<PAGE>

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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                               ----------------
                                   FORM 10-K
(Mark One)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
   OF 1934
   For the fiscal year ended: December 31, 2000
                                       OR
[_]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 000-25977

                               ----------------
                               LIQUID AUDIO, INC.
             (Exact name of Registrant as specified in its charter)

<TABLE>
<CAPTION>
                     Delaware                                77-0421089
     <S>                                       <C>
         (State or other jurisdiction of       (I.R.S. Employer Identification Number)
          incorporation or organization)
<CAPTION>
      2221 Broadway Redwood City, California                    94063
     <S>                                       <C>
     (address of principal executive offices)                (zip code)
</TABLE>

       Registrant's telephone number, including area code: (650) 549-2000

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

   Securities registered pursuant to Section 12(g) of the Act: Common Stock,
                                $0.001 par value

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

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

   The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $44,919,341 as of December 31, 2000 based on the
closing price of the Common Stock as reported on The Nasdaq Stock Market for
that date. Shares of Common Stock held by each executive officer and director
and by each person who owns 5% or more of the outstanding Common Stock have
been excluded in that such persons may be deemed to be affiliates. The
determination of affiliate status is not necessarily a conclusive determination
for other purposes. There were 22,556,554 shares of the Registrant's Common
Stock issued and outstanding on March 14, 2001.

                      DOCUMENTS INCORPORATED BY REFERENCE
   Certain sections of Liquid Audio, Inc.'s definitive Proxy Statement for the
2001 Annual Meeting of Stockholders, scheduled to be held on June 1, 2001, are
incorporated by reference in Part III of this Form 10-K to the extent stated
herein.

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<PAGE>

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                          Page
                                                                          ----

                                     PART I

 <C>      <S>                                                             <C>
 ITEM 1.  BUSINESS......................................................    1
 ITEM 1A. COMPANY RISK FACTORS..........................................   12
 ITEM 2.  PROPERTIES....................................................   22
 ITEM 3.  LEGAL PROCEEDINGS.............................................   22
 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........   23

                                    PART II

 ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
          MATTERS.......................................................   24
 ITEM 6.  SELECTED FINANCIAL DATA.......................................   26
 ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
          AND RESULTS OF OPERATIONS.....................................   27
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....   35
 ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................   36
 ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
          AND FINANCIAL DISCLOSURE......................................   36

                                    PART III

 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   37
 ITEM 11. EXECUTIVE COMPENSATION........................................   41
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT....................................................   41
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   41

                                    PART IV

 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
          8-K...........................................................   42
</TABLE>
<PAGE>

                                     PART I

ITEM 1. BUSINESS

   This Annual Report on Form 10-K and the documents incorporated herein by
reference contain forward-looking statements that have been made in reliance on
the provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are based on current expectations, estimates and
projections about our industry, management's beliefs, and certain assumptions
made by management. Words such as "anticipates," "expects," "intends," "plans,"
"believes," "seeks" and "estimates" and similar expressions are intended to
identify forward-looking statements. These statements are not guarantees of
future performance and actual actions or results may differ materially. These
statements are subject to certain risks, uncertainties and assumptions that are
difficult to predict, including those noted in the documents incorporated
herein by reference. We undertake no obligation to update publicly any forward-
looking statements as a result of new information, future events or otherwise,
unless required by law. Readers should, however, carefully review the risk
factors included herein and in other reports or documents filed by us from time
to time with the Securities and Exchange Commission.

The Company

   We provide a leading open platform that enables the digital delivery of
music over the Internet. Our software products and services give artists and
record companies the ability to create, syndicate and sell recorded music with
copy protection and copyright management through websites and retailers.
Through our Liquid Music Network, a network of over 1,000 third party music
related websites and retailers, we help artists and record companies
distribute, promote and sell their recorded music. From the growing catalog of
syndicated music which is available through our Liquid Music Network affiliates
and online stores using our Retail Integration and Fulfillment System,
consumers can preview and purchase digital music. Consumers then can transfer
downloaded music to recordable compact discs and to digital audio devices
manufactured by consumer electronics companies. Our solution is based on an
open technical architecture that is designed to support multiple leading
digital music formats, including Liquid Audio, MP3 and Microsoft Windows Media.
Numerous record companies and recording artists have used our distribution
system to sell music, including labels such as Artemis Records, Avex, Inc., BMG
Entertainment, EMI Music Group, Warner Music Group and Zomba Records Group, and
artists such as David Bowie, Lenny Kravitz, Aimee Mann, "N SYNC and Britney
Spears.

The Liquid Audio Platform

   We provide a variety of products and services to enable the publication and
distribution, syndication, promotion and sale of downloadable digital music
files over the Internet:

  . Publication and Distribution. We offer services to encode content as
    secure digital music files and have the ability to encode up to
    approximately 20,000 individual music samples per day. Our system hosts
    digital music files and distributes them through a network of music
    websites.

  . Syndication. Our distribution system syndicates music content to a
    network of 1,000 affiliates that make up the Liquid Music Network,
    including music websites and websites operated by music retailers. In
    addition, our system enables digital music delivery through kiosks
    located in retail stores.

  . Promotion and Sale. We offer services to manage the secure promotion,
    transfer and sale of digital music, including reporting on digital music
    sales. Our Liquid Player software, a desktop software application, allows
    the consumer to preview or purchase and download digital recorded music.
    Liquid Player also enables the output of digital music to recordable
    compact discs and digital audio devices. To enable online sales, we
    provide a set of e-commerce services, including credit card processing,
    the remittance of royalty payments and detailed transaction reports. In
    addition, we provide promotional services that help build market
    awareness for content available through our network.

                                       1
<PAGE>

     Our solution provides the following benefits:

    . Increased Revenues and Lower Costs. Through our solution, record
      companies and artists can generate increased revenues by offering
      their entire catalog of existing music, as well as singles and
      periodic releases, for sale online. Our products and services provide
      a cost-effective way to digitally offer entire music catalogs to
      consumers, thus reducing the costs associated with physical
      manufacturing, warehousing and shipping.

    . Superior Consumer Experience. Our solution enables consumers to
      preview, purchase, download and export a wide variety of near compact
      disc quality music online. We make it simple to search for, sample
      and buy selected digital recorded music from a rapidly growing
      inventory. Our Liquid Player also enables digital music to be
      transferred to a compact disc by means of a recordable compact disc
      device and output to digital audio devices. We further simplify the
      user experience by supporting multiple music download formats,
      including Liquid Audio, Windows Media and MP3.

    . Security and Compliance. Our digital rights management (DRM) system
      protects against piracy by authenticating, limiting and tracking the
      number of copies made of a digitally delivered sound recording. Our
      platform also includes patented territory restriction capabilities
      that enable the sale over the Internet of digital recorded music in
      compliance with geographic distribution limitations.

    . Multiple Formats and Digital Rights Management Systems. Our multi-
      format distribution solution is based on an open architecture and can
      publish, syndicate and sell content using leading download formats,
      including Liquid Audio, Windows Media and MP3. We also support
      several leading DRM systems, including Liquid Audio, Windows Media
      and Sony OpenMG.

    . Global Reach. Our platform allows the Internet to be used as a global
      distribution channel for artists, record companies and retailers.
      This is particularly significant to independent record labels who
      have limited access to traditional retail distribution channels.

Strategic Relationships and Customers

   We plan to continue to build relationships with key third parties engaged in
the encoding, hosting, distribution, promotion, syndication and sale of digital
music. We believe that these relationships will enhance our ability to provide
a rich variety of music to consumers. Such relationships can be separated into
three major areas, the three C's--content, channel and consumer.

   Content Provider Relationships. In the content area, several labels make
music available for sale and promotion through our distribution system and
network.

  . BMG Entertainment. We entered into a digital music distribution agreement
    with BMG Entertainment whereby BMG will use our technology and
    distribution services to promote and sell albums from BMG's recording
    artists through Liquid Audio kiosks at participating retailers in the
    United States and Europe.

  . edel music. In Europe, we entered into a digital music distribution
    agreement with edel music whereby edel will use our technology and
    distribution services to promote and sell albums from edel's recording
    artists through kiosks at participating retailers.

  . EMI Recorded Music. Under an agreement with Virgin Holdings, Inc., an
    affiliate of EMI Recorded Music, in July 2000 we started to sell EMI
    songs and albums through designated music destination and retail sites,
    including CDNOW and towerrecords.com.

  . Warner Music Group. Under an agreement with Warner Music Group, in
    November 2000 we started to sell Warner songs and albums through our
    Liquid Music Network.

  . Zomba Records Group. Zomba has made songs and albums from some of the
    most popular artists available for sale through the Liquid Music Network.
    These artists include Britney Spears and "N SYNC.

                                       2
<PAGE>

  . Independent Labels. Many independent record labels have chosen to make
    their catalogs available online using our solution. These labels include
    Artemis Records, Avex, Beggars Banquet, Del-Fi Records, Rounder Records,
    Strictly Rhythm, Sub Pop Records, Twin/Tone Records and Vanguard Records.
    As of December 31, 2000, record labels have chosen to promote and sell
    more than 140,000 digital music recordings through our Liquid Music
    Network. This compares to approximately 50,000 digital music recordings
    at the beginning of 2000.

   Channel Partners. Our distribution channel has grown to 1,000 outlets,
including some of the most popular music websites.

  . Amazon.com. Under our agreement with Amazon.com, we are encoding, hosting
    and delivering promotional music downloads for the free downloads section
    of Amazon.com's music website, which is designed to increase compact disc
    sales.

  . Best Buy. Leading retailer Best Buy uses our Retail Integration and
    Fulfillment System (RIFFS) to sell music from our catalog of content on
    its bestbuy.com website.

  . CDNOW. CDNOW uses RIFFS to promote and sell digital music to consumers
    through its online retail website, cdnow.com. The website began offering
    music from our catalog of content for sale in February 2000.

  . Musicland. Musicland is using RIFFS for its destination sites,
    SamGoody.com, Suncoast.com, OnCue.com and MediaPlay.com, and started
    selling music from our catalog of content in August 2000.

  . Towerrecords.com. Under an agreement with its parent company MTS, Inc.,
    Tower Records is using RIFFS to promote and sell digital music to
    consumers through its online retail website, towerrecords.com. The
    website began offering music content for sale in October 1999.

  . Yahoo! Yahoo! Inc. has integrated Liquid Audio music samples using our
    music clips service on the Yahoo! Shopping and Yahoo! Music websites.

   Consumer Adoption. We distribute music to millions of consumers in concert
with technology companies whose innovative products complement our digital
music distribution system. These include the following:

  . AOL. We have developed a software "plug-in" that enables the AOL Nullsoft
    Winamp player software to purchase and play music encoded in our format.
    The plug-in will be distributed by AOL on the winamp.com website, its
    other websites and ours.

  . ARM. We have entered into an agreement with ARM to create a turnkey
    platform for the development of secure digital audio devices. We will
    work together to integrate our Secure Portable Player Platform (SP3) onto
    the ARM architecture. This integration will make it easier for consumer
    electronics and wireless device manufacturers to create new products,
    using the same chip set platforms they are already using, that support
    the playback of secure digital downloads distributed by us.

  . Microsoft. To maximize the number of consumers getting music through our
    distribution network, we added support for the Windows Media format. We
    encoded and distribute more than 50,000 songs and 1 million music
    previews in the Windows Media format. We deployed Windows Media-based
    servers in our data centers to host and distribute that content to
    retailers in our Liquid Music Network. We operate clearinghouse functions
    for the Windows Media DRM system and are adding support for Windows Media
    to Liquid Player.

  . RealNetworks Inc. We have developed software "plug-ins" that enable
    RealNetwork's RealPlayer G2 and RealJukebox software to play music
    encoded in our format. The plug-ins, which are distributed by
    RealNetworks, enable music in our Liquid Music Network to be previewed by
    RealPlayer G2 users and securely downloaded by RealJukebox users.

  . Sony. Sony delivers a custom-branded version of our Liquid Player
    software to consumers with certain compact disc recorder (CD-R) devices
    they sell in the United States and United Kingdom, as

                                       3
<PAGE>

   well as to customers of its VAIO Music Clip and Memory Stick Walkman
   devices. Additionally, we enable the distribution of content using Sony's
   ATRAC3 and OpenMG technologies.

  . Texas Instruments Inc. We collaborated with Texas Instruments to develop
    a reference design based on our SP3 specification for secure music
    delivery. Texas Instruments uses our SP3 reference design in chipsets to
    enable future flash memory-based consumer electronics devices to be
    compatible with our platform.

  . Digital Audio Device Manufacturers. We are also collaborating with the
    following companies to develop digital audio devices that interoperate
    with our SP3 specification:

<TABLE>
       <S>                                              <C>
       Aiwa                                             PocketPyro Porteson
       Digitalw@y Company, Ltd.                         RHAS TEL Company, Ltd.
       e.Digital Corporation                            Saewon Telecom Ltd.
       Haitai Electronics Co., Ltd.                     Sanyo Corporation
       IOData                                           RHAS TEL Company, Ltd.
       Jungmyung Telecom                                TDK
       Mpuls3                                           Toshiba Corporation
</TABLE>

International Relationships

   We believe that relationships with key partners outside the United States
are important to establish a complementary international distribution
infrastructure. Because personal computers have not achieved high levels of
penetration in most international markets, our emphasis in these markets has
been and will continue to be on enabling the distribution of digital music
through physical kiosks and other consumer-oriented technologies. Our
international relationships include the following:

  . Liquid Audio Europe. We formed a wholly-owned subsidiary based in London.
    Liquid Audio Europe is focused on selling our products and services to
    markets in the United Kingdom, France, German, Italy and other European
    countries. Several customers in Europe have adopted RIFFS.

  . Liquid Audio Japan. In Japan, along with local investors, we established
    Liquid Audio Japan. Liquid Audio Japan is the exclusive reseller and
    distributor of our software products, and the exclusive music
    distribution services provider, in Japan.

  . Liquid Audio Korea. In Korea, Liquid Audio and local partners established
    Liquid Audio Korea in 1998. Liquid Audio Korea is currently focused on
    kiosk-based retail applications of our technology. These applications
    allow consumers to preview and purchase custom compact discs and other
    transportable media from retail entertainment centers. Liquid Audio Korea
    released these kiosks in the first retail entertainment center in October
    1999.

  . Liquid Audio Greater China. For the Hong Kong and Taiwan markets, Liquid
    Audio and local partners established Liquid Audio Greater China in 2000.
    Liquid Audio Greater China and its subsidiaries have the opportunity to
    deploy and resell Liquid Audio's secure music delivery services and
    software products in Hong Kong and Taiwan.

  . Liquid Audio South East Asia. In south east Asia, Liquid Audio and a
    local partner are in the process of establishing Liquid Audio South East
    Asia. Liquid Audio South East Asia will form affiliates in Singapore,
    Thailand, the Philippines, Australia and New Zealand. We expect these
    affiliates to be the exclusive reseller of our software products, and the
    exclusive music distribution services provider, in those local markets.

                                       4
<PAGE>

Customers

   We license our software and services to a variety of customers from various
market segments. A selected list of our customers includes the following, each
of which accounted for more than $10,000 of our revenues in 2000:

<TABLE>
       <S>                                               <C>
       BMG North America                                 Microsoft
       Cube                                              Napster
       Duty Free Shops                                   Random House
       EMI Music Distribution                            Sony Electronics Inc.
       HMV                                               Sony UK
       Launch.com                                        Tower Records
</TABLE>

   In 1998, SKM Group accounted for 34% of our total net revenues. In 1999,
Adaptec, Super Stage and Liquid Audio Korea accounted for 31%, 30% and 12% of
our total net revenues, respectively. In 2000, Liquid Audio Japan and Liquid
Audio South East Asia through our strategic partner accounted for 42% and 11%
of our total net revenues, respectively.

   Promotional Relationships. Numerous record labels and recording artists have
used our products and services to promote new releases and create consumer
awareness. These mutually beneficial promotional efforts have generated little
or no direct revenue for us, individually or in the aggregate. The following
table represents a partial list of artists and record labels for whom we have
provided promotional services:

                                 Record Labels

--------------------------------------------------------------------------------
<TABLE>
   <S>                     <C>                          <C>
   Angel Records           Arista Records Inc.          Atlantic Records
   Blue Note Records       Capitol Records              Dreamworks Records
   Elektra Records         EMI Recorded Music           Epic Records
   Geffen Records          Giant/Revolution             GRP
   Hollywood Records       Interscope Records           Island Records/Def Jam
   Jive                    LaFace Records               Maverick Records
   MCA Records             Mercury Nashville            RCA Records
   Reprise Records         Rhino Records                Smithsonian Folkways
   Tommy Boy Records       TVT Records                  V2 Records
   Virgin                  Warner Music Group           Wind-up Entertainment
   Zomba Records Group


                               Recording Artists

------------------------------------------------------------------------------
   Aaron Neville           Al Jarreau                   Alanis Morissette
   A Perfect Circle        Beck                         Ben Harper
   Brian Setzer Orchestra  Britney Spears               Carlos Santana
   Creed                   Crosby, Stills, Nash & Young The Dave Matthews Band
   David Bowie             Duran Duran                  Elton John
   Emmylou Harris          Enya                         Everclear
   Faith Hill              Hanson                       (Hed) Planet Earth
   Herbie Hancock          Hole                         Jamie O'Neal
   Jimi Hendrix            Joni Mitchell                Kenny G
   Led Zeppelin            Lee Ann Womack               Lenny Kravitz
   Madonna                 matchbox twenty              Moby
   Natalie Merchant        Nelly Furtado                N'SYNCH
   Page/Plant              P.O.D.                       Sarah McLachlan
   Scorpions               Sinead O'Connor              Snoop Dog
   Tori Amos               XTC
</TABLE>


                                       5
<PAGE>

Products and Services

   Our platform includes software products and services that enable the secure
digital delivery and sale of recorded music over the Internet. Our products and
services can be separated into three major areas: publishing and distribution,
syndication and consumer delivery.

Publishing and Distribution

   Encoding Services. These services prepare music by artists and record
companies for publishing. We use software tools to set rules by which the
content can be used by consumers. Such software tools use security features,
including digital rights management (DRM), encryption and watermarking, to
provide copy protection. Our software tools also enable us to attach
descriptive text, such as lyrics or album liner notes, graphics such as compact
disc cover art, and copyright information to the music file. These are scalable
services and we have developed an automated high capacity encoding production
service that is currently able to encode up to approximately 20,000 individual
sample sound recordings per day.

   Hosting Services. These services can store and serve digital music for
recording artists and labels. Content owners can use our services to feature
music links on their websites and promote and sell music. Since launching these
services in December 1997, more than 10,800 artists have used our hosting
services. These artists have made more than 140,000 songs available for
downloading either through the Liquid Music Network or their own websites.

   Distribution Services. Content owners can leverage our distribution services
to deliver music through a network of more than 1,000 affiliates that offer our
music. They can also leverage these services to begin selling their music from
their own website.

   Promotion Services. We provide promotional services that leverage the
Internet to help build awareness of artists and increase consumer traffic to
retail and music sites. Liquid Promotions include Internet advertisements,
promotional Internet events such as Liquid Live performances and featured
placement of artists' music on hundreds of websites.

   Clearinghouse Services. Through our multi-format clearinghouse, we can clear
online financial transactions and manage rights reporting for music downloads
that are protected by either the Liquid Audio or Windows Media DRM solutions.
Our clearinghouse tracks streaming, downloading and purchase information and
records it in tamper-resistant logs. This information is used for commerce
management and to generate reports and invoices for the appropriate copyright
owners.

   Music Meeting. Music Meeting is an Internet music auditioning service for
radio stations. We have partnered with Radio & Records (R&R) to develop,
promote and sell this service, which permits radio stations to retrieve
promotional copies of new songs via real-time stream or secure digital download
from the R&R ONLINE website. Using our digital music delivery software, Music
Meeting allows a radio station program director to audition and download new
music, organize new releases and get updates on a record's airplay progress via
R&R's various music charts. This service began in January 2001.

Syndication

   Liquid Store. The Liquid Music Network, launched in July 1998, is a music
distribution network of more than 1,000 affiliates including music-related and
retail websites. We provide these music-related websites with the Liquid Store,
a ready-made online music store, including its own shopping cart, through which
consumers can preview, purchase and download digital recorded music from our
catalog of content. Liquid Music Network affiliates simply sign up for the
service and add hyperlinks to their home page to begin selling digital music.

   Retail Integration and Fulfillment System (RIFFS). Liquid Audio's RIFFS
solution enables the sale of secure digital music through existing e-commerce
websites. RIFFS enables online retailers to seamlessly sell

                                       6
<PAGE>

our music catalog right alongside physical goods through their existing
shopping carts. Participating retailers can merchandise and offer any of the
music downloads we distribute. We host the music and transparently fulfill
digital delivery to the consumer. Regular reports let websites track download
and sales activity.

   Liquid Commerce. For websites that have a search engine but are not e-
commerce enabled, we offer a pre-built online shopping cart that websites can
use to custom brand and leverage to sell music. Websites can supplement their
existing content with music from our catalog of content.

   Digital Music Kiosks. We provide retailers with the ability to digitally
deliver music in brick-and-mortar stores using our platform through kiosks
located in entertainment centers or other retail locations. These digital music
kiosks let consumers preview and purchase custom compilations of songs and
transfer them to a personalized compact disc right in the store. The first
kiosk installation opened in Korea in October 1999. We have also sold kiosks to
customers in the United States, United Kingdom, Austria, Japan and Singapore.

Consumer Delivery

   Liquid Player. Our Liquid Player is a consumer desktop software application
that enables users to stream, download and purchase digital music. To enhance
the consumer experience, our Liquid Player presents lyrics, liner notes and
album art with the music. Once content is downloaded, our Liquid Player can be
used to organize the content into playlists. Our Liquid Player can be easily
customized with faceplates to tie into the logo and branding of our partners'
websites and is available for both PC and Macintosh platforms. The product can
be downloaded free of charge from our website and currently is distributed by
the hundreds of websites in our Liquid Music Network. An enhanced version of
the product, Liquid Player Plus, adds capabilities for transferring digital
music to a recordable compact disc or outputting music to digital audio devices
for later playback. Delivered in 2000, Liquid Player Plus is the first Secure
Digital Music Initiative (SDMI) compliant digital music solution for original
equipment manufacturers (OEMs) who license the product for a fee to bundle with
their products, including digital audio devices, CD-R devices and personal
computers. SDMI is sponsored by the Recording Industry Association of America
(RIAA) to develop an open standard for the secure digital delivery and use of
recorded music.

   Plug-ins. To expand our consumer base, we integrate our music delivery
system with those from several of our partners. We provide plug-in software for
AOL WinAmp, RealNetworks RealPlayer and RealJukebox to enable consumers using
these software products to preview and purchase content we distribute.

Technology

   We have developed a technology platform and systems infrastructure that is
designed to optimize the digital delivery of music. Our platform is based on
four principal technology layers: component technologies, system technologies,
network services and content syndication. We have developed and deployed
technology in all of these layers to provide specific advantages for our music
delivery products and services. We have invested significant amounts toward
research and development to date. Our expenses in this area totaled
approximately $4.1 million, $11.7 million and $22.9 million in 1998, 1999 and
2000, respectively.

   Component Technologies. Our platform begins with component technologies,
which include digital rights management, portable device platform, multi-format
distribution container, watermarking and audio compression.

  . Digital Rights Management (DRM). Our DRM solution protects content
    delivered online through a digital identification and rights reporting
    system. Consumers can use our FastTrack Security technology to enjoy
    secure music on one computer or use our Liquid Passport to move their
    music to multiple machines while still providing anti-piracy protections.

  . Consumer Electronics Technology. Our Secure Portable Player Platform
    (SP3) provides content management and protection technology for consumer
    electronic devices. We have developed specific

                                       7
<PAGE>

   technologies to enable music to be securely copied to portable digital
   audio devices. The SP3 system also provides a technology interface that
   facilitates compatibility with other digital rights management systems.

  . Multi-Format Distribution Container. We have developed a master media
    container that facilitates the delivery of media through our system. This
    container structure is designed to permit extension to other media types,
    such as third-party formats or video. The container is optimized for
    music distribution and includes multiple images that can be used to
    preview and purchase media content in multiple formats including Liquid
    Audio, MP3 and soon, Windows Media, and at multiple resolutions. The
    multi-format nature of the container also facilitates compatibility
    across systems. This container also facilitates the real-time insertion
    of information such advertising and promotions.

  . Watermarking. Watermarking embeds indelible and inaudible digital
    information into the audio waveform. We have developed our own
    watermarking technology that is specifically designed to operate in
    conjunction with compression technologies. The embedded information is
    useful for identifying and tracking audio usage and cannot be removed
    without destroying the recorded music.

  . Audio Compression. Audio compression reduces the bandwidth required to
    stream and download music over network connections. Our format-neutral
    music distribution system supports the delivery of music using several
    leading compression technologies: Dolby Digital AC-3, AAC, Sony ATRAC3,
    MS-Audio and MP3. We have developed a version of Dolby Digital technology
    (AC-3) that is optimized for online music distribution. We have also
    added extensions to the AAC audio compression technology that further
    improve audio quality. In addition, we have developed an exclusive,
    proprietary lossless compression algorithm that is useful for
    professional audio applications.

   System Technologies. Our system technologies build on top of the base
features provided through our component technologies to enable our digital
music delivery services.

  . Liquid Server. Our Liquid Server software is the heart of our platform
    and manages and delivers encoded music files for streaming or
    downloading. We have built transaction, security and copyright management
    functionality into the Liquid Server. We have integrated this software
    with a variety of e-commerce and database software applications so that a
    large volume of digital music and associated information can be securely
    sold or distributed through the Internet.

  . Territory Restrictions. We have been awarded a patent by the U.S. Patent
    Office for the territory restrictions capabilities in our platform. This
    technology identifies the approximate geographic location of consumers.
    We use this technology to enforce rules for content access related to
    territory. This enforcement is necessary since complex worldwide music
    licensing arrangements often preclude the sale of some content in
    specific territories.

  . Open Interfaces. We have developed interfaces to third-party systems for
    commerce, databases and general purpose media delivery. Our commerce
    interfaces allow our platform to take advantage of many payment methods
    from credit cards to micro-payment solutions. The database interfaces
    allow our system to dynamically update time sensitive information, such
    as pricing, without requiring expensive re-encoding of content. Our
    third-party system interfaces permit us to connect and provide
    compatibility with general purpose media delivery systems such as those
    provided by RealNetworks and Microsoft Corporation.

  . Secure Protocols. We have created secure protocols for communication
    between all parts of the system. Secure communications are necessary to
    prevent theft of content as it moves through the system. Secure links
    exist between the Liquid Server and content creation tools for
    publishing, the server and Liquid Player for consumer downloading, and
    the server and clearinghouse for transaction reporting.

  . Device Interfaces. We have developed SP3, which provides a set of
    security interfaces and techniques for secure digital audio devices. SP3
    is an open specification for use by many device manufacturers. SP3 is
    consistent with the goals of the SDMI and is in use by several leading
    device manufactures.

                                       8
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   Network Services and Content Syndication. The implementation of our
component and system technologies enables us to provide our network services
and content syndication offerings. Our network services are driven out of the
Liquid Operations Center, which operates primarily as a processing, security,
copyright management and rights reporting center. Our content syndication
services encompass RIFFS, the Liquid Store and kiosks.

   We believe that our technology architecture and our advanced stage of
development and deployment provide distinct competitive advantages. We are
currently developing the sixth generation of our digital music delivery
products. The advantages of our technology are summarized below:

  . Content Distribution Technology. We have developed systems and technology
    to manage the distribution of content to online merchants such as
    retailers and service providers. This distribution technology automates
    and controls the terms for which content is made available to consumers
    via online retailers and service providers. This system also provides
    distribution tracking that facilitates customer support for online
    merchants.

  . Automated Encoding, Publication and Content Management. We have created
    technologies that improve the efficiency of online music distribution and
    reduce operating costs. Our content encoding system allows us to format
    large amounts of quality audio content for online use in a timely and
    cost effective manner. We also have developed a content management system
    that automates the services that are necessary for content creators to
    publish and manage their content. We have also developed database
    technology that permits us to manage the large volume of content in our
    distribution system.

  . Open Technical Architecture. An open system design is important because
    standard formats are not yet available for online music distribution. Our
    technology has been designed to provide an open and flexible solution
    that can adapt to many competing compression technologies and formats,
    including Sony ATRAC3, MP3 and soon, Microsoft Windows Media, as well as
    future changes that may occur in digital music distribution. Our open
    system design allows the integration of new technologies while
    maintaining compatibility with existing content. In addition, our
    flexible architecture allows us to continue to integrate technologies
    such as audio compression and audio watermarking as they continue to
    improve in the future.

  . Robust and Scalable System Architecture. A comprehensive and robust
    system architecture is important to meet the demands that may result from
    large scale consumer adoption. We have developed a broad range of
    technologies that enables efficient music distribution services. We have
    developed specific technologies that permit our system to scale across
    multiple systems and locations. This technology provides unique
    advantages for efficiently delivering music and other media to a global
    audience. We have also developed technology that allows us to extend our
    system beyond online applications to include physical locations for sales
    of music via kiosks, broadening our reach to include both online and
    traditional consumers.

  . Superior Audio Quality. We believe consumers will pay for quality music,
    and we believe that we have consistently provided superior audio quality
    for digital music. We employ specific techniques and optimize industry
    algorithms to improve sound quality. We believe that our use of
    standardized compression algorithms such as AAC, MP3 and soon, Windows
    Media, provides greater compatibility than proprietary audio compression
    solutions.

Sales and Marketing

   Our sales and marketing efforts are principally concentrated on selling our
products and services, developing complementary business opportunities,
aggregating digital music recordings for syndication and sale, and broadening
our content syndication reach by expanding the number and geographic reach of
music and retail websites in our Liquid Music Network. We sell our products and
services to artists, record companies, websites and online retailers through a
62-person sales and marketing organization. These employees are located in
Redwood City, Los Angeles, New York and London. Our software products and

                                       9
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services are also bundled and distributed by third-party manufacturers of
various computer hardware and software products.

   We use a variety of marketing programs to create market awareness and
generate demand for our products and services. Our marketing activities include
event-based promotions with popular recording artists and record labels, web
advertising and sponsorships, press tours, participation in trade events and
conferences, and other public relations activities.

   In addition to maintaining relationships with worldwide rights societies and
expanding the distribution opportunities for our products and services, our
business development group works to develop new international markets and
business opportunities for our products and services. We believe that
establishing strategic relationships in each of the major international markets
will accelerate the international deployment of our products and services.

Intellectual Property

   Our success will depend in part on our ability to protect our proprietary
software and other intellectual property. To protect our proprietary rights we
rely generally on patent, copyright, trademark and trade secret laws,
confidentiality agreements with employees and third parties, and license
agreements with consultants, vendors and customers. Despite these protections a
third party could, without authorization, copy or otherwise obtain and use our
products or technology to develop similar technology independently.

   Our agreements with employees, consultants and others who participate in
product and service development activities may be breached, we may not have
adequate remedies for any breach, and our trade secrets may become known or
independently developed by competitors.

   We currently have 17 patents pending in the United States and four patents
pending in other countries relating to our product architecture and technology
and hold seven patents. Those patents expire between October 2015 and October
2018. We have had claims allowed on two of our patent applications. Any pending
or future patent applications may not be granted, existing or future patents
may be challenged, invalidated or circumvented, and the rights granted under a
patent that has issued or any patent that may issue may not provide competitive
advantages to us. Many of our current and potential competitors dedicate
substantially greater resources to protection and enforcement of intellectual
property rights, especially patents. If a blocking patent has issued or issues
in the future, we would need either to obtain a license or to design around the
patent. We may not be able to obtain a required license on acceptable terms, if
at all, or to design around the patent. See "Legal Proceedings."

   We pursue the registration of our trademarks and service marks in the United
States and in other countries, although we have not secured registration of all
our marks. A significant portion of our marks begin with the word "Liquid." We
are aware of other companies that use "Liquid" in their marks, alone or in
combination with other words, and we do not expect to be able to prevent all
third-party uses of the word "Liquid." In addition, the laws of some foreign
countries do not protect our proprietary rights to the same extent as do the
laws of the U.S., and effective patent, copyright, trademark and trade secret
protection may not be available in these jurisdictions. We license our
proprietary rights to third parties, and these licensees may fail to abide by
compliance and quality control guidelines with respect to our proprietary
rights or take actions that would harm our business.

   To license many of our products, we rely in part on "shrinkwrap" and
"clickwrap" licenses that are not signed by the end user and, therefore, may be
unenforceable under the laws of certain jurisdictions. As with other software
products, our products are susceptible to unauthorized copying and uses that
may go undetected. Policing unauthorized use is difficult.

   We attempt to avoid infringing known proprietary rights of third parties in
our product and service development efforts. We have not, however, conducted,
and do not conduct comprehensive patent searches to

                                       10
<PAGE>

determine whether the technology used in our products infringes patents held
by third parties. In addition, it is difficult to proceed with certainty in a
rapidly evolving technological environment in which there may be numerous
patent applications pending, many of which are confidential when filed, with
regard to similar technologies. If we were to discover that our products
violate third-party proprietary rights, we might not be able to obtain
licenses to continue offering these products without substantial
reengineering. Effort to undertake this reengineering might not be successful,
licenses might be unavailable on commercially reasonable terms, if at all, and
litigation might not be avoided or settled without substantial expense and
damage awards.

   Any claims relating to the infringement of third-party proprietary rights,
even if not meritorious, could result in the expenditure of significant
financial and managerial resources and could result in injunctions preventing
us from distributing certain products and services. These claims could harm
our business. We also rely on technology that we license from third parties,
including software that is integrated with internally developed software and
used in our products and services, to perform key functions. Third-party
technology licenses may not continue to be available to us on commercially
reasonable terms. The loss of any of these technologies could harm our
business. Moreover, although we are generally indemnified against claims that
third-party technology infringes the proprietary rights of others, this
indemnification may be unavailable for all types of intellectual property
rights, for example, patents may be excluded, and in some cases the scope of
indemnification is limited. Even if we receive broad indemnification, third-
party indemnitors are not always well capitalized and may not be able to
indemnify us in the event of infringement, resulting in substantial exposure
to us. Infringement or invalidity claims may arise from the incorporation of
third-party technology, and our customers may make claims for indemnification.
These claims, even if not meritorious, could result in the expenditure of
significant financial and managerial resources in addition to potential
product and service redevelopment costs and delays, all of which could harm
our business. Sightsound, Inc. and Intouch Group, Inc. have recently claimed
that our products infringe their patent rights. See "Legal Proceedings."

Competition

   Competition among companies in the business of delivering digital music
over the Internet is intense. We compete against a number of technology
companies that are offering or plan to offer products, services or
technologies for the delivery of digital music over the Internet. The number
of websites competing for the attention and spending of consumers and
advertisers has increased, and we expect it to continue to increase. We may
also compete with consumer electronics companies as they begin to market
Internet music player devices. New or current competitors may emerge that are
more successful than us. See "Company Risk Factors--The Market for Digital
Delivery of Music Over the Internet is Highly Competitive, and if We Cannot
Compete Effectively, Our Revenues Might Decline."

   We compete with providers of infrastructure technology, products and
services such as Preview Systems, SuperTracks and Loudeye Technologies, and
aggregators of digital music content for delivery over the Internet and kiosks
such as eMusic, Amplified.com and RedDot.net.

   We believe that the primary competitive factors in our market are the
following:

  . price and cost of products and services;

  . quantity and variety of digital recorded music content;

  . ease of consumer experience;

  . the number and quality of music-related and retail websites;

  . brand awareness;

  . ability to adapt to changes in component technologies and consumer
    preferences;

  . fidelity and quality of sound of digital recorded music; and

  . ability to ensure secure digital delivery of recorded music.

                                      11
<PAGE>

   We believe our products and services offer significant advantages over those
of our competitors:

  . our music catalog features over 10,800 artists and 1,200 individual
    record labels. We believe that we offer more artists and more labels than
    most digital music distribution services;

  . through our Liquid Music Network, we believe we have the potential to
    reach more music consumers than other digital music delivery solutions;

  . our platform offers better copy protection and copyright management than
    Windows Media or MP3-based solutions;

  . our open architecture will allow us to adapt to changing component
    technologies; and

  . the fidelity and sound quality of music encoded by our products and
    services are superior to competitive systems due to optimizations we
    perform on audio compression technologies used in our products and
    services.

   Additionally, music community websites, such as Napster and MP3.com, may
attract consumers who want to download music from the Internet. These websites
compete directly with our affiliates. To the extent that consumers download
digital music from these websites rather than from our affiliates, our business
may be harmed. Additionally, some of these music community websites are
developing business models that compete directly with us, whereby they will
also provide infrastructure technology and aggregate digital music content for
delivery over the Internet. To the extent that retailers choose such websites
for the distribution technology and aggregated content rather than ours, our
business may be harmed. Finally, there are other companies, such as IBM,
Microsoft, RealNetworks and InterTrust Technologies Corporation, that provide
component software technologies that facilitate the digital delivery of goods
over the Internet, including music. To the extent that the market standardizes
on these technologies and we are unable to incorporate these components into
our music delivery services, our business may be harmed.

Employees

   As of December 31, 2000, we had 218 full-time employees, including 62 in
sales and marketing, 86 in research and development, 37 in general and
administrative and 33 in operations. We consider our relationships with
employees to be good. None of our employees is covered by collective bargaining
agreements.

ITEM 1A. COMPANY RISK FACTORS

Our Limited Operating History in the New Market of Digital Delivery of Music
over the Internet Increases the Possibility that the Value of Your Investment
Will Decline

   We incorporated in January 1996. We did not start generating revenues until
the first quarter of 1997. In early 1999 we began to place greater emphasis on
developing and marketing our digital music delivery services. Accordingly, we
are still in the early stages of development and have only a limited operating
history upon which you can evaluate our business. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses, delays and difficulties associated with starting a new
business, many of which may be beyond our control.

We Have a History of Losses, We Expect Losses to Continue and We Might Not
Achieve or Maintain Profitability

   Our accumulated deficit as of December 31, 2000 was approximately $73.9
million. We had net losses of approximately $24.2 million and $33.7 million in
1999 and 2000, respectively. Given the level of our planned operating and
capital expenditures, we expect to continue to incur losses and negative cash
flows through at least 2002. Even if we ultimately do achieve profitability, we
may not be able to sustain or increase profitability on a quarterly or annual
basis. If our revenues grow more slowly than we anticipate, or if our operating

                                       12
<PAGE>

expenses exceed our expectations and cannot be adjusted accordingly, our
business will be harmed. See "Selected Financial Data" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

Fluctuations in Our Quarterly Revenues and Operating Results Might Lead to
Reduced Prices for Our Stock

   Our quarterly results of operations have varied in the past, and you should
not rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In some future periods, our results of
operations are likely to be below the expectations of public market analysts
and investors. In this event, the price of our common stock would likely
decline. Factors that have caused our results to fluctuate in the past and that
are likely to affect us in the future include the following:

  . competition for consumers from traditional retailers as well as providers
    of online music services;

  . the announcement and introduction of new products and services by us and
    our competitors;

  . our ability to increase the number of websites that will use our platform
    for digital music delivery;

  . the timing of our partners' introduction of new products and services for
    digital music sales; and

  . variability and length of the sales cycle associated with our product and
    service offerings.

   In addition, other factors may also affect us, including:

  . market adoption and growth of sales of digitally downloaded recorded
    music over the Internet;

  . our ability to attract significant numbers of music recordings to be
    syndicated in our format;

  . our ability to provide reliable and scalable service, including our
    ability to avoid potential system failures;

  . market acceptance of new and enhanced versions of our products and
    services; and

  . the price and mix of products and services we offer.

   Some of these factors are within our control and others are outside of our
control.

Several of Our Customers Have Had Limited Operating Histories, Are Unprofitable
and Might Have Difficulty Meeting Their Payment Obligations to Us

   Several of our significant customers, including our international partners
Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid
Audio South East Asia through our strategic partner, have had limited operating
histories and have not achieved profitability. We believe that this will be
true of other customers in the future. As of December 31, 2000, 60% and 96% of
our trade accounts receivable and receivables from related parties,
respectively, or $789,000 and $1.2 million, respectively, were more than 30
days past due. You should evaluate the ability of these companies to meet their
payment obligations to us in light of the risks, expenses and difficulties
encountered by companies with limited operating histories. If one or more of
our customers were unable to pay for our services in the future, or paid more
slowly than we anticipate, recognition of revenue might be delayed and our
business might be harmed.

If Our Relationships with Our International Partners Terminate, Our Revenues
Might Decline

   We derive a portion of our revenues from business development fees from
relationships with our international partners, including Liquid Audio Korea,
Liquid Audio Japan, Liquid Audio Greater China and Liquid Audio South East Asia
through our strategic partner. These relationships vary in size and scope. If
one of these relationships does not generate a similar amount of revenue in
subsequent periods or if a party is

                                       13
<PAGE>

unable to make its scheduled payments to us, then our business could be harmed.
Furthermore, the commercial terms for these relationships could cause our
revenues to vary from period-to-period, which might result in unpredictability
of our revenues.

Our Revenues Would Be Negatively Effected by the Loss of a Significant Customer

   We have derived, and we believe that we will continue to derive, a
substantial portion of our net revenues from a limited number of customers and
projects. Our ten largest customers for 1999 and 2000 represented approximately
86% and 78%, respectively, of our total net revenues. The loss of any
significant customer or any significant reduction of total net revenues
generated by significant customers, without an increase in revenues from other
sources, would harm our business. The volume of products or services we sell to
specific customers is likely to vary year to year, and a major customer in one
year may not use our services in a subsequent year. A customer's decision not
to use our services in a subsequent year might harm our business.

If Standards for the Secure, Digital Delivery of Recorded Music Are Not
Adopted, the Piracy Concerns of Record Companies and Artists Might Not Be
Satisfied, and They Might Not Use Our Platform for Digital Delivery of Their
Music

   Because other digital recorded music formats, such as MP3, do not contain
mechanisms for tracking the source or ownership of digital recordings, users
are able to download and distribute unauthorized or "pirated" copies of
copyrighted recorded music over the Internet. This piracy is a significant
concern to record companies and artists, and is the reason many record
companies and artists are reluctant to digitally deliver their recorded music
over the Internet. The Secure Digital Music Initiative (SDMI) is a committee
formed by the Recording Industry Association of America (RIAA) to propose a
standard format for the secure digital delivery and use of recorded music. If a
standard format is not adopted, however, unsecure copies of recorded music may
continue to be available on the Internet, and record companies and artists
might not permit the digital delivery of their music. Additionally, as long as
pirated recordings are available, many consumers will choose free pirated
recordings rather than paying for legitimate recordings. Accordingly, if a
standard format for the secure digital delivery of music is not adopted, our
business might be harmed.

   We have designed our current products to be adaptable to different music
industry and technology standards. Numerous standards in the marketplace,
however, could cause confusion as to whether our products and services are
compatible. If a competitor were to establish the dominant industry standard,
our business would be harmed.

We Might Need Additional Capital in the Future and Additional Financing Might
Not Be Available

   We currently anticipate that our available cash resources and financing
available under existing lease agreements will be sufficient to meet our
anticipated working capital and capital expenditure requirements for the
foreseeable future. However, we may need to raise additional funds through
public or private debt or equity financing in order to:

  . take advantage of opportunities, including more rapid international
    expansion or acquisitions of complementary businesses or technologies;

  . develop new products or services; or

  . respond to competitive pressures.

   Any additional financing we may need 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, we might not be able to take advantage of unanticipated
opportunities, develop new products or services, or otherwise respond to
unanticipated competitive pressures, and our business could be harmed. Our
forecast of the period of time through which our

                                       14
<PAGE>

financial resources will be adequate to support our operations is a forward-
looking statement that involves risks and uncertainties, and actual results
could vary materially as a result of a number of factors, including those set
forth in this "Risk Factors" section. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations."

Our Future Success Depends on Our Key Personnel

   Our future success depends to a significant extent on the continued service
of our key technical, sales and senior management personnel and their ability
to execute our growth strategy. The loss of the services of any of our senior
level management, or other key employees, could harm our business. Our future
performance will depend, in part, on the ability of our executive officers to
work together effectively. Our executive officers may not be successful in
carrying out their duties or running our company. Any dissent among executive
officers could impair our ability to make strategic decisions quickly in a
rapidly changing market.

   Our future success also depends on our ability to attract, retain and
motivate highly skilled employees. Competition for employees in our industry is
intense. Although we provide compensation packages that include incentive stock
options, cash incentives and other employee benefits, the volatility and
current market price of our common stock may make it difficult for us to
attract, assimilate and retain highly qualified employees in the future. We
have from time to time in the past experienced, and we expect to continue to
experience in the future, difficulty in hiring and retaining highly skilled
employees with appropriate qualifications.

We Depend on Proprietary Rights to Develop and Protect Our Technology

   Our success and ability to compete substantially depends on our internally
developed technologies and trademarks, which we protect through a combination
of patent, copyright, trade secret and trademark laws. Patent applications or
trademark registrations may not be approved. Even if they are approved, our
patents or trademarks may be successfully challenged by others or invalidated.
If our trademark registrations are not approved because third parties own these
trademarks, our use of these trademarks would be restricted unless we enter
into arrangements with the third-party owners, which might not be possible on
commercially reasonable terms or at all.

   The primary forms of intellectual property protection for our products and
services internationally are patents and copyrights. Patent protection
throughout the world is generally established on a country-by-country basis. To
date, we have applied for four patents outside the United States. Copyrights
throughout the world are protected by several international treaties, including
the Berne Convention for the Protection of Literary and Artistic Works. Despite
these international laws, the level of practical protection for intellectual
property varies among countries. In particular, United States government
officials have criticized countries such as China and Brazil for inadequate
intellectual property protection. If our intellectual property is infringed in
any country without a high level of intellectual property protection, our
business could be harmed.

   We generally enter into confidentiality or license agreements with our
employees, consultants and corporate partners, and generally control access to
and distribution of our technologies, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights from
unauthorized use or disclosure, parties may attempt to disclose, obtain or use
our solutions or technologies. The steps we have taken may not prevent
misappropriation of our solutions or technologies, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States. See "Business--
Intellectual Property."

   We have licensed, and we may license in the future, certain proprietary
rights to third parties. While we attempt to ensure that the quality of our
brand is maintained by our business partners, they may take actions that could
impair the value of our proprietary rights or our reputation. In addition,
these business partners may not take the same steps we have taken to prevent
misappropriation of our solutions or technologies.

                                       15
<PAGE>

We Face and Might Face Intellectual Property Infringement Claims that Might Be
Costly to Resolve

   From time to time, we receive letters from corporations and other entities
suggesting that we review patents to which they claim rights or claiming that
we infringe on their patent rights. Such claims may result in our being
involved in litigation. Although we do not believe we infringe the proprietary
rights of any party, we cannot assure you that parties will not assert
additional claims in the future or that any claims will not be successful. We
could incur substantial costs and diversion of management resources to defend
any claims relating to proprietary rights, which could harm our business. In
addition, we are obligated under certain agreements to indemnify the other
party for claims that we infringe on the proprietary rights of third parties.
If we are required to indemnify parties under these agreements, our business
could be harmed. If someone asserts a claim against us relating to proprietary
technology or information, we might seek licenses to this intellectual
property. We might not be able to obtain licenses on commercially reasonable
terms, or at all. The failure to obtain the necessary licenses or other rights
might harm our business. See "Legal Proceedings."

Companies Might Not Develop or Consumers Might Not Adopt Devices That Will Play
Digitally Downloaded Music

   We believe that the market for digitally recorded music delivered over the
Internet will not develop significantly until consumers are able to enjoy this
music other than solely through the use of a personal computer. Several
consumer electronics companies have introduced or announced plans to introduce
devices that will allow digital music delivered over the Internet to be played
away from the personal computer. If companies fail to introduce additional
devices, consumers do not adopt these devices or our products and services are
incompatible with these devices, our business would be harmed. In addition,
digital music can be transferred to a compact disc, but that transfer requires
a compact disc recorder (CD-R). Many desktop computer manufacturers offer CD-Rs
in their computers. If companies do not continue to offer CD-Rs in their
computers, consumers do not adopt CD-Rs or our products and services are
incompatible with CD-Rs, our business might be harmed.

If We Do Not Increase the Number of Websites that Use Our Platform, Our
Business Will Not Grow

   In order to grow our business, we need to increase the number of websites,
including websites operated by music retailers, that use our technology and our
syndicated content to digitally deliver recorded music. To increase the number
of websites, we must do the following:

  . offer competitive products and services that meet industry standards;

  . attract more music content;

  . make it easy and cost-effective for music-related websites to sell
    digital music;

  . develop relationships with online retailers, music websites, online
    communities, broadband providers and Internet broadcasters; and

  . develop relationships with international music websites, retailers and
    broadband providers.

   Any failure to achieve one or more of these objectives would harm our
business. We may not be successful in achieving any of these objectives.

If Artists and Record Labels Are Not Satisfied that They Can Securely,
Digitally Deliver Their Music Over the Internet, We Might Not Have Sufficient
Content to Attract Consumers

   Our success depends on our ability to aggregate a sufficient amount and
variety of digital recorded music for syndication. In particular, until a
significant number of artists and their record labels adopt a strategy of
digitally delivering music over the Internet, the growth of our business might
be limited. We currently do not

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<PAGE>

create our own content; rather, we rely on record companies and artists for
digital recorded music to be syndicated using our format. We believe record
companies will remain reluctant to distribute their recorded music digitally
unless they are satisfied that the digital delivery of their music over the
Internet will not result in the unauthorized copying and distribution of that
music. If record companies do not believe that recorded music can be securely
delivered over the Internet, they will not allow the digital distribution of
their recorded music and we might not have sufficient content to attract
consumers. If we cannot offer a sufficient amount and variety of digital
recorded music for syndication, our business might be harmed.

Due to the Many Factors that Influence Market Acceptance, Consumers Might Not
Accept Our Platform

   Our success will depend on growth in consumer acceptance of our platform as
a method for digital delivery of recorded music over the Internet. Factors that
might influence market acceptance of our platform include the following, over
which we have little or no control:

  . the availability of sufficient bandwidth on the Internet to enable
    consumers to download digital recorded music rapidly and easily;

  . the willingness of consumers to invest in computer technology that
    facilitates the downloading of digital music;

  . the cost of time-based Internet access;

  . the number, quality and variety of digital recordings available for
    purchase through our system relative to those available through other
    online digital delivery companies, digital music websites, music swapping
    or sharing websites or through traditional physical delivery of
    recordings;

  . the availability of portable devices to which digital recorded music can
    be transferred;

  . the fidelity and quality of the sound of the digital recorded music; and

  . the level of consumer comfort with the process of downloading and paying
    for digital music over the Internet, including ease of use and lack of
    concern about transaction security.

The Market for Digital Delivery of Music Over the Internet is Highly
Competitive, and if We Cannot Compete Effectively, Our Ability to Generate
Meaningful Revenues Would Suffer Dramatically

   Competition among companies in the business of digital delivery of music
over the Internet is intense. If we do not compete effectively or if we
experience pricing pressures, reduced margins or loss of market share resulting
from increased competition, our business might be harmed.

   Competition is likely to increase as new companies enter the market and
current competitors expand their products and services or merge with other
competitors. Many of these potential competitors are likely to enjoy
substantial competitive advantages, including the following:

  . larger audiences;

  . larger technical, production and editorial staffs;

  . greater brand recognition;

  . access to more recorded music content;

  . a more established Internet presence;

  . a larger advertiser base; and

  . substantially greater financial, marketing, technical and other
    resources.

   See "Business--Competition."

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New Competitors Could Enter the Industry with Alternative Business Models,
Which, if Successful, Could Harm Our Business

   New companies may enter our market with alternative business models. For
example, companies may provide free music downloading from a website, earning
revenues on an advertising or subscription basis. This model could be more
attractive to consumers. If we are unable to compete with such companies or
adapt our business model, products or services to a more consumer-favorable
model, our business could be harmed.

If Our Platform Does Not Provide Sufficient Rights Reporting Information,
Record Companies and Artists Are Unlikely to Digitally Deliver Their Recorded
Music Using Our Platform

   Record companies and artists must be able to track the number of times their
recorded music is downloaded so that they can make appropriate payments to
music rights organizations, such as the American Society of Composers, Authors
and Publishers, Broadcast Music Incorporated and SESAC, Inc. If our products
and services do not accurately or completely provide this rights reporting
information, record companies and artists might not use our platform to
digitally deliver their recorded music, and our business might be harmed.

Our Business Might Be Harmed if We Fail to Price Our Products and Services
Appropriately

   The price of Internet products and services is subject to rapid and frequent
change. We may be forced, for competitive or technical reasons, to reduce or
eliminate prices for certain of our products or services. If this happens, our
business might be harmed.

Our Business Might Be Harmed if Challenges Against Intellectual Property Laws
by New Digital Music Delivery Technologies Are Successful

   New music sharing technologies allowing users to locate and download copies
of digital music stored on the hard drives of other users without payment have
been introduced into the market. Because some digital recorded music formats,
such as MP3, do not contain mechanisms for tracking the source of ownership of
digital recordings, users are able to download copies of copyrighted recorded
music over the Internet without being required to compensate the owners of
these copyrights. These downloads are a significant concern to record companies
and artists. The Recording Industry Association of America has filed a suit
seeking a permanent injunction against the use of these file-sharing
technologies for exchange of copyrighted works. Several recording artists have
also taken action against companies providing music sharing technology. If the
injunction is denied, and it is determined that this file sharing technology is
non-infringing, record companies and artists may limit their use of the
Internet to sell and distribute their copyrighted materials. Even if the
technology is determined to be infringing, it may be difficult to prevent this
type of file sharing because of the non-centralized character of these
technologies. As long as free shared copies are available, legally or
illegally, consumers may choose not to pay for downloads from retail and other
music delivery sites in our Liquid Music Network, which could harm our
business.

We Might Not Be Able to Scale Our Technology Infrastructure to Meet Demand for
Our Products and Services

   Our success will depend on our ability to scale our technology
infrastructure to meet the demand for our products and services. Adding this
new capacity will be expensive, and we might not be able to do so successfully.
In addition, we might not be able to protect our new or existing data centers
from unexpected events as we scale our systems. To the extent that we do not
address any capacity constraints effectively, our business would be harmed.

                                       18
<PAGE>

We Might Not Be Successful in Our Attempts to Keep Up With Rapid Technological
Change and Evolving Industry Standards

   The markets for our products and services are characterized by rapidly
changing technology, evolving industry standards, changes in customer needs,
emerging competition, and frequent new product and service introductions. Our
future success will depend, in part, on our ability to:

  . use leading technologies effectively;

  . continue to develop our strategic and technical expertise;

  . enhance our current products and services;

  . develop new products and services that meet changing customer needs;

  . advertise and market our products and services; and

  . influence and respond to emerging industry standards and other
    technological changes.

   This must be accomplished in a timely and cost-effective manner. We may not
be successful in effectively using new technologies, developing new products or
services or enhancing our existing products or services on a timely basis.
These new technologies or enhancements may not achieve market acceptance. Our
pursuit of necessary technological advances may require substantial time and
expense. Finally, we may not succeed in adapting our services to new
technologies as they emerge.

We Might Not Be Successful in the Development and Introduction of New Products
and Services

   We depend in part on our ability to develop new or enhanced products and
services in a timely manner and to provide new products and services that
achieve rapid and broad market acceptance. We may fail to identify new product
and service opportunities successfully and develop and bring to market new
products and services in a timely manner. In addition, product innovations may
not achieve the market penetration or price stability necessary for
profitability.

   As the online medium continues to evolve, we plan to leverage our technology
by introducing complementary products and services as additional sources of
revenue. Accordingly, we may change our business model to take advantage of new
business opportunities, including business areas in which we do not have
extensive experience. For example, we will continue to devote significant
resources to the development of digital music delivery services, as well as our
software licensing business. If we fail to develop these or other businesses
successfully, our business would be harmed.

We Might Experience Delays in the Development of New Products and Services

   We must continue to innovate and develop new versions of our software to
remain competitive in the market for digital delivery of recorded music
solutions. Our software products and services development efforts are
inherently difficult to manage and keep on schedule. Our failure to manage and
keep those development projects on schedule might harm our business.

Our Products and Services Might Contain Errors

   We offer complex products and services. They may contain undetected errors
when first introduced or when new versions are released. If we market products
and services that have errors or that do not function properly, then we may
experience negative publicity, loss of or delay in market acceptance, or claims
against us by customers, any of which might harm our business.

We Might Have Liability for the Content of the Recorded Music That We Digitally
Deliver

   Because we digitally deliver recorded music to third parties, we might be
sued for negligence, copyright or trademark infringement or other reasons.
These types of claims have been brought, sometimes successfully,

                                       19
<PAGE>

against providers of online products and services in the past. Others could
also sue us for the content that is accessible from our website through links
to other websites. These claims might include, among others, claims that by
hosting, directly or indirectly, the websites of third parties, we are liable
for copyright or trademark infringement or other wrongful actions by these
third parties through these websites. Our insurance may not adequately protect
us against these types of claims and, even if these claims do not result in
liability, we could incur significant costs in investigating and defending
against these claims.

   We have taken steps to prevent these claims. For example, we have
arrangements with companies that use our hosting services that will allow us to
delete potentially infringing or misappropriating materials quickly and
securely. We also have put into place indemnification agreements with music
content providers, where practicable. Under the Digital Millennium Copyright
Act of 1999, Internet service providers are insulated from several types of
these claims, upon compliance with the requirement that they appoint an agent
to receive claims relating to their service, and we have appointed an agent.

System Failures or Delays Might Harm Our Business

   Our operations depend on our ability to protect our computer systems against
damage from fire, water, power loss, telecommunications failures, computer
viruses, vandalism and other malicious acts, and similar unexpected adverse
events. Our corporate headquarters are located in northern California.
California is currently experiencing power outages due to a shortage in the
supply of power within the state. Although we maintain a comprehensive disaster
recovery plan, if the power outages increase in severity, they could disrupt
our operations. Interruptions or slowdowns in our services have resulted from
the failure of our telecommunications providers to supply the necessary data
communications capacity in the time frame we required, as well as from
deliberate acts. Despite precautions we have taken, unanticipated problems
affecting our systems could in the future cause temporary interruptions or
delays in the services we provide. Our customers might become dissatisfied by
any system failure or delay that interrupts our ability to provide service to
them or slows our response time. Sustained or repeated system failures or
delays would affect our reputation, which would harm our business. Slow
response time or system failures could also result from straining the capacity
of our software or hardware due to an increase in the volume of products and
services delivered through our servers. While we carry business interruption
insurance, it might not be sufficient to cover any serious or prolonged
emergencies, and our business might be harmed.

We Might Be Unable to License or Acquire Technology

   We rely on certain technologies that we license or acquire from third
parties, including Dolby Laboratories Licensing Corporation, Fraunhofer
Institut, RSA Data Security, Inc. and Thomson Consumer Electronics Sales GmbH.
These technologies are integrated with our internally developed software and
used in our products, to perform key functions and to enhance the value of our
platform. These third-party licenses or acquisitions may not continue to be
available to us on commercially reasonable terms or at all. Any inability to
acquire these licenses or software on commercially reasonable terms might harm
our business.

Difficulties Presented by International Economic, Political, Legal, Accounting
and Business Factors Could Harm Our Business in International Markets

   A key component of our strategy is to expand into international markets. The
following risks are inherent in doing business on an international level and we
have little or no control over them:

  . unexpected changes in regulatory requirements;

  . export restrictions;

  . export controls relating to encryption technology;

  . longer payment cycles;

                                       20
<PAGE>

  . problems in collecting accounts receivable;

  . political and economic instability; and

  . potentially adverse tax consequences.

   In addition, other factors that may also affect us and over which we have
some control include the following:

  . difficulties in staffing and managing international operations;

  . differences in music rights reporting structures; and

  . seasonal reductions in business activity.

   We have entered into individual agreements in Japan, Korea, greater China
and south east Asia, and we may enter into similar arrangements in the future
in other countries. We also established a wholly-owned subsidiary in the
United Kingdom. One or more of the factors listed above may harm our present
or future international operations and, consequently, our business.

Our Management and Internal Systems Might Be Inadequate to Handle the
Potential Growth of Our Personnel

   To manage future growth, our management must continue to improve our
operational and financial systems and expand, train, retain and manage our
employee base. Our management may not be able to manage our growth
effectively. If our systems, procedures and controls are inadequate to support
our operations, our expansion would be halted and we could lose our
opportunity to gain significant market share. Any inability to manage growth
effectively may harm our business.

                         Risks Related to Our Industry

Internet Security Concerns Could Hinder E-Commerce

   A significant barrier to e-commerce and communications over the Internet
has been the need for secure transmission of confidential information.
Internet usage may not increase at the rate we expect unless some of those
concerns are adequately addressed and found acceptable by the market. Internet
usage could also decline if any well-publicized compromise of security occurs.
We may incur significant costs to protect against the threat of security
breaches or to alleviate problems caused by these breaches. Protections may
not be available at a reasonable price or at all. If a third person were able
to misappropriate a user's personal information, users could bring claims
against us.

Imposition of Sales and Other Taxes On E-Commerce Transactions Might Hinder E-
Commerce

   We do not collect sales and other taxes when we sell our products and
services over the Internet. State or local governments may seek to impose
sales tax collection obligations on out-of-state companies, such as ours,
which engage in or facilitate e-commerce. A number of proposals have been made
at the state and local level that would impose additional taxes on the sale of
products and services through the Internet. These proposals, if adopted, could
substantially impair the growth of e-commerce and could reduce our opportunity
to derive profits from e-commerce. Moreover, if any state or local government
or foreign country were to successfully assert that we should collect sales or
other taxes on the exchange of products and services on our system, our
business might be harmed.

   In 1998, Congress passed the Internet Freedom Act, which imposes a three-
year moratorium on state and local taxes on Internet-based transactions. We
cannot assure you that this moratorium will be extended. Failure to renew this
moratorium would allow various states to impose taxes on e-commerce, which
might harm our business.

                                      21
<PAGE>

Demand for Our Products and Services Might Decrease if Growth in the Use of the
Internet Declines

   Our future success substantially depends upon the continued growth in the
use of the Internet. The number of users on the Internet may not increase and
commerce over the Internet may not become more accepted and widespread for a
number of reasons, including the following, over which we have little or no
control:

  . actual or perceived lack of security of information, such as credit card
    numbers;

  . lack of access and ease of use;

  . inconsistent quality of service and lack of availability of cost-
    effective, high speed service;

  . possible outages due to damage to the Internet;

  . excessive governmental regulation; and

  . uncertainty regarding intellectual property rights.

   If the necessary infrastructure, products, services or facilities are not
developed, or if the Internet does not grow as a commercial medium, our
business would be harmed.

Government Regulation of the Internet Might Harm Our Business

   The applicability to the Internet of existing laws governing issues such as
property ownership, libel and personal privacy is uncertain. In addition,
governmental authorities may seek to further regulate the Internet with respect
to issues such as user privacy, pornography, acceptable content, e-commerce,
taxation, and the pricing, characteristics and quality of products and
services. Finally, the global nature of the Internet could subject us to the
laws of a foreign jurisdiction in an unpredictable manner. Any new legislation
regulating the Internet could inhibit the growth of the Internet and decrease
the acceptance of the Internet as a communications and commercial medium, which
might harm our business.

   In addition, the growing use of the Internet has burdened the existing
telecommunications infrastructure and has caused interruptions in telephone
service. Telephone carriers have petitioned the government to regulate the
Internet and impose usage fees on Internet service providers. Any regulations
of this type could increase the costs of using the Internet and impede its
growth, which could in turn decrease the demand for our services or otherwise
harm our business.

ITEM 2. PROPERTIES

   Our headquarters are located in 11,400 square feet of leased office space in
Redwood City, California. The lease term extends to April 14, 2002 with a
three-year renewal, at our option. We lease an office suite near our
headquarters in Redwood City on a month-to-month basis, for additional office
space and storage needs. We lease an additional 18,200 square feet of office
space near our headquarters. The lease term for this additional space extends
to November 15, 2002 with two five-year renewals, at our option. We lease an
additional 26,800 square feet of office space near our headquarters. The lease
term for this additional space extends to August 31, 2002 with a three-year
renewal, at our option.

ITEM 3. LEGAL PROCEEDINGS

   In February 2000, Sightsound, Inc. notified one of our customers that it
intended to add the customer as a party to a pending patent litigation in the
United States District Court for the Eastern District of Pennsylvania
(Pittsburgh). The litigation alleges infringement of unspecified claims of
three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440).
Damages have not been specified. Our customer has agreed to be added to the
case, subject to a revision in the trial schedule. Our customer has requested
indemnification, including defense costs, from us, based upon the terms of our
contract with them. Based on this request, we are negotiating an agreement with
our customer under which we would (i) assume control of the defense, (ii) pay

                                       22
<PAGE>

the expenses of the defense and (iii) reserve certain rights as to
indemnification. During negotiation of this agreement we have agreed to assume
the costs of the defense for our customer. These costs could be significant.
There is no assurance that we will enter into this agreement. If we do not
reach an agreement with our customer and the defense is not successful, our
customer might seek full indemnification from us for the damages, if any. There
can be no assurance regarding the outcome of the litigation. If there is a
finding of infringement, we may be required to indemnify our customer as to the
full amount of the damages.

   On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against us
in the Northern District of California alleging patent infringement. On April
26, 2000, Intouch filed an amended complaint, which was served on us shortly
thereafter. The complaint names us and Amazon.com International, Inc.,
Listen.com, Inc., Entertaindom LLC, Discovermusic.com, Inc. and Muze, Inc. It
alleges that we infringe or induce infringement of, the claims of United States
Patent Nos. 5,237,157 and 5,963,916 by operating a website and/or a kiosk that
allows interactive previewing of portions of pre-recorded music products. The
complaint seeks unspecified damages and injunctive relief. On May 30, 2000, we
filed our answer to Intouch's first amended complaint. The action is currently
in discovery, and the trial date has been set for January 11, 2002. We believe
that we have meritorious defenses to Intouch's claims and we intend to
vigorously defend against such claims. However, we cannot assure you that we
will be successful in defending these lawsuits. If there is a finding of
infringement, we might be required to pay substantial damages to Intouch and
could be enjoined from selling any of our products or services that are held to
infringe Intouch's patents unless and until we are able to negotiate a license
from them.

   On August 14, 2000, a former employee filed a charge of discrimination with
the California Department of Fair Employment and Housing against us, and
several of our employees and former employees. The charge alleges sexual
harassment and unlawful retaliation. We believe, after consultation with
counsel, that these claims are without merit, and we intend to defend ourselves
vigorously. However, should a lawsuit be filed and decided adversely to us, we
may have to pay damages.

   From time to time we receive letters from corporations or other business
entities notifying us of alleged infringement of patents held by them or
suggesting that we review patents to which they claim rights. These
corporations or entities often indicate a willingness to discuss licenses to
their patent rights.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   There were no submissions of matters to a vote of security holders during
the quarter ended December 31, 2000.

                                       23
<PAGE>

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Price of Common Stock

   Our common stock has been quoted on the Nasdaq National Market under the
symbol "LQID" since July 8, 1999. The following table presents, for the periods
indicated, the high and low closing prices per share of the common stock as
reported on the Nasdaq National Market.

<TABLE>
<CAPTION>
                                                                   High   Low
                                                                  ------ ------
     <S>                                                          <C>    <C>
     Year Ended December 31, 1999
       Third Quarter (since July 8, 1999)........................ $40.44 $20.88
       Fourth Quarter............................................  45.13  26.25
     Year Ended December 31, 2000
       First Quarter.............................................  34.06  13.25
       Second Quarter............................................  19.00   6.69
       Third Quarter.............................................  14.50   4.25
       Fourth Quarter............................................   6.00   2.16
</TABLE>

   The closing price per share of the common stock at March 15, 2001 was $2.13.
As of February 28, 2001, there were approximately 131 holders of record of our
common stock. Because many shares of our common stock are held by brokers and
other institutions on behalf of stockholders, we are unable to estimate the
total number of stockholders represented by these record holders.

Dividend Policy

   We have never declared or paid any dividends on our common stock. We do not
anticipate paying any cash dividends in the foreseeable future. We currently
intend to retain future earnings, if any, to finance operations and the
expansion of our business. Any future determination to pay cash dividends will
be at the discretion of the board of directors and will depend upon our
financial condition, operating results, capital requirements and other factors
the board of directors deems relevant.

Recent Sales of Unregistered Securities

  1. In February 2000, we issued 1,426 shares of common stock to a record
     label upon the exercise of a warrant to purchase common stock. The
     shares were purchased using the warrant's net exercise provision.
     Accordingly, we did not receive any cash upon exercise of the warrant;
     the shares were purchased by the acceptance of a lesser number of shares
     in exchange for not having to pay the exercise price.

  2. In April 2000, we issued 4,072 shares of common stock to a former
     consultant in consideration for the purchase of certain intellectual
     property.

  3. In April 2000, we issued 30,000 shares of common stock to another former
     consultant in connection with a legal settlement.

  4. In May 2000, we issued 25,156 shares of common stock to an online
     retailer upon the exercise of a warrant to purchase common stock. The
     shares were purchased using the warrant's net exercise provision in the
     same manner described in item 1 above.

  5. In July 2000, we issued 150,000 shares of common stock to a major record
     label in exchange for a letter agreement to promote the distribution of
     digital music over the Internet using our technology.

                                       24
<PAGE>

  6. In December 2000, we issued 50,000 shares of common stock and a warrant
     to purchase up to an additional 233,300 shares of common stock to
     another major record label in connection with an agreement to distribute
     its music through kiosks.

   No underwriters were employed in connection with any of the transactions set
forth above.

   The issuances of securities described in items 1, 2, 4, 5 and 6 were deemed
to be exempt from registration under the Securities Act of 1933, as amended, in
reliance on Section 4(2) of the Securities Act, as transactions by an issuer
not involving a public offering. The issuance of securities described in item 3
was deemed to be exempt from registration under the Securities Act in reliance
on Section 3(a)(10) of the Securities Act, as a transaction involving an exempt
security in which the terms and conditions of the issuance were approved, after
a hearing upon the fairness of such terms and conditions, by a court. The
recipients of securities in each such transaction represented their intention
to acquire the securities for investment only and not with a view to or for
sale in connection with any distribution thereof and appropriate legends were
affixed to the share certificates and other instruments issued in such
transactions. All recipients either received adequate information about us or
had access, through employment or other relationships, to such information.

                                       25
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

   The following selected financial data should be read in conjunction with our
consolidated financial statements and related notes and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this document.
<TABLE>
<CAPTION>
                                                                        Period From
                                                                        January 30,
                                                                            1996
                                                                        (inception)
                                   Year Ended December 31,                Through
                          --------------------------------------------  December 31,
                             2000        1999       1998       1997         1996
                          ----------  ----------  ---------  ---------  ------------
                             (in thousands, except share and per share data)
<S>                       <C>         <C>         <C>        <C>        <C>
Statement of Operations
 Data:
Net revenues:
 License................  $    1,284  $    1,537  $   1,235  $     246    $    --
 Services...............       2,977         733        268         10         --
 Business development
  (related party).......       7,307       2,137      1,300         --         --
                          ----------  ----------  ---------  ---------    -------
  Total net revenues....      11,568       4,407      2,803        256         --
                          ----------  ----------  ---------  ---------    -------
Cost of net revenues:
 License................         290         235        310        302         --
 Services...............       2,722       1,122        242         91         --
 Business development
  (related party).......          75          79          2         --         --
 Non-cash cost of
  revenues..............          28          25         36         15         --
                          ----------  ----------  ---------  ---------    -------
  Total cost of net
   revenues.............       3,115       1,461        590        408         --
                          ----------  ----------  ---------  ---------    -------
Gross profit (loss).....       8,453       2,946      2,213       (152)        --
                          ----------  ----------  ---------  ---------    -------
Operating expenses:
 Sales and marketing....      17,114      10,217      4,035      2,820        237
 Non-cash sales and
  marketing.............         314         783        741        304          8
 Research and
  development...........      22,917      11,706      4,109      1,880        692
 Non-cash research and
  development...........          80         371        210        127         23
 General and
  administrative........       7,131       2,770      1,642        898        327
 Non-cash general and
  administrative........          13         190        254         88         --
 Strategic marketing-
  equity instruments....       1,935       3,130         --         --         --
                          ----------  ----------  ---------  ---------    -------
  Total operating
   expenses.............      49,504      29,167     10,991      6,117      1,287
                          ----------  ----------  ---------  ---------    -------
Loss from operations....     (41,051)    (26,221)    (8,778)    (6,269)    (1,287)
Other income (expense),
 net....................       8,236       2,015        239         53         23
Equity in net loss of
 investment.............        (870)         --         --         --         --
                          ----------  ----------  ---------  ---------    -------
Net loss................  $  (33,685) $  (24,206) $  (8,539) $  (6,216)   $(1,264)
                          ==========  ==========  =========  =========    =======
Net loss per share:
 Basic and diluted......  $    (1.52) $    (2.28) $   (3.60) $   (4.95)   $(14.93)
 Weighted average
  shares................  22,133,403  10,615,566  2,370,564  1,256,114     84,635

<CAPTION>
                                               December 31,
                          ----------------------------------------------------------
                             2000        1999       1998       1997         1996
                          ----------  ----------  ---------  ---------  ------------
                                              (in thousands)
<S>                       <C>         <C>         <C>        <C>        <C>
Balance Sheet Data:
Cash and cash
 equivalents............  $   96,398  $  138,692  $  14,143  $   2,387    $   864
Short-term investments..      27,378      19,157      3,001         --         --
Working capital.........     119,089     152,030     15,060        858        660
Total assets............     138,210     166,109     19,913      3,275      1,086
Long-term debt, less
 current portion........         564       1,321        969        218        103
Mandatorily redeemable
 convertible preferred
 stock..................          --          --     29,801      8,247      2,001
Total stockholders'
 equity (deficit).......     128,674     157,745    (14,133)    (6,879)    (1,228)
</TABLE>

                                       26
<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

   The following Management's Discussion and Analysis contains forward-looking
statements within the meaning of Federal securities laws. You can identify
these statements because they use forward-looking terminology such as "may,"
"will," "expect," "anticipate," "estimate," "continue," "believe" and "intend"
or other similar words. These words, however, are not the exclusive means by
which you can identify these statements. You can also identify forward-looking
statements because they discuss future expectations, contain projections of
results of operations or of financial conditions, characterize future events or
circumstances or state other forward-looking information. We have based all
forward-looking statements included in Management's Discussion and Analysis on
information currently available to us, and we assume no obligation to update
any such forward-looking statements. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, actual results could differ materially from those projected in the
forward-looking statements. Potential risks and uncertainty include, among
others, those set forth in the "Risk Factors" section.

Overview

   We are a leading provider of software products and services that enable
artists, record companies and retailers to create, syndicate and sell music
digitally over the Internet. Our products and services are based on an open
technical architecture that is designed to support a variety of digital music
formats. From our inception in January 1996 through early 1997, we devoted
substantially all of our efforts to product development, raising capital and
recruiting personnel. We first generated revenues in the first quarter of 1997
through the licensing of our Liquifier Pro, Liquid Server and Liquid Player
software products. In November 1997, we introduced a subscription-based hosting
service for digital recorded music using our technology. In July 1998, to
enhance consumer access to the music we were hosting, we launched the Liquid
Music Network (LMN), a syndicated network that currently links over 1,000
affiliated music-related and music retailer websites.

   In early 1999, we began to place greater emphasis on developing and
marketing our digital music delivery services. Since that time, we have
invested significant resources to increase our distribution reach by expanding
the LMN, building our syndicated music catalog available for sale, actively
participating in standards initiatives and establishing our international
presence. We also have established international initiatives within the Pacific
Rim and a subsidiary in Europe to lay the groundwork for offering digital music
download services to consumers in these markets. As a provider of digital music
delivery services, we expect our revenue sources to expand beyond software
license sales to include hosting service fees and sales of digital recorded
music. Revenues from digital music sales and transaction fees from our music
delivery services represented less than 6% of total net revenues in 2000 and
less than 1% of total net revenues in 1999 and 1998. Our Liquid Music Network
began offering syndicated music through music retailer websites in the third
quarter of 1999.

   To date, we have derived our revenues primarily from the licensing of
software products and service fees associated with business development
contracts. Business development revenues primarily consist of license and
maintenance fees from agreements under which we give our strategic related
partners the right to license and use our digital recorded music delivery
technology. These U.S. dollar-denominated, non-refundable fees are allocated
among the various elements of the contract based on vendor specific objective
evidence (VSOE) of fair value. When VSOE of fair value exist for the
undelivered elements, primarily maintenance, we account for the license portion
based on the "residual method" as prescribed by SOP No. 98-9, "Modification of
SOP 97-2 with Respect to Certain Transactions." When VSOE of fair value does
not exist for the undelivered elements, we recognize the total fee from a
business development contract ratably over the term of the contract. We also
license our software products to record companies, artists and websites.
Software license revenues are recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, collection is probable
and delivery has occurred. Services revenues from maintenance fees related to
our licensed software products and hosting fees from record companies and
artists are recognized over the service period, typically one year. We intend
to increase our services revenues by significantly expanding our hosting and
music

                                       27
<PAGE>

delivery services. Revenue derived from hosting services include subscription
fees from artists for encoding and storing music files, e-commerce services and
transaction reporting. Music delivery services revenue include transaction fees
from sales of digital recorded music through our LMN website affiliates and
fees from music retailers and websites related to the sample digital music
clips delivery service. Revenue from kiosk sales consist of software licenses
and services revenue from equipment and kiosk-related services. We bear full
credit risk with respect to substantially all sales.

   Business development revenues as a percentage of total net revenues were
63%, 48% and 46% in 2000, 1999 and 1998, respectively. Liquid Audio Korea (LAK)
stopped making its contractual payments as scheduled. LAK is undergoing a
recapitalization through the addition of new investment partners so that it can
continue making its payments to us. Until such time contractual payments are
resumed, we are deferring recognition of revenue from LAK. In late 2000, Liquid
Audio Greater China and Liquid Audio South East Asia through our strategic
partner did not make their contractual payments as scheduled. We are pursuing
collection for the missed payments. No revenue will be recognized until
payments are on schedule.

   In 2000, approximately 53% of total net revenues came from sales to two
customers, Liquid Audio Japan and Liquid Audio South East Asia through our
strategic partner. In 1999, approximately 73% of total net revenues came from
sales to three customers, Adaptec, Inc., Super Stage, Inc. and Liquid Audio
Korea. In 1998, approximately 34% of total net revenues came from sales to one
customer, SKM Group. International revenues represented approximately 69%, 49%
and 65% of total net revenues in 2000, 1999 and 1998, respectively. We expect
international revenues will continue to represent a significant portion of our
total net revenues.

   We have a limited operating history upon which investors may evaluate our
business and prospects. Since inception we have incurred significant losses,
and as of December 31, 2000 we had an accumulated deficit of approximately
$73.9 million. We expect to incur additional losses and continued negative cash
flow from operations through at least 2002. Our revenues may not increase or
even continue at their current levels or we may not achieve or maintain
profitability or generate cash from operations in future periods. Our prospects
must be considered in light of the risks, expenses and difficulties frequently
encountered by companies in their early stages of development, particularly
companies in new and rapidly evolving markets such as the digital delivery of
recorded music. We may not be successful in addressing these risks, and our
failure to do so would harm our business.

                                       28
<PAGE>

                             Results of Operations

   The following table sets forth, for the periods presented, certain data
derived from our statement of operations as a percentage of total net revenues.
The operating results in any period are not necessarily indicative of the
results that may be expected for any future period.

<TABLE>
<CAPTION>
                                                              Year Ended
                                                             December 31,
                                                            ------------------
                                                            2000   1999   1998
                                                            ----   ----   ----
<S>                                                         <C>    <C>    <C>
Net revenues:
  License..................................................   11 %   35 %   44 %
  Services.................................................   26     17     10
  Business development (related party).....................   63     48     46
                                                            ----   ----   ----
    Total net revenues.....................................  100    100    100
                                                            ----   ----   ----
Cost of net revenues:
  License..................................................    3      5     11
  Services.................................................   23     25      9
  Business development (related party).....................    1      2     --
  Non-cash cost of revenues................................   --      1      1
                                                            ----   ----   ----
    Total cost of net revenues.............................   27     33     21
                                                            ----   ----   ----
Gross profit...............................................   73     67     79
                                                            ----   ----   ----
Operating expenses:
  Sales and marketing......................................  148    232    144
  Non-cash sales and marketing.............................    2     18     26
  Research and development.................................  198    266    146
  Non-cash research and development........................    1      8      8
  General and administrative...............................   62     63     59
  Non-cash general and administrative......................   --      4      9
  Strategic marketing-equity instruments...................   17     71     --
                                                            ----   ----   ----
    Total operating expenses...............................  428    662    392
                                                            ----   ----   ----
Loss from operations....................................... (355)  (596)  (313)
Other income (expense), net................................   72     47      8
Equity in net loss of investment...........................   (8)    --     --
                                                            ----   ----   ----
Net loss................................................... (291)% (549)% (305)%
                                                            ====   ====   ====
</TABLE>

Years Ended December 30, 2000, 1999 and 1998

Total Net Revenues

   Total net revenues increased 162% to $11.6 million in 2000 from $4.4 million
in 1999. Total net revenues increased 57% in 1999 from $2.8 million in 1998.

   License. License revenues decreased 16% to $1.3 million in 2000 from $1.5
million in 1999. License revenues increased 24% in 1999 from $1.2 million in
1998. The decrease in 2000 and increase in 1999 relates principally to Liquid
Player license fees received under an agreement with a customer. Under this
agreement, we received $1.5 million in license fees over a 14-month period.
These fees were recognized as license revenue over the license period, which
ended on December 31, 1999. The decrease in 2000 from Liquid Player license
fees were partially offset by an increase in license fees related to digital
music kiosk sales. Due to our shift in marketing emphasis from software
licensing to digital music delivery services, however, revenues from licensing
of our Liquifier Pro and Liquid Server software decreased in 1999 from 1998,
which partially offset the increase in Liquid Player revenues described above.

                                       29
<PAGE>

   Services. Services revenues increased 306% to $3.0 million in 2000 from
$733,000 in 1999. Services revenues increased 174% in 1999 from $268,000 in
1998. The increase in 2000 was due to increases in encoding services, kiosk-
related equipment and services, digital music and transaction fees from our
music delivery services and promotion and advertising services. The increase in
1999 was due to increased maintenance and hosting fees and the addition to
revenues from promotion and advertising services, sample music clips service
and music sales.

   Business Development (Related Party). Business development revenues
increased 242% to $7.3 million in 2000 from $2.1 million in 1999. Business
development revenues increased 64% in 1999 from $1.3 million in 1998. Total
business development revenues are summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                                Year Ended
                                                               December 31,
                                                           --------------------
                                                            2000   1999   1998
                                                           ------ ------ ------
   <S>                                                     <C>    <C>    <C>
   Liquid Audio Japan and strategic partner............... $5,047 $1,105 $  250
   Liquid Audio South East Asia and strategic partner.....  1,261     --     --
   Liquid Audio Greater China and strategic partner.......    705    500     --
   Liquid Audio Korea and strategic partner...............    294    532  1,050
                                                           ------ ------ ------
                                                           $7,307 $2,137 $1,300
                                                           ====== ====== ======
</TABLE>

   Of the total fees earned from Liquid Audio Japan and strategic partner, $4.9
million and $272,000 were earned from Liquid Audio Japan and relate to software
licensing and maintenance fees in 2000 and 1999, respectively, and $167,000 and
$833,000 were earned from our strategic partner in Liquid Audio Japan in 2000
and 1999, respectively, and relate to a non-refundable service fee of $1.0
million received in March 1999 and recognized ratably over the one-year term of
the service agreement. The fee of $250,000 earned from our strategic partner in
Liquid Audio Japan in 1998 relates to consulting services. The total fee of
$1.3 million and $705,000 earned in 2000 from Liquid Audio South East Asia
through our strategic partner and Liquid Audio Greater China, respectively,
consist of software licensing and maintenance fees. The total fee of $500,000
earned from our strategic partner in Liquid Audio Greater China in 1999 relates
to a service fee to develop a local business in Taiwan and Hong Kong. The total
fee of $294,000 and $532,000 earned from Liquid Audio Korea in 2000 and 1999,
respectively, consist primarily of software licensing and maintenance fees. Of
the $1.1 million earned from our strategic partner in Liquid Audio Korea in
1998, $950,000 relates to service fees earned under two separate agreements and
$100,000 relates to software licensing fees. In 1998, we recognized our
proportionate share (40%) of losses recorded by Liquid Audio Korea. Our share
of the equity losses amounted to $400,000, which equaled our total investment
in Liquid Audio Korea. These equity losses were offset against the revenue
earned in 1998 from our strategic partner in Korea to more clearly reflect the
substance of the business development transactions with our strategic partner.

Total Cost of Net Revenues

   Our gross profit increased to approximately 73% of total net revenues in
2000 from 67% in 1999. Our gross profit decreased to approximately 67% of total
net revenues in 1999 from 79% in 1998. Total cost of net revenues increased
113% to $3.1 million in 2000 from $1.5 million in 1999. Total cost of net
revenues increased 148% in 1999 from $590,000 in 1998.

   License. Cost of license revenues primarily consists of royalties paid to
third-party technology vendors and costs of documentation, duplication and
packaging. Cost of license revenues increased 23% to $290,000 in 2000 from
$235,000 in 1999. Cost of license revenues decreased 24% in 1999 from $310,000
in 1998. Cost of license revenues increased in 2000 due to the addition of
certain technology licenses. Cost of license revenues decreased in 1999 due to
product mix differences and the cancellation of certain technology licenses.

   Services. Cost of services revenues primarily consists of compensation for
customer service, encoding and professional services personnel, kiosk-related
equipment and an allocation of our occupancy costs and

                                       30
<PAGE>

other overhead attributable to our services revenues. Cost of services revenues
increased 143% to $2.7 million in 2000 from $1.1 million in 1999. Cost of
services revenues increased 364% in 1999 from $242,000 in 1998. The increases
in cost of services revenues were due primarily to the addition of encoding and
customer service personnel. Additionally, 2000 included the addition of
professional services personnel and kiosk-related equipment.

   Business Development (Related Party). Cost of business development revenues
primarily consists of kiosk-related equipment and royalties paid to third-party
technology vendors. Cost of business development revenues were $75,000, $79,000
and $2,000 in 2000, 1999 and 1998, respectively.

   Non-Cash Cost of Revenues. Non-cash cost of revenues consist of expenses
associated with the value of common stock and warrants issued to partners as
part of our content acquisition agreements and stock-based employee
compensation arrangements. Common stock expense is based on the fair value of
the stock at the time it was issued. Warrant expense is based on the estimated
fair value of the warrants based on the Black-Scholes option pricing model and
the provisions of EITF 96-18. In December 2000, we signed an agreement with BMG
Entertainment to obtain the right to distribute BMG sound recordings and
related artwork through kiosks. In connection with this agreement, we issued
50,000 shares of common stock to BMG, valued at $195,000 and are being
recognized ratably over the initial one-year term of the agreement; as a
result, $14,000 was recognized as non-cash cost of revenues. Also in connection
with this agreement, we granted a warrant for a total of 233,300 shares of
common stock. Of the total, 77,768 shares vest in December 2001, and the cost
will be remeasured each quarter until a commitment for performance has been
reached or the warrant vests, based on current market data. At December 31,
2000, the 77,768 shares under this warrant were valued at $156,000, of which
$12,000 was recognized as non-cash cost of revenues. The unamortized portion
will be remeasured at each balance sheet date through the vesting date and
amortized over the remaining vesting period. If BMG renews the agreement after
December 2001, the remaining shares will vest at 6,481 shares per month
commencing January 2002 for one year and 6,480 shares per month commencing
January 2003 for one year. Such shares will be valued at the fair market value
of our common stock upon BMG renewing the agreement at each renewal date. Stock
compensation expense for customer service, encoding and professional services
personnel were $2,000, $25,000 and $36,000 in 2000, 1999 and 1998,
respectively. We expect quarterly amortization related to these options to be
less than $1,000 per quarter during 2001 and annual amortization to be
approximately $1,000 in 2002. These future compensation charges would be
reduced if any customer service, encoding or professional services employee
terminates employment prior to the expiration of the employee's option vesting
period.

Operating Expenses

   Sales and Marketing. Sales and marketing expenses consist primarily of
compensation for our sales, marketing and business development personnel,
compensation for customer service and professional services personnel
attributable to sales and marketing activities, advertising, trade show and
other promotional costs, design and creation expenses for marketing literature
and our website and an allocation of our occupancy costs and other overhead.
Sales and marketing expenses increased 68% to $17.1 million in 2000 from $10.2
million in 1999. Sales and marketing expenses increased 153% in 1999 from $4.0
million in 1998. These increases were primarily due to increases in the number
of sales and marketing personnel and advertising and promotional programs. We
expect that sales and marketing expenses will remain at or decline from levels
of the fourth quarter of 2000.

   Research and Development. Research and development expenses consist
primarily of compensation for our research and development, network operations
and product management personnel, payments to outside contractors and, to a
lesser extent, depreciation on equipment used for research and development and
an allocation of our occupancy costs and other overhead. Research and
development expenses increased 96% to $22.9 million in 2000 from $11.7 million
in 1999. Research and development expenses increased 185% in 1999 from $4.1
million in 1998. These increases were primarily due to increases in the number
of personnel and outside contractors needed to enhance our existing software
products, develop and enhance our online services, develop new products and

                                       31
<PAGE>

services and build our external network and computer data center
infrastructure. We expect that research and development expenses will remain at
or decline from levels of the fourth quarter of 2000.

   General and Administrative. General and administrative expenses consist
primarily of compensation for personnel and payments to outside contractors for
general corporate functions, including finance, information systems, human
resources, facilities, legal and general management, fees for professional
services, bad debt expense and an allocation of our occupancy costs and other
overhead. General and administrative expenses increased 157% to $7.1 million in
2000 from $2.8 million in 1999. General and administrative expenses increased
69% in 1999 from $1.6 million in 1998. These increases were primarily due to
increases in the number of personnel and outside contractors needed to support
the growth of our business and professional fees. The 2000 period includes
legal fees related to patent infringement claims against us and a non-cash
charge of $354,000 related to the issuance of common stock in the settlement of
a lawsuit with a former consultant. General and administrative expenses
declined as a percentage of total net revenues. We expect that general and
administrative expenses will remain at or decline from levels of the fourth
quarter of 2000.

   Strategic Marketing-Equity Instruments. Strategic marketing-equity
instruments consist of expenses associated with the value of common stock and
warrants issued to partners as part of our strategic marketing agreements.
Common stock expense is based on the fair value of the stock at the time it was
issued. Warrant expense is based on the estimated fair value of the warrants
based on the Black-Scholes option pricing model and the provisions of EITF 96-
18. Strategic marketing-equity instruments expense was $1.9 million and
$3.1 million in 2000 and 1999, respectively. No strategic marketing-equity
instruments expense was recorded in 1998. In 1999, $1.1 million relates to
100,000 shares of common stock issued to Virgin Holdings, Inc., an affiliate of
EMI Recorded Music, in exchange for the right to create digitally encoded
copies of EMI sound recordings using the Liquid Audio and Genuine MP3 formats,
and $95,000 relates to fully vested warrants issued to other record companies
as part of our content and distribution agreements with them. In June 1999, we
signed an advertising agreement with Amazon.com to collaborate on event-based
advertising using our digital delivery services. In connection with this
agreement, we issued a fully vested warrant to purchase approximately 254,000
shares of common stock to Amazon.com. The warrant was valued at $2.0 million
and was recognized ratably over the one-year term of the agreement; as a
result, $843,000 and $1.2 million was recognized as strategic marketing-equity
instruments expense in 2000 and 1999, respectively. In August 1999, we signed a
Digital Audio Co-Marketing and Distribution Agreement with Yahoo! to promote
the distribution of digital music on its web site. In connection with this
agreement, we granted Yahoo! three warrants totaling 250,000 shares of common
stock. The first warrant for 83,334 shares vested immediately. The first
warrant was valued at $903,000 and was recognized ratably over the one-year
term of the agreement. The second warrant for 83,333 shares vested in August
2000. The second warrant was initially valued at $426,000 and was recognized
ratably over the one-year period ending at the vesting date. The second warrant
was revalued at each balance sheet date through the vesting date. As a result,
the original charge of $426,000 was reduced to $312,000 based on current market
data. The third warrant for 83,333 shares will vest in August 2001. The third
warrant was initially valued at $105,000 and is recognized ratably over the
one-year period ending at the vesting date. The third warrant will be revalued
at each balance sheet date through the vesting date based on current market
data. In 2000, $577,000, $(114,000) and $38,000 were recognized as strategic
marketing-equity instruments expense for the first, second and third warrants,
respectively. In 1999, $330,000 and $426,000 were recognized as strategic
marketing-equity instruments expense for the first and second warrants,
respectively. In July 2000, we signed an agreement with Virgin to promote the
distribution of digital music over the Internet using our technology. Pursuant
to this agreement, we issued 150,000 shares of common stock to Virgin. These
shares were valued at $1.2 million and are being recognized ratably over the
one-year term of the agreement. As a result, $591,000 was recognized as
strategic marketing-equity instruments expense in 2000.

   Non-Cash Sales and Marketing, Research and Development and General and
Administrative. Non-cash sales and marketing, research and development and
general and administrative expenses relate to stock-based employee compensation
arrangements. The total unearned compensation recorded by us from inception to

                                       32
<PAGE>

December 31, 2000 was $4.3 million. We recognized $407,000, $1.3 million and
$1.2 million of stock compensation expense for 2000, 1999 and 1998,
respectively. We expect quarterly amortization related to those options to be
between $77,000 and $43,000 per quarter during 2001 and annual amortization to
be approximately $81,000 during 2002. These future compensation charges would
be reduced if any sales and marketing, research and development and general and
administrative employee terminates employment prior to the expiration of the
employee's option vesting period.

   Other Income (Expense), Net. Interest income consists of earnings on our
cash, cash equivalents and short-term investments. Interest income increased to
$8.8 million in 2000 from $2.3 million in 1999, and increased in 1999 from
$379,000 in 1998. The increases were primarily due to interest received on
higher average cash and cash equivalent balances resulting from proceeds of the
initial and follow-on public offerings of our common stock in July 1999 and
December 1999, respectively.

   Interest expense consists of expenses related to our financing obligations,
which include borrowings under equipment loans, short-term loans and capital
lease obligations. Interest expense declined to $144,000 in 2000 from $193,000
in 1999, and increased in 1999 from $140,000 in 1998. The decline in 2000 is
due to several capital leases expiring during the period. The increases in 1999
and 1998 were primarily due to interest paid on higher average financing
obligation balances resulting from additional capital leases and borrowings
under the equipment loans during each year, and borrowings under short-term
loan agreements in 1998.

   Other income (expense), net of $429,000 in 2000 consists primarily of the
write-off of loans receivable from Liquid Audio Korea.

Liquidity and Capital Resources

   Since inception, we have financed our operations primarily through the
initial and follow-on public offerings of common stock, private placements of
our preferred stock, equipment financing, lines of credit and short-term loans.
As of December 31, 2000, we had raised $65.9 million and $93.7 million through
our initial and follow-on public offerings of common stock, respectively, and
$29.8 million through the sale of our preferred stock. At December 31, 2000, we
have approximately $123.8 million of cash, cash equivalents and short-term
investments.

   Net cash used in operating activities was $26.8 million, $14.8 million and
$5.8 million in 2000, 1999 and 1998, respectively. Net cash used for operating
activities in 2000 was primarily the result of net losses from operations,
depreciation and amortization of $3.4 million, amortization of unearned
compensation of $409,000, strategic marketing-equity instruments charges of
$1.9 million, an increase in the allowance for doubtful accounts and sales
returns reserve by $315,000, notes receivable write-off of $470,000, equity
investment losses of $870,000, other charges of $(47,000) and a net decrease in
working capital items by $949,000. The net decrease in working capital items
include an increase in accounts receivable by $2.2 million, increase in other
assets by $878,000, increase in accounts payable by $1.4 million, increase in
accrued expenses and other liabilities by $909,000 and a decrease in deferred
revenue by $145,000. Net cash used for operating activities in 1999 was
primarily the result of net losses from operations, depreciation and
amortization of $1.1 million, amortization of unearned compensation of $1.4
million, strategic marketing-equity instruments charges of $3.1 million, an
increase in the allowance for doubtful accounts and sales returns reserve by
$101,000, equity investment losses of $378,000, other charges of $63,000 and a
net decrease in working capital items by $3.3 million. The net decrease in
working capital items include a decrease in accounts receivable by $190,000,
increase in other assets by $474,000, increase in accounts payable by $1.2
million, increase in accrued expenses and other liabilities by $1.9 million and
an increase in deferred revenue by $395,000. Net cash used for operating
activities in 1998 was primarily the result of net losses from operations,
depreciation and amortization of $451,000, amortization of unearned
compensation of $1.2 million, an increase in the allowance for doubtful
accounts and sales returns reserve by $263,000, equity investment losses of
$400,000, and a net decrease in working capital items by $369,000. The net
decrease in working capital items include an increase in

                                       33
<PAGE>

accounts receivable by $1.1 million, increase in other assets by $191,000,
increase in accounts payable by $397,000, increase in accrued expenses and
other liabilities by $206,000 and an increase in deferred revenue by $1.1
million.

   Net cash used in investing activities was $15.7 million, $20.5 million and
$4.4 million in 2000, 1999 and 1998, respectively. The net cash used in
investing activities was due primarily to the acquisition of property and
equipment of $7.4 million, $4.5 million and $982,000 in 2000, 1999 and 1998,
respectively. We purchased short terms investments totaling $8.2 million, $16.1
million and $3.0 million, net in 2000, 1999 and 1998, respectively. In 1998, an
investment of $400,000 in LAK was made.

   Net cash provided by financing activities was $268,000, $159.9 million and
$21.9 million in 2000, 1999 and 1998, respectively. The net cash provided by
financing activities in 2000 was due primarily to proceeds from sales of our
common stock under the employee stock purchase plan, offset by payments of
$588,000 made under our equipment loan and $195,000 under capital leases. The
net cash provided by financing activities in 1999 was due primarily to the
proceeds from our initial and follow-on public offerings of common stock. The
net cash provided by financing activities in 1998 was due primarily to the
proceeds from the private sales of our preferred stock.

   We had a bank revolving line of credit for up to $1.0 million based on 80%
of eligible accounts receivable that expired on November 15, 1999. As of
December 31, 1999, we had no borrowings under the revolving line of credit. We
had a bank equipment loan facility that provided for advances of up to $3.0
million through November 1999. Borrowings under the equipment loan facility are
repayable in monthly installments over three years and bear interest at the
bank's prime interest rate plus 0.25% (9.75% at December 31, 2000). Borrowings
under the equipment loan facility are secured by the related equipment and
other assets. Under the equipment loan facility, we had borrowed amounts
totaling $1.8 million through December 31, 2000. We also have lease financing
agreements that provide for the lease of computers and office equipment of up
to $1.0 million. As of December 31, 2000, we had borrowed $737,000 under the
lease financing agreements. Our other significant commitments consist of
obligations under non-cancelable operating leases, which totaled $2.7 million
as of December 31, 2000 and are payable in monthly installments through 2005,
and a strategic related partner note in the amount of $393,000 that was issued
in the three months ended March 31, 1999. The strategic related partner note
payable was issued to an entity affiliated with our Japanese strategic partner
and is repayable in Japanese yen and bears interest at 0.5% above a Japanese
bank's prime rate (approximately 2.6% at December 31, 2000). The principal is
due on December 31, 2003, with quarterly interest payments.

   In 1999, we recorded an impairment loss of $378,000 related to our
investment in Liquid Audio Japan (LAJ), and in 1998 we recorded equity losses
of $400,000 related to our investment in Liquid Audio Korea. In December 1999,
LAJ completed its initial public offering in Japan, which raised total proceeds
of approximately $28.3 million and resulted in the Company's ownership in LAJ
reducing to 6.92%. Accordingly, we booked an investment in LAJ of $2.0 million,
which was recorded as additional paid in capital, to reflect the increase in
the our share of LAJ's net assets. Our ownership was further reduced to 6.81%
during 2000 due to an increase in LAJ's total outstanding shares. The
investment is being accounted for using the equity method since we have the
ability to exercise significant influence, and is valued at $1.1 million and
$2.0 million at December 31, 2000 and 1999, respectively. The fair value of our
ownership in LAJ, based on the quoted trading price, was approximately $2.6
million and $63.4 million at December 31, 2000 and 1999, respectively. Although
high risk in nature, we believe that these types of investments outside of the
United States are important to establish a complementary international
distribution infrastructure. In Japan, we have partnered with local partners to
have Liquid Audio Japan exclusively resell and distribute a Japanese version of
our software technology and to develop business services that enable the
digital delivery of music in the local market. In Korea, we have partnered with
a local partner to have Liquid Audio Korea focus on kiosk-based retail
applications of our technology. These applications are intended to allow
consumers to preview and purchase compact discs and other transportable media
from retail entertainment centers. Liquid Audio Korea released these kiosks in
the first retail entertainment center in October 1999. In Taiwan and Hong Kong,
we partnered with a local partner to have Liquid Audio Greater

                                       34
<PAGE>

China exclusively resell and distribute our software technology and to develop
business services that enable the digital delivery of music in the local
markets. In south east Asia, we partnered with a local partner to have Liquid
Audio South East Asia exclusively resell and distribute and distribute our
software technology and to develop business services that enable the digital
delivery of music in the Singapore, Thailand, Malaysia, Indonesia, Philippines,
Australia and New Zealand markets.

   Although we have no material commitments for capital expenditures or
strategic investments, we anticipate a decline in the rate of capital
expenditures. We may also use cash to acquire or license technology, products
or businesses related to our current business. In addition, we anticipate that
we will experience low or no growth or a decline in our operating expenses for
the foreseeable future and that our operating expenses will be a material use
of our cash resources.

   We believe that our existing cash and cash equivalents and financing
available under lease agreements will be sufficient to meet our anticipated
cash needs for working capital and capital expenditures for the foreseeable
future, although we may seek to raise additional capital during that period.
The sale of additional equity or convertible debt securities could result in
additional dilution to our stockholders. There can be no assurance that
financing will be available in amounts or on terms acceptable to us, if at all.

Recent Accounting Pronouncements

   In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes a new
model for accounting for derivatives and hedging activities and supercedes and
amends a number of existing accounting standards. SFAS No. 133 requires that
all derivatives be reported on the balance sheet at their fair market value and
the corresponding derivative gains or losses be either reported in the
statement of operations or as a deferred item depending on the type of hedge
relationship that exists with respect to any derivatives. In July 1999, the
FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities--Deferral of the Effective Date of FASB Statement No. 133." SFAS No.
137 deferred the effective date until fiscal years commencing after June 15,
2000. In June 2000, the FASB issued SFAS No. 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities." SFAS No. 138 amends
certain terms and conditions of SFAS No. 133. We will adopt SFAS No. 133 and
138 in our quarter ending March 31, 2001. We do not believe that the
pronouncement will have a material impact on our financial position or results
of operations as currently conducted.

   In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) 101, "Revenue Recognition." SAB 101 outlines the
basic criteria that must be met to recognize revenue and provides guidance for
presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with the SEC. In June 2000, the SEC
issued SAB 101B to defer the effective date of implementation of SAB 101 until
the fourth quarter of fiscal 2000. Adopting SAB 101 did not have a material
impact on our financial position or results of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   At December 31, 2000, we had an investment portfolio of cash, money market
funds, commercial securities and U.S. Government bonds including those
classified as short-term investments, of $123.8 million. We had a related party
loan outstanding at December 31, 2000 of $393,000, which was denominated in
Japanese yen and bore interest at 2.6%. These instruments, like all fixed
income instruments, are subject to interest rate risk. The fixed income
portfolio will fall in value and the related party note payable interest would
increase if there were an increase in interest rates. If market interest rates
were to increase immediately and uniformly by 10% from levels as of December
31, 2000 and 1999, the decline of the fair value of the fixed income portfolio
and related party note payable would not be material. See notes 1 and 2 of
notes to financial statements.

                                       35
<PAGE>

   As a global concern, we face exposure to adverse movements in foreign
currency exchange rates. These exposures may change over time as business
practices evolve and could seriously harm our financial results. Substantially
all of our international sales are currently denominated in U.S. dollars. An
increase in the value of U.S. dollar relative to foreign currencies could make
our products and services more expensive and therefore, reduce the demand for
our products and services. Reduced demand for our products and services could
seriously harm our financial results. Currently, we do not hedge against any
foreign currencies and as a result, could incur unanticipated gains or losses.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   Reference is made to the Index to Financial Statements which appears on page
F-1 of this report. The Report of Independent Accountants, Financial Statements
and Notes to Financial Statements which are listed in the Index to Financial
Statements and which appear beginning on page F-2 of this report are
incorporated into this Item 8.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

   Not applicable.

                                       36
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   The following table presents our directors and executive officers, their
ages and the positions held by them as of December 31, 2000:

<TABLE>
<CAPTION>
            Name            Age                     Position
 -------------------------- --- -----------------------------------------------
 <C>                        <C> <S>
 Gerald W. Kearby.......... 53  President, Chief Executive Officer and Director
 Robert G. Flynn........... 46  Senior Vice President of Business Development
                                and Secretary
 Philip R. Wiser........... 34  Senior Vice President of Engineering, Chief
                                Technical Officer and Director
 Richard W. Wingate........ 48  Senior Vice President of Content Development
                                and Label Relations
 James Lynch III........... 37  Vice President of Information Technology
                                (resigned February 2001)
 Kevin M. Malone........... 35  Vice President of Business Development, Europe
 Mathieu "Charly" Prevost.. 52  Vice President of Promotions
 Andrea Cook Fleming....... 34  Vice President of Corporate Marketing
 Leon Rishniw.............. 35  Vice President of Engineering
 Paul W. Melnychuck........ 41  Vice President of Sales and Business
                                Development
 Ann Winblad............... 50  Director
 Silvia Kessel............. 49  Director
 Sanford R. Climan......... 45  Director (resigned March 2001)
</TABLE>

   Mr. Kearby co-founded Liquid Audio in January 1996. Since January 1996, Mr.
Kearby has served as our President and Chief Executive Officer and one of our
directors. From June 1995 to December 1995, Mr. Kearby was co-founder and Chief
Executive Officer of Integrated Media Systems, a manufacturer of computer-based
professional audio equipment. From January 1989 until June 1995, Mr. Kearby
served as Vice President of Sales and Marketing at Studer Editech Corporation,
a professional audio recording equipment company. Mr. Kearby holds a B.A. in
broadcast management and audio engineering from San Francisco State University.

   Mr. Flynn co-founded Liquid Audio in January 1996. Since July 1999, Mr.
Flynn has served as our Senior Vice President of Business Development and
Secretary. From January 1996 to July 1999, Mr. Flynn served as our Vice
President of Business Development and Secretary. Mr. Flynn also served as our
Chief Financial Officer from January 1996 to August 1997 and as one of our
directors from January 1996 to June 1996. From March 1987 until November 1995,
Mr. Flynn served as a general partner of Entertainment Media Venture Partners
I, L.P., an institutional venture capital fund investing in the entertainment,
media and communications technology industries. During this time, Mr. Flynn
also served on the board of directors of Integrated Media Systems. Mr. Flynn
holds a B.A. in English from Stanford University and an M.B.A. from University
of California at Los Angeles.

   Mr. Wiser co-founded Liquid Audio in January 1996. Since July 1999, Mr.
Wiser has served as our Senior Vice President of Engineering and Chief
Technical Officer. From May 1996 to July 1999, Mr. Wiser served as our Vice
President of Engineering and from November 1998 to July 1999 as our Chief
Technical Officer. Since June 1996, he has also served as one of our directors.
From July 1995 to May 1996, Mr. Wiser served as a senior software engineer,
directing audio compression work at Chromatic Research, a multimedia
semiconductor device company. From October 1994 to July 1995, Mr. Wiser was a
senior software engineer and the director of digital signal processing research
for Studer Editech Corporation. From June 1994 to October 1994, Mr. Wiser was a
software engineer for Sonic Solutions, a developer of digital media tools. Mr.
Wiser holds a B.S. in electrical engineering from the University of Maryland,
College Park and an M.S. in electrical engineering from Stanford University.

   Mr. Wingate has served as our Senior Vice President of Content Development
and Label Relations since November 1999 and as our Vice President of Content
Development and Label Relations since August 1998.

                                       37
<PAGE>

Mr. Wingate operated his own new media marketing consulting company, Wingate
Marketing, from July 1996 until June 1998. From August 1997 to June 1998, Mr.
Wingate was also a private music industry consultant. From June 1994 to July
1996, Mr. Wingate was Senior Vice President, Marketing for Arista Records
Incorporated, a music recording company. Prior to June 1994, Mr. Wingate held
several senior management positions with major music industry record labels,
including Polygram, Inc. and Columbia Records. Mr. Wingate holds a B.A. in
communications from Brown University.

   Mr. Lynch served as our Vice President of Information Technology from
November 1999 to February 2001. From August 1997 to November 1999, Mr. Lynch
was Manager of Integration Services at Wells Fargo & Company, a banking
institution. From November 1996 to August 1997, Mr. Lynch was an Internet
development consultant, providing services to several companies, including
Internet service providers. Prior to November 1996, Mr. Lynch owned Business
Link Communications, a prepress company, and worked as a music journalist and
artist manager. Mr. Lynch holds a B.A. in English from Columbia University.

   Mr. Malone has served as our Vice President of Sales since February 1998.
From June 1997 to February 1998, Mr. Malone was our Director, International
Sales. From May 1993 to June 1997, Mr. Malone held a variety of positions at
Silicon Graphics, Inc., a manufacturer of work stations, servers and
supercomputing systems, including Manager, Strategic Marketing, Operations
Manager, Portugal and International Business Development Manager. Mr. Malone
holds a B.S. in business administration from the University of Arizona and an
M.B.A. in international business studies from the University of South Carolina.

   Mr. Prevost has served as our Vice President of Promotions since December
1998. From April 1996 to November 1998, Mr. Prevost was Vice President, Retail
at The Album Network, a media company trade journal. Prior to April 1996, Mr.
Prevost was president of his own company, the Charly Prevost Company, a
multimedia management company. Mr. Prevost has also held several senior
management positions within the music recording industry, including president
of Island Records.

   Ms. Fleming has served as our Vice President of Corporate Marketing since
June 1999. From February 1999 to June 1999, Ms. Fleming was our Director of
Corporate Marketing. From December 1995 to February 1999, Ms. Fleming served as
Public Relations Director at Netscape Communications Corporation, an Internet
services provider. From June 1994 to December 1995, Ms. Fleming was a Corporate
Public Relations Manager for Microsoft Corporation, a software company. Ms.
Fleming holds a B.A. in English from Stanford University.

   Mr. Rishniw has served as our Vice President of Engineering since October
1999. He was originally employed by us as a software engineer in August 1996,
became one of our Development Managers in January 1997 and Director of
Engineering in November 1998. From May 1995 until August 1996, Mr. Rishniw
served as a senior software engineer for Studer Editech, a professional audio
recording equipment company. From August 1994 until May 1995, Mr. Rishniw
served as a software engineer for Signal Stream Technology, a medical imaging
technology provider. Mr. Rishniw holds a B.S. in engineering from Melbourne
Institute of Technology.

   Mr. Melnychuck has served as our Vice President of Sales and Business
Development since February 2000. From April 1998 to February 2000, Mr.
Melnychuck served as Director of Corporate Marketing and Communications at
Digidesign, a manufacturer of digital audio workstations and a division of Avid
Technology, Inc. From May 1981 to April 1998, Mr. Melnychuck held a variety of
positions at Eastman Kodak Company, an imaging company, including Senior Vice
President and General Manager of Kodak Recording Products, a division of FPC,
Inc., a Kodak Company from January 1996 to April 1998 and other sales,
marketing, product development, manufacturing and research positions in prior
years. Mr. Melnychuck holds a B.S. in chemistry, a M.S. in imaging science from
Rochester Institute of Technology and a M.S. in electrical engineering from
National Technological University.

   Ms. Winblad has served as one of our directors since May 1996. Ms. Winblad
has been a general partner of Hummer Winblad Venture Partners, a venture
capital investment firm, since 1989. She is a member of the

                                       38
<PAGE>

board of trustees of the University of St. Thomas and is an advisor to numerous
entrepreneurial groups such as the Software Development Forum and Software
Industry Business Practices. Ms. Winblad also serves on the boards of directors
of Net Perceptions Inc., a developer and supplier of realtime recommendation
technology for the Internet, The Knot, Inc., an Internet-based wedding services
company, and several private companies. Ms. Winblad holds a B.S. in mathematics
and business administration from the College of Saint Catherine and an M.A. in
education with an economics focus from the University of St. Thomas.

   Ms. Kessel has served as one of our directors since October 1998. Since
November 1995, Ms. Kessel has held several positions at Metromedia
International Group, Inc., a global communications and media company, including
Executive Vice President, Chief Financial Officer and Treasurer. From January
1993 to June 1997, Ms. Kessel was Executive Vice President and a director of
Orion Pictures Corporation, a movie production company. Since January 1994, Ms.
Kessel has served as Senior Vice President of Metromedia Company, a privately-
held partnership. Ms. Kessel has also served as President of Kluge & Company, a
privately-held company, for over five years. Ms. Kessel is currently a director
and Executive Vice President of Metromedia Fiber Network, Inc., a fiber optic
network provider, and Big City Radio, Inc., an owner and operator of radio
station combinations in New York City, Chicago and Los Angeles. Ms. Kessel
received an M.B.A. in finance from Columbia University.

   Mr. Climan served as one of our directors from April 1999 to March 2001.
Since February 1999, Mr. Climan has been President of Entertainment Media
Ventures, Inc., an investment and advisory company focused on traditional and
new media. From October 1995 to May 1997, Mr. Climan was Executive Vice
President and President of Worldwide Business Development for Universal
Studios, Inc., a media production company. From June 1997 to February 1999 and
from June 1986 to September 1995, Mr. Climan was a member of the senior
management team at Creative Artists Agency, a talent and literary
representation firm. Mr. Climan also serves on the boards of directors of
Equity Marketing, Inc., a provider of custom promotional programs, and Sunterra
Corporation, a developer and operator of vacation ownership resorts. Mr. Climan
holds a B.A. in chemistry from Harvard College, an M.S. in health policy and
management from the Harvard School of Public Health and an M.B.A. from Harvard
Business School.

Section 16(a) Beneficial Ownership Reporting Compliance

   Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
officers and directors, and persons who own more than 10% of a registered class
of the Company's equity securities, to file certain reports regarding ownership
of, and transactions in, the Company's securities with the Securities and
Exchange Commission (SEC) and with Nasdaq. Such officers, directors and 10%
shareholders are also required by SEC rules to furnish the Company with copies
of all Section 16(a) forms that they file.

   Based solely on its review of copies of Forms 3 and 4 and amendments thereto
furnished to the Company pursuant to Rule 16(a)-(e) and Forms 5 and amendments
thereto furnished to the Company with respect to the last fiscal year, and any
written representations referred to in Item 405(b)(2)(i) of Regulation S-K
stating that no Forms 5 were applicable to the Company's officers, directors
and 10% shareholders were complied with, except a late filing of a Form 4 by
Sanford Climan, resulting in one sales transaction not being reported on time
and a late filing of a Form 3 by Paul Melnychuck, resulting in his initial
holdings not being reported on time.

Board Composition

   We currently have four directors. Sanford R. Climan resigned in March 2001
and did not have any disagreements with the other directors or our management.
Our restated certificate of incorporation divides our board of directors into
three classes: Class I, whose term will expire at the annual meeting of
stockholders to be held in 2003; Class II, whose term will expire at the annual
meeting of stockholders to be held in 2001; and Class III, whose term will
expire at the annual meeting of stockholders to be held in 2002. The Class I
director position is vacant, the Class II directors are Silvia Kessel and Ann
Winblad and the Class III directors are

                                       39
<PAGE>

Gerald W. Kearby and Philip R. Wiser. At each annual meeting of stockholders
after the initial classification, the successors to directors whose terms have
expired will be elected to serve from the time of election and qualification
until the third annual meeting following their election. In addition, our
bylaws provide that the authorized number of directors may be changed only by
resolution of the board of directors. Any additional directorships resulting
from an increase in the number of directors will be distributed among the three
classes so that, as nearly as possible, each class will consist of one-third of
the total number of directors. This classification of the board of directors
may have the effect of delaying or preventing changes in our control or
management.

   Each officer is elected by, and serves at the discretion of, the board of
directors. Each of our officers and directors, other than non-employee
directors, devotes his or her full time to our affairs. Our non-employee
directors devote the amount of time necessary to discharge their duties to us.
There are no family relationships among any of our directors, officers or key
employees.

Board Committees

   The audit committee of the board of directors reviews our internal
accounting procedures and consults with and reviews the services provided by
our independent accountants. The audit committee currently consists of Silvia
Kessel and Ann Winblad. Sanford R. Climan served on the audit committee prior
to his resignation.

   The compensation committee of the board of directors reviews and recommends
to the board of directors the compensation and benefits of all of our executive
officers, administers our stock and option plans and establishes and reviews
general policies relating to compensation and benefits of our employees. The
compensation committee currently consists of Ann Winblad and Silvia Kessel.
Sanford R. Climan served on the compensation committee prior to his
resignation. No interlocking relationships exist between our board of directors
or compensation committee and the board of directors or compensation committee
of any other company, nor has an interlocking relationship existed in the past.

Director Compensation

   Our directors do not receive cash compensation for their service as members
of the board of directors, although they are reimbursed for certain expenses in
connection with attendance at board and committee meetings. Non-employee
directors are granted a fully vested option to purchase 30,000 shares of common
stock upon initial election and a fully vested option to purchase 10,000 shares
of common stock on each anniversary of becoming a director during their term of
service. We do not provide additional compensation for committee participation
or special assignments of the board of directors. In October 2000, we granted
Silvia Kessel, Ann Winblad and Sanford R. Climan an option to purchase 10,000
shares of common stock each.

Change of Control Arrangements

   We have granted options to purchase common stock to James Lynch III. The
shares underlying the options are subject to a vesting schedule that
accelerates with respect to the lesser of 25% of the total number of shares
subject to each option or the remaining unvested shares upon certain corporate
transactions, as described in each individual option grant.

                                       40
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

   The information required by this item is incorporated by reference to the
information set forth in our proxy statement for the 2001 Annual Meeting of
Stockholders to be filed with the Commission within 120 days after the end of
our fiscal year ended December 31, 2000.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   The information required by this item is incorporated by reference to the
information set forth in our proxy statement for the 2001 Annual Meeting of
Stockholders to be filed with the Commission within 120 days after the end of
our fiscal year ended December 31, 2000.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information required by this item is incorporated by reference to the
information set forth in our proxy statement for the 2001 Annual Meeting of
Stockholders to be filed with the Commission within 120 days after the end of
our fiscal year ended December 31, 2000.

                                       41
<PAGE>

                                   PART IV.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

   (a)(1) Index to Financial Statements

   Please see the accompanying Index to Financial Statements which appears on
page F-1 of this report. The Report of Independent Accountants, Financial
Statements and Notes to Financial Statements which are listed in the Index to
Financial Statements and which appear beginning on page F-2 of this report are
included in Item 8 above.

   (a)(2) Schedules not listed have been omitted because the information
required to be set forth therein is not applicable or is included in the
Financial Statements or notes thereto.

   (a)(3) Exhibits

   Please see subsection (c) below.

   (b) Reports on Form 8-K

   Not applicable.

   (c) Exhibits

   The following exhibits are incorporated herein by reference or are filed
with this report as indicated below:

<TABLE>
<CAPTION>
 Number                               Description
 ------ -----------------------------------------------------------------------
 <C>    <S>
  3.1   Certificate of Incorporation as currently in effect (1)
  3.2   Bylaws as currently in effect (4)
  4.1   Reference is made to Exhibits 3.1 and 3.2
  4.2   Form of Specimen Stock Certificate (1)
  4.3   Second Amended and Restated Investor Rights Agreement dated July 31,
        1998 (1)
 10.1   Form of Indemnification Agreement entered into between the registrant
        and each of its directors and executive officers (1)
 10.2   1996 Equity Incentive Plan (1)
 10.3   1999 Employee Stock Purchase Plan (1)
 10.4   Licensing Agreement with SESAC dated May 21, 1998 (1)
 10.5+  Software Cross License Agreement with Adaptec, Inc. dated June 12, 1998
        (1)
 10.6   Form of Liquid Music Network Agreement (1)
 10.7+  Letter Agreement with Compaq Computer Corporation dated March 23, 1998
        (1)
 10.8+  LA Agreement with Real Networks, Inc. dated April 26, 1998 (1)
 10.9+  Binary Software License Agreement with Precept Software, Inc. dated
        September 30, 1997 (1)
 10.10+ Patent License Agreement with Fraunhofer-Gesellschaft, zur Forderung
        der angewandten Forschung e.V. dated August 14, 1998 (1)
 10.11+ Software License Agreement with Fraunhofer-Gesellschaft, zur Forderung
        der angewandten Forschung e.V. dated August 14, 1998 (1)
 10.12+ OEM Master License Agreement with RSA Data Security, Inc. dated July
        18, 1997 (1)
 10.13+ Agreement in Principle with N2K, Inc. dated February 12, 1997 (1)
 10.14+ Patent License Agreement with Dolby Laboratories Licensing Corporation,
        dated May 3, 1996 (1)
</TABLE>

                                      42
<PAGE>

<TABLE>
<CAPTION>
 Number                               Description
 ------ -----------------------------------------------------------------------
 <C>    <S>
 10.15+ Adjustment to Patent and License Agreement with Dolby Laboratories
        Licensing Corporation, dated September 18, 1997 (1)
 10.16+ Source Code, Trademark and Know-How License Agreement with Dolby
        Laboratories Licensing Corporation dated May 3, 1996 (1)
 10.17  Founders Restricted Stock Purchase Agreement (with amendments) with
        Gerald W. Kearby dated April 25, 1996 (1)
 10.18  Founders Restricted Stock Purchase Agreement (with amendments) with
        Philip R. Wiser dated April 25, 1996 (1)
 10.19  Founders Restricted Stock Purchase Agreement (with amendments) with
        Robert G. Flynn dated April 25, 1996 (1)
 10.20  Master Equipment Lease No. 0044 (with amendments) with Phoenix Leasing
        Incorporated dated as of October 15, 1996 (1)
 10.21  Summary Plan Description of 401(K) Plan (1)
 10.22  Loan and Security Agreement with Silicon Valley Bank dated April 16,
        1998 (1)
 10.23  Loan and Security Agreement with Silicon Valley Bank dated November 16,
        1998 (1)
 10.24  Lease Agreement with Master Lease, a Division of Tokai Financial
        Services, dated March 3, 1998 (1)
 10.25  Lease Agreement with John Anagnostou Realty and Michael J. Monte, dated
        February 16, 1999, for property located at 2221 Broadway, Redwood City,
        California (1)
 10.26  Lease and Service Agreement with Alliance Business Centers, dated
        August 17, 1998, and Office Rider dated February 1, 1999, for property
        located at 599 Lexington Avenue, New York, New York (1)
 10.27  Lease Agreement with New Retail Concepts Ltd., dated September 1, 1998,
        for property located at 21 Bridge Square, Westport, Connecticut (1)
 10.28  Commercial Lease with Jim and Jeannette Beeger, dated November 3, 1998,
        for property located at 820 Winslow Street, Redwood City, California
        (1)
 10.29  Commercial Lease with John Anagnostou Realty, dated October 9, 1997,
        for property located at 810 Winslow Street, Redwood City, California
        (1)
 10.30+ Software Reseller Agreement with Liquid Audio Japan, dated as of August
        9, 1998 (1)
 10.31+ Shareholder Agreement with Super Stage, Inc., Liquid Audio Japan, Inc.,
        ITOCHU Corporation, and Hikari Tsushin, Inc., dated March 31, 1999 (1)
 10.32  Loan Agreement with Super Factory, Inc., dated March 31, 1999 (1)
 10.33+ Share Sale and Purchase and Option Agreement with Super Stage, Inc.,
        dated March 31, 1999 (1)
 10.34+ Shareholders Agreement with SKM Limited and Liquid Audio Korea Co. Ltd.
        dated December 31, 1998 (1)
 10.35+ Software Reseller and Services Agreement with Liquid Audio Korea Co.
        Ltd. dated December 31, 1998 (1)
 10.36+ Consulting Agreement with Liquid Audio Korea Co. Ltd. dated December
        31, 1998 (1)
 10.37  Consulting Agreement with SKM Limited dated December 31, 1998 (1)
 10.38  Guaranty issued to Liquid Audio, Inc. by SKM Limited dated December 31,
        1998 (1)
 10.39  Software License Agreement with Intel Corporation dated May 4, 1999 (1)
 10.40  Liquid Remote Inventory Fulfillment Systems(TM) Merchant Affiliate and
        License Agreement with MTS, Inc., dated May 14, 1999 (1)
</TABLE>

                                       43
<PAGE>

<TABLE>
<CAPTION>
 Number                               Description
 ------ -----------------------------------------------------------------------
 <C>    <S>
 10.41+ OEM Agreement with Sanyo Electric Co., Ltd. dated June 2, 1999 (1)
 10.42  Amazon.com/Liquid Audio Advertising Agreement, including exhibits,
        dated as of June 9, 1999 (1)
 10.43  Online Program Agreement with Muze, Inc., dated as of February 9, 1999
        (1)
 10.44  Letter Agreement By and Between Texas Instrument Incorporated, dated as
        of January 29, 1999 (1)
 10.45+ OEM Agreement with Toshiba Corporation, dated June 9, 1999 (1)
 10.46  Stock Option Agreement with Gary J. Iwatani, dated November 10, 1997
        (1)
 10.47  Letter Agreement with Virgin Holdings, Inc., an affiliate of EMI
        Recorded Music, dated June 16, 1999 (1)
 10.48  Commercial Lease with George Anagnostou, dated August 1, 1999, for
        property located at 2317 Broadway, Redwood City, California (2)
 10.49+ Amended and Restated License Agreement with Liquid Audio Japan, Inc.,
        dated January 1, 2000 (3)
 10.50  2000 Nonstatutory Stock Option Plan (4)
 10.51  Letter Agreement with Virgin Holdings, Inc., an affiliate of EMI
        Recorded Music, dated July 10, 2000 (5)
 11.1   Statement regarding computation of per share earnings (6)
 21.1   Subsidiary of Liquid Audio, Inc.
 23.1   Consent of PricewaterhouseCoopers LLP
 24.1   Power of Attorney (contained in the signature page to this report)
</TABLE>
--------
 +  confidential treatment received as to certain portions
(1) incorporated by reference to the Registration Statement on Form S-1 and all
    amendments thereto, Registration No. 333-77707, filed with the Securities
    and Exchange Commission on May 4, 1999 and declared effective July 8, 1999
(2) incorporated by reference to the Registration Statement on Form S-1 and all
    amendments thereto, Registration No. 333-91541, filed with the Securities
    and Exchange Commission on November 23, 1999 and declared effective
    December 14, 1999
(3) incorporated by reference to the Form 10-Q filed with the Securities and
    Exchange Commission on May 15, 2000
(4) incorporated by reference to the Form 10-Q filed with the Securities and
    Exchange Commission on August 14, 2000
(5) incorporated by reference to the Form 10-Q filed with the Securities and
    Exchange Commission on November 13, 2000
(6) this exhibit has been omitted because the information is shown in the
    financial statements or notes thereto

                                       44
<PAGE>

                                   SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Palo Alto, State of California on March 30, 2001.

                                                   /s/ Gerald W. Kearby
                                          By: _________________________________
                                                      Gerald W. Kearby
                                                  Chief Executive Officer

                               POWER OF ATTORNEY

   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below hereby constitutes and appoints, jointly and severally, Gerald W. Kearby
and Lyman Yip, and each of them, as his or her attorney-in-fact, with full
power of substitution, for him or her in any and all capacities, to sign any
and all amendments to this report, and to file the same, with exhibits thereto
and other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming his or her signatures as they may
be signed by his or her said attorney to any and all amendments to said report.

   PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE
DATES INDICATED:

<TABLE>
<CAPTION>
         Signature                       Title                      Date
   ---------------------- -----------------------------------  --------------
   <C>                    <S>                                  <C>
   /s/ Gerald W. Kearby   President, Chief Executive Officer   March 30, 2001
   ______________________  and Director
      Gerald W. Kearby     (Principal Executive Officer)

      /s/ Lyman Yip       Controller and Acting Chief          March 30, 2001
   ______________________  Financial Officer
         Lyman Yip         (Principal Financial and
                           Accounting Officer)

   /s/ Philip R. Wiser    Senior Vice President of             March 30, 2001
   ______________________  Engineering,
      Philip R. Wiser      Chief Technical Officer and
                           Director

     /s/ Ann Winblad      Director                             March 30, 2001
   ______________________
        Ann Winblad

    /s/ Silvia Kessel     Director                             March 30, 2001
   ______________________
       Silvia Kessel
</TABLE>

                                       45
<PAGE>

                               LIQUID AUDIO, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
Report of Independent Accountants.......................................... F-2
Consolidated Balance Sheets................................................ F-3
Consolidated Statement of Operations....................................... F-4
Consolidated Statement of Stockholders' Equity (Deficit)................... F-5
Consolidated Statement of Cash Flows....................................... F-6
Notes to Consolidated Financial Statements................................. F-7
</TABLE>

                                      F-1
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
 Liquid Audio, Inc.

   In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations and comprehensive income (loss), of
stockholders' equity (deficit) and of cash flows present fairly, in all
material respects, the financial position of Liquid Audio, Inc. ("Liquid
Audio") and its subsidiary at December 31, 2000, and 1999, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2000 in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of Liquid Audio's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and
perform the audit 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, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

PricewaterhouseCoopers LLP

San Jose, California
February 2, 2001

                                      F-2
<PAGE>

                               LIQUID AUDIO, INC.

                          CONSOLIDATED BALANCE SHEETS
               (in thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                 ------------------
                                                                   2000      1999
                                                                 --------  --------
                             Assets
                             ------

<S>                                                              <C>       <C>
Current assets:
 Cash and cash equivalents...................................... $ 96,398  $138,692
 Short-term investments.........................................   27,378    19,157
 Accounts receivable from third parties, net....................      725       151
 Accounts receivable from related parties.......................    1,253       435
 Other current assets                                               2,307       638
                                                                 --------  --------
  Total current assets..........................................  128,061   159,073
 Investment in strategic partner................................    1,089     1,959
 Property and equipment, net....................................    8,860     4,857
 Other assets...................................................      200       220
                                                                 --------  --------
      Total assets.............................................. $138,210  $166,109
                                                                 ========  ========
<CAPTION>
              Liabilities and Stockholders' Equity
              ------------------------------------
<S>                                                              <C>       <C>
Current liabilities:
 Accounts payable............................................... $  3,314  $  1,952
 Accrued expenses and other current liabilities.................    3,522     2,736
 Deferred revenue from third parties............................      440       405
 Deferred revenue from related parties..........................      987     1,167
 Capital lease obligations, current portion.....................      120       194
 Equipment loan, current portion................................      589       589
                                                                 --------  --------
  Total current liabilities.....................................    8,972     7,043
Capital lease obligations, non-current portion..................       28       149
Equipment loan, non-current portion.............................      143       731
Note payable to related party...................................      393       441
                                                                 --------  --------
    Total liabilities...........................................    9,536     8,364
                                                                 --------  --------

Commitments and contingencies (Note 9)

Stockholders' equity:
 Common stock, $0.001 par value; 50,000,000 shares authorized;
  22,541,959 and
  21,875,256 shares issued and outstanding......................       23        22
 Additional paid-in capital.....................................  202,877   198,973
 Unearned compensation..........................................     (333)   (1,097)
 Accumulated deficit............................................  (73,910)  (40,225)
 Accumulated other comprehensive income.........................       17        72
                                                                 --------  --------
    Total stockholders' equity..................................  128,674   157,745
                                                                 --------  --------
      Total liabilities and stockholders' equity................ $138,210  $166,109
                                                                 ========  ========
</TABLE>

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

                                      F-3
<PAGE>

                               LIQUID AUDIO, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
               (in thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                              ---------------------------------
                                                 2000        1999       1998
                                              ----------  ----------  ---------
<S>                                           <C>         <C>         <C>
Net revenues:
 License..................................... $    1,284  $    1,537  $   1,235
 Services....................................      2,977         733        268
 Business development (related party)........      7,307       2,137      1,300
                                              ----------  ----------  ---------
    Total net revenues.......................     11,568       4,407      2,803
                                              ----------  ----------  ---------

Cost of net revenues:
 License.....................................        290         235        310
 Services....................................      2,722       1,122        242
 Business development (related party)........         75          79          2
 Non-cash cost of revenues...................         28          25         36
                                              ----------  ----------  ---------
    Total cost of net revenues...............      3,115       1,461        590
                                              ----------  ----------  ---------
 Gross profit................................      8,453       2,946      2,213
                                              ----------  ----------  ---------
Operating expenses:
 Sales and marketing.........................     17,114      10,217      4,035
 Non-cash sales and marketing................        314         783        741
 Research and development....................     22,917      11,706      4,109
 Non-cash research and development...........         80         371        210
 General and administrative..................      7,131       2,770      1,642
 Non-cash general and administrative.........         13         190        254
 Strategic marketing--equity instruments.....      1,935       3,130        --
                                              ----------  ----------  ---------
    Total operating expenses.................     49,504      29,167     10,991
                                              ----------  ----------  ---------

Loss from operations.........................    (41,051)    (26,221)    (8,778)
Interest income..............................      8,809       2,271        379
Interest expense.............................       (144)       (193)      (140)
Other income (expense), net..................       (429)        (63)       --
Equity in net loss of investment.............       (870)        --         --
                                              ----------  ----------  ---------
Net loss..................................... $  (33,685) $  (24,206) $  (8,539)
                                              ==========  ==========  =========

Net loss per share:
 Basic and diluted........................... $    (1.52) $    (2.28) $   (3.60)
                                              ==========  ==========  =========
 Weighted average shares..................... 22,133,403  10,615,566  2,370,564
                                              ==========  ==========  =========
</TABLE>

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

                                      F-4
<PAGE>

                               LIQUID AUDIO, INC.

           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                      (in thousands, except share amounts)

<TABLE>
<CAPTION>
                            Common Stock     Additional Unearned                  Other
                          ------------------  Paid-in   Compen-   Accumulated Comprehensive
                            Shares    Amount  Capital    sation     Deficit   Income (Loss)  Total
                          ----------  ------ ---------- --------  ----------- ------------- --------
<S>                       <C>         <C>    <C>        <C>       <C>         <C>           <C>
Balance at December 31,
 1997...................   3,899,643   $ 4    $  2,159  $(1,562)   $ (7,480)      $--       $ (6,879)
Repurchase of founders'
 common stock...........     (87,868)  --          --       --          --         --            --
Repurchase of common
 stock in connection
 with unvested stock
 options previously
 exercised..............     (24,219)  --           (2)     --          --         --             (2)
Issuance of common stock
 in connection with
 exercise of stock
 options................      90,173   --            6      --          --         --              6
Issuance of common stock
 in connection with a
 strategic marketing
 agreement..............      38,316   --           40      --          --         --             40
Unearned compensation,
 net of effect of
 cancellations..........         --    --        1,714   (1,714)        --         --            --
Amortization of unearned
 compensation...........         --    --          --     1,241         --         --          1,241
Net loss................         --    --          --       --       (8,539)       --         (8,539)
                          ----------   ---    --------  -------    --------       ----      --------
Balance at December 31,
 1998...................   3,916,045     4       3,917   (2,035)    (16,019)       --        (14,133)
Repurchase of common
 stock in connection
 with unvested stock
 options previously
 exercised..............     (50,861)  --           (3)     --          --         --             (3)
Issuance of common stock
 in connection with
 strategic marketing
 agreements.............     100,000   --        1,100      --          --         --          1,100
Issuance of common stock
 warrants in connection
 with strategic
 marketing agreements...         --    --        2,030      --          --         --          2,030
Conversion of
 mandatorily redeemable
 convertible preferred
 stock upon initial
 public offering........   9,744,199    10      29,791      --          --         --         29,801
Issuance of common stock
 in connection with
 public stock offerings,
 net of offering
 expenses of $1,481.....   7,750,147     8     159,592      --          --         --        159,600
Issuance of common stock
 in connection with
 exercise of stock
 options................     398,581   --          156      --          --         --            156
Issuance of common stock
 in connection with
 exercise of warrants...      17,145   --          --       --          --         --            --
Unearned compensation,
 net of effect of
 cancellations..........         --    --          431     (431)        --         --            --
Amortization of unearned
 compensation...........         --    --          --     1,369         --         --          1,369
Gain on investment in
 strategic partner......         --    --        1,959      --          --         --          1,959
Unrealized gain on
 investments............         --    --          --       --          --          72           --
Net loss................         --    --          --       --      (24,206)       --            --
Comprehensive loss......         --    --          --       --          --         --        (24,134)
                          ----------   ---    --------  -------    --------       ----      --------
Balance at December 31,
 1999...................  21,875,256    22     198,973   (1,097)    (40,225)        72       157,745
Repurchase of common
 stock in connection
 with unvested stock
 options previously
 exercised..............     (18,845)  --          (12)     --          --         --            (12)
Issuance of common stock
 for intellectual
 property...............       4,072   --           16      --          --         --             16
Issuance of common stock
 warrants in connection
 with strategic
 marketing agreements...         --    --        1,356      --          --         --          1,356
Issuance of common stock
 in connection with
 strategic marketing
 agreements.............     200,000   --        1,376      --          --         --          1,376
Issuance of common stock
 in connection with
 settlement of legal
 claim..................      30,000   --          354      --          --         --            354
Issuance of common stock
 in connection with
 employee stock purchase
 plan...................     194,877   --          934      --          --         --            934
Issuance of common stock
 in connection with
 exercise of stock
 options................     230,017     1         128      --          --         --            129
Issuance of common stock
 in connection with
 exercise of warrants...      26,582   --          107      --          --         --            107
Unearned compensation,
 net of effect of
 cancellations..........         --    --         (355)     355         --         --            --
Amortization of unearned
 compensation...........         --    --          --       409         --         --            409
Cumulative translation
 adjustment.............         --    --          --       --          --          23           --
Unrealized loss on
 investments............         --    --          --       --          --         (78)          --
Net loss................         --    --          --       --      (33,685)       --            --
Comprehensive loss......         --    --          --       --          --         --        (33,740)
                          ----------   ---    --------  -------    --------       ----      --------
Balance at December 31,
 2000...................  22,541,959   $23    $202,877  $  (333)   $(73,910)      $ 17      $128,674
                          ==========   ===    ========  =======    ========       ====      ========
</TABLE>

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

                                      F-5
<PAGE>

                               LIQUID AUDIO, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                     Year Ended December 31,
                                                    ---------------------------
                                                      2000      1999     1998
                                                    --------  --------  -------
<S>                                                 <C>       <C>       <C>
Cash flows from operating activities:
Net loss..........................................  $(33,685) $(24,206) $(8,539)
Adjustments to reconcile net loss to net cash used
 in operating activities:
 Depreciation and amortization....................     3,436     1,143      451
 Amortization of unearned compensation............       409     1,369    1,241
 Allowance for doubtful accounts and sales returns
  reserve.........................................       315       101      263
 Notes receivable write-off.......................       470       --       --
 Equity in net loss of investments................       870       378      400
 Strategic marketing-equity instruments...........     1,935     3,130      --
 Non-cash cost of revenue.........................        26       --       --
 Issuance of common stock in connection with
  settlement of a legal claim.....................       354       --       --
 Other............................................       (47)       63      --
 Changes in assets and liabilities:
 Accounts receivable from third parties...........      (889)       10     (502)
 Accounts receivable from related parties.........    (1,288)      180     (615)
 Other assets.....................................      (878)     (474)    (191)
 Accounts payable.................................     1,362     1,150      397
 Accrued expenses and other current liabilities...       909     1,918      206
 Deferred revenue.................................      (145)      395    1,087
                                                    --------  --------  -------
 Net cash used in operating activities............   (26,846)  (14,843)  (5,802)
                                                    --------  --------  -------
Cash flows from investing activities:
 Acquisition of property and equipment............    (7,439)   (4,456)    (982)
 Sales/(purchases) of short-term investments,
  net.............................................    (8,221)  (16,084)  (3,001)
 Equity investment................................       --        --      (400)
                                                    --------  --------  -------
 Net cash used in investing activities............   (15,660)  (20,540)  (4,383)
                                                    --------  --------  -------
Cash flows from financing activities:
 Proceeds from issuance of mandatorily redeemable
  convertible preferred stock.....................       --        --    21,535
 Proceeds from issuance of common stock, net of
  repurchases.....................................     1,051   159,753        4
 Payments made under capital leases...............      (195)     (221)    (118)
 Proceeds from equipment loan.....................       --        846      920
 Payments made under equipment loan...............      (588)     (446)     --
 Payments under line of credit....................       --        --      (400)
 Proceeds from short-term loan....................       --        --     1,330
 Payments on short-term loan......................       --        --    (1,330)
                                                    --------  --------  -------
 Net cash provided by financing activities........       268   159,932   21,941
                                                    --------  --------  -------
Effect of exchange rates on cash and cash
 equivalents......................................       (56)      --       --
                                                    --------  --------  -------
Net increase (decrease) in cash and cash
 equivalents......................................   (42,294)  124,549   11,756
Cash and cash equivalents at beginning of period..   138,692    14,143    2,387
                                                    --------  --------  -------
Cash and cash equivalents at end of period........  $ 96,398  $138,692  $14,143
                                                    ========  ========  =======
Supplemental cash flow disclosures:
 Cash paid for interest...........................  $    144  $    193  $   121

Supplemental non-cash investing and financing
 activities:
 Acquisition of property and equipment through
  capital leases..................................  $    --   $     37  $   305
 Issuance of warrants in connection with strategic
  marketing agreements............................     1,356     2,030      --
 Issuance of common stock in connection with
  strategic marketing agreements..................     1,376     1,100       40
 Issuance of common stock upon exercise of
  warrant.........................................       107       --       --
 Issuance of common stock for intellectual
  property........................................        16       --       --
 Equity investment with note payable..............       --        378      --
</TABLE>

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

                                      F-6
<PAGE>

                               LIQUID AUDIO, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

The Company

   Liquid Audio, Inc. (the "Company") was incorporated in California in January
1996 and reincorporated in Delaware in April 1999. In July 2000, the Company
established a wholly-owned subsidiary in the United Kingdom, Liquid Audio
Europe PLC, to develop sales in Europe. The Company was formed with the goal of
becoming the premier provider of software applications and services that enable
the secure delivery and sale of digital music over the Internet. The Company's
end-to-end solutions enable the secure distribution, promotion and sale of high
quality music files while providing consumers with the ability to access,
preview and purchase that music via the Internet.

   In July 1999, the Company completed its initial public offering of common
stock. A total of 4,800,000 shares were sold at $15.00 per share. Net proceeds
to the Company, after deducting the underwriting discount and offering
expenses, were $65.9 million. In December 1999, the Company completed a follow-
on public offering of common stock. A total of 2,946,076 shares were sold at
$33.63 per share. Net proceeds to the Company, after deducting the underwriting
discount and offering expenses, were $93.7 million.

Reclassifications

   Certain reclassifications have been made to the prior years' consolidated
financial statements to conform to current period presentation. The statement
of operations reflects reclassifications to allocate the non-cash compensation
expense related to the issuance of stock options from a single line
presentation within operating expenses to the respective amounts in cost of net
revenues, sales and marketing, research and development and general and
administrative expense.

Principles of Consolidation

   The financial statements include the accounts of the Company and its
subsidiary. Significant intercompany transactions and balances have been
eliminated.

Use of estimates

   The preparation of financial statements in conformity with generally
accepted accounting principles requires the Company's 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 consolidated financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.

Cash and cash equivalents and short-term investments

   All highly liquid investments with a maturity of three months or less when
purchased are considered to be cash equivalents, and those with maturities
greater than three months and less than twelve months are considered short-term
investments. Cash and cash equivalents consist of cash on deposit with banks,
money market funds and commercial securities that are stated at cost, which
approximates fair value. The Company classifies all short-term investments as
available-for-sale in accordance with Statement of Financial Accounting
Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." In addition, the cost of securities sold is based upon the
specific identification method. At December 31, 2000 and 1999, amortized cost
approximated fair value and unrealized gains and losses were insignificant.
Accordingly,

                                      F-7
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

these investments are carried at fair value at the balance sheet date, with
unrealized gains and losses recorded net of taxes in stockholders' equity. The
following schedule summarizes the estimated fair value of the Company's cash,
cash equivalents and short-term investments (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                              ----------------
                                                               2000     1999
                                                              ------- --------
   <S>                                                        <C>     <C>
   Cash and cash equivalents:
     Cash.................................................... $79,683 $ 10,237
     Money market funds......................................     265    8,613
     Commercial securities...................................  16,450  119,842
                                                              ------- --------
                                                              $96,398 $138,692
                                                              ======= ========
   Short-term investments:
     Commercial securities................................... $27,378 $  1,003
     U.S. Government bonds...................................     --    18,154
                                                              ------- --------
                                                              $27,378 $ 19,157
                                                              ======= ========
</TABLE>

   All short-term investments had a contractual maturity of one year or less.

Concentration of credit risk

   Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist primarily of cash and cash equivalents,
short term investments and accounts receivable. Substantially all of the
Company's cash and cash equivalents are invested in a highly-liquid money
market fund and commercial securities with major financial institutions. Short
term investments are invested in government and corporate bonds. The Company
performs ongoing credit evaluations of its customers and maintains an allowance
for potential credit losses. Credit losses to date have been within
management's estimates.

   The following table sets forth customers comprising 10% or more of the
Company's total net revenues for each of the periods indicated:

<TABLE>
<CAPTION>
                                                      Year Ended December 31,
                                                      -----------------------
   Customer                                            2000     1999     1998
   --------                                           -------  -------  -------
   <S>                                                <C>      <C>      <C>
   A (related party).................................     --       --        34%
   B.................................................     --        31%     --
   C (related party).................................     --        30%     --
   D (related party).................................     --        12%     --
   E (related party).................................      42%     --       --
   F (related party).................................      11%     --       --
</TABLE>

   At December 31, 2000, one customer represented 29% of gross accounts
receivable. At December 31, 1999, three customers represented 31%, 21% and 13%,
respectively, of gross accounts receivable.

Fair value of financial instruments

   The Company's financial instruments, including cash and cash equivalents,
short-term investments, accounts receivable, accounts payable, capital lease
obligations, an equipment loan, a line of credit and a note payable to a
related party are carried at cost and in the case of short-term investments, at
fair value which

                                      F-8
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

equates to market. The Company's short-term financial instruments, except for
short-term investments, approximate fair value due to their relatively short
maturities. The carrying value of the Company's long-term financial instruments
approximate fair value as the interest rates approximate current market rates
of similar debt. The Company does not hold or issue financial instruments for
trading purposes.

Property and equipment

   Property and equipment, including leasehold improvements, are stated at
historical cost. Depreciation and amortization are computed using the straight-
line method over the estimated useful lives of the assets, generally three
years, or for leasehold improvements, the term of the lease, whichever is
shorter. Assets held under capital leases are amortized using the straight-line
method over the shorter of the estimated useful life of the asset or the life
of the lease, generally three years.

Software development costs

   Costs incurred in connection with the development of the Company's Internet
site and services and other software for internal use are accounted for in
accordance with Statement of Position ("SOP") No. 98-1, "Accounting for the
Cost of Computer Software Developed or Obtained for Internal Use." SOP 98-1
requires that costs incurred in the preliminary project and post implementation
stages of an internal software project be expensed as incurred and that certain
costs incurred in the application development stage of a project be
capitalized. Costs qualifying for capitalization are amortized using the
straight-line method over the expected economic life of the software, generally
three years. The Company evaluates the net realizable value of capitalized
software and website costs on an ongoing basis, relying on a number of business
and economic factors.

Long-lived assets

   The Company accounts for long-lived assets under SFAS No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed of," which requires the Company to review the impairment of long-lived
assets whenever events or changes in circumstances indicate that the carrying
amount of an asset might not be recoverable. When such an event occurs, the
Company estimates the future of cash flows expected to result from the use of
an asset and its eventual disposition. If the undiscounted expected future cash
flows is less than the carrying amount of the asset, an impairment loss is
recognized. To date, the Company has not recognized an impairment loss on its
long-lived assets.

Revenue recognition

   Software license revenues are recognized when persuasive evidence of an
arrangement exists, delivery has occurred, no significant Company obligations
with regard to implementation or integration exist, the fee is fixed or
determinable and collection is probable as prescribed in SOP No. 97-2,
"Software Revenue Recognition." For arrangements with multiple elements, the
total fee from the arrangement is allocated among each element based upon
vendor specific objective evidence ("VSOE") of fair value. VSOE of fair value
for the service elements is based upon the standard hourly rate the Company
charges for services when such services are sold separately. VSOE of fair value
for annual maintenance is established based upon the optional stated renewal
rate. When VSOE of fair value exist for all undelivered elements, the Company
accounts for the delivered elements, primarily the license portion, based upon
the "residual method" as prescribed by SOP No. 98-9, "Modification of SOP 97-2
with Respect to Certain Transactions." The Company recognizes revenue allocated
to maintenance ratably over the contract period, which is generally twelve
months.

                                      F-9
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Business development revenue primarily consists of license and maintenance
fees derived from contractual agreements with the Company's strategic partners.
These U.S. dollar-denominated, non-refundable fees are based upon agreements
whereby the strategic partners are contractually obligated to pay to the
Company a fixed fee for the right to license and use the Company's proprietary
technology in various countries. The total fee from business development
agreements are allocated among the various elements of the contracts based on
VSOE of fair value. The fees are recognized by the Company as earned, the
specific timing of which depends on the terms and conditions of the particular
contractual arrangements, including payment terms. When VSOE of fair value does
not exist for the undelivered elements, the total fee from the business
development arrangement is recognized ratably over the period of the contract.

   The Company also generates license and service revenues from digital music
kiosk sales and hosting services. Revenue derived from hosting services include
subscription fees from artists for encoding and storing music files, e-commerce
services and transaction reporting. Music delivery services revenue include
transaction fees from sales of digital recorded music through the Company's
website affiliates and fees from music retailers and websites related to the
sample digital music clips delivery service. Revenue from kiosk sales consist
of software licenses and services revenue from equipment and kiosk-related
services. The Company bears full credit risk with respect to substantially all
sales.

Research and development costs

   Costs incurred in the research and development of new products and
enhancements of existing products are charged to expense as incurred until the
technological feasibility has been established through the development of a
working model. After establishing technological feasibility, additional
development costs incurred through the date the product is available for
general release to customers would be capitalized and amortized over the
estimated product life. To date, the period between achieving technological
feasibility and general release has been short and software development costs
qualifying for capitalization has been insignificant. Accordingly, the Company
has not capitalized any development costs in all periods presented.

Advertising

   Advertising costs are expensed as incurred. The following table sets forth
advertising costs for the periods indicated (in thousands):

<TABLE>
<CAPTION>
                                                                  Year Ended
                                                                 December 31,
                                                              ------------------
                                                               2000   1999  1998
                                                              ------ ------ ----
   <S>                                                        <C>    <C>    <C>
   Advertising costs......................................... $1,552 $1,659 $247
</TABLE>

Stock-based compensation

   The Company accounts for stock-based employee compensation arrangements in
accordance with provisions of Accounting Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees" and Financial Accounting
Standards Board Interpretation ("FIN") No. 28, "Accounting for Stock
Appreciation Rights and Other Variable Stock Option or Award Plans," and
complies with the disclosure provisions of SFAS No. 123, "Accounting for Stock-
Based Compensation." Under APB No. 25, compensation expense is based on the
difference, if any, on the date of the grant, between the fair value of the
Company's stock and the exercise price. Stock-based compensation is amortized
in accordance with FIN 28 using a multiple option approach. SFAS No. 123
defines a "fair value" based method of accounting for an employee stock option
or similar equity instrument. The pro forma disclosure of the difference
between compensation expense included in net loss and the cost presented by the
fair value method is presented in Note 7.

                                      F-10
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The Company accounts for stock issued to non-employees in accordance with
the provisions of SFAS No. 123 and Emerging Issues Task Force ("EITF") No. 96-
18 "Accounting for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or Services."

Foreign currency translation

   The functional currency of the Company's subsidiary is its local currency.
Foreign currency assets and liabilities are translated at the current exchange
rate at each balance sheet date. Revenues and expenses are translated at
weighted average exchange rates in effect during the year. The related gains
and losses from foreign currency translation are recorded in accumulated other
comprehensive income. Realized gains and losses on foreign currency
transactions are included in other income (expense), net.

Income taxes

   Income taxes are accounted for using the asset and liability approach, which
requires the recognition of taxes payable or refundable for the current year
and deferred tax liabilities and assets for the future tax consequences of
events that have been recognized in the Company's financial statements or tax
returns. The measurement of current and deferred tax liabilities and assets are
based on provisions of the enacted tax laws; the effects of future changes in
tax laws or rates are not anticipated. The measurement of deferred tax assets
is reduced, if necessary, by the amount of any tax benefits that, based on
available evidence, are not expected to be realized.

Net loss per share

   Basic and diluted net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. The calculation of diluted net
loss per share excludes potential common shares if the effect is anti-dilutive.
Potential common shares consist of unvested restricted common stock,
incremental common shares issuable upon the exercise of stock options, shares
issuable upon conversion of the Series A, Series B and Series C mandatorily
redeemable convertible preferred stock and common shares issuable upon the
exercise of common and mandatorily redeemable convertible preferred stock
warrants.

   The following table sets forth the computation of basic and diluted net loss
per share for the periods indicated (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ---------------------------
                                                    2000      1999     1998
                                                  --------  --------  -------
   <S>                                            <C>       <C>       <C>
   Numerator:
    Net loss..................................... $(33,685) $(24,206) $(8,539)
                                                  ========  ========  =======
   Denominator:
    Weighted average shares......................   22,211    11,199    3,888
    Weighted average unvested common shares
     subject to repurchase.......................      (78)     (583)  (1,517)
                                                  --------  --------  -------
    Denominator for basic and diluted
     calculation.................................   22,133    10,616    2,371
                                                  ========  ========  =======
   Net loss per share:
    Basic and diluted............................ $  (1.52) $  (2.28) $ (3.60)
                                                  ========  ========  =======
</TABLE>

                                      F-11
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table sets forth potential shares of common stock that are not
included in the diluted net loss per share calculation above because to do so
would be anti-dilutive for the periods indicated (in thousands):

<TABLE>
<CAPTION>
                                                              December 31,
                                                            -----------------
                                                            2000  1999  1998
                                                            ----- ----- -----
   <S>                                                      <C>   <C>   <C>
   Series A mandatorily redeemable convertible preferred
    stock..................................................   --  3,050 3,050
   Series B mandatorily redeemable convertible preferred
    stock..................................................   --  3,187 3,187
   Series C mandatorily redeemable convertible preferred
    stock..................................................   --  3,507 3,507
   Mandatorily redeemable convertible preferred stock
    warrants...............................................   --    --     18
   Common stock options.................................... 2,830 1,520 1,067
   Common stock warrants...................................   875   609    49
   Unvested common stock subject to repurchase.............    17   583 1,517
</TABLE>

Comprehensive income

   The Company adopted SFAS No. 130, "Reporting Comprehensive Income" effective
January 1, 1998. SFAS No. 130 establishes standards for disclosure and
financial statement presentation for reporting total comprehensive income
(loss) and its individual components. Comprehensive income (loss), as defined,
includes all changes in equity during a period from non-owner sources. The
Company's comprehensive income (loss) includes net income (loss), unrealized
gains and losses on investments and foreign currency translation adjustments
and is displayed in the statement of stockholders' equity (deficit).

Segment information

   Effective January 1, 1998, the Company adopted the provisions of SFAS No.
131, "Disclosures about Segments of an Enterprise and Related Information."
SFAS No. 131 establishes standards for the method companies report information
about operating segments in financial statements. SFAS No. 131 focuses on the
internal organization that is used by management for making operating decisions
and assessing performance as the source of the Company's reportable segments.
SFAS No. 131 also requires disclosures about products and services, geographic
areas and major customers. The Company has determined that it operates in only
one operating segment.

   International revenues are based on the country in which the customer is
located. The following is a summary of total net revenues by geographic area
(in thousands):

<TABLE>
<CAPTION>
                                                                Year Ended
                                                                December 31,
                                                           ---------------------
                                                            2000    1999   1998
                                                           ------- ------ ------
   <S>                                                     <C>     <C>    <C>
   Domestic............................................... $ 3,629 $2,236 $  982
   International..........................................   7,939  2,171  1,821
                                                           ------- ------ ------
                                                           $11,568 $4,407 $2,803
                                                           ======= ====== ======
</TABLE>

   It is impractical for the Company to compute revenues by type of product and
service for the years ended December 31, 2000, 1999 and 1998.

Recent accounting pronouncements

   In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS
No. 133 establishes a new model for accounting for derivatives and hedging
activities and supercedes and amends a number of existing accounting standards.
SFAS No. 133 requires that all derivatives be reported on the balance sheet at
their fair market value and the corresponding derivative gains or losses be
either reported in the statement of operations or as a deferred item

                                      F-12
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

depending on the type of hedge relationship that exists with respect to any
derivatives. In July 1999, the FASB issued SFAS No. 137, "Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133." SFAS No. 137 deferred the effective date until
fiscal years commencing after June 15, 2000. In June 2000, the FASB issued SFAS
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities." SFAS No. 138 amends certain terms and conditions of SFAS No. 133.
The Company will adopt SFAS No. 133 and 138 in its quarter ending March 31,
2001. The Company does not believe that the pronouncement will have a material
impact on its financial position or results of operations as currently
conducted.

   In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin ("SAB") 101, "Revenue Recognition." SAB 101 outlines
the basic criteria that must be met to recognize revenue and provides guidance
for presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with the SEC. In June 2000, the SEC
issued SAB 101B to defer the effective date of implementation of SAB 101 until
the fourth quarter of fiscal 2000. The adoption of SAB 101 did not have a
material impact on the Company's financial position or results of operations.

NOTE 2--RELATED PARTIES:

Investment in Liquid Audio Japan

   In April 1998, the Company signed an agreement with a strategic partner (the
"Strategic Partner") to establish a Japanese corporation, Liquid Audio Japan
("LAJ"). LAJ is the exclusive reseller and distributor of the Company's
software products in Japan. In March 1999, the Company purchased 18% of the
issued and outstanding shares in LAJ from the Strategic Partner for $378,000.
The Company retains the option, expiring on December 31, 2003, to purchase up
to 20% of the capital of LAJ from the Strategic Partner, at the then fair
market value of LAJ's shares. The Company also has a put option whereby the
Company can require the Strategic Partner to purchase its shares in LAJ at the
then fair market value, if certain performance measures of LAJ, as defined, are
not met. The Company's purchase of shares in LAJ was funded by a loan from a
related entity of the Japanese Strategic Partner. This loan, denominated in
Japanese yen, is repayable on December 31, 2003. Interest on the loan bears
interest at 0.5% above a Japanese bank's prime rate (2.6% at December 31, 2000)
and is payable quarterly. The loan is classified in the balance sheet as a non-
current note payable to a related party and recorded at the prevailing exchange
rate at December 31, 2000.

   In March 1999, the Company's investment in LAJ of $378,000 was deemed to be
impaired due to substantial doubt regarding recoverability and the significant
losses that are expected to be incurred during LAJ's initial operating periods.
The write-off of this investment was included in sales and marketing expenses.

   In December 1999, LAJ completed its initial public offering in Japan, which
raised total proceeds of approximately $28.3 million and resulted in the
Company's ownership in LAJ reducing to 6.92%. The Company booked an investment
in LAJ of $1,959,000, which was recorded as additional paid in capital as
prescribed by SAB Topic No. 5, "Miscellaneous Accounting," to reflect the
increase in the Company's share of LAJ's net assets. The Company's ownership
percentage was further reduced to 6.81% during the current year due to an
increase in LAJ's total outstanding shares. The fair value of the Company's
ownership in LAJ, based on the quoted trading price, was approximately $2.6
million at December 31, 2000.

Investment in Liquid Audio Korea

   In December 1998, the Company signed an agreement with another strategic
partner to establish a Korean corporation, Liquid Audio Korea Co. Ltd. ("LAK"),
to develop a local business to enable the digital delivery of music to
customers in Korea. LAK is the exclusive reseller and distributor of the
Company's software products in

                                      F-13
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Korea, under an agreement expiring on December 31, 2003. The Company paid
$400,000 for 40% of the outstanding common stock of LAK and accounts for its
investment in LAK using the equity method of accounting. The investment of
$400,000 was recorded as an offset to the business development revenue
recognized from LAK in December 1998. The Company is not recording its share of
additional losses beyond its investment since there is no obligation on the
part of the Company to pay LAK or any other party for those losses. If LAK
generates sufficient profits to recoup its initial operating losses, the
Company will re-instate the equity method of accounting. LAK stopped making its
contractual payments as scheduled. LAK is undergoing a recapitalization through
the addition of new investment partners so that it can continue making its
payments to the Company. Until such time contractual payments are resumed, the
Company is deferring recognition of revenue from LAK. The Company additionally
wrote off its loans of $470,000 to LAK as of December 31, 2000.

Liquid Audio Greater China

   In June 2000, the Company signed an agreement with a strategic partner to
establish a British Virgin Islands corporation, Liquid Audio Greater China
("LAGC"). LAGC is the exclusive reseller of the Company's products in Taiwan
and Hong Kong and will work to develop business services that enable the
digital delivery of music in those local markets. The Company owns 40% of the
outstanding common stock of LAGC and accounts for its investment in LAGC using
the equity method of accounting. LAGC stopped making its contractual payments
in late 2000 as scheduled. Until such time contractual payments are resumed,
the Company is deferring recognition of revenue from LAGC.

Liquid Audio South East Asia

   In September 2000, the Company signed an agreement with a strategic partner
to establish a Singaporean corporation, Liquid Audio South East Asia ("LASE").
LASE will be the exclusive reseller of the Company's products in Singapore,
Thailand, Malaysia, Indonesia, Philippines, Australia and New Zealand and will
work to develop business services that enable the digital delivery of music in
those local markets. The Company will own 30% of the outstanding common stock
of LASE and will account for its investment in LASE using the equity method of
accounting. The strategic partner of LASE did not make its contractual payments
in late 2000 as scheduled. Until such time contractual payments are resumed,
the Company is deferring recognition of revenue from LASE.

Other transactions

   Total business development revenues are summarized as follows (in
thousands):

<TABLE>
<CAPTION>
                                                           Year Ended December
                                                                   31,
                                                           --------------------
                                                            2000   1999   1998
                                                           ------ ------ ------
   <S>                                                     <C>    <C>    <C>
   Liquid Audio Japan and strategic partner............... $5,047 $1,105 $  250
   Liquid Audio South East Asia and strategic partner.....  1,261    --     --
   Liquid Audio Greater China and strategic partner.......    705    500    --
   Liquid Audio Korea and strategic partner...............    294    532  1,050
                                                           ------ ------ ------
                                                           $7,307 $2,137 $1,300
                                                           ====== ====== ======
</TABLE>

   Of the total fees earned from Liquid Audio Japan and strategic partner,
$4,880,000 and $272,000 were earned from Liquid Audio Japan and relate to
software licensing and maintenance fees in 2000 and 1999, respectively, and
$167,000 and $833,000 were earned from the strategic partner in Liquid Audio
Japan in 2000 and 1999, respectively, and relate to a non-refundable service
fee of $1,000,000 received in March 1999 and recognized ratably over the one-
year term of the service agreement. The fee of $250,000 earned from the
strategic partner in Liquid Audio Japan in 1998 relates to consulting services.

                                      F-14
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The total fee of $1,261,000 and $705,000 earned in 2000 from Liquid Audio
South East Asia through the strategic partner and Liquid Audio Greater China,
respectively, primarily consist of software licensing and maintenance fees. The
total fee of $500,000 earned from the strategic partner in Liquid Audio Greater
China in 1999 relates to a service fee to develop a local business in Taiwan
and Hong Kong.

   The total fee of $294,000 and $532,000 earned from Liquid Audio Korea in
2000 and 1999, respectively, consist primarily of software licensing and
maintenance fees. Of the $1,050,000 earned from the strategic partner in Liquid
Audio Korea in 1998, $950,000 relates to service fees earned under two separate
agreements and $100,000 relates to software licensing fees.

   At December 31, 2000 and 1999, fees billed or received in advance of
recognition as business development revenues were $987,000 and $1,167,000,
respectively. These amounts are classified as deferred revenue from related
parties on the balance sheet.

NOTE 3--BALANCE SHEET COMPONENTS (in thousands):

<TABLE>
<CAPTION>
                                                              December 31,
                                                             ----------------
                                                              2000     1999
                                                             -------  -------
   <S>                                                       <C>      <C>
   Accounts receivable, net:
    Accounts receivable..................................... $ 1,313  $   468
    Allowance for doubtful accounts and sales returns
     reserve................................................    (588)    (317)
                                                             -------  -------
                                                             $   725  $   151
                                                             =======  =======

   The allowance for doubtful accounts and sales returns reserve increased
(decreased) by $271,000, $(28,000) and $229,000 in the years ended December 31,
2000, 1999 and 1998, respectively. Bad debt write-offs against the allowance
for doubtful accounts were $44,000, $129,000 and $34,000 in the years ended
December 31, 2000, 1999 and 1998, respectively.

<CAPTION>
                                                              December 31,
                                                             ----------------
                                                              2000     1999
                                                             -------  -------
   <S>                                                       <C>      <C>
   Property and equipment:
    Computer equipment and purchased software............... $12,190  $ 5,614
    Website and software development costs..................     399       --
    Furniture and fixtures..................................     774      544
    Leasehold improvements..................................     682      448
                                                             -------  -------
                                                              14,045    6,606
    Less: accumulated depreciation and amortization.........  (5,185)  (1,749)
                                                             -------  -------
                                                             $ 8,860  $ 4,857
                                                             =======  =======

   Property and equipment includes $784,000 of equipment under capital leases
at December 31, 2000 and 1999. Accumulated amortization for equipment under
capital leases was $734,000 and $581,000 at December 31, 2000 and 1999,
respectively.

<CAPTION>
                                                              December 31,
                                                             ----------------
                                                              2000     1999
                                                             -------  -------
   <S>                                                       <C>      <C>
   Accrued expenses and other current liabilities:
    Compensation and benefits............................... $ 2,321  $ 1,305
    Consulting and professional services....................     475      418
    Accrued marketing expenses..............................      48      282
    Other...................................................     678      731
                                                             -------  -------
                                                             $ 3,522  $ 2,736
                                                             =======  =======
</TABLE>

                                      F-15
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 4--BORROWINGS:

Equipment loan

   Pursuant to the terms of an equipment financing agreement with a bank ("the
Bank"), the Company had a $3,000,000 line of credit ("Equipment Line") to be
used specifically to purchase computer and office equipment. The Equipment Line
expired in November 1999 through which time the Company borrowed amounts
totaling $1,766,000. Borrowings under the Equipment Line are repayable in
monthly installments of principal and interest over three years and bear
interest at the Bank's prime interest rate plus 0.25% (9.75% and 8.75% at
December 31, 2000 and 1999, respectively). Borrowings outstanding at December
31, 2000 and 1999 were $732,000 and $1,030,000, respectively. Borrowings are
secured by the related equipment and other assets of the Company.

   Under the Equipment Line, the Company is required to meet certain monthly
reporting and financial covenants, including minimum operating results and
certain liquidity, leverage and debt service ratios. At December 31, 2000 and
1999, the Company was in compliance with all such covenants.

   Future maturities under the Equipment Line as of December 31, 2000 are as
follows (in thousands):

<TABLE>
<CAPTION>
   Year Ending December 31,
   ------------------------
   <S>                                                                     <C>
    2001.................................................................. $589
    2002..................................................................  143
                                                                           ----
                                                                           $732
                                                                           ====
</TABLE>

NOTE 5--COMMON STOCK:

   In April 1999, the Company's Certificate of Incorporation was amended and
restated to authorize the issuance of 50,000,000 shares of common stock at
$0.001 par value.

   Following the completion of the Company's Initial Public Offering in 1999,
9,744,199 shares of mandatorily redeemable preferred stock were converted into
common stock. In addition, warrants to purchase 15,306 shares of Series B
mandatorily redeemable preferred stock and 4,544 of Series C mandatorily
redeemable preferred stock were converted into 19,850 shares of common stock
upon the Company's completion of its Initial Public Offering.

   In June 1999, the Company signed an agreement with Virgin Holdings, Inc.
("Virgin"), an affiliate of EMI Recorded Music, to facilitate the production of
music for delivery over the Internet using the Company's technology. Pursuant
to this agreement, the Company issued 100,000 shares of common stock to Virgin.
These shares were valued at $1,100,000 and immediately recognized as strategic
marketing-equity instruments expense during the three months ended June 30,
1999.

   In July 2000, the Company signed an agreement with Virgin to promote the
distribution of digital music over the Internet using the Company's technology.
Pursuant to this agreement, the Company issued 150,000 shares of common stock
to Virgin. These shares were valued at $1,181,000 and are being recognized as
strategic marketing-equity instruments expense ratably over the one-year term
of the agreement. As a result, $591,000 was recognized as strategic marketing-
equity instruments expense in 2000.

   In December 2000, the Company signed an agreement with BMG Entertainment to
obtain the right to distribute BMG sound recordings and related artwork through
kiosks. In connection with this agreement, the Company issued 50,000 shares of
common stock to BMG. These shares were valued at $195,000 and are being
recognized as non-cash cost of net revenues ratably over the one-year term of
the agreement. As a result, $14,000 was recognized as non-cash cost of net
revenues in 2000.

                                      F-16
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 6--WARRANTS:

   In February 1997, the Company entered into a marketing agreement whereby the
Company and another company jointly developed and marketed a certain feature
specification of the Company's software products. Pursuant to this agreement,
the Company issued 38,316 shares of the Company's common stock and a warrant to
purchase 48,860 shares of common stock at $6.14 per share. The warrant expires
on January 1, 2001. The Company accrued $107,000 during the year ended December
31, 1997 for the estimated fair value of the warrant, based on the Black-
Scholes option pricing model.

   In March and April 1999, the Company granted fully vested common stock
warrants to purchase 15,000 shares at $6.56 per share. These warrants were
valued at $95,000 using the Black-Scholes option pricing model and was
recognized as strategic marketing-equity instruments expense. The warrants
expire in April 2004.

   In June 1999, the Company signed an Advertising Agreement with Amazon.com,
Inc. ("Amazon.com") to collaborate on event-based advertising using the
Company's digital delivery services. In connection with this agreement, the
Company issued a fully vested warrant to purchase approximately 254,000 shares
of common stock to Amazon.com. The warrant was valued at $2,022,000 and was
recognized as strategic marketing-equity instruments expense ratably over the
one-year term of the agreement, which ended in June 2000. As a result, $843,000
and $1,179,000 were recognized as strategic marketing equity instruments
expense in 2000 and 1999, respectively.

   In August 1999, the Company signed a Digital Audio Co-Marketing and
Distribution Agreement with Yahoo! to promote the distribution of digital music
on its web site. In connection with this agreement, the Company granted Yahoo!
three warrants totaling 250,000 shares of common stock. The first warrant for
83,334 shares vested immediately. The first warrant was valued at $903,000 and
was recognized ratably over the one-year term of the agreement as strategic
marketing-equity instruments expense. The second warrant for 83,333 shares
vested in August 2000. The second warrant was initially valued at $426,000 and
was recognized ratably over the one-year period ending at the vesting date as
strategic marketing-equity instruments expense. The second warrant was revalued
at each balance sheet date through the vesting date. As a result, the original
charge of $426,000 was reduced to $312,000 based on current market data. The
third warrant for 83,333 shares will vest in August 2001. The third warrant was
initially valued at $105,000 and is recognized ratably over the one-year period
ending at the vesting date. The third warrant will be revalued at each balance
sheet date through the vesting date based on current market data. In 2000,
$577,000, $(114,000) and $38,000 were recognized as strategic marketing-equity
instruments expense for the first, second and third warrants, respectively. In
1999, $330,000 and $426,000 were recognized as strategic marketing-equity
instruments expense for the first and second warrants, respectively.

   In December 2000, the Company signed an agreement with BMG Entertainment to
obtain the right to distribute BMG sound recordings and related artwork through
kiosks. In connection with this agreement, the Company granted a warrant for a
total of 233,300 shares of common stock. Of the total, 77,768 shares vest in
December 2001, and the cost will be remeasured each quarter until a commitment
for performance has been reached or the warrant vests, based on current market
data. At December 31, 2000, the 77,768 shares under this warrant was valued at
$156,000, of which $12,000 was recognized as non-cash cost of net revenues. The
unamortized portion will be remeasured at each balance sheet date through the
vesting date and amortized over the remaining vesting period. If BMG renews the
agreement after December 2001, the remaining shares will vest at 6,481 shares
per month commencing January 2002 for one year and 6,480 shares per month
commencing January 2003 for one year. Such shares will be valued at the fair
market value of the Company's common stock upon BMG renewing the agreement at
each renewal date.

                                      F-17
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 7--EMPLOYEE BENEFIT PLANS:

401(k) Savings Plan

   The Company sponsors a 401(k) defined contribution plan covering eligible
employees who elect to participate. The Company elected to contribute matching
and discretionary contributions to the plan. The company is not required to
contribute to the 401(k) plan, but in 2000 elected to match contributions up to
a maximum of $2,000 per employee, with a two year vesting schedule. As a
result, the Company contributed $177,000, which was expensed in 2000.

Stock Option Plans

   In September 1996, the Board of Directors adopted the 1996 Equity Incentive
Plan (the "1996 Plan"), which initially provided for the granting of up to
1,144,000 incentive stock options and nonqualified stock options. In August
1997, October 1998 and April 1999, an additional 441,000, 88,000 and 1,600,000
shares, respectively, were authorized for grants under the 1996 Plan. Under the
1996 Plan, incentive stock options may be granted to employees of the Company
and nonqualified stock options and stock purchase rights may be granted to
consultants, employees, directors and officers of the Company. Options granted
under the 1996 Plan are for periods not to exceed ten years, and must be issued
at prices not less than 100% and 85%, for incentive and nonqualified stock
options, respectively, of the fair market value of the stock on the date of
grant as determined by the Board of Directors. Options granted under the 1996
Plan generally vest 25% after the first year and then 2.083% each month
thereafter until 100% vested. Options granted to stockholders who own greater
than 10% of the outstanding stock must be for periods not to exceed five years
and must be issued at prices not less than 110% of the estimated fair market
value of the stock on the date of grant as determined by the Board of
Directors. In April 1999, the 1996 Plan was also amended to provide for annual
increases on January 1 equal to the lesser of 1,500,000 shares, 5% of the
outstanding shares on such date or a lesser amount determined by the Board of
Directors.

   In April 2000, the Board of Directors adopted the 2000 Nonstatutory Stock
Option Plan (the "2000 Plan"), which provided for the granting of up to 500,000
nonqualified stock options. Under the 2000 Plan, stock options may be granted
to employees of the Company. Options granted under the 2000 Plan are for
periods not to exceed ten years, and are issued at prices determined by the
Board of Directors or any of its committees. Options granted under the 2000
Plan vest at terms and conditions determined by the Board of Directors or any
of its committees. Options granted for the year ended December 31, 2000 vest
25% after the first year and then 2.083% each month thereafter until 100%
vested.

                                      F-18
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes stock option activity under the plans (shares
in thousands):

<TABLE>
<CAPTION>
                                                          Options Outstanding
                                                        ------------------------
                                               Options              Weighted
                                              Available         Average Exercise
                                              for Grant Shares  Price Per Share
                                              --------- ------  ----------------
   <S>                                        <C>       <C>     <C>
   Balance at December 31, 1997..............     255     861        $0.130
    Additional options authorized............      88     --            --
    Repurchase of common stock in connection
     with unvested stock options previously
     exercised...............................      24     --            --
    Options granted..........................    (512)    512          1.01
    Options exercised........................     --      (90)        0.067
    Options canceled.........................     216    (216)         0.11
                                               ------   -----
   Balance at December 31, 1998..............      71   1,067          0.68
    Additional options authorized............   1,600     --            --
    Repurchase of common stock in connection
     with unvested stock options previously
     exercised...............................      51     --            --
    Options granted..........................  (1,044)  1,044         17.62
    Options exercised........................      --    (399)         0.39
    Options canceled.........................     192    (192)         2.45
                                               ------   -----
   Balance at December 31, 1999..............     870   1,520         12.17
    Additional options authorized............   1,594     --            --
    Repurchase of common stock in connection
     with unvested stock options previously
     exercised...............................      19     --            --
    Options granted..........................  (2,310)  2,310         11.53
    Options exercised........................     --     (230)         0.57
    Options canceled.........................     770    (770)        13.55
                                               ------   -----
   Balance at December 31, 2000..............     943   2,830         12.06
                                               ======   =====
</TABLE>

   The following table summarizes information concerning outstanding and
exercisable options for all stock option plans as of December 31, 2000 (shares
in thousands):

<TABLE>
<CAPTION>
                                                                 Options Vested and
                                     Options Outstanding            Exercisable
                              --------------------------------- --------------------
                                                       Weighted             Weighted
                                            Weighted   Average              Average
                                            Average    Exercise             Exercise
                                           Remaining    Price                Price
                                Number    Contractual    Per      Number      Per
   Range of Exercise Prices   Outstanding Life (Years)  Share   Outstanding  Share
   ------------------------   ----------- ------------ -------- ----------- --------
   <S>                        <C>         <C>          <C>      <C>         <C>
   $0.07...................          5        5.1       $ 0.07        5      $0.07
   0.19....................         49        6.8         0.19       49       0.19
   0.33-0.40...............         52        7.2         0.40       52       0.40
   1.50-2.00...............        106        7.5         1.78      106       1.78
   2.50....................         74        8.1         2.50       74       2.50
   3.91-5.44...............        248        9.7         4.59       47       4.68
   6.50-9.47...............      1,009        9.6         7.56       41       8.11
   11.00-15.81.............        796        8.8        11.63      321      11.10
   23.25-33.50.............        398        9.0        29.32      140      31.66
   43.75...................         93        8.8        43.75       93      43.75
                                 -----                              ---
                                 2,830                              928
                                 =====                              ===
</TABLE>

                                      F-19
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Fair value disclosures

   Pro forma information regarding net loss and net loss per share is required
by SFAS No. 123, which also requires that the information be determined as if
the Company had accounted for its employee stock options granted under the fair
value method. The fair value for these options was estimated using the Black-
Scholes option pricing model.

   The Company calculated the fair value of each option grant on the date of
grant using the Black-Scholes option pricing method as prescribed by SFAS No.
123 using the following assumptions:

<TABLE>
<CAPTION>
                                                      Year Ended December
                                                              31,
                                                     ------------------------
                                                      2000     1999     1998
                                                     -------  -------  ------
   <S>                                               <C>      <C>      <C>
   Risk-free rates.................................. 5.4-6.7%     5.7%    5.8%
   Expected lives (in years)........................     4.0      4.0     4.0
   Dividend yield...................................     0.0%     0.0%    0.0%
   Expected volatility..............................     130%    78.0%    0.0%

   Had compensation costs been determined based upon the fair value at the
grant date for awards under these plans, consistent with the methodology
prescribed under SFAS No. 123, the Company's pro forma net loss attributable to
common stockholders and pro forma basic and diluted net loss per share under
SFAS No. 123 would have been:

<CAPTION>
                                                      Year Ended December,
                                                               31
                                                     ------------------------
                                                      2000     1999     1998
                                                     -------  -------  ------
   <S>                                               <C>      <C>      <C>
   Pro forma net loss (in thousands)................ $43,291  $24,534  $8,579
   Pro forma net loss per share..................... $  1.96  $  2.31  $ 3.62
   The weighted average fair value of options
    granted were:
<CAPTION>
                                                      Year Ended December
                                                              31,
                                                     ------------------------
                                                      2000     1999     1998
                                                     -------  -------  ------
   <S>                                               <C>      <C>      <C>
   Weighted average fair value of options granted
    during period................................... $  9.58  $ 17.62  $ 4.84

Unearned stock-based compensation

   In connection with certain stock option grants, the Company recognized
unearned compensation which is being amortized over the vesting periods of the
related options, usually four years, using an accelerated basis. Future
compensation charges are subject to reduction for any employee who terminates
employment prior to the expiration of such employee's option vesting period.

   The following table sets forth unearned compensation and the amortization of
unearned compensation (in thousands):

<CAPTION>
                                                      Year Ended December
                                                              31,
                                                     ------------------------
                                                      2000     1999     1998
                                                     -------  -------  ------
   <S>                                               <C>      <C>      <C>
   Unearned compensation, net of effect of
    cancellation upon termination................... $  (355) $   431  $1,714
   Amortization of unearned compensation............ $   409  $ 1,369  $1,241
</TABLE>

Employee Stock Purchase Plan

   In April 1999, the Board of Directors adopted the 1999 Employee Stock
Purchase Plan (the "Purchase Plan") and reserved 500,000 shares of common stock
for issuance thereunder. The Purchase Plan was

                                      F-20
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

approved by the stockholders in June 1999. On each January 1, the aggregate
number of shares reserved for issuance under the Purchase Plan is increased by
the lesser of 750,000 shares, 3% of the outstanding shares on such date or a
lesser amount determined by the Board of Directors. The Purchase Plan became
effective on the first business day on which price quotations for the Company's
common stock were available on the Nasdaq National Market, which was July 8,
1999. Employees are eligible to participate if they are customarily employed by
the Company or any participating subsidiary for at least 20 hours per week and
more than five months in any calendar year and do not (i) immediately after
grant own stock possessing 5% or more of the total combined voting capital
stock, or (ii) possess rights to purchase stock under all of the employee stock
purchase plans at an accrual rate which exceeds $25,000 worth of stock for each
calendar year. The Purchase Plan permits participants to purchase common stock
through payroll deductions up to 15% of the participant's compensation, as
defined in the Purchase Plan, but limited to 2,500 shares per participant per
purchase period. Each offering period includes four six-month purchase periods,
and the Purchase Plan was amended in June 2000 so that purchase periods begin
on April 1 and October 1 of each year, except for the offering period which
started on the first trading day on or after the effective date of the public
offering. The price at which the common stock is purchased under the Purchase
Plan is 85% of the lesser of the fair market value at the beginning of the
offering period or at the end of the purchase period. The Purchase Plan will
terminate after a period of ten years unless terminated earlier as permitted by
the Purchase Plan.

NOTE 8--INCOME TAXES:

   Deferred taxes are composed of the following (in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                               2000      1999
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred tax assets (liabilities)
    Net operating loss and credit carryforwards............. $ 22,419  $ 12,840
    Research and development credit carryforwards...........    1,780       405
    Depreciation and amortization...........................      263        42
    Accruals and other liabilities..........................      435       511
    Other...................................................        2       --
                                                             --------  --------
    Total deferred tax assets...............................   24,899    13,798
    Less: Valuation allowance...............................  (24,899)  (13,798)
                                                             --------  --------
   Net deferred tax assets.................................. $    --   $    --
                                                             ========  ========
</TABLE>

   At December 31, 2000, the Company had approximately $60.0 million of federal
and $33.0 million of state net operating loss carryforwards available to offset
future taxable income. The federal and state net operating loss carryforwards
expire in varying amounts beginning in 2011 and 2004, respectively. At December
31, 2000, the Company had approximately $1.0 million of federal and $738,000 of
state research and development credit carryforwards available to offset future
taxable income, which, in the case of the federal carryforwards, expire in
varying amounts beginning in 2011. Under the Tax Reform Act of 1986, the
amounts of and benefits from net operating loss carryforwards may be impaired
or limited in certain circumstances.

   The Company has incurred a loss in each period since its inception. Based on
the available objective evidence, including the Company's history of losses,
management believes it is more likely than not that the net deferred tax assets
will not be fully realizable. Accordingly, the Company has provided for a full
valuation allowance against its total deferred tax assets at December 31, 2000
and 1999. The valuation allowance increased by $11,101,000, $8,234,000 and
$2,999,000 in the years ended December 31, 2000, 1999 and 1998, respectively.

                                      F-21
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 9--COMMITMENTS AND CONTINGENCIES:

Leases

   The Company leases its office facilities and certain equipment under
noncancelable operating lease agreements which expire at various dates through
2005. The terms of the facility lease provide for rental payments on a
graduated scale. The Company recognizes rent expense on a straight-line basis
over the lease period, and has accrued for rent expense incurred but not paid.
The lease requires that the Company pay all costs of maintenance, utilities,
insurance and taxes. Rent expense under these leases is as follows (in
thousands):

<TABLE>
<CAPTION>
                                                                   Year Ended
                                                                  December 31,
                                                                ----------------
                                                                 2000  1999 1998
                                                                ------ ---- ----
   <S>                                                          <C>    <C>  <C>
   Rent expense................................................ $1,642 $643 $294
</TABLE>

   Future minimum lease payments under all noncancelable capital and operating
leases at December 31, 2000 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                               Capital Operating
   Year Ending December 31,                                    Leases   Leases
   ------------------------                                    ------- ---------
   <S>                                                         <C>     <C>
   2001.......................................................  $ 137   $1,646
   2002.......................................................     31      904
   2003.......................................................    --        47
   2004.......................................................    --        47
   2005.......................................................    --        16
                                                                -----   ------
     Total minimum payments...................................    168   $2,660
                                                                        ======
   Less: amount representing interest.........................    (20)
                                                                -----
   Present value of capital lease obligations.................    148
   Less: current portion......................................   (120)
                                                                -----
   Capital lease obligations, non-current portion.............  $  28
                                                                =====
</TABLE>

Litigation

   In February 2000, an entity notified one of the Company's customers that it
intended to add the customer as a party to a pending patent litigation in the
United States District Court for the Eastern District of Pennsylvania
(Pittsburgh). The litigation alleges infringement of unspecified claims of
three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440).
Damages have not been specified. The customer has agreed to be added to the
case, subject to a revision in the trial schedule. The customer has requested
indemnification, including defense costs, from the Company, based upon the
terms of the Company's contract with them. Based on this request, the Company
is negotiating an agreement with the customer under which the Company would (i)
assume control of the defense, (ii) pay the expenses of the defense and (iii)
reserve certain rights as to indemnification. During negotiation of this
agreement the Company has agreed to assume the expense of the defense for the
customer. These expenses could be significant. There is no assurance that the
Company will enter into this agreement. If the Company does not reach an
agreement with the customer and the defense is not successful, the customer
might seek full indemnification from the Company for the damages, if any. There
can be no assurance regarding the outcome of the litigation. If there is a
finding of infringement, the Company may be required to indemnify the customer
as to the full amount of the damages. No amount has been accrued for any
potential liabilities in relation to these matters.

   On March 31, 2000, Intouch Group, Inc. ("Intouch") filed a lawsuit against
the Company in the Northern District of California alleging patent
infringement. On April 26, 2000, Intouch filed an amended complaint,

                                      F-22
<PAGE>

                               LIQUID AUDIO, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

which was served on the Company shortly thereafter. The complaint names the
Company and Amazon.com International, Inc., Listen.com, Inc., Entertaindom LLC,
Discovermusic.com, Inc. and Muze, Inc. It alleges that the Company infringe or
induce infringement of, the claims of United States Patent Nos. 5,237,157 and
5,963,916 by operating a website and/or a kiosk that allows interactive
previewing of portions of pre-recorded music products. The complaint seeks
unspecified damages and injunctive relief. On May 20, 2000, the Company filed
an answer to Intouch's first amended complaint. The action is currently in
discovery, and the trial date has been set for January 11, 2002. The Company
believes that it has meritorious defenses to Intouch's claims and the Company
intends to vigorously defend against such claims. However, the Company cannot
assure that it will be successful in defending these lawsuits. If there is a
finding of infringement, the Company might be required to pay substantial
damages to Intouch and could be enjoined from selling any of the Company's
products or services that are held to infringe Intouch's patents unless and
until the Company is able to negotiate a license from them. No amount has been
accrued for any potential liabilities in relation to these matters.

   On August 14, 2000, a former employee filed a charge of discrimination with
the California Department of Fair Employment and Housing against the Company,
and several of the Company's employees and former employees. The charge alleges
sexual harassment and unlawful retaliation. The Company believes, after
consultation with counsel, that these claims are without merit, and the Company
intends to defend itself vigorously. However, should a lawsuit be filed and
decided adversely to the Company, the Company may have to pay damages. No
amount has been accrued for any potential liabilities in relation to these
matters.

Contingencies

   From time to time, in the normal course of business, various claims are made
against the Company. In the opinion of the management, there are no pending
claims the outcome of which is expected to result in a material adverse effect
on the financial position or results of operations of the Company.

NOTE 10--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED):

   The following is a summary of the unaudited quarterly results of operations
for the periods shown (in thousands except per share data):

<TABLE>
<CAPTION>
                                                        Three Months Ended
                            ------------------------------------------------------------------------------
                            March 31, June 30,  Sept. 30, Dec. 31,  March 31, June 30,  Sept. 30, Dec. 31,
                              1999      1999      1999      1999      2000      2000      2000      2000
                            --------- --------  --------- --------  --------- --------  --------- --------
   <S>                      <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
   Net revenues............  $   531  $   745    $ 1,785  $ 1,346    $ 2,995  $ 3,454    $ 3,355  $  1,764
   Gross profit............      323      514      1,330      779      2,453    2,463      2,562       975
   Net loss................   (4,143)  (6,072)    (5,820)  (8,171)    (6,524)  (7,718)    (8,892)  (10,551)
   Net loss per share,
    basic and diluted......    (1.39)   (1.89)     (0.35)   (0.43)     (0.30)   (0.35)     (0.40)    (0.47)
   Weighted average shares
    used in per share
    calculation............    2,972    3,213     16,821   19,133     21,918   22,013     22,304    22,429
</TABLE>

                                      F-23
<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
   Exhibit
     No.                Description
   ------- -------------------------------------
   <C>     <S>
    21.1   Subsidiary of Liquid Audio, Inc.
    23.1   Consent of PricewaterhouseCoopers LLP
</TABLE>