costs, maintenance
agreement costs and address verification costs. As a percentage of the total
change in this account these factors accounted for 75%, 131%, (61%), (16%) and
(26%), respectively. The decrease in connectivity resulted from moving our
network production environment in-house. In the first six months of 2003, the
network production environment was hosted by EDS Corporation. Similarly the
decrease in email delivery costs was a result of moving the remaining email
programs in-house. In 2003, a third party performed the majority of the email
delivery. The increase in labor related costs is a result of pay reductions,
which were in place in the first quarter of 2003, the hiring of an additional
network engineer during the quarter, and a net income based bonus that was
accrued in 2004. In the fourth quarter of 2002 and the first quarter of 2003,
our existing employees agreed to a reduction in pay to improve our cash flows.
In the first quarter of 2004, we paid our employees an amount equal to the
reduction in pay they agreed to during these two quarters. The increased
maintenance is related to additional maintenance contracts on hardware and
software. Address verification costs are campaign related and vary from month to
month depending on the number of offers requiring this service. Connectivity and
network costs for 2005 are expected to be similar to levels in
2004.





36


**


*Research
and Development.* Research
and development expenses primarily consist of personnel costs related to
maintaining and enhancing the features, content and functionality of our Web
sites, network and related systems.





(In
      thousands, except percentages)
    
    
    2003
    
    
    %
      of
      revenue
    
    
    2004
    
    
    %
      of
      revenue
    
    
    Percentage
      Inc.
      (Dec.
    )Year
      Ended December 31,
    
    $
    527
    
    
    11.5
    %
    $
    615
    
    
    4.4
    %
    
    16.7
    %





This
increase in research and development expense was primarily due to increases in
labor costs. In the fourth quarter of 2002 and the first quarter of 2003, our
existing employees agreed to a reduction in pay to improve our cash flows. In
the first quarter of 2004, we paid our employees an amount equal to the
reduction in pay they agreed to during these two quarters, resulting in an
increase in labor related costs in 2004. In addition there was also a bonus
based on net income that was accrued in 2004. Research and development expense
for 2005 is expected to be slightly higher than levels in 2004 as a result of
hiring an additional employee in the development group.





*General
and Administrative.* General
and administrative expenses primarily consist of management, financial and
administrative personnel expenses and related costs and professional service
fees.





(In
      thousands, except percentages)
    
    2003
    
    %
      of
      revenue
    
    2004
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      Ended December 31,
    
    $
    1,423
    
    
    31.1
    %
    $
    1,564
    
    
    11.2
    %
    
    9.9
    %





The
majority, 53%, of the increase in general and administrative expense was due to
increases in labor costs. In the fourth quarter of 2002 and the first quarter of
2003, our existing employees agreed to a reduction in pay to improve our cash
flows. In the first quarter of 2004, we paid our employees an amount equal to
the reduction in pay they agreed to during these two quarters, resulting in an
increase in labor related costs in 2004. In addition there was also a bonus
based on net income that was accrued in 2004. The primary other cause of the
increase in general and administrative costs was an increase in business taxes
paid. These taxes are based on revenues for Washington State and the city of
Seattle and gross payroll for the city of San Francisco. Since both revenues and
labor costs increased in 2004 the related tax liabilities also increased. Total
general and administrative expenses for 2005 are expected to be higher than 2004
primarily as a result of additional costs incurred to regain listing on the
NASDAQ National Market Exchange and additional increases in revenue based
business taxes.





*Depreciation
and Amortization.* Depreciation
and amortization expenses consist of depreciation on leased and owned computer
equipment, software, office equipment and furniture and amortization on
intellectual property and purchased email lists.





(In
      thousands, except percentages)
    
    2003
    
    %
      of
      revenue
    
    2004
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      Ended December 31,
    
    $
    315
    
    
    6.9
    %
    $
    255
    
    
    1.8
    %
    
    (19.0
    )%





Depreciation
and amortization expense decreased in 2004 as additional computer equipment has
become fully depreciated. We anticipate depreciation and amortization expense in
2005 to remain on a level consistent with 2004. Although additional equipment
will become fully depreciated in 2005, we plan on purchasing additional
equipment that will offset and possibly reverse this trend of expense
reduction.





*Loss
(gain) on disposal of long-term assets.* Loss
(gain) on disposal of long-term assets consists of gains and losses on disposals
of assets and impairments on long-term investments. Some computer hardware,
furniture, and leasehold improvements were retired in the second quarter,
however the majority of the assets were fully depreciated or insurance proceeds
were received and no material gain or loss was recorded during 2004. No material
gains or losses are expected in 2005.





37


**


*Interest
Expense.* Interest
expense in the current year results from capital equipment leases and
convertible notes payable. Interest expense totaled $35,000 for the year ended
December 31, 2004 and $41,000 in 2003. Interest expense is expected to be zero
2005 as the convertible notes payable were converted to common stock on March
30, 2004 and the capital equipment leases were paid in full in July
2004.





*Interest
Income.* Interest
income results from earnings on our available cash reserves. Interest income
totaled $33,000 in the year ended December 31, 2004 and $8,000 in 2003. The
increase in interest income is primarily a result of our improved cash position
resulting from the proceeds from the sale of common stock in December 2003 and
the positive cash flow generated in the second half of 2004. Interest income is
expected to increase slightly in 2005 as the Company’s cash position is expected
to continue to improve.





*Income
Taxes.* No
provision for federal income taxes has been recorded for any of the periods
presented due to taxable losses incurred in those years. The Company has
provided full valuation allowances on the related net deferred tax assets
because of the uncertainty regarding their realizability. As of December 31,
2004, approximately $64.6 million of net operating losses remain for federal
income tax reporting purposes. We determined that a change in ownership, as
defined in the Internal Revenue Code Section 382 and similar state provisions,
has occurred and may substantially limit the utilization of the net operating
loss carry-forwards. The annual limitation may result in the expiration of net
operating losses before utilization.





**Year
Ended December 31, 2003 Compared to Year Ended December 31,
2002**




*Revenues.* We derive
our revenues primarily from response-based advertising contracts. Leads are
obtained through promoting our clients’ offers across our Aptimus Network of web
site publishers and opt-in email lists. Revenues generated through network
publishers and opt-in email list owners are recorded on a gross basis in
accordance with Emerging Issues Task Force Issue Number 99-19 (EITF 99-19). Fees
paid to network publishers and opt-in email list owners related to these
revenues are shown as Cost of revenues on the Statement of
Operations.




Revenue
      (In
      thousands, except percentages)
    
    2002
    
    2003
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    2,915
    
    $
    4,571
    
    
    56.8
    %




Year
      Ended December 31,Revenue
      Per Thousand Impression (CPM)
      (In
      thousands, except percentages and CPM data)
    
    2002
    
    2003
    
    Percentage
      Increase
      (Decrease)Core
      placement CPM
    
    $
    45.41
    
    $
    266.06
    
    
    486.0
    %Core
      placement page impressions
    
    
    1,932
    
    
    3,172
    
    
    64.2
    %Other
      placements CPM
    
    $
    16.84
    
    $
    14.08
    
    
    (16.4
    %)Other
      placement page impressions
    
    
    60,299
    
    
    117,000
    
    
    94.0
    %




The
increase in revenue is primarily due to expansion of our Aptimus Network,
including the addition of new web site distribution publishers thereby
increasing our page impressions and corresponding user transactions, and the
expansion of our advertiser client base. A primary focus for the company in 2004
is to continue expanding the number of publishers in our Network, thereby
increasing the number of placements, both core and other, and corresponding page
impressions. We source our results based leads from two primary network sources
- web sites and email lists. In 2003, we distinguished for the first time the
two client types we have identified since that time: continuity-type clients and
campaign-type clients. For the period ending December 31, 2003, campaign clients
accounted for $839,000 or 18% of our revenue. As we did not distinguish between
campaign-type and continuity-type clients prior to 2003, no campaign-type client
revenue was identified in the comparable period in 2002 or in prior years. For
the year ended December 31, 2003, our average revenue per thousand impressions
for our core placements increased to $266 per thousand impressions compared to
$45 for the comparable period in 2002. Our average revenue per thousand
impressions for our other placements for the year ended December 31, 2003
decreased to $14 from $16 for the comparable period in 2002. The number of page
impressions for core placements and other placements for the year ending
December 31, 2003 increased to 3,172,000 and 117,000,000, respectively, compared
to 1,932,000 and 60,299,000, respectively, for the comparable period in 2002.
The increase in page impressions was the result of adding more publishers to the
Aptimus Network and adding additional placements within existing publisher
websites. In addition, the average revenue per thousand impressions for our core
placements increased as a result of further refinements to our Dynamic Revenue
Optimization technology and a higher performing offer mix. The average revenue
per thousand impressions for our other placements decreased slightly as a result
of a higher concentration of lower paying offers in the offer mix. For the year
ended December 31, 2003, leads derived from email list sources accounted for
$2.1 million or 45% of our overall revenue compared to $1.7 million or 58% for
the year ended December 31, 2002. While we expect our revenues from lead
generation sourced via our email lists to remain at close to current revenue
levels in future periods subject to quarterly positive and negative
fluctuations, we anticipate their contribution as a percentage of total revenues
will continue to decline as we focus all our efforts in respect to offer
distribution on expansion of our network of website publishers. The average
number of emails sent per month in the year ending December 31, 2003 increased
by 158% to 439 million compared from 170 million for the same period in 2002.
The increase was due to the fact we added approximately 15 million names to our
email database and we substantially increased the use of our third-party bulk
mail service provider. This increase in email volume was tempered by a 53.6%
decrease in email revenue per thousand impressions to $0.39, compared to $0.84
for the corresponding period in 2002.




38


**


*Cost
of revenues.* Cost of
revenues consists of fees to web site publishers and email list owners
participating in our network.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    1,013
    
    
    34.8
    %
    $
    1,436
    
    
    31.4
    %
    
    41.8
    %




This
increase is directly related to the increase in our revenue. Cost of revenues
have increased at a lower rate than revenues as a result of email based
campaigns. Email based campaigns that are sent to Company-owned lists do not
have any publisher fees associated with them. Also the cost of delivering the
emails and certain third-party costs are generally deducted before calculating
the fees due publishers for email based campaigns not sent to Company-owned
lists.




*Sales
and marketing.* Sales and
marketing expenses consisted primarily of marketing and operational personnel
costs, bad debts, and outside sales costs.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    1,971
    
    
    67.6
    %
    $
    1,288
    
    
    28.2
    %
    
    (34.7
    )%




The
decrease in sales and marketing expenses is primarily a result of a $430,000
reduction in payroll costs and a $230,000 reduction in rent expense. The
decrease in payroll costs is a result of a decrease in the amount of high level
management in the sales and marketing area. The reduction in rent expense is a
result of renegotiating the Seattle lease in October of 2002, and the San
Francisco lease in January 2003. In November 2003, we signed a lease for new
office space in San Francisco. The cost of the new lease is consistent with the
cost of the lease for our former San Francisco office space. We have also signed
a lease for new office space in Seattle that commences at the June 30, 2004,
termination of our current Seattle office lease. The cost of the new Seattle
office lease is consistent with that of our current lease. Bad debt expense, net
of recoveries, was $26,000 and $(2,000) in the year ended December 31, 2003 and
2002, respectively. As we add employees and our business grows, we will likely
need to hire a management-level employee, most likely in the sales and business
development area, to help manage our expanding activities.




39


**


*Connectivity
and network costs.* Connectivity and network costs consist of expenses associated with the fees,
maintenance and usage of our network as well as email delivery costs. Such costs
include email delivery costs, Internet connection charges, hosting facility
costs, banner ad serving fees and personnel costs.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    1,312
    
    
    45.0
    %
    $
    1,023
    
    
    22.4
    %
    
    (22.0
    )%




The
decrease in connectivity and network costs is primarily a result of an $182,000
decrease in connectivity costs and an $114,000 decrease in email delivery costs.
These reductions were offset by small increases in several other categories.
Connectivity costs decreased primarily as a result of terminating our offsite
hosting contract with EDS. Email delivery costs decreased as a result of using
different email delivery vendors with lower costs for delivery. The EDS contract
was cancelled in July 2003, which resulted in five months of savings in 2003.
Also January 2004 was the last month that an external provider was used for
delivery of email. In 2003 email delivery fees were approximately
$300,000.




*Research
and development.* Research
and development expenses primarily include personnel costs related to
maintaining and enhancing the features, content and functionality of our web
sites, network and related systems.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    559
    
    
    19.2
    %
    $
    527
    
    
    11.5
    %
    
    (5.7
    )%




*General
and administrative.* General
and administrative expenses primarily consist of management, financial and
administrative personnel expenses and professional service fees.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    1,687
    
    
    57.9
    %
    $
    1,319
    
    
    28.9
    %
    
    (21.8
    )%




The
decrease in general and administrative expenses is primarily a result of a
$154,000 reduction in payroll costs and an $115,000 reduction in rent expense.
The decrease in payroll costs is a result of a decrease in the number of general
and administrative staff. The reduction in rent expense is a result of
renegotiating the Seattle lease in October of 2002, and the San Francisco lease
in January 2003. General and administrative expenses in 2004 are expected to be
slightly higher than amounts in 2003. We expect our external legal and
accounting fees will increase in 2004 and beyond as a result of ongoing efforts
to insure compliance with evolving federal securities laws.




40


**


*Depreciation
and amortization.* Depreciation
and amortization expenses consist of depreciation on leased and owned computer
equipment, software, office equipment and furniture and amortization on
intellectual property.




(In
      thousands, except percentages)
    
    2002
    
    %
      of
      revenue
    
    2003
    
    %
      of
      revenue
    
    Percentage
      Inc.
      (Dec.)Year
      ended December 31,
    
    $
    1,305
    
    
    44.8
    %
    $
    315
    
    
    6.9
    %
    
    (75.9
    )%




The
decrease in depreciation is a result of fixed assets becoming fully depreciated.




*Loss
(Gain) on Disposal of Long-Term Assets* ***.*** Loss
(gain) on disposal of long-term assets consists of gains and losses on disposals
of assets and impairments on long-term investments. Loss on disposal of
long-term assets decreased by $68,000, or 65%, to $37,000 in 2003 from $105,000
in 2002. In the prior year the majority of the loss related to the write down of
a long-term investment. In the current year the loss on disposal of assets
relates to disposal of many smaller fixed assets.




*Lease
renegotiation costs and impairment of leasehold improvements.* No
significant additional lease renegotiation costs or impairments of leasehold
improvements occurred in 2003.




*Interest
expense.* Interest
expense in 2003 relates to capital equipment leases, the line-of-credit, and the
convertible notes payable. Interest expense totaled $41,000 and $24,000 in the
years ended December 31, 2003, and 2002, respectively.




*Interest
Income.* Interest
income consists of interest income on cash and cash equivalents and short-term
investments. Interest income decreased by $38,000, or 83%, to $8,000 in 2003
from $46,000 in 2002. Interest income has decreased as the balance available for
investment has decreased due to use of cash for operations.




*Income
Taxes.* No
provision for federal income taxes has been recorded for any of the periods
presented due to our current loss position.




**Liquidity
and Capital Resources**




Since we
began operating as an independent company in July 1997, we have financed our
operations primarily through the issuance of equity securities. Net proceeds
from the issuance of stock through December 31, 2004, totaled $67.2 million. As
of December 31, 2004, we had approximately $3.6 million in cash and cash
equivalents, providing working capital of $4.6 million. Other than the deferred
tax asset, as described more fully below, no off-balance sheet assets or
liabilities existed at December 31, 2004. We raised an additional $5.7 million
in net proceeds from the sale of unregistered common stock in March
2005.




Net cash
used in operating activities was $1.2 million during the year ended December 31,
2003. Net cash provided by operating activities was $1.6 million during the year
ended December 31, 2004. Cash provided by (used in) operating activities
consisted of:




Years
      ended December 31,2003
    
    2004Cash
      received from customers
    
    $
    4,126
    
    $
    11,928Cash
      paid to employees and vendors
    
    
    (5,302
    )
    
    (10,297
    )Interest
      received
    
    
    8
    
    
    32Interest
      paid
    
    
    (33
    )
    
    (30
    )Net
      cash provided by (used in) operations
    
    $
    (1,201
    )
    $
    1,633





41





Net cash
used in investing activities was $84,000 and $382,000 in the years ended
December 31, 2003 and 2004, respectively. For the year ended December 31, 2003,
$118,000 was used to acquire fixed assets, $35,000 was used to acquire
intangible assets, $51,000 was provided by the sale of short-term investments
and $18,000 was provided by the sale of fixed assets. In addition to these cash
transaction $203,000 of computer equipment was purchased with capital leases
during the year ended December 31, 2003. For the year ended December 31, 2004
$415,000 was used to acquire fixed assets, $8,000 was used to acquire intangible
assets, and $41,000 was provided by proceeds from disposal of fixed
assets.




Net cash
provided by (used in) financing activities was $3.0 million and $(9,000) for the
years ended December 31, 2003 and 2004, respectively. Net cash provided by
financing activities in 2003 was $2.8 million from the sale of stock in a
private placement and $305,000 from the issuance of convertible notes payable.
These sources of cash were offset by the repayment of $162,000 of lease
obligation in the year ended December 31, 2003. Net cash used in financing
activities during the year ended December 31, 2004 resulted from $101,000 in
principal payments made on capital leases and $168,000 in payments made related
to the registration of shares offset by $260,000 in proceeds from option and
warrant exercises.




We
believe our current cash and cash equivalents will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures for the
foreseeable future. This is based on the cash generated by operations during the
year ended December 31, 2004. We currently anticipate spending $400,000 to
$500,000 on capital expenditures in 2005 in order to expand and improve our
network infrastructure. Should our goal of maintaining positive cash flow not be
met, we may need to raise additional capital to meet our long-term operating
requirements.




Our cash
requirements depend on several factors, including the rate of market acceptance
of our services and the extent to which we use cash for acquisitions and
strategic investments. Although, no acquisitions or major strategic investments
are currently planned, unanticipated expenses, poor financial results or
unanticipated opportunities requiring financial commitments could give rise to
earlier financing requirements. In addition, we do not currently anticipate any
expenditures outside the ordinary course of business in pursuing the market
strategies described in this annual report. If we raise additional funds through
the issuance of equity or convertible debt securities, the percentage ownership
of our shareholders would be reduced, and these securities might have rights,
preferences or privileges senior to those of our common stock. Additional
financing may not be available on terms favorable to us, or at all. If adequate
funds are not available or are not available on acceptable terms, our ability to
fund our expansion, take advantage of business opportunities, develop or enhance
services or products or otherwise respond to competitive pressures would be
significantly limited, and we might need to significantly restrict our
operations.




The
following table summarizes the contractual obligations and commercial
commitments entered into by the Company, in thousands.




42




**Year
      ending December 31,**Contractual
      Obligations
    
    Total
    
    **2005**
    
    **2006**
    
    **2007**
    
    **2008**
    
    **2009**Operating
      leases (1)
    
    
    860
    
    
    227
    
    
    233
    
    
    250
    
    
    100
    
    
    50Operating
      agreements (2)
    
    
    109
    
    
    79
    
    
    30Total
      Contractual Obligations
    
    $
    969
    
    $
    306
    
    $
    263
    
    $
    250
    
    $
    100
    
    $
    50


(1)  These
commitments relate to the leasing of our offices in Seattle and San Francisco.
We expect to fund these commitments with existing cash and cash flows from
operations.




(2)  These
commitments relate to connectivity and collocation contracts. We expect to fund
these commitments with existing cash and cash flows from
operations.




**Off-Balance
Sheet Arrangements**




No
off-balance sheet arrangements existed as of December 31, 2004.




**Critical
Accounting Policies**




Our
significant accounting policies are described in Note 2 to the financial
statements included in this annual report. We believe those areas subject to the
greatest level of uncertainty are the valuation allowance for deferred tax
assets, the allowance for doubtful accounts receivable and depreciation of fixed
and intangible assets. In addition to those areas subject to the greatest level
of uncertainty revenue recognition is also considered a critical accounting
policy.




**Reclassification**




Certain
prior year amounts have been reclassified to conform to the current year's
presentation. Amounts previously included in the statement of operations as
partner fees have been reclassified to cost of revenues for all periods
presented. Cost of revenues consists entirely of the reclassified partner fees.
Included in cost of revenues are fees to web site publishers and email list
owners participating in our network. Costs associated with connectivity and
support of the network infrastructure are not included in cost of revenues.
These costs are classified in connectivity and network costs as they are
considered as more of a fixed cost than a variable cost of revenue. Also amounts
related to the impairment of certain long-term investments were previously
included in the statement of operations under the caption “Loss (gain) on
disposal of long-term assets.” Amount related to the impairment of certain
long-term investments have been reclassified to the “Impairment of long-term
investment” caption.




**Revenue
Recognition**




The
Company currently derives revenue from providing response-based advertising
programs through a network of web site and email distribution publishers.




Revenue
earned for response-based advertising through the Aptimus network is based on a
fee per lead and is recognized when the lead information is delivered to the
client. Revenue earned for email mailings can be based on a fee per lead, a
percentage of revenue earned from the mailing, or a cost per thousand emails
delivered. Revenue from email mailings delivered on a cost per thousand basis is
recognized when the email is delivered. Revenues from email mailings sent on a
fee per lead or a percentage of revenue earned from the mailing basis are
recognized when amounts are determinable, generally when the customer receives
the leads.




Revenues
generated through network publishers and opt-in email list owners are recorded
on a gross basis in accordance with Emerging Issues Task Force Issue Number
99-19 (EITF 99-19). Fees paid to network publishers and opt-in email list owners
related to these revenues are shown as Publisher fees on the Statement of
Operations. Aptimus shares a portion of the amounts it bills its advertiser
clients with the third-party web site owners or “publishers” and email list
owners on whose web properties and email lists Aptimus distributes the
advertisements. While this “revenue share” approach is Aptimus’ primary payment
model, it will as a rare alternative pay web site owners either a fixed fee for
each completed user transaction or a fee for each impression of an advertisement
served on the web site. Email based campaigns that are sent to Company owned
lists do not have publisher fees associated with them.




43





The
Company has evaluated the guidance provided by EITF 99-19 as it relates to
determining whether revenue should be recorded gross or net for the payments
made to network publishers and opt-in email list owners. The Company has
determined the recording of revenues gross is appropriate based upon the
following factors:




·
    Aptimus
      acts as a principal in these transactions;




·
    Aptimus
      and its customer are the only companies identified in the signed
      contracts;




·
    Aptimus
      and its customer are the parties who determine pricing for the
      services;




·
    Aptimus
      is solely responsible to the client for fulfillment of the
      contract;




·
    Aptimus
      bears the risk of loss related to
collections




·
    Aptimus
      determines how the offer will be presented across the network;
      and




·
    Amounts
      earned are based on leads or emails delivered and are not based on amounts
      paid to publishers.




In
addition to response-based advertising revenues, the Company earns revenue from
list rental activities. List rental revenues are received from the rental of
customer names to third parties through the use of list brokers. Revenue from
list rental activities are recognized in the period the payment is received due
to uncertainty surrounding the net accepted number of names.




In
addition to the ongoing revenue related to the network and email mailings some
revenue has been recognized through March 31, 2002, related to services
performed on the FreeShop site. These revenues have been recognized when
received, as collection was not reasonably assured at the time the services were
performed. As of December 31, 2004, it is not expected that any additional
amounts will be received that have not been previously recognized as
revenue.




**Valuation
Allowance for Deferred Tax Assets**




SFAS 109,
“Accounting for Income Taxes,” requires that deferred tax assets be evaluated
for future realization and reduced by a valuation allowance to the extent we
believe a portion will not be realized. We consider many factors when assessing
the likelihood of future realization of our deferred tax assets including our
recent cumulative earnings experience by taxing jurisdiction, expectations of
future taxable income, the carry-forward periods available to us for tax
reporting purposes, and other relevant factors. At December 31, 2004, our net
deferred tax assets are $22.7 million. Currently a valuation allowance equal to
the balance of the deferred tax assets has been recorded. This valuation
allowance has been recorded, as the ability of the Company to utilize the
deferred tax assets has not been assessed as being more likely than not.




Any
change in the assessment of whether it is more likely than not that the deferred
tax assets will be utilized will have a significant impact on the estimate of
the valuation allowance. We believe the impact of he section 382 change in
control limitations may result in an inability to fully remove the valuation
allowance. Should the ability of the company to utilize the deferred tax assets
not be assessed as more likely than not, no reduction in the valuation allowance
would be made.




44


****


**Allowance
for Doubtful Accounts**




The
estimate of allowance for doubtful accounts is comprised of two parts, a
specific account analysis and a general reserve. Accounts where specific
information indicates a potential loss may exist are reviewed and a specific
reserve against amounts due is recorded. As additional information becomes
available such specific account reserves are updated. Additionally, a general
reserve is applied to the aging categories based on historical collection and
write-off experience. As trends in historical collection and write-offs change,
the percentages applied against the aging categories are updated. Except where
specific information indicates otherwise, the following rates were applied
against the total balance due from the client when they had an amount in the
applicable aging category as of the date the reserve analysis was
performed:




As
      of December 31,2002
    
    2003
    
    2004Current
    
    
    0
    %
    
    0
    %
    
    0
    %Past
      due 1-30 days
    
    
    0
    %
    
    0
    %
    
    0
    %Past
      due 31-60 days
    
    
    25
    %
    
    25
    %
    
    25
    %Past
      due 61-90 days
    
    
    50
    %
    
    50
    %
    
    50
    %Past
      due greater than 90 days
    
    
    100
    %
    
    100
    %
    
    100
    %





Additional
metrics related to the allowance for doubtful accounts are as
follow:




As
      of December 31,2002
    
    2003
    
    2004Reserve
      balance
    
    $
    76,000
    
    $
    61,000
    
    $
    100,000%
      Of overall AR reserved
    
    
    12.5
    %
    
    6.2
    %
    
    3.4
    %Days
      sales outstanding (1)
    
    
    59
    
    
    64
    
    
    55


(1)  Days
sales outstanding is calculated by dividing net accounts receivable by revenue
for the preceding quarter divided by the number of days in the preceding
quarter.





As of
December 31, 2002, 2003, and 2004, reserves were based on applying the standard
rates to the aging categories as no specific accounts were identified as needing
to be reserved.




Over the
past three years accounts receivable has increased and the allowance for
doubtful accounts has remained relatively consistent. This trend results from
the recovery of the economic downturn that occurred in 2001. As a result of the
economic downturn in 2001, a large number of companies went out of business or
filed for bankruptcy protection during 2001 and 2002. As a result of these
events, the collectibility of our accounts receivable was reduced and we
recorded additional reserves to properly value accounts receivable. All of the
accounts from this time period were written off or collected by the third
quarter of 2003. As these problem accounts were addressed and written off or
collected the reserve declined as a percentage of total accounts receivable. We
do not expect to see this trend continue but rather expect our overall reserve
balance will stabilize around the 4-7% range as the economy stabilizes. Prior to
this challenging time, reserves were historically in the range of 7-10% of
accounts receivable. As a result of our focus on credit and collections we
believe the 4-7% range is a more accurate expectation of reserve balances,
although they could be reduced further or increase again should future
information indicate a need to do so.




Days
sales outstanding has remained relatively consistent between 55-64 days over the
three years ended December 31, 2004.




Any
increase in the rates used to calculate the reserve would result in the
recognition of additional bad debts expense and reduce the net accounts
receivable balance.




45


****


**Depreciation
of Fixed and Intangible Assets**





Property
and equipment are stated at cost less accumulated depreciation and are
depreciated using the straight-line method over their estimated useful lives.
Leasehold improvements are amortized on a straight-line method over their
estimated useful lives or the term of the related lease, whichever is shorter.
Equipment under capital leases, which all contain bargain purchase options, is
recorded at the present value of minimum lease payments and is amortized using
the straight-line method over the estimated useful lives of the related assets.
The estimated useful lives are as follows:




Office
      furniture and equipment
      Computer
      hardware and software
      Leaseholdimprovements
    Five years
      Three
      years
      Three
      to Five years







Intangible
assets are stated at cost less accumulated amortization and are amortized using
the straight-line method over their estimated useful lives. The estimated useful
lives are as follows:


Email
      names
      Aptimus
      patents and trademarks
    Two years
      Three years


The cost
of normal maintenance and repairs are charged to expense as incurred and
expenditures for major improvements are capitalized. Gains or losses on the
disposition of assets in the normal course of business are reflected in
operating expenses as part of the results of operations at the time of
disposal.




Changes
in circumstances such as technological advances or changes to our business model
can result in the actual useful lives differing from our estimates. In the event
we determine that the useful life of a capital asset should be shortened we
would depreciate the net book value in excess of the estimated salvage value,
over its remaining useful life thereby increasing depreciation expense.
Long-lived assets, including fixed assets and intangible assets other than
goodwill, are reviewed for impairment whenever events or changes in
circumstances indicate the carrying amount of the asset may not be recoverable.
A review for impairment involves developing an estimate of undiscounted cash
flow and comparing this estimate to the carrying value of the asset. The
estimate of cash flow is based on, among other things, certain assumptions about
expected future operating performance. Our estimates of undiscounted cash flow
may differ from actual cash flow due to, among other things, technological
changes, economic conditions, changes to our business model or changes in our
operating performance.




**RECENT
ACCOUNTING PRONOUNCMENTS**




In
December 2004, the FASB revised SFAS No. 123(R) Share-Based Payment. This
Statement requires a public entity to measure the cost of employee services
received in exchange for an award of equity instruments based on the grant-date
fair value of the award (with limited exceptions). That cost will be recognized
over the period during which an employee is required to provide service in
exchange for the award—the requisite service period (usually the vesting
period). No compensation cost is recognized for equity instruments for which
employees do not render the requisite service. Employee share purchase plans
will not result in recognition of compensation cost if certain conditions are
met; those conditions are much the same as the related conditions in Statement
123. This statement is effective as of the beginning of the first interim or
annual reporting period that begins after June 15, 2005. Early adoption is
encouraged and retroactive application of the provisions of SFAS 123R to the
beginning of the fiscal year that includes the effective date is permitted, but
not required. This statement will be implemented using a modified version of
prospective application. Under that transition method, compensation cost is
recognized on or after the required effective date for the portion of
outstanding awards for which the requisite service has not yet been rendered,
based on the grant-date fair value of those awards calculated under Statement
123 for either recognition or pro forma disclosures. For periods before the
required effective date, those entities may elect to apply a modified version of
retrospective application under which financial statements for prior periods are
adjusted on a basis consistent with the pro forma disclosures required for those
periods by Statement 123. The impact of this statement on net income in periods
beginning after June 15, 2005 is expected to be similar to the pro-form
disclosure amounts previously include in the financial statements.




46


****


**Item
7A:** ***Quantitative
And Qualitative Disclosures About Market Risk***




All of
our cash equivalents are at fixed interest rates and therefore the fair value of
these instruments is affected by changes in market interest rates. As of
December 31, 2004, however, our cash equivalents mature within three months. As
of December 31, 2004, we believe the reported amounts of cash equivalents to be
reasonable approximations of their fair values. As a result, we believe that the
market risk and interest risk arising from its holding of financial instruments
is minimal.


47


****


**Item
8:** ***Financial
Statements and Supplementary Data***




**INDEX
TO FINANCIAL STATEMENTS**





**Aptimus,
Inc.**


**Financial
Statements**





****
    
    **Page**Reports
      of Moss Adams, LLP, Independent Registered Public Accounting
      Firm
    
    
    49Balance
      Sheets as of December 31, 2003 and 2004
    
    
    50Statements
      of Operations for the years ended December 31,2002,
      2003 and 2004
    
    
    51Statements
      of Shareholders' Equity for the years endedDecember
      31, 2002, 2003 and 2004
    
    
    52Statements
      of Cash Flows for the years ended December 31, 2002, 2003 and
      2004
    
    
    53Notes
      to Financial Statements
    
    
    54





48


****


**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To the
Board of Directors and Shareholders


Aptimus,
Incorporated





We have
audited the accompanying balance sheets of Aptimus, Inc. as of December 31, 2004
and 2003, and the related statements of operations, shareholders’ equity and
cash flows for each of the three years in the period ended December 31, 2004. In
connection with our audit of the financial statements, we also have audited the
financial statement schedule as of and for each of the three years in the period
ended December 31, 2004, listed at Item 15 (a)(2). These financial statements
and financial statement schedule are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audit.





We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Aptimus, Inc., as of December 31,
2004 and 2003, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 2004, in conformity with
accounting principles generally accepted in the United States of America. Also,
in our opinion, the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly in
all material respects the information set forth therein.




Moss
Adams LLP


Seattle,
Washington


March 28,
2005




49




**APTIMUS,
INC.**





**BALANCE
SHEETS**


**(in
thousands)**








**December
      31,****2003**
    
    **2004**Cash
      and cash equivalents
    
    $
    2,368
    
    $
    3,610Accounts
      receivable, net
    
    
    919
    
    
    2,857Prepaid
      expenses and other assets
    
    
    166
    
    
    130Total
      current assets
    
    
    3,453
    
    
    6,597Fixed
      assets, net of accumulated depreciation
    
    
    408
    
    
    549Intangible
      assets, net
    
    
    30
    
    
    15Long-term
      investments
    
    
    40
    
    
    —Deposits
    
    
    44
    
    
    45$
    3,975
    
    $
    7,206**LIABILITIES
      AND SHAREHOLDERS’ EQUITY**Accounts
      payable
    
    $
    636
    
    $
    1,375Accrued
      and other liabilities
    
    
    259
    
    
    631Current
      portion of capital lease obligations
    
    
    101
    
    
    —Total
      current liabilities
    
    
    996
    
    
    2,006Convertible
      notes payable, net of unamortized discount
    
    
    267
    
    
    —Total
      liabilities
    
    
    1,263
    
    
    2,006Commitments
      and contingent liabilities (note 9)Shareholders’
      equity Common stock, no par value; 100,000 Shares authorized, 5,213 and
      5,973issued and outstanding at December 31, 2003 and 2004,
      respectively
    
    
    63,098
    
    
    63,495Additional
      paid-in capital
    
    
    2,679
    
    
    2,644Accumulated
      deficit
    
    
    (63,065
    )
    
    (60,939
    )Total
      shareholders’ equity
    
    
    2,712
    
    
    5,200$
    3,975
    
    $
    7,206




The
accompanying notes are an integral part of these financial
statements.




50




**APTIMUS,
INC.**





**STATEMENTS
OF OPERATIONS**


**(in
thousands, except per share data)**




**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004**Revenues
    
    $
    2,915
    
    $
    4,571
    
    $
    13,993Operating
      expenses:Cost
      of revenues
    
    
    1,013
    
    
    1,436
    
    
    6,262Sales
      and marketing
    
    
    1,974
    
    
    1,288
    
    
    2,316Connectivity
      and network costs
    
    
    1,312
    
    
    1,023
    
    
    812Research
      and development
    
    
    559
    
    
    527
    
    
    615General
      and administrative
    
    
    1,695
    
    
    1,423
    
    
    1,564Depreciation
      and amortization
    
    
    1,305
    
    
    315
    
    
    255Lease
      renegotiation costs and abandonment of leasehold
    improvements
    
    
    478
    
    
    —Loss
      (gain) on disposal of long-term assets
    
    
    (2
    )
    
    37
    
    
    1Total
      operating expenses
    
    
    8,441
    
    
    6,049
    
    
    11,825Operating
      income (loss)
    
    
    (5,526
    )
    
    (1,478
    )
    
    2,168Interest
      expense
    
    
    24
    
    
    41
    
    
    35Interest
      income
    
    
    46
    
    
    8
    
    
    33Impairment
      of long-term investment
    
    
    107
    
    
    —
    
    
    40Net
      income (loss)
    
    $
    (5,504
    )
    $
    (1,511
    )
    $
    2,126Earnings
      (loss) per share:Basic
    
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.38Diluted
    
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.30Weighted
      average shares outstanding:Basic
    
    
    4,073
    
    
    4,333
    
    
    5,630Diluted
    
    
    4,073
    
    
    4,333
    
    
    7,182




The
accompanying notes are an integral part of these financial
statements.




51





**APTIMUS,
INC.**





**STATEMENTS
OF SHAREHOLDERS’ EQUITY**


**(in
thousands)**





**Additional**
    
    **Deferred**
    
    
    
    **Total****Common
      stock**
    
    **paid-in**
    
    **stock**
    
    **Accumulated**
    
    **Shareholders’****Shares**
    
    **Amount**
    
    **capital**
    
    **Compensation**
    
    **Deficit**
    
    **equity****Balance
      on December 31, 2001**
    
    
    3,985
    
    
    60,173
    
    
    2,534
    
    
    (13
    )
    
    (56,050
    )
    
    6,644Exercise
      of stock options and warrants
    
    
    86
    
    
    34
    
    
    (29
    )
    
    
    
    
    
    
    
    5Issuance
      of common stock in
      connection
      with lease renegotiation
    
    
    150
    
    
    75
    
    
    
    
    
    
    
    
    
    
    
    75Compensation
      related to issuance of
      stock
      options to outside contractor
    
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    
    1Amortization
      of deferred stock
      Compensation
    
    
    
    
    
    
    
    
    
    
    
    11
    
    
    
    
    
    11Net
      loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,504
    )
    
    (5,504
    )**Balance
      on December 31, 2002**
    
    
    4,221
    
    $
    60,282
    
    $
    2,506
    
    $
    (2
    )
    $
    (61,554
    )
    $
    1,232Issuance
      of stock
    
    
    777
    
    
    2,694
    
    
    
    
    
    
    
    
    
    
    
    2,694Exercise
      of stock options and warrants
    
    
    221
    
    
    129
    
    
    
    
    
    
    
    
    
    
    
    129Issuance
      of warrants and options
    
    
    
    
    
    
    
    
    166
    
    
    
    
    
    
    
    
    166Forfeiture
      of shares
    
    
    (6
    )
    
    (7
    )
    
    7
    
    
    
    
    
    
    
    
    —Amortization
      of deferred stock
      Compensation
    
    
    
    
    
    
    
    
    
    
    
    2
    
    
    
    
    
    2Net
      loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,511
    )
    
    (1,511
    )**Balance
      on December 31, 2003**
    
    
    5,213
    
    $
    63,098
    
    $
    2,679
    
    $
    —
    
    $
    (63,065
    )
    $
    2,712Costs
      related to issuance of stock
    
    
    
    
    
    (168
    )
    
    
    
    
    
    
    
    
    
    
    (168
    )Issuance
      of shares under employee stock purchase program
    
    
    10
    
    
    44
    
    
    
    
    
    
    
    
    
    
    
    44Exercise
      of stock options and warrants
    
    
    369
    
    
    216
    
    
    
    
    
    
    
    
    
    
    
    216Conversion
      of Note Payable
    
    
    381
    
    
    305
    
    
    (35
    )
    
    
    
    
    
    
    
    270Net
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,126
    
    
    2,126**Balance
      on December 31, 2004**
    
    
    5,973
    
    $
    63,495
    
    $
    2,644
    
    $
    —
    
    $
    (60,939
    )
    $
    5,200





The
accompanying notes are an integral part of these financial
statements.




52





**APTIMUS,
INC.**





**STATEMENTS
OF CASH FLOWS**


**(in
thousands)**




**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004****Cash flows from operating
      activities**Net
      income (loss)
    
    $
    (5,504
    )
    $
    (1,511
    )
    $
    2,126Adjustments
      to reconcile net income (loss) to net cash used in operating
      activities:Depreciation
      and amortization
    
    
    1,305
    
    
    315
    
    
    255Bad
      debt expense (recovery)
    
    
    (2
    )
    
    26
    
    
    127Amortization
      of deferred stock compensation
    
    
    11
    
    
    103
    
    
    —Compensation
      on shares of common stock issued
    
    
    76
    
    
    —
    
    
    —Abandonment
      of fixed assets from lease renegotiation
    
    
    377
    
    
    —
    
    
    —Cash
      paid for restructuring costs
    
    
    (15
    )
    
    —
    
    
    —Loss
      (gain) on disposal of property and equipment
    
    
    (2
    )
    
    37
    
    
    1Impairment
      of long-term investment
    
    
    107
    
    
    —
    
    
    40Amortization
      of discount on short-term investments
    
    
    (4
    )
    
    —
    
    
    —Amortization
      of discount on convertible notes payable
    
    
    —
    
    
    7
    
    
    3Changes
      in assets and liabilities:Accounts
      receivable
    
    
    (259
    )
    
    (415
    )
    
    (2,065
    )Prepaid
      expenses and other assets
    
    
    60
    
    
    (17
    )
    
    35Accounts
      payable
    
    
    108
    
    
    339
    
    
    739Accrued
      and other liabilities
    
    
    (77
    )
    
    (85
    )
    
    372Net
      cash used by operating activities
    
    
    (3,819
    )
    
    (1,201
    )
    
    1,633**Cash flows from investing
      activities**Purchase
      of property and equipment
    
    
    (29
    )
    
    (118
    )
    
    (415
    )Proceeds
      from disposal of fixed assets
    
    
    43
    
    
    18
    
    
    41Purchase
      of intangible asset
    
    
    (10
    )
    
    (35
    )
    
    (8
    )Purchase
      of short-term investments
    
    
    (1
    )
    
    —
    
    
    —Sale
      of short-term investments
    
    
    1,000
    
    
    51
    
    
    —Net
      cash provided (used) by investing activities
    
    
    1,003
    
    
    (84
    )
    
    (382
    )**Cash flows from financing
      activities**Proceeds
      from convertible note payable
    
    
    —
    
    
    305
    
    
    —Repayment
      of notes payable
    
    
    (89
    )
    
    —
    
    
    —Principal
      payments under capital leases
    
    
    (84
    )
    
    (162
    )
    
    (101
    )Issuance
      of common stock
    
    
    5
    
    
    2,887
    
    
    260Costs
      of issuing common stock
    
    
    —
    
    
    (44
    )
    
    (168
    )Net
      cash provided (used) by financing activities
    
    
    (168
    )
    
    2,986
    
    
    (9
    )Net
      increase (decrease) in cash and cash equivalents
    
    
    (2,984
    )
    
    1,701
    
    
    1,242Cash
      and cash equivalents at beginning of period
    
    
    3,651
    
    
    667
    
    
    2,368Cash
      and cash equivalents at end of period
    
    $
    667
    
    $
    2,368
    
    $
    3,610





The
accompanying notes are an integral part of these financial
statements.





53





**APTIMUS,
INC.**





**NOTES
TO FINANCIAL STATEMENTS**





**1.
Organization and business**




Aptimus
operates an online direct marketing network. Aptimus is primarily an online
marketing service that generates sales leads, creates product awareness, and
initiates consumer purchases through promotional offers. Aptimus began as a
division of Online Interactive, Inc. (Online), a Washington corporation,
incorporated in July 1994. On June 30, 1997, Online Interactive contributed the
FreeShop Division, including certain net assets, to its wholly owned subsidiary,
FreeShop International, Inc., a Washington corporation incorporated on June 23,
1997, which then began operating as a separate entity.




On
February 19, 1999, FreeShop International, Inc. changed its name to
FreeShop.com, Inc. On October 16, 2000, FreeShop.com, Inc. changed its name to
Aptimus, Inc. (Aptimus).




**2.
Summary of significant accounting policies**




*Reclassifications*





Certain
prior year amounts have been reclassified to conform to the current year's
presentation. Amounts previously included in the statement of operations as
partner fees have been reclassified to cost of revenues for all periods
presented. Cost of revenues consists entirely of the reclassified partner fees.
Also amounts related to the impairment of certain long-term investments were
previously included in the statement of operations under the caption “Loss
(gain) on disposal of long-term assets.” Amounts related to the impairment of
certain long-term investments have been reclassified to the “Impairment of
long-term investment” caption.




*Use
of estimates*





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ materially from those
estimates. Significant accounting policies and estimates underlying the accompanying
financial statements include:




·
    the
      timing of revenue recognition;


·
    the
      allowance for doubtful accounts;


·
    the
      lives and recoverability of equipment;


·
    our
      determination of the need for reserves for deferred tax
      assets;


·
    stock-based
      compensation.




It is
reasonably possible that the estimates we make may change in the
future .




*Cash,
cash equivalents and short-term investments*




Aptimus
generally considers any highly liquid investments purchased with an original or
remaining maturity of three months or less at the date of purchase to be cash
equivalents.




Aptimus
classifies, at the date of acquisition, its marketable securities into
categories in accordance with the provisions of Statement of Financial
Accounting Standards No. 115, “Accounting for Certain Investments in Debt and
Equity Securities.” At December 31, 2002, short-term investments consisted of a
certificate of deposit with a maturity of less than one year. At that time, we
classified all of our short-term investments as held to maturity, which are
reported at amortized cost, which approximated their fair value at December 31,
2002. There are no short-term investments at December 31, 2003 or 2004. Realized
gains and losses and declines in value of securities judged to be other than
temporary are included in other income (expense), net.




54





Aptimus
invests its cash and cash equivalents in deposits at a major financial
institution that may, at times, exceed federally insured limits. We believe that
the risk of loss is minimal. To date, we have not experienced any losses related
to temporary cash investments.




*Accounts
receivable*




Aptimus
grants credit to its customers for substantially all of its sales. Accounts
receivable are stated at their estimated net realizable value. The estimate of
allowance for doubtful accounts is comprised of two parts, a specific account
analysis and a general reserve. Accounts where specific information indicates a
potential loss may exist are reviewed and a specific reserve against amounts due
is recorded. As additional information becomes available such specific account
reserves are updated. Additionally, a general reserve is applied to the aging
categories based on historical collection and write-off experience. As trends in
historical collection and write-offs change, the percentages applied against the
aging categories are updated. We have reserved for all outstanding balances past
due greater than ninety days as of December 31, 2003 and 2004. Accounts
receivable are considered past due when payment has not been received within the
contractual terms, which are generally net 30 days from invoice date. Amounts
are considered uncollectible and written of to the reserve for bad debts when
all internal collection efforts have been exhausted.




*Fixed
assets*




Property
and equipment are stated at cost less accumulated depreciation and are
depreciated using the straight-line method over their estimated useful lives.
Leasehold improvements are amortized on a straight-line method over their
estimated useful lives or the term of the related lease, whichever is shorter.
The estimated useful lives for financial reporting purposes are as
follows:







Office
      furniture and equipment
    Five
      yearsComputer
      hardware and software
    Three
      yearsLeasehold
      improvements
    Three
      to Five years





The cost
of normal maintenance and repairs are charged to expense as incurred and
expenditures for major improvements are capitalized. Gains or losses on the
disposition of assets in the normal course of business are reflected in the
results of operations at the time of disposal.




*Intangible
assets*




Intangible
assets are stated at cost less accumulated amortization and are amortized using
the straight-line method over their estimated useful lives. The estimated useful
lives are as follows:





Email
      names
    Two
      yearsAptimus
      trademark and logo
    Three
      years





At
December 31, 2003 and 2004, accumulated amortization of intangible assets was
$72,000 and $95,000, respectively.




55


**


*Long-term
investments*




Long-term
investments consist of minority equity investments in non-public companies.
These investments are being accounted for on the cost basis and will be
evaluated for impairment each quarter. During the years ended December 31, 2002
and 2004, Aptimus recorded charges of approximately $107,000 and 40,000,
respectively, related to the impairment of these investments. During 2003 there
were no identified events or changes in circumstances that would have a
significant adverse effect on the fair value of the investments.




*Impairment
of long-lived assets*




Aptimus
evaluates its long-lived assets for impairment and continues to evaluate them as
events or changes in circumstances indicate that the carrying amount of such
assets may not be fully recoverable. We evaluate the recoverability of
long-lived assets by measuring the carrying amount of the assets against the
estimated undiscounted future cash flows associated with these assets. If at the
time, such evaluations indicate that the future undiscounted cash flows of
certain long-lived assets are not sufficient to recover the carrying value of
such assets, the assets are adjusted to their fair values. As discussed further
in Note 5, we recorded charges of $377,000 during 2002 related to the
abandonment of leasehold improvements. No impairment charges were recognized
during the year ended December 31, 2003 or 2004.




*Fair
value of financial instruments*




The
carrying amounts of financial instruments, including cash and cash equivalents,
accounts receivable, accounts payable, accrued liabilities and long-term debt
approximate fair value because of their short maturities.




*Deferred
revenues*




Deferred
revenues consist of advance billings and payments on marketing contracts and are
included in accrued and other liabilities in the accompanying balance
sheet.




*Revenue
recognition*





Aptimus
currently derives revenue from providing response-based advertising programs
through a network of web site and email distribution publishers.




Revenue
earned for response-based advertising through the Aptimus network is based on a
fee per lead and is recognized when the lead information is delivered to the
client. Revenue earned for email mailings can be based on a fee per lead, a
percentage of revenue earned from the mailing, or a cost per thousand emails
delivered. Revenue from email mailings delivered on a cost per thousand basis is
recognized when the email is delivered. Revenues from email mailings sent on a
fee per lead or a percentage of revenue earned from the mailing basis are
recognized when amounts are determinable, generally when the customer receives
the leads.




Revenues
generated through network publishers and opt-in email list owners are recorded
on a gross basis in accordance with Emerging Issues Task Force consensus 99-19
(EITF 99-19). Fees paid to network publishers and opt-in email list owners
related to these revenues are shown as Cost of revenues on the Statement of
Operations. Aptimus shares a portion of the amounts it bills its advertiser
clients with the third-party web site owners or “publishers” and email list
owners on whose web properties and email lists Aptimus distributes the
advertisements. While this “revenue share” approach is Aptimus’ primary payment
model, it will as an alternative occasionally pay web site owners either a fixed
fee for each completed user transaction or a fee for each impression of an
advertisement served on the web site. Email based campaigns that are sent to
Company owned lists do not have publisher fees associated with
them.




56





hawse
have evaluated the guidance provided by EITF 99-19 as it relates to determining
whether revenue should be recorded gross or net for the payments made to network
publishers and opt-in email list owners. hawse have determined the recording of
revenues gross is appropriate based upon the following factors:




·
    Aptimus
      acts as a principal in these transactions;




·
    Aptimus
      and its customer are the only companies identified in the signed
      contracts;




·
    Aptimus
      and its customer are the parties who determine pricing for the
      services;




·
    Aptimus
      is solely responsible to the client for fulfillment of the
      contract;




·
    Aptimus
      bears the risk of loss related to
collections




·
    Aptimus
      determines how the offer will be presented across the network;
      and




·
    Amounts
      earned are based on leads or emails delivered and are not based on amounts
      paid to publishers.




In
addition to response-based advertising revenues, Aptimus earns revenue from list
rental activities. List rental revenues are received from the rental of customer
names to third parties through the use of list brokers. Revenue from list rental
activities are recognized in the period the payment is received due to
uncertainty surrounding the net accepted number of names.




In
addition to the ongoing revenue related to the network and email mailings some
revenue has been recognized through March 31, 2002, related to services
performed on the FreeShop site. These revenues have been recognized when
received, as collection was not reasonably assured at the time the services were
performed. As of December 31, 2004, it is not expected that any additional
amounts will be received related to services performed on the FreeShop site that
have not been previously recognized as revenue.




*Advertising
costs*




Aptimus
expenses advertising costs as incurred. Total advertising expense for the years
ended December 31, 2002, 2003, and 2004, were $8,000, $45,000, and $67,000,
respectively.




*Research
and development costs*




Research
and development costs are expensed as incurred.




*Web
site development costs*




Costs
incurred in developing our web sites are accounted for in accordance with
Emerging Issues Task Force Issues Number 00-02, “Accounting for web site
Development Costs.” As such, we expense all costs incurred that relate to the
planning and post implementation phases of development. Costs incurred in the
development phase are capitalized and recognized over the web site’s estimated
useful life if the web site is expected to have a useful life beyond one year.
Costs capitalized are included in fixed assets and are amortized over three
years. Costs associated with repair or maintenance of existing sites or
development of web site content are expensed as incurred.




*Income
taxes*




Aptimus
accounts for income taxes under the asset and liability method, which requires
recognition of deferred tax assets and liabilities for the expected future tax
consequences of temporary differences between the carrying amounts and the tax
bases of assets and liabilities. If it is more likely than not that some portion
of a deferred tax asset will not be realized, a valuation allowance is
recorded.




57


**


*Net
earnings (loss) per share*




Basic
earnings (loss) per share represents net income (loss) available to common
shareholders divided by the weighted average number of shares outstanding during
the period. Diluted earnings (loss) per share represents net income (loss)
available to common shareholders divided by the weighted average number of
shares outstanding, including the potentially dilutive impact of common stock
options and warrants. Common stock options and warrants are converted using the
treasury stock method.




The
following table sets forth the computation of the numerators and denominators in
the basic and diluted earnings (loss) per share calculations for the periods
indicated and those common stock equivalent securities not included in the
diluted net loss per share calculation as their effect on earnings (loss) per
share is anti-dilutive (in thousands):







**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004**Numerator:Net
      income (loss) (A)
    
    $
    (5,504
    )
    $
    (1,511
    )
    $
    2,126Denominator:Weighted
      average outstanding shares of common stock (B)
    
    
    4,073
    
    
    4,333
    
    
    5,630Weighted
      average dilutive effect of options to purchase common
stock
    
    
    —
    
    
    —
    
    
    1,326Weighted
      average dilutive effect of shares to be issued on conversion of
      convertible notes payable
    
    
    —
    
    
    —
    
    
    86Weighted
      average dilutive effect of warrants to purchase common
    stock
    
    
    —
    
    
    —
    
    
    140Weighted
      average of common stock and common stock equivalents (C)
    
    
    4,073
    
    
    4,333
    
    
    7,182Earnings
      (loss) per share:Basic
      (A) / (B)
    
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.38Diluted
      (A) / (C)
    
    $
    (1.35
    )
    $
    (0.35
    )
    $
    0.30Antidilutive
      securities excluded consist of the following:Options
      to purchase common stock
    
    
    1,394
    
    
    1,522
    
    
    32Warrants
      to purchase common stock
    
    
    14
    
    
    183
    
    
    —Shares
      to be issued on conversion of convertible notes payable
    
    
    —
    
    
    381
    
    
    —1,408
    
    
    2,086
    
    
    32




*Concentrations
of credit risk*




Concentrations
of credit risk with respect to accounts receivable exist due to the large number
of Internet based companies. This risk is mitigated due to the wide variety of
customers to which Aptimus provides services, as well as the customer’s
dispersion across many different geographic areas. During the year ended
December 31, 2002, no single customer accounted for greater than 10% of total
revenues. During the year ended December 31, 2003, two customers accounted for
13.6% and 10.1% of revenues. During the year ended December 31, 2004, two
customers accounted for 20.2% and 12.3% of revenues. As of December 31, 2002,
two customers accounted for 18.2% and 11.6%, of outstanding accounts receivable.
As of December 31, 2003, two customers accounted for 34.4% and 17.2%, of
outstanding accounts receivable. As of December 31, 2004, three customers
accounted for 18.6%, 11.6% and 11.1%, of outstanding accounts receivable. The
Company maintains an allowance for doubtful accounts receivable based upon its
historical experience and the expected collectibility of all accounts
receivable.




58




*Stock
compensation*




At
December 31, 2004, Aptimus has two stock-based employee compensation plans,
which are more fully described in Note 9. Aptimus accounts for those plans under
the recognition and measurement principles of APB Opinion No. 25, *Accounting
for Stock Issued to Employees* , and
related Interpretations. The following table illustrates the effect on net
income and earnings per share if the Company had applied the fair value
recognition provisions of FASB Statement No. 123, *Accounting
for Stock-Based Compensation* , to
stock-based employee compensation for the periods indicated:







**Years
      ended December 31,****2002**
    
    **2003**
    
    **2004**Net
      income (loss), as reported
    
    $
    (5,504
    )
    $
    (1,511
    )
    $
    2,126Add:
      Total stock-based employee compensation expense, included in the
      determination of net income as reported, net of related tax
      effects
    
    
    11
    
    
    104
    
    
    —Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all awards, net of related tax effects
    
    
    (373
    )
    
    (249
    )
    
    (552
    )Pro
      forma net income (loss)
    
    $
    (5,866
    )
    $
    (1,656
    )
    $
    1,574**Earnings
      per share:**Basic
      - as reported
    
    $
    (1.35
    )
    $
    (.35
    )
    $
    0.38Basic
      - pro forma
    
    $
    (1.44
    )
    $
    (.38
    )
    $
    0.28Diluted
      - as reported
    
    $
    (1.35
    )
    $
    (.35
    )
    $
    0.30Diluted
      - pro forma
    
    $
    (1.44
    )
    $
    (.38
    )
    $
    0.22




For SFAS
No. 123 pro forma disclosure, the fair value of each option is estimated on the
date of grant using the Black-Scholes option pricing model for the years ended
December 31, 2002, 2003 and 2004, with the following assumptions used for grants
to employees:


**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004**Weighted
      average risk free interest rate
    
    
    3.29
    %
    
    2.53
    %
    
    3.16
    %Weighted
      average expected life (in years)
    
    
    3.60
    
    
    4.00
    
    
    4.00Volatility
    
    
    100
    %
    
    100
    %
    
    100
    %Dividends
    
    
    None
    
    
    None
    
    
    None





*Comprehensive
income*




To date,
Aptimus has not had any transactions required to be reported in comprehensive
income other than its net income (loss).




59


**


*Segment
information*





Aptimus
has organized and managed its operations in a single operating segment providing
results based advertising to direct marketing clients. See Note 17 - Segment
Information.




*Recent
accounting pronouncements*




In
December 2004, the FASB revised SFAS No. 123(R) Share-Based Payment. This
Statement requires a public entity to measure the cost of employee services
received in exchange for an award of equity instruments based on the grant-date
fair value of the award (with limited exceptions). That cost will be recognized
over the period during which an employee is required to provide service in
exchange for the award—the requisite service period (usually the vesting
period). No compensation cost is recognized for equity instruments for which
employees do not render the requisite service. Employee share purchase plans
will not result in recognition of compensation cost if certain conditions are
met; those conditions are much the same as the related conditions in Statement
123. This statement is effective as of the beginning of the first interim or
annual reporting period that begins after June 15, 2005. Early adoption is
encouraged and retroactive application of the provisions of SFAS 123R to the
beginning of the fiscal year that includes the effective date is permitted, but
not required. This statement will be implemented using a modified version of
prospective application. Under that transition method, compensation cost is
recognized on or after the required effective date for the portion of
outstanding awards for which the requisite service has not yet been rendered,
based on the grant-date fair value of those awards calculated under Statement
123 for either recognition or pro forma disclosures. For periods before the
required effective date, those entities may elect to apply a modified version of
retrospective application under which financial statements for prior periods are
adjusted on a basis consistent with the pro forma disclosures required for those
periods by Statement 123. The impact of this statement on net income in periods
beginning after June 15, 2005 is expected to be similar to the pro-form
disclosures include above under “ *stock
compensation* .”




**3.
Accounts receivable**




Accounts
receivable consist of the following (in thousands):




**December
      31,****2003**
    
    **2004**Accounts
      receivable
    
    $
    980
    
    $
    2,957Less:
      Allowance for doubtful accounts
    
    
    (61
    )
    
    (100
    )$
    919
    
    $
    2,857





**4.
Property and equipment**





Property
and equipment consists of the following (in thousands):





**December
      31,****2003**
    
    **2004**Computer
      hardware and software
    
    $
    2,717
    
    $
    2,426Office
      furniture and equipment
    
    
    281
    
    
    141Leasehold
      improvements
    
    
    229
    
    
    743,227
    
    
    2,641Less:
      Accumulated depreciation and amortization
    
    
    (2,819
    )
    
    (2,092
    )$
    408
    
    $
    549





60





Property
and equipment includes equipment under capital leases in the amount of $203,000
and zero at December 31, 2003 and 2004, respectively. Accumulated amortization
on this equipment was $26,000 at December 31, 2003.




During
the third quarter of 2002 we negotiated and reached agreement with our Seattle
landlord to substantially reduce the amount of space we lease and the
corresponding rental rate we paid for our Seattle offices at that time. The new
arrangement accommodated our limited space requirements and reflected the
current market’s lower rates. Under the terms of the new lease, beginning
October 1, 2002, Aptimus began paying significantly less rent for a reduced
amount of office space and surrendered a majority of the leasehold improvements
made in Seattle. Lease renegotiation costs and impairment of leasehold
improvements of $478,000 were recorded; $377,000 related to the net book value
of the leasehold improvements being surrendered to the landlord, $25,000 related
to a cash payment required under the agreement to amend the lease and $76,000
related to 150,000 shares of unregistered common stock issued to the landlord.
Since July 2004, we no longer occupy this property. The remaining useful lives
of the leasehold improvements not surrendered to the landlord coincided with the
lease tern and no additional impairment or loss was recognized on such leasehold
improvements.




**5.
Line-of-credit**




In July
2003, Aptimus obtained a line-of-credit with Comerica Bank for up to $500,000,
with a term of one year that was secured by the Company’s assets. The
line-of-credit bore interest at prime plus three percent. Timothy C. Choate, the
Company Chief Executive Officer, personally guaranteed the line-of-credit. In
August 2003, Mr. Choate was granted an option to purchase 25,000 shares of our
common stock at an exercise price of $0.00 per share in recognition of and
gratitude for his personal guarantee of the line-of-credit debt. At December 31,
2003 there was no balance outstanding under the line-of-credit. The
line-of-credit was terminated in April of 2004.




**6.
Accrued and other liabilities**




Accrued
and other liabilities consist of the following (in thousands):




**December
      31,****2003**
    
    **2004**Accrued
      network publisher fees
    
    $
    27
    
    $
    73Accrued
      commissions
    
    
    55
    
    
    92Deferred
      revenue
    
    
    37
    
    
    44Accrued
      vacation
    
    
    68
    
    
    62Accrued
      bonus
    
    
    —
    
    
    236Other
    
    
    72
    
    
    124$
    259
    
    $
    631





**7.
Convertible note payable**




In July
2003, Aptimus borrowed $305,000 pursuant to the terms of a Convertible
Promissory Note, which paid interest of 6% per annum, but could be converted to
shares of common stock at the option of the holder at a fixed price of $0.80 per
share. The note had a 36-month term. Accrued interest was payable quarterly,
commencing one year from the closing date. In addition to the notes, Aptimus
issued warrants to the investors to purchase a total of 127,094 shares of common
stock for $0.50 per share. The warrants have a term of five years. On March 30,
2004, the Convertible Promissory Note was converted into 381,250 shares of
common stock. On conversion of the Convertible Promissory Note, $35,000 of the
$46,000 discount recorded related to the warrants issued in connection with the
Convertible Promissory Note was reversed against paid in capital. The difference
of $11,000 was reported as interest expense, throughout the period the
Convertible Promissory Note was outstanding. In addition, $13,000 of accrued
interest was paid directly to the holders of the Convertible Promissory Note in
April 2004.




61


****


**8.
Related party transactions**




In May
2002, 23,600 shares of our common stock were purchased from a departing
executive officer, on a ratable basis, by four of our executive officers for
total purchase consideration of $27,376. To facilitate this transaction Aptimus
loaned each of the four executive officers the $6,844 necessary to purchase
their respective shares. The notes receivable bear interest at the prime rate,
are secured by the stock purchased with the loan proceeds and are non-recourse.
The terms of the notes receivable called for repayment on the earlier of demand
by Aptimus or the self-initiated, voluntary termination of employment by the
executive officer. The terms also called for the loan to be forgiven on the
earlier of two years, the merger or sale of Aptimus, the filing of a bankruptcy
petition by or against Aptimus or election by the Company Board of Directors in
its sole discretion. However, due to the flexibility of the note terms, Aptimus
felt the value of the notes should not be reflected on the balance sheet. The
value of these notes of $27,376 was expensed as compensation expense in
September 2002. In June 2003, 5,900 of the shares outstanding were cancelled
along with $6,844 of notes receivable as a result of one of the executive
officers leaving the Company. As of June 2004, by their terms the remaining
notes have expired and the underlying loans have been forgiven.




In July
2003, we borrowed $305,000 pursuant to the terms of a Convertible Note Purchase
Agreement (see Note 7). The payment obligation, memorialized in a secured
convertible promissory note issued to each investor, had a 36-month term, bore
interest at 6% per annum, and could be converted to shares of common stock at
the option of the holder at a fixed price of $0.80 per share. Accrued interest
was payable quarterly, commencing one year from the closing date. As part of the
transaction, we issued to the investors warrants to purchase a total of 127,094
shares of our common stock for $0.50 per share. The warrants have a term of five
years. The $45,627 value of these warrants was recorded as a discount on the
convertible note obligation and amortized to expense over the 36-month term of
the obligation. In July 2003, Timothy C. Choate, our CEO, and Robert W. Wrubel,
one of our independent directors, each participated in the convertible note
financing in the amount of $50,000 and $15,000, respectively. In his capacity as
an investor, Mr. Choate was granted a warrant to purchase 20,835 shares of our
common stock; and Mr. Wrubel was granted a warrant to purchase 6,250 shares of
our common stock. On March 30, 2004, the Convertible Promissory Note was
converted into 381,250 shares of common stock of which Mr. Choate received
62,500 and Mr. Wrubel received 18,750. In April 2004 Mr. Choate and Mr. Wrubel
received payments of $2,252.05 and $650.96, respectively, representing interest
on the convertible promissory notes.




In July
2003, Aptimus obtained a line-of-credit with Comerica Bank for up to $500,000,
with a term of one year, which is renewable at our option, and is secured by the
Company’s assets. The line-of-credit bears interest at prime plus three percent.
Timothy C. Choate, the Company Chief Executive Officer, personally guaranteed
the line-of-credit. In August 2003, Mr. Choate was granted an option to purchase
25,000 shares of our common stock at an exercise price of $0.00 per share in
recognition of and gratitude for his personal guarantee of the line-of-credit
debt. At December 31, 2003, there was no balance outstanding under the
line-of-credit. Equity-based compensation of $15,500, representing the fair
market value of the underlying shares at the time of the grant, was recorded
related to this option grant.




62


****


**9.
Commitments and contingencies**




The
Company’s office facilities are leased under operating leases that provide for
minimum rentals and require payment of property taxes and include escalation
clauses.




Future
minimum lease payments under the non-cancelable leases are as follows (in
thousands).





**Year
      ending December 31,**
    
    **Operating
      leases**
    
    **Other
      operating agreements**
    
    **Total**2005
    
    $
    227
    
    $
    79
    
    $
    3062006
    
    
    233
    
    
    30
    
    
    2632007
    
    
    250
    
    
    —
    
    
    2502008
    
    
    100
    
    
    —
    
    
    1002009
    
    
    50
    
    
    —
    
    
    50Total
      minimum lease payments
    
    $
    860
    
    $
    109
    
    $
    969





Rent
expense for the years ended December 31, 2002, 2003 and 2004, was $648,000,
$206,000 and $224,000 respectively.




*Litigation*




The
Company may be subject to various claims and pending or threatened lawsuits in
the normal course of business. Management believes that the outcome of any such
lawsuits would not have a materially adverse effect on the Company’s financial
position, results of operations or cash flows.




*Change
in Control Agreement*




In
December 2002, the Board of Directors approved a Change in Control Agreement.
Under the terms of this agreement, key members of management are to receive a
severance package ranging between eight and twelve months salary in the event of
a change in control of the Company and termination of the employee.




*Guarantees
and Indemnifications*




The
following is a summary of our agreements that hawse have determined are within
the scope of Interpretation No. 45, or FIN 45, which are separately
grandfathered because the guarantees were in effect prior to December 31, 2002.
Accordingly, hawse have no liabilities recorded for these agreements as of
December 31, 2004.





As
permitted under Washington law and our by-laws and certificate of incorporation,
Aptimus has agreements whereby we indemnify our officers and directors for
certain events or occurrences while the officer or director is, or was serving,
at our request in such capacity. The term of the indemnification period is the
applicable statute of limitations for indemnifiable claims. The maximum
potential amount of future payments we could be required to make under these
indemnification agreements is unlimited; however, Aptimus has a directors’ and
officers’ insurance policy that may enable us to recover a portion of any future
amounts paid. Assuming the applicability of coverage and the willingness of the
insurer to assume coverage and subject to certain retention, loss limits and
other policy provisions, we believe the estimated fair value of this
indemnification obligation is not material. However, no assurances can be given
that the insurers will not attempt to dispute the validity, applicability or
amount of coverage, which attempts may result in expensive and time-consuming
litigation against the insurers.




Aptimus’
standard advertising client and distribution publisher contracts include
standard cross indemnification language that requires, among other things, that
we indemnify the client or publisher, as the case may be, for certain claims and
damages asserted by third-parties that arise out of Aptimus’ breach of the
contract. In the past, Aptimus has not been subject to any claims for such
losses and has thus not incurred any material costs in defending or settling
claims related to these indemnification obligations. Accordingly, we believe the
estimated fair value of these obligations is not material.




63




Pursuant
to these agreements, Aptimus may indemnify the other party for certain losses
suffered or incurred by the indemnified party in connection with various types
of third-party claims, which may include, claims of intellectual property
infringement, breach of contract and intentional acts in the performance of the
contract. The term of these indemnification obligations is generally limited to
the term of the contract at issue. In addition, Aptimus limits the maximum
potential amount of future payments we could be required to make under these
indemnification obligations to the consideration paid during a limited period of
time under the applicable contract, but in some infrequent cases the obligation
may not be so limited. In addition, our standard policy is to disclaim most
warranties, including any implied or statutory warranties such as warranties of
merchantability, fitness for a particular purpose, quality and non-infringement,
as well as any liability with respect to incidental, indirect, consequential,
special, exemplary, punitive or similar damages. In some states, such
disclaimers may not be enforceable. If necessary, the Company would provide for
the estimated cost of service warranties based on specific warranty claims and
claim history. Aptimus has not been subject to any claims for such losses and
has not incurred any costs in defending or settling claims related to these
indemnification obligations. Accordingly, we believe the estimated fair value of
these agreements is not material.




**10.
Shareholders’ equity**




*Preferred
stock*




Subject
to the provisions of the articles of incorporation and limitations prescribed by
law, the Board of Directors has the authority to issue, without further vote or
action by the shareholders, up to 6,814,516 additional shares of preferred stock
in one or more series.




In March
2002, the Board of Directors of Aptimus declared a dividend distribution of one
preferred share purchase right (a “right”) for each outstanding share of our
Common Stock. The dividend was payable to the stockholders of record on March
29, 2002. Each right entitles the registered holder to purchase form Aptimus one
one-thousandth of a share of Series C Preferred Stock at a price of $15 per one
one-thousandth of a Preferred Share. In the event of an acquisition, except
pursuant to a tender or exchange offer which is for all outstanding Common
Shares at a price and on terms which a majority of certain members of the Board
of Directors determines to be adequate, each holder of a right will thereafter
have the right to receive upon exercise the number of Common Shares or of one
one-thousandth of a share of Preferred Shares having a value equal to two times
the exercise price of the right. There were no transactions during 2002, 2003 or
2004 related to the rights.




*Common
stock*




In
October of 2002, 150,000 shares of common stock were issued to the Seattle
landlord as compensation for renegotiation of the then Seattle lease.
Compensation of $76,000 was recorded related to this issuance of stock and is
included in the lease renegotiation costs and abandonment of leasehold
improvements line of the statement of operations.




In
December 2003, 776,690 shares of unregistered common stock were issued to
investors at a price of $3.55 per share. Gross proceeds were $2.757 million with
costs of approximately $64,000, including $20,000 of compensation related to the
issuance of warrants. On December 4, 2003, the date this sale closed, the price
of our shares on the over-the-counter market was $4.65 per share. This sale was
priced at $3.55 as the negotiations were initiated in November 2003, when our
stock traded between $3.25 and $4.10, the shares were not registered, and the
sale was for a significant quantity of shares. These shares were subsequently
registered on November 12, 2004.




64





On March
30, 2004, the Convertible Promissory Note was converted into 381,250 shares of
unregistered common stock. These shares were subsequently registered on November
12, 2004.




*Warrants*




In July
of 2003, in connection with the issuance of the $305,000 convertible note
payable, Aptimus issued warrants for 127,095 shares of common stock. The
warrants are fully vested, have an exercise price of $0.50 per share and a term
of five years. Compensation related to the issuance of the warrants in the
amount of $46,000 was recorded as a discount and was being amortized to interest
expense over the life of the notes. On March 30, 2004, the Convertible
Promissory Note was converted into 381,250 shares of common stock. On conversion
of the Convertible Promissory Note, $35,000 of the $46,000 discount recorded
related to the warrants issued in connection with the Convertible Promissory
Note was reversed against paid in capital. The difference of $11,000 was
reported as interest expense, throughout the period the Convertible Promissory
Note was outstanding.




In
October of 2003, Aptimus issued a warrant to purchase 50,000 shares of common
stock for services. The warrant is fully vested, has an exercise price of $2.05
per share and a term of five years. Compensation related to the issuance of this
warrant in the amount of $78,000 was recorded and is include in equity based
compensation on the statement of operations.




In
December of 2003, Aptimus issued a warrant to purchase 5,634 shares of common
stock related to the sale of 776,690 shares of common stock. The warrant is
fully vested, has an exercise price of $5.00 per share and a term of five years.
Compensation related to the issuance of this warrant in the amount of $20,000
was recorded and is include as an offset to common stock in the balance
sheet.




In return
for various services, Aptimus has issued warrants to purchase shares of common
stock. At December 31, 2004, warrants outstanding are as follows:




**Year
      of issue**
    
    **Shares**
    
    **Exercise
      price**
    
    **Year
      of expiration**2003
    
    
    68,758
    
    $
    0.50
    
    
    20082003
    
    
    43,125
    
    $
    2.05
    
    
    20082003
    
    
    5,634
    
    $
    5.00
    
    
    2008





*Stock
options*




Effective
June 30, 1997, Aptimus approved the 1997 Stock Option Plan (the 1997 Plan) to
provide for the granting of stock options to employees, directors and
consultants of Aptimus to acquire ownership in Aptimus and provide them with
incentives for their service. As of December 31, 2004, under the terms of the
1997 Plan, 628,731 shares of common stock remain unissued and not subject to
options and have been reserved for issuance to plan participants.




Effective
June 12, 2001, the shareholders approved the 2001 Stock Plan (the 2001 Plan) to
provide for the granting of stock options and restricted stock to employees,
directors and consultants of Aptimus to provide them with incentives for their
service. As of December 31, 2004, under the terms of the 2001 Plan, 918,282
shares of common stock remain unissued and not subject to options and have been
reserved for issuance to plan participants.




65





The Plans
are administered by the Board of Directors of Aptimus, which determines the
terms and conditions of the options or restricted stock shares granted,
including exercise price, number of shares granted and the vesting period of
such shares. The maximum term of options is ten years from the date of grant.
The options are generally granted at the estimated fair value of the underlying
stock, as determined by the Board of Directors, on the date of grant. As of
December 31, 2004, options to purchase 628,731 and 918,282 shares of common
stock were available for future grant under the 1997 Plan and the 2001 Plan,
respectively. For the years ended December 31, 2002, 2003 and 2004, $1,000, zero
and zero, respectively, of deferred compensation was recorded for options and
restricted stock grants for which the exercise price was lower than the fair
market value at the date of grant. The deferred compensation recognized is
amortized over the vesting period of the related options in accordance with
Financial Accounting Standards Board interpretation No. 28. During the years
ended December 31, 2002, 2003 and 2004, no unamortized deferred compensation was
reversed due to forfeitures of options.




The
following table presents option activity under the Plans (in thousands, except
prices):







**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004****Shares**
    
    **WeightedAverage
      Exercise Price**
    
    **Shares**
    
    **WeightedAverage
      Exercise Price**
    
    **Shares**
    
    **WeightedAverage
      Exercise Price**Options
      outstanding at beginning of period
    
    
    1,235
    
    $
    1.88
    
    
    1,394
    
    $
    1.02
    
    
    1,522
    
    $
    1.98Options
      granted
    
    
    755
    
    
    0.76
    
    
    643
    
    
    0.42
    
    
    174
    
    
    9.32Options
      exercised
    
    
    124
    
    
    0.38
    
    
    228
    
    
    0.60
    
    
    303
    
    
    0.57Options
      forfeited
    
    
    472
    
    
    3.04
    
    
    287
    
    
    6.92
    
    
    17
    
    
    2.73Options
      outstanding at end of period
    
    
    1,394
    
    $
    1.02
    
    
    1,522
    
    $
    0.87
    
    
    1,376
    
    $
    1.98Weighted
      average fair value of options granted during the period
    
    
    
    
    $
    0.48
    
    
    
    
    $
    0.32
    
    
    
    
    $
    5.83




The
following table summarizes information about stock options outstanding under the
Plans at December 31, 2004 (in thousands, except prices and remaining
contractual life):




**Options
      outstanding**
    
    **Options
      exercisable******
    
    
    
    **Weighted
      average**
    
    ****
    
    ****
    
    ********
    
    
    
    **remaining**
    
    ****
    
    ****
    
    ******contractual**
    
    **Weighted
      average**
    
    
    
    **Weighted
      average******Range
      of****
    
    **Number
      of**
    
    **life**
    
    **exercise**
    
    ****Number
      of****
    
    **exercise******exercise
      prices****
    
    ****
      **shares**
    
    **(in
      years)**
    
    **price**
    
    **shares**
    
    **price**$0.00
    
    
    25
    
    
    8.6
    
    $
    0.00
    
    
    25
    
    $
    0.000.28
      — 0.82
    
    
    978
    
    
    7.4
    
    
    0.44
    
    
    901
    
    
    0.441.02
      — 1.95
    
    
    130
    
    
    6.0
    
    
    1.55
    
    
    113
    
    
    1.574.27
      — 6.90
    
    
    163
    
    
    7.9
    
    
    6.36
    
    
    82
    
    
    5.9910.00
      — 20.60
    
    
    80
    
    
    8.8
    
    
    13.27
    
    
    29
    
    
    11.781,376
    
    
    7.4
    
    $
    1.98
    
    
    1,150
    
    $
    1.23
  66





The
weighted average fair values and weighted average exercise prices per share at
the date of grant for options granted under the plans were as
follows:




****
    
    **Year
      ended December 31,******
    
    **Weighted
      average****fair
      value**
    
    **Weighted
      average****exercise
      price******
    
    **2002**
    
    **2003**
    
    **2004**
    
    **2002**
    
    **2003**
    
    **2004**Options
      granted with exercise prices less thanthe
      fair value of the stock on the date ofgrant
    
    $
    —
    
    $
    0.58
    
    $
    4.43
    
    $
    —
    
    $
    0.07
    
    $
    10.00Options
      granted with exercise prices equal to thefair
      value of the stock on the date of grant
    
    $
    0.48
    
    $
    0.31
    
    $
    6.36
    
    $
    0.76
    
    $
    0.44
    
    $
    9.06Options
      granted with exercise prices greater thanthe
      fair value of the stock on the date ofgrant
    
    $
    0.10
    
    $
    —
    
    $
    —
    
    $
    1.49
    
    $
    —
    
    $
    —


During
the years ended December 31, 2002, 2003 and 2004, Aptimus granted options to
purchase 6,000, 35,000, and zero shares of common stock, respectively, to
consultants and advisors.




Aptimus
follows SFAS No. 123 in accounting for options and warrants issued to
non-employees. During the years ended December 31, 2002 and 2003, we recognized
$1,000 and $8,000, respectively, of expense in connection with options issued to
consultants and advisors. Aptimus did not issue any options to non-employees
during the year ended December 31, 2004. In determining the fair value of the
options and warrants granted or issued to non-employees on the date of grant, we
used the Black-Scholes option-pricing model with the following
assumptions:




****
    
    **Year
      ended December 31,******
    
    **2002**
    
    **2003**
    
    **2004**Weighted
      average risk free interest rate
    
    
    1.75
    %
    
    2.53
    %
    
    N/AWeighted
      average expected life (in years)
    
    
    1.00
    
    
    4.00
    
    
    N/AVolatility
    
    
    100
    %
    
    100
    %
    
    N/ADividends
    
    
    none
    
    
    none
    
    
    N/A


**11.
Equity based compensation**





Amounts
included in the statement of operations for equity based compensation is as
follows, in thousands:


**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004**Sales
      and marketing
    
    $
    3
    
    $
    1
    
    $
    —Internet
      and network
    
    
    —
    
    
    —
    
    
    —Research
      and development
    
    
    —
    
    
    —
    
    
    —General
      and administrative
    
    
    8
    
    
    103
    
    
    —Total
      Equity-based compensation
    
    $
    11
    
    $
    104
    
    $
    —





67


****


**12.
Stock purchase plan**




Aptimus’
Board of Directors adopted the Employee Stock Purchase Plan (the Purchase Plan)
on April 17, 2000, under which two million shares have been reserved for
issuance. Under the Purchase Plan, eligible employees may purchase common stock
in an amount not to exceed 50% of the employees’ cash compensation or 1,800
shares per purchase period. The purchase price per share will be 85% of the
common stock fair value at the lower of certain plan-defined dates. Pursuant to
the Purchase Plan, 9,906 shares were purchased at a weighted average price of
$4.42 per share for the year ended December 31, 2004. No shares were purchased
under the Purchase Plan in the years ended December 31, 2002 and
2003.




**13.
Employee retirement plan**




During
1999, Aptimus established the Aptimus 401(k) plan, a tax-qualified savings and
retirement plan intended to qualify under Section 401 of the Internal Revenue
Code. All employees who satisfy the eligibility requirements relating to minimum
age and length of service are eligible to participate in the plan and may enter
the plan on the first day of any month after they become eligible to
participate. Participants may make pre-tax contributions to the plan of up to
50% of their eligible earnings, subject to a statutorily prescribed annual
limit. Aptimus may make matching contributions of up to 100% of the first 6% of
the compensation elected for contribution to the plan by an employee. Each
participant is fully vested in his or her contributions and the investment
earnings thereon, but vesting in any matching contributions by Aptimus takes
place over a period of five years. Aptimus has made no matching contributions to
the plan as of December 31, 2004.




**14.
Income taxes**




A current
provision for income taxes was not recorded for the years ended December 31,
2002, 2003 and 2004 due to taxable losses incurred in those years. In addition,
no benefit for income taxes has been recorded due to the uncertainty of the
realization of any tax assets. A valuation allowance has been recorded for
deferred tax assets because realization is primarily dependent on generating
sufficient taxable income prior to the expiration of net operating loss
carry-forwards.




The items
accounting for differences between income taxes computed at the federal
statutory rate and the provision (benefit) recorded for income taxes are as
follows:




**December
      31,****2002**
    
    **2003**
    
    **2004**Federal
      Statutory rate
    
    
    (34.00
    )%
    
    (34.00
    )%
    
    34.00
    %Stock
      based compensation
    
    
    (0.62
    )%
    
    (8.62
    )%
    
    (63.43
    )%Other
    
    
    0.04
    %
    
    0.27
    %
    
    0.14
    %(34.58
    )%
    
    (42.35
    )%
    
    (29.29
    )%Losses
      producing no current benefit
    
    
    34.58
    
    
    42.35
    
    
    29.29
    %Effective
      income tax rate
    
    
    0.00
    %
    
    0.00
    %
    
    0.00
    %




Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial statement purposes and
the amounts used for income tax purposes. Significant components of our deferred
tax assets and liabilities at December 31, 2003 and 2004 are as follows (in
thousands):




****
    
    **December
      31,******
    
    **2003**
    
    **2004**Deferred
      tax assets:Net
      operating loss carryforwards
    
    $
    20,222
    
    $
    22,396Write
      down of long-term investment
    
    
    103
    
    
    132Nondeductible
      allowances and accruals
    
    
    51
    
    
    99Expense
      related to stock options and warrants
    
    
    108
    
    
    78Total
      deferred tax assets
    
    
    20,484
    
    
    22,705Deferred
      tax liabilities:Difference
      between book and tax depreciation
    
    
    (48
    )
    
    (14
    )Net
      Deferred tax assets before valuation allowance
    
    
    20,436
    
    
    22,691Less:
      Valuation allowance
    
    
    (20,436
    )
    
    (22,691
    )$
    —
    
    $
    —





68





At
December 31, 2004, Aptimus had approximately $64.6 million of federal and $4.9
million of state net operating losses. The net operating loss carryforwards, if
not utilized, will begin to expire in 2012 for federal purposes and in 2010 for
California purposes. We determined that a change in ownership, as defined in the
Internal Revenue Code Section 382 and similar state provisions, has occurred and
may substantially limit the utilization of the net operating loss
carry-forwards. The annual limitation may result in the expiration of net
operating losses before utilization.


Approximately
$2.8 million of the valuation allowance is attributable to stock options, the
benefit of which will be credited to additional paid in capital when
realized.





**15.
Supplemental cash flow information**





The
following items are supplemental information required for the statement of cash
flows (in thousands):





**Year
      ended December 31,****2002**
    
    **2003**
    
    **2004**Cash
      paid during the period for interest
    
    $
    24
    
    $
    24
    
    $
    30Fixed
      assets acquired with capital leases
    
    $
    —
    
    $
    203
    
    $
    —





**16.
Quarterly financial information (unaudited)**





The
following table sets forth Aptimus’ unaudited quarterly financial information
for the years ending December 31, 2002, 2003, and 2004 (in thousands, except per
share data).




**Three
      months ended******
    
    **3/31/02**
    
    **6/30/02**
    
    **9/30/02**
    
    **12/31/02**Revenue
    
    $
    773
    
    $
    782
    
    $
    537
    
    $
    823Net
      loss
    
    $
    (1,297
    )
    $
    (1,486
    )
    $
    (2,000
    )
    $
    (721
    )Basic
      and diluted net loss per share
    
    $
    (0.33
    )
    $
    (0.37
    )
    $
    (0.49
    )
    $
    (0.17
    )





**Three
      months ended******
    
    **3/31/03**
    
    **6/30/03**
    
    **9/30/03**
    
    **12/31/03**Revenue
    
    $
    911
    
    $
    938
    
    $
    1,405
    
    $
    1,317Net
      loss
    
    $
    (604
    )
    $
    (437
    )
    $
    (273
    )
    $
    (197
    )Basic
      and diluted net loss per share
    
    $
    (0.14
    )
    $
    (0.10
    )
    $
    (0.06
    )
    $
    (0.04
    )





**Three
      months ended******
    
    **3/31/04**
    
    **6/30/04**
    
    **9/30/04**
    
    **12/31/04**Revenue
    
    $
    1,806
    
    $
    2,976
    
    $
    4,441
    
    $
    4,770Net
      income (loss)
    
    $
    (65
    )
    $
    300
    
    $
    901
    
    $
    990Basic
      net income (loss) per share
    
    $
    (0.01
    )
    $
    0.05
    
    $
    0.16
    
    $
    0.17Diluted
      net income (loss) per share
    
    $
    (0.01
    )
    $
    0.04
    
    $
    0.13
    
    $
    0.14





69




**17. 
Segment Information**




Statement
of Financial Accounting Standards (“SFAS”) No. 131, *Disclosures
about Segments of an Enterprise and Related Information,* establishes
standards for the manner in which public companies report information about
operating segments in annual and interim financial statements. It also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. The method for determining what
information to report is based on the way management organizes the operating
segments within the Company for making operating decisions and assessing
financial performance. Aptimus’ chief operating decision-maker is considered to
be our chief executive officer (“CEO”). The CEO reviews financial information
presented on an entity level basis for purposes of making operating decisions
and assessing financial performance. In addition the CEO also receives
disaggregated information about revenues by client, offer, web site publisher
and email list owner. The entity level financial information is identical to the
information presented in the accompanying statements of operations. Therefore,
Aptimus has determined that it operates in a single operating segment: results
based advertising services.




Aptimus
has no operations outside of the United States and no significant amount of
revenues are derived from outside of the United States.


****


**18. 
Subsequent Events**




In March
2005, the Company completed a $6 million private placement investment with seven
accredited investors. The Company sold the accredited investors 351,083 shares
of unregistered Aptimus, Inc. common stock at a price of $17.09 per share. In
connection with this sale warrants for an additional 95,494 shares of common
stock at a strike price of $20.22 were also issued to the
investors.




In March
2005, shares of our common stock (APTM) were re-listed on the NASDAQ National
Market Exchange.


****


70


****


**Item
9:** ***Changes
in and Disagreements with Accountants on Accounting and Financial
Disclosure***




Not
applicable.




**Item
9A:** ***Controls
And Procedures***




**(a)**  **Evaluation
of Disclosure Controls and Procedures**




Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated the effectiveness of
the design and operation of our disclosure controls and procedures (as defined
in Rule 13a-15(e) under the Exchange Act) as of December 31, 2004 (the
“Evaluation Date”). Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that, as of the Evaluation Date, our
disclosure controls and procedures were effective in timely alerting them to the
material information relating to us required to be included in our periodic SEC
filings and Form 8-K reports.




**(b)**  **Changes
in Internal Controls**




There
were no significant changes made in our internal controls during the period
covered by this report or, to our knowledge, in other factors that could
significantly affect these controls subsequent to the date of their
evaluation.




**Item
9B:** ***Other
Information***




None.


****


II-1


****


**PART
III**




**Item
10:** ***Directors
and Executive Officers of the Registrant***




Information
with respect to Directors may be found under the caption "Election of Directors
and Management Information" in the Company's Proxy Statement for the Annual
Meeting of Shareholders to be held June 8, 2005 (the "Proxy Statement"). Such
information is incorporated herein by reference.





Code of
Ethics





We have
adopted a Code of Ethics that applies to all directors, officers and employees
of Aptimus, Inc., including the Chief Executive Officer and Chief Financial
Officer. The key principles of the Code of Ethics are to act legally and with
integrity in all work for Aptimus, Inc. The Code of Ethics is posted on the
corporate governance page of our website at http://www.aptimus.com/ethics.shtml.
We will post any amendments to our Code of Ethics on our website. In the
unlikely event that the Board of Directors approves any sort of waiver to the
Code of Ethics for our executive officers or directors, information concerning
such waiver will also be posted on our website. In addition to posting
information regarding amendments and waivers on our website, the same
information will be included in a Current Report on Form 8-K within four
business days following the date of the amendment or waiver, unless website
posting of such amendments or waivers is permitted by the rules of The Nasdaq
Stock Market, Inc.





**Item
11: Executive Compensation**







The
information in the Proxy Statement set forth under the captions "Information
Regarding Executive Officer Compensation" and "Information Regarding the Board
and its Committees" is incorporated herein by reference.





**Item
12: Security Ownership of Certain Beneficial Owners and Management and related
Stockholder Matters**







The
information set forth under the caption "Information Regarding Beneficial
Ownership of Principal Shareholders, Directors, and Management" of the Proxy
Statement is incorporated herein by reference.





**Item
13: Certain Relationships and Related Transactions**







The
information set forth under the caption "Certain Relationships and Related
Transactions" of the Proxy Statement is incorporated herein by
reference.





**Item
14: Principle Accountant Fees and Services**




It is the
policy of the Company for the Audit Committee to pre-approve all audit, tax and
financial advisory services. All services rendered by Moss Adams were
pre-approved by the audit committee in the year ended December 31, 2004. The
aggregate fees billed by Moss Adams for professional services rendered for the
audit of the Company’s financial statements and other services were as
follows:




Year
      ended December 31,2003
    
    2004Audit
      fees
    
    $
    76,633
    
    $
    132,351Audit
      related fees
    
    $
    3,563
    
    $
    48,982Tax
      fees
    
    $
    8,492
    
    $
    17,713All
      other fees
    
    $
    —
    
    $
    —


II-2
 ****
 **PART
IV**


**Item
15.** ***Exhibits
and Financial Statement Schedules***




(a)1. *Financial
Statements*




The
following financial statements of the registrant and the Reports of our
Independent Registered Public Accounting Firm thereon are included herewith in
Item 8 above.




****
    
    **Page**Reports
      of Independent Registered Public Accounting Firm
    
    
    49Balance
      Sheet as of December 31, 2003 and 2004
    
    
    50Statement
      of Operations for the years ended December 31, 2002, 2003 and
      2004
    
    
    51Statement
      of Shareholders' Equity for the years endedDecember
      31, 2002, 2003 and 2004
    
    
    52Statement
      of Cash Flows for the years ended December 31, 2002, 2003 and
      2004
    
    
    53Notes
      to Financial Statements
    
    
    54





(a)2. *Financial
Statement Schedules*





**Schedule
      No.**
    **Description**1.1
    Valuation
      and Qualifying Accounts and Reserves 2002, 2003 and
2004





**Valuation
and Qualifying Accounts and Reserves 2002, 2003 and 2004**





****
      ****
    
    **Balance
      at**
      **beginning**
      **of
      period**
    
    **Charges
      to**
      **costs
      and**
      **expenses**
    
    **Charges
      to**
      **other**
      **accounts**
    
    ****
      ****
      **Deductions**
    
    **Balance
      at**
      **end
      of**
      **period**Year
      ended December 31, 2002 Allowance for doubtful
accounts
    
    
    68,000
    
    
    (2,361
    )
    
    —
    
    
    (10,361
    )
    
    76,000Tax
      valuation allowance
    
    
    18,234,233
    
    
    —
    
    
    2,765,767
    
    
    —
    
    
    21,000,000Year
      ended December 31, 2003 Allowance for doubtful
accounts
    
    
    76,000
    
    
    26,395
    
    
    —
    
    
    (41,395
    )
    
    61,000Tax
      valuation allowance
    
    
    21,000,000
    
    
    —
    
    
    (564,000
    )
    
    —
    
    
    20,436,000Year
      ended December 31, 2004 Allowance for doubtful
accounts
    
    
    61,000
    
    
    39,000
    
    
    —
    
    
    
    
    
    100,000Tax
      valuation allowance
    
    
    20,436,000
    
    
    —
    
    
    2,255
    
    
    
    
    
    22,691,000




II-3


**


*(a)3
Exhibits:*


**


**Exhibit**
      **Number**
    ****
      **Description**3.1*
    Second
      Amended and Restated Articles of Incorporation of
    registrant.3.1.1(2)
    Articles
      of Amendment filed September 16, 2000.3.1.2(6)
    Articles
      of Amendment filed March 29, 2002.3.2*
    Amended
      and Restated Bylaws of registrant.4.1*
    Specimen
      Stock Certificate.4.2*
    Form
      of Common Stock Warrant.4.3(3)
    Rights
      Agreement dated as of March 12, 2002 between registrant and Mellon
      Investor Services LLC, as rights agent.10.1*(8)
    Form
      of Indemnification Agreement between the registrant and each of its
      directors.10.2*(8)
    1997
      Stock Option Plan, as amended.10.3*(8)
    Form
      of Stock Option Agreement.10.4(1)(8)
    Aptimus,
      Inc. 2001 Stock Plan.10.4.1(2)(8)
    Form
      of Stock Option Agreement.10.4.2(2)(8)
    Form
      of Restricted Stock Agreement (for grants).10.4.3(2)(8)
    Form
      of Restricted Stock Agreement (for rights to purchase).10.5(4)(8)
    Change
      in Control Agreement, dated as of December 6, 2002, by and between
      registrant and Timothy C. Choate10.6(4)(8)
    Form
      of Change in Control Agreement, dated as of December 6, 2002, by and
      between registrant and each of certain executive managers of
      registrant10.7(5)
    Form
      of Convertible Note Purchase Agreement, dated as of July 1, 2003, by and
      between the Company and certain investors.10.8(5)
    Form
      of Convertible Secured Promissory Note, dated July 2003, executed by and
      between the Company and payable to the order of certain
      investors.10.9(5)
    Form
      of Common Stock Warrant, dated July 2003, by and between the Company and
      certain investors.10.10(5)
    Form
      of Security Agreement, dated as of July 1, 2003, by and between the
      Company and certain investors.10.11(5)
    Form
      of Registration Rights Agreement, dated as of July 1, 2003, by and between
      the Company and certain investors.10.12(10)
    Agreement
      of Lease, dated as of April 29, 2004, by and between Sixth and Virginia
      Properties and the Company.10.13(9)
    Stock
      Purchase Agreement, dated as of December 4, 2003, by and between the
      Company and certain investors.23.1
    Consent
      of Moss Adams LLP, Independent Registered Public Accounting
      Firm.31.1
    Rule
      13a-14(a) Certification of the Chief Executive Officer31.2
    Rule
      13a-14(a) Certification of the Chief Financial Officer32.1
    Section
      1350 Certification of the Chief Executive Officer32.2
    Section
      1350 Certification of the Chief Financial
Officer
 
 II-4
 __________
 
 *  Incorporated
by reference to the Company’s Registration Statement on Form S-1 (No.
333-81151).
 (1) Incorporated
by reference to the Company’s Proxy Statement on Schedule 14A, dated May 17,
2001.
 (2) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated November 14,
2001.
 (3) Incorporated
by reference to the Company’s Current Report on Form 8-K, dated March 12,
2002.
 (4) Incorporated
by reference to the Company’s Annual Report on Form 10-K, dated March 28,
2003.
 (5) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated August 14,
2003.
 (6) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated May 15,
2002.
 (7) Confidential
treatment has been granted as to certain portions of this Exhibit. Omitted
portions have been filed separately with the Securities and Exchange
Commission.
 (8) Management
compensation plan or agreement.
 (9) Incorporated
by reference to the Company’s Annual Report on Form 10-K, dated March 30,
2004
 (10) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated May 17,
2004.





II-5





**SIGNATURES**





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, Aptimus, Inc. has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





March 31, 2005
    APTIMUS,
  INC.By:
    /s/ TIMOTHY C. CHOATETimothy C. Choate,*Chief Executive
      Officer*




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report to be
signed by the following persons on behalf of the registrant in the capacities
and on the dates indicated.





**Signature**
    **Title**
    **Date**/s/TIMOTHY
      C. CHOATE
    Chairman
      of the Board,
    March
      31, 2005Timothy
      C. Choate
    President,
      Chief ExecutiveOfficer
      and Director/s/JOHN
      A. WADE
    Vice
      President, Finance
    March
      31, 2005John
      A. Wade
    Chief
      Financial Officer andChief
      Accounting Officer/s/JOHN
      B. BALOUSEK
    Director
    March
      31, 2005John
      B. Balousek/s/
      ERIC HELGELAND
    Director
    March
      31, 2005Eric
      Helgeland/s/ROBERT
      W. WRUBEL
    Director
    March
      31, 2005Robert
      W. Wrubel




II-6


****


**EXHIBITS
INDEX**


**Exhibit**
      **Number**
    ****
      **Description**3.1*
    Second
      Amended and Restated Articles of Incorporation of
    registrant.3.1.1(2)
    Articles
      of Amendment filed September 16, 2000.3.1.2(6)
    Articles
      of Amendment filed March 29, 2002.3.2*
    Amended
      and Restated Bylaws of registrant.4.1*
    Specimen
      Stock Certificate.4.2*
    Form
      of Common Stock Warrant.4.3(3)
    Rights
      Agreement dated as of March 12, 2002 between registrant and Mellon
      Investor Services LLC, as rights agent.10.1*(8)
    Form
      of Indemnification Agreement between the registrant and each of its
      directors.10.2*(8)
    1997
      Stock Option Plan, as amended.10.3*(8)
    Form
      of Stock Option Agreement.10.4(1)(8)
    Aptimus,
      Inc. 2001 Stock Plan.10.4.1(2)(8)
    Form
      of Stock Option Agreement.10.4.2(2)(8)
    Form
      of Restricted Stock Agreement (for grants).10.4.3(2)(8)
    Form
      of Restricted Stock Agreement (for rights to purchase).10.5(4)(8)
    Change
      in Control Agreement, dated as of December 6, 2002, by and between
      registrant and Timothy C. Choate10.6(4)(8)
    Form
      of Change in Control Agreement, dated as of December 6, 2002, by and
      between registrant and each of certain executive managers of
      registrant10.7(5)
    Form
      of Convertible Note Purchase Agreement, dated as of July 1, 2003, by and
      between the Company and certain investors.10.8(5)
    Form
      of Convertible Secured Promissory Note, dated July 2003, executed by and
      between the Company and payable to the order of certain
      investors.10.9(5)
    Form
      of Common Stock Warrant, dated July 2003, by and between the Company and
      certain investors.10.10(5)
    Form
      of Security Agreement, dated as of July 1, 2003, by and between the
      Company and certain investors.10.11(5)
    Form
      of Registration Rights Agreement, dated as of July 1, 2003, by and between
      the Company and certain investors.10.12(10)
    Agreement
      of Lease, dated as of April 29, 2004, by and between Sixth and Virginia
      Properties and the Company.10.13(9)
    Stock
      Purchase Agreement, dated as of December 4, 2003, by and between the
      Company and certain investors.23.1
    Consent
      of Moss Adams LLP, Independent Registered Public Accounting
      Firm.31.1
    Rule
      13a-14(a) Certification of the Chief Executive Officer31.2
    Rule
      13a-14(a) Certification of the Chief Financial Officer32.1
    Section
      1350 Certification of the Chief Executive Officer32.2
    Section
      1350 Certification of the Chief Financial
Officer
 
 II-7
 
 __________
 
 *  Incorporated
by reference to the Company’s Registration Statement on Form S-1 (No.
333-81151).
 (1) Incorporated
by reference to the Company’s Proxy Statement on Schedule 14A, dated May 17,
2001.
 (2) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated November 14,
2001.
 (3) Incorporated
by reference to the Company’s Current Report on Form 8-K, dated March 12,
2002.
 (4) Incorporated
by reference to the Company’s Annual Report on Form 10-K, dated March 28,
2003.
 (5) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated August 14,
2003.
 (6) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated May 15,
2002.
 (7) Confidential
treatment has been granted as to certain portions of this Exhibit. Omitted
portions have been filed separately with the Securities and Exchange
Commission.
 (8) Management
compensation plan or agreement.
 (9) Incorporated
by reference to the Company’s Annual Report on Form 10-K, dated March 30,
2004
 (10) Incorporated
by reference to the Company’s Quarterly Report on Form 10-Q, dated May 17,
2004.
  II-8