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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





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FORM 10-K/A


(Amendment No. 1)


(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, 2001





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





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LIQUID AUDIO, INC.


(Exact name of Registrant as specified in its charter)








Delaware (State or other
jurisdiction of incorporation or organization)

77-0421089 (I.R.S.
Employer Identification Number)800 Chesapeake Drive, Redwood
City, California (address of principal executive offices)

94063 (zip code)





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





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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


Preferred Stock Purchase Rights





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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 $44,632,535 as of December 31, 2001 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 22,710,335 shares of the Registrants Common Stock issued and outstanding on March 13, 2002.


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##### Table of Contents

TABLE OF CONTENTS





PagePART IITEM 1.

BUSINESS

1ITEM 1A.

COMPANY RISK FACTORS

11ITEM 2.

PROPERTIES

22ITEM 3.

LEGAL PROCEEDINGS

22ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

25PART IIITEM 5.

MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

26ITEM 6.

SELECTED FINANCIAL DATA

27ITEM 7.

MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

28ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

40ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

40ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

40PART IIIITEM 10.

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

41ITEM 11.

EXECUTIVE COMPENSATION

45ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

47ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

49PART IVITEM 14.

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

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PART I





ITEM 1.    BUSINESS





This Annual Report on Form 10-K 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. 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





Liquid Audio, Inc. was incorporated in California in January 1996 and
reincorporated in Delaware in April 1999. In July 1999, we completed our initial public offering of common stock. Our principal executive offices are located at 800 Chesapeake Drive, Redwood City, California 94063, and our telephone number is (650)
549-2000.





We provide an open platform that enables the digital delivery of media over the Internet. Our
software products and services are designed to 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 third party music related websites, OEMs, 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 (RIFFS), and Liquid Store, 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 Atlantic Records, BMG Entertainment, EMI Music Group, Sup Pop Records, Warner Music Group and Zomba Records
Group, and artists such as Backstreet Boys, Enya, Mick Jagger, Jewel, matchbox twenty and N SYNC, although such services have not, to date, resulted in significant revenues.





Contractual arrangements between us and our related parties, Liquid Audio Korea, Liquid Audio Greater China, Liquid Audio South East Asia and Liquid Audio Japan resulted in
approximately 61%, 63% and 48% of our revenues in 2001, 2000 and 1999, respectively. Each of such related party contracts has been terminated due to nonpayment by the customers as a result of their lack of financial resources and we will not receive
additional revenues from such parties in the future. Although we have not yet successfully generated significant revenues from third party customers, we continue to pursue our strategy of providing secure digital music delivery distribution of major
label and independent music content to retail and consumer electronics and personal computer manufacturers through our Liquid Music Network and through the licensing of our Liquid Player and server technologies. We have not historically generated
significant revenue from these business activities and it is uncertain whether these activities will be successful in generating sufficient revenue in the future to fund our operations. Our efforts to create a successful business plan have been
materially adversely impacted by the growth and pervasiveness of free music sharing from companies such as Napster, Kazaa, Morpheus and WinMX and from the lack of complete and compelling catalogs of music content from our content partners. We cannot
be sure that we will be able to overcome the obstacles presented by these factors to develop a profitable business but we believe that the strategy outlined below will position us for growth opportunities in the future.




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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 approximately 20,000 individual music samples per day. Our system hosts digital music files and distributes them through a network of music websites and a digital music subscription service.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Syndication.    Our distribution system syndicates music content to a network of leading retail, music and
original equipment manufacturer (OEM) websites.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | 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, purchase and download digital recorded music. Our Liquid Player includes the capability of purchasing digital
Christian music from EMI CMG through its digital music subscription service, burnitfirst.com. We also enable 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.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Our services provide the following benefits:





| |  |  | Potential for Increased Revenues and Lower Costs for Content Partners.    Our services are designed to enable
record companies and artists to 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 growing inventory. Our Liquid Player enables customers to purchase digital Christian music from EMI CMG through
our digital music subscription service, burnitfirst.com. 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, Microsoft Windows Media and MP3.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Security and Compliance.    Our digital rights management (DRM) system protects copyright owners
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 and DRMs, including Liquid Audio, Microsoft Windows Media, MP3 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 could be particularly significant to independent record labels that have limited access to traditional retail distribution channels. Our patented territory restriction technology identifies the approximate
geographic location of consumers to enforce content rules worldwide.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Strategic Relationships and Customers





We plan to continue to build relationships with key third parties engaged in the creation and distribution of digital music. While
these third party relationships have not generated significant revenues to date, we believe that these relationships will enhance our ability to provide a rich variety of music to consumers and, depending upon customer acceptance of digital music
delivered via the Internet for a fee and our ability to offer complete and compelling music selections, could be the basis for revenue opportunities in the future. 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 selected music titles available for sale and promotion through our distribution system and network. We derive revenue from the sale of music through our distribution
system and network by charging retail or marked-up prices for the titles, resulting in revenue in the amount of the difference between the price that we charge for such titles and the wholesale price we pay for such titles.





| |  |  | 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. We also sell music from EMI CMG or we encode, through its digital music subscription service, burnitfirst.com.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Sony Music.    We are encoding, hosting and delivering promotional downloads from Sony Music on
Amazon.coms website, through our agreement with Amazon.com.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Universal Music Group.    We are encoding, hosting and delivering promotional downloads from Universal Music
Group on Amazon.coms website, through our agreement with Amazon.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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | 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, edel music, Rounder Records, Strictly Rhythm, Sub Pop Records, Twin/Tone Records and Vanguard Records. As of December 31, 2001, record labels have chosen to
promote and sell more than 180,000 digital music recordings through our Liquid Music Network. This compares to approximately 140,000 digital music recordings at the beginning of 2001.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Channel Partners.    Our distribution channel continues to grow and includes some
of the most popular music websites on the Internet today. While we do not derive revenue from our channel partners, our relationship with these partners gives it a distribution network through which we are able to generate revenue by selling music
titles made available through our content provider relationships.





| |  |  | 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.
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| |  |  | Best Buy.    Leading retailer Best Buy uses the Liquid Store commerce solution and offers a custom branded
version of Liquid Player software to sell music from our catalog of content on our bestbuy.com website.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




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



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| |  |  | 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Consumer Adoption.    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 the PC platform. The product can be downloaded free of charge from our website and currently is distributed by the websites in our Liquid Music Network. An enhanced version of the product, Liquid
Player Plus, is available to consumers for $19.95 and 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 distributed
through leading consumer device manufacturers and through our Liquid Music Network of retail and music websites. Our Liquid Player also includes the capability to purchase digital Christian music through our digital music subscription service,
burnitfirst.com.





We distribute music to consumers in concert with technology companies whose innovative
products complement our digital music distribution system by offering software that can be downloaded to enable customers to utilize existing player software, such as the AOL Nullsoft Winamp player and RealNetworks players, to purchase and play
music encoded in our format, and integrating its Secure Portable Player Platform (SP3) on chip set platforms already used in consumer and wireless electronics devices, such as ARM, Cirrus Logic, Inc. and Texas Instruments, Inc. In
addition, to maximize the number of consumers getting music through its distribution network, we added support for the Microsoft Windows Media format. To date, we have encoded and distributed more than 51,000 songs in the Windows Media format. We
also 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 added support for Windows Media to
our Liquid Player software.





We have also encountered difficulties in licensing the Liquid Player
software effectively. While we believe the Liquid Player has several advantages over competing music player software, it has proven difficult to distribute sufficient numbers of such players to generate significant revenue over the long term. In the
past, we have bundled the Liquid Player with certain products of major OEMs of consumer electronics for a per-unit fee. Currently, our strategy involves bundling the Liquid Player with OEM products without a fee in return for potential future
upgrade licensing revenues from consumers of those OEM products. This change in strategy was necessary as we compete with other companies that offer music player software without a fee to OEMs, and the competitive pressures resulting from the
exclusivity of bundling arrangements between each OEM and the relevant vendor of music player software. Accordingly, it has been difficult for us to displace existing bundling arrangements that OEMs may have with our competitors. Additionally, the
rate at which consumers pay a fee to upgrade the free Liquid Player to a premium version of the Liquid Player has been lower than expected and thus upgrade licensing revenues have been lower than expected.





Customers





In 1999, Adaptec, Super Stage and our strategic related partner, Liquid Audio Korea, accounted for 31%, 30% and 12% of our total net revenues, respectively. In 2000, our strategic related partners Cyber Music Entertainment, formerly
Liquid Audio Japan, and Liquid Audio South East Asia through our strategic partner accounted for 42% and 11% of our total net revenues, respectively. In 2001, our strategic related partners Cyber Music Entertainment and Liquid Audio Greater China,
accounted for 39% and 22% of our total net revenues, respectively.





Due to the
financial condition of our strategic related partners and their lack of funds to meet their contractual payment obligations, these strategic related partners stopped making payments to us in late 2000 and early 2001, and accordingly we have ceased
recognizing revenues from these entities and terminated the




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licensing and reseller agreements with them. See Managements Discussion and Analysis of Financial Condition and Results of Operations.





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, and we do not expect these efforts to result in
meaningful revenue in the future. The following table represents a partial list of artists and record labels for whom we have provided promotional services:





Record LabelsAmerican Gramaphone

Arista Records

Artist DirectAtlantic Records

Blue Note Records

BMG DistributionCapitol Records

Columbia Records

Dreamworks RecordsElektra Records

EMI Recorded Music

Epic RecordsGeffen Records

Hollywood Records

Interscope RecordsIsland Records/Def Jam

Jive

MatadorMaverick Records

MCA Records

Mercury NashvilleRCA Records

Reprise Records

Rhino RecordsRoadrunner

Sony

SparrowTommy Boy Records

TVT Records

Universal Music GroupV2 Records

Verve

VirginWarner Music Group

Wind-up Entertainment

Zomba Records Group





Recording ArtistsBarenaked Ladies

Basement Jaxx

BjorkBlink 182

Boz Scaggs

Brad MelhdauBritney Spears

Bush

Busta RhymesCharlie Haden

Custom

Dave Matthews BandDe La Soul

Depeche Mode

Diana KrallDrowning Pool

Dwight Yokam

Elvis CostelloEnya

Green Day

Ice CubeJoe

Josh Groban

Lee GreenwoodMannheim Steamroller

Melissa Etheridge

MystikalNatalie Merchant

New Order

NickelbackNo Doubt

Pink Floyd

P.O.D.Powerman 5000

R. Kelley

RadioheadRamones

Randy Travis

REMRod Stewart

Steven Curtis Chapman

Sugar RayThe Grateful Dead

The Strokes

Toby KeithUncle Kracker

Willie Nelson

ZOEgirl





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.





Further information regarding products and services may be found in Part II, Item 8 of this Form 10-K/A in the Notes to Consolidated Financial Statements at Note 1, Segment Information,
which information is hereby incorporated by reference.




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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 it 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 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 16,000 artists have used our hosting services. These artists have made more than 180,000 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 leading retail and music websites. They can also leverage these services to begin selling their music from their own website.





Subscription Services.    We have developed a turnkey solution for artists and content owners that wish to sell digital downloads through online
subscription services. This service offering leverages our existing publishing and distribution services, player technology and commerce platform. Our consumer offering features an integrated Liquid Player and exclusive major label content that can
be output to recordable compact discs and portable digital audio devices.





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. Our Promotions Manager is a web-based application that
provides record labels and retailers with real-time access to digital music promotions and related customization features and merchandising resources.





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 Microsoft 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.





Syndication





Liquid Store.    The Liquid Music Network, launched in July 1998, is a music distribution network of
leading music-related and retail websites and OEM customers. We provide these 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).    Our RIFFS solution enables the sale of secure digital music through existing
e-commerce websites. RIFFS enables online retailers to seamlessly sell our music catalog right alongside physical goods through our 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.




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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 $11.7 million, $22.9 million and $17.0 million in 1999, 2000 and 2001, 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 its 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 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, Microsoft Windows Media and Sony ATRAC3, 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 patented 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: AAC, Sony ATRAC3, MS-Audio and MP3. We have 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.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | 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 Secure Digital Music Initiative (SDMI) and is in use by several leading device manufactures. 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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




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 and the Liquid Store.





While we have not been able to generate significant revenue from
the sale of our network services, we believe that our technology architecture and its advanced stage of development and deployment provide a product that is superior to the products offered by certain of our competitors. We are currently developing
the seventh 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
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Sony ATRAC3, MP3 and 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 we 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.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Superior Audio Quality.    Although the growth and pervasiveness of free music sharing has materially adversely
impacted our efforts to create a successful business plan, we continue to believe consumers will pay for quality music, and 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 Microsoft Windows Media, provide 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, OEMs and online retailers through a 11-person sales and marketing organization. These employees are located in Redwood City and New York. Our software products and 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-based consumer outreach including a weekly music e-mail,
press tours, participation in key trade events and conferences and other public relations activities.





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 nine patents pending in the United States and eight patents pending in other countries relating to our product architecture and technology and hold fourteen 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




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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.





Our attempts 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 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. Efforts 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., Intouch
Group, Inc. and Network Commerce, Inc. have 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. New or current competitors may emerge that are more successful than us.





Our efforts to create a successful business plan have been materially adversely impacted by the growth and pervasiveness of free music sharing from companies such as Napster, Kazaa and
Morpheus and WinMX. To the extent that consumers continue to download digital music from these websites rather than from us, our business




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has been harmed and it is likely that we will continue to be harmed in the foreseeable future. Additionally, there are other companies, such as IBM, Microsoft, RealNetworks, RioPort 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.





While we
believe that our products and services are superior to the products and services offered by many of our competitors, we have not been as successful as many of our competitors for reasons including the lack of quantity and variety of digital recorded
music content offered by us, lower consumer adoption of our technology due to consumer preference of competing formats such as Microsoft Windows Media and MP3 and other companies abilities to offer music player software for free without
significant impact on their revenues. Other companies also enjoy a more competitive position than we do due to their participation in exclusive arrangements such as bundling arrangements which diminish our opportunities as vendors to partner with
certain OEMS.





We compete with providers of infrastructure technology, products and services such as Full
Audio, RioPort and Loudeye Technologies, providers of digital music subscription services such as Listen.com, MusicNet and pressplay and providers of music player software such as MusicMatch, RealOne or Microsoft Windows Media Player.





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





| |  |  | quantity and variety of digital recorded music content;
| | - |  | -------------------------------------------------------




| |  |  | copyright licenses associated with digital recorded music;
| | - |  | ----------------------------------------------------------




| |  |  | the number and quality of music-related and retail websites;
| | - |  | ------------------------------------------------------------




| |  |  | ease of consumer experience;
| | - |  | ----------------------------




| |  |  | number of music players distributed;
| | - |  | ------------------------------------




| |  |  | price and cost of products and services;
| | - |  | ----------------------------------------




| |  |  | ability to ensure secure digital delivery of recorded music;
| | - |  | ------------------------------------------------------------




| |  |  | ability to adapt to changes in component technologies and consumer preferences;
| | - |  | -------------------------------------------------------------------------------




| |  |  | brand awareness; and
| | - |  | --------------------




| |  |  | fidelity and quality of sound of digital recorded music.
| | - |  | --------------------------------------------------------




Employees





As of December 31, 2001, we had 105
full-time employees, including 24 in sales and marketing, 52 in research and development, 17 in general and administrative and 12 in operations. Following a reduction in work force made in July 2002, the total number of our full time employees as of
July 31, 2002 was 72. We consider our relationships with employees to be good. None of our employees are 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




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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 in the new market of digital delivery of music, 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, 2001 was approximately $111.1 million. We had net losses of approximately $24.2 million, $33.7 million and $37.2 million in 1999, 2000 and 2001, 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 mid-2003. 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 expenses exceed our expectations and cannot be adjusted accordingly, our business and operating results will be harmed.





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 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, 2001, 69% or $315,000 of our accounts receivable from third parties and 100% or $1.6 million of our account receivables from related parties, 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 operating results will be harmed.





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





We have recently decided to focus on providing a subscription-based service offering and a licensing-based offering for our customers. We have limited experience in pricing such new models, and failure to properly price and adjust
these new pricing models may result in a loss of customers which would have an adverse effect on our business and operating results. Moreover, 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 we are forced to reduce or eliminate prices, it would diminish our revenues and impact our margins, which will harm our business.





If We Do Not Establish Relationships with Additional International Partners, Our Revenues Might Decline





In the past, we derived a significant 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. We recently terminated our relationships with these partners. Consequently, we do not expect
additional revenue will be generated from them. If we are unable to establish additional relationships with international partners, and if such additional relationships do not generate a significant amount of revenue in future periods, then our
future revenues could be lower than we anticipate and our business and operating results could be harmed. Furthermore, the commercial terms for these new relationships could cause our revenues to vary from period-to-period, which might result in
unpredictability of our revenues.





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, such as our
subscription-based service offering and server-based license offering, in a timely manner and to provide new




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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 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. We hold fourteen existing patents and currently have nine
patents pending in the United States and eight patents pending in other countries. Our patents expire between October 2015 and October 2018. We have had claims allowed on two of our patent applications. We are presently pursuing the registration of
our trademarks. Our patent applications or trademark registrations in the United States 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
in the United States 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 eight 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, two countries in which we do business, for inadequate intellectual property protection. If our intellectual property is infringed in any country in
which we do business without a high level of intellectual property protection, our business and operating results 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.





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.





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 intellectual property rights. Such claims may result in our being involved in litigation. Although we do not believe we infringe the proprietary rights of any




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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 and operating results. See Legal Proceedings.





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, record companies and artists are unable to prevent users from downloading and distributing unauthorized or pirated copies of
copyrighted recorded music in these formats over the Internet. This piracy is a significant concern to record companies and artists, and is the primary reason many record companies and artists are reluctant to digitally deliver their recorded music
over the Internet. If record companies and artists do not adopt a standard format, however, it may permit unsecure copies of recorded music to continue to be available on the Internet, and as a result 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 and operating results 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. It is too soon to determine whether our standard will be adopted as the dominant industry standard, if a standard is so adopted.





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.





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 and selling music over the Internet, the growth of our business might be limited. We currently do not 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 may 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 will be harmed.




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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.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




It is too soon to determine whether consumers will accept our platform
as their primary application to download, manage and play digital music. A lack of customer acceptance would harm our business and operating results.





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.





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.





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. We expect that present competitors will increase competitive pressure in the market for digital delivery of music.




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Competition is likely to increase further 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.
| | - |  | --------------------------------------------------------------------------




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 and
operating results would be harmed.





If MusicNet and pressplay License its Services to Our Competitors, and We Are Unable to License
Similar Content, Our Business Could be Harmed





The major U.S. record companies have recently formed ventures
for the licensing of their digital music subscription services to online music service providers. BMG Entertainment, EMI, Real Networks and Warner Music Group have formed a venture called MusicNet. Also, Universal Music Group (an unit of
Vivendi Universal) and Sony Music Entertainment have formed a venture called pressplay. Musicnet and pressplay have recently launched their services, and may license their services to other third party online music service providers.





pressplay has reported that it has entered into distribution agreements with affiliates, including Yahoo!,
Microsoft Network and MP3.com, and that is has entered into licensing agreements with six independent record labels including Madacy, Navarre, OWIE, Razor & Tie, Roadrunner and Rounder. The press has reported that MusicNet has licensed its
service to America Online, Real Networks and Napster and that MusicNet has entered into a licensing agreement with Zomba Label Group which encompasses seven record labels: flagship Jive Records, Jive Electro, Silvertone, Verity, Brentwood, Reunion,
and Volcano. If our competitors obtain licenses for digital music subscription services from MusicNet and pressplay and we are unable to obtain similar content provided by those services on commercially reasonable terms, these competitors may be
able to develop a more compelling consumer product and our business could 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.





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




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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 legal 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 digital music copies are available through file sharing without payment, 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.





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.
| | - |  | -------------------------------------------------------------------------------------




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.





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,




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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 had recently experienced 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 recur or 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.





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 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.





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




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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:





| |  |  | the timing of individual software licenses to customers;
| | - |  | --------------------------------------------------------




| |  |  | 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;
| | - |  | -----------------------------------------------------------------------------------------




| |  |  | distribution of the player through OEM and retail partners;
| | - |  | -----------------------------------------------------------




| |  |  | the upgrade percentage of our promotional player to the paid Player Plus version;
| | - |  | ---------------------------------------------------------------------------------




| |  |  | 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;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | legal developments with respect to copyright law and downloadable music;
| | - |  | ------------------------------------------------------------------------




| |  |  | 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.
| | - |  | ----------------------------------------------------




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 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 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 Additional Factors
Affecting Future Results section.





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;
| | - |  | ----------------------------------------------



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| |  |  | export restrictions;
| | - |  | --------------------




| |  |  | export controls relating to encryption technology;
| | - |  | --------------------------------------------------




| |  |  | longer payment cycles;
| | - |  | ----------------------




| |  |  | 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 recently terminated our individual agreements in Japan, Korea, greater China and south east Asia. We may enter into similar arrangements in the future in these and other countries. We also
established a wholly-owned subsidiary in the United Kingdom and an office in Tokyo. 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.





Our Charter Documents and Delaware Law
May Impede Or Discourage A Takeover, Which Could Lower Our Stock Price





Provisions of our restated certificate
of incorporation and bylaws, and provisions of Delaware law, may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. For example, we have a classified
board of directors which may tend to discourage a third party from making a tender offer or otherwise attempting to obtain control of us and may maintain the incumbency of our board of directors, as the classification of the board of directors
increases the difficulty of replacing a majority of the directors. These provisions may have the effect of deferring hostile takeovers, delaying changes in our control or management, or may make it more difficult for stockholders to take certain
corporate actions. Consequently, these provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock.





Our Rights Plan May Impede Or Discourage a Takeover, Which Could Lower Our Stock Price





Our board of directors has approved a shareholders rights plan. The rights will become exercisable the tenth day after a person or group announces acquisition of 15% or more of our common stock or
announces commencement of a tender or exchange offer the consummation of which would result in ownership by the person or group of 15% or more of our common stock. If the rights become exercisable, the holders of the rights (other than the person
acquiring 15% or more of our common stock) will be entitled to acquire, in exchange for the rights exercise price, shares of our common stock or shares of any company in which we are merged, with a




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value equal to twice the rights exercise price. The rights may have the effect of rendering more difficult or discouraging an acquisition of the Company deemed undesirable by the board of
directors. As a result, the rights could limit the price that certain investors might be willing to pay in the future for shares of our common stock.





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 Tax Freedom Act, which imposed a three-year moratorium on
state and local taxes on Internet-based transactions. The moratorium was scheduled to expire in October 2001. Recently, Congress extended the Internet Tax Freedom Act until November 1, 2003. We cannot assure you that this moratorium will be extended
beyond November 1, 2003. Failure to extend this moratorium beyond that date would allow various states to impose taxes on e-commerce, which might harm our business.





In February 2002, European Finance Ministers announced that beginning July 2003 Value Added Tax (VAT) will be imposed on services delivered electronically over
the Internet from suppliers outside the European Union (EU). The tax may substantially impair the growth of e-commerce in the EU and may reduce our opportunity to derive e-commerce in the EU, and our business could be harmed.





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.
| | - |  | ---------------------------------------------------



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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 40,795
square feet of leased office space in Redwood City, California. The lease term extends to May 30, 2005. We lease an office suite near the former headquarters in Redwood City, California on a month-to-month basis, for additional storage needs. In
connection with our restructuring in May 2001, we consolidated our then three Redwood City, California offices into the aforementioned headquarters. We continue to lease these three offices until the expiration of their terms, and have subleased one
of the offices. We lease an additional 18,200 square feet of office space near our former 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 former headquarters. The lease term for this additional space extends to August 31, 2002 with a three-year renewal, at our option. We have subleased this space to a tenant through July 31, 2002.





ITEM 3.    LEGAL PROCEEDINGS





In November 2001, two
lawsuits were filed in Delaware Chancery Court naming us and certain of our officers and directors as defendants. Both actions related to our response to recent acquisition offers and purported to be class actions brought on behalf of our
stockholders. On February 1, 2002, the two complaints were consolidated into a single action, titled In Re Liquid Audio, Inc., Shareholders Litigation, Consolidated Civil Action No. 19212-NC. That action was brought against Gerald W. Kearby,
Silvia Kessel, Ann L. Winblad and us. The complaint alleges that defendants had breached their fiduciary duties owed to our stockholders in connection with our response to acquisition offers from Steel Partners II, LLP and an investor group formed
by MMC (formerly known as musicmaker.com). The complaint seeks, among other things, a court order barring us from adopting or maintaining measures that would make us less attractive as a takeover candidate or, alternatively, awarding compensatory
damages to the purported plaintiff class. To date, we have not responded to the complaint, nor has the court set a date for discovery cutoff or trial. We intend to vigorously defend the action. There is no assurance concerning the outcome of either
action, or whether either action would have a material effect on our financial condition or business operations.





On May 3, 2002, MMC filed an action in the Delaware Chancery Court, pursuant to Title 8 Delaware Code section 211, seeking to compel us to hold an annual meeting of stockholders. We moved to dismiss on the grounds that the court
lacked subject matter jurisdiction as 13 months had not elapsed since our last annual stockholder meeting, held on June 1, 2001. On May 10, 2002, the board of directors set July 1, 2002 as the date




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for the 2002 Annual meeting and our motion to dismiss was held in abeyance. On June 13, 2002, we publicly announced the execution of the original merger agreement and announced that, in light of
the merger, our board of directors had determined to postpone the 2002 annual meeting. The next day, MMC filed an amended complaint requesting that the court order us to hold our annual meeting on July 1, 2002. The court allowed the parties to take
expedited discovery and scheduled a hearing for July 15, 2002. At the hearing, the court granted our request that the annual meeting be scheduled for September 26, 2002 so that the vote on the election of directors and the vote on the issuance of us
stock in the merger could proceed on the same day.





On July 23, 2002, MMC filed an action in Delaware
Chancery Court against us, each member of our board of directors, and Alliance Entertainment Corp. The complaint alleges that our directors violated their fiduciary duties by entering into the merger and approving the merger agreement, and that our
directors further violated their fiduciary duties by making certain changes to our shareholders rights plan. Alliance is alleged to have aided and abetted the alleged breaches of fiduciary duty by our directors. According to the complaint, the
plaintiff is seeking, among other things, to (i) invalidate the merger agreement, (ii) prevent us or Alliance from taking any actions to effectuate or enforce the merger agreement, the merger of us or Alliance, or the self tender-offer,
(iii) direct our board of directors to restore the trigger of our shareholders rights plan to 15%, (iv) prevent enforcement of our shareholders rights plan to the extent it prohibits the plaintiff and other stockholders from
cooperating to assist in the solicitation of proxies for our annual meeting, (v) damages for incidental injuries, and (vi) costs and expenses, including attorneys fee and experts fees. In connection with its complaint, MMC filed a motion
for a preliminary injunction and a motion for expedited proceedings. On July 31, 2002, MMC withdrew its motion for a preliminary injunction and for expedited proceedings, and stated that it would file an amended complaint. To date, no amended
complaint has been filed. If MMC elects to pursue its claims in this matter, we intend to vigorously defend the action.





On August 27, 2002, MMC filed a lawsuit against us, Raymond A. Doig, Gerald W. Kearby, Robert G. Flynn, Stephen V. Imbler and Ann Winblad in the Delaware Chancery Court seeking injunctive and other equitable relief to prevent the
defendants from appointing two additional directors to our board of directors. MMCs complaint alleges that the defendants decision to expand our board of directors was in violation of Delaware law. MMC further alleges that the
defendants actions were taken solely to interfere with the vote of our stockholders and to deny MMC and our other stockholders a substantial presence on our board of directors. The complaint alleges that the defendants actions are a
disproportionate defensive response to a third party offer for Liquid Audio and to the current proxy contest. MMC charges that the expansion of our board of directors constitutes a breach of the directors fiduciary duties of loyalty, care and
good faith to our stockholders. We intend to vigorously defend against MMCs claims.





We filed a
lawsuit on August 21, 2002 against MMC and Steel Partners II, L.P. (Steel Partners) in U.S. District Court for the Southern District of New York. We are asking the Court to prohibit MMC and Steel Partners from violating the federal
securities laws in connection with their campaigns to take control of Liquid Audio, as well as seeking compensatory and punitive damages as a result of their alleged violations. Our complaint alleges that MMC has failed to register as an investment
company under the Investment Company Act of 1940, and that its purchase of our shares and subsequent proxy contest to take control of the board is therefore in violation of that Act. The complaint also charges that Steel Partners is conducting an
illegal proxy contest by failing to make the proper filings with the SEC and that, in the course of its contest, Steel Partners has distributed false and misleading statements to our stockholders. We are seeking to enjoin MMC from continuing its
campaign to take control of us and from communicating with our stockholders. In addition, we are seeking to require Steel Partners to comply with the SECs proxy rules, to retract its recent press release concerning our proposed merger with
Alliance and to disseminate corrective disclosure.





On or about September 27, 2001, Network Commerce,
Inc. (NCI) filed a complaint against us in the United States District Court for the Western District of Washington (Seattle). The suit alleges that we infringe the claims of United States Patent No. 6,073,124. NCI requests that we be
enjoined from our allegedly infringing activities and seeks unspecified damages. We were served with the complaint on November 2, 2001 and




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subsequently submitted an answer to the complaint that included counterclaims. We also filed a motion for summary judgment in November 2001. In March 2002, our motion for summary judgment was
denied and in August 2002, we filed an amended motion for summary judgment. A hearing on the motion has been scheduled in September 2002.





On August 23, 2001, we received a demand letter from a former employees legal counsel alleging claims for sexual harassment and retaliation. On September 13, 2001, the former employee filed a
charge with the California Department of Fair Employment and Housing alleging such claims against us and one of our former employees. We completed an investigation and believe that there is no merit to the former employees allegations. In May
2002, the parties entered into a final settlement regarding this matter. The settlement did not have a material impact on our financial position or results of operations.





On July 20, 2001, a putative securities class action, captioned Murowa Financial v. Liquid Audio, Inc. et al., Civil Action No. 01-CV-6661, was filed against us,
certain of our officers and directors (the Individual Defendants) and three underwriters in our initial public offering (the IPO), in the United States District Court for the Southern District of New York. The Complaint seeks
unspecified damages on behalf of a purported class of purchasers of our common stock between July 8, 1999 and December 6, 2000. Several complaints substantially identical to Murowa were later filed against us, the Individual Defendants, and several
of the IPO underwriters in the Southern District of New York. These cases have been consolidated under Civil Action No. 01-CV-6661. These complaints generally allege that various investment bank underwriters engaged in improper and undisclosed
activities related to the allocation of shares in our initial public offering and secondary offering of securities. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and also
against us and certain of our directors and officers. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other companies. The lawsuit and all other IPO allocation securities
class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. We believe that we have meritorious defenses to the claims and intend to vigorously defend
against such claims.





On or about April 7, 2000, Sightsound, Inc. (Sightsound) filed an
amended complaint against one of our customers in the United States District Court for the Eastern District of Pennsylvania (Pittsburgh). The suit alleges that our customer infringes one or more of three patents (United States Patent Nos. 5,191,573;
5,675,734 and 5,996,440). Sightsound claims damages of $20 million plus an unspecified royalty. We have entered into an agreement with our customer whereby we have agreed to assume control of the defense and pay the defense costs, while reserving
our rights as to indemnification obligations. The customer filed an answer to the amended complaint on April 27, 2000 denying the material allegations of the complaint, and asserting counterclaims for declaratory judgment of non-infringement and
patent invalidity. Following a claims construction hearing in 2001 and an initial report and recommendation on claim construction by the magistrate judge in February, 2002 (which ruling is on appeal to the district judge), we renegotiated our
agreement with the customer concerning the defense of the case going forward. We have now ceded control of the defense of the case to the customer/Bertelsmann AG (the customers ultimate owner), and are splitting the costs of the defense with
the customer/Bertelsmann AG. We are still reserving our rights as to indemnification issues. A trial date had been set for September 28, 2001 in the matter, but that date will be reset after the Court rules on the claim construction appeal and other
pending matters.





On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against us
in the United States District Court for the Northern District of California alleging patent infringement. The Complaint names us, Amazon.com, Inc., Listen.com, Inc., Entertaindom LLC, DiscoverMusic.com, Inc. and Muze, Inc. It alleges that these
parties infringe, or induce infringement of, the claims of United States Patent Nos. 5,237,157 (the 157 patent) and 5,963,916 (the 916 patent) by operating a web site and/or a kiosk that allows interactive
previewing of pre-recorded music products. The Complaint seeks unspecified damages and injunctive relief. We answered Intouchs first amended complaint, denying the material allegations of the amended complaint, and




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##### Table of Contents

asserting counterclaims for declaratory judgment of non-infringement, patent invalidity and inequitable conduct. In May 2001, the parties reached an agreement in principle to settle
Intouchs claims on the 157 patent. On February 6, 2002, the parties executed a final settlement regarding the 916 patent. Pursuant to the settlement, the terms of which are confidential, Intouch has dismissed its suit with
prejudice as to us and granted us a nonexclusive license on the 916 patent. The settlement did not have a material impact on our financial position or results of operations.





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 securities holders during the quarter ended December 31, 2001.




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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.





High

LowYear Ended December 31, 1999Third Quarter (since July 8, 1999)

$
40.44

$
20.88Fourth Quarter


45.13


26.25Year Ended December 31, 2000First Quarter


34.06


13.25Second Quarter


19.00


6.69Third Quarter


14.50


4.25Fourth Quarter


6.00


2.16Year Ended December 31, 2001First Quarter


3.88


2.00Second Quarter


2.95


1.81Third Quarter


2.95


2.03Fourth Quarter


2.72


2.10





The closing price per share of the common stock at March 13, 2002
was $2.27. As of March 13, 2002, there were approximately 126 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.





Preferred Stock Rights Agreement





On August 7, 2001, our Board of Directors adopted a Preferred Stock Rights Agreement under which we
declared a dividend of one right to purchase one one-thousandth share of our Series A participating preferred stock for each outstanding share of common stock. The rights will separate from the common stock and become exercisable following (i) the
tenth day (or such later date as may be determined by our Board of Directors) after a person or group of affiliated or associated persons has acquired, or obtained the right to acquire, beneficial ownership of 15% or more of the common stock then
outstanding or (ii) the tenth business day (or such later date as may be determined by our Board of Directors) after a person or group announces a tender of exchange offer, the consummation of which would result in ownership by a person or group of
15% or more of our then outstanding common stock. These thresholds were amended to 10% on July 14, 2002. Each right will entitle the holder to purchase for $17.00 one one-thousandth of a share of Series A preferred stock with economic terms similar
to that of one share of our common stock.




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##### Table of Contents

ITEM 6.    SELECTED FINANCIAL DATA





The following selected
financial data should be read in conjunction with Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and related notes thereto included in Item 8
included elsewhere in this document to fully understand factors that may affect the comparability of the information presented below.





Year Ended December 31,2001


2000


1999


1998


1997(in thousands, except per share data)Statement of Operations Data:Net revenues:License

$
682


$
1,284


$
1,537


$
1,235


$
246Services


1,173



2,977



733



268



10Business development (related party)


2,873



7,307



2,137



1,300



Total net revenues


4,728



11,568



4,407



2,803



256Cost of net revenues:License


491



290



235



310



302Services


1,503



2,722



1,122



242



91Business development (related party)






75



79



2



Non-cash cost of revenues


349



28



25



36



15Total cost of net revenues


2,343



3,115



1,461



590



408Gross profit (loss)


2,385



8,453



2,946



2,213



(152
)Operating expenses:Sales and marketing


11,404



17,114



10,217



4,035



2,820Non-cash sales and marketing


(43
)


314



783



741



304Research and development


16,957



22,917



11,706



4,109



1,880Non-cash research and development






80



371



210



127General and administrative


9,077



7,131



2,770



1,642



898Non-cash general and administrative


(14
)


13



190



254



88Strategic marketing-equity instruments


607



1,935



3,130







Restructuring


4,497















Total operating expenses


42,485



49,504



29,167



10,991



6,117Loss from operations


(40,100
)


(41,051
)


(26,221
)


(8,778
)


(6,269
)Other income (expense), net


4,170



8,236



2,015



239



53Loss in equity investment


(1,254
)


(870
)










Net loss

$
(37,184
)

$
(33,685
)

$
(24,206
)

$
(8,539
)

$
(6,216
)Net loss per share:Basic and diluted

$
(1.64
)

$
(1.52
)

$
(2.28
)

$
(3.60
)

$
(4.95
)Weighted average shares


22,614



22,133



10,616



2,371



1,256December 31,2001


2000


1999


1998


1997(in thousands)Balance Sheet Data:Cash and cash equivalents

$
91,594


$
96,398


$
138,692


$
14,143


$
2,387Short-term investments






27,378



19,157



3,001



Working capital


87,233



119,089



152,030



15,060



858Total assets


97,415



138,210



166,109



19,913



3,275Long-term debt, less current portion






564



1,321



969



218Mandatorily redeemable convertible preferred stock














29,801



8,247Total stockholders equity (deficit)


91,825



128,674



157,745



(14,133
)


(6,879
)




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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 this Managements Discussion and Analysis on information currently available to us, and we assume no obligation to update any of these
forward-looking statements. Although we believe that the expectations reflected in any of these 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. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included
in Item 8 of this Form 10-K.





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 of leading 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. More recently, we began focusing additional attention on licensing our server software products. As a provider of digital music delivery services, we expect our revenue sources to expand beyond software
license sales to include sales of digital recorded music and digital music subscriptions. Revenues from digital music sales and transaction fees from our music delivery services represented less than 7%, 6% and 1% of total net revenues in 2001, 2000
and 1999, respectively. Our Liquid Music Network began offering syndicated music through music retailer websites in the third quarter of 1999.





Business Development Revenue





Business development revenues as a percentage of
total net revenues were 61%, 63% and 48% in 2001, 2000 and 1999, respectively. Liquid Audio Korea (LAK), Liquid Audio Greater China (LAGC), Liquid Audio South East Asia (LASE) through our strategic partner, Epi
Entertainment Group, Ltd., and Liquid Audio Japan (LAJ) stopped making their contractual payments as scheduled in the third quarter of 2000, fourth quarter of 2000, fourth quarter of 2000 and the second quarter of 2001, respectively, due
to deterioration of their financial condition and lack of funds available to meet their contractual payment obligations. We have been unsuccessful in receiving any additional contractual payments from these customers, and, as a result of the
financial condition of these customers, we do not anticipate that such customers will be a source of additional revenue or that we will receive payments owed for existing contractual arrangements.





In June 2001, we and LAJ mutually agreed to terminate the licensing and reseller agreements (the Agreements) between the
two companies. As a result, Liquid Audio Japan renamed its company to Cyber




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Music Entertainment (CME) and no longer distributes our technology nor utilizes our digital distribution platform to offer services to the Japanese music market. Effective September
30, 2001, CME ceased using Liquid Audio trademarks, including the company name, and returned all of our products, technology and licenses. We do not believe we have any outstanding obligations in connection with the Agreements. As a result, we
recognized the remaining deferred revenue balance of $890,000, which had been paid in cash, from CME in the three months ended September 30, 2001. In October 2001, we established a new office in Tokyo to build new relationships with label, retail
and consumer electronic companies directly.





In September 2001, we notified LAK, LAGC and LASE through
our strategic partner of their defaults under the licensing and reseller agreements between us and the aforementioned companies due to their failures to make contractual payments as scheduled. LAK, LAGC and our strategic partner of LASE did not cure
the defaults during the cure periods. Accordingly, we exercised our rights to terminate the licensing and reseller agreements. Outstanding accounts receivable from LAK, LAGC and our strategic partner of LASE have been fully reserved, and no revenue
from LAK, LAGC or LASE through our strategic partner were recorded in the three months ended September 30, 2001. We do not believe we have any outstanding obligations in connection with the Agreements. As a result, we recognized the remaining
deferred revenue balance of $569,000, which had been paid in cash, from LAGC in the three months ended December 31, 2001.





Corporate Restructuring





In May 2001, we adopted a corporate restructuring program to
reduce expenses to preserve our cash position while the digital music market develops. The restructuring included a worldwide workforce reduction, a consolidation of three Redwood City, California offices into one facility and other expense
management initiatives. We have de-emphasized our efforts in less productive, non-core business areas that do not directly support secure digital download opportunities, including digital music kiosks, music hosting for independent artists and
labels, music clips service and encoding services. We plan to continue to focus on software licensing and digital music delivery services that complement our secure digital download business. We plan to support the emerging market for digital music
subscriptions, enabling major portals, online retailers and secure audio device manufacturers to offer subscription-based digital music download services. This strategy leverages and enhances both our core digital download services and our player
software licensing business. We recorded restructuring charges of $4.5 million in the twelve months ended December 31, 2001.





The restructuring charge included involuntary employee separation costs of $1.1 million for 79 employees worldwide representing approximately 40% of all Liquid Audio employees, 20 in sales and marketing, 32 in research and
development, 13 in general and administrative and 6 in operations functions in the U.S., and 2 in sales an marketing, 3 in research and development and 3 in operations functions outside the U.S. Lease costs of $1.2 million were accrued pertaining to
the estimated future obligations for non-cancelable lease payments for excess facilities that were vacated due to reductions in workforce. Asset impairment costs of $2.2 million were recorded, primarily for property and equipment, furniture and
fixtures, computer software and leasehold improvements for assets no longer in use from de-emphasized business lines, reductions in workforce and excess facilities. At December 31, 2001, the remaining $523,000 accrual balance will be paid over the
lease terms through the fourth quarter of 2002.





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, 2001 we had an accumulated deficit of approximately $111.1 million. We expect to incur additional losses and continued negative cash
flow from operations through at least mid-2003. 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.




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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.





Year Ended December 31,2001


2000


1999Net revenues:License

14
%

11
%

35
%Services

25


26


17Business development (related party)

61


63


48Total net revenues

100


100


100Cost of net revenues:License

10


3


5Services

33


23


25Business development (related party)




1


2Non-cash cost of revenues

7





1Total cost of net revenues

50


27


33Gross profit

50


73


67Operating expenses:Sales and marketing

241


148


232Non-cash sales and marketing

(1
)

2


18Research and development

359


198


266Non-cash research and development




1


8General and administrative

192


62


63Non-cash general and administrative







4Strategic marketing-equity instruments

13


17


71Restructuring

95





Total operating expenses

899


428


662Loss from operations

(849
)

(355
)

(596
)Other income (expense), net

89


72


47Loss in equity investment

(27
)

(8
)

Net loss

(787
)%

(291
)%

(549
)%





Years Ended December 31, 2001, 2000 and 1999





Total Net Revenues





Total net revenues decreased 59% to $4.7 million in 2001 from $11.6 million in 2000. Total net revenues increased 162% in 2000 from $4.4 million in 1999.





License.    License revenues primarily consist of fees from licensing our software
products to third parties. License revenues decreased 47% to $682,000 in 2001 from $1.3 million in 2000. License revenues decreased 16% in 2000 from $1.5 million in 1999. The decrease in 2001 was due to a reduction in kiosk software and other
technology licenses as a result of our decision to discontinue our digital music kiosk business area based on the high costs associated with the operation of such business relative to the historical and projected revenues of such business, partially
offset by an increase in Liquid Player license fees of approximately $241,000 due to an OEM bundling agreement with a major consumer electronics company. The decrease in 2000 relates primarily to the




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expiration of a Liquid Player license agreement with Adaptec, Inc. 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 was partially offset by an increase in license fees related to digital music kiosk sales of approximately $371,000.





Services.    Services revenues primarily consist of maintenance fees related
to our licensed software products, hosting fees, encoding, music delivery and transaction fees, promotion and advertising services and kiosk related equipment sales from third parties. Services revenues decreased 61% to $1.2 million in 2001 from
$3.0 million in 2000. Services revenues increased 306% in 2000 from $733,000 in 1999. The decrease in 2001 was due to decreases in encoding services, services from the expiration of a contract with Microsoft, decrease in kiosk related equipment
sales due to a de-emphasis in the digital music kiosk business area in connection with our corporate restructuring, decrease in promotion and advertising services resulting from the softness in the Internet advertising market, disappearance of
revenue from Liquid Muze Previews service due to the termination of the agreement with Muze and decrease of hosting fees due to the de-emphasis of music hosting for independent artists and labels in connection with Liquid Audios corporate
restructuring. The increase in 2000 was due to increases in encoding services from a new agreement with Microsoft, increase in kiosk related equipment and services from the new business area, increase in digital music and transaction fees from our
Muze Previews service and increase in promotion and advertising services.





Business Development
(Related Party).    Business development revenues primarily consist of license and maintenance fees from agreements under which we gave our strategic related partners listed below the right to license and use our digital
recorded music delivery technology. Business development revenues decreased 61% to $2.9 million in 2001 from $7.3 million in 2000. Business development revenues increased 242% in 2000 from $2.1 million in 1999. The increase in business development
revenues in 2000 was primarily due to contracts between Cyber Music Entertainment and Liquid Audio pursuant to which Cyber Music Entertainment made quarterly license payments to Liquid Audio beginning in 1999 continuing through 2000. The decrease in
business development revenues in 2001 was due to Cyber Music Entertainments inability to make the scheduled payments under its agreement after the first quarter of 2001 as a result of its financial condition. Total business development
revenues are summarized as follows (in thousands):





Year Ended December 31,2001

2000

1999Cyber Music Entertainment and strategic partner

$
1,837

$
5,047

$
1,105Liquid Audio South East Asia and strategic partner





1,261


Liquid Audio Greater China and strategic partner


1,036


705


500Liquid Audio Korea and strategic partner





294


532$
2,873

$
7,307

$
2,137





Of the total fees earned from Cyber Music Entertainment
and strategic partner, Super Stage, Inc., $1.8 million, $4.9 million and $272,000 were earned from Cyber Music Entertainment and relate to software licensing and maintenance fees in 2001, 2000 and 1999, respectively, and $167,000 and $833,000
were earned from our strategic partner in Cyber Music Entertainment, Super Stage Inc., in 2000 and 1999, respectively, relate to a non-refundable service fee of $1.0 million received in March 1999 which was recognized ratably over the one-year term
of the service agreement. The increase in the 2000 period relates to contractual payments received by us from Cyber Music Entertainment, and the decrease in the 2001 period relates to the decrease in contractual payments received from Cyber Music
Entertainment due to its financial condition and lack of funds available to meet the contractual payment obligations. The total fee of $1.0 million and $705,000 earned from Liquid Audio Greater China in 2001 and 2000 consist of software licensing
and maintenance fees. The total fee of $500,000 earned from our strategic partner in Liquid Audio Greater China, Super Stage, Inc., in 1999 relates to a service fee to develop a local business in Taiwan and Hong Kong. The total fee of $1.3 million
earned in 2000 from Liquid Audio South East Asia through our strategic partner, Epi Entertainment Group, Ltd., consisted of software




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licensing and maintenance fees. 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.
We do not expect to derive significant revenue from business development arrangements in the foreseeable future.





In 2001, approximately 61% of total net revenues came from sales to two customers, Cyber Music Entertainment and Liquid Audio Greater China. In 2000, approximately 53% of total net revenues came from sales to two customers, Cyber
Music Entertainment 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. International revenues
represented approximately 64%, 69% and 49% of total net revenues in the twelve months ended December 31, 2001, 2000 and 1999, respectively.





Total Cost of Net Revenues





Our gross profit decreased to approximately 50% of
total net revenues in 2001 from 73% in 2000. Our gross profit increased to approximately 73% of total net revenues in 2000 from 67% in 1999. Total cost of net revenues decreased 25% to $2.3 million in 2001 from $3.1 million in 2000. Total cost of
net revenues increased 113% in 2000 from $1.5 million in 1999.





License.    Cost of license revenues consists of royalties paid to third party technology vendors and costs of documentation, duplication and packaging. Cost of license revenues increased 69% to $491,000 in
2001 from $290,000 in 2000. Cost of license revenues increased 23% in 2000 from $235,000 in 1999. Cost of license revenues increased in 2001 and 2000 due to the addition of certain technology licenses to include additional and enhanced functionality
to the Liquid Player, such as broader support for CD-R/RW devices, anti-piracy features, MP3 ripping and playback and AAC support.





Services.    Cost of services revenues consists of compensation for customer service, encoding and professional services personnel, kiosk related equipment and an allocation
of our occupancy costs and other overhead attributable to our services revenues. Cost of services revenues decreased 45% to $1.5 million in 2001 from $2.7 million in 2000. Cost of services revenues increased 143% in 2000 from $1.1 million in 1999.
The decrease in cost of services revenue in 2001 was due to the reduction in compensation and related expenses of approximately $660,000 from the decrease in the number of encoding, customer service and professional services personnel from 33 to 12
and kiosk related equipment due to our corporate restructuring and expense management initiative. The increase in cost of service revenues in 2000 was due to the increase in compensation and related expenses of approximately $539,000 from the
addition of encoding, customer service and professional services personnel from 18 to 33 to support anticipated customer service demands and additional product lines and an increase in kiosk related equipment of approximately $447,000.





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 $0, $75,000 and $79,000 in 2001, 2000 and 1999, respectively. The decrease in cost of business development revenue
relates to our decision to discontinue our digital music kiosk business as a result of the unfavorable coast structure of such business relative to the historical and projected revenues generated by the kiosk related business.





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 which was recognized ratably over the initial one-year term of the
agreement; as a result, $181,000 and $14,000




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was recognized as non-cash cost of revenues in 2001 and 2000, respectively. Also in connection with this agreement, we granted a warrant for a total of 233,300 shares of common stock. Of the
total, warrants to purchase 77,768 shares vested in December 2001, and the cost was remeasured each quarter until a commitment for performance was reached or the warrant vested based on market data. At December 4, 2001, the 77,768 shares under this
warrant were valued at $175,000, of which $163,000 and $12,000 was recognized as non-cash cost of revenues in 2001 and 2000, respectively. The remaining warrants to purchase common shares will vest at 6,481 shares per month commencing December 2001
for one year and 6,480 shares per month commencing December 2002 for one year. We recorded a total of $9,000 as non-cash cost of revenue at December 31, 2001 related to the remaining warrants. Such warrants will be valued at the fair market value of
our common stock on each reporting date. Stock-based compensation expense (income) for customer service, encoding and professional services personnel were $(4,000), $2,000 and $25,000 in 2001, 2000 and 1999, respectively. We have fully amortized
stock compensation expense related to these personnel in 2001, and accordingly no future expense related to these stock options will be incurred.





Operating Expenses





Sales and
Marketing.    Sales and marketing expenses consist 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 decreased 33%
to $11.4 million in 2001 from $17.1 million in 2000. Sales and marketing expenses increased 68% in 2000 from $10.2 million in 1999. The decrease in 2001 was due to the reduction in compensation and related expenses of approximately $2.0 million from
decreases in the number of sales and marketing personnel from 62 to 24 due to our corporate restructuring and expense management initiatives, advertising and promotions programs of approximately $1.9 million, travel and entertainment of
approximately $571,000, trade shows of approximately $299,000, marketing literature of approximately $166,000 and allocation of occupancy costs and other overhead expenses of approximately $376,000. The increase in 2000 was due to the addition in
compensation and related expenses of approximately $3.3 million due to the increase in the number of sales and marketing personnel from 36 to 62 to support the growth and sales of additional product lines and related marketing and promotional
activities, travel and entertainment of approximately $680,000, tradeshows of approximately $362,000, depreciation and amortization of approximately $350,000, allocation of compensation for customer service and professional services personnel
attributable to sales and marketing activities of approximately $875,000 and allocation of occupancy costs and other overhead of approximately $873,000.





Research and Development.    Research and development expenses consist 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 decreased 26% to $17.0 million in
2001 from $22.9 million in 2000. Research and development expenses increased 96% in 2000 from $11.7 million in 1999. The decrease in 2001 was primarily due to the reduction in compensation and related expenses of approximately $5.6 million from
decreases in the number of personnel from 86 to 52 and outside contractors due to our corporate restructuring and expense management initiatives. The increase in 2000 was due to addition in compensation and related expenses of approximately $6.5
million from increases in the number of personnel from 62 to 86 and outside contractors needed to enhance our existing software products, develop and enhance our online services, develop new products and services and build our external network and
computer data center infrastructure, shared project costs with Radio and Records of approximately $407,000, depreciation and amortization of approximately $1.4 million, and allocation of occupancy costs and other overhead of approximately $1.4
million.





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




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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 27% to $9.1 million in 2001 from $7.1 million in 2000. General and administrative expenses increased 157% in 2000 from $2.8 million in 1999. The increase in 2001 was primarily due to an increase in the allowance of
doubtful accounts related to accounts receivables from related and third parties of approximately $1.5 million and legal fees related to patent infringement claims against us of approximately $1.2 million, partially offset by the reduction in
compensation and related expense of approximately $1.0 million from decreases due to a reduction in the number of personnel from 37 to 17 and outside contractors due to our corporate restructuring and expense management initiatives. The increase in
2000 was primarily due to the additional compensation and related expenses of approximately $2.5 million from increases in the number of personnel from 20 to 37 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 the lawsuit with former consultants.





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 $607,000, $1.9 million and $3.1 million in 2001, 2000 and 1999, respectively.
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, $0, $843,000 and $1.2 million was recognized as strategic marketing-equity instruments expense in 2001, 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 to purchase a total of 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 market data during the vesting period. The third warrant for 83,333 shares vested in August 2001. The third warrant was initially valued at $105,000 and was recognized ratably over the one-year period ending at the vesting date.
The third warrant was revalued at each balance sheet date through the vesting date. As a result, the original charge of $105,000 was reduced to $54,000 based on market data during the vesting period. In 2001, $16,000 was recognized as strategic
marketing-equity instruments expense for the third warrant. 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 were recognized ratably over the one-year term of the agreement. As a result, $591,000 was recognized as
strategic marketing-equity instruments expense in 2001 and 2000 each.





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 December 31, 2001 was $3.6 million. We recognized $(57,000), $407,000 and $1.3 million of stock




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compensation expense (income) for 2001, 2000 and 1999, respectively. We expect quarterly amortization related to those options to be between $16,000 and $3,000 per quarter during 2002. These
future compensation charges will 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.





Restructuring.    Restructuring charge relates to costs associated with our corporate
restructuring program adopted in May 2001. The $4.5 million charge in 2001 consists of involuntary employee separation costs of $1.1 million, lease costs of $1.2 million pertaining to estimated future obligations for non-cancelable lease
payments for excess facilities that were vacated due to reductions in workforce, and asset impairment costs of $2.2 million for property and equipment, furniture and fixtures, computer software and leasehold improvements no longer in use from
de-emphasized product lines, reductions in workforce and excess facilities.





Other Income (Expense),
Net.    Interest income consists of earnings on our cash, cash equivalents and short-term investments. Interest income decreased to $4.3 million in 2001 from $8.8 million in 2000, and increased in 2000 from $2.3 million in
1999. The decrease in 2001 was due to lower average cash and cash equivalent balances resulting from cash used in operating activities, and lower interest rates. The increase in 2000 was 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 decreased to $111,000 in 2001 from $144,000 in 2000, and decreased in 2000 from $193,000 in 1999. The declines in 2001 and 2000 is due to several capital leases expiring during the period, and in 2001, also included the expiration
of several equipment loans. The increase in 1999 was primarily due to interest paid on higher average financing obligation balances resulting from additional capital leases and borrowings under the equipment loans during the year.





Other income (expense), net of $429,000 in 2000 consists primarily of the write-off of loans receivable from Liquid Audio
Korea due to its deterioration in financial condition and lack of funds available to pay the amounts due under the loan.





Loss in Equity Investment.    Loss in equity investment consists of our share of losses from our investment in a related party accounted for using the equity method of accounting. Our share of losses were
$1.3 million and $870,000 for 2001 and 2000, respectively. The net balance of our investments in Cyber Music Entertainment has been reduced to zero at December 31, 2001. We have discontinued recording losses from our investment in Cyber Music
Entertainment as we have no contractual or planned obligation to provide funding to Cyber Music Entertainment.





Critical
Accounting Policies





Our critical accounting policies are as follows:





| |  |  | revenue recognition;
| | - |  | --------------------




| |  |  | estimating valuation allowances, specifically the allowance for doubtful accounts and sales returns reserve; and
| | - |  | ----------------------------------------------------------------------------------------------------------------




| |  |  | accounting for income taxes.
| | - |  | ----------------------------




Revenue recognition.    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 (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




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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. The total fee from business development arrangements is recognized when payment becomes due if extended payment terms exist. Extended payment terms are defined as payment terms outside our
customary business practice, generally greater than 90 days. Revenue is not recognized if the Partners stop making their contractual payments. We also license our software products to original equipment manufacturers, 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. Similarly with business development contracts, the total fee
from the arrangement is allocated among the various elements based on VSOE of fair value. Maintenance revenue related to our licensed software products and hosting revenue from record companies and artists are recognized over the service period,
typically one year. 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 revenues 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.





Allowance for doubtful accounts and sales returns
reserve.    The preparation of financial statements requires our management to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, our management must make estimates of the uncollectability of our accounts receivables. Management specifically analyzes accounts
receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Similarly, our
management must make estimates of the potential future product returns related to current period product revenue. Management analyzes historical returns, current economic trends, and changes in customer demand and acceptance of our products when
evaluating the adequacy of the sales returns reserve. Significant management judgments and estimates must be made and used in connection with establishing the allowance for doubtful accounts and sales returns reserve in any accounting period.
Material differences may result in the amount and timing of our revenue and bad debt expense for any period if management made different judgments or used different estimates. Our accounts receivable from third parties balance was $130,000, net of
allowance for doubtful accounts of $325,000, as of December 31, 2001. Our accounts receivable from related parties balance was $0, net of allowance for doubtful accounts of $1.6 million, as of December 31, 2001.





Accounting for income taxes.    As part of the process of preparing our consolidated financial statements we
are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of
items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax
assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must
include an expense within the tax provision in the statement of operations.





Significant management judgment is
required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance of $40.6 million as of December 31,
2001, due to uncertainties related to our ability to utilize some of our deferred tax assets, primarily consisting of certain net operating losses carried forward, before they expire. The valuation allowance is based on our estimates of taxable
income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual




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results differ from these estimates or we adjust these estimates in future periods we may need to establish an additional valuation allowance which could materially impact our financial position
and results of operations.





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, 2001, 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, 2001, we have approximately $91.6 million of cash and cash equivalents.





Net cash used in operating activities was $30.7 million, $26.8 million and $14.9 million in 2001, 2000 and 1999, respectively. Net cash used for operating activities in 2001 was primarily the result of net losses from operations of
$37.2 million, depreciation and amortization of $3.9 million, amortization of unearned compensation of $(62,000), strategic marketingequity instruments charges of $607,000, an increase in the allowance for doubtful accounts and sales returns
reserve of $1.5 million, equity investment losses of $1.3 million, loss on disposal of property and equipment of $2.2 million and a net decrease in working capital items of $3.2 million. The net decrease in working capital items include a
decrease in accounts receivable of $390,000, increase in restricted cash of $826,000, decrease in other assets of $473,000, decrease in accounts payable of $2.2 million, increase in accrued expenses and other liabilities of $299,000 and a decrease
in deferred revenue of $1.3 million. Net cash used for operating activities in 2000 was primarily the result of net losses from operations of $33.7 million, 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 of $315,000, notes receivable write-off of $470,000, equity investment losses of $870,000 and
a net decrease in working capital items of $929,000. The net decrease in working capital items include an increase in accounts receivable of $2.2 million, increase in other assets of $878,000, increase in accounts payable of $1.4 million, increase
in accrued expenses and other liabilities of $909,000 and a decrease in deferred revenue of $145,000. Net cash used for operating activities in 1999 was primarily the result of net losses from operations of $24.2 million, 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 of $101,000,
equity investment losses of $378,000 and a net decrease in working capital items of $3.2 million. The net decrease in working capital items include a decrease in accounts receivable of $190,000, increase in other assets of $474,000, increase in
accounts payable of $1.2 million, increase in accrued expenses and other liabilities of $1.9 million and an increase in deferred revenue of $395,000.





Net cash provided by (used in) investing activities was $26.4 million, $(15.7) million and $(20.5) million in 2001, 2000 and 1999, respectively. The net cash provided by investing activities in 2001
was primarily due to the net sales of short-term investments of $27.4 million, partially offset by the acquisition of property and equipment of $861,000 and an investment in Liquid Audio Japan of $165,000. The net cash used in investing activities
in 2000 and 1999 was due to the acquisition of property and equipment of $7.4 million and $4.5 million, respectively, and net purchases and sales of short-term investments totaling $8.2 million and $16.1 million in 2000 and 1999, respectively.





Net cash provided by (used in) financing activities was $(427,000), $268,000 and $159.9 million in 2001, 2000 and
1999, respectively. The net cash used in financing activities in 2001 was primarily due to payments of $563,000 made under our equipment loan and $120,000 under capital leases, partially offset by proceeds from sales of our common stock under the
employee stock purchase plan. The net cash provided by financing activities in 2000 was primarily due to proceeds from net sales of our common stock under the employee stock purchase plan, partially 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 net proceeds from our initial and follow-on public offerings of common stock.




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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% (5.25% at December 31, 2001). Borrowings under the equipment loan facility
are collateralized by the related equipment and other assets. Under the equipment loan facility, we had borrowed amounts totaling $1.8 million through December 31, 2001. 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, 2001, we had borrowed $737,000 under the lease financing agreements. Our other significant commitments consist of obligations under non-cancelable operating leases, which totaled $8.0
million, net of rental income of $145,000, as of December 31, 2001 and are payable in monthly installments through 2005, and a strategic related partner note in the amount of $343,000 that was issued in March 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 2.4% at December 31, 2001). The principal is due on
December 31, 2003, with quarterly interest payments. The terms of the strategic related partner note payable require us to make quarterly interest payments. At December 31, 2001, we were not in compliance with the interest payment requirement. We
are currently applying for a waiver from the strategic related partner with respect to our non-compliance with making quarterly interest payments. To obtain a waiver, we may have to make payments of all interest due to date and additional default
interest of 10% on unpaid amounts outstanding. As a result of our default of these payments, the strategic related partner has a right to accelerate payment of all amounts outstanding under the note payable and demand immediate full payment of all
amounts due, including outstanding interest and penalties. Accordingly, we have classified the outstanding balance under the note payable as a current liability. If we are successful in obtaining a waiver from the strategic partner, then the note
payable will be reclassified as a long-term liability.





In the past, we derived a significant portion of our
revenues from business development fees from relationships with our international partners, including Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid Audio South East Asia through our strategic partner. We recently
terminated our relationships with these partners. Consequently, we do not expect additional revenue or cash payments will be generated from them. At December 31, 2001, we held 6.52% of the outstanding stock of Cyber Music Entertainment
(CME), formerly Liquid Audio Japan, and had written down our investment to $0 under the equity method of accounting.





We have no material commitments for capital expenditures or strategic investments and anticipate a low rate of capital expenditures. We may 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.





Future payments due under debt and lease obligations as of December 31 are as follows (in thousands):





Note Payable to Related Party

Equipment Loan

Capital Leases

Operating Leases

Total2002

$
343

$
169

$
31

$
2,785

$
3,3282003











2,100


2,1002004











2,163


2,1632005











904


904$
343

$
169

$
31

$
7,952

$
8,495





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




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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 May 2000, the Emerging Issues Task Force (EITF) issued EITF Issue No. 00-14,
Accounting for Certain Sales Incentives. EITF Issue No. 00-14 addresses the recognition, measurement, and income statement classification for sales incentives that a vendor voluntarily offers to customers (without charge), which the
customer can use in, or exercise as a result of, a single exchange transaction. Sales incentives that fall within the scope of EITF Issue No. 00-14 include offers that a customer can use to receive a reduction in the price of a product or service at
the point of sale. The EITF changed the transition date for Issue No. 00-14, concluding that a company should apply this consensus no later than the companys annual or interim financial statements for the periods beginning after December 15,
2001. In June 2001, the EITF issued EITF Issue No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendors Products, effective for periods beginning after December 15, 2001. EITF Issue No.
00-25 addresses whether consideration from a vendor to a reseller is (a) an adjustment of the selling prices of the vendors products and, therefore, should be deducted from revenue when recognized in the vendors statement of operations
or (b) a cost incurred by the vendor for assets or services received from the reseller and, therefore, should be included as a cost or expense when recognized in the vendors statement of operations. Upon application of these EITFs, financial
statements for prior periods presented for comparative purposes should be reclassified to comply with the income statement display requirements under these Issues. In September of 2001, the EITF issued EITF Issue No. 01-09, Accounting for
Consideration Given by Vendor to a Customer or a Reseller of the Vendors Products, which is a codification of EITF Issues No. 00-14, No. 00-25 and No. 00-22 Accounting for Points and Certain Other Time- or Volume-Based
Sales Incentive Offers and Offers for Free Products or Services to be Delivered in the Future. We are currently assessing the impact of the adoption of these issues on our financial statements.





In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards
(SFAS) No. 141, Business Combinations. SFAS No. 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. We believe that the
adoption of SFAS No. 141 will not have a significant impact on our financial statements.





In July 2001, the FASB
issued SFAS No. 142, Goodwill and Other Intangible Assets, which is effective for fiscal years beginning after December 15, 2001. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the
standard includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of
previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. We believe that the adoption of SFAS No. 142 will not have a significant impact on our financial statements.





In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144
addresses significant issues relating to the implementation of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and develops a single accounting method under which long-lived
assets that are to be disposed of by sale are measured at the lower of book value or fair value less cost to sell. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that
(1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after
December 15, 2001 and its provisions are to be applied prospectively. We are currently assessing the impact of SFAS No. 144 on our financial position and results of operations.




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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





At December 31, 2001, we had an investment portfolio of cash and money market funds of $91.6 million. We had a related party loan outstanding at December 31, 2001 of $343,000, which was denominated in Japanese yen and bore interest
at 2.4%. 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, 2001 and 2000, the decline of the fair value of the fixed income portfolio and related party note payable would not be material.





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 the 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.




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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 March 29, 2002:





Name

Age

PositionGerald W. Kearby

54

President, Chief Executive Officer and DirectorRobert G. Flynn

48

Senior Vice President of Business Development, Director and SecretaryMichael R. Bolcerek

40

Senior Vice President and Chief Financial OfficerRichard W. Wingate

49

Senior Vice President of Content Development and Label RelationsLeon Rishniw

36

Vice President of EngineeringAnn Winblad

51

DirectorStephen V. Imbler

50

DirectorRaymond A. Doig

64

Director





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 and since July 2001, as one of our directors. 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. Bolcerek has served as our Senior Vice President and Chief Financial Officer since April 2001. From June to September 2000, Mr. Bolcerek was Chief Operating Officer and Vice President of
Finance for Mongomusic.com, an online music service provider. From January 1999 to June 2000, Mr. Bolcerek was a finance consultant to several high technology and Internet companies. From June 1997 to September 1998, Mr. Bolcerek was President,
Chief Financial Officer and Vice President of Finance for Spatializer Audio Laboratories Inc., an audio technology licensing company. From January 1997 to May 1997, Mr. Bolcerek was acting Corporate Controller for Novadigm, Inc., a software company.
From June 1995 to July 1996, Mr. Bolcerek was Controller for Nokia Display Products, Inc., a computer monitor manufacturer and division of Nokia Group. From January 1994 to March 1995, Mr. Bolcerek was Acting Chief Financial Officer and
Treasurer for Axil Computer, Inc., a computer hardware manufacturer. Prior to January 1994, Mr. Bolcerek held finance positions at NeXT Computer, Inc. and Oracle Corporation. Mr. Bolcerek holds a B.A. in economics from Brown 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. 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




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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. 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.





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 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 real-time 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.





Mr. Imbler has served as one of our directors since November 2001. Mr. Imbler has held a variety of
positions at Hyperion Solutions Corporation, a business intelligence software company, since July 1995, including Advisor from October 2001 to present, President and Chief Operating Officer from April 1999 to October 2001 and Senior Vice President
and Chief Financial Officer from July 1995 to April 1999. Mr. Imbler served as Senior Vice President and Chief Financial Officer for Gupta Corporation, an enterprise database software company, from November 1994 to July 1995, Vice President and
Chief Financial Officer for QuickResponse Services Inc., a developer of supply chain software applications, from May 1993 to October 1994, and Vice President of Finance for Oracle Corporation, an enterprise database and software developer, from July
1987 to May 1993. Mr. Imbler also serves on the board of directors for Wavecom, Inc., a French telecommunications company. Mr. Imbler holds an M.B.A. from University of Texas at Austin and a B.M. in piano performance from Wichita State University.





Mr. Doighas served as one of our directors since November 2001. Mr. Doig has served as President of EMV
Partners Corp., a company engaged in business consulting and as the general partner of a venture capital limited partnership, from 1986 to 1998. From 1983 to 1986, Mr. Doig was co-founder and Chief Operating Officer of Stanfill, Doig & Co., a
consulting firm. From March 1977 to August 1983, Mr. Doig served as President and CEO of 20th Century Fox International and as Vice President of Corporate Development for 20th Century Fox Film Corp. During 1998 and 1999, Mr. Doig served as a
fulltime operations consultant to Entertainment Properties, Inc., a wholly-owned privately held company. Mr. Doig continues to act as a consultant to Entertainment Properties, Inc. on an as needed basis. Mr. Doig holds an M.B.A., an M.S. in Public
Administration and a B.S. in Physical Sciences from the University of Southern California.





Section 16(a) Beneficial Ownership
Reporting Compliance





Section 16(a) of the Securities Exchange Act of 1934 requires our officers and
directors, and persons who own more than 10% of a registered class of our equity securities, to file certain reports regarding ownership of, and transactions in, our 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 us with copies of all Section 16(a) forms that they file.





Based solely on our review of copies of Forms 3, 4, 5 and amendments thereto furnished to us pursuant to Rule 16(a)-(e) 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 our officers, directors and 10% shareholders were




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complied with, we believe that all reports required to be filed under Section 16(a) have been filed on a timely basis by the foregoing persons for our 2001 fiscal year, except as follows: a late
filing of a Form 3 by Stephen V. Imbler, resulting in his initial holdings not being timely reported; a late filing of a Form 3 by Raymond A. Doig, resulting in his initial holdings not being timely reported; a late filing of a Form 4 by Gerald W.
Kearby, resulting in one sales transaction not being timely reported; a late filing of a Form 4 by Philip R. Wiser, resulting in one sales transaction not being timely reported; a late filing of a Form 5 by Ann Winblad, resulting in an option grant
not being timely reported; and a late filing of a Form 5 by Robert G. Flynn, resulting in an option grant not being timely reported. Form 5s by Michael R. Bolcerek, Gerald W. Kearby, Silvia Kessel, Mathieu Prevost, Leon Rishniw, Richard W. Wingate
and Philip R. Wiser have not been filed as of date but are in the process of being filed, hence, options granted to them during our 2001 fiscal year have not been timely reported.





Board Composition





We currently have five directors. 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 2004; and Class III, whose term will expire at the annual meeting of stockholders to be held in 2002. The Class I directors are Robert G. Flynn and Stephen V. Imbler, the Class II directors are Ann Winblad and one position vacant and
the Class III directors are Gerald W. Kearby and Raymond A. Doig. 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 Stephen V. Imbler, Ann Winblad and Raymond A. Doig.





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 Raymond A. Doig. 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.





The compensation committee believes that the compensation of the executive officers, including that of the Chief Executive Officer (each, an Executive Officer
and collectively, the Executive Officers), should be influenced by our performance. The compensation committee establishes the salaries and bonuses of all of the Executive Officers by considering: (i) our financial performance for the
past year; (ii) the achievement of certain objectives related to the particular Executive Officers area of responsibility; (iii) the salaries and bonuses of Executive Officers in similar positions of comparably-sized companies; and (iv) the
relationship between revenue and Executive Officer compensation.




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In addition to salary and bonus, the compensation committee, from time to time,
grants options to Executive Officers. The compensation committee views option grants as an important component of its long-term, performance-based compensation philosophy. Since the value of an option bears a direct relationship to our stock price,
the compensation committee believes that options motivate Executive Officers to manage us in a manner that will also benefit stockholders. As such, options are granted at the current market price. One of the principal factors considered in granting
options to an Executive Officer is the Executive Officers ability to influence our long-term growth and profitability.





Director
Compensation





In February 2002, our board of directors approved a plan to that provides our non-employee
directors with cash compensation of $10,000 upon initial election and on each anniversary of becoming a director during their term of service, and $1,000 per meeting of the board of directors attended during their term of service. Previously, our
directors did not receive cash compensation for their service as members of the board of directors. Our directors 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 June 2001, we granted Ann Winblad an option to purchase 10,000 shares of common stock, and in November 2001, we granted Stephen V. Imbler and
Raymond A. Doig an option to purchase 30,000 shares of common stock each.





Change of Control Arrangements





The compensation committee of our board of directors has approved a plan that provides that in the event of a change of control of Liquid
Audio, the stock options of each our executive officers will immediately vest the greater of one year or 25% of all of their outstanding or unvested stock options. Executive officers qualifying under this plan include Gerald W. Kearby and Robert G.
Flynn; the executive officers listed under DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT, and, H. Thomas Blanco (Vice President of Human Resources), Matthew Smith (Vice President of Product Marketing) and Kay Marsh (Vice President
of Information Technology). Under a separate employment agreement, the stock options of Michael R. Bolcerek will vest an additional 12.5% in the event of his termination as a result of a change of control of Liquid Audio. For purposes of this plan,
a change of control is defined as an event at which either (1) we enter into an agreement to dispose of all or substantially all of our assets; or (2) our stockholders dispose of 50% or more of our outstanding common stock.




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ITEM 11.    EXECUTIVE COMPENSATION





The following table sets forth
the total compensation received for services rendered to us for the years ended December 31, 2001, 2000 and 1999 by our Chief Executive Officer and our four other most highly compensated executive officers who received salary and bonus in 2001 in
excess of $100,000 (Named Executive Officers).





Annual Compensation

Long-Term CompensationName and Principal Position

Year

Salary

Bonus

Other Annual Compensation(1)

# Securities Underlying Options/SARsGerald W. Kearby

2001

$
238,423

$
52,000

$
2,000

75,000President and Chief Executive Officer

2000


216,963


105,685


2,000

125,0001999


167,692


100,000




Robert G. Flynn

2001


187,646


40,000


12,800

50,000Senior Vice President of Business Development

2000


161,053


73,520


4,433

100,0001999


136,154


75,000




Leon Rishniw

2001


163,423


26,000


2,000

100,000Vice President of Engineering

2000


144,445


71,223


2,000

63,7801999


114,615


17,500




30,000Richard W. Wingate

2001


216,846


60,000


2,000

50,000Senior Vice President of Content Development

2000


293,255


86,900


2,000

109,000and Label Relations

1999


179,099


75,000




25,000H. Thomas Blanco

2001


167,404


26,000


2,000

50,000Vice President of Human Resources

2000


115,192


20,000


2,000

100,0001999













---

|(1) |  | Amounts represent matching contributions to our 401(k) savings plan, and for Robert G. Flynn, also include reimbursement of relocation costs.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------




We granted stock options to certain Named Executive Officers during 2001. We have never granted any stock
appreciation rights.




45




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##### Table of Contents




Option Grants in Last Fiscal Year





The following table provides information relating to stock options awarded to each of the Named Executive Officers and Non-employee Directors during the year ended December
31, 2001. All such options were awarded under our 1996 Equity Incentive Plan.





Individual Grants

Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Options
Term(4)Name

Number of Securities Underlying Options Granted(1)

Percent of Total Options Grantedin Fiscal 2001(2)


Exercise Price(3)

Expiration Date5%

10%Gerald W. Kearby

75,000

4.5
%

$
2.70

6/19/11

$
127,351

$
322,733Robert G. Flynn

50,000

3.0



2.70

6/19/11


84,901


215,155Richard W. Wingate

50,000

3.0



2.70

6/19/11


84,901


215,155Leon Rishniw

50,000

3.0



1.84

4/24/11


57,858


146,624Leon Rishniw

50,000

3.0



2.70

6/19/11


84,901


215,155H. Thomas Blanco

50,000

3.0



1.84

4/24/11


57,858


146,624Ann Winblad

10,000

0.6



2.51

5/31/11


15,785


40,003Stephen V. Imbler

30,000

1.8



2.72

11/1/11


51,318


130,049Raymond A. Doig

30,000

1.8



2.72

11/1/11


51,318


130,049


---

|(1) |  | Options were granted under our 1996 Equity Incentive Plan and generally vest over four years from the date of grant.
|--- |  | --------------------------------------------------------------------------------------------------------------------

|(2) |  | Based on an aggregate of 1,650,750 options granted by us in the year ended December 31, 2001 to our employees, directors and consultants, including the Named
Executive Officers.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Options were granted at an exercise price equal to the fair market value per share of common stock on the grant date, as determined by our board of directors
according to the provisions of the 1996 Equity Incentive Plan.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | The potential realizable value is calculated based on the term of the option at its time of grant, or 10 years. In accordance with the rules of the Securities
and Exchange Commission, the following table also sets forth the potential realizable value over the term of the options, the period from the grant date to the expiration date, based on assumed rates of stock appreciation of 5% and 10% compounded
annually. These amounts do not represent our estimate of future stock price performance. Actual realizable values, if any, of stock options will depend on the future performance of the common stock.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Fiscal Year End Option Values





The following table provides summary information concerning stock options held as of December 31, 2001 by each of the Named Executive Officers and Non-employee Directors. No officers or directors exercised options in 2001.





Name

Shares Acquired on Exercise

Value Realized ($)

Number of Securities Underlying Unexercised Options at Fiscal Year-End

Value of UnexercisedIn-the-Money Options at Fiscal Year-End(1)Exercisable

Unexercisable

Exercisable

UnexercisableGerald W. Kearby



$


56,250

143,750

$


$
Robert G. Flynn






43,749

106,251





Richard W. Wingate






113,292

99,375


24,367


Leon Rishniw






55,477

58,303


19,250


21,250H. Thomas Blanco






47,916

102,084


4,250


21,250Ann Winblad






20,000







Stephen V. Imbler






30,000







Raymond A. Doig






30,000










---

|(1) |  | The value of unexercised in-the-money options at fiscal year-end is based on a price per share of $2.35 less the exercise price.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------



46




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##### Table of Contents




Performance Graph





The following graph compares the cumulative total return to stockholders on our common stock with the cumulative total return of the Nasdaq Stock Market Index-U.S. and a
group of peer issuers selected in good faith and comprised of Intertrust Technologies Corporation (ITRU), Musicmaker.com, Inc. (HITS), Preview Systems, Inc. (PRVW) and RealNetworks, Inc. (RNWK). The graph assumes that $100 was invested on July 9,
1999, the date of our initial public offering, in our common stock, the Nasdaq Stock Market Index-U.S. and the peer group, including reinvestment of dividends. No dividends have been declared or paid on our common stock. Historic stock price
performance is not necessarily indicative of future stock price performance.





LOGO


---

|* |  | $100 invested on July 9, 1999 in stock or index, including reinvestment of dividends. Fiscal year ending December 31.
|- |  | ---------------------------------------------------------------------------------------------------------------------




Company/Index

7/9/99

9/99

12/99

3/00

6/00

9/00

12/00

3/01

6/01

9/01

12/01Liquid Audio

100.00

246.67

175.00

88.33

63.13

30.00

17.09

16.25

19.67

13.67

15.67Peer Group

100.00

108.83

122.74

105.40

78.37

58.59

13.49

12.20

15.86

6.81

8.29Nasdaq Stock Market (U.S.)

100.00

98.42

145.46

163.30

141.99

130.66

87.49

65.31

76.98

53.40

69.42





ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT





The following table presents information with respect to beneficial ownership of our common stock as of March 13, 2002 by:





| |  |  | each person known by us who beneficially owns more than 5% of the common stock;
| | - |  | -------------------------------------------------------------------------------




| |  |  | each of our executive officers;
| | - |  | -------------------------------




| |  |  | each of our directors and nominees for director; and
| | - |  | ----------------------------------------------------




| |  |  | all executive officers and directors as a group.
| | - |  | ------------------------------------------------



47




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##### Table of Contents




Except as otherwise noted, the address of each 5% stockholder listed in the table
is c/o Liquid Audio, Inc., 800 Chesapeake Drive, Redwood City, CA 94063. The table includes all shares of common stock issuable within 60 days of March 13, 2002 upon the exercise of options and other rights beneficially owned by the indicated
stockholders on that date. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting and investment power with respect to all shares of common stock. To our knowledge, except under
applicable community property laws or as otherwise indicated, the persons named in the table have sole voting and sole investment control with respect to all shares of common stock beneficially owned. The applicable percentage of ownership for each
stockholder is based on 22,710,335 shares of common stock outstanding as of March 13, 2002, together with applicable options for that stockholder. Shares of common stock issuable upon exercise of options and other rights beneficially owned are
deemed outstanding for the purpose of computing the percentage ownership of the person holding those options and other rights, but are not deemed outstanding for computing the percentage ownership of any other person.





Shares Beneficially OwnedName of Beneficial Owner

Number

PercentSteel Partners II, L.P.

1,866,366

8.2150 East 52nd Street, 21st FloorNew York, NY 10022Gerald W. Kearby(1)

906,078

4.0Robert G. Flynn(2)

732,290

3.2Richard W. Wingate(3)

173,249

*Leon Rishniw(4)

135,003

*H. Thomas Blanco(5)

66,046

*Ann Winblad(6)

360,738

1.6Stephen V. Imbler(7)

30,000

*Raymond A. Doig(7)

30,000

*All executive officers and directors as a group (8 persons)(8)

2,433,404

10.5


---

|(1) |  | Includes 74,478 shares of common stock issuable upon the exercise of options exercisable within 60 days of March 13, 2002.
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(2) |  | Includes 57,290 shares of common stock issuable upon the exercise of options exercisable within 60 days of March 13, 2002.
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(3) |  | Includes 125,916 shares of common stock issuable upon the exercise of stock options exercisable within 60 days of March 13, 2002.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(4) |  | Includes 103,504 shares of common stock issuable upon the exercise of stock options exercisable within 60 days of March 13, 2002.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(5) |  | Includes 60,414 shares of common stock issuable upon the exercise of options exercisable within 60 days of March 13, 2002.
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(6) |  | Includes 80,943 shares of common stock owned by Hummer Winblad Venture Partners II, L.P., 488 shares of common stock owned by Hummer Winblad Technology Fund II,
L.P. (collectively, the Hummer Winblad Funds) and 20,000 shares of common stock issuable upon the exercise of stock options exercisable within 60 days of March 13, 2002. Ann Winblad is a general partner of Hummer Winblad Equity Partners
II, L.P. (HWII), the general partner of each of the Hummer Winblad Funds. Consequently, Ms. Winblad may be deemed to beneficially own all of the shares held by the Hummer Winblad Funds. Ms. Winblad disclaims beneficial ownership of such
shares, except to the extent of her respective pecuniary interest therein.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | Includes 30,000 shares of common stock issuable upon the exercise of stock options exercisable within 60 days of March 13, 2002.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------

|(8) |  | Includes 501,602 shares of common stock issuable upon the exercise of stock options exercisable within 60 days of March 13, 2002.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|* |  | Does not exceed 1%.
|- |  | -------------------



48




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##### Table of Contents




ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS





Since
our inception in January 1996, we have never been a party to any transaction or series of similar transactions in which the amount involved exceeded or will exceed $60,000 and in which any director, executive officer or holder of more than 5% of our
common stock had or will have an interest, other than as described under Security Ownership of Certain Beneficial Owners and Management and the transactions described below.





Gerald W. Kearby, Philip R. Wiser and Robert G. Flynn were involved in our founding and organization and may be considered as our promoters. Mr. Kearby and Mr. Flynn are
current executives and Mr. Wiser is a former executive. Following our inception in January 1996, we issued 937,500 shares of common stock to Mr. Kearby, 843,750 shares of common stock to Mr. Wiser and 750,000 shares of common stock to Mr.
Flynn. Mr. Kearby, Mr. Wiser and Mr. Flynn each contributed a nominal amount of capital for our initial capitalization.





From May to July 1996, we sold an aggregate of 3,049,989 shares of Series A preferred stock to certain investors at a purchase price of $0.656 per share. In May 1997, we sold an aggregate of 3,186,888 shares of Series B preferred
stock to certain investors at a purchase price of $1.96 per share. In July and September 1998, we sold an aggregate of 3,507,322 shares of Series C preferred stock to certain investors at a purchase price of $6.14 per share. The shares of Series A,
Series B and Series C preferred stock automatically converted into 9,744,199 shares of common stock upon the closing of our initial public offering on July 8, 1999.





The investors in the preferred stock included the following entities, which are 5% stockholders or are affiliated with our directors:





Investor

Shares of Series A Preferred Stock

Shares of Series B Preferred Stock

Shares of Series C Preferred StockEntities Affiliated with Directors:Entities affiliated with Ann Winblad(1)

1,829,272

788,928

81,431(Entities affiliated with Hummer Winblad Venture Partners)(2)


---

|(1) |  | Ann Winblad is a member of our board of directors. Ms. Winblad is a general partner of Hummer Winblad Venture Partners.
|--- |  | -----------------------------------------------------------------------------------------------------------------------

|(2) |  | Hummer Winblad Venture Partners II, L.P. purchased 1,756,098 shares of Series A preferred stock, 757,370 shares of Series B preferred stock and 80,943
shares of Series C preferred stock. Hummer Winblad Technology Fund II, L.P. purchased 62,198 shares of Series A preferred stock and 26,825 shares of Series B preferred stock. Hummer Winblad Technology Fund II, L.P. purchased 10,976 shares of Series
A preferred stock, 4,733 shares of Series B preferred stock and 488 shares of Series C preferred stock.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




In the past, we have granted options to our executive officers and directors. We intend to grant options to our officers and directors in the future. See DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTDirector
Compensation and EXECUTIVE COMPENSATIONOption Grants in Last Fiscal Year.





We have entered
into indemnification agreements with our officers and directors containing provisions which may require us, among other things, to indemnify our officers and directors against certain liabilities that may arise by reason of their status or service
as officers or directors (other than liabilities arising from willful misconduct of a culpable nature) and to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified. We also intend to execute
such agreements with our future directors and executive officers.





All of our securities referenced above were
purchased or sold at prices equal to the fair market value of such securities, as determined by our board of directors, on the date of issuance.




49




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##### Table of Contents




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:





Number

Description3.1

Certificate of Incorporation as currently in effect (1)3.2

Bylaws as currently in effect (4)4.1

Preferred Stock Rights Agreement, dated as of August 7, 2001, between Liquid Audio, Inc. and Mellon Investor Services LLC, including the Certificate of
Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C respectively (6)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 Förderung der angewandten Forschung e.V. dated August 14, 1998 (1)10.11+

Software License Agreement with Fraunhofer-Gesellschaft, zur Förderung 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)




50




---

##### Table of Contents

Number

Description10.14+

Patent License Agreement with Dolby Laboratories Licensing Corporation, dated May 3, 1996 (1)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)10.38

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Merchant Affiliate and License Agreement with MTS, Inc., dated May 14, 1999 (1)10.41+

OEM Agreement with Sanyo Electric Co., Ltd. dated June 2, 1999 (1)




51




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##### Table of Contents

Number

Description10.42

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 (7)21.1

Subsidiary of Liquid Audio, Inc. (8)23.1

Consent of PricewaterhouseCoopers LLP (8)24.1

Power of Attorney (contained in the signature page to this report)99.1

Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 200299.2

Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002


---

|+ |  | 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) |  | incorporated by reference to Exhibits of the Form 8-A filed with the Securities and Exchange Commission on August 15, 2001
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(7) |  | this exhibit has been omitted because the information is shown in the financial statements or notes thereto
|--- |  | -----------------------------------------------------------------------------------------------------------

|(8) |  | incorporated by reference to the Form 10-K filed with the Securities and Exchange Commission on March 29, 2002
|--- |  | --------------------------------------------------------------------------------------------------------------



52




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##### Table of Contents




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 September 9, 2002.





By:

/s/    GERALD W.
KEARBYGerald 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 Michael R. Bolcerek, 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:





Signature

Title

Date/S/    GERALD W.
KEARBY Gerald W. Kearby

President, Chief Executive Officer and Director (Principal Executive Officer)

September 9, 2002/S/    MICHAEL R.
BOLCEREK Michael R. Bolcerek

Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

September 9, 2002/S/    ROBERT G.
FLYNN Robert G. Flynn

Senior Vice President of Business Development, Secretary and Director

September 9, 2002/S/    ANN
WINBLAD* Ann Winblad

Director

September 9, 2002/S/    STEPHEN V.
IMBLER* Stephen V. Imbler

Director

September 9, 2002/S/    RAYMOND A.
DOIG* Raymond A. Doig

Director

September 9, 2002/S/    JUDITH N.
FRANK Judith N. Frank

Director

September 9, 2002/S/    JAMES D.
SOMES James D. Somes

Director

September 9, 2002





*By:

/S/    GERALD W.
KEARBYAttorney-in-Fact




53




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##### Table of Contents




Liquid Audio, Inc.


Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002


(Securities Exchange Act of 1934, § 13a-14)





I, Gerald W. Kearby, certify that:





1.  I have reviewed this annual report on Form 10-K of Liquid Audio, Inc.;





2.  Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;





3.  Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all
material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.





Date: September 9, 2002





/s/    GERALD W. KEARBY Gerald W. Kearby President, Chief Executive Officer and Director (Principal Executive Officer)








I, Michael R. Bolcerek, certify that:





1.  I have reviewed this annual report on Form 10-K of Liquid Audio, Inc.;





2.  Based on my knowledge, this annual report does not contain any untrue statement of
a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;





3.  Based on my knowledge, the financial statements, and other financial information included in this
annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.





Date: September 9, 2002





/s/    MICHAEL R. BOLCEREK Michael R. Bolcerek Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)




54




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##### Table of Contents




LIQUID AUDIO, INC.





INDEX TO CONSOLIDATED FINANCIAL STATEMENTS





PageReport of Independent Accountants

F-2Consolidated Balance Sheets

F-3Consolidated Statement of Operations

F-4Consolidated Statement of Stockholders Equity (Deficit)

F-5Consolidated Statement of Cash Flows

F-6Notes to Consolidated Financial Statements

F-7




F-1




---

##### Table of Contents




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, 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, 2001, and 2000, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2001 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 1, 2002




F-2




---

##### Table of Contents



LIQUID AUDIO, INC.





CONSOLIDATED BALANCE SHEETS


(in thousands, except share and per share amounts)







December 31,2001


2000AssetsCurrent assets:Cash and cash equivalents

$
91,594


$
96,398Short-term investments






27,378Accounts receivable from third parties, net


130



725Accounts receivable from related parties, net






1,253Other current assets


1,099



2,307Total current assets


92,823



128,061Restricted cash


826



Investment in strategic partner






1,089Property and equipment, net


3,603



8,860Other assets


163



200Total assets

$
97,415


$
138,210Liabilities and Stockholders EquityCurrent liabilities:Accounts payable

$
1,107


$
3,314Accrued expenses and other current liabilities


3,821



3,522Deferred revenue from third parties


122



440Deferred revenue from related parties






987Capital lease obligations, current portion


28



120Equipment loan, current


169



589Note payable to related party, current


343



Total current liabilities


5,590



8,972Capital lease obligations, non-current portion






28Equipment loan, non-current portion






143Note payable to related party






393Total liabilities


5,590



9,536Commitments and contingencies (Note 10)Stockholders equity:Common stock, $0.001 par value; 50,000,000 shares authorized; 22,709,305 and 22,541,959 shares issued and
outstanding


23



23Additional paid-in capital


202,969



202,877Unearned compensation


(43
)


(333
)Accumulated deficit


(111,094
)


(73,910
)Accumulated other comprehensive income


(30
)


17Total stockholders equity


91,825



128,674Total liabilities and stockholders equity

$
97,415


$
138,210





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




F-3




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##### Table of Contents



LIQUID AUDIO, INC.





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


Year Ended December 31,2001


2000


1999Net revenues:License

$
682


$
1,284


$
1,537Services


1,173



2,977



733Business development (related party)


2,873



7,307



2,137Total net revenues


4,728



11,568



4,407Cost of net revenues:License


491



290



235Services


1,503



2,722



1,122Business development (related party)






75



79Non-cash cost of revenues


349



28



25Total cost of net revenues


2,343



3,115



1,461Gross profit


2,385



8,453



2,946Operating expenses:Sales and marketing


11,404



17,114



10,217Non-cash sales and marketing


(43
)


314



783Research and development


16,957



22,917



11,706Non-cash research and development






80



371General and administrative


9,077



7,131



2,770Non-cash general and administrative


(14
)


13



190Strategic marketingequity instruments


607



1,935



3,130Restructuring


4,497







Total operating expenses


42,485



49,504



29,167Loss from operations


(40,100
)


(41,051
)


(26,221
)Interest income


4,321



8,809



2,271Interest expense


(111
)


(144
)


(193
)Other income (expense), net


(40
)


(429
)


(63
)Loss in equity investment


(1,254
)


(870
)


Net loss

$
(37,184
)

$
(33,685
)

$
(24,206
)Net loss per share:Basic and diluted

$
(1.64
)

$
(1.52
)

$
(2.28
)Weighted average shares


22,614



22,133



10,616





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




F-4




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##### Table of Contents



LIQUID AUDIO, INC.





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


Common Stock

Additional Paid-in Capital


Unearned Compensation


Accumulated Deficit


Other Comprehensive Income (Loss)


Total


Comprehensive Income (Loss)Shares


AmountBalance 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 a strategic marketing agreement

100,000






1,100















1,100Issuance of common stock warrants in connection with strategic marketing agreements








2,030















2,030Conversion of mandatorily redeemable convertible preferred stock upon initial public offering

9,744,199



10


29,791















29,801Issuance of common stock in connection with public stock offerings, net of offering expenses of $1,481

7,750,147



8


159,592















159,600Issuance of common stock in connection with exercise of stock options

398,581






156















156Issuance 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











1,369Gain on investment in strategic partner








1,959















1,959Unrealized gain on investments




















72



72


$
72Net loss
















(24,206
)






(24,206
)


(24,206
)Comprehensive loss



























$
(24,134
)Balance at December 31, 1999

21,875,256



22


198,973



(1,097
)


(40,225
)


72



157,745Repurchase 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















16Issuance of common stock warrants in connection with strategic marketing agreements








1,356















1,356Issuance of common stock in connection with strategic marketing agreements

200,000






1,376















1,376Issuance of common stock in connection with settlement of legal claim

30,000






354















354Issuance of common stock in connection with employee stock purchase plan

194,877






934















934Issuance of common stock in connection with exercise of stock options

230,017



1


128















129Issuance of common stock in connection with exercise of warrants

26,582






107















107Unearned compensation, net of effect of cancellations








(355
)


355











Amortization of unearned compensation












409











409Cumulative translation adjustment




















23



23


$
23Unrealized loss on investments




















(78
)


(78
)


(78
)Net loss
















(33,685
)






(33,685
)


(33,685
)Comprehensive loss



























$
(33,740
)Balance at December 31, 2000

22,541,959



23


202,877



(333
)


(73,910
)


17



128,674Issuance of common stock warrants in connection with strategic marketing agreements








188















188Issuance of common stock in connection with employee stock purchase plan

115,986






239















239Issuance of common stock in connection with exercise of stock options

51,360






17















17Unearned compensation, net of effect of cancellations








(352
)


352











Amortization of unearned compensation












(62
)










(62
)Cumulative translation adjustment




















(47
)


(47
)

$
(47
)Net loss
















(37,184
)






(37,184
)


(37,184
)Comprehensive loss



























$
(37,231
)Balance at December 31, 2001

22,709,305


$
23

$
202,969


$
(43
)

$
(111,094
)

$
(30
)

$
91,825





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




F-5




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##### Table of Contents



LIQUID AUDIO, INC.





CONSOLIDATED STATEMENTS OF CASH FLOWS  (in thousands)


Year Ended December 31,2001


2000


1999Cash flows from operating activities:Net loss

$
(37,184
)

$
(33,685
)

$
(24,206
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


3,859



3,436



1,143Amortization of unearned compensation


(62
)


409



1,369Allowance for doubtful accounts and sales returns reserve


1,458



315



101Notes receivable write-off






470



Equity in net loss of investments


1,254



870



378Strategic marketing-equity instruments


607



1,935



3,130Non-cash cost of revenue


353



26



Loss on disposal of and write-down of property and equipment


2,184







Issuance of common stock in connection with settlement of a legal claim






354



Changes in assets and liabilities:Accounts receivable from third parties


647



(889
)


10Accounts receivable from related parties


(257
)


(1,288
)


180Restricted cash


(826
)






Other assets


473



(878
)


(474
)Accounts payable


(2,207
)


1,362



1,150Accrued expenses and other current liabilities


299



909



1,918Deferred revenue from third parties


(318
)


35



395Deferred revenue from related parties


(987
)


(180
)


Net cash used in operating activities


(30,707
)


(26,799
)


(14,906
)Cash flows from investing activities:Acquisition of property and equipment


(861
)


(7,439
)


(4,456
)Proceeds from sale of property and equipment


33







Sales (purchases) of short-term investments, net


27,384



(8,221
)


(16,084
)Equity investment


(165
)






Net cash provided by (used in) investing activities


26,391



(15,660
)


(20,540
)Cash flows from financing activities:Proceeds from issuance of common stock, net of repurchases


256



1,051



159,753Payments made under capital leases


(120
)


(195
)


(221
)Proceeds from equipment loan










846Payments made under equipment loan


(563
)


(588
)


(446
)Net cash provided by (used in) financing activities


(427
)


268



159,932Effect of exchange rates on cash and cash equivalents


(61
)


(103
)


63Net increase (decrease) in cash and cash equivalents


(4,804
)


(42,294
)


124,549Cash and cash equivalents at beginning of period


96,398



138,692



14,143Cash and cash equivalents at end of period

$
91,594


$
96,398


$
138,692Supplemental cash flow disclosures:Cash paid for interest

$
67


$
144


$
193Supplemental non-cash investing and financing activities:Acquisition of property and equipment through capital leases

$



$



$
37Issuance of warrants in connection with strategic marketing agreements


188



1,356



2,030Issuance of common stock in connection with strategic marketing agreement


771



1,376



1,100Issuance of common stock upon exercise of warrant






107



Issuance of common stock for intellectual property






16



Equity investment with note payable










378





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




F-6




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##### Table of Contents



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, which was reregistered in August 2001 as Liquid Audio Europe Limited, 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.





Liquidity and capital resources





The Company has
incurred losses and negative cash flows from operations for every year since inception. For the year ended December 31, 2001, the Company incurred a net loss of approximately $37.2 million and negative cash flows from operations of $30.7 million. As
of December 31, 2001, the Company had an accumulated deficit of approximately $111.1 million. The Company expects to incur operating losses and negative cash flows through at least mid-2003. Failure to generate sufficient revenues, raise additional
capital or reduce spending could adversely affect the Companys ability to achieve its intended business objectives.





Reclassifications





Certain reclassifications have been made to the prior years
consolidated financial statements to conform to current period presentation.





Principles of consolidation





The financial statements include the accounts of the Company and its subsidiary. Significant intercompany transactions and
balances have been eliminated. Investments in entities in which the Company can exercise significant influence, but are less than majority owned and not otherwise controlled by the Company, are accounted for under the equity method.





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




F-7




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




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, 2001 and 2000, amortized cost approximated fair value and unrealized gains and losses were insignificant. Accordingly, 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):





December 31,2001

2000Cash and cash equivalents:Cash

$
1,819

$
79,683Money market funds


89,775


265Commercial securities





16,450$
91,594

$
96,398Short-term investments:Commercial securities

$


$
27,378U.S. Government bonds





$


$
27,378





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





Restricted cash





At December 31, 2001, the Company had a cash balance of $826,000 in the form of certificates of deposit, which were restricted from withdrawal. The amount serves as collateral to a letter of credit
issued by the Companys bank to the Companys lessor as security deposit on a long-term lease.





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:





Year Ended December 31,Customer

2001


2000


1999A (related party)

39
%

42
%

B (related party

22
%




C (related party)




11
%

D







31
%E (related party)







30
%F (related party)







12
%




F-8




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







At December 31, 2001, one customer represented 14% of gross accounts
receivable from third parties. At December 31, 2000, one customer represented 29% of gross accounts receivable from third parties. At December 31, 2001, two customers represented 81% and 19%, respectively, of gross accounts receivable from
related parties. At December 31, 2000, two customers represented 78% and 18%, respectively, of gross accounts receivable from related parties.





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 and a note payable to a related party are carried at cost and in the case of short-term investments, at
fair value which 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 debt 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 No. 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




F-9




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




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. When VSOE of fair value exist for the undelivered elements, primarily maintenance, the Company accounts 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, the total fee from the arrangement is
recognized ratably over the period of the contract. The Company recognizes revenue allocated to maintenance ratably over the contract period, which is generally twelve months.





Business development revenue primarily consists of license and maintenance fees from agreements under which the Company gives its strategic partners the right to license
and use the Companys digital recorded music delivery technology. These U.S. dollar-denominated, non-refundable fees are allocated among the various elements of the contract based on VSOE of fair value. When VSOE of fair value exist for the
undelivered elements, primarily maintenance, the Company accounts for the license portion based on the residual method as prescribed by SOP No. 98-9. 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 total fee from business development arrangements is recognized when payment becomes due if extended payment terms exist. Extended payment terms are
defined as payment terms outside the Companys customary business practice, generally greater than 90 days. Revenue is not recognized if the strategic partners stop making their contractual payments.





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 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):





Year Ended December 31,2001

2000

1999Advertising costs

$
113

$
1,552

$
1,659




F-10




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







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 No. 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 8.





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





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.




F-11




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







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):





Year Ended December 31,2001


2000


1999Numerator:Net loss

$
(37,184
)

$
(33,685
)

$
(24,206
)Denominator:Weighted average shares


22,621



22,211



11,199Weighted average unvested common shares subject to repurchase


(7
)


(78
)


(583
)Denominator for basic and diluted calculation


22,614



22,133



10,616Net loss per share:Basic and diluted

$
(1.64
)

$
(1.52
)

$
(2.28
)





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):





December 31,2001

2000

1999Series A mandatorily redeemable convertible preferred stock





3,050Series B mandatorily redeemable convertible preferred stock





3,187Series C mandatorily redeemable convertible preferred stock





3,507Mandatorily redeemable convertible preferred stock warrants





Common stock options

2,921

2,830

1,520Common stock warrants

875

875

609Unvested common stock subject to repurchase

1

17

583





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.




F-12




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







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):





Year Ended December 31,2001

2000

1999Domestic

$
1,692

$
3,629

$
2,236International


3,036


7,939


2,171$
4,728

$
11,568

$
4,407





It is impractical for the Company to compute revenues by type of
product and service for the years ended December 31, 2001, 2000 and 1999.





Recent accounting pronouncements





In May 2000, the Emerging Issues Task Force (EITF) issued EITF Issue No. 00-14, Accounting for Certain Sales
Incentives. EITF Issue No. 00-14 addresses the recognition, measurement, and income statement classification for sales incentives that a vendor voluntarily offers to customers (without charge), which the customer can use in, or exercise as a
result of, a single exchange transaction. Sales incentives that fall within the scope of EITF Issue No. 00-14 include offers that a customer can use to receive a reduction in the price of a product or service at the point of sale. The EITF changed
the transition date for Issue No. 00-14, concluding that a company should apply this consensus no later than the companys annual or interim financial statements for the periods beginning after December 15, 2001. In June 2001, the EITF issued
EITF Issue No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendors Products, effective for periods beginning after December 15, 2001. EITF Issue No. 00-25 addresses whether
consideration from a vendor to a reseller is (a) an adjustment of the selling prices of the vendors products and, therefore, should be deducted from revenue when recognized in the vendors statement of operations or (b) a cost incurred by
the vendor for assets or services received from the reseller and, therefore, should be included as a cost or expense when recognized in the vendors statement of operations. Upon application of these EITFs, financial statements for prior
periods presented for comparative purposes should be reclassified to comply with the income statement display requirements under these Issues. In September of 2001, the EITF issued EITF Issue No. 01-09, Accounting for Consideration Given by
Vendor to a Customer or a Reseller of the Vendors Products, which is a codification of EITF Issues No. 00-14, No. 00-25 and No. 00-22 Accounting for Points and Certain Other Time-or Volume-Based Sales Incentive Offers
and Offers for Free Products or Services to be Delivered in the Future. The Company is currently assessing the impact of the adoption of these issues on its financial statements.





In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations. SFAS No. 141 requires the purchase method
of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. The Company believes that the adoption of SFAS No. 141 will not have a significant impact on its financial statements.





In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which is effective
for fiscal years beginning after December 15, 2001. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions upon adoption for the reclassification of certain existing
recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other
intangibles. The Company believes that the adoption of SFAS No. 142 will not have a significant impact on its financial statements.




F-13




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







In October 2001, the FASB issued SFAS No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses significant issues relating to the implementation of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of, and develops a single accounting method under which long-lived assets that are to be disposed of by sale are measured at the lower of book value or fair value less cost to sell. Additionally, SFAS No. 144 expands the scope of discontinued
operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for
financial statements issued for fiscal years beginning after December 15, 2001 and its provisions are to be applied prospectively. The Company is currently assessing the impact of SFAS No. 144 on its financial position and 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 was 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 accounts for its investment under the equity method of accounting since it had the ability to exercise significant influence over the operations of LAJ. 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 (2.4% at December 31,
2001) and is payable quarterly. Under this loan, the Company is required to make quarterly interest payments. At December 31, 2001, the Company was not in compliance with making quarterly interest payments. The loan is classified in the balance
sheet as a current note payable to a related party and recorded at the prevailing exchange rate at December 31, 2001.





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 were 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 recorded an investment in LAJ of $1,959,000,
which was recorded as additional paid in capital as prescribed by Staff Accounting Bulletin (SAB) Topic No. 5, Miscellaneous Accounting, to reflect the increase in the Companys share of LAJs net assets.





In March 2001, the Company exercised its option to purchase additional shares of LAJ from the Strategic Partner
for $165,000. As a result, the Companys ownership increased to 9.81%.





In June 2001, the Company and LAJ
mutually agreed to terminate the licensing and reseller agreements (the Agreements) between the two companies. As a result, Liquid Audio Japan renamed its company to Cyber Music Entertainment (CME) and no longer distributes
the Companys technology nor utilizes the Companys digital distribution platform to offer services to the Japanese music market. According to the mutual termination agreement, effective September 30, 2001, CME ceased using Liquid Audio
trademarks, including the company




F-14




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




name, and returned all of the Companys products, technology and licenses. The Company does not believe that it has any outstanding obligations in connection with the Agreements. As a
result, the Company recognized as revenue the cash received during the period before termination. The Company established a new office in Tokyo to build new relationships with label, retail and consumer electronic companies directly.





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 was the exclusive reseller and distributor of the Companys software products in 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.





In September 2001, the Company notified LAK of its default under the licensing and reseller agreements between the two companies due to LAKs failure to make
contractual payments as scheduled. LAK did not cure the default during the cure period. Accordingly, the Company exercised its rights under the agreements to terminate the licensing and reseller agreements. Outstanding accounts receivable from LAK
have been fully reserved.





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 was the exclusive reseller of the Companys products in Taiwan and Hong Kong and was to 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.





In September 2001,
the Company notified LAGC of its default under the licensing and reseller agreements between the two companies due to LAGCs failure to make contractual payments as scheduled. LAGC did not cure the defaults during the cure period. Accordingly,
the Company exercised its rights under the agreements to terminate the licensing and reseller agreements. Outstanding accounts receivable from LAGC have been fully reserved.





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 was to be the exclusive reseller of the Companys products in Singapore, Thailand, Malaysia,
Indonesia, Philippines, Australia and New Zealand and was to work to develop business services that enable the digital delivery of music in those local markets.





In September 2001, the Company notified the strategic partner of LASE of its default under the licensing and reseller agreements between the two companies due to the strategic partners failure to
make contractual payments as scheduled. The strategic partner did not cure the defaults during the cure period. Accordingly, the Company exercised its rights under the agreements to terminate the licensing and reseller agreements. Outstanding
accounts receivable from the strategic partner have been fully reserved.




F-15




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Other transactions





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





Year Ended December 31,2001

2000

1999Cyber Music Entertainment and strategic partner

$
1,837

$
5,047

$
1,105Liquid Audio South East Asia and strategic partner





1,261


Liquid Audio Greater China and strategic partner


1,036


705


500Liquid Audio Korea and strategic partner





294


532$
2,873

$
7,307

$
2,137





Of the total fees earned from Cyber Music Entertainment and
strategic partner, $1,837,000, $4,880,000 and $272,000 were earned from Cyber Music Entertainment and relate to software licensing and maintenance fees in 2001, 2000 and 1999, respectively, and $167,000 and $833,000 were earned from the strategic
partner in Cyber Music Entertainment in 2000 and 1999, respectively, 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 total fee of $1,036,000 and $705,000 earned from Liquid Audio Greater China in 2001 and 2000 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 $1,261,000 earned in 2000 from Liquid Audio South East Asia through our strategic partner consist of software licensing and maintenance fees.





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.





At December 31, 2001 and 2000, fees billed or received in
advance of recognition as business development revenues were $0 and $987,000, respectively. These amounts are classified as deferred revenue from related parties on the balance sheet.





The Company provided professional services to Muze, Inc., in which one of the Companys directors is also a director of Muze, Inc. The Company recognized revenue from
Muze, Inc. of approximately $155,000, $511,000 and $99,000 in 2001, 2000 and 1999, respectively. Amounts outstanding from Muze, Inc. were approximately $79,000 and $234,000 at December 31, 2001 and 2000, respectively. During 2001, the Companys
director resigned from her director position with the Company. As a result, revenues and outstanding accounts receivables from Muze, Inc. have not been classified as related party.





NOTE 3BALANCE SHEET COMPONENTS (in thousands):





December 31,2001


2000Accounts receivable from third parties, net:Accounts receivable

$
455


$
1,313Allowance for doubtful accounts


(325
)


(588
)$
130


$
725







F-16




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




The allowance for doubtful accounts increased (decreased) by $(52,000), $271,000 and $(28,000) in the years
ended December 31, 2001, 2000 and 1999, respectively. Bad debt write-offs against the allowance for doubtful accounts were $211,000, $44,000 and $129,000 in the years ended December 31, 2001, 2000 and 1999, respectively.





December 31,2001


2000Accounts receivable from related parties, net:Accounts receivable

$
1,555


$
1,298Allowance for doubtful accounts


(1,555
)


(45
)$



$
1,253





The allowance for doubtful accounts increased by $1,510,000,
$45,000 and $0 in the years ended December 31, 2001, 2000 and 1999, respectively. No write-offs against the allowance for doubtful accounts and were in the years ended December 31, 2001, 2000 and 1999, respectively.





December 31,2001


2000Property and equipment:Computer equipment and purchased software

$
11,016


$
12,190Website and software development costs


235



399Furniture and fixtures


555



774Leasehold improvements


599



68212,405



14,045Less: accumulated depreciation and amortization


(8,802
)


(5,185
)$
3,603


$
8,860





Property and equipment includes $99,000 and $784,000 of equipment
under capital leases at December 31, 2001 and 2000. Accumulated amortization for equipment under capital leases was $95,000 and $734,000 at


December 31, 2001 and 2000,
respectively. Depreciation expense for 2001, 2000 and 1999 was $3,715,000, $3,070,000 and $1,070,000, respectively. Amortization expense for purchased software, website and software development costs for 2001, 2000 and 1999 was $144,000, $366,000
and $73,000, respectively. Unamortized purchased software, website and software development costs was $672,000, $1,389,000 and $395,000 at December 31, 2001, 2000 and 1999, respectively. Property and equipment includes an asset impairment write-down
of $2,167,000 at December 31, 2001.





December 31,2001

2000Accrued expenses and other current liabilities:Compensation and benefits

$
1,124

$
2,321Consulting and professional services


1,357


792Restructuring


523


Other


817


409$
3,821

$
3,522




F-17




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##### Table of Contents



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% (5.25 and 9.75% at December 31, 2001 and 2000, respectively). Borrowings outstanding at December 31, 2001 and 2000 were $169,000 and $732,000, 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 quarterly reporting and financial covenants,
including minimum operating results and certain liquidity, leverage and debt service ratios. At December 31, 2001 and 2000, the Company was in compliance with all such covenants.





Future maturities under the Equipment Line as of December 31, 2001 are as follows (in thousands):





Year Ending December 31,2002

$
169





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 were 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 2001 and 2000 each.





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 which was recognized as non-cash cost of net revenues ratably over the one-year term of the agreement. As a result, $181,000 and $14,000 was recognized
as non-cash cost of net revenues in 2001 and 2000, respectively.




F-18




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







NOTE 6PREFERRED STOCK RIGHTS AGREEMENTS:





On August 7, 2001, the Companys Board of Directors adopted a Preferred Stock Rights Agreement under which the Company declared a
dividend of one right to purchase one one-thousandth share of the Companys Series A participating preferred stock for each outstanding share of common stock. The rights will separate from the common stock and become exercisable following (i)
the tenth day (or such later date as may be determined by the Board of Directors) after a person or group of affiliated or associated persons has acquired, or obtained the right to acquire, beneficial ownership of 15% or more of the common stock
then outstanding or (ii) the tenth business day (or such later date as may be determined by the Board of Directors) after a person or group announces a tender of exchange offer, the consummation of which would result in ownership by a person or
group of 15% or more of the then outstanding common stock. Each right will entitle the holder to purchase for $17.00 one one-thousandth of a share of Series A preferred stock with economic terms similar to that of one share of common stock.





NOTE 7WARRANTS:





In March and April 1999, the Company granted fully vested warrants to purchase 12,000 shares of common stock at $6.56 per share. These warrants were valued at $95,000 using the Black-Scholes option
pricing model and were recognized as strategic marketing-equity instruments expense. At December 31, 2001, warrants to purchase 10,200 shares of common stock are outstanding and 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, $0, $843,000 and $1,179,000 were recognized as strategic marketing-equity instruments
expense in 2001, 2000 and 1999, respectively. At December 31, 2001, warrants to purchase approximately 254,000 shares of common stock are outstanding and expire in June 2004.





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 to purchase a total of 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 market data during the vesting period. The third warrant for 83,333 shares vested in August 2001. The third warrant was initially valued at $105,000 and was recognized ratably over the one-year period ending at the vesting date. The third
warrant was revalued at each balance sheet date through the vesting date. As a result, the original charge of $105,000 was reduced to $54,000 based on market data during the vesting period. In 2001, $16,000 was recognized as strategic
marketing-equity instruments expense for the third warrant. 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. At December 31, 2001, warrants to purchase 83,334 and 166,666 shares of common stock are outstanding and expire in September
2002 and 2003, respectively.







F-19




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




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 warrants to purchase a total of 233,300 shares of common stock. Of the total, warrants to purchase 77,768 shares vested in December 2001,
and the cost was remeasured each quarter until a commitment for performance was reached or the warrant vested based on market data. At December 4, 2001, the 77,768 shares under this warrant was valued at $175,000, of which $163,000 and $12,000
was recognized as non-cash cost of net revenues in 2001 and 2000, respectively. The remaining warrants to purchase common shares will vest at 6,481 shares per month commencing December 2001 for one year and 6,480 shares per month commencing
December 2002 for one year. We recorded a total of $9,000 as non-cash cost of revenue at December 31, 2001 related to the remaining warrants. Such warrants will be valued at the fair market value of the Companys common stock on each reporting
date. At December 31, 2001, warrants to purchase 77,768 shares of common stock are outstanding and expire in December 2005.





NOTE 8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 2001 and 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 and expensed $159,000 and $177,000 for the years ended December 31, 2001 and 2000, respectively.





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. Options granted for the year ended December 31, 2001 vest 2.083% each month until 100% vested.




F-20




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







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





Options OutstandingOptions Available forGrant


Shares


WeightedAverage Exercise Price Per ShareBalance at December 31, 1998

71


1,067


$
0.68Additional options authorized

1,600






Repurchase of common stock in connection with unvested stock options previously exercised

51






Options granted

(1,044
)

1,044



17.62Options exercised




(399
)


0.39Options canceled

192


(192
)


2.45Balance at December 31, 1999

870


1,520



12.17Additional options authorized

1,594






Repurchase of common stock in connection with unvested stock options previously exercised

19






Options granted

(2,310
)

2,310



11.53Options exercised




(230
)


0.57Options canceled

770


(770
)


13.55Balance at December 31, 2000

943


2,830



12.06Additional options authorized

1,127






Options granted

(1,651
)

1,651



2.27Options exercised




(51
)


0.32Options canceled

1,509


(1,509
)


11.86Balance at December 31, 2001

1,928


2,921



6.84





The following table summarizes information concerning outstanding
and exercisable options for all stock option plans as of December 31, 2001 (shares in thousands):





Options Outstanding

Options Vested and ExercisableRange of Exercise Prices

Number Outstanding

Weighted Average Remaining Contractual Life (Years)

Weighted Average Exercise Price Per Share

Number Outstanding

Weighted Average Exercise Price Per Share$0.19

4

5.6

$
0.19

4

$
0.190.33-0.40

19

6.3


0.39

19


0.391.50-2.19

753

8.9


1.84

171


1.812.30-3.00

766

9.4


2.56

145


2.643.69-5.44

126

8.6


4.49

59


4.646.50-9.47

703

8.0


7.51

298


7.5011.00-15.81

353

7.7


11.62

243


11.4626.13-33.50

123

7.6


27.97

73


28.6843.75

74

7.6


43.75

74


43.752,921






1,086




F-21




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##### Table of Contents



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:





Year Ended December 31,2001


2000


1999Risk-free rates

4.24
%

5.4-6.7
%

5.7
%Expected lives (in years)

4.0


4.0


4.0Dividend yield

0.0
%

0.0
%

0.0
%Expected volatility

97.5
%

130
%

78.0
%





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 and pro forma basic and diluted net loss per share under SFAS No. 123 would have been:





Year Ended December, 312001

2000

1999Pro forma net loss (in thousands)

$
38,625

$
43,291

$
24,534Pro forma net loss per share

$
1.71

$
1.96

$
2.31





The weighted average fair value of options granted were:





Year Ended December 31,2001

2000

1999Weighted average fair value of options granted during period

$
1.41

$
9.58

$
17.62





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.





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 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




F-22




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




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 9INCOME TAXES:





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





December 31,2001


2000Deferred tax assets (liabilities)Net operating loss and credit carryforwards

$
34,261


$
22,419Research and development tax credits


3,373



1,780Accruals


2,660



435Depreciation and amortization


327



263Other


7



2Total deferred tax assets


40,628



24,899Less: Valuation allowance


(40,628
)


(24,899
)Net deferred tax assets

$



$






At December 31, 2001, the Company had approximately $94.2 million
of federal and $38.3 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, 2001, the Company had approximately $2.0 million of federal and $2.1 million of state research and development tax credit carryforwards available to offset future taxes. The federal tax credit carryforwards expire in varying amounts beginning in
2001. The California tax credit carryforwards can be carried forward indefinitely.





The Tax Reform Act of 1986
limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. In the event the Company has had a change in ownership, utilization of the carryforwards could be
limited.





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, 2001 and 2000. The valuation allowance increased by $15,728,000, $11,101,000 and $8,234,000 in the years ended December 31, 2001, 2000 and 1999, respectively.




F-23




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







NOTE 10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):





Year Ended December 31,2001

2000

1999Rent expense

$
2,188

$
1,642

$
643





Future minimum lease payments under all noncancelable capital and
operating leases, net of sublease rental income of $145,000, at December 31, 2001 are as follows (in thousands):





Year Ending December 31,

Capital Leases


Operating Leases2002

$
31


$
2,7852003






2,1002004






2,1632005






904Total minimum payments


31


$
7,952Less: amount representing interest


(3
)Present value of capital lease obligations


28Less: Current portion


(28
)Capital lease obligations, non-current portion

$






Litigation





From time to time, the Company has been subject to litigation including the pending litigation described below. Because of the uncertainties related to both the amount and
range of loss on the pending litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, the Company will assess its potential liability
and revise its estimates. Pending or future litigation could be costly, could cause the diversion of managements attention and could upon resolution, have a material adverse effect on the Companys business, results of operations,
financial condition and cash flow.





In addition, the Company is engaged in certain legal and administrative
proceedings incidental to its normal business activities and believes that these matters will not have a material adverse effect on its financial position, results of operations or cash flow.





In November 2001, two lawsuits were filed in Delaware Chancery Court naming the Company and certain of the Companys officers and directors as defendants. Both
actions related to the Companys response to recent acquisition offers and purported to be class actions brought on behalf of the Companys shareholders. On February 1, 2002, the two complaints were consolidated into a single action,
titled In Re Liquid Audio, Inc., Shareholders Litigation, Consolidated Civil Action No. 19212-NC. That action was brought against Gerald W.




F-24




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




Kearby, Silvia Kessel, Ann L. Winblad and the Company. The complaint alleges that defendants had breached their fiduciary duties owed to the Companys shareholders in connection with the
Companys response to acquisition offers from Steel Partners II, LLP and an investor group formed by musicmaker.com, Inc. The complaint seeks, among other things, a court order barring the Company from adopting or maintaining measures that
would make the Company less attractive as a takeover candidate or, alternatively, awarding compensatory damages to the purported plaintiff class. To date, the Company has not responded to the complaint, nor has the court set a date for discovery
cutoff or trial. The Company intends to vigorously defend the action. There is no assurance concerning the outcome of either action, or whether either action would have a material effect on the Companys financial condition or business
operations.





On or about September 27, 2001, Network Commerce, Inc. (NCI) filed a Complaint against
the Company in the United States District Court for the Western District of Washington (Seattle). The suit alleges that the Company infringes the claims of United States Patent No. 6,073,124. NCI requests that the Company be enjoined from its
allegedly infringing activities and seeks unspecified damages. The Company was served with the Complaint on November 2, 2001 and subsequently submitted an answer to the Complaint that included counterclaims. In February 2002, the Company entered
into settlement negotiations but have yet to reach a settlement.





On August 23, 2001, the Company received a
demand letter from a former employees legal counsel alleging claims for sexual harassment and retaliation. On September 13, 2001, the former employee filed a charge with the California Department of Fair Employment and Housing alleging such
claims against the Company and one of its former employees. The Company completed an investigation and believes that there is no merit to the former employees allegations. The Company does not know at this time whether a settlement can be
achieved. To date, the Company has not been served with a complaint.





On July 20, 2001, a putative securities
class action, captioned Murowa Financial v. Liquid Audio, Inc. et al., Civil Action No. 01-CV-6661, was filed against the Company, certain of the Companys officers and directors (the Individual Defendants) and three
underwriters in the Companys initial public offering (the IPO), in the United States District Court for the Southern District of New York. The Complaint seeks unspecified damages on behalf of a purported class of purchasers of the
Companys common stock between July 8, 1999 and December 6, 2000. Several complaints substantially identical to Murowawere later filed against the Company, the Individual Defendants, and several of the IPO underwriters in the
Southern District of New York. These cases have been consolidated under Civil Action No. 01-CV-6661. These complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation
of shares in the Companys initial public offering and secondary offering of securities. The complaints bring claims for violation of several provisions of the federal securities laws against those underwriters, and also against the Company and
certain of its directors and officers. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other companies. The lawsuit and all other IPO allocation securities class actions
currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. The Company believes that it has meritorious defenses to the claims and intends to vigorously defend against
such claims.





On or about April 7, 2000, Sightsound, Inc. (Sightsound) filed an Amended Complaint
against one of the Companys customers in the United States District Court for the Eastern District of Pennsylvania (Pittsburgh). The suit alleges that the Companys customer infringes one or more of three patents (United States Patent
 Nos. 5,191,573; 5,675,734 and 5,996,440). Sightsound claims damages of $20 million plus an unspecified royalty. The Company has entered into an agreement with its customer whereby the Company has agreed to assume control of the defense and pay
the defense costs, while reserving the Companys rights as to




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




indemnification obligations. The customer filed an Answer to the Amended Complaint on April 27, 2000 denying the material allegations of the complaint, and asserting counterclaims for declaratory
judgment of non-infringement and patent invalidity. A trial date had been set for September 28, 2001 in the matter, but that date will be reset after the Court rules on pending matters.





On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against the Company in the United States District Court for the Northern District of California
alleging patent infringement. The Complaint names the Company, Amazon.com, Inc., Listen.com, Inc., Entertaindom LLC, DiscoverMusic.com, Inc. and Muze, Inc. It alleges that these parties infringe, or induce infringement of, the claims of United
States Patent Nos. 5,237,157 (the 157 patent) and 5,963,916 (the 916 patent) by operating a web site and/or a kiosk that allows interactive previewing of pre-recorded music products. The Complaint seeks
unspecified damages and injunctive relief. The Company answered Intouchs first amended complaint, denying the material allegations of the amended complaint, and asserting counterclaims for declaratory judgment of non-infringement, patent
invalidity and inequitable conduct. In May 2001, the parties reached an agreement in principle to settle Intouchs claims on the 157 patent. On February 6, 2002, the parties executed a final settlement regarding the 916 patent.
Pursuant to the settlement, the terms of which are confidential, Intouch has dismissed its suit with prejudice as to the Company and granted it a nonexclusive license on the 916 patent. The settlement did not have a material impact on the
Companys financial position or results of operations.





NOTE 11RESTRUCTURING:





In May 2001, the Company adopted a corporate restructuring program to reduce expenses to preserve the Companys cash position while
the digital music market develops. The restructuring included a worldwide workforce reduction, a consolidation of three Redwood City, California offices into one facility and other expense management initiatives. A restructuring charge of $4,497,000
was recorded in operating expense in the twelve months ended December 31, 2001.





The restructuring charge included
involuntary employee separation costs of $1,116,000 for 79 employees worldwide, 20 in sales and marketing, 32 in research and development, 13 in general and administrative and 6 in operations functions in the U.S., and 2 in sales and marketing, 3 in
research and development and 3 in operations functions outside the U.S.





Lease costs of $1,214,000 were accrued
pertaining to the estimated future obligations for non-cancelable lease payments for excess facilities that were vacated due to reductions in workforce.





Asset impairment costs of $2,167,000 were recorded, primarily for property and equipment, furniture and fixtures, computer software and leasehold improvements for assets no longer in use from
de-emphasized business lines, reductions in workforce and excess facilities.





A summary of the restructuring cost
is outlined as follows (in thousands):





Severance and Benefits


Facilities


Asset Impairments


TotalSeverance and benefits

$
1,116


$



$



$
1,116Accrued lease costs






1,214







1,214Property and equipment impairment










2,167



2,167Total


1,116



1,214



2,167



4,497Cash paid


(1,116
)


(691
)






(1,807
)Non-cash










(2,167
)


(2,167
)Restructuring reserve balance at December 31, 2001

$



$
523


$



$
523




F-26




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##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Remaining cash expenditures related to net lease expense due to the
consolidation of facilities will be paid over the lease terms through the fourth quarter of 2002.





NOTE 12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):





Three Months EndedMarch 31, 2000


June 30, 2000


Sept. 30, 2000


Dec. 31, 2000


March 31, 2001


June 30, 2001


Sept. 30, 2001


Dec. 31, 2001Net revenues

$
2,995


$
3,454


$
3,355


$
1,764


$
1,661


$
1,024


$
1,275


$
768Gross profit


2,453



2,463



2,562



975



708



434



926



317Net loss


(6,524
)


(7,718
)


(8,892
)


(10,551
)


(11,267
)


(14,034
)


(6,060
)


(5,823
)Net loss per share, basic and diluted


(0.30
)


(0.35
)


(0.40
)


(0.47
)


(0.50
)


(0.62
)


(0.27
)


(0.26
)Weighted average shares used in per share calculation


21,918



22,013



22,304



22,429



22,528



22,593



22,640



22,689




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##### Table of Contents

EXHIBIT INDEX





Exhibit No.

Description99.1

Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of 200299.2

Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002