** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON,D.C. 20549**

** **

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**FORM 10-KSB**

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| **x**      | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------|----------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                               |
| ** ** | ** ** | **For the fiscal year ended  December 31, 2007**                                                    |
| ** ** | ** ** | ** **                                                                                               |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number:  000-30063**

 

**ARTISTdirect, Inc.**(Name of SmallBusiness Issuer in Its Charter)

 

| **Delaware**                       | ** ** | **95-4760230**          |
|------------------------------------|------------|-------------------------|
| (State  or Other Jurisdiction      |       | (I.R.S.  Employer       |
| of  Incorporation or Organization) |       | Identification  Number) |

 

**1601Cloverfield Boulevard, Suite 400 South, Santa Monica, California90404-4082**(Address ofPrincipal Executive Offices, including Zip Code)

 

Issuer’sTelephone Number, Including Area Code:  **(310) 956-3300**

 

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Securitiesregistered pursuant to Section 12(b) of the Act:  **None**

 

Securitiesregistered pursuant to Section 12(g) of the Act:  **Commonstock, $0.01 par value**

 

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Check whether the issuer is not required to filereports pursuant to Section 13 or 15(d) of the Exchange Act. o

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes xNo o

 

Check if there is no disclosure of delinquent filersin response to Item 405 of Regulation S-B contained in this form, and no disclosurewill be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-KSB or any amendment to this Form 10-KSB o

 

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

 

State issuer’s revenues for its most recent fiscalyear. $24,171,000.

 

As of March 24, 2008, the aggregate market valueof the voting common stock held by non-affiliates of the registrant wasapproximately $1,609,402, based on the closing price per share of $0.41 for theregistrant’s common stock as reported on the Over-the-Counter Bulletin Board onsuch date.

 

As of March 24, 2008, there were 10,344,666shares of the registrant’s common stock, par value $0.01 per share, issued andoutstanding.

 

Transitional Small Business Disclosure Format. Yes o No x

 

Documents incorporated byreference:  None.

 

 

 

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**ARTISTDIRECTINC.ANNUAL REPORT ON FORM 10-KSB**

 

**TABLE OFCONTENTS**

 
| PART I.      |                                                                                                                                                 | 2      |
|-------------------|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                                                                 |   |
| ITEM 1.           | DESCRIPTION OF BUSINESS                                                                                                                              | 2      |
|              |                                                                                                                                                 |   |
| ITEM 2.           | DESCRIPTION OF  PROPERTY                                                                                                                             | 15     |
|              |                                                                                                                                                 |   |
| ITEM 3.           | LEGAL PROCEEDINGS                                                                                                                                    | 15     |
|              |                                                                                                                                                 |   |
| ITEM 4.           | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                                                 | 16     |
|              |                                                                                                                                                 |   |
| PART II      |                                                                                                                                                 | 16     |
|              |                                                                                                                                                 |   |
| ITEM 5.           | MARKET FOR  COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS  PURCHASES OF EQUITY SECURITIES                                    | 16     |
|              |                                                                                                                                                 |   |
| ITEM 6.           | MANAGEMENT’S  DISCUSSION AND ANALYSIS OR PLAN OF OPERATION                                                                                      | 17     |
|              |                                                                                                                                                 |   |
| ITEM 7.           | FINANCIAL STATEMENTS                                                                                                                                 | 43     |
|              |                                                                                                                                                 |   |
| ITEM 8.           | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                                                                | 43     |
|              |                                                                                                                                                 |   |
| ITEM 8AT.         | MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER  FINANCIAL REPORTING                                                                        | 43     |
|              |                                                                                                                                                 |   |
| ITEM 8B.          | OTHER INFORMATION                                                                                                                                    |   |
|              |                                                                                                                                                 |   |
| PART III     |                                                                                                                                                 | 44     |
|              |                                                                                                                                                 |   |
| ITEM 9.           | DIRECTORS,  EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS AND CORPORATE GOVERNANCE;  COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT | 44     |
|              |                                                                                                                                                 |   |
| ITEM 10.          | EXECUTIVE  COMPENSATION                                                                                                                              | 48     |
|              |                                                                                                                                                 |   |
| ITEM 11.          | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                                                     | 50     |
|              |                                                                                                                                                 |   |
| ITEM 12.          | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                                                           | 57     |
|              |                                                                                                                                                 |   |
| ITEM 13.          | EXHIBITS                                                                                                                                             | 59     |
|              |                                                                                                                                                 |   |
| ITEM 14.          | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                                                              | 59     |
|              |                                                                                                                                                 |   |
| SIGNATURES        | 60                                                                                                                                                   |
|              |                                                                                                                                                 |   |
| POWER OF ATTORNEY | 61                                                                                                                                                   |

 

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**NOTECONCERNING FORWARD-LOOKING STATEMENTS**

 

*In addition to historicalinformation, this Annual Report on Form 10-KSB (“Annual Report”) forARTISTdirect, Inc. (“ARTISTdirect,” the “Company,” “we,” “our”  or “us”) contains “forward-looking”statements within the meaning of the United States Private SecuritiesLitigation Reform Act of 1995, including statements that include the words “may,”“will,” “believes,” “expects,” “anticipates,” or similar expressions. Theseforward looking statements may include, among others, statements concerning ourexpectations regarding our business, growth prospects, revenue trends,operating costs, accounting, working capital requirements, competition, resultsof operations and other statements of expectations, beliefs, future plans andstrategies, anticipated events or trends, and similar expressions concerningmatters that are not historical facts. The forward-looking statements in thisAnnual Report involve known and unknown risks, uncertainties and other factorsthat could cause our actual results, performance or achievements to differmaterially from those expressed or implied by the forward-looking statementscontained herein.*

 

*Each forward-looking statementshould be read in context with, and with an understanding of, the variousdisclosures concerning our business made elsewhere in this Annual Report, aswell as other public reports filed by us with the United States Securities andExchange Commission. Investors should not place undue reliance on anyforward-looking statement as a prediction of actual results of developments.Except as required by applicable law or regulation, we undertake no obligationto update or revise any forward-looking statement contained in this AnnualReport.*

 

**PART I**

 

**ITEM1.****                            ****DESCRIPTION OF BUSINESS**

 

**General**

 

Incorporated under the laws of the****State of Delaware in July 1999, wewere exclusively a digital media entertainment company that is home to an on-linemusic network. Through our acquisition of MediaDefender, Inc., a Delawarecorporation (“MediaDefender”), in July 2005, we also became a provider ofanti-piracy solutions in the Internet piracy protection industry and in thesecond quarter of 2006, became a provider of Internet-based marketingservices.  Below is an overview of ourthree business segments:

 

·                  *Internet PiracyPrevention.*OurInternet piracy prevention (“IPP”) segment is currently operated byMediaDefender, as a wholly-owned subsidiary of ARTISTdirect. MediaDefender’sproprietary suite of IPP solutions offers significant levels of protection onmajor peer-to-peer (“P2P”) file-sharing networks. MediaDefender’s uber-levelsolutions are capable of providing up to 95% effectiveness in preventingunauthorized downloads of customer-specified content. Our IPP segment accountedfor approximately 61% and approximately 62% of our revenue during the fiscalyears ended December 31, 2007 and December 31, 2006respectively.  Refer to “MediaDefenderOverview - Internet Anti-Piracy Segment below for more information.

 

·                  *Media.*Our media operations include ourcontent-oriented web-sites, a network of third party music sites, ouradvertising and other marketing initiatives. Revenue from media operations is generatedfrom the sale of online advertising and integrated marketing solutions. Wemarket and sell advertising on a cost-per-impression basis to advertisingagencies and directly to various companies as part of their marketing programs.Customers may purchase advertising space for the entire ARTISTdirect network,or they may tailor advertising based on music genre (e.g., jazz, country orrock music) or based on functionality (e.g., directing advertising to customersusing music download features or broadband-only features of the ARTISTdirectnetwork). Since we are increasingly aware of web-sites outside the ARTISTdirectnetwork that are frequently visited by artists and music fans, we have alsooffered our customers advertising space on behalf of third party music-relatedweb-sites. Our media segment accounted for approximately 33% and approximately27% of our revenue during the fiscal years ended December 31, 2007 and2006, respectively. Refer to “ARTISTdirect Overview-Media and E-CommerceSegments” below for additional information.

 

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·                  *E-Commerce.*E-commerce operations consist of the saleof recorded music and artist-related merchandise on our web-sites. Most of oursales come from our ARTISTdirect shopping area, which offers a comprehensiveselection of music CDs and a  range ofartist and lifestyle merchandise. Effective August 31, 2007, the Companyrestructured the relationship with its merchandising partner to eliminatemerchandise sales and focus on music sales. Our e-commerce segment accountedfor approximately 6% and approximately 11% of our revenue during the fiscalyears ended December 31, 2007 and 2006, respectively.

 

Refer to “ARTISTdirect Overview-Media and E-CommerceSegments” below for additional information.

 

At December 31, 2007, we employed 80 full-timeemployees, none of whom are covered by a collective bargaining agreement. Webelieve that our relationship with our employees and consultants is good.

 

**Recent Developments**

 

*Engagement of Investment BankingFirm*

 

On February 7, 2008 the Company retained the servicesof Salem Partners, LLC, to serve as a fianancial advisor to the Company inconnection with the sale, merger, consolidation, reorganization or otherbusiness combination and the restructuring of the material terms of theRegistrant’s Senior Notes and/or Subordinated Convertible Notes.

 

*Forbearance and Consent Agreement*

 

On March 17, 2008, the Company entered into aForbearance and Consent Agreement with the investors in the Company’s SeniorDebt Financing, which was effective as of February 20, 2008, whereby theinvestors agreed to forbear from exercising any of their rights and remediesunder the Senior Financing transaction documents through December 31, 2008in exchange for an adjustment in the interest rate associated with the SeniorNotes from 11.25% to 15%, provided the loan is repaid prior to September 30,2008 or 16%, if the loan remains outstanding subsequent to that date.

 

*Managementand Director Changes*

 

On February 25, 2008, the company announced that Mr. NeilMcCarthy, provided notice that he was resigning as Interim Chief FinancialOfficer of the Company effective March 31, 2008.

 

Effective March 6, 2008, the Company announcedthat, Mr. Jon Diamond’s employment as Chief Executive Officer had endedand he was appointed Chairman of the Board of Directors.  Mr. Fredrick W.(Ted) Field, who had beenserving as the Company’s Chairman, agreed to continue serving as a Director ofthe Company.  Mr. Dimitri Villard,who had been serving as a Director and Member of the Company’s Audit andCompensation Committees agreed, in addition to those duties, to serve asInterim Chief Executive Officer.

 

On March 24, 2008, Mr. James Lane advisedthe Company that he would no longer serve as a Director and member of the AuditCommittee.  As Mr. Lane was, at thattime, the only independent member of the Audit Committee, the Company hassuspended the activities of the Audit Committee until a new independentDirector is appointed. In the interim, the functions of the audit committeehave been assumed by the Board of Directors.

 

**MediaDefender Overview- InternetAnti-Piracy Segment**

 

MediaDefender was incorporated under the laws of theState of Delaware in July 2000 as a provider of anti-piracy solutions. Wecompleted the acquisition of MediaDefender in the third quarter of fiscal 2005.MediaDefender’s solutions have been adopted by major entertainment companies asa practical means to thwart Internet piracy and drive consumers to pay fordigitized content distributed through authorized Internet sites.  MediaDefender charges customers per file itdistributes to the massive P2P audience.

 

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*Internet-Based Piracy.*Piracy has long been and continues to bea problem for the global content industries. The International IntellectualProperty Alliance (“IIPA”) estimates that the worldwide cost of music andcomputer software piracy costs content providers as much as $35 billion peryear in lost sales. Due to the relatively small size of MP3 files, music wasthe first industry to be severely impacted by Internet piracy.  Retail music sales decreased 10% in 2007, anincrease from the 6.5% decrease in 2006. According to the RIAA, the decline, in sales has been due in part, towidespread copying and illegal Internet downloading of music.  The growth of broadband Internet access isnow making larger-sized files, such as movies, software and video games,similarly vulnerable to Internet-based piracy. Already, the majority of motionpictures are available in some form on the Internet before theatrical release.

 

To date, attempts to limit Internet-piracy have beenlargely unsuccessful. Litigation, legislation, education, commercialinnovation, packaged media and digital rights management (“DRM”) anti-piracytechnologies have been employed with limited impact.

 

*IPP Solutions.*MediaDefender employs a wide array oftechnical countermeasures on P2P networks to frustrate users’ attempts to find,copy and share unauthorized copyrighted materials. MediaDefender’s customersspecify the timing, duration, scope and level of effectiveness of desiredprotection on a track-by-track, album-by-album or movie-by-movie basis. Usersof P2P networks attempting  to download afile that is successfully protected by MediaDefender either cannot begin thedownloading process, download the specified file to find that it is not thecontent for which they were searching, or download a file to find that it worksfor the first few seconds and then reverts to white noise or static. By makingit more difficult for P2P users to access unauthorized content on the Internet,MediaDefender induces consumers to pay for content distributed throughlegitimate means, such as Apple Corporation’s iTunes.

 

*Suite of Solutions.*MediaDefender’s solutions are a practicaland proven means of thwarting Internet piracy and driving consumers to pay foronline content. MediaDefender’s piracy-detection techniques can pinpoint theinitial leak of content onto the Internet and allow MediaDefender to direct itsefforts to limit replication at the point of origin. Customers also receiveaccess to MediaDefender’s secure on-line reporting system, which providescritical information regarding the number of attempted and blocked illegaldownloads per specified title.

 

The primary means by which MediaDefender’s solutionshinder illegal Internet file-sharing and downloading include:

 

·                  *Spoofing*. Spoofs are false signals that representthemselves as legitimate content.

 

·                  *Swarming*. Swarms are corrupt data packet segmentsthat are spliced into existing copies and subsequent downloads of illegitimatefiles of specified titles.

 

·                  *Decoying*. Decoys are false files that are namedand titled so as to appear to be legitimate content.

 

·                  *Interdiction*. Interdiction creates long lines thatinhibit would-be pirates from obtaining access to protected copyrightedmaterials.

 

·                  *Monitoring.*In addition to providing IPP solutions,MediaDefender also tracks attempts by P2P users to access files illegally andprovides such information to its customers in the form of weekly monitoringreports. By continuously monitoring the Internet to detect leaks of copyrightedmaterial, MediaDefender is able to advise its customers concerning theorigination of such leaks and help determine when MediaDefender’s IPP solutionsare needed. Customers often employ MediaDefender’s monitoring capabilities inanticipation of executing a full-scale IPP solutions contract. This earlymonitoring allows its customers to observe the level of piracy affecting theircopyrighted materials and has proven to be an effective marketing tool forMediaDefender’s IPP solutions.

 

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In addition to an automated web crawler device thatmonitors leaks, MediaDefender also employs several individuals who detectcustomer content leaks by monitoring activity on the various networks web-sitesand chat rooms. MediaDefender is able to make customers aware of any leaks perday seven days per week. This awareness enables customers to better managetheir relationships with creative talent by demonstrating control and knowledgeof the situation. Monitoring reports contain information that allows customersto determine:

 

·                  The piracy problem’s size and nature foreach individual release;

 

·                  When particular copyrighted materialsshould be protected;

 

·                  The IP addresses of individuals who aredownloading copyrighted content;

 

·                  How often a specific title is requested;

 

·                  How often a title is illegally shared;and

 

·                  Demographics of illegal sharers.

 

*Ancillary Solutions.*MediaDefender can provide ancillarysolutions to customers to achieve a number of different goals. MediaDefenderhas assisted customers in identifying the IP address responsible for theorigination of illegal content on P2P networks allowing customers to pursuelegal action against the source of the piracy.

 

*Next-Generation Solutions.*Due to the rapidly evolving nature of theP2P environment, MediaDefender must continually adapt its technologies in orderto offer customers increasing levels of effectiveness against the latestInternet-piracy threats. In the third quarter of 2003, MediaDefendercommercially released its next-generation solution, called “uber.”  Uber-level solutions allow MediaDefender toprovide an approximate 95 percent effectiveness in preventing unauthorizeddownloads of customer-specified content. MediaDefender’s development team isconstantly monitoring advances in peer-to-peer networking and developingsolutions to target new networks.

 

*Advertising.*During 2007 MediaDefender worked with severaladvertising agencies and their clients to launch trial programs whichdistributed branded content on P2P networks. The Company was paid on a typical ad impression, cost per thousand (CPM)basis per delivered files.  Theseprograms, while limited in quantity, were successful and the Companyanticipates to significantly increase the volume of such programs during 2008and beyond which would serve to reduce the potential negative impact of areduction in the growth of its IPP solutions services in the recorded  music and television area.

 

*PatentPending Technology.*MediaDefender’sIPP solutions utilize proprietary software and a robust, scalable IT platform .This patent-pending combination of software and IT was created over time andbased upon the successes and failures of real-world trials. Computer equipmentand software is monitored and maintained on a 24/7 basis. The use of back-upand redundant systems, combined with constant monitoring, allows MediaDefenderto provide continuous coverage and rapidly address potential technicalproblems.

 

*Intellectual Property.*In December 2002, MediaDefenderfiled an umbrella patent application that covers a variety of its concept andback-end technologies, which is still pending. Due to the evolving nature ofP2P networks, these technologies are not based on any one service, but ratherhave the fluidity to be transferred to any P2P network. The claims in thepatent filing are predominantly methods for managing a large array of computersfor the purpose of preventing piracy on P2P networks.

 

*Sales and Marketing.*MediaDefender’s sales process isrelationship-based with a relatively long sales cycle. Initial customerrelationships were with music and movie industry clients, targeted due to theimpact of piracy on these businesses, and has since expanded to software andgaming clients. MediaDefender management has invested significant time inbuilding relationships with its clients, which has resulted in word-of-mouthreferrals.

 

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*Customers .*MediaDefender’s current principalcustomers include four major record labels and four major movie studios.  Approximately 68% of MediaDefender’sconsolidated revenues were from four customers.  Of those four customers, two customersaccounted for 21%  and 18%, respectfully,of MediaDefender’s revenues during the year ended December 31, 2007.

 

*Market Share and Competition.*Management believes that MediaDefenderhas a majority of the  IPP solutionmarket. Its major existing competitor, Safenet, Inc.  has been in the IPP market for seven years without gaining significant market share and  Macrovison, a firm which had been competingin the IPP business, recently stopped offering the service due to a lack ofperformance in the market.

 

**ARTISTdirect Overview – Media andE-Commerce Segments**

 

The ARTISTdirect network (www.artistdirect.com) is anetwork of web-sites offering multi-media content, music news and information,community around shared music interests, advertising sponsorships,music-related specialty commerce and digital music services.

 

Our network consists of our music search engine anddatabase containing information on more than 100,000 artists, retail goods,e-commerce offering a wide selection of artist merchandise and music, ourproprietary music guide that enables users to browse music by artist, genre ortime period, a music-oriented online community and the ability for users todownload and listen to music and view music videos.

 

*Technology*. Our infrastructure is designed to beintegrated, scalable, reliable and secure. The software that we use supportsthe acquisition, management and publication of content on our web-sites. Duringfiscal 2007, the management of our web-sites and servers for content,applications, database and electronic commerce was handled internally. Ourservers are maintained at three co-location facilities in El Segundo and LosAngeles, California. Our operations depend on the ability to protect oursystems against fire, power loss, telecommunications failure, break-ins andother events. All web-sites, servers, and systems are monitored and periodicbackups are stored at our data center.

 

*Order Processing and Fulfillment.*Our web-sites include an ordering systemthat is designed to facilitate convenient online purchasing of pre-recordedmusic and merchandise.  We utilize anoutside fulfillment house to verify orders submitted for credit card paymentfor fraud detection and sufficient funds before we release the order forshipment.  The fulfillment house insuresthat the credit card numbers are encrypted, and all customer, commerce andtransactional data are stored in secure databases protected by firewalls. Thetransmission of information over the Internet uses Secure Socket Layer securitytechnology verified by VeriSign, an industry leader in online security.

 

We have an agreement with Alliance Entertainment Corp.(“Alliance”) to be the primary supplier of our music and movie-relatedmerchandise.  Alliance processes andfulfills the orders by our customers and we pay Alliance the wholesale costs ofthe merchandise plus transaction fees. Alliance also provides customer service and shipping services.  Alliance provides a complete one stopfulfillment service pursuant to a contract which expires in July of2008.  If we are unable to continue ouragreement with Alliance or identify a suitable alternative fulfillment house,our E-commerce business could be adversely affected.

 

*Sales and Marketing.*We sell advertising and sponsorships tocompanies seeking to reach one or more of the distinct demographic audiencesviewing content in the ARTISTdirect network. Advertisers may choose singleelements such as targeted or run-of-network banners or sponsorship of fixedplacement on our web-sites. Pricing is negotiated based upon the size of thetarget audience, the duration and intensity of the campaign and the size andplacement of the advertisement.

 

We use a number of methods to create awareness of theARTISTdirect network designed to drive traffic to our web-sites. We havefocused much of our marketing activity on e-mail direct marketing tocommunicate with registered users about specific artists and the ARTISTdirectnetwork. Campaigns have included direct notification of special merchandiseoffers, contests, promotions and available music downloads. To the extent ourregistered users in the future opt out of e-mails or use technology to blockmarketing e-mails, our operating results could be adversely affected.Ad-blocking technologies may be used to limit the effectiveness of webadvertising.

 

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*Customers.*During the year ended December 31,2007, one customer accounted for $1.2 million or 16% of total mediarevenue.  During the year ended December 31,2006, one customer accounted for  13% oftotal media revenue. No other customer accounted for more than 10.0% of ourmedia or e-commerce revenue during those years.

 

*Competition.*The market for the online promotion anddistribution of music and music-related products and services is highlycompetitive and rapidly changing. There are a large number of web-sitescompeting for the attention and spending of consumers and advertisers, and weexpect that number to increase, because there are few barriers to entry toInternet commerce. In addition, the competition for advertising revenue, bothon web-sites and in more traditional media, is intense. We compete as follows:

 

·                  for music consumers and advertisers withproviders of music information, community and content such as MTV, AmericaOnline, MSN, Yahoo!, Listen.com, myspace.com, mp3.com, billboard.com andvarious other companies;

 

·                  with major online music retailers such asAmazon.com and iTunes Music Store in selling music and merchandise;

 

·                  for music consumers and artistrelationships with traditional music industry companies, including Sony BMGMusic Entertainment, EMI Music, a unit of EMI Group, Warner Music Group, andUniversal Music Group, a unit of Vivendi. Some of these companies haveestablished online presences to promote and distribute the music and tours oftheir respective artists;

 

·                  for music consumers and advertisers withpublishers and distributors of traditional media, such as television, radio andprint, including MTV, CMT, Rolling Stone and Spin and their Internetaffiliates; and

 

·                  with traditional retailers targeting music consumers,including Wal-Mart and Virgin Megastore and their Internet affiliates, inselling music and merchandise.

 

Our competitors have worked together to offer musicover the Internet, and we may face increased competitive pressures as a result.We believe that we are able to compete effectively on the basis of:

 

·                  the breadth and quality of our search,database and the community features of our site;

 

·                  the variety, availability and price ofmusic-related merchandise on our sites; and

 

·                  the ease of use and consumer acceptanceof the ARTISTdirect network.

 

Competition is likely to increase significantly as newcompanies enter the market and current competitors expand their services. Manyof our current and potential competitors in the Internet and musicentertainment businesses may have substantial competitive advantages over us, including:

 

·                  longer operating histories;

 

·                  significantly greater financial,technical, management capital and marketing resources;

 

·                  greater brand name recognition;

 

·                  larger existing customer bases; and

 

·                  more popular content or artists.

 

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These competitors may be able to respond more quicklyto new or emerging technologies, regulatory developments and changes incustomer requirements and to devote greater resources to the development,promotion and sale of their products or services than we can. Web-sitesmaintained by our existing and potential competitors may be perceived byconsumers, artists, talent management companies and other music-related vendorsor advertisers as being superior to ours. In addition, we may not be able tomaintain or increase our web-site traffic levels, purchase inquiries and numberof click-through on our online advertisements. Further, our competitors mayexperience greater growth in these areas than we do. Increased competitioncould result in advertising price reduction, reduced margins or loss of marketshare, any of which could materially harm our business.

 

*Governmental Regulation*. The laws and regulations that governour business change rapidly. Although our operations are currently based inCalifornia, the United States government and the governments of other statesand foreign jurisdictions have attempted to regulate activities on theInternet. The following is a general discussion of some of the evolving areasof law that are relevant to our business:

 

*Content Regulation.*Federal, state and foreign governmentshave adopted and proposed laws governing the content of material transmittedover the Internet. These include laws relating to obscenity, indecency, libeland defamation. For example, the Child Online Protection Act, or “COPA,”prohibits and imposes criminal penalties and civil liability on anyonecommunicating material harmful to minors through the Internet for commercialpurposes, unless access to such material is blocked to minors under age 17. TheThird U.S. Circuit Court of Appeals has upheld a preliminary injunctionprecluding enforcement of COPA. In June 2004, the U.S. Supreme Courtupheld the injunction and remanded the case to the District Court. We could beliable if the injunction against COPA is lifted and if content delivered by usor placed on our web-sites violates COPA.

 

*Privacy Law.*The state of privacy law is unsettled,and rapidly changing. Current and proposed federal, state and foreign privacyregulations and other laws restricting the collection, use and disclosure ofpersonal information could limit our ability to use the information in ourdatabases to generate revenues. In late 1998, the Children’s Online PrivacyProtection Act, or “COPPA,” was enacted, mandating that measures be taken tosafeguard minors under the age of 13. The Federal Trade Commission (“FTC”)promulgated regulations implementing COPPA on October 21, 1999, whichbecame effective on April 21, 2000.

 

The principal COPPA requirement is that individuallyidentifiable information about minors under the age of 13 not be collected,used, displayed or otherwise collected without first obtaining informedparental consent that is verifiable in light of present technology. The FTCfinal regulations create a “sliding scale” of permissible methods for obtainingsuch consent based on how the information will be used. Consent for internaluse of the individually identifiable information of children under the age of13 can be obtained through e-mail plus an additional safeguard, such asconfirming consent with a delayed e-mail, telephone call, or letter.

 

We comply with the COPPA requirements by notcollecting or displaying the individually identifying information of users who,when attempting to register on the web-sites, enter their birth date indicatingthey are under the age of 13. Complying with the COPPA requirements is costlyand may dissuade some of our potential customers.

 

Because we have posted a privacy policy pertaining toall users and visitors to our web-site, we are subject the jurisdiction of theFTC.  We may also be subject to the lawsand regulations of other states, for example we are aware that Californiapassed the California Online Privacy Protection Act, which took effect July 1,2004 and mandates content and posting requirements for web-sites privacypolicies of web-sites that collect personal information from Californiaresidents. While we are attempting to be fully compliant with the FTC andCalifornia requirements, our efforts may not be entirely successful. Inaddition, at times we rely upon outside vendors to maintain data-collectionsoftware, and there can be no assurance that they will at all times comply withour instructions to comply with COPPA, our Privacy Policy and FTC andCalifornia or other state requirements. If our methods of complying with theserequirements are inadequate, we may face litigation with the FTC, Californiagovernmental authorities or individuals, which would adversely affect ourbusiness. Should any of our business practices be found to differ from ourprivacy policy, we could be subject to sanctions and penalties from the FTC orinjunctions and penalties from California governmental authorities. It is alsopossible that users or visitors could try to recover damages in a civil actionas well. Attorney Generals in various States also have in the past sought toenforce posted privacy policies and may continue to do so in the future.

 

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*Laws Governing Sending ofUnsolicited Commercial E-mail.*We typically provide our customers and other visitorsto our web-sites with an opportunity to “opt-in,” or agree to receive e-mailfrom us. The federal government signed the Controlling the Assault ofNon-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM) designed tolimit unsolicited commercial e-mail commonly referred to as “spam.” Inaddition, California and a number of other states regulate the sending ofe-mails for commercial purposes to third parties where there is no preexistingbusiness relationship. Further, several states give Internet service providers(“ISPs”) a private right of action against those who send large e-mailingsacross their servers in contravention of the ISP’s posted policy. There is noguarantee that we will always be fully compliant in all of our communicationsat all times. Our failure to comply with applicable laws regarding these typesof e-mails could result in significant fines, actual or statutory damages, andinjunctive actions.

 

*Conformance to E-Commerce StatutoryRequirements for Formation of Contracts.*We conduct e-commerce on our web-sites, and throughaffiliated web-sites. The applicable law on online formation of contracts isevolving. On June 30, 2000, the federal government enacted the ElectronicSignatures in Global and National Commerce Act (“E-SIGN”), whichprovides that certain electronic signatures and electronic contracts withconsumers, of the type that we enter into, are not unenforceable solely becausethey are electronic.  E-SIGN alsospecifies requirements for electronic record retention.  On January 1, 2000, California adopted aversion of the Uniform Electronic Transactions Act (“UETA”), which alsopermits electronic signatures and record-keeping for certain types ofcontracts.  Forty-six states have adopteda version of UETA.  Because allstate-UETA laws are not identical, there are potentially conflictingrequirements applicable to electronic signatures and electronic contracts.  We attempt to comply with these laws, butthere is no guarantee that we will be successful.   Judicial interpretation or issuance ofgovernmental regulations interpreting E-SIGN and potentially conflicting StateUETA laws with regard to contracts of the type entered into by our customers throughout web-sites and affiliated web-sites could result in customer contracts beingset aside or modified. In that case, our e-commerce revenue could be materiallyadversely affected.

 

*Sales Tax.*The tax treatment of goods sold over theInternet is currently unsettled. We collect sales taxes for goods shipped toCalifornia and Florida, where we have a physical presence (i.e., a “nexus”). Anumber of proposals have been made at the state and local level that wouldimpose additional taxes on the sale of goods through the Internet. Suchproposals, if adopted, could substantially impair the growth of electroniccommerce and could adversely affect our opportunity to derive financial benefitfrom electronic commerce.

 

*Online Contests and Sweepstakes.*We occasionally conduct onlinepromotional contests and sweepstakes. No purchase is necessary to participate.Our official rules, with material terms and conditions, eligibilityrestrictions, dates of participation, methods of entry, prize descriptions andrestrictions, and odds of winning, are posted on our web-sites. To avoid havingto register and bond our online promotions in the states of New York andFlorida, the approximate retail value of the prizes we offer is generally lessthan $5,000 for a single promotion.****Althoughwe structure our promotions in a way that attempts to comply with applicablestatutes as we believe they are currently interpreted and enforced in all fiftystates, many of those statutes were drafted long before the advent ofpromotions over the Internet, and different states have interpretedsubstantially similar statutes differently. Thus, our ability to conduct onlinepromotions is subject to the broad discretionary enforcement powers vested invarious authorities. Further, our ability to conduct online promotions may beaffected in whole or in part by various business method patents that may havebeen issued. In addition, foreign jurisdictions may attempt to regulate or banour promotional contests. Under any of those three scenarios, we could facefines or possible exposure to liability or lose an effective tool forincreasing traffic to and keeping visitors at our web-sites, and our businesscould be adversely affected.

 

9

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* *

*IntellectualProperty.*Software,**contentand other material that we develop, as well as our service marks and domainnames relating to the ARTISTdirect or UBL brands, and other proprietary rightsare important to our business prospects. Significant impairment of ourintellectual property rights could harm our business. We seek to protectcertain of our common-law trademarks through Federal registration in the UnitedStates of America and State registrations in Puerto Rico. We also havetrademark registrations in Argentina, Australia, Brazil, Canada, Chile, CostaRica, the European Union, Japan, Mexico, Panama, Peru, the United Kingdom andVenezuela. Given the cost of filing, maintaining and protecting federalregistrations, we may choose not to register or enforce certain of ourtrademarks that later turn out to be important. Despite our efforts, it ispossible that the scope of protection gained from seeking trademarkregistration will be insufficient or that the registration may be deemedinvalid or unenforceable.

 

We seek to protect manyof our innovations as trade secrets and principally rely upon trade secret andcontract law in the Unites States to protect our proprietary rights. Wegenerally enter into confidentiality agreements, “work-made-for-hire” contractsand intellectual property licenses with our employees, consultants andcorporate partners, respectively, as part of our efforts to control access toand distribution of our technologies, content and other proprietaryinformation. For example, where consultants develop copyrighted content for us,our general policy is to use written agreements prior to content creation toobtain ownership of that content.

 

The following sets fortha schedule of our active trademarks:

 

Federal Trademark Filings

 
| **MARK**               | ** ** | **APPL. NO.** | ** ** | **REG. NO.** | ** ** | **REG. DATE**       |
|------------------------|------------|--------------------|------------|-------------------|------------|--------------------------|
| ARTISTDIRECT           |       | 75927362           |       | 2742630           |       | July 29,  2003      |
| CORPORATE LOGO         |       | 76072567           |       | 2764726           |       | September 16,  2003 |
| CORPORATE LOGO         |       | 76072566           |       | 2457335           |       | June 5,  2001       |
| CORPORATE LOGO         |       | 76072563           |       | 2469613           |       | July 17,  2001      |
| CORPORATE LOGO         |       | 76072562           |       | 2473501           |       | July 31,  2001      |
| CORPORATE LOGO         |       | 76072561           |       | 2473500           |       | July 31,  2001      |
| CORPORATE LOGO         |       | 76072560           |       | 2524524           |       | January 1,  2002    |
| THE ULTIMATE BAND LIST |       | 75306059           |       | 2407553           |       | November 28,  2000  |
| ARTISTDIRECT           |       | 75418187           |       | 2355839           |       | June 6,  2000       |
| ARTISTDIRECT           |       | 75061781           |       | 2288100           |       | October 19,  1999   |

 

State Trademark Filings

 
| **MARK**               | ** ** | **STATE**   | ** ** | **REG. NO.** | ** ** | **REG. DATE** |
|------------------------|------------|-------------|------------|-------------------|------------|--------------------|
| THE ULTIMATE BAND LIST |       | Puerto Rico |       | 50161             |       | May 11,  2000 |
| ARTISTDIRECT           |       | Puerto Rico |       | 50159             |       | May 11,  2000 |
| ARTISTDIRECT           |       | Puerto Rico |       | 49609             |       | May 11,  2000 |
| UBL                    |       | Puerto Rico |       | 49616             |       | May 11,  2000 |
| UBL                    |       | Puerto Rico |       | 49615             |       | May 11,  2000 |
| THE ULTIMATE BAND LIST |       | Puerto Rico |       | 49614             |       | May 11,  2000 |
| THE ULTIMATE BAND LIST |       | Puerto Rico |       | 49613             |       | May 11,  2000 |
| THE ULTIMATE BAND LIST |       | Puerto Rico |       | 49612             |       | May 11,  2000 |
| UBL                    |       | Puerto Rico |       | 50158             |       | May 11,  2000 |
| UBL                    |       | Puerto Rico |       | 50157             |       | May 11,  2000 |

 

10

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International Filings

 
| **MARK**            | ** ** | **COUNTRY**    | ** ** | **APPL. NO.** | ** ** | **REG. NO.** | ** ** | **REG. DATE** |
|---------------------|------------|----------------|------------|--------------------|------------|-------------------|------------|--------------------|
| A & Design |       | Argentina      |       | 2,320,737          |       | 1911466           |       | 1/27/2003          |
| A & Design |       | Argentina      |       | 2,320,739          |       | 1911467           |       | 1/27/2003          |
| A & Design |       | Argentina      |       | 2,374,722          |       | 1988933           |       |               |
| A & Design |       | Australia      |       | 908102             |       | 908102            |       | 3/28/2002          |
| A & Design |       | Brazil         |       | 824492609          |       | *                 |       |               |
| A & Design |       | Brazil         |       | 822892340          |       | 822892340         |       | 5/15/2007          |
| A & Design |       | Brazil         |       | 822892359          |       | 822892359         |       | 5/8/2007           |
| A & Design |       | Brazil         |       | 822892332          |       | *                 |       |               |
| A & Design |       | Costa Rica     |       | 2002-0003186       |       | 136855            |       | 1/21/2003          |
| A & Design |       | European Union |       | 2006336            |       | 2006336           |       | 6/20/2002          |
| A & Design |       | France         |       | 23158012           |       | 23158012          |       | 4/8/2002           |
| A & Design |       | Germany        |       | 30217397.8/09      |       | 30217397          |       | 4/5/2002           |
| A & Design |       | Japan          |       | 2002-24589         |       | 4648627           |       | 2/28/2003          |
| A & Design |       | Mexico         |       | 464672             |       | 708608            |       | 7/30/2001          |
| A & Design |       | Mexico         |       | 464671             |       | 699283            |       | 5/24/2001          |
| A & Design |       | Mexico         |       | 464670             |       | 703484            |       | 6/21/2001          |
| A & Design |       | Mexico         |       | 541631             |       | 785949            |       | 3/31/2003          |
| A & Design |       | Panama         |       | 112008             |       | *                 |       |               |
| A & Design |       | Panama         |       | 112010             |       | *                 |       |               |
| A & Design |       | Panama         |       | 112009             |       | *                 |       |               |
| A & Design |       | Peru           |       | 120227             |       | *                 |       |               |
| A & Design |       | Peru           |       | 120228             |       | *                 |       |               |
| A & Design |       | Peru           |       | 120229             |       | *                 |       |               |
| A & Design |       | Peru           |       | 151886-2002        |       | 82635             |       | 8/22/2002          |
| A & Design |       | United Kingdom |       | 2296994            |       | 2296994           |       | 8/30/2002          |
| ARTISTDIRECT        |       | Argentina      |       | 2,264,378          |       | 1886206           |       | 9/20/2002          |
| ARTISTDIRECT        |       | Argentina      |       | 2,264,379          |       | 1886207           |       | 9/20/2002          |
| ARTISTDIRECT        |       | Argentina      |       | 2,264,380          |       | 1886208           |       | 9/20/2002          |
| ARTISTDIRECT        |       | Argentina      |       | 2,264,381          |       | 1886209           |       | 9/20/2002          |
| ARTISTDIRECT        |       | Argentina      |       | 2,374,721          |       | 1920978           |       | 4/3/2003           |
| ARTISTDIRECT        |       | Australia      |       | 818867             |       | 818867            |       | 12/30/1999         |
| ARTISTDIRECT        |       | Australia      |       | 908101             |       | 908101            |       | 3/28/2002          |
| ARTISTDIRECT        |       | Canada         |       | 864116             |       | 512153            |       | 5/25/1999          |
| ARTISTDIRECT        |       | Chile          |       | 471162             |       | 574481            |       | 8/18/2000          |
| ARTISTDIRECT        |       | Chile          |       | 471163             |       | 574480            |       | 8/18/2000          |
| ARTISTDIRECT        |       | Chile          |       | 471161             |       | 574482            |       | 8/18/2000          |
| ARTISTDIRECT        |       | Chile          |       | 471160             |       | 574469            |       | 8/18/2000          |
| ARTISTDIRECT        |       | Costa Rica     |       | 1999-0010547       |       | 121896            |       | 8/24/2000          |
| ARTISTDIRECT        |       | Costa Rica     |       | 1999-0010548       |       | 121134            |       | 7/27/2000          |
| ARTISTDIRECT        |       | Costa Rica     |       | 1999-0010549       |       | 121133            |       | 7/27/2000          |
| ARTISTDIRECT        |       | Costa Rica     |       | 1999-0010550       |       | 121132            |       | 7/27/2000          |
| ARTISTDIRECT        |       | Costa Rica     |       | 2002-0003185       |       | 136854            |       | 1/21/2003          |
| ARTISTDIRECT        |       | European Union |       | 699538             |       | 699538            |       | 6/5/2000           |
| ARTISTDIRECT        |       | France         |       | 23158011           |       | 23158011          |       | 4/8/2002           |
| ARTISTDIRECT        |       | Germany        |       | 30217395.1/09      |       | 30217395          |       | 4/5/2002           |
| ARTISTDIRECT        |       | Japan          |       | 183723/1997        |       | 4359836           |       | 2/10/2000          |
| ARTISTDIRECT        |       | Japan          |       | 2002-24588         |       | 4648626           |       | 2/28/2003          |
| ARTISTDIRECT        |       | Mexico         |       | 409261             |       | 645860            |       | 3/22/2000          |
| ARTISTDIRECT        |       | Mexico         |       | 409262             |       | 645861            |       | 3/22/2000          |
| ARTISTDIRECT        |       | Mexico         |       | 409263             |       | 649514            |       | 3/31/2000          |
| ARTISTDIRECT        |       | Mexico         |       | 409264             |       | 645862            |       | 3/22/2000          |
| ARTISTDIRECT        |       | Mexico         |       | 541632             |       | 743912            |       | 4/29/2002          |
| ARTISTDIRECT        |       | Panama         |       | 105638             |       | 105638            |       | 2/15/2001          |
| ARTISTDIRECT        |       | Panama         |       | 105641             |       | 105641            |       | 2/15/2001          |

 

11

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| ARTISTDIRECT           |   | Panama         |   | 105640       |   | 105640   |   | 2/15/2001  |
|------------------------|--------|----------------|--------|--------------|--------|----------|--------|------------|
| ARTISTDIRECT           |   | Panama         |   | 105642       |   | 105642   |   | 2/15/2001  |
| ARTISTDIRECT           |   | Peru           |   | 99622        |   | 22837    |   | 9/12/2000  |
| ARTISTDIRECT           |   | Peru           |   | 99623        |   | 22761    |   | 9/8/2000   |
| ARTISTDIRECT           |   | Peru           |   | 99624        |   | 22762    |   | 9/8/2000   |
| ARTISTDIRECT           |   | Peru           |   | 099625-2000  |   | 25765    |   | 5/24/2001  |
| ARTISTDIRECT           |   | Peru           |   | 151884-2002  |   | 82854    |   | 9/4/2002   |
| ARTISTDIRECT           |   | United Kingdom |   | 2296996      |   | 2296996  |   | 10/4/2002  |
| ARTISTDIRECT           |   | Venezuela      |   | 2000-003045  |   | S-015483 |   | 11/22/2000 |
| ARTISTDIRECT           |   | Venezuela      |   | 2000-003043  |   | S-015481 |   | 11/22/2000 |
| ARTISTDIRECT           |   | Venezuela      |   | 2000-003044  |   | S-015482 |   | 11/22/2000 |
| ARTISTDIRECT           |   | Venezuela      |   | 2000-003042  |   | S-015480 |   | 11/22/2000 |
| ARTISTDIRECT DIGITAL   |   | Japan          |   | 2002-095128  |   | 4688729  |   | 7/4/2003   |
| THE ULTIMATE BAND LIST |   | Argentina      |   | 2.119.984    |   | 1720730  |   | 2/10/1999  |
| THE ULTIMATE BAND LIST |   | Argentina      |   | 2.119.985    |   | 1720731  |   | 2/10/1999  |
| THE ULTIMATE BAND LIST |   | Australia      |   | 750646       |   | 750646   |   | 12/9/1997  |
| THE ULTIMATE BAND LIST |   | Brazil         |   | 820399086    |   | *        |   |       |
| THE ULTIMATE BAND LIST |   | Canada         |   | 863917       |   | 511964   |   | 5/18/1999  |
| THE ULTIMATE BAND LIST |   | Chile          |   | 471173       |   | 574472   |   | 8/18/2000  |
| THE ULTIMATE BAND LIST |   | Chile          |   | 471172       |   | 574473   |   | 8/18/2000  |
| THE ULTIMATE BAND LIST |   | Chile          |   | 471171       |   | 574474   |   | 8/18/2000  |
| THE ULTIMATE BAND LIST |   | Chile          |   | 471170       |   | 574475   |   | 8/18/2000  |
| THE ULTIMATE BAND LIST |   | Costa Rica     |   | 1999-0010555 |   | 121887   |   | 8/24/2000  |
| THE ULTIMATE BAND LIST |   | Costa Rica     |   | 1999-0010556 |   | 121894   |   | 8/24/2000  |
| THE ULTIMATE BAND LIST |   | Costa Rica     |   | 1999-0010557 |   | 121130   |   | 7/27/2000  |
| THE ULTIMATE BAND LIST |   | Costa Rica     |   | 1999-0010558 |   | 121895   |   | 8/24/2000  |
| THE ULTIMATE BAND LIST |   | European Union |   | 699355       |   | 699355   |   | 2/25/2000  |
| THE ULTIMATE BAND LIST |   | Japan          |   | 183722/1997  |   | 4359835  |   | 2/10/2000  |
| THE ULTIMATE BAND LIST |   | Mexico         |   | 409269       |   | 647112   |   | 3/27/2000  |
| THE ULTIMATE BAND LIST |   | Mexico         |   | 409270       |   | 647113   |   | 3/27/2000  |
| THE ULTIMATE BAND LIST |   | Mexico         |   | 409271       |   | 645866   |   | 3/22/2000  |
| THE ULTIMATE BAND LIST |   | Mexico         |   | 409272       |   | 645867   |   | 3/22/2000  |
| THE ULTIMATE BAND LIST |   | Panama         |   | 105628       |   | 105628   |   | 2/15/2001  |
| THE ULTIMATE BAND LIST |   | Panama         |   | 105627       |   | 105627   |   | 4/6/2001   |
| THE ULTIMATE BAND LIST |   | Panama         |   | 105626       |   | 105626   |   | 2/13/2001  |
| THE ULTIMATE BAND LIST |   | Panama         |   | 105629       |   | 105629   |   | 2/13/2001  |
| THE ULTIMATE BAND LIST |   | Peru           |   | 99630        |   | 23005    |   | 9/28/2000  |
| THE ULTIMATE BAND LIST |   | Peru           |   | 99631        |   | 22959    |   | 9/20/2000  |
| THE ULTIMATE BAND LIST |   | Peru           |   | 99632        |   | 26107    |   | 6/18/2001  |
| THE ULTIMATE BAND LIST |   | Peru           |   | 99633        |   | 23034    |   | 9/29/2000  |

 

12

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| UBL |   | Argentina      |   | 2,119,987    |   | 1846303   |   | 10/2/2001  |
|-----|--------|----------------|--------|--------------|--------|-----------|--------|------------|
| UBL |   | Argentina      |   | 2,119,986    |   | 1870610   |   | 5/10/2002  |
| UBL |   | Australia      |   | 750647       |   | 750647    |   | 12/9/1997  |
| UBL |   | Brazil         |   | 820399060    |   | *         |   |       |
| UBL |   | Brazil         |   | 820399051    |   | 820399051 |   | 5/23/2006  |
| UBL |   | Canada         |   | 863917       |   | 503204    |   | 10/28/1998 |
| UBL |   | Chile          |   | 471167       |   | 574476    |   | 8/18/2000  |
| UBL |   | Chile          |   | 471166       |   | 574477    |   | 8/18/2000  |
| UBL |   | Chile          |   | 471165       |   | 574478    |   | 8/18/2000  |
| UBL |   | Chile          |   | 471164       |   | 574479    |   | 8/18/2000  |
| UBL |   | Costa Rica     |   | 1999-0010551 |   | 121890    |   | 8/24/2000  |
| UBL |   | Costa Rica     |   | 1999-0010552 |   | 121888    |   | 8/24/2000  |
| UBL |   | Costa Rica     |   | 1999-0010553 |   | 121131    |   | 7/27/2000  |
| UBL |   | Costa Rica     |   | 1999-0010554 |   | 121889    |   | 8/24/2000  |
| UBL |   | European Union |   | 698951       |   | 698951    |   | 3/3/2000   |
| UBL |   | Japan          |   | 183721/1997  |   | 4359834   |   | 2/10/2000  |
| UBL |   | Mexico         |   | 409265       |   | 645863    |   | 3/22/2000  |
| UBL |   | Mexico         |   | 409266       |   | 645864    |   | 3/22/2000  |
| UBL |   | Mexico         |   | 409267       |   | 684935    |   | 1/31/2001  |
| UBL |   | Mexico         |   | 409268       |   | 645865    |   | 3/22/2000  |
| UBL |   | Panama         |   | 105636       |   | 105636    |   | 2/15/2001  |
| UBL |   | Panama         |   | 105635       |   | *         |   |       |
| UBL |   | Panama         |   | 105634       |   | 105634    |   | 2/13/2001  |
| UBL |   | Panama         |   | 105637       |   | 105637    |   | 2/13/2001  |
| UBL |   | Peru           |   | 99626        |   | 23004     |   | 9/28/2000  |
| UBL |   | Peru           |   | 99627        |   | 22958     |   | 9/20/2000  |
| UBL |   | Peru           |   | 99628        |   | 25918     |   | 5/31/2001  |
| UBL |   | Peru           |   | 99629        |   | 23033     |   | 9/29/2000  |
| UBL |   | Venezuela      |   | 2000-003035  |   | S-015477  |   | 11/22/2000 |
| UBL |   | Venezuela      |   | 2000-003036  |   | S-015478  |   | 11/22/2000 |
| UBL |   | Venezuela      |   | 2000-003034  |   | S-015476  |   | 11/22/2000 |
| UBL |   | Venezuela      |   | 2000-003037  |   | S-015479  |   | 11/22/2000 |

 

----

* Indicates that application is pending and not yetregistered.

 

Despite our efforts toprotect our proprietary rights from unauthorized use or disclosure, our effortsmay not be sufficient or successful. It may be possible that some of ourinnovations may not be protectable. The steps that we have taken may notprevent misappropriation of our proprietary rights, particularly in foreigncountries where laws or law enforcement practices may not protect ourproprietary rights at all, or as fully as in the United States**.**Confidentiality may be compromisedintentionally or accidentally by contractors, customers, other third parties orour employees. If third parties were to use or otherwise misappropriate ourweb-site content, source code, other copyright materials, trademarks, servicemarks or other proprietary rights without our consent or approval, ourcompetitive position could be harmed, or we could become involved in costly anddistracting litigation to enforce our rights.

 

A copyright gives theowner divisible rights, including those of performance, reproduction anddistribution. The music featured by us is typically comprised of copyrightedworks owned, controlled or administered by multiple third parties, includingrecord labels, artists, songwriters, music publishers and performance rightsand licensing organizations such as (but not limited to) The Harry Fox Agency,Broadcast Music Inc. (“BMI”) and the American Society of Composers, Authors andPublishers (“ASCAP”). Each song often has multiple copyright owners, whocontrol rights which may include performance, reproduction and distributionrights in the “musical composition” comprised of the lyrics and music, as wellas with the “sound recording” of the artist’s interpretation of the “musicalcomposition.” In the case of music videos, there are separate copyrights to thevisual content, as well as “synchronization rights” for integrating the musicand video. We, or our artists, may have different licensing arrangements withsome or all of these parties to perform, reproduce and distribute worksdepending upon how the song or music video is used by us.

 

13

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Our web-sites, dependingupon the specific musical work, may offer audio streaming of part or all of anentire song or “Web casting,” or the downloading of an entire song in MP3 orother compressed audio formats. Full-length streaming only occurs in specialinstances after obtaining a license from the record label or band manager forthe “sound recording.” In that case, an ASCAP or BMI blanket music license isalso obtained by us or by our artists for rights to perform the associatedunderlying “musical composition.” Where we offer full-length downloads of songsin MP3 or other compressed audio formats, we seek to obtain the rights totransmit, reproduce and perform the “sound recording” in writing from theperson or entity owning or controlling copyrights in such “sound recording.”With respect to rights in the “musical compositions” embodied in such “sound recordings”offered for download, we seek to clear rights in musical composition in one ormore of the following three ways:

 

·                  a licenseagreement with the publisher, writer or other owner of such copyright in the “musicalcomposition”.

 

·                  a waiver of anyfees or royalties that would otherwise be required for such use; and/or;

 

·                 arepresentation and warranty from the owner of the copyrights in the “soundrecording” that no mechanical royalties are owed to any third parties.

 

In the event that theforegoing steps are insufficient to clear rights, or we otherwise fail toobtain rights, we could be exposed to claims of copyright infringement, withattendant disruption to our operations and liability including potentialstatutory or actual damages and loss of profits attributable to infringement,plus payment of attorneys’ fees to the claimant and entry of an injunctionagainst us.

 

There are othersituations, such as a limited 30-second sample of a song that is “streamed,”where we use content relying upon a sub-license from an artist’s record label.However, the laws in this area are uncertain, and we may be obligated to obtainadditional licenses or may be prevented from third party content use, and may,in the event proper licenses and clearances have not been secured, further beliable to pay actual or statutory damages, profits attributable to any allegedinfringement, as well as attorneys’ fees. Our licensing arrangements forthird-party content vary from formal contracts to informal agreements based onthe promotional nature of the content. In some cases we pay a fee to thelicensor for use of the “sound recording,” “musical composition” or music videoand in other cases the use is free. We also use other third-party content,including photographs, artist names, likenesses and concert reviews. While itis our general policy to obtain a written release or license for such use, in manyinstances we rely only upon an oral license for such use. We rely upon ourpositive working relationships with copyright owners to obtain licenses onfavorable terms. Any changes in the nature or terms of these arrangements,including any requirement that we pay significant fees for the use of thecontent, could have a negative impact on the availability of content or ourbusiness.

 

*Linkingand Framing of Third-Party web-sites.*We link to and “frame”third-party web-sites of our artists without express written permission to doso. In addition, in the past we have provided a search feature to allow usersto find music residing elsewhere on the Internet. Those practices arecontroversial, and have, in instances not involving us, resulted in litigation.Various claims, including trademark and copyright infringement, unfaircompetition, and commercial misappropriation, as well as infringement of theright of publicity may be asserted against us as a result of these practices.The law regarding linking and framing remains unsettled; it is uncertain as tohow existing laws, especially trademark and copyright law, will be applied bythe judiciary to the Internet. Also, Congress is increasingly active in passingnew laws related to the Internet, and there is uncertainty as to the impact offuture potential laws, especially those involving domain names, databases andprivacy.

 

*Defamationor Contributory Infringement.*Our web-site features acommunity area where visitors can post comments. We do not censor such commentsand it is possible that a customer could use our web-sites as a forum to makefalse, misleading or disparaging remarks about others. Such on-line commentscould lead to claims for defamation or infringement. As to libel claims broughtin the United States, we believe that we qualify for safe harbor protection forthird-party postings under 47 U.S.C. Section 230(c)(1). However, othercountries, notably the United Kingdom, may impose such liability, and it ispossible we could be sued there for third-party postings. Separately, ourweb-sites allow consumers to use our personal web publishing tools to postsamples of their works. Such postings could be misused to post unlicensedcopyrighted content of others. We have obtained limited safe-harbor protectionunder the Digital Millennium Copyright Act against liability for infringingmaterial of which we do not have control and knowledge.

 

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*Seasonality.*The seasonality of our e-commerce segment affects our revenue.Our CDs and other online goods are most often purchased during the winterholiday season and also during the summer months, traditionally when artists goon concert tour.

 

**ITEM 2.****                             DESCRIPTION OF PROPERTY**

 

The following tableprovides a schedule of corporate offices and facilities leased by us:

 
| **Location**             | ** ** | **Primary Function**                                  | ** ** | **Square Footage** | ** ** | **Lease Term**               |
|--------------------------|------------|------------------------------------------------------------|------------|-------------------------|------------|-----------------------------------|
| ** **               | ** ** | ** **                                                 | ** ** | ** **              | ** ** | ** **                        |
| Santa Monica, California |       | Corporate headquarters for ARTISTdirect and  MediaDefender |       | 14,817                  |       | Lease ends November 30, 2011 |
|                     |       |                                                       |       |                    |       |                              |
| Los Angeles, California  |       | Secured co-location space                                  |       | 300                     |       | Monthly                           |
|                     |       |                                                       |       |                    |       |                              |
| Los Angeles, California  |       | Secured co-location facility                               |       | NA                      |       | Lease ends February 2010     |
|                     |       |                                                       |       |                    |       |                              |
| El Segundo, California   |       | Secured co-location facility                               |       | NA                      |       | Lease ends February 2010     |

 

We believe that all realproperty and facilities leased by us are in good repair and adequate for ourpurposes for the next 12 months.

 

**ITEM 3.****                             LEGAL PROCEEDINGS**

 

We are periodicallysubject to various pending and threatened legal actions, which arise in thenormal course of business. Our management currently believes that the impact ofany such litigation will not have a material adverse impact on our financialposition or results of operations.

 

As a result of therestatement of our financial statements and the other events describedelsewhere in this Annual Report on Form 10-KSB, we have triggered variousevents of default under our senior debt and subordinated debt financingdocuments.  We could be subject to futureclaims under our financing documents, see “Item 6. Management’s Discussion andAnalysis — Going Concern”.

 

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**ITEM4.****                                                     SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

There were no matterssubmitted to a vote of our stockholders during the fourth quarter of the fiscalyear ended December 31, 2007.

 

**PART II**

 

**ITEM 5.****                       MARKET FOR COMMON EQUITY,RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS PURCHASES OF EQUITYSECURITIES**

 

*Market Information*

 

Our common stock has beenlisted for quotation on the Over-the-Counter Bulletin Board under the symbol “ARTD.OB”since May 9, 2003.  The followingtable sets forth the high and low sales prices for our common stock, asreported by the Over-the-Counter Bulletin Board for fiscal 2007 and 2006,respectively:

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2007**       |       |     |       |    |       |
| First Quarter  |       | $        | 2.40       |    | $          | 1.40 |   |
| Second Quarter |       | $        | 2.38       |    | $          | 1.75 |   |
| Third Quarter  |       | $        | 2.30       |    | $          | 1.75 |   |
| Fourth Quarter |       | $        | 1.90       |    | $          | 0.38 |   |
|           |       |     |       |    |       |
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 4.53       |    | $          | 2.50 |   |
| Second Quarter |       | $        | 4.65       |    | $          | 2.75 |   |
| Third Quarter  |       | $        | 3.55       |    | $          | 2.90 |   |
| Fourth Quarter |       | $        | 3.55       |    | $          | 2.25 |   |

 

The closing price of ourcommon stock on March 24, 2008 was $0.41 per share, as reported on theOver-The-Counter Bulletin Board.  TheOver-the-Counter quotations reflect inter-dealer prices, without retailmark-up, mark-down or commission, and may not represent actual transactions.

 

*Holders of Record*

 

As of March 24,2008, we had 265 holders of record of our common stock, excluding shares heldin “street name” by brokerage firms and other nominees who hold shares formultiple investors.

 

*Dividends*

 

The Company has notdeclared or paid any cash dividends on our common stock since itsinception.  The Company’s various seniorand subordinated financing documents prevent the Company from paying any cashdividends on account of our common stock. Subject to the Company’s obligations to our senior and subordinatedlenders, the Company intends to retain any future earnings, if any, to financethe Company’s business, and we do not expect to declare or pay any cashdividends in the foreseeable future.

 

*Equity Compensation Plan Information*

 

Refer to Item 11 “SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters” below for information with respect to our equity compensation plans.

 

*Additional Information*

 

Copies of our priorAnnual Reports on Form 10-KSB, Quarterly Reports on Form 10-QSB,Current Reports on Form 8-K, and any amendments to those reports, areavailable free of charge on the Internet at www.sec.gov. All statements made inany of our filings, including all forward-looking statements, are made as ofthe date of the document in which the statement is included, and we do notassume or undertake any obligation to update any of those statements unless weare required to do so by law.

 

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**ITEM 6.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION**

 

Overview:

 

The Company conducts its media and e-commerce businessoperations through an online music network appealing to music fans, artists andmarketing partners.  The ARTISTdirectNetwork (www.artistdirect.com) is a network of web-sites offering multi-mediacontent, music news and information, communities organized around shared musicinterests, music-related specialty commerce and digital music services.

 

On July 28, 2005, the Company completed theacquisition of MediaDefender, Inc., a privately-held Delaware corporation,(“MediaDefender”).  The stockholders ofMediaDefender received aggregate consideration of $42,500,000 in cash, subjectto certain holdbacks and adjustments described in the Merger Agreement.

 

The acquisition ofMediaDefender was accounted for as a purchase in accordance with SFAS No. 141,“Business Combinations”, and the operations of the two companies have beenconsolidated commencing August 1, 2005. Due to the restrictions imposed by Internal Revenue Code Section 382regarding substantial changes in the stock ownership of companies with losscarryforwards, the utilization of the Company’s federal net operating losscarryforward was severely reduced as a result of the change in the effectivestock ownership of the Company resulting from the debt financings arranged inconjunction with the acquisition of MediaDefender.

 

MediaDefender is theleading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”)industry.  It should be noted thatrevenue related to anti-piracy activities declined in 2007 from 2006 andmanagement anticipates a further decline in 2008.  The largest source of this decline is reducedspending on the part of the major music labels due to a significant reductionin their sales and profitability.  Seeadditional details and discussion in the Net Revenue section below.

 

During 2007,MediaDefender began offering advertisers specific programs to download brandedcontent on file-sharing networks.  Whilesuch advertising based programs provided approximately $560,000 of revenueduring 2007, management believes such activities could be a significant factorin 2008 and beyond as advertisers become more familiar with branded promotionactivities on peer-to-peer networks, which currently carry the majority ofinternet traffic.  Advertising relatedrevenue will be needed to offset anticipated declines in revenues fromanti-piracy programs, especially those related to music.

 

During 2006,MediaDefender offered file-sharing marketing services, wherein MediaDefenderreceives a fee for redirecting specific peer-to-peer traffic on the Internet todesignated client destinations.  This typeof redirect program activity was not significant during 2007 and managementdoes not anticipate this to be a major source of revenue going forward.

 

In order to fund the acquisition of MediaDefender, theCompany completed a $15,000,000 senior secured debt transaction and a$30,000,000 convertible subordinated debt transaction, as described below at “FinancingTransactions with Respect to MediaDefender, Inc. Acquisition”.

 

Going Concern:

 

As a result ofcommunications with the Staff of the Securities and Exchange Commission in2006, in particular regarding the application of accounting rules andinterpretations related to embedded derivatives associated with the Company’ssubordinated convertible notes payable issued in July 2005, the Companydetermined that it was necessary to restate previously issued financialstatements. 

 

As a result, on December 20,2006, the Company was required to suspend the use of its then effectiveregistration statement for the holders of its senior and subordinatedindebtedness, which then triggered an event of default with respect to itsregistration rights agreements with the holders of such indebtedness.  Accordingly, beginning December 20,2006, the Company began to incur liquidated damages under its registrationrights agreements aggregating approximately $540,000 per month, and theinterest rate on its subordinated convertible notes payable increased from 4.0%per annum to 12.0% per annum, an increase of approximately $183,000 permonth.  On July 6, 2007, the Company’sregistration statement was declared effective by the SEC, thus making itavailable to the investors in the Senior Financing and Sub-Debt Financing.

 

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The adjustments to thefinancial statements with respect to the restatements were non-cash in natureand were not caused by or related to any changes in the underlying operatingperformance of the Company’s business, including revenues, operating costs andexpenses, operating income or loss, income taxes, operating cash flows oradjusted EBITDA.  Primarily as a resultof the requirement to restate previously issued financial statements, whichresulted in the recording of an embedded derivative liability, thereclassification of the senior and subordinated indebtedness to currentliabilities, and the recording of liquidated damages payable under registrationrights agreements, the Company was not in compliance with certain of itsfinancial covenants under both the Senior Financing and the Sub-Debt Financingat December 31, 2007 and 2006. Notwithstanding such developments, the Company believes that it wouldhave been out of compliance with certain of its financial covenants at December 31,2007.

 

During 2007 and 2006, theCompany’s consolidated operations generated sufficient cash flows fromoperations to enable the Company to fund its operating requirements and itsoriginally scheduled (i.e., undefaulted) debt service obligations to both thesenior and subordinated debt holders. All quarterly interest payments due on the outstanding senior andsubordinated indebtedness were timely paid by the Company through December 2006.  In addition, the quarterly interest paymentsdue on the outstanding senior indebtedness during 2007 were timely paid.  Pursuant to the terms of the SubordinationAgreement, interest on the outstanding subordinated convertible notes payablecannot be paid as a result of the existence of the events of default describedherein.

 

As of December 31,2007 and 2006, approximately $13,307,000 principal amount was outstanding withrespect to the Senior Financing, and approximately $27,658,000 principal amountwas outstanding with respect to the Sub-Debt Financing.  In addition, at December 31,2007, approximately $410,000 and $1,972,000 was outstanding with respect toaccrued registration delay penalties to the holders of the Senior Financing andthe Sub-Debt Financing, respectively, and approximately $146,000 and $3,206,000was outstanding with respect to accrued interest payable to the holders of theSenior Financing and the Sub-Debt Financing, respectively.  Through December 31, 2007, the Companyhad not paid the registration delay penalties to Sub-Debt Notes, although ithad made advance payments to the holders of the Senior Notes aggregating$1,000,000 in exchange for multiple forbearance agreements.

 

As a result of theregistration failure, the failure to pay the registration delay penalties andthe various financial covenant and other breaches of the terms of the SeniorFinancing and the Sub-Debt Financing, multiple events of default exist underthe Senior Financing and the Sub-Debt Financing.  The terms of the Subordination Agreementamong the Company and the creditor parties thereto (the “SubordinationAgreement”) prevent the Company from making any cash payments to the Sub-DebtNote holders until the events of default under the Senior Financing are eithercured or waived.  Furthermore, upon theoccurrence of an event of default, holders of at least 25% of the outstandingsenior indebtedness may declare the outstanding principal and accrued intereston all senior notes immediately due and payable upon written notice to theCompany, and each holder of outstanding subordinated indebtedness may onlydemand redemption of all or any portion of their respective notes under certaincircumstances as described in the Subordination Agreement. The Company does nothave the capital resources necessary to cure the existing events of default, orto repay any accelerated indebtedness or redemption or penalty amounts.

 

Pursuant to a series of Forbearance and ConsentAgreements with the investors in the Senior Financing, such investors agreed toforbear from the exercise of their rights and remedies under the SeniorFinancing documents as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that existed or that could come into existence duringthe forbearance period, from April 17, 2007 through February 20,2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and$494,446 in February 2008.  Thepayments made by the Company under the Forbearance and Consent Agreements werecredited against the registration delay cash penalties and interest on thepenalties resulting from the Company’s default under the various agreementsbetween the Company and the Senior Financing investors.  On March 17, 2008, the Company enteredinto a Forbearance and Consent Agreement with the investors in the Company’sSenior Debt Financing, which was effective as of February 20, 2008,whereby the investors  agreed to forbearfrom exercising any of their rights and remedies under the Senior Financingtransaction documents through December 31, 2008 in exchange for anadjustment in the interest rate associated with the Senior Notes from 11.25% to15%, provided the loan is repaid prior to September 30, 2008 or 16%, ifthe loan remains outstanding subsequent to that date.

 

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The registration delaypenalties and ongoing default interest charges are continuing to have asignificant and material negative impact on the Company’s operations and cashflows.  The Company and itsrepresentatives and advisors are in ongoing discussions with the holders of itssenior and subordinated debt obligations to obtain a waiver of and amendment tocertain of the financing documents with respect to the events of default, theimpact of the restatements, the payment of cash penalties and default interest,and various related matters.  The Companyis exploring various alternatives to resolve the defaults under its senior andsecured debt obligations, but is unable to predict the outcome of suchnegotiations.  On February 7, 2008the Company retained the services of Salem Partners, LLC, to serve as afinancial advisor to the Company in connection with the sale, merger,consolidation, reorganization or other business combination and therestructuring of the material terms of the Company’s senior notes and/orsubordinated convertible notes.  To theextent that the Company is unable to complete a sale or merger, or restructureits senior and subordinated debt obligations in a satisfactory manner and/orthe lenders begin to exercise additional remedies to enforce their rights, theCompany will not have sufficient cash resources to maintain itsoperations.  In such event, the Companymay be required to consider a formal or informal restructuring orreorganization, including a filing under Chapter 11 of the United StatesBankruptcy Code.

 

The accompanyingconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America, whichcontemplate continuation of the Company as a going concern.  As a result of the foregoing, the Company’sindependent registered public accounting firm, in its report on the Company’s2007 consolidated financial statements, expressed substantial doubt about theCompany’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments relating to the recoverability and classification ofrecorded asset amounts or the amounts and classification of liabilities thatcould result from the outcome of this uncertainty.

 

Critical AccountingPolicies:

 

The discussion andanalysis of the Company’s financial condition and results of operations isbased upon its consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of thesefinancial statements requires the Company to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities.  On an ongoing basis, the Company evaluatesits estimates, including those related to accounts receivable, tangible andintangible assets, warrant and derivative liabilities, income taxes, andcontingencies and litigation, among others. The Company bases its estimates on historical experience and on variousother assumptions that it believes to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.  Actual results may differ fromthese estimates under different assumptions or conditions.  The Company believes that the followingcritical accounting policies affect the more significant judgments andestimates used in the preparation of its consolidated financialstatements:   revenue recognition,stock-based compensation, goodwill, intangible assets and long-lived assets,derivative instruments, income taxes and accounts receivable.

 

Revenue Recognition.  The Company complies with the provisions ofStaff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition inFinancial Statements”, as amended by SAB No. 104, and recognizes revenuewhen all four of the following criteria are met:  (i) persuasive evidence that anarrangement exists; (ii) delivery of the products and/or services hasoccurred; (iii) the selling price is both fixed and determinable; and (iv) colectabilityis reasonably assured.

 

E-commerce revenueconsists primarily of the gross amount of sales revenue paid by the customerfor recorded music and merchandise sold via the Internet, including shippingfees, and is recognized when the products are shipped.  The Company has a contract with a fulfillmenthouse to service its music-related e-commerce activity.  The Company records e-commerce revenue on agross basis as the Company enters into the sale transactions with customers,establishes the prices of the products, chooses the suppliers of the products,assumes the risk of inventory loss and collects all amounts from the customersand assumes the credit risk.  In certaincircumstances, e-commerce revenue is subject to royalties, and such expense isrecorded as part of cost of e-commerce revenue.

 

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The Company recordsamounts charged to customers for shipping and handling in accordance withEITF 00-10, “Accounting for Shipping and Handling Fees and Costs” (“EITF 00-10”).  Pursuant to EITF 00-10, the Companyrecords amounts charged to customers for shipping and handling as revenue, andrecords the related costs incurred for shipping and handling to direct cost ofproduct sales in the statement of operations.

 

Media revenue consists primarily of the sale ofadvertisements and sponsorships under short-term contracts.  To date, the duration of the Company’sadvertising commitments has generally averaged from one to three months,although certain programs can last up to one year.  The Company’s online obligations typicallyinclude the guarantee of a minimum number of times (“impressions”) that anadvertisement appears in pages viewed by the users of the Company’s onlineproperties.  Online advertising revenueis generally recognized as the impressions are served during the period inwhich the advertisement is displayed, provided that no significant obligationsof the Company remain and collection of the resulting receivable is reasonablyassured.  To the extent that minimumguaranteed page deliveries are not met, recognition of the correspondingrevenue is deferred until the guaranteed impressions are delivered.

 

The Company recognizesrevenue for sponsorship arrangements over the period during which theadvertising is provided, generally on a straight-line basis.  The Company recognizes revenue for a banner impressiondeliverable as the banner impressions are delivered.  The Company recognizes revenue for web-page sponsorshipson a straight-line basis over the term of the sponsorship.  The Company recognizes revenue for customcontent when the content is provided to the customer.

 

Anti-piracy and file-sharing marketing servicesrevenue is recognized on a monthly basis as services are provided tocustomers.  Deferred revenue is recordedfor customers who prepay the full, or any portion, of their respective contracts.

 

Stock-BasedCompensation.  Effective January 1,2006, the Company adopted Statement of Financial Accounting Standard No. 123(revised 2004), “Share-Based Payment” (“SFAS No. 123R”), a revision toSFAS No. 123, “Accounting for Stock-Based Compensation”.  SFAS No. 123R requires that the Companymeasure the cost of employee services received in exchange for equity awardsbased on the grant date fair value of the awards, with the cost to berecognized as compensation expense in the Company’s financial statements overthe vesting period of the awards. Accordingly, the Company recognizes compensation cost for equity-basedcompensation for all new or modified grants issued after December 31,2005.  In addition, commencing January 1,2006, the Company recognized the unvested portion of the grant date fair valueof awards issued prior to adoption of SFAS No. 123R based on the fairvalues previously calculated for disclosure purposes over the remaining vestingperiod of the outstanding stock options and warrants.

 

TheCompany accounts for stock option and warrant grants issued and vesting tonon-employees in accordance with EITF No. 96-18, “Accounting for EquityInstruments that are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services”, and EITF 00-18, “AccountingRecognition for Certain Transactions involving Equity Instruments Granted toOther Than Employees”, whereas the value of the stock compensation is basedupon the measurement date as determined at either (a) the date at which aperformance commitment is reached or (b) at the date at which thenecessary performance to earn the equity instrument is complete.

 

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Goodwill, Intangible Assets and Long-Lived Assets.  Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“SFAS No. 142”), requirespurchased intangible assets other than goodwill to be amortized over theiruseful lives unless these lives are determined to be indefinite.

 

SFAS No. 142 requires goodwill to be tested forimpairment at least on an annual basis and more often under certaincircumstances, and written down when impaired. An interim impairment test is required if an event occurs or conditionschange that would more likely than not reduce the fair value of the reportingunit below the carrying value.

 

We completed a goodwillimpairment test during the Third Quarter of 2007 and found no need for anadjustment.  Due to the reduced salesactivity in our anti-piracy business for the year 2007 and our internalprojections for 2008, we again revisited the impairment work during our yearend review for 2007 and noted that while the test thresholds were narrower, anadjustment was still not required.  Weplan to closely monitor the sales activity within this segment during eachfiscal quarter of 2008 and, if warranted, will record an impairment loss toadjust downward the carrying value of the segment at that time.

 

Impairment losses are limited to the carrying value ofthe goodwill, which represents the excess of the carrying amount of a reportingunit’s goodwill over the implied fair value of that goodwill.  In determining the estimated future cashflows, the Company considers current and projected future levels of incomebased on management’s plans for that business, as well as business trends,prospects and market and economic conditions.

 

Derivative Instruments. Statement of FinancialAccounting Standards No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS No. 133”), requires all derivatives to berecorded on the balance sheet at fair value.  When multiple derivatives(both assets and liabilities) exist within a financial instrument, they arebundled together as a single hybrid compound instrument in accordance with SFASNo. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple DerivativeFeatures Embedded in a Single Hybrid Instrument”.  The calculation of the fair value ofderivatives utilizes highly subjective and theoretical assumptions that canmaterially affect fair values from period to period.  The change in the fair value of thederivatives from period to period is recorded in other income (expense) in thestatement of operations.  As a result, theCompany’s financial statements are impacted quarterly based on factors such asthe price of the Company’s common stock and the principal amount of Sub-DebtNotes converted into common stock. Consequently, the Company’s results of operations and financial positionmay vary from quarter to quarter based on factors other than those directlyassociated with the Company’s operating revenues and expenses.  The recognition of these derivative amountsdoes not have any impact on cash flows.

 

EITF 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock (“EITF 00-19”), requires freestanding contracts that aresettled in a company’s own stock, including common stock warrants, to bedesignated as an equity instrument, an asset or a liability.  When theability to physically or net-share settle a conversion option or the exerciseof freestanding options or warrants is deemed to be not within the control ofthe Company, the embedded conversion option or freestanding options or warrantsmay be required to be accounted for as a derivative liability.  Under the provisions of EITF 00-19, acontract designated as an asset or a liability must be carried at fair value ona company’s balance sheet, with any changes in fair value recorded in a company’sresults of operations.

 

The Company has accountedfor registration rights penalties in accordance with EITF 00-19-2, “Accountingfor Registration Payment Arrangements”, which the Company adopted as of December 31,2006, and Statement of Financial Accounting Standards No. 5, “Accountingfor Contingencies”.  Since the registration rights component of thederivative liabilities was not material through September 30, 2006, therewas no cumulative-effect adjustment recorded as a result of the transition rules withrespect to the adoption of EITF-00-19-2 at December 31, 2006.

 

The Company accounts forderivatives, including the embedded derivatives associated with the Sub-DebtNotes and the warrants issued in conjunction with the Senior Financing and theSub-Debt Financing, at fair value, adjusted at the end of each reporting periodto reflect any material changes, with any such changes included in other income(expense) in the statement of operations.

 

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At the date of theconversion of Sub-Debt Notes into common stock or the principal repayment ofSenior Notes, the pro rata portion of the related unamortized discount on debtand deferred financing costs is charged to operations and included in otherincome (expense).  At the date ofexercise of any of the warrants, or the conversion of Sub-Debt Notes intocommon stock, the pro rata portion of the fair value of the related warrantliability and/or embedded derivative liability is transferred to additionalpaid-in capital.

 

Income Taxes.  The Company accounts for income taxes underStatement of Financial Accounting Standards No. 109, “Accounting forIncome Taxes” (“SFAS No. 109”). SFAS No. 109 requires recognition of deferred tax assets andliabilities for the expected future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled.  The effect on deferred tax assets andliabilities of a change in tax rates is recognized in the statement ofoperations in the period that includes the enactment date.  A valuation allowance is established, whennecessary, to reduce deferred tax assets to the amount expected to be realized.

 

Accounts Receivable.  The Company grants credit to its customers generallyin the form of short-term trade accounts receivable.  Accounts receivable are stated at the amountthat management expects to collect from outstanding balances.  When appropriate, management provides forprobable uncollectible amounts through a provision for doubtful accounts and anadjustment to a valuation allowance. Management primarily determines the allowance based on the aging ofaccounts receivable balances, historical write-off experience, customer concentrations,customer creditworthiness and current industry and economic trends.  Balances that are still outstanding aftermanagement has used reasonable collection efforts are written off through acharge to the valuation allowance and a credit to accounts receivable.  Concentrations of credit risk with respect totrade receivables generated by the Company’s operations are generallylimited.  However, MediaDefender’scustomers consist primarily of large reputable companies in the music andentertainment industries.

 

Adoption of NewAccounting Policies:

 

In June 2006, theEmerging Issues Task Force (“EITF”) reached a consensus on EITF Issue 06-3, “HowTaxes Collected From Customers and Remitted to Governmental Authorities ShouldBe Presented in the Income Statement (That Is, Gross versus Net Presentation)”(“EITF 06-3”).  The scope of EITF 06-3includes any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction between a seller and a customer, andprovides that a company may adopt a policy of presenting taxes either on agross basis - that is, including the taxes within revenue - or on a netbasis.  For any such taxes that arereported on a gross basis, a company should disclose the amounts of those taxesfor each period for which an income statement is presented if those amounts aresignificant.  The Company collectsvarious state sales taxes that fall under the scope of EITF 06-3 on goods thatit sells in its e-commerce business segment and is accounting for and reportingsuch taxes on a net basis.  EITF 06-3 iseffective for financial reports for interim periods and annual reportingperiods beginning after December 15, 2006. The Company adopted EITF 06-3 effective January 1, 2007.  The adoption of EITF 06-3 did not have amaterial effect on the Company’s financial statements.

 

In December 2006,the Financial Accounting Standards Board (“FASB”) issued FSP EITF 00-19-2, “**Accounting forRegistration Payment Arrangements” (“EITF 00-19-2”), which**addresses an issuer’s accounting for registration payment arrangements.  EITF 00-19-2 specifies that the contingentobligation to make future payments or otherwise transfer consideration under aregistration payment arrangement, whether issued as a separate agreement orincluded as a provision of a financial instrument or other agreement, should beseparately recognized and measured in accordance with SFAS No. 5, “**Accounting forContingencies”**. EITF 00-19-2 further clarifies that a financial instrument subject to aregistration payment arrangement should be accounted for in accordance withother applicable generally accepted accounting principles without regard to thecontingent obligation to transfer consideration pursuant to the registrationpayment arrangement.  EITF 00-19-2 iseffective immediately for registration payment arrangements and the financialinstruments subject to those arrangements that are entered into or modifiedsubsequent to the date of issuance of EITF 00-19-2.  For registration payment arrangements and financialinstruments subject to those arrangements that were entered into prior to theissuance of EITF 00-19-2, EITF 00-19-2 is effective for financial statementsissued for fiscal years beginning after December 15, 2006, and interimperiods within those fiscal years.  Earlyadoption of EITF 00-19-2 for interim or annual periods for which financialstatements or interim reports have not been issued is permitted.  The Company chose to early adopt EITF 00-19-2effective December 31, 2006.

 

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Effective January 1,2007, the Company adopted FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed orexpected to be claimed on a tax return should be recorded in the financialstatements.  Under FIN 48, the Companymay recognize the tax benefit from an uncertain tax position only if it is morelikely than not that the tax position will be sustained on examination by thetaxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financialstatements from such a position should be measured based on the largest benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement.  FIN 48 alsoprovides guidance on de-recognition, classification, interest and penalties onincome taxes, accounting in interim periods and requires increaseddisclosures.  The adoption of the provisionsof FIN 48 did not have a material effect on the Company’s financialstatements.  As of December 31,2007, no liability for unrecognized tax benefits was required to be recorded.

 

The Company files incometax returns in the U.S. federal jurisdiction and various states.  The Company is subject to U.S. federal orstate income tax examinations by tax authorities for years after 2003 (see Note11).

 

The Company’s policy isto record interest and penalties on uncertain tax provisions as income taxexpense

 

Recent AccountingPronouncements:

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”),which establishes a formal framework for measuring fair value under GenerallyAccepted Accounting Principles (“GAAP”). SFAS No. 157 defines and codifiesthe many definitions of fair value included among various other authoritativeliterature, clarifies and, in some instances, expands on the guidance forimplementing fair value measurements, and increases the level of disclosurerequired for fair value measurements. Although SFAS No. 157 applies to andamends the provisions of existing FASB and American Institute of CertifiedPublic Accountants (“AICPA”) pronouncements, it does not, of itself, requireany new fair value measurements, nor does it establish valuation standards.SFAS No. 157 applies to all other accounting pronouncements requiring orpermitting fair value measurements, except for: SFAS No. 123R, share-basedpayment and related pronouncements, the practicability exceptions to fair valuedeterminations allowed by various other authoritative pronouncements, and AICPAStatements of Position 97-2 and 98-9 that deal with software revenue recognition.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those fiscalyears. The Company is currently assessing the potential effect of SFAS No. 157on its financial statements.

 

In February 2007,the FASB issued Statement of Financial Accounting Standards No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”),which provides companies with an option to report selected financial assets andliabilities at fair value. SFAS No. 159’s objective is to reduce bothcomplexity in accounting for financial instruments and the volatility inearnings caused by measuring related assets and liabilities differently.Generally accepted account principles have required different measurementattributes for different assets and liabilities that can create artificialvolatility in earnings. SFAS No. 159 helps to mitigate this type ofaccounting-induced volatility by enabling companies to report related assetsand liabilities at fair value, which would likely reduce the need for companiesto comply with detailed rules for hedge accounting. SFAS No. 159also establishes presentation and disclosure requirements designed tofacilitate comparisons between companies that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159requires companies to provide additional information that will help investorsand other users of financial statements to more easily understand the effect ofthe company’s choice to use fair value on its earnings. SFAS No. 159 alsorequires companies to display the fair value of those assets and liabilitiesfor which the company has chosen to use fair value on the face of the balancesheet. SFAS No. 159 does not eliminate disclosure requirements included inother accounting standards, including requirements for disclosures about fairvalue measurements included in SFAS No. 157 and SFAS No. 107.SFAS No. 159 is effective as of the beginning of a company’s firstfiscal year beginning after November 15, 2007. Early adoption is permittedas of the beginning of the previous fiscal year provided the company makes thatchoice in the first 120 days of that fiscal year and also elects to applythe provisions of SFAS No. 157. The Company is currently assessing thepotential effect of SFAS No. 159 on its financial statements.

 

23

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In December 2007, the FASB issuedSFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”),which requires an acquirer to recognize in its financial statements as ofthe acquisition date (i) the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree, measured at theirfair values on the acquisition date, and (ii) goodwill as the excess ofthe consideration transferred plus the fair value of any noncontrollinginterest in the acquiree at the acquisition date over the fair values of theidentifiable net assets acquired.  Acquisition-relatedcosts, which are the costs an acquirer incurs to effect a business combination,will be accounted for as expenses in the periods in which the costs areincurred and the services are received, except that costs to issue debt orequity securities will be recognized in accordance with other applicableGAAP.  SFAS No. 141(R) makessignificant amendments to other Statements and other authoritative guidance toprovide additional guidance or to conform the guidance in that literature tothat provided in SFAS No. 141(R). SFAS No. 141(R) also provides guidance as to what informationis to be disclosed to enable users of financial statements to evaluate thenature and financial effects of a business combination.  SFAS No. 141(R) is effectivefor financial statements issued for fiscal years beginning on or after December 15,2008. Early adoption is prohibited. The Company has not yet determined theeffect on its consolidated financial statements, if any, upon adoption of SFAS No. 141(R).

 

In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51”(“SFAS No. 160”), which revises the relevance, comparability, andtransparency of the financial information that a reporting entity provides inits consolidated financial statements by establishing accounting and reportingstandards that require (i) the ownership interests in subsidiaries held byparties other than the parent be clearly identified, labeled, and presented inthe consolidated statement of financial position within equity, but separatefrom the parent’s equity, (ii) the amount of consolidated net incomeattributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated statement of income, (iii) changesin a parent’s ownership interest while the parent retains its controllingfinancial interest in its subsidiary be accounted for consistently as equitytransactions, (iv) when a subsidiary is deconsolidated, any retainednoncontrolling equity investment in the former subsidiary be initially measuredat fair value, with the gain or loss on the deconsolidation of the subsidiarybeing measured using the fair value of any noncontrolling equity investmentrather than the carrying amount of that retained investment, and (v) entitiesprovide sufficient disclosures that clearly identify and distinguish betweenthe interests of the parent and the interests of the noncontrolling owners.SFAS No. 160 amends FASB No. 128 to provide that the calculation ofearnings per share amounts in the consolidated financial statements willcontinue to be based on the amounts attributable to the parent. SFAS No. 160is effective for financial statements issued for fiscal years, and interimperiods within those fiscal years, beginning on or after December 15,2008. Early adoption is prohibited. SFAS No. 160 shall be appliedprospectively as of the beginning of the fiscal year in which it is initiallyapplied, except for the presentation and disclosure requirements, which shallbe applied retrospectively for all periods presented. The requirements of SFASNo. 160 does not apply to the Company as it is currently structured.

 

On March 19,2008—The Financial Accounting Standards Board (FASB) issued FASB Statement No. 161,Disclosures about Derivative Instruments and Hedging Activities. The newstandard is intended to improve financial reporting about derivativeinstruments and hedging activities by requiring enhanced disclosures to enableinvestors to better understand their effects on an entity’s financial position,financial performance, and cash flows. It is effective for financial statementsissued for fiscal years and interim periods beginning after November 15,2008, with early application encouraged. The Company is currently assessing the potential effect of FASB No. 161on its financial statements.

 

 

24

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Results of Operations - Years Ended December 31,2007 and 2006:

 

The table shown below presents information withrespect to the Company’s consolidated statements of operations as to actualamounts and as a percentage of total net revenue, for the years ended December 31,2007 and 2006.

 
| ** **                                                                                                                                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                                                            | ** ** | **$**                                       | ** ** | **$** | ** ** | **%** | ** ** | **%** | ** ** |
| Net revenue                                                                                                                                                                                           |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                                                                            |       | $                                           | 1,497      |   | 6.2 | % | $ | 2,649 |   | 11.0 | % |
| Media                                                                                                                                                                                                 |       | 7,500                                       |       | 31.0 | % | 5,670 |   | 23.6 | % |
| Anti-piracy and  file-sharing marketing services                                                                                                                                                      |       | 15,174                                      |       | 62.8 | % | 15,743 |   | 65.4 | % |
| Total net  revenue                                                                                                                                                                                    |       | 24,171                                      |       | 100.0 | % | 24,062 |   | 100.0 | % |
| Cost of revenue:                                                                                                                                                                                      |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                                                                            |       | 1,531                                       |       | 6.3 | % | 2,495 |   | 10.4 | % |
| Media                                                                                                                                                                                                 |       | 3,688                                       |       | 15.3 | % | 3,088 |   | 12.8 | % |
| Anti-piracy and  file-sharing marketing services                                                                                                                                                      |       | 9,414                                       |       | 38.9 | % | 7,797 |   | 32.4 | % |
| Total cost of  revenue                                                                                                                                                                                |       | 14,633                                      |       | 60.5 | % | 13,380 |   | 55.6 | % |
| Gross profit                                                                                                                                                                                          |       | 9,538                                       |       | 39.5 | % | 10,682 |   | 44.4 | % |
| Operating  expenses:                                                                                                                                                                                  |       |                                        |       |   |   |   |   |   |   |
| Sales and  marketing                                                                                                                                                                                  |       | 1,993                                       |       | 8.2 | % | 1,163 |   | 4.9 | % |
| General and  administrative (including stock-based compensation)                                                                                                                                      |       | 10,867                                      |       | 45.0 | % | 9,918 |   | 41.2 | % |
| Development and  engineering                                                                                                                                                                          |       | 525                                         |       | 2.2 | % | — |   | — | % |
| Write-off of fixed  assets                                                                                                                                                                            |       | 97                                          |       | 0.4 | % | — |   | — | % |
| Total operating  costs                                                                                                                                                                                |       | 13,482                                      |       | 55.8 | % | 11,081 |   | 46.1 | % |
| Loss from  operations                                                                                                                                                                                 |       | (3,944                                      | )          | (16.3 | )% | (399 | ) | (1.7 | )% |
| Interest income                                                                                                                                                                                       |       | 211                                         |       | 0.9 | % | 126 |   | 0.5 | % |
| Interest expense                                                                                                                                                                                      |       | (7,923                                      | )          | (32.8 | )% | (5,852 | ) | (24.3 | )% |
| Loss on foreign currency                                                                                                                                                                              |       | (14                                         | )          | (0.1 | )% | — |   | — | % |
| Other income                                                                                                                                                                                          |       | —                                      |       | — | % | 57 |   | 0.2 | % |
| Liquidated  damages under registration rights agreements                                                                                                                                              |       | 395                                         |       | 1.6 | % | (3,777 | ) | (15.7 | )% |
| Change in fair  value of warrant liability                                                                                                                                                            |       | 4,551                                       |       | 18.8 | % | 1,124 |   | 4.7 | % |
| Change in fair  value of derivative liability                                                                                                                                                         |       | 18,043                                      |       | 74.7 | % | 7,792 |   | 32.4 | % |
| Reduction in  exercise price of warrants                                                                                                                                                              |       | —                                      |       | — | % | (641 | ) | (2.6 | )% |
| Amortization of  deferred financing costs                                                                                                                                                             |       | (841                                        | )          | (3.4 | )% | (858 | ) | (3.6 | )% |
| Write-off of  unamortized discount on debt and deferred financing costs resulting from  principal payments on senior secured notes payable and conversions of  subordinated convertible notes payable |       | —                                      |       | — | % | (1,624 | ) | (6.7 | )% |
| Income (loss)  before income taxes                                                                                                                                                                    |       | 10,478                                      |       | 43.4 | % | (4,052 | ) | (16.8 | )% |
| Tax (benefit)  provision for income taxes                                                                                                                                                             |       | (1,039                                      | )          | (4.3 | )% | 838 |   | 3.5 | % |
| Net income  (loss)                                                                                                                                                                                    |       | $                                           | 11,517     |   | 47.7 | % | $ | (4,890 | ) | (20.3 | )% |
| Consolidated  Statements of Operations ($000):                                                                                                                                                        |       |                                        |       |   |   |   |   |   |   |

 

The Company evaluates performance based on, amongother factors, earnings or loss before interest, taxes, depreciation andamortization (“Adjusted EBITDA”), which is a non-GAAP financial measure.  Adjusted EBITDA also excludes stock-basedcompensation, changes in the fair value of warrant liability and derivativeliability, and other non-cash write-offs and charges.  Management excludes these items in assessingfinancial performance, primarily due to their non-operational nature or becausethey are outside of the Company’s normal operations.  The Company has provided this informationbecause management believes that it is useful to investors in understanding theCompany’s financial condition and results of operations.

 

25

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Management believes that Adjusted EBITDA enhances anoverall understanding of the Company’s financial performance by investorsbecause it is frequently used by securities analysts and other interestedparties in evaluating companies in its industry segment.  In addition, management believes thatAdjusted EBITDA is useful in evaluating the Company’s operating performancecompared to that of other companies in its industry segment because thecalculation of Adjusted EBITDA eliminates the accounting effects of financingcosts, income taxes and capital spending, which items may vary for different companiesfor reasons unrelated to overall operating performance.

 

However, Adjusted EBITDA has certain limitations.  Adjusted EBITDA is not a recognizedmeasurement under GAAP, and when analyzing the Company’s operating performance,investors should use Adjusted EBITDA in addition to, and not as an alternativefor, standard GAAP financial measures such as net income (loss) or cash flowfrom operations, or any other measure utilized in determining the Company’soperating performance that is calculated in accordance with GAAP.  Because Adjusted EBITDA is not calculated inaccordance with GAAP, it may not be comparable to similarly-titled measuresutilized by other companies.  AdjustedEBITDA eliminates certain substantial recurring items from net income (loss),such as depreciation, amortization, interest expense and income taxes, amongothers.  Each of these items has beenincurred in the past, will continue to be incurred in the future, and should beconsidered in the overall evaluation of the Company’s operatingperformance.  The Company compensates forthese limitations by providing the relevant disclosure of the items excluded inthe calculation of Adjusted EBITDA, both in the reconciliation to the GAAPfinancial measure of net income (loss) and in the consolidated financialstatements and footnotes, all of which should be considered when evaluating theCompany’s operating performance. Furthermore, Adjusted EBITDA is not intended to be a measure of theCompany’s free cash flow or liquidity in general, as it does not considercertain ongoing cash requirements, such as a required debt service payments andincome taxes.

 

Included in Adjusted EBITDA are direct operatingexpenses for each segment.  Corporateexpenses consist of general operating expenses that are not directly related tothe operations of the segments

 

The table shown below summarizes net revenue andAdjusted EBITDA by operating segment for the years ended December 31, 2007and 2006, respectively.  A reconciliationof Net Income (Loss) to Adjusted EBITDA is also provided.

 
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | **(in thousands)**                     | ** ** |
| Net Revenue:                                             |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | 1,497      |   | $ | 2,649 |   |
| Media                                                    |       | 7,500                                       |       | 5,670 |   |
| Anti-piracy and  file-sharing marketing services         |       | 15174                                       |       | 15,743 |   |
|                                                     |       | $                                           | 24,171     |   | $ | 24,062 |   |
|                                                     |       |                                        |       |   |   |
| Adjusted EBITDA:                                         |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | (218       | ) | $ | 6 |   |
| Media                                                    |       | 2,604                                       |       | 1,919 |   |
| Anti-piracy and  file-sharing marketing services         |       | 5,304                                       |       | 8,935 |   |
|                                                     |       | 7,690                                       |       | 10,860 |   |
| Corporate:                                               |       |                                        |       |   |   |
| General and  administrative expenses                     |       | (4,824                                      | )          | (4,672 | ) |
| Liquidated  damages under registration rights agreements |       | 395                                         |       | (3,777 | ) |
|                                                     |       | $                                           | 3,261      |   | $ | 2,411 |   |

 

26

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| ** **                                                                                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Reconciliation  of Adjusted EBITDA to Net Income (Loss):                                                                                                                                             |       |                                        |       |   |   |
| Adjusted EBITDA  per segments                                                                                                                                                                        |       | $                                           | 3,261      |   | $ | 2,411 |   |
| Stock-based  compensation                                                                                                                                                                            |       | (2,110                                      | )          | (2,281 | ) |
| Depreciation and  amortization                                                                                                                                                                       |       | (1,015                                      | )          | (554 | ) |
| Amortization of  intangible assets                                                                                                                                                                   |       | (3,602                                      | )          | (3,752 | ) |
| Amortization of  deferred financing costs                                                                                                                                                            |       | (841                                        | )          | (858 | ) |
| Reduction in  exercise price of warrants                                                                                                                                                             |       | —                                      |       | (641 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs resulting from  principal payments on senior secured notes payable and conversion of  subordinated convertible notes payable |       | —                                      |       | (1,624 | ) |
| Interest income                                                                                                                                                                                      |       | 211                                         |       | 126 |   |
| Other income                                                                                                                                                                                         |       | —                                      |       | 57 |   |
| Write-off of  fixed assets                                                                                                                                                                           |       | (97                                         | )          | — |   |
| Interest  expense, including amortization of discount on debt of $3,081 and $3,142 in  2007 and 2006, respectively                                                                                   |       | (7,923                                      | )          | (5,852 | ) |
| Change in fair  value of warrant liability                                                                                                                                                           |       | 4,551                                       |       | 1,124 |   |
| Change in fair  value of derivative liability                                                                                                                                                        |       | 18,043                                      |       | 7,792 |   |
| Provision for  income taxes                                                                                                                                                                          |       | 1,039                                       |       | (838 | ) |
| Net income  (loss)                                                                                                                                                                                   |       | $                                           | 11,517     |   | $ | (4,890 | ) |

 

Net Revenue. The Company’s net revenue increased by $109,000 or 0.5%, to $24,171,000for the year ended December 31, 2007, as compared to $24,062,000 for theyear ended December 31, 2006.

 

MediaDefender provided revenue of $15,174,000 for theyear ended December 31, 2007, as compared to $15,743,000 for the yearended December 31, 2006.  During2006, MediaDefender’s revenues included $580,000 from file-sharing marketingservices (including $500,000 from a short-term program with a new entertainmentservices customer during the three months ended June 30, 2006), no similarrevenues were recorded during 2007.

 

MediaDefender’srevenue for the year ended December 31, 2007 was negatively impacted byapproximately $600,000 of service credits provided to customers (which wererecorded as a reduction to revenues) as a result of the online security breachthat occurred in mid-September 2007. During the weekend of September 15 and 16, 2007,MediaDefender experienced an unlawful online security breach by hackers, whichresulted in approximately 6,000 e-mails, as well as access to otherconfidential information and data, for the period from mid-December 2006through September 10, 2007 being stolen and posted at numerous web-siteson the Internet.  These e-mails containedconfidential information and communications covering a wide variety of internalissues, including personal data, customer data and pricing information, andother sensitive information.  This matterhas been referred to the appropriate federal, state and local law enforcementorganizations and an investigation is ongoing. An internal investigation of this matter is continuing. As a result ofwhich the Company has revised various procedures and policies and enhanced itsonline and Internet security protocols.

 

During 2007,MediaDefender began offering advertisers specific programs to download brandedcontent on file-sharing networks and recognized $560,000 in connection withsuch activity.

 

MediaDefender’s revenueaccounted for 62.8% of the Company’s total net revenue for the year ended December 31,2007, as compared to 65.4% of the Company’s total net revenue for the yearended December 31, 2006.  TheCompany expects that revenues from MediaDefender will continue to represent asignificant proportion of its total revenues for the foreseeable future.

 

During the year ended December 31,2007, approximately 31% of MediaDefender’s revenues were from two customers,with one customer accounting for 18% and another customer accounting for13%.  During the year ended December 31,2006, approximately 73% of MediaDefender’s revenues were from four customers,with one customer accounting for 27%, another customer accounting for 25%, athird customer accounting for 11%, and a fourth customer accounting for10%.  In January of 2008,MediaDefender was notified by a customer accounting for 12% of 2007 revenue,that they were discontinuing service and were evaluating the use of othermethods to offset the negative impact of piracy.  In November of 2007, a record labelcustomer, which accounted for 4% of MediaDefenders’ 2007 revenue, also discontinuedservice citing cost pressures subsequent to a change in ownership.

 

27

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Media revenue increased by $1,830,000, or 32.3%, to$7,500,000 for the year ended December 31, 2007, as compared to $5,670,000for the year ended December 31, 2006. Media revenueincreased in 2007 as compared to 2006 as a result of the Company entering intoa strategic partnership with T-Mobile in April 2007 with the launchof a specially designed United Kingdom counterpart to the Company’s UnitedStates-based online music destination web-site. The United Kingdom version of ARTISTdirect.com (www.ARTISTdirect.com/uk)includes numerous T-Mobile enhancements, including exclusive branded contentprovided by T-Mobile.  During the year ended December 31, 2007,approximately $1,270,000 or 17% of media revenues were generated by T-Mobile.

 

The Company markets and sells advertising on a CPMbasis to advertising agencies and directly to various companies seeking toreach one or more of the distinct demographic audiences viewing content in theARTISTdirect Network.  The Company alsomarkets and sells sponsorships for various portions of the ARTISTdirectNetwork.  Customers may purchaseadvertising space on the entire ARTISTdirect Network, or they may tailoradvertising to specific areas or sections of the Company’s web-sites.

 

During the year ended December 31, 2007, theCompany’s media revenues were generated primarily by two outside salesorganizations that represented the Company with respect to advertising andsponsorship sales on the Company’s web-site and through affiliated web-sites,as well as by in-house sales personnel. During the year ended December 31,2006, the Company’s media revenues were generated primarily by one outsidesales organization that represented the Company with respect to advertising andsponsorship sales on the Company’s web-site and through affiliatedweb-sites.  In February 2007, the Companyhired an advertising industry veteran as vice president of worldwide sales tobe responsible for domestic and international advertising and sales initiativesto compliment the efforts of the Company’s outside sales agencies.

 

During the year ended December 31, 2007, onecustomer accounted for $1,270,000 or 16% of total media revenue.  During the year ended December 31, 2006,a different customer accounted for $730,000 or 13% of total media revenue.

 

E-commerce revenue decreased by $1,152,000, or 43.5%,to $1,497,000 for the year ended December 31, 2007, as compared to$2,649,000 for the year ended December 31, 2006.  Due to limited opportunities for revenuegrowth and acceptable gross margins, the Company has been de-emphasizinge-commerce activities over the past few years. During the years ended December 31, 2007 and 2006, approximately 59%and 67% of e-commerce revenues were generated from the products related to asingle music merchandising entity. Effective August 31, 2007, the Company restructured its relationship with thismerchandising entity to eliminate such merchandise sales and focus on musicsales, which had a negative impact on e-commerce sales for the remainder of2007, and will have a significant negative impact on future e-commercerevenues, although such restructuring is expected to have limited impact onoperating margins.

 

Cost of Revenue. The Company’s total cost of revenue increased by $1,253,000 or 9.4%, to$14,633,000 for the year ended December 31, 2007, as compared to$13,380,000 for the year ended December 31, 2006.  Depreciation of property and equipment isincluded in cost of revenue for all business segments.

 

MediaDefender’s cost of revenue was $9,414,000 or62.0% of its net revenue in 2007, as compared to $7,797,000 or 49.5% of its netrevenue in 2006.  MediaDefender hasexperienced increasing bandwidth, personnel and occupancy costs, which arecontinuing to have a negative impact on cost of revenue in 2007 as compared to2006.  Bandwidth / co-location costsincreased by $1,273,000 in 2007 over the prior year. A contributing factor to thisincrease was MediaDefender’s relocation of its servers to higher qualityco-location facilities and a change in bandwidth providers in early 2007.  These actions were taken in order to improvereliability and increase capacity in anticipation of growth in MediaDefender’santi-piracy services.  Included inMediaDefender’s 2006 cost of revenue are third-party development costs andpayroll and related expenses for in-house development costs incurred in thedesign and production of MediaDefender’s services of approximately$120,000.  Also included in MediaDefender’scost of revenue for the years ended December 31, 2007 and 2006 was theamortization of proprietary technology acquired in the MediaDefendertransaction of $2,534,000.

 

28

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Media cost of revenue increased by $600,000 or 19.4%to $3,688,000 for the year ended December 31, 2007, as compared to$3,088,000 for the year ended December 31, 2006, as a result of theincrease in media revenue discussed above.

 

E-commerce cost of revenue decreased by $964,000, or38.60%, to $1,531,000 for the year ended December 31, 2007, as compared to$2,495,000 for the year ended December 31, 2006, primarily as a result ofthe decrease in e-commerce revenues discussed above.

 

As a result of the foregoing, gross profit was$9,538,000 for the year ended December 31, 2007, as compared to$10,682,000 for the year ended December 31, 2006, reflecting a combinedgross margin of 39.5% and 44.4%, respectively. A summary of gross profit and gross margin by segment is as follows($000):

 
| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Segment:**                                     | ** ** | **Gross  Profit**                           | ** ** | **Gross  Margin** | ** ** | **Gross  Profit** | ** ** | **Gross  Margin** | ** ** |
| E-commerce                                       |       | $                                           | (34        | ) | (2.3 | )% | $ | 154 |   | 5.8 | % |
| Media                                            |       | 3,812                                       |       | 50.8 | % | 2,582 |   | 45.5 | % |
| Anti-piracy and  file-sharing marketing services |       | 5,760                                       |       | 38.0 | % | 7,946 |   | 50.5 | % |
| Totals                                           |       | $                                           | 9,538      |   | 39.5 | % | $ | 10,682 |   | 44.4 | % |

 

Sales and Marketing. The Company’s sales and marketing expense increased by $830,000, or71.4%, to $1,993,000 for the year ended December 31, 2007, as compared to$1,163,000 for the year ended December 31, 2006, primarily as a result ofadditional headcount and personnel-related costs.  Also included in sales and marketing expensefor the years ended December 31, 2007 and 2006 was the amortization ofcustomer relationships acquired in the MediaDefender transaction of $755,000per year.

 

General and Administrative.  The Company’s general and administrativeexpense increased by $949,000 or 9.6%, to $10,867,000 for the year ended December 31,2007, as compared to $9,918,000 for the year ended December 31, 2006.

 

During the years ended December 31, 2007 and2006, the Company incurred legal, accounting, consulting, printing fees andother costs of approximately $1,880,000 and $750,000, respectively, relating tothe preparation and filing of various documents with the SEC (including therestated financial statements and the registration statement), negotiationswith senior and subordinated note holders, review and analysis of variousrestructuring alternatives, amendments to financing agreements, the 2006 annualstockholders meeting, and other ordinary course legal and accountingmatters.  As a result of the events ofdefault related to the Company’s senior and subordinated debt agreements (see PartII - “Going Concern” above), the Company expects to incur significantcontinuing costs in this regard during 2008.

 

For the years ended December 31, 2007 and 2006,general and administrative expense included stock-based compensation costs of$2,110,000 and $2,281,000, respectively, and a provision for doubtful accountsof $203,000 and $705,000, respectively. Also included in general and administrative expense for the years ended December 31,2007 and 2006 was the amortization of non-competition agreements resulting fromthe MediaDefender transaction of $312,000 and $463,000, respectively.

 

Also included in general and administrative expensefor the year ended December 31, 2007 was approximately $244,000 of legal,consulting and other direct costs related to the MediaDefender security breachand $700,000 that was accrued with respect to 2007 contractual performancebonuses payable to senior operating management.

 

Development and Engineering.  The Company incurred $525,000 of developmentand engineering costs for the year ended December 31, 2007. Developmentand engineering costs consist primarily of third-party development costs andpayroll and related expenses for in-house development costs incurred in thedesign and production of the Company’s content and services, includingrevisions to the Company’s web-site.  During the year ended December 31, 2006, these costs were includedin cost of revenues.

 

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** **

Write-Off of FixedAssets. During the year ended December 31, 2007, the Company recorded acharge to operations of $97,000 to write-off the net book value of obsoletecomputer equipment that it does not expect to utilize in future periods.

 

Loss from Operations. As a result of theaforementioned factors, the loss from operations for the year ended December 31,2007 was $3,944,000, as compared to a loss from operations of $399,000 for theyear ended December 31, 2006.

 

Interest Income. Interest income was $211,000 and$126,000 for the years ended December 31, 2007 and 2006, respectively.

 

Interest Expense. Interest expense of $7,923,000 and$5,852,000 for the years ended December 31, 2007 and 2006, respectively,relates to the $15,000,000 of secured notes payable issued in the SeniorFinancing, which bear interest at 11.25% per annum, and the $30,000,000 ofsubordinated convertible notes payable issued in the Sub-Debt Financing, whichbear interest at 4.0% per annum, both of which were issued to finance the acquisitionof MediaDefender in July 2005. Effective January 18, 2007, theinterest rate on the Sub-Debt Financing increased from 4.0% to 12.0% due to thedefault on the Company’s senior and subordinated debt agreements in January 2007(see Part II - “Going Concern”). On August 3, 2007, the Company enteredinto a Waiver and Forbearance Agreement with the holders of the Sub-DebtFinancing pursuant to which the holders agreed to waive their right to chargethe 12.0% default interest rate triggered by the Company’s defaults under theSubordinated Financing transaction documents and instead charge the 4.0%standard interest rate on the Sub-Debt Notes for the period from July 16,2007 through August 31, 2007. Effective September 1, 2007, theinterest rate returned to the 12.0% default interest rate. Included in interestexpense for the year ended December 31, 2007 is interest expense of$251,000 relating to the accrued registration penalty obligation.

 

Additional consideration in the form of warrantsissued to the lenders was accounted for at fair value and recorded as areduction to the carrying amount of the debt, and is being amortized tointerest expense over the term of the debt. Accordingly, the amortization ofthis discount on debt included in interest expense for the years ended December 31,2007 and 2006 was $717,000 and $730,000, respectively.

 

The Sub-Debt Notes contain several embedded derivativefeatures that have been accounted for at fair value. The various embeddedderivative features of the Sub-Debt Notes have been valued at the date ofinception of the Sub-Debt Financing and at the end of each reporting periodthereafter. The value of the embedded derivatives were bifurcated from theSub-Debt Notes and recorded as derivative liability, with the initial amountrecorded as discount on the related Sub-Debt Notes. This discount is beingamortized to interest expense over the life of the Sub-Debt Notes. Accordingly,the amortization of this discount on debt included in interest expense for theyears ended December 31, 2007 and 2006 was $3,081,000 and $3,142,000,respectively.

 

Loss on Foreign Currency Transactions. The loss onforeign currency transactions was $14,000 for the year ended December 31,2007. The Company did not have any loss on foreign currency transactions forthe year ended December 31, 2006.

 

Other Income. Other income was $57,000 for the year ended December 31,2006. The Company did not have any other income for the year ended December 31,2007.

 

Liquidated Damages Under Registration Rights Agreements. In accordancewith EITF 00-19-2, which the Company adopted as of December 31, 2006, andSFAS No. 5, the Company accrued seven months liquidated damages (throughmid-August 2007) under the registration rights agreements aggregatingapproximately $3,777,000 as a charge to operations at December 31, 2006. Asa result of the Company’s registration statement being declared effective on July 6,2007, which was earlier than originally estimated, the Company recorded a netreduction to the original accrual of $395,000 in other income (expense) in thestatement of operations during the year ended December 31, 2007.

 

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Change in Fair Value of Warrant Liability. In accordance with EITF00-19, the fair value of the warrants issued in connection with the financingof the MediaDefender acquisition in July 2005 was recorded as a warrantliability. The carrying value of the warrants is adjusted quarterly to reflectany changes in the fair value such liability and is included in the statementof operations as other income (expense). For the years ended December 31,2007 and 2006, the Company recorded income of $4,551,000 and $1,124,000,respectively, to reflect the change in warrant liability during such periods.

 

Change in Fair Value of Derivative Liability. In accordance with EITF00-19, the fair value of the embedded derivatives was bifurcated from thesubordinated convertible notes payable issued in connection with the financingof the MediaDefender acquisition in July 2005 and recorded as a derivativeliability. The carrying value of the derivative liability is adjusted quarterlyto reflect any changes in the fair value of such liability and is included inthe statement of operations as other income (expense). For the years ended December 31,2007 and 2006, the Company recorded income of $18,043,000 and $7,792,000,respectively, to reflect the change in derivative liability during suchperiods.

 

Reduction in Exercise Price of Warrants. Effective April 7, 2006,the Company entered into various agreements with the investors in its SeniorFinancing and Sub-Debt Financing to amend their respective registration rightsagreements and to amend and waive certain financial covenants.  Inconsideration thereof, the Company offered to temporarily reduce the exerciseprice of the 3,250,000 warrants held by the investors in the Senior Financingfrom $2.00 to $1.85 per share through April 30, 2006, and agreed topermanently reduce the exercise price of the 1,596,744 warrants held by theinvestors in the Sub-Debt Financing from $1.55 to $1.43 per share on certainterms and conditions.  Any exercise of the aforementioned warrants at thereduced exercise price was required to be for cash only.  The conversionprice of the Sub-Debt Notes of $1.55 per share was not affected.  TheCompany also entered into similar agreements, as applicable, and providedidentical temporary and permanent reductions to warrant exercise prices, withBroadband Capital Management LLC (1,516,935 warrants originally exercisable at$1.55 per share) and Libra FE, LP (237,500 warrants originally exercisable at$2.00 per share).  As a result of the aforementioned warrant exerciseprice reductions, during the year ended December 31, 2006, the Companyrecorded a charge to operations for the aggregate fair value of such exerciseprice reductions of $641,000, consisting of $218,000 relating to the warrantsheld by the investors in the Sub-Debt Financing and $423,000 relating to thewarrants held and exercised by the investors in the Senior Financing.

 

Amortization of Deferred Financing Costs. Amortization of deferredfinancing costs was $841,000 and $858,000 for the years ended December 31,2007 and 2006, respectively. Deferred financing costs consist of considerationpaid to third parties with respect to the acquisition and financing of theMediaDefender transaction, including cash payments, subordinated convertiblenotes payable and the fair value of warrants issued for placement agent fees,which were deferred and are being amortized over the term of the related debt.

 

Write-Off of Unamortized Discount on Debt and Deferred Financing CostsResulting from Principal Payments on Senior Secured Notes Payable andConversion of Subordinated Convertible Notes Payable. Deferred financing costsand debt discount costs aggregating $1,624,000 were charged to operations as aresult of the conversion of subordinated convertible notes payable and theprincipal payments on senior secured notes payable during the year ended December 31,2006.

 

Income (Loss) Before Income Taxes. As a result of the aforementionedfactors, income before income taxes was $10,478,000 for the year ended December 31,2007, as compared to a loss before income taxes of $(4,052,000) for the yearended December 31, 2006.

 

Provision (Benefit) for Income Taxes. The Company recorded a benefitfor income taxes of $1,039,000 for the year ended December 31, 2007, as aresult of the carryback of 2007 tax losses to 2005 and 2006. As a result of theprofitable operations of MediaDefender, the non-deductibility of certainnon-cash charges for tax reporting purposes, and permanent limitations on theCompany’s ability to utilize its net operating loss carry-forwards, the Companyrecorded a provision for income taxes of $838,000 for the year ended December 31,2006.

 

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Net Loss. As a result of the foregoing factors, netincome was $11,517,000 for the year ended December 31, 2007, as comparedto a net loss of $(4,890,000) for the year ended December 31, 2006.

 

Liquidity and Capital Resources:

 

Going Concern:

 

As more fully described above at “Going Concern”, as aresult of communications with the Staff of the SEC in 2006, in particularregarding the application of accounting rules and interpretations relatedto embedded derivatives associated with the Company’s subordinated convertiblenotes payable issued in July 2005, the Company determined that it wasnecessary to restate previously issued financial statements.

 

As a result, in December 20, 2006, the Companywas required to suspend the use of its then effective registration statementfor the holders of its senior and subordinated indebtedness, which thentriggered an event of default with respect to its registration rights agreementswith the holders of such indebtedness. Accordingly, beginning December 20,2006, the Company began to incur liquidated damages under its registrationrights agreements aggregating approximately $540,000 per month, and theinterest rate on its subordinated convertible notes payable increased from 4.0%per annum to 12.0% per annum as of January 1, 2007, an increase ofapproximately $183,000 per month. On July 6, 2007, the Company’sregistration statement was declared effective by the SEC, thus making it availableto the investors in the Senior Financing and Sub-Debt Financing.

 

A summary of the registration penalty accrual at December 31,2007 and 2006 is presented below.

 
| ** **                              | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                                    |       |                        |       |                        |       |
| Senior secured  notes payable           |       | $                           | 410,000    |                        | $          | 1,575,000 |   |
| Subordinated  convertible notes payable |       | 1,972,000                   |       | 2,202,000                   |       |
| Total  registration penalty accrual     |       | $                           | 2,382,000  |                        | $          | 3,777,000 |   |

 

A summary of accruedinterest payable at December 31, 2007 and 2006 is presented below.

 
| ** **                              | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                                    |       |                        |       |                        |       |
| Senior secured  notes payable           |       | $                           | 67,000     |                        | $          | 67,000 |   |
| Subordinated  convertible notes payable |       | 3,034,000                   |       | —                      |       |
| Liquidated  damages with respect to:    |       |                        |       |                        |       |
| Senior secured  notes payable           |       | 79,000                      |       | —                      |       |
| Subordinated  convertible notes payable |       | 172,000                     |       | —                      |       |
| Total accrued  interest payable         |       | $                           | 3,352,000  |                        | $          | 67,000 |   |

 

As a result of the requirement to restate previouslyissued financial statements, which resulted in the recording of an embeddedderivative liability, the reclassification of the senior and subordinatedindebtedness to current liabilities, and the recording of liquidated damagespayable under registration rights agreements, the Company was not in compliancewith certain of its financial covenants under both the Senior Financing and theSub-Debt Financing at December 31, 2007 and 2006. Notwithstanding suchdevelopments, the Company believes that it would have been out of compliancewith certain of its financial covenants at December 31, 2007.

 

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The accompanying consolidated financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States of America, which contemplate continuation of the Companyas a going concern. As a result of the foregoing, the Company’s independentregistered public accounting firm, in its report on the Company’s 2007consolidated financial statements, expressed substantial doubt about theCompany’s ability to continue as a going concern. The consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or the amounts and classification ofliabilities that could result from the outcome of this uncertainty.

 

Pursuant to a series of Forbearance and ConsentAgreements with the investors in the Senior Financing, such investors agreed toforbear from the exercise of their rights and remedies under the SeniorFinancing documents as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that existed or that could come into existence duringthe forbearance period, from April 17, 2007 through February 20,2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and$494,446 in February 2008. The payments made by the Company under theForbearance and Consent Agreements were credited against the registration delaycash penalties and interest on the penalties resulting from the Company’sdefault under the various agreements between the Company and the SeniorFinancing investors. On March 17, 2008, the Company entered into aForbearance and Consent Agreement with the investors in the Company’s SeniorDebt Financing, which was effective as of February 20, 2008, whereby theinvestors agreed to forbear from exercising any of their rights and remediesunder the Senior Financing transaction documents through December 31, 2008in exchange for an adjustment in the interest rate associated with the SeniorNotes from 11.25% to 15%, provided the loan is repaid prior to September 30,2008 or 16%, if the loan remains outstanding subsequent to that date.

 

The registration delay penalties and ongoing default interest chargesare continuing to have a significant and material negative impact on theCompany’s operations and cash flows. The Company and its representatives andadvisors are in ongoing discussions with the holders of its senior andsubordinated debt obligations to obtain a waiver of and amendment to certain ofthe financing documents with respect to the events of default, the impact ofthe restatements, the payment of cash penalties and default interest, andvarious related matters. The Company is exploring various alternatives to resolvethe defaults under its senior and secured debt obligations, but is unable topredict the outcome of such negotiations. On February 7, 2008 the Companyretained the services of Salem Partners, LLC, to serve as a financial advisorto the Company in connection with the sale, merger, consolidation,reorganization or other business combination and the restructuring of thematerial terms of the Company’s senior notes and/or subordinated convertiblenotes. To the extent that the Company is unable to complete a sale or merger orrestructure its senior and subordinated debt obligations in a satisfactorymanner, and the lenders begin to exercise additional remedies to enforce theirrights, the Company will not have sufficient cash resources to maintain itsoperations. In such event, the Company may be required to consider a formal orinformal restructuring or reorganization, including a filing under Chapter 11of the United States Bankruptcy Code.

 

Overview:

 

Until the acquisition of MediaDefender effective July 28, 2005,the Company financed its continuing operations primarily from the sale of itsequity securities. Concurrent with the acquisition of MediaDefender in July 2005,the Company completed a $15,000,000 Senior Financing and a $30,000,000 Sub-DebtFinancing, which generated approximately $1,000,000 for general working capitalpurposes. In addition, MediaDefender had working capital of $2,745,000 at theacquisition date.

 

As of December 31, 2007 and 2006, the Company had $4,268,000 and$5,602,000 of unrestricted cash and cash equivalents, respectively.

 

At December 31, 2007, the Company had a working capital deficiencyof $32,273,000, primarily because of the classification of senior secured notespayable and subordinated convertible notes payable as current liabilities, theaccrual of default interest on the subordinated convertible notes payable of$3,034,000, liquidated damages payable under registration rights agreements of$2,382,000, and warrant liability of $164,000 and derivative liability of$313,000 at such date.

 

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At December 31, 2006, the Company had a working capital deficiencyof $50,763,000, primarily because of the classification of senior secured notespayable and subordinated convertible notes payable as current liabilities, theaccrual of liquidated damages payable under registration rights agreements of$3,777,000, and warrant liability of $4,715,000 and derivative liability of$18,356,000 at such date.

 

The decrease in the working capital deficiency at December 31,2007 as compared to December 31, 2006 of $18,490,000 was primarilyattributable to a decrease in warrant liability and derivative liabilityaggregating $22,594,000 during the year ended December 31, 2007.

 

During December 2006, the Company made the required $1,050,000cash payment to the founders of MediaDefender.

 

During the year ended December 31, 2006, the Company issued2,203,870 shares of common stock upon the conversion of $3,416,000 ofsubordinated convertible notes payable.

 

During 2006 and 2007, the Company’s consolidated operations generatedsufficient cash flows from operations to enable the Company to fund itsoperating requirements and its originally scheduled (i.e., undefaulted) debtservice obligations to both the senior and subordinated debt holders.

 

Operating. Net cash used in operating activities was $1,038,000 for theyear ended December 31, 2007, as compared to net cash provided byoperating activities for the year ended December 31, 2006 of $900,000.Operating cash flow decreased in 2007 as compared to 2006 primarily as a resultof the decrease in operating profitability at MediaDefender.

 

Investing. Net cash used in investing activities for the year ended December 31,2007 was $481,000, which consisted of additions to property and equipment. Netcash used in investing activities for the year ended December 31, 2006 was$2,127,000, which consisted of guaranteed payments to MediaDefender managementof $1,050,000 and additions to property and equipment of $1,077,000. Additionsto property and equipment in 2006 included leasehold improvements related tothe Company’s Santa Monica office facility of $261,000 and purchases ofproperty and equipment of $816,000, primarily by MediaDefender.

 

Financing. Net cash provided by financing activities for the year endedDecember 31, 2007 was $185,000, which consisted of $101,000 from theexercise of stock options and a net decrease of $84,000 in restricted cash thatsecures certain letters of credit. Net cash provided by financing activitiesfor the year ended December 31, 2006 was $3,727,000, which consisted of$5,326,000 from the exercise of warrants and $99,000 from the exercise of stockoptions, offset by principal payments on senior secured notes payable of$1,693,000 and an increase of $5,000 in restricted cash that secures certainletters of credit.

 

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Contractual Obligations:

 

As of December 31, 2007, the Company’s principalcommitments for the next five fiscal years consisted of contractual commitmentsas summarized below. The summary shown below assumes that the senior securednotes payable and the subordinated convertible notes payable are outstandingfor their full terms (based on the original terms as contemplated in the seniorand subordinated loan agreements), without any early reduction of the principalbalances based on cash flows.

 
| ** **                                                                   | ** ** | ** ** | ** ** | **Payments Due by Year (in thousands)** | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------|------------|
| **Contractual cash obligations**                                   | ** ** | **Total**  | ** ** | **2008**                                                         | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
| Employment  contracts (1)                                                    |       | $          | 1,523      |                                                             | $          | 1,490 |   | $ | 33 |   | $ | — |   | $ | — |   |
| Lease  obligations                                                           |       | 4,143      |       | 1,618                                                            |       | 1,442 |   | 613 |   | 470 |   |
| Liquidated  damages payable under registration rights agreements             |       | 2,382      |       | 410                                                              |       | 1,972 |   | — |   | — |   |
| Interest on  liquidated damages payable under registration rights agreements |       | 597        |       | 423                                                              |       | 174 |   | — |   | — |   |
| Senior secured  notes payable                                                |       | 13,307     |       | —                                                           |       | 13,307 |   | — |   | — |   |
| Interest on  senior secured notes payable (2)                                |       | 3,106      |       | 2,047                                                            |       | 1,059 |   | — |   | — |   |
| Subordinated  convertible notes payable                                      |       | 27,658     |       | —                                                           |       | 27,658 |   | — |   | — |   |
| Interest on subordinated  convertible notes payable (3)                      |       | 5,219      |       | 3,319                                                            |       | 1,900 |   | — |   | — |   |
| Total  contractual cash obligations                                          |       | $          | 57,935     |                                                             | $          | 9,307 |   | $ | 47,545 |   | $ | 613 |   | $ | 470 |   |

 

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(1)  Basecompensation only; does not include any performance bonuses.

 

(2)  Assumesinterest at 16% from February 20, 2008 through June 2009.

 

(3)  Assumes interest at 12% default rate throughJuly 2009.

 

Capital Expenditures. The Company estimates that itwill have capital expenditures aggregating approximately $950,000 for the yearending December 31, 2008, primarily related to the expansion ofMediaDefender’s operations.

 

Off-Balance Sheet Arrangements. At December 31,2007, the Company did not have any transactions, obligations or relationshipsthat could be considered off-balance sheet arrangements.

 

**RISKFACTORS**

 

Our actual results may differ materially from thoseanticipated in these forward-looking statements. We operate in a marketenvironment that is difficult to predict and that involves significant risksand uncertainties, many of which will be beyond our control. Refer also to “SpecialNote Regarding Forward-Looking Statements.”

 

**RISKSRELATED TO OUR BUSINESS**

 

***It is difficult toevaluate our business and prospects because we have a limited operating historyand a rapidly evolving business.***

 

We were incorporated under the laws of the state ofDelaware in July 1999. Our limited operating history and rapidly evolvingbusiness make it difficult to evaluate our prospects or to accurately predictour future revenue or results of operations. Our revenue and income potentialare unproven, and our business model is constantly and rapidly evolving. Inparticular, the Internet is constantly changing and we may need to modify ourbusiness model to adapt to these changes.

 

***The music industryis under extreme pressure to reduce costs.***

 

The major music labels are suffering from significantsales and profit deterioration and wherever possible are reducing expenditures.This has negatively impacted the amount of business that MediaDefender hasconducted with these customers and this trend is expected to continue.

 

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***The loss of keypersonnel in the MediaDefender business could adversely affect our businessbecause these individuals are important to our business.***

 

The future success of MediaDefender depends to asignificant extent on the continued services of its senior management, RandySaaf and Octavio Herrera. The loss of these individuals would likely have anadverse effect on our business.

 

***We have substantialdebt obligations, which are materially and adversely affecting our business.***

 

To obtain sufficient cash resources to fund theacquisition of MediaDefender, we incurred approximately $45.0 million worth ofindebtedness. We require substantial amounts of cash to fund scheduled paymentsof interest on the notes issued in the debt transactions, payment of theprincipal amount of the notes, future capital expenditures, payments on ourleases and any increased working capital requirements due to the acquisition.If we are unable to meet our cash requirements out of cash flow fromoperations, there can be no assurance that we will be able to obtainalternative financing.

 

***The success of ourInternet piracy prevention segment depends heavily on the continued success ofMediaDefender’s content protection technology.***

 

If current MediaDefender customers, which include bothmajor movie studios and record labels, determine that the benefits ofMediaDefender’s technology do not justify the expense, or other competitive technologiesare superior than those provided by MediaDefender, demand for its IPPtechnology would decline and our operating results would be significantlyharmed.

 

***Global sales ofrecorded music have recently declined and this trend may continue in the future.***

 

Based on data compiled by The Recording IndustryAssociation of America, or RIAA, the number of CDs shipped from recordcompanies to retail distribution channels fell approximately 10% in 2007 on topof a 13% decline in 2006. According to the RIAA, the decline, in sales had beendue in part, to widespread copying and illegal Internet downloading of music. Ifthe overall trend continues, it may affect our e-commerce business and have amaterial effect on our revenues.

 

***We may not be ableto develop or obtain sufficiently compelling content to attract and retain ourtarget audience.***

 

For our media and e-commerce segments to besuccessful, we must provide content and services that attract consumers whowill purchase music and related merchandise online. We may not be able toprovide consumers with an acceptable mix of products, services, information andcommunity to attract them to our web-sites or to encourage them to remain onour web-sites for an extended period of time. If our audience determines thatour content does not reflect its tastes, then our audience size could decreaseor the demographic characteristics of our audience could change and we may beunable to react to those changes effectively or in a timely manner. Any ofthese results would adversely affect our ability to attract advertisers andsell music and other related merchandise.

 

***We depend on alimited number of customers and if we were to lose any of these customers, ourbusiness could be adversely affected.***

 

During the year ended December 31, 2007, onecustomer accounted for $1.3 million, or 16.0% of total media revenue. During2006, no one customer accounted for more than 10.0% of our media revenue. Duringthe year ended December 31, 2007, approximately 68% of MediaDefender’srevenues were from four customers. Two of those four customers accounted for21% and 18% of MediaDefenders revenues. In January of 2008 MediaDefenderwas notified by a customer accounting for 12% of 2007 revenue, that they werediscontinuing service and were evaluating the use of other methods to offsetthe negative impact of piracy. In November of 2007, a record labelcustomer, which accounted for 4% of MediaDefenders’ 2007 revenue, alsodiscontinued service citing costs pressures subsequent to a change in ownership.Should MediaDefender, lose any of its remaining major customers, our businessand results of operations could be adversely affected. During the year ended December 31,2006, approximately 73% of MediaDefender’s consolidated revenues were from fourcustomers. Of those four customers, two customers accounted for 27.0% and25.0%, respectively.

 

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***If we do not buildand maintain strong brands, we may not be able to attract a significant numberof users to our web-sites.***

 

To attract users we must develop a brand identity forARTISTdirect and increase public awareness of the ARTISTdirect network;however, to conserve cash we have not been able to spend large amounts on offlineand online advertising and promotional efforts to increase brand awareness,traffic and revenue. Accordingly, our marketing activities may not result inincreased revenue and, even if they do, any increased revenue may not offsetthe expenses we incur in building our brands. Moreover, despite these effortswe may be unable to increase public awareness of our brands, which would havean adverse effect on our results of operations.

 

***The market foronline promotion and distribution of music and related merchandise is highlycompetitive and we may not be able to compete successfully against our currentand future competitors.***

 

The market for the online promotion and distributionof music and related merchandise is highly competitive and rapidly changing.There are a significant number of web-sites promoting and distributing musicand related merchandise that compete for the attention and spending ofconsumers, advertisers and users. We face competitive pressures from numerousactual and potential competitors. Our competitors include America Online, MSN,Yahoo!, Amazon.com, MTV, myspace.com, mp3.com, billboard.com and otherweb-sites and traditional music companies.

 

These competitors may be able to respond more quicklyto new or emerging technologies and changes in customer requirements and devotegreater resources to develop, promote and sell their products or services thanwe can. Consumers, artists, talent management companies and other music-relatedvendors or advertisers may perceive web-sites maintained by our existing andpotential competitors as being superior to ours. In addition, increasedcompetition could result in reduced advertising rates and margins and loss ofmarket share, any of which could harm our business.

 

***We depend on alimited number of suppliers for music merchandise, fulfillment and distributionand if we cannot secure alternate suppliers, our business may be harmed.***

 

We rely to a large extent on timely distribution bythird parties. During 2007, we relied on Alliance Entertainment to fulfill anddistribute our orders for music. Our contract with Alliance is through July 2008and our business could be adversely affected if that contract terminateswithout a suitable replacement.

 

***We depend on thirdparty inventory and financial systems and carrier services.***

 

Because we rely on third parties to fulfill orders, wedepend on their systems for tracking inventory and financial data. If ourdistributors’ systems fail or are unable to scale or adapt to changing needs,or if we cannot integrate our information systems with the systems of any newdistributors, we may not have adequate, accurate or timely inventory orfinancial information. We also rely on third-party carriers for shipments toand from distribution facilities. We are therefore subject to the risks,including employee strikes and inclement weather, associated with our carriers’ability to provide delivery services to meet our distribution and shippingneeds. In the past, we have occasionally experienced an unusually high volumeof orders, which resulted in shipping delays to our customers. These delays didnot have a material adverse effect, however, our failure to deliver products toour customers in a timely and accurate manner in the future could harm ourreputation, our relationship with customers, the ARTISTdirect brand and ourresults of operations.

 

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***Our media ande-commerce segments are subject to seasonality, which could adversely affectour operating results.***

 

We have experienced and expect to continue toexperience seasonal fluctuations in our online sales. These seasonal patternswill cause quarterly fluctuations in our operating results. In particular, a disproportionateamount of our online sales have been realized during the fourth calendarquarter and during the summer months, traditionally when artists go on tour.Due to our limited operating history, it is difficult to predict the seasonalpattern of our online sales and the impact of such seasonality on our businessand operating results. Our seasonal online sales patterns may become morepronounced, strain our personnel, warehousing, and order shipment activitiesand cause our operating results to be significantly less than expected for anygiven period.

 

***We may be subjectto system disruptions, which could reduce our revenue.***

 

Our ability to attract and retain artists, users,advertisers and merchants for our online network depends on the performance,reliability and availability of our web-sites and network infrastructure. Ourown staff performs the maintenance and operation of substantially all of ourInternet communications hardware and servers. We have periodic maintenancewindows, and we experience outages from time to time caused by temporaryproblems in our own systems or software. While we have implemented proceduresdesigned to improve the reliability of our systems, these interruptions maycontinue to occur from time to time. Our users also depend on third partyInternet service providers and web-site operators for access to our web-sites.These entities have experienced significant outages in the past, and couldexperience outages, delays and other difficulties due to system failures in thefuture which are unrelated to our systems, but which could nonethelessadversely affect our business.

 

***If we are unable toprotect our intellectual property rights, our competitive position could beharmed or we could be required to incur expenses to enforce our rights.***

 

We rely upon the registered trademark rights in theUnited States for our commercial use of the ARTISTdirect, UBL, Ultimate BandList and other brand names and their respective associated domain names, andthe ARTISTdirect logo. We seek to protect some of our trademarks byregistration and other means and copyrights and other proprietary rights throughconfidentiality requirements and other means, but these actions may beinadequate. It may be possible that some of our innovations may not beprotectable. We have trademark applications pending in several jurisdictions,but our registrations may not be accepted or may be preempted by third partiesand/or we may not be able to register our trademarks in all jurisdictions inwhich we intend to do business. We generally enter into confidentiality orlicense agreements with our employees, consultants and corporate partners, andgenerally attempt to control access to and distribution of our proprietaryinformation.

 

The steps we have taken may not preventmisappropriation of our proprietary rights, or disclosure of trade secrets,particularly in foreign jurisdictions where laws or law enforcement practicesmay not protect our proprietary rights as fully as those in the United States.Confidentiality may be compromised intentionally or accidentally bycontractors, customers, other third parties or our employees. If third partieswere to use or otherwise misappropriate our copyrighted materials, trademarksor other proprietary rights without our consent or approval, our competitiveposition could be harmed, or we could become involved in litigation to enforceour rights. In addition, policing unauthorized use of our content, trademarksand other proprietary rights could be very expensive, difficult or impossible,particularly given the global nature of the Internet, and we may not be able todetermine the existence or extent of any unauthorized use. We also cannot becertain that others will not develop independently equivalent or superiortechnology or intellectual property rights.

 

***Our access tocopyrighted content depends upon the willingness of content owners to maketheir content available.***

 

The music content available on the ARTISTdirectnetwork is typically comprised of copyrighted works owned or controlled bymultiple third parties. Most of the content on our artist-specific web-sites iseither owned or licensed by the artist. On other parts of the ARTISTdirectnetwork, depending on the nature of the content and how we use the musiccontent, we typically license such rights from publishers, record labels,performing rights societies or artists.

 

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We frequently either do not have written contracts orhave short-term contracts with copyright owners, and, accordingly, our accessto copyrighted content depends upon the willingness of such parties to continueto make their content available. If the fees for music content increasesubstantially or if significant music content becomes unavailable, our abilityto offer music content could be materially limited. We have not obtained alicense for some of the content offered on the ARTISTdirect network, includinglinks to other music-related sites and thirty-second streamed song samples,because we believe that a license is not required under existing law. However,this area of law remains uncertain and may not be resolved for a number ofyears. When this area of law is resolved, we may be required to obtain licensesfor such content, alter or remove the content from our web-sites and be forcedto pay potentially significant financial damages for past conduct. We continueto discuss the potential for license arrangements with many of the major musicpublishers.

 

***If our onlinesecurity measures fail, we could lose visitors to our sites and could besubject to claims for damage from our users, content providers, advertisers andmerchants.***

 

Our relationships with consumers would be adverselyaffected and we may be subject to claims for damages if the security measuresthat we use to protect their personal information, especially credit cardnumbers, are ineffective. We rely on security and authentication technologythat we license from third parties to perform real-time credit cardauthorization and verification with our bank. We cannot predict whether eventsor developments will result in a compromise or breach of the technology we useto protect a customer’s personal information. Our infrastructure may bevulnerable to unauthorized access, physical or electronic computer break-ins,computer viruses and other disruptive problems. Internet service providers haveexperienced, and may continue to experience, interruptions in service as aresult of the accidental or intentional actions of Internet users, current andformer employees and others. Anyone who is able to circumvent our securitymeasures could misappropriate proprietary information or cause interruptions inour operations. Security breaches relating to our activities or the activitiesof third-party contractors that involve the storage and transmission ofproprietary information could damage our reputation and our relationships withour content providers, advertisers and merchants. We also could be liable toour content providers, advertisers and merchants for the damages caused by suchbreaches or we could incur substantial costs as a result of defending claimsfor those damages. We may need to expend significant capital and otherresources to protect against such security breaches or to address problemscaused by such breaches. Our security measures may not prevent disruptions orsecurity breaches.

 

***We may be subjectto liability if private information provided by our users were misused.***

 

Our privacy policy discloses how we use individuallyidentifiable information that we collect. This policy is displayed andaccessible throughout the ARTISTdirect network. Despite this policy, however,if third persons were able to penetrate our network security or otherwisemisappropriate our users’ personal information or credit card information, wecould be subject to liability. We could also be subject to liability for claimsfor unauthorized purchases with credit card information, impersonation or othersimilar fraud claims, or other misuses of personal information, such as forunauthorized marketing purposes. These claims could result in costly andtime-consuming litigation.

 

While we attempt to be fully compliant with ourprivacy policy, our efforts may not be entirely successful. In addition, attimes we rely upon outside vendors to maintain data-collection software, andthere can be no assurance that they will at all times comply with ourinstructions to comply with our privacy policy. If our methods of complyingwith our privacy policy are inadequate, or our business practices be found todiffer from our privacy policy, we may face litigation with the FTC, Californiaand other State’s governmental authorities or individuals, which wouldadversely affect our business. It is also possible that users or visitors couldtry to recover damages in a civil action as well.

 

***We may be sued forcontent available or posted on our web-sites or products sold through ourweb-sites or for linking and framing of third-party web-sites.***

 

We may be liable to third parties for contentpublished on our web-sites and other web-sites where our syndicated contentappears if the music, artwork, text or other content available violates theircopyright, trademark or other intellectual property rights or if the availablecontent is defamatory, obscene or pornographic. Similar claims have beenbrought, sometimes successfully, against web-site operators in the past. Wealso may be liable for content uploaded or posted by our users on ourweb-sites, such as digitally distributed music files, postings on our messageboards, chat room discussions and copyrightable works. In addition, we couldhave liability to some of our content licensors for claims made against themfor content available on our web-sites.

 

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We also could be exposed to these types of claims for content that maybe accessed from our web-sites or via links to other web-sites or for productssold through our web-site. While we have resolved all of these types of claimsmade against us in the past, we may not be able to do so in the future. Anylitigation as a result of defending these types of claims could result insubstantial costs and damages. Our insurance may not adequately protect usagainst these types of claims or the costs of their defense or payment ofdamages. We link to and “frame” third-party web-sites of our artists withoutexpress written permission to do so. In addition, in the past we have provideda search feature to allow users to find music residing elsewhere on theInternet. Those practices are controversial, and have, in instances notinvolving us, resulted in litigation. Various claims, including trademark andcopyright infringement, unfair competition, and commercial misappropriation, aswell as infringement of the right of publicity may be asserted against us as aresult. The law regarding linking and framing remains unsettled; it isuncertain as to how existing laws, especially trademark and copyright law, willbe applied by the judiciary to the Internet. Also, Congress is increasinglyactive in passing new laws related to the Internet, and there is uncertainty asto the impact of future potential laws, especially those involving domainnames, databases and privacy.

 

**RISKSRELATED TO OUR CAPITAL STRUCTURE**

 

***The Company has triggered events of default under the termsof the Senior Notes and Sub-Debt Notes, and the outstanding notes may becomedue and payable, and we may not have the ability to meet this obligation.***

 

The Company has triggered various events of defaultunder the terms of the Senior Notes and the Sub-Debt Notes.  Upon the occurrence of an event of default,holders of at least 25% of the outstanding Senior Notes may declare theoutstanding principal and accrued interest on all Senior Notes immediately dueand payable, and each holder of the outstanding Sub-Debt Notes may also demandredemption of all or any portion of their respective notes.   During 2007 the Company entered into aseries of Forbearance Agreements with the investors in the Senior Notes underwhich the investors agreed to forbear from the exercise of their rights underthe Senior Financing documents in exchange for the payment of amounts due forliquidated damages and interest on those damage amounts.  The most recent Senior Note ForbearanceAgreement is effective as of February 20, 2008 with a term extendingthrough December 31, 2008.  TheCompany has no such agreement with the Subordinated Debt investors and wecannot assure you that we will not receive demand requests, and if we do, wemay not have the ability to meet this obligation and this could have a materialnegative impact on our liquidity and cash flow.

 

***During a portion of 2007 the Company failed to maintain aneffective registration statement for the resale of the shares of our holders ofnotes and warrants issued in connection with the acquisition of MediaDefender,which has resulted in cash penalties and which could have a material negativeimpact on our liquidity and cash flow.***

 

Pursuant to registration rights granted to the holdersof our notes and warrants issued in connection with the acquisition ofMediaDefender, the Company was to maintain an effective registration statementcovering the resale of shares of common stock underlying these notes andwarrants.  As discussed under the caption“Going Concern” on page 17 of this document, the Company restated itsfinancial statements and as a result of those restatements, the Form SB-2was not available to the holders of our notes and warrants from December 20,2006 to July 6, 2007.  The financingdocuments provide that while the Form SB-2 remains unavailable for use,the holders of the Senior Notes and the Sub-Notes are entitled to cashpenalties which bear interest until they are paid.  Through December 31, 2007 the Companyincurred a total of $3,633,000 for such charges due the holders of the SeniorDebt and Sub-Debt.  As of February 6,2008, amounts due the Senior Debt were fully paid and as of December 31,2007, $2,143,000 remains outstanding to the Sub Debt and continues to bearinterest at the rate of 1% per month. No payments have been made to the holdersof the Sub Debt and such payments could have a material negative impact on ourliquidity and cash flow.

 

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***Our stock price isvolatile and could decline in the future.***

 

The price of our commonstock may fluctuate in the future.  Thestock market, in general, and the market price for shares of technologycompanies in particular, have experienced extreme stock price fluctuations. Insome cases, these fluctuations have been unrelated to the operating performanceof the affected companies.  Manycompanies in the technology and related industries have experienced dramaticvolatility in the market prices of their common stock.  We believe that a number of factors, bothwithin and outside of our control, could cause the price of our common stock tofluctuate, perhaps substantially.

 

***The limited tradingmarket may cause volatility in the market price of our common stock.***

 

Our common stock is currently traded on a limitedbasis on the Over-the-Counter Bulletin Board under the symbol “ARTD.OB.”  The quotation of our common stock on theOver-the-Counter Bulletin Board does not assure that a meaningful, consistentand liquid trading market currently exists, and in recent years such market hasexperienced extreme price and volume fluctuations that have particularlyaffected the market prices of many smaller companies like us.  Our common stock is thus subject to volatility.In the absence of an active trading market:

 

·                  investorsmay have difficulty buying and selling or obtaining market quotations;

 

·                  marketvisibility for our common stock may be limited; and

 

·                  alack of visibility for our common stock may have a depressive effect on themarket for our common stock.

 

***Our common stock isconsidered a “penny stock” and may be difficult to sell.***

 

Our common stock isconsidered to be a “penny stock” since it meets one or more of the definitionsin Rule 3a51-1 under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”).    The principal result or effectof being designated a “penny stock” is that securities broker-dealers cannotrecommend the stock but must trade in it on an unsolicited basis.  Section 15(g) of the Exchange Actand Rule 15g-2 promulgated thereunder by the SEC require broker-dealersdealing in penny stocks to provide potential investors with a documentdisclosing the risks of penny stocks and to obtain a manually signed and datedwritten receipt of the document before effecting any transaction in a pennystock for the investor’s account.

 

Potential investors in our common stock are urged toobtain and read such disclosure carefully before purchasing any shares that aredeemed to be “penny stock.”  Moreover, Rule 15g-9requires broker-dealers in penny stocks to approve the account of any investorfor transactions in such stocks before selling any penny stock to thatinvestor.  This procedure requires thebroker-dealer to (i) obtain from the investor information concerning hisor her financial situation, investment experience and investment objectives; (ii) reasonablydetermine, based on that information, that transactions in penny stocks aresuitable for the investor and that the investor has sufficient knowledge andexperience as to be reasonably capable of evaluating the risks of penny stocktransactions; (iii) provide the investor with a written statement settingforth the basis on which the broker-dealer made the determination in (ii) above;and (iv) receive a signed and dated copy of such statement from theinvestor, confirming that it accurately reflects the investor’s financialsituation, investment experience and investment objectives.  Compliance with these requirements may makeit more difficult for holders of our common stock to resell their shares tothird parties or to otherwise dispose of them in the market or otherwise.

 

***Standards forcompliance with Section 404 of the Sarbanes-Oxley Act of 2002 areuncertain, and if we fail to comply in a timely manner, our business could beharmed and our stock price could decline.***

 

Rules adopted by the SEC pursuant to Section 404of the Sarbanes-Oxley Act of 2002 require annual assessment of our internalcontrol over financial reporting.  Thestandards that must be met for management to assess the internal control overfinancial reporting as effective are new and complex, and require significantdocumentation, testing and possible remediation to meet the detailedstandards.  We may encounter problems ordelays in completing activities necessary to make an assessment of our internalcontrol over financial reporting.  If wecannot assess our internal control over financial reporting as effective,investor confidence and share value may be negatively impacted.  We expect to incur additional accountingrelated expenses associated with compliance with Section 404.

 

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***If all of theequity-based securities issued by us to finance the acquisition ofMediaDefender are converted or exercised in accordance with their respectiveterms, significant dilution to our existing stockholders will result.***

 

There are currently 10,344,666 shares of our commonstock issued and outstanding.  Assumingthe conversion or exercise of all equity-based securities issued in connectionwith the financing transactions completed to finance the acquisition ofMediaDefender, there will be approximately 38,000,000 shares of our commonstock issued and outstanding (which also assumes exercise of all our currentlyoutstanding options and warrants).  Anysales in the public market of the common stock issuable upon the conversion orexercise of all equity-based securities issued in connection with suchfinancing transactions could adversely affect prevailing market prices of ourcommon stock.

 

***Changes in financial accounting standards or interpretationsof existing standards could affect reported results of operation.***

 

Generally acceptedaccounting principles and accompanying accounting pronouncements,implementation guidelines, and interpretations for many aspects of our businessare complex and involve subjective judgments. Changes in these accounting standards, new accounting pronouncements andinterpretations, by us or by our regulatory agencies, may occur that couldadversely affect the Company’s reported financial position, results ofoperations and/or cash flows.

 

**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

In addition to historical information, this AnnualReport contains statements relating to our future business and/or results,including, without limitation, the statements under the captions “Risk Factors,”“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and “Description of Business.” These statements include certain projections and business trends thatare “forward-looking” within the meaning of the United States PrivateSecurities Litigation Reform Act of 1995. You can identify these statements by the use of words like “may,” “will,”“could,” “should,” “project,” “believe,” “anticipate,” “expect,” “plan,” “estimate,”“forecast,” “potential,” “intend,” “continue” and variations of these words orcomparable words.

 

Forward-looking statements do not guarantee futureperformance and involve risks and uncertainties.  Actual results will differ, and may differmaterially, from projected results as a result of certain risks anduncertainties.  These risks anduncertainties include, without limitation, those described under “Risk Factors”and those detailed from time to time in our filings with the SEC, and include,among others, the following:

 

·                  Ourlimited operating history;

 

·                  Ourability to protect our intellectual property rights;

 

·                  Ourability to successfully develop and commercialize our proposed products;

 

·                  Thedegree and nature of our competition;

 

·                  Ourability to employ and retain qualified employees;

 

·                  Thelimited trading market for our common stock; and

 

·                  Theother factors referenced in this report, including, without limitation, underthe sections entitled “Risk Factors,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” and “Description of Business.”

 

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These risks are not exhaustive.  Other sections of this Annual Report mayinclude additional factors which could adversely impact our business andfinancial performance.  Moreover, weoperate in a very competitive and rapidly changing environment.  New risk factors emerge from time to time andit is not possible for our management to predict all risk factors, nor can weassess the impact of all factors on our business or to the extent to which anyfactor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements.  Given these risks and uncertainties,investors should not place undue reliance on forward-looking statements as aprediction of actual results.  Theseforward-looking statements are made only as of the date of this AnnualReport.  Except for our ongoingobligation to disclose material information as required by federal securitieslaws, we do not intend to update you concerning any future revisions to anyforward-looking statements to reflect events or circumstances occurring afterthe date of this Annual Report.

 

**ITEM 7.****                         FINANCIAL STATEMENTS**

 

Our consolidated financial statements appear in aseparate section of this Annual Report, see “Index to Consolidated FinancialStatements.”  Such information isincorporated herein by reference.

 

**ITEM 8.****                       CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not Applicable.

 

**ITEM 8AT - MANAGEMENT’S ANNUAL REPORTON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting as defined inRules 13a-15(f) under the Exchange Act. Our internal control over financial reporting is designed to ensure thatmaterial information regarding our operations is made available to managementand the board of directors to provide them reasonable assurance that thepublished financial statements are fairly presented.  There are limitations inherent in anyinternal control, such as the possibility of human error and the circumventionor overriding of controls.  As a result,even effective internal controls can provide only reasonable assurance withrespect to financial statement preparation. As conditions change over time so too may the effectiveness of internalcontrols.

 

Disclosure controls and procedures are controls andother procedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms. Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to management, includingthe chief executive officer and chief financial officeras appropriate, to allow timely decisions regarding required disclosure.Management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives, and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

 

It should be noted that during the weekend ofSeptember 15 and 16, 2007, MediaDefender experienced an unlawful onlinesecurity breach by hackers, which resulted in approximately 6,000 e-mails, aswell as access to other confidential information and data, for the period frommid-December 2006 through September 10, 2007 being stolen and posted atnumerous web-sites on the Internet. These e-mails contained confidential information and communicationscovering a wide variety of internal issues, including personal data, customerdata and pricing information, and other sensitive information.  This matter has been referred to theappropriate federal, state and local law enforcement organizations and aninvestigation is ongoing.  An internalinvestigation of this matter is continuing and as a result of this review, theCompany has revised various procedures and policies and enhanced its online andInternet security protocols.  This breachof MediaDefender’s email system did not cross over to the Company’s systems andfinancial records due to the internal controls and procedures the Company hadin place at that time.

 

Our management, with the participation of our interimchief executive officer and interim chief financial officer, has evaluated ourinternal controls over financial reporting as of December 31, 2007 based on theframework in Internal Control – Integrated Framework issued by the Committee ofSponsoring Organizations (COSO) of the Treadway Commission.  Based on this assessment, our managementconcluded that our internal control over financial reporting was effective asof December 31, 2007.

 

This annual report does not include an attestationreport of the Company’s registered public accounting firm regarding internalcontrol over financial reporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to temporary rules of the Securitiesand Exchange Commission that permit the Company to provide only management’sreport in this annual report.

 

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***Changes in InternalControl Over Financial Reporting***

 

There were no changes to our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during our most recently completed fiscal quarter thatmaterially affected, or are reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART III**

 

**ITEM 9.****                         DIRECTORS, EXECUTIVE OFFICERS,PROMOTERS AND CONTROL PERSONS AND CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(A) OFTHE EXCHANGE ACT**

 

**Directors**

 

The following table sets forth, as of March 24, 2008,the names of, and certain information concerning, our directors:

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                  | ** ** | **Director Since** | ** ** | **End of Term** |
|-----------------------|------------|---------|------------|-----------------------------------------------|------------|-------------------------|------------|---------------------------|
| Jonathan V. Diamond   |       | 49      |       | Chairman of the Board  of Directors           |       | 2003                    |       | 2008                      |
| Dimitri Villard       |       | 65      |       | Interim Chief Executive  Officer and Director |       | 2005                    |       | 2009                      |
| Frederick W. Field    |       | 55      |       | Director                                      |       | 2001                    |       | 2008                      |
| Teymour Boutros-Ghali |       | 52      |       | Director                                      |       | 2005                    |       | 2008                      |
| Eric Pulier           |       | 41      |       | Director                                      |       | 2004                    |       | 2009                      |
| Fred Davis            |       | 48      |       | Director                                      |       | 2005                    |       | 2008                      |
| James N. Lane         |       | 56      |       | Director (resigned as  of March 24,2008) |       | 2005                    |       | 2010                      |

 

*JonathanV. Diamond.*   Mr. Diamond has served as ourChairman of the Board since March 6, 2008 and was previously ChiefExecutive Officer of the Company and a director since September 2003. FromJanuary 2003 to August 2006, he served as the Chairman, ChiefExecutive Officer and currently serves as a director of ALJ Regional Holdings, Inc.,formerly YouthStream Media Networks, Inc., a publicly-traded company(ALJJ. PK).  He was the co-founder of N2K, Inc.and served as its Vice Chairman and Chief Executive Officer through its 1999merger with CDnow, Inc., an e-commerce company. He continued to serve asChairman of the combined company until its sale to Bertelsmann Music Group in August 2000.Mr. Diamond was a co-founder of GRP Records, an independent music labelacquired by MCA in 1990. 

 

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Mr. Diamond receiveda M.B.A. from the Columbia University Graduate School of Business and a B.A. inEconomics and Music from the University of Michigan Honors College.

 

*DimitriVillard.*   Mr. Villard has served as InterimChief Executive officer since March 6, 2008 and as a director since January 2005.Mr. Villard has also served as President and a director of PivotalBioSciences, Inc., a biotechonology company, since September 1998. Inaddition, since January 1982 to present, he has served as President anddirector of Byzantine Productions, Inc. Previously, Mr. Villard was adirector at the investment banking firm of SG Cowen and affiliated entities, aposition he held from January 1997 to July 1999. Mr. Villardcurrently serves as Chairman of the Board of Dax Solutions, Inc. (“*Dax*”), an entertainment industry digitalasset management venture. He has served as a director of Dax since May 2004.He is also a member of the Executive Committee of the Los Angeles chapter ofthe Tech Coast Angels, a private venture capital group. Mr. Villardreceived a B.A. Degree in Government from Harvard University in 1964 and alsoreceived a Master of Science degree from China International MedicalUniversity.

 

*FrederickW. Field.*   Mr. Field served as Chairman ofthe Board from June 2001 to March 2008 and served as our ChiefExecutive Officer from June 2001 until September 2003. Mr. Fieldalso currently serves as Chief Executive Officer of ARTISTdirect Records, LLCand as Chairman of the Board and Chief Executive Officer of Radar Pictures, Inc.,a film production company. From 1990 to 2001, Mr. Field served asCo-Chairman of Interscope Records, a music production company. From 1979 to1997, Mr. Field served as Chairman of the Board and Chief ExecutiveOfficer of Interscope Communications, Inc.

 

*TeymourBoutros-Ghali.*   Mr. Boutros-Ghali has servedas director since January 2005. From January 2002 to the present, Mr. Boutros-Ghalihas served as Managing Partner of Monitor Ventures, an early-stage venturecapital firm. From January 2000 to January 2002, he served as anangel investor and a member of the Board Directors of several media andtechnology companies, including Digital Evolution, AllBusiness, Switchouse andIGR. Mr. Boutros-Ghali received his SM and PhD from the MassachusettsInstitute of Technology and his BA from Cambridge University.

 

*EricPulier.*   Mr. Pulier has served as a directorsince November 2004. Currently, Mr. Pulier serves as the Founder andExecutive Chairman of SOA Software, Inc., a position which he has heldsince 2001. Mr. Pulier also served as a Director and/or founder ofmultiple technology companies in the United States, including US Interactive, Inc.,Gluecode, Inc., Media Platform On-Demand, Santa Monica Media Corporation,a publicly-traded company, and the Center for Telecommunications Management. Mr. Pulierhas been a pioneer in the software and digital interactive industries for over15 years. He has been instrumental in establishing ground-breakingcompanies in several sectors including corporate communications, professionalservices, security and enterprise software. Mr. Pulier is a Magna CumLaude graduate of Harvard University.

 

*FredDavis.  * Mr. Davishas served as a director since November 2005. Mr. Davis currentlyserves as a Senior Partner at the Law Firm of Davis, Shapiro, Lewit, &Hayes which he co-founded in 1997. Prior to 1997, Mr. Davis served as anExecutive Vice President at EMI Records. Mr. Davis received a bachelorsdegree from Tufts University and a J.D. degree from Fordham School of Law.

 

*JamesN. Lane.*   Mr. Lane has served as a directorfrom May 2005 to March 24, 2008. Mr. Lane has also served as Chairman and Chief Executive Officer ofDevonwood Capital Partners since 2002.  From 1997-2002, Mr. Lane wasChairman and Chief Executive Officer of SG Capital Partners, a private equityfirm affiliated with Societe General and SG Cowen Securities.  Prior toestablishing SG Capital Partners, Mr. Lane’s career spanned approximately20 years at Goldman Sachs, & Co. He was a former General Partnerand founding member and Co-Head of Goldman Sachs’ Principal Investment Area.Until August 31, 2006, Mr. Lane served as a director of ALJ RegionalHoldings, Inc., formerly YouthStream Media Networks, Inc., apublicly-traded company (ALJJ. PK).  Mr. Lanereceived a B.A. degree from Wheaton College and a M.B.A. from ColumbiaUniversity.

 

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**ExecutiveOfficers**

 

The following table setsforth, as of March 24, 2008, the names of, and certain informationconcerning, our executive officers that do not also serve as a director:

 
| **Name**        | ** ** | **Age** | ** ** | **Position**                                         |
|-----------------|------------|---------|------------|------------------------------------------------------|
| Neil McCarthy   |       | 58      |       | Interim Chief Financial  Officer                     |
| Rene Rousselet  |       | 52      |       | Corporate Controller of  ARTISTdirect                |
| Randy Saaf      |       | 31      |       | Chief Executive Officer  of MediaDefender, Inc. |
| Octavio Herrera |       | 31      |       | President of  MediaDefender, Inc.               |

 

*NeilMcCarthy. *Mr. McCarthyhas served as Interim Chief Financial Officer of the Company since September 2007and was a consultant to the Company from July through August 2007.  On February, 25, 2008, Mr. McCarthyadvised the Company of his intention to resign the post of Interim ChiefFinancial Officer as of March 31, 2008. Prior to working with the Company,Mr. McCarthy was involved in various consulting activities includingassignments with Colortone Graphics, Automotive X Prize, Cooking.com, Wetzel’sPretzels and Air Wave Wireless. Mr. McCarthy is also a member of theExecutive Committee of the Tech Coast Angels, an angel investment networkfocusing on early stage technology related companies.

 

*RenéRousselet*. Mr. Rousselet has served as our CorporateController since September 2006 and as our Principal Accounting Officersince February 2007. From May 2006 to September 2006, Mr. Rousseletworked as a consultant for Tag-It Pacific, Inc. (TAG), a publicly-tradedapparel company. From November 2004 to May 2006, he served as theChief Financial Officer of Asbestos Control Testing, Inc., a privatelyheld interior demolition company, and from 1999 to 2004 he was the Presidentand Chief Financial Officer of a privately held professional employmentorganization called ProService Inc. Prior to 1999, Mr. Rousselet served aseither the Chief Financial Officer or Corporate Controller for a variety ofentertainment companies in Los Angeles including two public companies calledHemdale Communications Inc. (no longer in existence) and The Kushner-LockeCompany (KLOC.PK), a television programming company. Mr. Rousselet receiveda Degree in Accounting from California State University Northridge in 1977 andbecame a Certified Public Accountant in 1979 while working as a Senior Auditorat Arthur Andersen & Co.

 

*RandySaaf.*   Mr. Saaf currently serves as ChiefExecutive Officer of our wholly-owned subsidiary MediaDefender, Inc.,which was acquired on July 28, 2005. Mr. Saaf previously served asboth President and Chief Executive Officer of MediaDefender, Inc. since heco-founded the company in July 2000. Effective February 2008, Mr. Saaf was elected to the Board ofDirectors of Jibro, Inc. a mobile entertainment company.  Mr. Saaf received his Bachelor ofScience degree in Engineering from Harvey Mudd College in 1998.

 

*OctavioHerrera.*   Mr. Herrera currently serves asPresident of our wholly-owned subsidiary MediaDefender, Inc., which wasacquired on July 28, 2005. Mr. Herrera previously served as VP,Business Development and Chief Financial Officer of MediaDefender, Inc.since he co-founded the company in July 2000.  Effective February 2008, Mr. Herrerawas elected to the Board of Directors of Jibro, Inc. a mobileentertainment company.  Mr. Herrerareceived a Bachelor degree in Physics from Occidental College in 1998.

 

**FamilyRelationships**

 

There are no familyrelationships among the directors and executive officers.

 

**Term ofOffice**

 

Our directors andofficers hold office until the earlier of their death, resignation, or removalor until their successors have been qualified.

 

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**Procedurefor Consideration of Director-Nominees**

 

*StockholderNominees.*

 

The Nominating Committeeconsiders nominees to the Board proposed by stockholders.  The Nominating Committee was established toensure that the Company is able to attract and retain qualified individuals toserve on the Board of Directors and to establish a fair process for thehandling of stockholder nominations to the Board of Directors.

 

**Section 16(a) BeneficialOwnership Compliance**

 

Section 16(a) ofthe Securities Exchange Act of 1934 requires our directors and certainexecutive officers and persons who own more than ten percent of a registeredclass of ARTISTdirect’s equity securities (collectively, the “*Reporting Persons*”), to file reports ofownership and changes in ownership with the Securities and Exchange Commission.The Reporting Persons are required by Securities and Exchange Commissionregulation to furnish the Company with copies of all Section 16(a) formsthey file.

 

To our knowledge, basedsolely on our review of the copies of such forms received by us, or writtenrepresentations from the Reporting Persons, all Section 16(a) formswere timely filed during fiscal 2007.

 

**Code ofEthics**

 

We have adopted a Code ofEthics that is applicable to our directors and our employees, including ourprincipal executive officer, principal financial officer, principal accountingofficer, controller, or persons performing similar functions. The Code ofEthics was included as an exhibit to our Form 10-K filed with theSecurities and Exchange Commission on May 17, 2004. A copy is availablefree of charge on the Securities and Exchange Commission’s website located onthe Internet at *www.sec.gov*.Amendments to and waivers from the Code of Ethics will also be disclosed infuture filings with the Securities and Exchange Commission.

 

**TheBoard of Directors and Committees**

 

The Board is responsiblefor the supervision of the overall affairs of the Company. The Board met 9times during the fiscal year ended December 31, 2007. During fiscal 2007,each director attended, either in-person or by telephone, at least 90% percentof all Board meetings and meetings of any committee on which he served, withthe exception of Mr. Pulier who attended 44% percent of the Boardmeetings.

 

***Audit Committee***

 

The Board re-establishedan Audit Committee in November 2005. For the years of 2006 and 2007, theCommittee had the following responsibilities, but were not limited to:

 

·       appointing,evaluating and retaining the independent registered public accounting firm,

 

·       reviewingand discussing with management and the independent registered public accountingfirm our annual and quarterly financial statements and disclosures,

 

·       discussingour systems of internal control over financial reporting, and

 

·       meetingindependently with the independent registered public accounting firm andmanagement.

 

The Audit Committee consisted of James N. Lane andDimitri Villard, both of whom were considered “independent” for the year ended December 31,2007.  Mr. Lane qualified as a “financialexpert” under Item 401 of Regulation S-B of the Securities and Exchange Act of1934, as amended. The Audit Committee operates under a written Audit CommitteeCharter that was previously approved by the Board.  A copy of the Audit Committee Charter wasfiled as an exhibit to the Company’s Proxy Statement filed on May 8, 2006with the SEC. The Audit Committee met 7 times during the fiscal year ended December 31,2007.

 

47

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On March 24, 2008, Mr. James Lane advisedthe Company that he would no longer serve as a Director and member of the AuditCommittee.  As Mr. Lane was, at thattime, the only independent member of the Audit Committee, the Company hassuspended the activities of the Audit Committee until a new independentDirector is appointed. In the interim, the functions of the Audit Committeehave been assumed by the Board of Directors.

 

***Compensation Committee***

 

The Board established aCompensation Committee in November 2005. The Compensation Committeeadministers the Company’s compensation and benefit plans, in particular, theincentive compensation and equity-based plans, and approves salaries, bonuses,and other compensation arrangements and policies for the Company’s officers,including the Chief Executive Officer. The Board has adopted a written charterfor the Compensation Committee, a copy of which was filed as an exhibit to theCompany’s Proxy Statement filed on May 8, 2006 with the Securities andExchange Commission. The Compensation Committee currently consists of FredDavis and Dimitri Villard, both of whom were considered “independent” for theyear ended December 31, 2007.  TheCompensation Committee met 7 times during the fiscal year ended December 31,2007.

 

***Nominating Committee***

 

The Board established aNominating Committee in June 2006. The Nominating Committee during 2007 consisted of James N. Lane and FredDavis, both of whom were considered “independent”.  The Nominating Committee was established toensure that the Company is able to attract and retain qualified individuals toserve on the Board of Directors and to establish a fair process for thehandling of stockholder nominations to the Board of Directors.  There were no meetings of the NominatingCommittee during 2007.

 

**ITEM 10.****                   EXECUTIVECOMPENSATION**

 

**ExecutiveCompensation**

 

The following table setsforth information concerning the compensation earned by our Chief ExecutiveOfficer, our other most highly compensated executive officers (who servedduring fiscal years ended December 31, 2007 and 2006, and whose totalcompensation during fiscal years ended December 31, 2007 and 2006 exceeded$100,000) (collectively, the “*NamedExecutive Officers*”).  We havealso included two additional individuals who serve as executive officers ofMediaDefender, our wholly-owned subsidiary.

 

**Summary Compensation Table**

** **
| ** **                                 | ** ** | ** ** | ** ** | ** **      | ** ** | ** **     | ** ** | ** **             | ** ** | ** **              | ** ** | **Compensation**                     | ** ** | ** **                      | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------|------------|----------------|------------|------------------------|------------|-------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| **Name and  Principal Position** | ** ** | **Year**   | ** ** | **Salary  ($)** | ** ** | **Bonus  ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive  Plan  ($)** | ** ** | **Nonqualified  Deferred  ($)** | ** ** | **All Other  ($)** | ** ** | **Total  ($)** | ** ** |
| Jonathan V. Diamond              |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| Chief Executive  Officer                   |       | 2006       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       |   |   | 342,250 |   |
| Neil McCarthy                              |       | 2007       |       | 87,500          |       | 25,000         | (2)        |                   |       |                    |       |                                 |       |                            |       | 62,500 | (3) | 175,000 |   |
| Interim Chief  Financial Officer           |       | 2006       |       | —          |       |           |       |                   |       |                    |       |                                 |       |                            |       |   |   | — |   |
| Rene Rousselet                             |       | 2007       |       | 136,667         |       | 19,000         | (2)        |                   |       | 59,500                  | (4)        |                                 |       |                            |       |   |   | 215,167 |   |
| Senior Accounting  Officer                 |       | 2006       |       | 42,086          |       | 2,000          | (2)        |                   |       |                    |       |                                 |       |                            |       |   |   | 44,086 |   |
| Randy Saaf -  MediaDefender                |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| Chief Executive  Officer              |       | 2006       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 534,600 | (5) | 884,600 |   |
| Octavio Herrera                            |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| President,  MediaDefender                  |       | 2006       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 534,600 | (5) | 884,600 |   |

 

----

(1)             Auto allowance.

 

(2)             Discretionary bonus.

 

(3)             Consulting fees.

 

(4)             50,000 options granted with a Black-Scholesvalue of $1.19

 

(5)             Includes $9,600 for auto and $525,000 for anon-compete payment required as part of the acquisition of MediaDefender, Inc.in 2005. In December 2006, we paid the CEO and the President ofMediaDefender $525,000 each as non-compete payments in exchange for theiragreement as part of the acquisition of MediaDefender, Inc., not tocompete with the Company.  Thenon-compete agreement specified that Messrs. Herrera and Saaf may notcompete with the Company through July 28, 2009.

 

48

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**OUTSTANDINGEQUITY AWARDS AT FISCAL YEAR-END**

 

The following table setsforth certain information relating to unexercised and outstanding options foreach named executive officer as of December 31, 2007. No other equityawards otherwise reportable in this table have been granted to any of our namedexecutive officers.

 
| ** **                                      | ** ** | **Option Awards**                                                                 | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| **Name**                                        | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)  Exercisable** | ** ** | **Number of  Securities  Underlying  Unexercised  Options  (#)  Unexercisable** | ** ** | **Option  Exercise  Price  ($)** | ** ** | **Option  Expiration  Date** | ** ** |
| Jonathan V. Diamond                   |       | 1,043,407                                                                              |       | 1,969,350 |   | $ | 1.49 |   | 08/05/10 |   |
| Chief Executive  Officer                        |       |                                                                                   |       |   |   |   |   |   |   |
|                                            |       |                                                                                   |       |   |   |   |   |   |   |
| Rene Rousselet                                  |       | 50,000                                                                                 |       | — |   | 1.50 |   | 02/02/12 |   |
| Senior Finance  Officer                         |       |                                                                                   |       |   |   |   |   |   |   |
|                                            |       |                                                                                   |       |   |   |   |   |   |   |
| Randy Saaf                                      |       | 138,095                                                                                |       | 61,905 |   | 3.00 |   | 07/28/12 |   |
| Chief Executive  Officer, MediaDefender(1) |       |                                                                                   |       |   |   |   |   |   |   |
|                                            |       |                                                                                   |       |   |   |   |   |   |   |
| Octavio Herrera                                 |       | 138,095                                                                                |       | 61,905 |   | 3.00 |   | 07/28/12 |   |
| President,  MediaDefender(1)                    |       |                                                                                   |       |   |   |   |   |   |   |
|                                                 |            |                                                                                        |            |  |  |  |  |  |  |  |

 

----

(1) The Options shall vest over a three and one-half (3.5) yearperiod on a quarterly basis for each named executive officer.

 

**DIRECTORCOMPENSATION**

 

**DirectorCompensation**

 

*Boardof Directors Compensation:*

 

For the year ended December 31,2007, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000, and a grant of 10,000 stock options having a value(based upon the appropriate Black-Scholes option valuation methodology) equalto $16,200.  The strike price for the options was set on the date of grantand the options vested entirely on December 31, 2007.  In addition,each director that serves on a Committee of the Board of Directors received,for each committee served, an additional cash retainer of $10,000, and a grantof 5,000 stock options having a value equal to $8,100, having the same termsand conditions as options granted to all non-employee members of the Board ofDirectors generally.  During 2007, atotal of 80,000 Stock options were granted to the directors as compensation,having an aggregate Black-Scholes value of $129,600.  The stock option grants were made on June 30,2007 under the 2006 Equity Plan.

 

Upon the recommendation of the Compensation Committee,the board of directors approved an annual compensation arrangement for ourindependent directors for fiscal 2008, which is identical to the compensationpaid in 2007 as outlined above.

 

 

49

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** **

**Tabular Format**

 

Thefollowing table sets forth the compensation paid to all persons who served asmembers of our board of directors (other than our named executive officers)during the 2007 fiscal year. No director who is also a named executive officerreceived any compensation for services as a director in 2007.

 

Wereimburse each of our non-employee directors for their reasonable expensesincurred in connection with attending meetings of the board of directors andrelated committees.  Fees also include amountspaid to our directors for their services as consultants to the Company inconnection with its restructuring.

 
| ** **            | ** ** | ** **                                                | ** ** | ** **             | ** ** | ** **              | ** ** | **Compensation**                         | ** ** | ** **                      | ** ** |
|-----------------------|------------|-----------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| **Name**              | ** ** | **Fees Earned  or Paid in  Cash ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive  Plan ($)** | ** ** | **Nonqualified  Deferred  ($)** | ** ** | **All Other  ($)** | ** ** | **Total ($)** | ** ** |
| ** **            | ** ** | ** **                                                | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                               | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Frederick W.  Field   |       | 15,000                                                    |       | 0                      |       | 16,200                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 31,000 |   |
| Fred Davis            |       | 25,000                                                    |       | 0                      |       | 24,300                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 50,000 |   |
| Teymour  BoutrosGhali |       | 75,000                                                    | (1)        | 0                      |       | 16,200                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 91,000 |   |
| Eric Pulier           |       | 15,000                                                    |       | 0                      |       | 16,200                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 31,000 |   |
| Dimitri Villard       |       | 95,000                                                    | (1)        | 0                      |       | 32,400                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 127,000 |   |
| James N. Lane         |       | 25,000                                                    |       | 0                      |       | 24,300                  | (2)        | 0                                        |       | 0                               |       | 0 |   | 50,000 |   |

 

----

(1)           Fees earned include payments of $60,000 each to two directors who servedon the Company’s special committee related to restructuring matters.

 

(2)           This amount represents the fair market value calculated in accordancewith the Black-Scholes method of certain issuances of stock options (at thetime of issuance) to this director in payment of fees earned in connection withhis services as a member of the Board of Directors.

 

**ITEM 11.****   ****SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

Thefollowing table sets forth, as of March 24, 2008, the number andpercentage of shares of Common Stock beneficially owned, directly orindirectly, by each of our directors, director-nominees, the Named ExecutiveOfficers (as defined below), beneficial owners known by the Company of morethan five percent of the outstanding shares of our Common Stock and by ourdirectors and executive officers as a group. Beneficial ownership is determinedin accordance with the Rule 13d-3(a) of the Securities Exchange Actof 1934, as amended, and do not necessarily indicate ownership for any otherpurpose, and generally includes voting or investment power with respect to theshares and shares which such person has the right to acquire within 60 days of March 24,2008.

 

50

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| ** **                                                                                                                                    | ** ** | ** **                   | ** ** | **Amount and Nature** | ** ** | ** **          | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                                                                                                                                    | ** ** | **Title of Class** | ** ** | **of Beneficial**          | ** ** | **Percent**         | ** ** |
| **Beneficial Owner(1)**                                                                                                                  | ** ** | **of Stock**            | ** ** | **Ownership(2)**                | ** ** | **of Class**** | ** ** |
| *5%  Stockholders:*                                                                                                                           |       |                         |       |                            |       |                |       |
|                                                                                                                                          |       |                         |       |                            |       |                |       |
| JMB Capital  Partners, L.P. 1999 Avenue of the Stars, Suite 2040 Los Angeles, California  90067                                          |       | Common                       |       | 1,916,667                       | (3)        | 18.5                |       |
| WNTO7 Holdings,  LLC   c/o Wayne, Gaynor, Umanoff & Pollack, LLP   6100 Center Drive, Suite 950   Los Angeles, California 90045 |       | Common                       |       | 1,224,017                       | (4)        | 11.8                |       |
| CCM Master  Qualified Fund, Ltd.   One North Wacker Drive, Suite 4725   Chicago, Illinois 60606                                          |       | Common                       |       | 1,942,605                       | (5)        | 18.8                | (6)        |
| Act II Master  Fund, Ltd.   444 Madison Avenue   New York, New York 10022                                                                |       | Common                       |       | 590,050                         | (5)        | 5.7                 |       |
| Jonathan M.  Glaser   11601 Wilshire Boulevard, Suite 2180   Los Angeles, California 90025                                               |       | Common                       |       | 622,400                         | (5)        | 6.0                 |       |
| * *                                                                                                                                      |       |                         |       |                            |       |                |       |
| *Current  Executive Officers and Directors:*                                                                                                  |       |                         |       |                            |       |                |       |
|                                                                                                                                          |       |                         |       |                            |       |                |       |
| Frederick W.  Field                                                                                                                           |       | Common                       |       | 324,694                         | (7)        | 3.1                 |       |
| Jonathan V.  Diamond                                                                                                                          |       | Common                       |       | 1,304,659                       | (7)        | 12.6                |       |
| Robert N.  Weingarten                                                                                                                         |       | Common                       |       | 395,000                         | (7)        | 3.8                 |       |
| Teymour  Boutros-Ghali                                                                                                                        |       | Common                       |       | 193,603                         | (8)        | 1.9                 |       |
| Eric Pulier                                                                                                                                   |       | Common                       |       | 1,050,414                       | (9)        | 10.2                |       |
| Dimitri Villard                                                                                                                               |       | Common                       |       | 127,888                         | (7)        | 1.2                 |       |
| James N. Lane                                                                                                                                 |       | Common                       |       | 117,606                         | (7)        | 1.1                 |       |
| Fred Davis                                                                                                                                    |       | Common                       |       | 41,409                          | (12)       | *                   |       |
| Randy Saaf                                                                                                                                    |       | Common                       |       | 281,663                         | (10)       | 2.7                 |       |
| Octavio Herrera                                                                                                                               |       | Common                       |       | 281,663                         | (10)       | 2.7                 |       |
| Rene Rousselet                                                                                                                                |       | Common                       |       | 50,000                          | (7)        | *                   |       |
| All current  directors and executive officers as a group (12 Persons)                                                                    |       | Common                       |       | 4,168,599                       | (11)       | 40.3                |       |

 

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| *      |   | Indicates less than  1.0%                                                                                                                                                                                                                                                                                                                                         |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| **     |   | Based on 10,344,666 shares  of Common Stock outstanding as of March 24, 2008.                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (1)    |   | Unless otherwise  indicated, the address for each of the individuals listed in the table is  c/o ARTISTdirect, Inc., 1601 Cloverfield Boulevard, Suite 400  South, Santa Monica, California, 90404-4082.                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (2)    |   | Unless otherwise  indicated by footnote, the persons named in the table have sole voting and  sole investment power with respect to all shares of common stock shown as  beneficially owned by them, subject to applicable community property laws.                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (3)    |   | Based on Schedule 13G  filed on August 17, 2007.                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (4)    |   | Includes 114,985 shares  of Common Stock that may be exercised within 60 days of March 24,  2008 pursuant to a warrant. Members of WNT07 Holdings, LLC include Teymour  Boutros-Ghali and FDT Trust-2005. Teymour Boutros-Ghali and Eric Pulier, both  members of our Board are the managing members and have voting power with  respect to the shares. |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (5)    |   | Based on Schedule 13G  filed on February 14, 2008.                                                                                                                                                                                                                                                                                                           |

 

51

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| (6)    |   | CCM Master Qualified  Fund, Ltd. was also issued a $13,000,000 principal amount convertible  subordinated note and a warrant to purchase 691,935 shares of common stock in  the subordinated debt financing completed by us in July 2005. Both contain  a limitation on exercise provision that prevents CCM Master Qualified Fund,  Ltd. from holding more than 9.99% of our outstanding Common Stock.                                                                           |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (7)    |   | Consists solely of  stock options to purchase shares of Common Stock that are exercisable within  60 days of March 24, 2008.                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (8)    |   | Refer to footnote  (4) above. Mr. Boutros-Ghali holds a 15% economic interest in WNT07  Holdings, LLC. In addition, this number consists of 22,324 options owned  personally by Mr. Boutros-Ghali that can be exercised within 60 days of  March 24, 2008.                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (9)    |   | Refer to footnote  (4) above. FDT Trust-2005 holds a 85% economic interest in WNT07  Holdings, LLC. The trustee of FDT Trust-2005 is Greg Pulier, the brother of  Eric Pulier. The beneficiaries of the trust consist of the living descendants  of Myron Pulier, the father of Eric Pulier, as determined by Greg Pulier. In  addition, this number consists of 10,000 options owned personally by  Mr. Pulier that can be exercised within 60 days of March 24, 2008. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (10)   |   | Consists of a warrant  to purchase 119,758 shares of Common Stock and options to purchase  161,905 shares of Common Stock that are exercisable within 60 days  of March 24, 2008. Messrs. Saaf and Herrera each elected to invest  $2.25 million in our subordinated financing completed by us in  July 2005.                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (11)   |   | Refer to footnotes  (4) and (7)-(10) above.                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (12)   |   | Consists of 41,409  options that have fully vested as of December 31, 2007.                                                                                                                                                                                                                                                                                                                                                                                                       |

 

**EmploymentAgreements**

 

As of March 6, 2008,the Company entered into an Amended and Restated Services Agreement (the “ServicesAgreement”) with Jon Diamond under which his employment as Chief ExecutiveOfficer was ended and he was elected as the Company’s Chairman of the Board ofDirectors.  Under the Services Agreement,the Company agreed to (a) pay a severance payment of $350,000 payable insemi-monthly installments over a period of six months, (b) accelerate thevesting of  the Time Vesting Optionsunder his previous employment agreement, (c) accelerate the vesting ofoptions granted in 2004 to purchase 259,659 shares, (d) extend to February 5,2011 the period for exercising the Time Vesting Options and to March 29,2011 for the 2004 Options, and (e) pay 40 days of accrued vacation time.

 

Inaccordance with the MediaDefender transaction, the Company acknowledged theterms of Employment Agreements entered into on July 28, 2005 byMediaDefender with each of Randy Saaf, who serves as Chief Executive Officer ofMediaDefender, and Octavio Herrera, who serves as President ofMediaDefender.  Mr. Saaf and Mr. Herrerawill each earn a base salary of no less than $350,000 per annum during theinitial term of the agreements, which shall continue until December 31,2008.  Mr. Saaf and Mr. Herreraare each entitled to receive twelve months of severance pay at the rate of 100%of their monthly salary and the pro-rata portion of the performance bonusreferenced below if they are terminated “without cause.”  In addition, the Company granted stockoptions to purchase 200,000 shares of common stock to each of Mr. Saaf andMr. Herrera, exercisable for a period of five years at $3.00 pershare.  On July 28, 2006, theCompany entered into agreements with Mr. Saaf and Mr. Herrera toincorporate non-material modifications into the Employment Agreements.

 

52

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Future payments underemployment agreements are as follows:

 
| **Years Ending December 31,** | ** ** | **(in thousands)** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
|                                         |       |                    |       |
| 2008                                         |       | $                       | 1,490      |   |
| 2009                                         |       | 33                      |       |
|                                         |       | $                       | 1,523      |   |

 

*ConsultingAgreements*

 

EffectiveAugust 31, 2007, Robert N. Weingarten, the Chief Financial Officer andSecretary of the Company resigned from all positions he held with theCompany.  As a result of this resignation, the Company and Mr. Weingartenentered into a twelve month consulting agreement under which he is paid $16,250per month.

 

Inaddition, the Company and Mr. Weingarten entered into an Omnibus StockOption Amendment Agreement which extended the exercise date for 120,000 stockoptions granted to him in 2004 until March 29, 2011; altered the terms ofhis time vesting options to acquire 275,000 shares to accelerate their vestingto August 31, 2007 and extend their exercise date to August 5,2010.   The vesting of his performancebased options shall occur only upon the closing of a change of controltransaction at a price above $3.10 per share occurring prior to August 31,2008.  In addition, Mr. Weingarten will be able to exercise the timevesting options and the performance vesting options, if vested, until August 5,2010, provided he does not breach his Consulting Agreement.

 

**OptionPlans**

 

Wecurrently maintain our 2006 Equity Incentive Plan, our 1999 Employee StockOption Plan, our 1999 Artist Plan, our 1999 Artist and Artist Advisor Plan andour 2004 Consultant Plan (collectively, the “*Current**Option Plans*”). At March 24,2008, an aggregate of 1,419,628 stock options were outstanding under theCurrent Option Plans. There are an additional 2,287,029 stock optionsoutstanding at March 24, 2008 that were issued by us outside of theCurrent Option Plans.

 

**EQUITY COMPENSATION PLAN INFORMATION**

 

Thefollowing table provides information as of March 24, 2008 regardingcompensation plans (including individual compensation arrangements) under whichour securities are authorized for issuance. Information is included for both equitycompensation plans approved by our stockholders and equity compensation plansnot approved by our stockholders.

 
| **Plan Category Teri to revise data** | ** ** | **Number of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights  (a)** | ** ** | **Weighted-average  Exercise Price of  Outstanding  Options, Warrants  and Rights  (b)** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  Under Equity  Compensation Plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders            |       | 302,370                                                                                                                                                   |       | $                                                                                                            | 7.50       |                                                                                                                                                                                                              | 142,110    |   |
| Equity  compensation plans not approved by stockholders        |       | 3,404,287                                                                                                                                                 |       | $                                                                                                            | 1.92       |                                                                                                                                                                                                              | 2,973,762  |   |
| Total                                                          |       | 3,706,657                                                                                                                                                 |       | $                                                                                                            | 2.54       |                                                                                                                                                                                                              | 3,115,872  |   |

 

53

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*1999Employee Stock Option Plan*

 

The1999 Employee Stock Option Plan became effective on October 6, 1999 inconnection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc.All options to purchase membership units in the limited liability company whichwere outstanding at the time of such conversion were assumed by the corporationand converted into options for shares of our Common Stock. The number of sharessubject to each assumed and converted option was equal to the number ofmembership units in the limited liability company which were subject to thatoption immediately prior to the conversion, and the exercise price per shareremained the same as the per unit exercise price in effect under the option atthe time of conversion.

 

Exceptfor the conversion of the securities subject to the option into shares of ourCommon Stock, each option will continue to be governed by the terms of theagreement evidencing that option at the time of our conversion into acorporation.

 

The1999 Employee Stock Option Plan is a non-stockholder approved plan under whichoptions may be granted to employees, non-employee members of our Board, andconsultants and other independent advisors in our employ or service. The numberof shares of Common Stock issuable over the term of the 1999 Employee StockOption Plan was initially 650,000 shares and automatically increases each yearby two percent of the total number of shares of our Common Stock outstanding onthe last trading day in December in the immediately preceding calendaryear, provided that no annual increase shall exceed 87,500.

 

Alloption grants under the 1999 Employee Stock Option Plan will have an exerciseprice per share equal to the fair market value per share of our Common Stock onthe grant date, subject to certain adjustments for stock splits,recapitalizations and similar transactions. Each option will vest ininstallments over the optionee’s period of service with us. The options willvest on an accelerated basis in the event we are acquired and those options arenot assumed or replaced by the acquiring entity. The options that were grantedwhile we were a limited liability company, however, will terminate in the eventwe are acquired and those options are not assumed by the acquiring entity(unless their vesting is accelerated by our Compensation Committee). Eachoption will have a maximum term (not to exceed ten years) set by the planadministrator at the time of grant, subject to earlier termination followingthe optionee’s cessation of employment. All options are non-statutory optionsunder the Federal tax law, unless they are incentive stock options granted toemployees.

 

*1999Artist Plan*

 

The1999 Artist Plan became effective on October 6, 1999 in connection withour conversion from ARTISTdirect, LLC into ARTISTdirect, Inc. All optionsto purchase membership units in the limited liability company which wereoutstanding at the time of such conversion were assumed by the corporation andconverted into options for shares of our Common Stock. The number of sharessubject to each assumed and converted option was equal to the number ofmembership units in the limited liability company which were subject to thatoption immediately prior to the conversion, and the exercise price per shareremained the same as the per unit exercise price in effect under the option atthe time of conversion. Except for the conversion of the securities subject tothe option into shares of our Common Stock, each option will continue to begoverned by the terms of the agreement evidencing that option at the time ofour conversion into a corporation.

 

The1999 Artist Plan is a non-stockholder approved plan under which options weregranted to performing artists who provided products and services through theARTISTchannel Web sites we operate and maintain for them pursuant toARTISTchannel agreements. The number of shares of Common Stock issuable overthe term of the 1999 Artist Plan was initially 400,000 shares and automaticallyincreases each year by two percent of the total number of shares of our Common Stockoutstanding on the last trading day in December in the immediatelypreceding calendar year, provided that no annual increase shall exceed 87,500.

 

Alloption grants under the 1999 Artist Plan have an exercise price per share equalto the fair market value per share of our Common Stock on the grant date. Eachoption vests in installments over the period the optionee’s ARTISTchannelagreement remains in effect. The options will vest on an accelerated basis inthe event ARTISTdirect is acquired and those options are not assumed orreplaced by the acquiring entity. Each option has a maximum term (not to exceedten years) set by the plan administrator (our Compensation Committee) at thetime of grant, subject to earlier termination following the termination of theoptionee’s ARTISTchannel agreement. All options are non-statutory options underthe Federal tax law.

 

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*1999Artist and Artist Advisor Plan*

 

The1999 Artist and Artist Advisor Plan became effective on October 6, 1999 inconnection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc.All options to purchase membership units in the limited liability company whichwere outstanding at the time of such conversion were assumed by the corporationand converted into options for shares of our Common Stock. The number of sharessubject to each assumed and converted option was equal to the number ofmembership units in the limited liability company which were subject to thatoption immediately prior to the conversion, and the exercise price per shareremained the same as the per unit exercise price in effect under the option atthe time of conversion. Except for the conversion of the securities subject tothe option into shares of our Common Stock, each option will continue to begoverned by the terms of the agreement evidencing that option at the time ofour conversion into a corporation.

 

The1999 Artist and Artist Advisor Plan is a non-stockholder approved plan underwhich options were granted to performing artists and their attorneys, businessmanagers, agents and other advisors who provided services to us. The number ofshares of Common Stock issuable over the term of the 1999 Artist and ArtistAdvisor Stock Option Plan was initially 185,000 shares and increased by37,500 shares on January 1, 2001 and 2002, respectively to a total of260,000 as of December 31, 2002 (subject to adjustment for certain changesin our capital structure). The share reserve will automatically increase on thefirst trading day in January each calendar year by an amount equal to onepercent of the total number of shares of our Common Stock outstanding on thelast trading day in December in the immediately preceding calendar year,but in no event will any such annual increase exceed 37,500 shares.

 

Alloption grants under the 1999 Artist and Artist Advisor Stock Option Plan havean exercise price per share equal to the fair market value per share of ourCommon Stock on the grant date. Each option vests in installments over theoptionee’s period of service with us. The options will vest on an acceleratedbasis in the event we are acquired and those options are not assumed orreplaced by the acquiring entity. Each option has a maximum term (not to exceedten years) set by the plan administrator at the time of grant, subject toearlier termination following the termination of the optionee’s service forcause. All options are non-statutory options under the Federal tax law.

 

Shareissuances under the 1999 Employee Stock Option Plan, the 1999 Artist Plan andthe 1999 Artist and Artist Advisor Plan will not reduce or otherwise affect thenumber of shares of Common Stock available for issuance under the 1999 EmployeeStock Purchase Plan, and share issuances under 1999 Employee Stock PurchasePlan will not reduce or otherwise affect the number of shares of Common Stockavailable for issuance under the 1999 Employee Stock Option Plan, the 1999Artist Plan and the 1999 Artist and Artist Advisor Plan.

 

*2004Consultant Stock Plan*

 

EffectiveSeptember 29, 2004, the Board adopted the 2004 Consultant Stock Plan inorder for us to be able to compensate consultants, at our option, who providebona fide services to us not in connection with capital raising or promotion ofour securities. The 2004 Consultant Stock Plan will expire on September 29,2014, and provides for the issuance of up to 500,000 shares of Common Stock toconsultants at fair market value. The 2004 Consultant Stock Plan is anon-stockholder approved plan.

 

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*2006Equity Incentive Plan*

 

The ARTISTdirect, Inc.2006 Equity Incentive Plan, referred to as the 2006 Equity Plan, becameeffective on June 19, 2006, the effective date of stockholder approval ofsuch plan. The Board of Directors of ARTISTdirect, Inc., a Delawarecorporation (the “*Registrant*”),had approved the 2006 Equity Plan in April 2006. The Registrant’sstockholders approved the 2006 Equity Plan at the Annual Meeting ofStockholders held June 19, 2006 (the “*AnnualMeeting*”).

 

A total of 1,500,000 newshares of the Registrant’s common stock have initially been reserved forissuance under the 2006 Equity Plan.

 

Awards under the 2006Equity Plan may be granted to any of the Registrant’s employees, directors,officers, consultants or those of the Registrant’s affiliates. Awards mayconsist of stock options (both incentive stock options and non-statutory stockoptions), stock awards, stock appreciation rights and cash awards. An incentivestock option may be granted under the 2006 Equity Plan only to a person who, atthe time of the grant, is an employee of the Registrant or a parent orsubsidiary of the Registrant.

 

The 2006 Equity Plan willbe administered by the Registrant’s Compensation Committee, which the Board ofDirectors appointed to be the “Administrator” of the plan, with full power toauthorize the issuance of shares of the Registrant’s common stock and to grantoptions or rights to purchase shares of the Registrant’s common stock. TheAdministrator has the power to determine the terms of the awards, including theexercise price, the number of shares subject to each award, the exercisabilityof the awards and the form of consideration payable upon exercise. TheCompensation Committee may delegate the day-to-day administration of the 2006Equity Plan to one or more individuals.

 

The 2006 Equity Planprovides that in the event of a merger of the Registrant with or into anothercorporation or of a “change in control” of the Registrant, including the saleof all or substantially all of the Registrant’s assets, and certain otherevents, the Board of Directors or the Compensation Committee may, in itsdiscretion, provide for the assumption or substitution of, or adjustment to,each outstanding award, accelerate the vesting of options and stockappreciation rights, and terminate any restrictions on stock awards or cashawards or provide for the cancellation of awards in exchange for a cash paymentto the participant.

 

The 2006 Equity Plan willterminate on June 19, 2016, unless terminated earlier by the Board ofDirectors or the Compensation Committee. No awards may be made after thetermination date; however, unless otherwise expressly provided in an applicableaward agreement, any award granted under the plan prior to the expiration mayextend beyond the end of such period through the award’s normal expirationdate.

 

The Board of Directors orthe Compensation Committee may generally amend or terminate the 2006 EquityPlan as determined to be advisable. The Internal Revenue Code or the rules ofthe Securities and Exchange Commission may also require the Registrant’sstockholders to approve certain amendments. The Board of Directors or theCompensation Committee may amend the 2006 Equity Plan without stockholderapproval to comply with legal, regulatory and listing requirements and to avoidunanticipated consequences determined to be inconsistent with the purpose ofthe plan or any award agreement.

 

A complete copy of the2006 Equity Plan can be found in the Registrant’s definitive proxy statement onSchedule 14A filed with the Securities and Exchange Commission on May 8,2006.

 

*Non-Plan;Non-Stockholder Approved Stock Option Grants*

 

Effective May 31,2001, we issued to Frederick W. (Ted) Field, our then Chairman and formerChief Executive Officer, a non-qualified stock option to purchase 302,370shares of common stock exercisable at $7.50 per share through May 30,2008.  The option vested over a period offive years from June 29, 2001, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $2,006,000,as the five year vesting period ended in 2006, no amount was charged off in2007 and $201,000 was charged to operations in 2006.

 

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EffectiveSeptember 29, 2003, we issued to Jonathan V. Diamond, our Chief ExecutiveOfficer, a non-plan, non-qualified stock option to purchase 259,659 shares ofcommon stock exercisable through August 15, 2010 at $0.85 per share, whichwas the approximate fair market value of the common stock on the date ofgrant.  The option vested over a periodof three years from the date of grant, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $221, 000,as the three year vesting period ended in 2006, no amount was charged off in2007 and $36,000 was charged to operations in 2006.

 

EffectiveMarch 29, 2004, we issued to Robert N. Weingarten, our Chief Financial Officer,a non-plan, non-qualified stock option to purchase 120,000 shares at $0.50 pershare, which was not less than the fair market value on the date of grant,exercisable through March 29, 2011. The option vests and becomes exercisable in a series of thirty-sixsuccessive equal monthly installments from March 29, 2004 through March 29,2007.  The fair value of the stockoption, determined pursuant to the Black-Scholes option-pricing model, was$42,000, of which $4,000 was charged to operations in 2007.

 

On July 28,2005, we issued Jonathan Diamond, our President and Chief Executive Officer, anon-plan, non-qualified stock option to purchase 2,753,098 shares of CommonStock exercisable at $1.55 per share, which was the approximate fairmarket value of the Common Stock on the date of grant, through August 25,2010. Approximately 38 percent of such stock options vests at the rate of 1/3rdper year over a three-year period and the remaining approximately 62 percentvests upon the achievement of certain financial milestones by ARTISTdirect. Thefair value of the time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $2,936,450, of which $979,000 wasrecorded as stock-based compensation cost in 2007.

 

OnJuly 28, 2005, we issued Robert Weingarten, our Chief Financial Officer, anon-plan, non-qualified stock option to purchase 550,000 shares of Common Stockexercisable at $1.55 per share, which was not less than the fair market valueon the date of grant, through August 25, 2010. One half of such stockoption vests at the rate of 1/3 per year over a three year period and one halfwill vest upon the achievement of certain financial milestones byARTISTdirect.  The fair value of the time-vestedoptions, calculated pursuant to the Black-Scholes option-pricing model, wasdetermined to be $772,750, of which $386,000 (due to acceleration) wasrecorded as stock-based compensation cost in 2007.

 

Theabove-referenced stock option grants were issued without registration in relianceupon the exemption afforded by Section 4(2) of the Securities Act of1933, as amended, based on certain representations made to us by therecipients.

 

**ITEM 12.****                     ****CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS, AND DIRECTOR INDEPENDENCE**

 

**CertainRelationships and Related Transactions**

 

*Transactions Related to MediaDefender Acquisition*

 

Inconjunction with the acquisition of MediaDefender, the Company issued 1,109,032shares of common stock and a seven-year warrant to purchase 114,985 shares ofcommon stock with an exercise price of $1.55 per share to WNT07 Holdings,LLC.  The managers of WNT07 Holdings, LLCare Eric Pulier and Teymour Boutros-Ghali, both of whom are members of theCompany’s Board of Directors.  The sharesand warrants were issued as consideration for services provided by Mr. Pulierand Mr. Boutros-Ghali as consultants to the Company in connection with theacquisition of MediaDefender.

 

TheCompany also acknowledged the terms of Non-Competition Agreements entered intoon July 28, 2005 by MediaDefender and Mr. Saaf and Mr. Herrera.  The Non-Competition Agreements prohibit Mr. Saafand Mr. Herrera from (i) engaging in certain competitive businessactivities, (ii) soliciting customers of MediaDefender or the Company, (iii) solicitingexisting employees of MediaDefender or the Company and (iv) disclosing anyconfidential information regarding MediaDefender or the Company.  Each agreement has a term of four yearsand shall continue to remain in force and effect in the event theabove-referenced Employment Agreements are terminated prior to the end of thefour-year term of the Non-Competition Agreements.  In consideration, Mr. Saaf and Mr. Herrerawere each entitled to a cash payment of $525,000 from MediaDefender on December 31,2006, which payments were timely made.

 

57

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RandySaaf and Octavio Herrera, formerly principals and stockholders of MediaDefenderand currently both executive officers of the Company’s wholly-owned subsidiary,MediaDefender, each invested $2,250,000 in the Sub-Debt Financing on the sameterms and conditions as the other Sub-Debt Financing investors.

 

*Eric Pulier*

 

Effectiveas of January 1, 2006, the Company entered into a one-year consultingagreement with Eric Pulier, a director of the Company, through WNT ConsultingGroup, a California limited liability company wholly-owned by Mr. Pulier (“WNT”).  The consulting agreement was approved by thedisinterested members of the Company’s Board of Directors.  Effective January 12, 2007, the partiesmutually agreed to terminate this consulting agreement, which had automaticallyrenewed for a second one-year term through December 31, 2007.  Underthe terms of the original consulting agreement, Mr. Pulier received a basefee of $10,000 per month, certain other mandatory payments, and was alsoeligible to receive cash bonuses on the achievement of certain specifiedmilestones.  The termination agreement provided for a one-time cashpayment to Mr. Pulier (through WNT) in the amount of $100,000 (which waspaid in January 2007), in consideration for the termination of theconsulting agreement and an acknowledgement and complete release of any and allclaims related to unpaid compensation, bonus amounts or other out-of-pocketexpenses (in cash or otherwise) that may have been owed by the Company as of January 12,2007.  Mr. Pulier will continue to serve as a member of the Company’sBoard of Directors.  The termination agreement was approved by theCompensation Committee of the Company’s Board of Directors.

 

On January 12,2007, the Company entered into a new consulting agreement with Mr. Pulier(through WNT).  During the term of the new consulting agreement, whichcommenced January 12, 2007 and continues in effect until any partyprovides ten days prior written notice to the other parties of its intention toterminate, Mr. Pulier will provide non-exclusive consulting and advisoryservices to the Company outside of the ordinary course of his services as amember of the Board of Directors.  In consideration, Mr. Pulier(through WNT) is entitled to receive hourly compensation at the rate of $500per hour.  Any consulting request made by the Company must be approved inadvance by all parties prior to commencement of services.  The newconsulting agreement was approved by the Compensation Committee of the Company’sBoard of Directors. No payments were made to Mr. Pulier during 2007 underthe terms of this agreement.

 

*FredDavis*

 

During the yearended December 31, 2007, the Company incurred legal fees of approximately$16,000 to Davis Shapiro Lewit & Hayes, LLP, a law firm in which FredDavis, a director of the Company, is a partner.

 

**DirectorIndependence**

 

Our board of directors iscomprised of a majority of independent directors.

 

*IndependentDirectors*. As of December 31,2007 the independent directors of the Board were:  Frederick W. Field ,Fred Davis (member of Compensation and Nominating Committees), James Lane(member of Audit and Nominating Committees) Teymour Boutros-Ghali and DimitriVillard (member of Audit Committee and Compensation Committee).****Each of these directors qualifies as anindependent director in accordance with the published listing requirements ofthe American Stock Exchange. In addition, our board of directors has made asubjective determination as to each independent director that no relationshipsexist which, in the opinion of our board of directors, would interfere with theexercise of independent judgment in carrying out the responsibilities of adirector. In making these determinations, our directors reviewed and discussedinformation provided by the directors and us with regard to each director’sbusiness and personal activities as they may relate to us and our management.

 

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**ITEM 13.****                     ****EXHIBITS**

 

The information requiredby this Item is set forth in the section of this Annual Report on Form 10-KSBentitled “EXHIBIT INDEX” and is incorporated herein by reference.

 

**ITEM 14.****                     ****PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

Aggregatefees billed by our current independent registered public accounting firms, forthe years ended December 31, 2007 and 2006, respectfully, are as follows:

 
| ** **                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
| Audit fees                                  |       | $        | 185,460    |     | $          | 213,970 |   |
| Audit-related  and restatement related fees |       | $        | 298,575    |     | $          | 167,920 |   |
| Tax Fees                                    |       | $        | 103,970    |     | $          | 40,490 |   |

 

**AuditFees; Audit-Related Fees**

 

Auditand audit-related fees consist of fees for the audit of our financialstatements, the review of our interim financial statements and other auditservices, including the review of and, as applicable, consent to documentsfiled by us with the Securities and Exchange Commission.

 

**Tax Fees**

 

Taxfees consist of fees for tax compliance, including the preparation of taxreturns, tax advice, and tax planning services. Tax advice and tax planningservices relate to advice regarding mergers and acquisitions and assistancewith tax audits and appeals.

 

**During2006 and 2007 Polices on Accounting Matters; Pre-Approval of Audit andNon-Audit Services of Independent Registered Public Accounting Firm**

 

Theprimary purpose of the Audit Committee during 2006 and 2007 was to assist theBoard in monitoring (i) the integrity of our financial statements anddisclosures, including oversight of the accounting and financial reportingprocesses and the audits of our financial statements (ii) the complianceby us with our legal, ethical and regulatory requirements and (iii) theindependence and performance of our independent registered public accountingfirm.

 

TheAudit Committee’s policy is to pre-approve all audit and non-audit services,other than *de minimis* non-auditservices, provided by the independent registered public accounting firm. Theseservices may include, among others, audit services, audit-related services, taxservices and other services. Pre-approval is generally provided for up to oneyear and any pre-approval is detailed as to particular service or category ofservices and is generally subject to a specific budget. The independentregistered public accounting firm and management are required to periodicallyreport to the full Board regarding the extent of services provided by theindependent registered public accounting firm in accordance with thispre-approval, and the fees for the services performed to date.

 

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TheAudit Committee has considered the provision of non-audit services provided byour independent registered public accounting firm to be compatible withmaintaining their independence.  As aresult of Mr. James Lane’s resignation from the Audit Committee on March 24,2008, the Company has suspended the activities of the Audit Committee until anew independent Director is nominated (see Subsequent footnote).

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 
|            | ** **          |       | **ARTISTdirect, Inc.** |
|------------|---------------------|------------|-----------------------------|
| ** ** | ** **          | ** ** | ** **                  | ** ** |
| Date:      | March 28, 2008 |       | By:                         | /s/ Dimitri Villard |
|       |                |       |                        | Dimitri Villard |
|       |                |       |                        | Interim Chief Executive Officer (Principal   Executive Officer) |
|       |                |       |                        |   |
| Date:      | March 28, 2008 |       | By:                         | /s/ Neil McCarthy |
|       |                |       |                        | Neil McCarthy |
|       |                |       |                        | Interim Chief Financial Officer (Principal   Financial Officer) |

 

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**POWER OF ATTORNEY**

 

KNOW ALL PERSONS BY THESEPRESENTS, that each of the persons whose signature appears below herebyconstitutes and appoints Dimitri Villard and Neil McCarthy, each of them actingindividually, as his attorney-in-fact, each with the full power ofsubstitution, for him in any and all capacities, to sign any and all amendmentsto this Annual Report on Form 10-KSB, and to file the same, with allexhibits thereto and other documents in connection therewith, with theSecurities and Exchange Commission, granting unto said attorneys-in-fact, andeach of them, full power and authority to do and perform each and every act andthing requisite and necessary to be done in and about the premises as fully toall intents and purposes as he might or could do in person, hereby ratifyingand confirming our signatures as they may be signed by our saidattorney-in-fact and any and all amendments to this Annual Report on Form 10-KSB.

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

 
| Signature                 | ** ** | **Title**                                                 | ** ** | **Date**             |
|---------------------------|------------|-----------------------------------------------------------|------------|----------------------|
|                      |       |                                                      |       |                 |
| /s/ Jonathan V. Diamond   |       | Chairman of the Board                                     |       | March 28,  2008 |
| Jonathan V. Diamond       |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       | Interim Chief Executive Officer and Director  (Principal  |       | March 28,  2008 |
| /s/ Dimitri Villard       |       | Executive Officer)                                        |       |                 |
| Dimitri Villard           |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       | Interim Chief Financial Officer and Secretary  (Principal |       | March 28,  2008 |
| /s/ Neil McCarthy         |       | Financial Officer)                                        |       |                 |
| Neil McCarthy             |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
| /s/ Rene Rousselet        |       | Corporate Controller (Principal Accounting Officer)       |       | March 28,  2008 |
| Rene Rousselet            |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
| /s/ Teymour Boutros-Ghali |       | Director                                                  |       | March 28,  2008 |
| Teymour Boutros-Ghali     |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
| /s/ Fred Davis            |       | Director                                                  |       | March 28,  2008 |
| Fred Davis                |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
| /s/ Eric Pulier           |       | Director                                                  |       | March 28,  2008 |
| Eric Pulier               |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
|                      |       |                                                      |       |                 |
| /s/ Frederick W. Field    |       | Director                                                  |       | March 28,  2008 |
| Frederick W. Field        |       |                                                      |       |                 |

 

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ARTISTDIRECT, INC.AND SUBSIDIARIES

 

INDEX TOCONSOLIDATED FINANCIAL STATEMENTS

 

YEARS ENDEDDECEMBER 31, 2007 AND 2006

 
| **Table of Contents**                                                                             | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                  |       |       |
| Report  of Independent Registered Public Accounting Firm:.                                                  |       | 63         |
|                                                                                                        |       |       |
| Consolidated Financial  Statements:                                                                         |       |       |
| Balance  Sheets — December 31, 2007 and 2006                                                      |       | 64         |
| Statements  of Operations — Years Ended December 31, 2007 and 2006                                |       | 66         |
| Statements  of Changes in Stockholders’ Deficiency — Years Ended December 31, 2007  and 2006 |       | 67         |
| Statements  of Cash Flows — Years Ended December 31, 2007 and 2006                                |       | 69         |
| Notes  to Consolidated Financial Statements — Years Ended December 31, 2007 and  2006             |       | 71         |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directorsand Stockholders

ARTISTdirect, Inc.

 

We have audited theaccompanying consolidated balance sheets of ARTISTdirect, Inc. and subsidiaries(the “Company”) as of December 31, 2007 and 2006, and the related consolidatedstatements of operations, stockholders’ equity (deficiency) and cash flows foreach of the years then ended.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion onthese consolidated financial statements based on our audits.

 

We conducted our auditsin accordance with standards of the Public Company Accounting****Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether theconsolidated financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the consolidatedfinancial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall consolidated financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all material respects,the financial position of ARTISTdirect, Inc. and subsidiaries as of December31, 2007 and 2006, and the results of their operations and their cash flows foreach of the years then ended in conformity with accounting principles generallyaccepted in the United States of America.

 

As discussed in Note 2 tothe consolidated financial statements, the Company adopted the provisions ofStatement of Financial Accounting Standards No. 123(R), “Share-BasedPayments”, and applied the modified prospective method at the beginning of theyear ended December 31, 2006.

 

The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern.  Asmore fully described in Notes 1 and 4, the Company is in default under itssenior and subordinated debt agreements. This could cause a request for accelerated payment or redemption of thedebt.  The Company does not have thecapital resources necessary to repay accelerated indebtedness or redemption ofthe debt.  These conditions raisesubstantial doubt regarding the Company’s ability to continue as a goingconcern.  The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

 
| /s/ Gumbiner Savett  Inc. |   |
|---------------------------|--------|
|                      |   |
|                      |   |
| GUMBINER SAVETT INC.      |   |
|                      |   |
| March 28, 2008       |   |
| Santa Monica,  California |   |

 

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedBalance Sheets

(amounts in thousands,except for share data)

 
| ** **                                                                                                                      | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                                                                                                            |       |                  |       |   |   |
| Assets                                                                                                                          |       |                  |       |   |   |
| Current assets:                                                                                                                 |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                      |       | $                     | 4,268      |   | $ | 5,602 |   |
| Restricted cash                                                                                                                 |       | 280                   |       | 364 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $418 and $421 at  December 31, 2007 and 2006, respectively |       | 8,168                 |       | 6,928 |   |
| Income taxes  refundable                                                                                                        |       | 1,147                 |       | — |   |
| Finished goods  inventory                                                                                                       |       | —                |       | 281 |   |
| Prepaid expenses  and other current assets                                                                                      |       | 351                   |       | 204 |   |
| Total current  assets                                                                                                           |       | 14,214                |       | 13,379 |   |
|                                                                                                                            |       |                  |       |   |   |
| Property and  equipment                                                                                                         |       | 4,452                 |       | 4,197 |   |
| Less accumulated  depreciation and amortization                                                                                 |       | (2,614                | )          | (1,729 | ) |
| Property and  equipment, net                                                                                                    |       | 1,838                 |       | 2,468 |   |
|                                                                                                                            |       |                  |       |   |   |
| Other assets:                                                                                                                   |       |                  |       |   |   |
| Intangible  assets:                                                                                                             |       |                  |       |   |   |
| Customer  relationships, net                                                                                                    |       | 440                   |       | 1,195 |   |
| Proprietary  technology, net                                                                                                    |       | 1,478                 |       | 4,012 |   |
| Non-competition  agreements, net                                                                                                |       | 416                   |       | 728 |   |
| Goodwill                                                                                                                        |       | 31,085                |       | 31,085 |   |
| Total intangible  assets, net                                                                                                   |       | 33,419                |       | 37,020 |   |
| Deferred  financing costs, net                                                                                                  |       | 1,243                 |       | 2,084 |   |
| Deposits                                                                                                                        |       | 20                    |       | 21 |   |
| Total other  assets                                                                                                             |       | 34,682                |       | 39,125 |   |
|                                                                                                                            |       | $                     | 50,734     |   | $ | 54,972 |   |

 

64

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| ** **                                                                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                   | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Liabilities and  Stockholders’ Equity (Deficiency)                                                                                      |       |                  |       |   |   |
| Current  liabilities:                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                             |       | $                     | 1,539      |   | $ | 1,832 |   |
| Accrued expenses                                                                                                                             |       | 1,885                 |       | 1,522 |   |
| Accrued interest  payable                                                                                                                    |       | 3,352                 |       | 67 |   |
| Deferred revenue                                                                                                                             |       | 230                   |       | 39 |   |
| Income taxes  payable                                                                                                                        |       | 200                   |       | 495 |   |
| Liquidated  damages payable under registration rights agreements, net of advance payments  of $1,000 at December 31, 2007               |       | 2,382                 |       | 3,777 |   |
| Warrant  liability                                                                                                                           |       | 164                   |       | 4,715 |   |
| Derivative  liability                                                                                                                        |       | 313                   |       | 18,356 |   |
| Senior secured  notes payable, net of discount of $651 and $1,110 at December 31, 2007  and 2006, respectively (in default)             |       | 12,656                |       | 12,197 |   |
| Subordinated  convertible notes payable, net of discount of $3,892 and $6,516 at December 31,  2007 and 2006, respectively (in default) |       | 23,766                |       | 21,142 |   |
| Total current  liabilities                                                                                                                   |       | 46,487                |       | 64,142 |   |
|                                                                                                                                         |       |                  |       |   |   |
| Long-term  liabilities:                                                                                                                      |       |                  |       |   |   |
| Deferred rent                                                                                                                                |       | 186                   |       | 199 |   |
| Financing  agreements                                                                                                                        |       | 19                    |       | 53 |   |
| Deferred income  taxes payable                                                                                                               |       | —                |       | 264 |   |
| Total long-term  liabilities                                                                                                                 |       | 205                   |       | 516 |   |
|                                                                                                                                         |       |                  |       |   |   |
| Commitments and  contingencies                                                                                                               |       |                  |       |   |   |
|                                                                                                                                         |       |                  |       |   |   |
| Stockholders’  equity (deficiency):                                                                                                     |       |                  |       |   |   |
| Common stock,  $0.01 par value - Authorized - 60,000,000 shares                                                                              |       |                  |       |   |   |
| Issued and  outstanding - 10,338,896 shares and 10,188,445 shares at December 31,  2007 and 2006, respectively                          |       | 103                   |       | 102 |   |
| Additional  paid-in-capital                                                                                                                  |       | 235,407               |       | 233,197 |   |
| Accumulated  deficit                                                                                                                         |       | (231,468              | )          | (242,985 | ) |
| Total  stockholders’ equity (deficiency)                                                                                                |       | 4,042                 |       | (9,686 | ) |
|                                                                                                                                         |       | $                     | 50,734     |   | $ | 54,972 |   |

 

See accompanyingnotes to consolidated financial statements.

 

65

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatements of Operations

(amounts inthousands, except for share data)

 
| ** **                                                                                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| Net revenue:                                                                                                                                                                                         |       |                                        |       |   |   |
| E-commerce                                                                                                                                                                                           |       | $                                           | 1,497      |   | $ | 2,649 |   |
| Media                                                                                                                                                                                                |       | 7,500                                       |       | 5,670 |   |
| Anti-piracy and  file-sharing marketing services                                                                                                                                                     |       | 15,174                                      |       | 15,743 |   |
| Total net  revenue                                                                                                                                                                                   |       | 24,171                                      |       | 24,062 |   |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Cost of revenue:                                                                                                                                                                                     |       |                                        |       |   |   |
| E-commerce                                                                                                                                                                                           |       | 1,531                                       |       | 2,495 |   |
| Media                                                                                                                                                                                                |       | 3,688                                       |       | 3,088 |   |
| Anti-piracy and  file-sharing marketing services                                                                                                                                                     |       | 9,414                                       |       | 7,797 |   |
| Total cost of  revenue                                                                                                                                                                               |       | 14,633                                      |       | 13,380 |   |
| Gross profit                                                                                                                                                                                         |       | 9,538                                       |       | 10,682 |   |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Operating  expenses:                                                                                                                                                                                 |       |                                        |       |   |   |
| Sales and  marketing                                                                                                                                                                                 |       | 1,993                                       |       | 1,163 |   |
| General and  administrative, including stock-based compensation costs of $2,110 and $2,281  in 2007 and 2006, respectively                                                                           |       | 10,867                                      |       | 9,918 |   |
| Development and  engineering                                                                                                                                                                         |       | 525                                         |       | — |   |
| Write-off of  fixed assets                                                                                                                                                                           |       | 97                                          |       | — |   |
| Total operating  costs                                                                                                                                                                               |       | 13,482                                      |       | 11,081 |   |
| Loss from  operations                                                                                                                                                                                |       | (3,944                                      | )          | (399 | ) |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Other income  (expense):                                                                                                                                                                             |       |                                        |       |   |   |
| Interest income                                                                                                                                                                                      |       | 211                                         |       | 126 |   |
| Interest expense                                                                                                                                                                                     |       | (7,923                                      | )          | (5,852 | ) |
| Loss on foreign  currency transactions                                                                                                                                                               |       | (14                                         | )          | — |   |
| Other income                                                                                                                                                                                         |       | —                                      |       | 57 |   |
| Liquidated  damages under registration rights agreements                                                                                                                                             |       | 395                                         |       | (3,777 | ) |
| Change in fair  value of warrant liability                                                                                                                                                           |       | 4,551                                       |       | 1,124 |   |
| Change in fair  value of derivative liability                                                                                                                                                        |       | 18,043                                      |       | 7,792 |   |
| Reduction in  exercise price of warrants                                                                                                                                                             |       | —                                      |       | (641 | ) |
| Amortization of  deferred financing costs                                                                                                                                                            |       | (841                                        | )          | (858 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs resulting from  principal payments on senior secured notes payable and conversion of  subordinated convertible notes payable |       | —                                      |       | (1,624 | ) |
| Income (loss)  before income taxes                                                                                                                                                                   |       | 10,478                                      |       | (4,052 | ) |
| Provision for  income (benefit) tax                                                                                                                                                                  |       | (1,039                                      | )          | 838 |   |
| Net income  (loss)                                                                                                                                                                                   |       | $                                           | 11,517     |   | $ | (4,890 | ) |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Net income  (loss) per common share:                                                                                                                                                                 |       |                                        |       |   |   |
| Basic                                                                                                                                                                                                |       | $                                           | 0.41       |   | $ | (0.56 | ) |
| Diluted                                                                                                                                                                                              |       | $                                           | (0.23      | ) | $ | (0.56 | ) |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Weighted average  common shares outstanding:                                                                                                                                                         |       |                                        |       |   |   |
| Basic                                                                                                                                                                                                |       | 28,100,179                                  |       | 8,764,038 |   |
| Diluted                                                                                                                                                                                              |       | 29,669,682                                  |       | 8,764,038 |   |
|                                                                                                                                                                                                      |            |                                             |            |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

66

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatement of Stockholders’ Equity (Deficiency)

(amounts inthousands, except for share data)

 
| ** **                                                                                                                           | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **                                                                                                                           | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital** | ** ** |
| Balance at  January 1, 2006                                                                                                     |       | 4,861,149             |       | $                       | 49         |   | $ | 208,207 |   |
| Fair value of  stock options granted for consulting services                                                                         |       | —                |       | —                  |       | 35 |   |
| Fair value of  stock options                                                                                                         |       | —                |       | —                  |       | 2,208 |   |
| Common stock  issued for consulting services                                                                                         |       | 5,769                 |       | —                  |       | 19 |   |
| Common stock  issued upon exercise of stock options                                                                                  |       | 97,287                |       | 1                       |       | 79 |   |
| Common stock  issued upon exercise of warrants                                                                                       |       | 3,020,370             |       | 30                      |       | 5, 296 |   |
| Common stock  issued upon conversion of subordinated convertible notes payable                                                       |       | 2,203,870             |       | 22                      |       | 3,394 |   |
| Warrant  liability transferred to additional paid-in capital as a result of exercise  of warrants                                    |       | —                |       | —                  |       | 9,483 |   |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —                |       | —                  |       | 4,053 |   |
| Reduction in  exercise price of warrants exercised by holders of senior secured notes  payable                                       |       | —                |       | —                  |       | 423 |   |
| Amortization of  deferred compensation                                                                                               |       | —                |       | —                  |       | — |   |
| Net loss                                                                                                                             |       | —                |       | —                  |       | — |   |
| Balance at  December 31, 2006                                                                                                   |       | 10,188,445            |       | 102                     |       | 233,197 |   |
| Fair value of  stock options                                                                                                         |       | —                |       | —                  |       | 2,035 |   |
| Common stock  issued for consulting services                                                                                         |       | 23,076                |       | —                  |       | 75 |   |
| Common stock  issued upon exercise of stock options                                                                                  |       | 127,375               |       | 1                       |       | 100 |   |
| Net income                                                                                                                           |       | —                |       | —                  |       | — |   |
| Balance at  December 31, 2007                                                                                                   |       | 10,338,896            |       | $                       | 103        |   | $ | 235,407 |   |

 

67

----

 
| ** **                                                                                                                           | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity  (Deficiency)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|
| Balance at  January 1, 2006                                                                                                     |       | $                          | (19        | )                        | $          | (238,095                                            | )          | $ | (29,858 | ) |
| Fair value of  stock options granted for consulting services                                                                         |       | —                     |       | —                   |       | 35                                                  |       |
| Fair value of  stock options                                                                                                         |       | —                     |       | —                   |       | 2,208                                               |       |
| Common stock  issued for consulting services                                                                                         |       | —                     |       | —                   |       | 19                                                  |       |
| Common stock  issued upon exercise of stock options                                                                                  |       | —                     |       | —                   |       | 80                                                  |       |
| Common stock  issued upon exercise of warrants                                                                                       |       | —                     |       | —                   |       | 5,326                                               |       |
| Common stock  issued upon conversion of subordinated convertible notes payable                                                       |       | —                     |       | —                   |       | 3,416                                               |       |
| Warrant  liability transferred to additional paid-in capital as a result of exercise  of warrants                                    |       | —                     |       | —                   |       | 9,483                                               |       |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —                     |       | —                   |       | 4,053                                               |       |
| Reduction in  exercise price of warrants exercised by holders of senior secured notes  payable                                       |       | —                     |       | —                   |       | 423                                                 |       |
| Amortization of  deferred compensation                                                                                               |       | 19                         |       | —                   |       | 19                                                  |       |
| Net loss                                                                                                                             |       | —                     |       | (4,890                   | )          | (4,890                                              | )          |
| Balance at  December 31, 2006                                                                                                   |       | —                     |       | (242,985                 | )          | (9,686                                              | )          |
| Fair value of  stock options                                                                                                         |       | —                     |       | —                   |       | 2,035                                               |       |
| Common stock  issued for consulting services                                                                                         |       | —                     |       | —                   |       | 75                                                  |       |
| Common stock  issued upon exercise of stock options                                                                                  |       | —                     |       | —                   |       | 101                                                 |       |
| Net income                                                                                                                           |       | —                     |       | 11,517                   |       | 11,517                                              |       |
| Balance at  December 31, 2007                                                                                                   |       | $                          | —     |                     | $          | (231,468                                            | )          | $ | 4,042 |   |

 

See accompanyingnotes to consolidated financial statements.

 

68

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(amounts in thousands)

 
| ** **                                                                                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                                                                                                                                               |       |                                        |       |   |   |
| Net income  (loss)                                                                                                                                                                                   |       | $                                           | 11,517     |   | $ | (4,890 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities:                                                                                                 |       |                                        |       |   |   |
| Depreciation and  amortization                                                                                                                                                                       |       | 8,539                                       |       | 8,287 |   |
| Write-off of  unamortized discount on debt and deferred financing costs resulting from  principal payments on senior secured notes payable and conversion of  subordinated convertible notes payable |       | —                                      |       | 1,624 |   |
| Provision for  doubtful accounts                                                                                                                                                                     |       | 203                                         |       | 705 |   |
| Stock-based  compensation                                                                                                                                                                            |       | 2,110                                       |       | 2,281 |   |
| Deferred income  taxes                                                                                                                                                                               |       | (264                                        | )          | — |   |
| Other                                                                                                                                                                                                |       | —                                      |       | (88 | ) |
| Change in fair  value of warrant liability                                                                                                                                                           |       | (4,551                                      | )          | (1,124 | ) |
| Change in fair  value of derivative liability                                                                                                                                                        |       | (18,043                                     | )          | (7,792 | ) |
| Reduction in  exercise price of warrants                                                                                                                                                             |       | —                                      |       | 641 |   |
| Changes in  liquidated damages payable under registration rights agreements                                                                                                                          |       | (395                                        | )          | 3,777 |   |
| Write-off of  fixed assets                                                                                                                                                                           |       | 97                                          |       | — |   |
| Sub-total                                                                                                                                                                                            |       | (787                                        | )          | 3,421 |   |
| Changes in  operating assets and liabilities:                                                                                                                                                        |       |                                        |       |   |   |
| (Increase)  decrease in - Accounts receivable                                                                                                                                                        |       | (1,443                                      | )          | (3,966 | ) |
| Finished goods  inventory                                                                                                                                                                            |       | 281                                         |       | 22 |   |
| Prepaid expenses  and other current assets                                                                                                                                                           |       | (1,147                                      | )          | (119 | ) |
| Income taxes  refundable                                                                                                                                                                             |       | (147                                        | )          | 1,211 |   |
| Deposits and  other assets                                                                                                                                                                           |       | 1                                           |       | 4 |   |
| Increase  (decrease) in - Accounts payable                                                                                                                                                           |       | (293                                        | )          | 921 |   |
| Accrued expenses                                                                                                                                                                                     |       | 363                                         |       | (463 | ) |
| Accrued interest  payable                                                                                                                                                                            |       | 3,285                                       |       | (540 | ) |
| Deferred revenue                                                                                                                                                                                     |       | 191                                         |       | (338 | ) |
| Deferred rent                                                                                                                                                                                        |       | (13                                         | )          | 199 |   |
| Financing  agreements                                                                                                                                                                                |       | (34                                         | )          | 53 |   |
| Income taxes  payable                                                                                                                                                                                |       | (295                                        | )          | 495 |   |
| Liquidated  damages payable under registration rights agreements                                                                                                                                     |       | (1,000                                      | )          | — |   |
| Net cash  provided by (used in) operating activities                                                                                                                                                 |       | (1,038                                      | )          | 900 |   |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Cash flows from  investing activities:                                                                                                                                                               |       |                                        |       |   |   |
| Purchases of  property and equipment                                                                                                                                                                 |       | (481                                        | )          | (1,077 | ) |
| Guaranteed  payments to MediaDefender management                                                                                                                                                     |       | —                                      |       | (1,050 | ) |
| Net cash used in  investing activities                                                                                                                                                               |       | (481                                        | )          | (2,127 | ) |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Cash flows from  financing activities:                                                                                                                                                               |       |                                        |       |   |   |
| Proceeds from  exercise of stock options                                                                                                                                                             |       | 101                                         |       | 99 |   |
| Proceeds from  exercise of warrants                                                                                                                                                                  |       | —                                      |       | 5,326 |   |
| Principal payments  on senior secured notes payable                                                                                                                                                  |       | —                                      |       | (1,693 | ) |
| Decrease  (increase) in restricted cash                                                                                                                                                              |       | 84                                          |       | (5 | ) |
| Net cash  provided by financing activities                                                                                                                                                           |       | 185                                         |       | 3,727 |   |
|                                                                                                                                                                                                 |       |                                        |       |   |   |
| Cash and cash  equivalents:                                                                                                                                                                          |       |                                        |       |   |   |
| Net increase  (decrease)                                                                                                                                                                             |       | (1,334                                      | )          | 2,500 |   |
| Balance at  beginning of year                                                                                                                                                                        |       | 5,602                                       |       | 3,102 |   |
| Balance at end  of year                                                                                                                                                                              |       | $                                           | 4,268      |   | $ | 5,602 |   |

 

69

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| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Supplemental  disclosure of cash flow information:                                                                                   |       |                                        |       |   |   |
| Cash paid for -                                                                                                                      |       |                                        |       |   |   |
| Interest                                                                                                                             |       | $                                           | 1,527      |   | $ | 3,243 |   |
| Income taxes                                                                                                                         |       | $                                           | 678        |   | $ | — |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Non-cash  investing and financing activities:                                                                                        |       |                                        |       |   |   |
| Warrant  liability transferred to additional paid-in capital as a result of exercise  of warrants                                    |       | $                                           | —     |   | $ | 9,483 |   |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | $                                           | —     |   | $ | 4,053 |   |
| Common stock  issued upon conversion of subordinated convertible notes payable                                                       |       | $                                           | —     |   | $ | 3,416 |   |

 

See accompanyingnotes to consolidated financial statements.

 

70

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ARTISTDIRECT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2007 AND 2006

 

1.  BASIS OF PRESENTATION

 

Organization and Business Activities

 

ARTISTdirect, Inc., a Delaware corporation, is adigital media entertainment company that is home to an online music networkand, through its MediaDefender subsidiary, is a leading provider of anti-piracysolutions in the Internet-piracy-protection (“IPP”) industry.  The ARTISTdirect Network(www.artistdirect.com) is a network of web-sites appealing to music fans,artists and marketing partners that offers multi-media content, music news andinformation, communities organized around shared music interests, music-relatedspecialty commerce and digital music services. The Company is headquartered in Santa Monica, California.  Unless the context indicates otherwise,ARTISTdirect, Inc. and its subsidiaries are referred to herein as the “Company”.

 

Principles ofConsolidation

 

The accompanying financial statements include theconsolidated accounts of the Company and its subsidiaries in which it hascontrolling financial interests.  Allintercompany accounts and transactions have been eliminated for all periodspresented.

 

Going Concern

 

As a result ofcommunications with the Staff of the Securities and Exchange Commission in2006, in particular regarding the application of accounting rules andinterpretations related to embedded derivatives associated with the Company’ssubordinated convertible notes payable issued in July 2005, the Companydetermined that it was necessary to restate previously issued financialstatements.

 

As a result, in December 2006,the Company was required to suspend the use of its then effective registrationstatement for the holders of its senior and subordinated indebtedness.  In addition to this initial default, theCompany has since entered into other events of default which continue to be ineffect as of December 31, 2007. During 2007, the Company entered into a series of forbearance agreementswith the investors in the senior notes with respect to these defaults.

 

As a result of therequirement to restate previously issued financial statements, which resultedin the recording of an embedded derivative liability, the reclassification ofthe senior and subordinated indebtedness to current liabilities, and therecording of liquidated damages payable under registration rights agreements,the Company was not in compliance with certain of its financial covenants underboth the Senior Financing and the Sub-Debt Financing at December 31,2006.  Notwithstanding such developments,the Company would have been out of compliance with certain of its financialcovenants at December 31, 2007.

 

Pursuant to a series of Forbearance and ConsentAgreements with the investors in the Senior Financing, such investors agreed toforbear from the exercise of their rights and remedies under the SeniorFinancing documents as a result of the events of default which were then inexistence during the period, from April 17, 2007 through February 20,2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and$494,446 in February 2008.  Thepayments made by the Company under the Forbearance and Consent Agreements werecredited against the registration delay cash penalties and interest on thepenalties resulting from the Company’s default under the various agreementsbetween the Company and the Senior Financing investors.  On March 17, 2008, the Company enteredinto a Forbearance and Consent Agreement with the investors in the Company’sSenior Debt Financing, which was effective as of February 20, 2008,whereby the investors  agreed to forbearfrom exercising any of their rights and remedies under the Senior Financingtransaction documents through December 31, 2008 in exchange for anadjustment in the interest rate associated with the Senior Notes from 11.25% to15%, provided the loan is repaid prior to September 30, 2008 or 16%, ifthe loan remains outstanding subsequent to that date.

 

71

----

 

The registration delaypenalties and ongoing default interest charges are continuing to have asignificant and material negative impact on the Company’s operations and cashflows.  The Company is exploring variousalternatives to resolve the defaults under its senior and secured debtobligations, but is unable to predict the outcome of such negotiations.  On February 7, 2008 the Company retainedthe services of Salem Partners, LLC, to serve as a financial advisor to theCompany in connection with the sale, merger, consolidation, reorganization orother business combination and the restructuring of the material terms of theCompany’s senior notes and/or subordinated convertible notes. To the extentthat the Company is unable to complete a sale or merger or restructure itssenior and subordinated debt obligations in a satisfactory manner and/or thelenders begin to exercise additional remedies to enforce their rights, theCompany will not have sufficient cash resources to maintain its operations.  In such event, the Company may be required toconsider a formal or informal restructuring or reorganization, including afiling under Chapter 11 of the United States Bankruptcy Code.

 

The accompanyingconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America, whichcontemplate continuation of the Company as a going concern.  As a result of the foregoing, the Company’sindependent registered public accounting firm, in its report on the Company’s2007 consolidated financial statements, expressed substantial doubt about theCompany’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments relating to the recoverability and classification ofrecorded asset amounts or the amounts and classification of liabilities thatcould result from the outcome of this uncertainty.

 

2.  SIGNIFICANT ACCOUNTING POLICIES

 

Cash Equivalents

 

Cash equivalents consist of investments, which arereadily convertible into cash and have maturities of three months or less atthe time of purchase.

 

Restricted Cash

 

As of December 31, 2007 and 2006, restricted cashconsisted of a bank certificate of deposit with balances of $190,000 and$184,000, respectively, securing a bank letter of credit provided as securityfor charge-backs to the Company’s e-commerce credit card processor.  In addition, at December 31, 2007 and2006, the Company had classified $90,000 and $180,000 of cash as restrictedcash as such cash was pledged to secure an irrevocable bank stand-by letter ofcredit for the same amount issued in conjunction with the Company’s new officelease which commenced in February 2006 (see Note 16).  During February 2007, the irrevocablebank stand-by letter of credit was reduced to $90,000, and restricted cash wasreduced commensurately.

 

Accounts Receivable

 

The Company grants credit to its customers generallyin the form of short-term trade accounts receivable.  Accounts receivable are stated at the amountthat management expects to collect from outstanding balances.  When appropriate, management provides forprobable uncollectible amounts through a provision for doubtful accounts and anadjustment to a valuation allowance. Management primarily determines the allowance based on the aging ofaccounts receivable balances, historical write-off experience, customerconcentrations, customer creditworthiness and current industry and economictrends.  Balances that are stilloutstanding after management has used reasonable collection efforts are writtenoff through a charge to the valuation allowance and a credit to accountsreceivable.

 

Property and Equipment

 

Expenditures for majorrenewal and betterments that extend the useful lives of property and equipmentare capitalized.  Expenditures formaintenance and repairs are charged to expense as incurred.  When property and equipment is sold orotherwise disposed of, the assets and related accumulated depreciation accountsare relieved, and any gain or loss is included in operations.

 

Depreciation is computedon the straight-line method based on the estimated useful lives of the assets,which is generally three years for computer equipment and software and sevenyears for furniture and fixtures.  Leaseholdimprovements are amortized over the remaining life of the related lease, whichhas been determined to be shorter than the life of the asset.

 

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Goodwill, IntangibleAssets and Long-Lived Assets

 

Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFASNo. 142”), requires purchased intangible assets other than goodwill to beamortized over their useful lives unless these lives are determined to beindefinite.  Accordingly, with respect tothe MediaDefender transaction, non-compete agreements are being amortized overthe life of the respective non-compete agreements, ranging from 20 months to 4years, and customer relationships and proprietary technology are beingamortized over 3 years.  Assetallocations and amortization periods with respect to the MediaDefendertransaction were determined with the assistance of an independent valuationfirm.

 

SFAS No. 142 alsorequires goodwill to be tested for impairment at least on an annual basis andmore often under certain circumstances, and written down when impaired.  An interim impairment test is required if anevent occurs or conditions change that would more likely than not reduce thefair value of the reporting unit below the carrying value.

 

The Company completed agoodwill impairment test during the third quarter of 2007 and found no need foran adjustment.  Due to the reduced salesactivity in the Company’s anti-piracy business for the year 2007 and internalprojections for 2008, management of the Company again revisited the impairmentwork during the year end review for 2007 and noted that while the testthresholds were narrower, an adjustment was still not required.  The Company’s management plans to closelymonitor the sales activity within this segment during each fiscal quarter of2008 and, if warranted, will record an impairment loss to adjust downward thecarrying value of the segment at that time.

 

The Company accounts forthe impairment of long-lived assets, such as property and equipment andintangible assets, under the provisions of Statement of Financial AccountingStandards No. 144, “Accounting for the Impairment of Long-Lived Assets” (“SFASNo. 144”).  SFAS No. 144establishes the accounting for impairment of long-lived tangible and intangibleassets other than goodwill and for the disposal of a business.  Pursuant to SFAS No. 144, the Companyperiodically evaluates, at least annually, whether facts or circumstancesindicate that the carrying value of its depreciable assets to be held and usedmay not be recoverable.  If suchcircumstances are determined to exist, an estimate of undiscounted future cashflows produced by the long-lived asset, or the appropriate grouping of assets,is compared to the carrying value to determine whether impairment exists.  In the event that the carrying amount oflong-lived assets exceeds the undiscounted future cash flows, then the carryingamount of such assets is adjusted to their fair value.  The Company reports an impairment cost as acharge to operations at the time it is recognized.

 

There was no impairment of long-lived assets in 2006or 2007.

 

Derivative Financial Instruments

 

Statement of FinancialAccounting Standards No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS No. 133”), requires all derivatives to berecorded on the balance sheet at fair value.  When multiple derivatives(both assets and liabilities) exist within a financial instrument, they arebundled together as a single hybrid compound instrument in accordance with SFASNo. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple DerivativeFeatures Embedded in a Single Hybrid Instrument”.  The calculation of the fair value ofderivatives utilizes highly subjective and theoretical assumptions that canmaterially affect fair values from period to period.  The change in the fair value of thederivatives from period to period is recorded in other income (expense) in thestatement of operations.  As a result,the Company’s financial statements are impacted quarterly based on factors suchas the price of the Company’s common stock and the principal amount of Sub-DebtNotes converted into common stock. Consequently, the Company’s results of operations and financial positionmay vary from quarter to quarter based on factors other than those directlyassociated with the Company’s operating revenues and expenses.  The recognition of these derivative amountsdoes not have any impact on cash flows.

 

EITF 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock (“EITF 00-19”), requires freestanding contracts that aresettled in a company’s own stock, including common stock warrants, to bedesignated as an equity instrument, an asset or a liability.  When theability to physically or net-share settle a conversion option or the exerciseof freestanding options or warrants is deemed to be not within the control ofthe Company, the embedded conversion option or freestanding options or warrantsmay be required to be accounted for as a derivative liability.  Under the provisions of EITF 00-19, acontract designated as an asset or a liability must be carried at fair value ona company’s balance sheet, with any changes in fair value recorded in a company’sresults of operations.

 

The Company has accountedfor registration rights penalties in accordance with EITF 00-19-2, “Accountingfor Registration Payment Arrangements”, which the Company adopted as of December 31,2006, and Statement of Financial Accounting Standards No. 5, “Accountingfor Contingencies”.  Since the registration rights component of thederivative liabilities was not material through September 30, 2006, therewas no cumulative-effect adjustment recorded as a result of the transition rules withrespect to the adoption of EITF-00-19-2 at December 31, 2006.

 

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The Company accounts forderivatives, including the embedded derivatives associated with the Sub-DebtNotes and the warrants issued in conjunction with the Senior Financing and theSub-Debt Financing, at fair value, adjusted at the end of each reporting periodto reflect any material changes, with any such changes included in other income(expense) in the statement of operations.

 

At the date of theconversion of Sub-Debt Notes into common stock or the principal repayment ofSenior Notes, the pro rata portion of the related unamortized discount on debtand deferred financing costs is charged to operations and included in otherincome (expense).  At the date ofexercise of any of the warrants, or the conversion of Sub-Debt Notes intocommon stock, the pro rata portion of the fair value of the related warrantliability and/or embedded derivative liability is transferred to additionalpaid-in capital.

 

Deferred Financing Costs

 

Deferred financing costsconsist of cash and non-cash consideration paid to third parties with respectto the acquisition and financing of the MediaDefender transaction, includinglegal fees and placement agent fees. Such costs are being deferred and amortized over the term of the relateddebt.  Upon the conversion ofsubordinated convertible notes payable into common stock and the partialrepayment of the senior secured notes payable, the pro rata portion of anyrelated unamortized deferred financing costs are charged to operations.

 

Discount on Debt

 

Additional considerationin the form of warrants and other derivative financial instruments issuedto lenders was accounted for at fair value based on reports prepared byindependent valuation firms.  The fairvalue of warrants and derivatives was recorded as a reduction to the carryingamount of the related debt, and is being amortized to interest expense over theterm of such debt, with the initial offsetting entries recorded as warrantliability and derivative liability on the balance sheet.  Upon the conversion of subordinatedconvertible notes payable into common stock, the pro rata portion of anyrelated unamortized discount on debt is charged to operations.

 

Revenue Recognition

 

The Company complies with the provisions of StaffAccounting Bulletin (“SAB”) No. 101, “Revenue Recognition in FinancialStatements”, as amended by SAB No. 104, and recognizes revenue when allfour of the following criteria are met:  (i) persuasiveevidence that an arrangement exists; (ii) delivery of the products and/orservices has occurred; (iii) the selling price is both fixed anddeterminable; and (iv) collectability is reasonably assured.

 

E-commerce revenue consists primarily of the grossamount of sales revenue paid by the customer for recorded music and merchandisesold via the Internet, including shipping fees, and is recognized when theproducts are shipped. The Company has a contract with a fulfillment house to serviceits music-related e-commerce activity. The Company records e-commerce revenueon a gross basis as the Company enters into the sale transactions withcustomers, establishes the prices of the products, chooses the suppliers of theproducts, assumes the risk of inventory loss and collects all amounts from thecustomers and assumes the credit risk. In certain circumstances, e-commerce revenue is subject to royalties,and such expense is recorded as part of cost of e-commerce revenue.

 

The Company records amounts charged to customers forshipping and handling in accordance with EITF 00-10, “Accounting forShipping and Handling Fees and Costs” (“EITF 00-10”).  Pursuant to EITF 00-10, the Companyrecords amounts charged to customers for shipping and handling as revenue, andrecords the related costs incurred for shipping and handling to direct cost ofproduct sales in the statement of operations. For the years ended December 31, 2007 and 2006, the Companyrecorded $236,000 and $581,000, respectively, as revenue for shipping andhandling fees charged to customers. For the years ended December 31, 2007and 2006, the Company recorded $253,000 and $374,000, respectively, of shippingand handling costs as direct cost of product sales in the statements ofoperations.

 

Media revenue consists primarily of the sale ofadvertisements and sponsorships under short-term contracts.  To date, the duration of the Company’sadvertising commitments has generally averaged from one to three months,although certain programs can last up to one year.  The Company’s online obligations typicallyinclude the guarantee of a minimum number of times (“impressions”) that anadvertisement appears in pages viewed by the users of the Company’s onlineproperties.  Online advertising revenueis generally recognized as the impressions are served during the period inwhich the advertisement is displayed, provided that no significant obligationsof the Company remain and collection of the resulting receivable is reasonablyassured.  To the extent that minimumguaranteed page deliveries are not met, recognition of the correspondingrevenue is deferred until the guaranteed impressions are delivered.

 

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The Company recognizesrevenue for sponsorship arrangements over the period during which theadvertising is provided, generally on a straight-line basis.  The Company recognizes revenue for a bannerimpression deliverable as the banner impressions are delivered.  The Company recognizes revenue for web-page sponsorshipson a straight-line basis over the term of the sponsorship.  The Company recognizes revenue for customcontent when the content is provided to the customer.

 

Anti-piracy and filesharing marketing services revenue is recognized on a monthly basis as servicesare provided to customers.  Deferredrevenue is recorded for customers who prepay the full, or any portion, of theirrespective contracts.

 

Cost of Revenue

 

Cost of product sales consists of amounts payablerelated to e-commerce sales, which includes the cost of merchandise sold androyalties, and online commerce transaction costs, including credit card fees,fulfillment charges and shipping costs. Distribution expenses consist of various distribution costs, includingthe cost of processing returns and warehousing inventory.  The Company has a contract with a fulfillmenthouse to service its music-related e-commerce activity.

 

Media cost of revenue consists primarily of web-sitehosting and maintenance costs, online content programming costs, onlineadvertising serving costs, sales commissions, payments to affiliated web-sites,and payroll and related expenses for staff involved with the web-site.  Costs related to the web-site are charged tooperations as incurred.  Anti-piracy andfile sharing marketing services cost of revenue consists primarily ofbandwidth, labor and occupancy costs. Amortization of proprietary technology is included in anti-piracy andfile sharing marketing services cost of revenue.

 

Depreciation expense is included in the related costof revenue category.

 

Inventories

 

Inventories, net of a provision for obsolescence of$69,000 at December 31, 2006, consisted of music-related merchandisemaintained in the warehouse of the Company’s distributor.  Inventories are stated at the lower of costor net realizable value.  Cost isdetermined using the first-in, first-out method.  As a result of the Company restructuringits relationship with a merchandising entity effective August 31, 2007 toeliminate merchandise sales (and the related inventory) and focus on musicsales, the Company does not currently carry any inventory.

 

Income Taxes

 

The Company accounts for income taxes under Statementof Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFASNo. 109”).  SFAS No. 109requires recognition of deferred tax assets and liabilities for the expectedfuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases.  Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled.  Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in the statement of operations in the period that includes theenactment date.  A valuation allowance isestablished, when necessary, to reduce deferred tax assets to the amountexpected to be realized.

 

Development and Engineering Costs

 

Development and engineering costs, which are presentedseparately in the statement of operations in 2007, consist primarily ofthird-party development costs and payroll and related expenses for in-housedevelopment costs incurred in the design and production of the Company’scontent and services, including revisions to the Company’s web-site.  These costs are charged to operations asincurred.  During the year ended December 31,2006, these costs were included in cost of revenues and totaled approximately$120,000.

 

Advertising Costs

 

Advertising costs are included in selling andmarketing expense and are charged to operations as incurred, and totaled $4,000and $104,000 during the years ended December 31, 2007 and 2006,respectively.

 

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Concentration of Risk

 

Financial instruments that potentially subject theCompany to significant concentrations of credit risk consist principally ofcash, short-term investments and trade accounts receivable.  The Company places its cash and short-terminvestments in high credit quality instruments. Cash balances at certain financial institutions may exceed the FDICinsurance limits.  The Company performsongoing credit evaluations of its customers but does not requirecollateral.  Exposure to losses onreceivables is principally dependent on each customer’s financialcondition.  The Company monitors itsexposure to credit losses and maintains appropriate allowances for anticipatedlosses.

 

Concentrations of credit risk with respect to tradereceivables generated by the Company’s operations are generally limited.  However, MediaDefender’s customers consistprimarily of large reputable companies in the music and entertainmentindustries.

 

During the year ended December 31, 2007, onecustomer accounted for $1,270,000 or 16% of total media revenue, of which$423,000 was due from this customer at December 31, 2007.  During the year ended December 31, 2006,a different customer accounted for $730,000 or 13% of total media revenue, ofwhich $335,000 was due from this customer at December 31, 2006.

 

During the year ended December 31, 2007, theCompany’s media revenues were generated primarily by two outside salesorganizations that represented the Company with respect to advertising andsponsorship sales on the Company’s web-site and through affiliated web-sites,as well as by in-house sales personnel. During the year ended December 31, 2006, the Company’s mediarevenues were generated primarily by one outside sales organization thatrepresented the Company with respect to advertising and sponsorship sales onthe Company’s web-site and through affiliated web-sites.

 

During the year ended December 31,2007, approximately 38% of MediaDefender’s revenues were from two customers,with one customer accounting for 21% and another customer accounting for17%.  At December 31, 2007, theamounts due from such customers were $1,872,000 and $677,000, respectively,which were included in accounts receivable. In January 2008, MediaDefender was notified by a customeraccounting for 12% of 2007 revenue, that they were discontinuing service andwere evaluating the use of other methods to offset the negative impact ofpiracy.  In November 2007, a recordlabel customer, which accounted for 4% of MediaDefenders’ 2007 revenue, alsodiscontinued service citing costs pressures subsequent to a change inownership.

 

During the year ended December 31,2006, approximately 73% of MediaDefender’s revenues were from four customers,with one customer accounting for 27%, another customer accounting for 25%, athird customer accounting for 11%, and a fourth customer accounting for10%.  At December 31, 2006, theamounts due from such customers were $854,039, $620,000, $773,333 and $649,549,respectively, which were included in accounts receivable.

 

During the year ended December 31,2007, MediaDefender purchased approximately 55% of its bandwidth from threesuppliers.  At December 31, 2007,amounts payable to two of these suppliers aggregated $124,000.  During the year ended December 31, 2006,MediaDefender purchased approximately 67% of its bandwidth from threesuppliers.  At December 31, 2006,there were no amounts payable to these suppliers.  Although there are other suppliers ofbandwidth, a change in suppliers could cause delays, which could adverselyaffect operations in the short-term.

 

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Foreign CurrencyTransactions

 

The Company’s reportingcurrency and functional currency is the United States dollar.  The Company periodically receives paymentsfor services in Canadian dollars and British pounds, which are translated intoUnited States dollars using the exchange rate in effect at the date of payment.  Gains or losses resulting from foreign currencytransactions, to the extent material, are included in other income (expense) inthe statement of operations.

 

Fair Value of FinancialInstruments

 

The carrying amounts ofcash and cash equivalents, accounts receivable, accounts payable and liquidateddamages payable under registration rights agreements approximate theirrespective fair values because of the short maturity of these instruments.  The carrying amounts of senior secured notespayable and subordinated convertible notes payable approximate their respectivefair values because of their current interest rates payable and other featuresof such debt in relation to current market conditions.  The carrying value of warrant liability andderivative liability approximate their respective fair values since they areadjusted to fair value at each period end.

 

Earnings Per Share

 

The Company calculatesearnings per share in accordance with Statement of Financial AccountingStandards No. 128, “Earnings Per Share” (“SFAS No. 128”), and EITF03-6, “Participating Securities and the Two-Class Method under FASBStatement No. 128”.  EITF 03-6clarifies the use of the “two-class” method of calculating earnings per shareas originally prescribed in SFAS No. 128 and provides guidance on how todetermine whether a security should be considered a “participating security”.

 

The Company hasdetermined that its convertible subordinated notes payable are a participatingsecurity, as each note holder is entitled to receive any dividends paid anddistributions made to the common stockholders as if the note had been convertedinto common stock on the record date.

 

Under the two-classmethod, basic income (loss) per common share is computed by dividing net income(loss) applicable to common stockholders by the weighted-average number ofcommon shares outstanding for the reporting period.  Diluted income (loss) per common share iscomputed using the more dilutive of the “two-class” method or the “if-converted”method.  Net losses are not allocable tothe holders of the subordinated convertible notes payable.  Diluted income (loss) per share gives effectto all potentially dilutive securities, including stock options, senior andsub-debt warrants, and convertible subordinated notes payable, unless they areanti-dilutive.

 

The calculation ofdiluted weighted average common shares outstanding for the years ended December 31,2007 and 2006 is based on the average of the closing price of the Company’scommon stock during each respective period.

 

The calculation ofdiluted income per share for the year ended December 31, 2007 included theimpact from dilutive stock options and senior and sub-debt warrants, butexcluded the effect from the conversion of subordinated convertible notespayable, as well as stock options and warrants representing 1,217,940 sharesand 433,333 shares, respectively, since their effect would have beenanti-dilutive.

 

The calculation ofdiluted loss per share for the year ended December 31, 2006 excluded theeffect from the conversion of subordinated convertible notes payable and theexercise of stock options and senior and sub-debt warrants aggregatingapproximately 25,785,830 shares of common stock, respectively, since theireffect would have been anti-dilutive.

 

Issued but unvestedshares of common stock are excluded from the calculation of basic earnings pershare, but are included in the calculation of diluted earnings per share, tothe extent that they are not anti-dilutive.

 

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The calculation ofearnings per share is summarized as follows:

 
| ** **                                                                                                              | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| Numerator:                                                                                                              |       |                                        |       |   |   |
| Net income  (loss), as reported                                                                                         |       | $                                           | 11,517,000 |   | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Allocation of  net (loss) income:                                                                                       |       |                                        |       |   |   |
| Basic:                                                                                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss) applicable to common stockholders                                                                    |       | $                                           | 4,204,000  |   | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss) applicable to convertible subordinated notes                                                         |       | 7,313,000                                   |       | — |   |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss)                                                                                                      |       | $                                           | 11,517,000 |   | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Diluted:                                                                                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** |
|                                                                                                                    |       |                                        |       |   |   |
| Net income (loss)  applicable to common stockholders                                                                    |       | $                                           | 2,710,000  |   | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss) applicable to convertible subordinated notes                                                         |       | 4,090,000                                   |       | — |   |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss)                                                                                                      |       | $                                           | 6,800,000  |   | $ | (4,890,000 | ) |
| Denominator:                                                                                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares outstanding                                                                             |       | 10,256,127                                  |       | 8,764,038 |   |
| Weighted average  common shares attributable to subordinated notes                                                      |       | 17,844,052                                  |       | — |   |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares used in calculating basic net income (loss) per common share                            |       | 28,100,179                                  |       | 8,296,876 |   |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares issuable upon exercise of outstanding stock options based on  the treasury stock method |       | 964,767                                     |       | — |   |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares issuable upon exercise of sub- debt warrants, based on the  treasury stock method       |       | 604,735                                     |       | — |   |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares used in computing diluted net income (loss) per common share                            |       | 29,669,682                                  |       | 8,296,876 |   |
|                                                                                                                    |       |                                        |       |   |   |
| Calculation of  net income (loss) per common share:                                                                     |       |                                        |       |   |   |
|                                                                                                                    |       |                                        |       |   |   |
| Basic:                                                                                                                  |       |                                        |       |   |   |
| Net income  (loss) applicable to common stockholders                                                                    |       | $                                           | 11,517,000 |   | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares used in calculating basic net income (loss) per common share                            |       | 28,100,179                                  |       | 8,764,038 |   |
| Net income  (loss) per share applicable to common stockholders                                                          |       | $                                           | 0.41       |   | $ | (0.56 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Diluted:                                                                                                                |       |                                        |       |   |   |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss) applicable to common stockholders                                                                    |       | $                                           | (6,800,000 | ) | $ | (4,890,000 | ) |
|                                                                                                                    |       |                                        |       |   |   |
| Weighted average  common shares used in calculating diluted net income (loss) per common share                          |       | 29,669,682                                  |       | 8,764,038 |   |
|                                                                                                                    |       |                                        |       |   |   |
| Net income  (loss) per common share applicable to common stockholders                                                   |       | $                                           | (0.23      | ) | $ | (0.56 | ) |

 

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Stock-Based Compensation

 

EffectiveJanuary 1, 2006, the Company adopted Statement of Financial AccountingStandards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”),a revision to SFAS No. 123, “Accounting for Stock-Based Compensation”.  SFAS No. 123R requires that the Companymeasure the cost of employee services received in exchange for equity awardsbased on the grant date fair value of the awards, with the cost to berecognized as compensation expense in the Company’s financial statements overthe vesting period of the awards. Accordingly, the Company recognizes compensation cost for equity-basedcompensation for all new or modified grants issued after December 31,2005.  In addition, commencing January 1,2006, the Company recognized the unvested portion of the grant date fair valueof awards issued prior to adoption of SFAS No. 123R based on the fairvalues previously calculated for disclosure purposes over the remaining vestingperiod of the outstanding stock options and warrants.

 

TheCompany accounts for stock option and warrant grants issued and vesting tonon-employees in accordance with EITF No. 96-18, “Accounting for EquityInstruments that are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services”, and EITF 00-18, “AccountingRecognition for Certain Transactions involving Equity Instruments Granted toOther Than Employees”, whereas the value of the stock compensation is basedupon the measurement date as determined at either (a) the date at which aperformance commitment is reached or (b) at the date at which thenecessary performance to earn the equity instruments is complete.

 

Duringthe years ended December 31, 2007 and 2006, the Company recorded$1,677,000 and $1,576,000, respectively, as a charge to operations to recognizethe unvested portion of the grant date fair value of awards issued prior to theadoption of SFAS No. 123R.

 

AtDecember 31, 2007, the unvested portion of the grant date fair value ofawards issued prior to adoption of SFAS No. 123R on January 1, 2006(excluding milestone–vested options), based on the fair values previouslycalculated, will be charged to operations over the remaining vesting period ofthe outstanding options as follows (amounts are in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| ** **                                   | ** ** | ** ** | ** ** |
| 2008                                         |       | $          | 883        |   |
| 2009                                         |       | 26         |       |
| Total                                        |       | $          | 909        |   |

 

For the past severalyears and in accordance with established public company accounting practice,the Company has consistently utilized the Black-Scholes option-pricing model tocalculate the fair value of stock options and warrants issued as compensation,primarily to management, employees and directors.  The Black-Scholes option-pricing model is awidely-accepted method of valuation that public companies typically utilize tocalculate the fair value of options and warrants that they issue in suchcircumstances.

 

In calculating the Black-Scholes value of stockoptions and warrants issued, the Company uses the full term of the option, anappropriate risk-free interest rate (generally from 4% to 5%), and a 0%dividend yield.

 

The Company utilizes the daily closing stock prices ofits common stock as quoted on the OTC Bulletin Board to calculate the expectedvolatility used in the Black-Scholes option-pricing model.  Since the Company’s business operations andcapital structure changed dramatically on July 28, 2005 as a result of theacquisition of MediaDefender and the related financing transactions, theCompany has utilized daily closing stock prices from August 1, 2005through each subsequent quarter end to generate a volatility factor for use incalculating the fair value of options and warrants issued during eachrespective period.  By utilizing dailytrading data related to the period of time that reflects the Company’s currentbusiness operations, the Company believes that this methodology generatesvolatility factors that more accurately reflect, as well as adjust for, normalmarket fluctuations in the Company’s common stock over an extended period oftime.  This methodology has generatedvolatility factors ranging from approximately 163% to 100% during 2005, 2006and 2007.  These volatility factors havegenerally trended downward during 2006 and 2007.

 

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Estimates

 

In preparing financial statements in conformity withgenerally accepted accounting principles, management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements and revenues and expenses during the reportingperiod.  Some of the more significantestimates include allowances for bad debts and sales returns, impairment oflong-lived assets, impairment of fixed assets, stock-based compensation, thevaluation allowance on deferred tax assets, and the change in fair value of thewarrant liability and derivative liability. Actual results could differ from those estimates.

 

Reclassification

 

Certain amounts have been reclassified from theirpresentation in 2006 to conform to the current year’s presentation.  Such reclassifications did not have anyeffect on income (loss) from operations or net income (loss).

 

Adoption of NewAccounting Policies

 

In June 2006, theEmerging Issues Task Force (“EITF”) reached a consensus on EITF Issue 06-3, “HowTaxes Collected From Customers and Remitted to Governmental Authorities ShouldBe Presented in the Income Statement (That Is, Gross versus Net Presentation)”(“EITF 06-3”).  The scope of EITF 06-3includes any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction between a seller and a customer, andprovides that a company may adopt a policy of presenting taxes either on a grossbasis - that is, including the taxes within revenue - or on a net basis.  For any such taxes that are reported on agross basis, a company should disclose the amounts of those taxes for eachperiod for which an income statement is presented if those amounts aresignificant.  The Company collectsvarious state sales taxes that fall under the scope of EITF 06-3 on goods thatit sells in its e-commerce business segment and is accounting for and reportingsuch taxes on a net basis.  EITF 06-3 iseffective for financial reports for interim periods and annual reportingperiods beginning after December 15, 2006. The Company adopted EITF 06-3 effective January 1, 2007.  The adoption of EITF 06-3 did not have amaterial effect on the Company’s financial statements.

 

In December 2006,the Financial Accounting Standards Board (“FASB”) issued FSP EITF 00-19-2, “**Accounting forRegistration Payment Arrangements” (“EITF 00-19-2”), which**addresses an issuer’s accounting for registration payment arrangements.  EITF 00-19-2 specifies that the contingentobligation to make future payments or otherwise transfer consideration under aregistration payment arrangement, whether issued as a separate agreement orincluded as a provision of a financial instrument or other agreement, should beseparately recognized and measured in accordance with SFAS No. 5, “**Accounting forContingencies”**. EITF 00-19-2 further clarifies that a financial instrument subject to aregistration payment arrangement should be accounted for in accordance withother applicable generally accepted accounting principles without regard to thecontingent obligation to transfer consideration pursuant to the registrationpayment arrangement.  EITF 00-19-2 iseffective immediately for registration payment arrangements and the financialinstruments subject to those arrangements that are entered into or modifiedsubsequent to the date of issuance of EITF 00-19-2.  For registration payment arrangements andfinancial instruments subject to those arrangements that were entered intoprior to the issuance of EITF 00-19-2, EITF 00-19-2 is effective for financialstatements issued for fiscal years beginning after December 15, 2006, andinterim periods within those fiscal years. Early adoption of EITF 00-19-2 for interim or annual periods for whichfinancial statements or interim reports have not been issued is permitted.  The Company chose to early adopt EITF 00-19-2effective December 31, 2006 (see Note 4).

 

Effective January 1,2007, the Company adopted FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed orexpected to be claimed on a tax return should be recorded in the financialstatements.  Under FIN 48, the Companymay recognize the tax benefit from an uncertain tax position only if it is morelikely than not that the tax position will be sustained on examination by thetaxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financialstatements from such a position should be measured based on the largest benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement.  FIN 48 alsoprovides guidance on de-recognition, classification, interest and penalties onincome taxes, accounting in interim periods and requires increaseddisclosures.  The adoption of theprovisions of FIN 48 did not have a material effect on the Company’s financialstatements.  As of December 31,2007, no liability for unrecognized tax benefits was required to be recorded.

 

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Recent AccountingPronouncements

 

In September 2006,the FASB issued Statement of Financial Accounting Standards No. 157, “FairValue Measurements” (“SFAS No. 157”), which establishes a formal frameworkfor measuring fair value under Generally Accepted Accounting Principles (“GAAP”).SFAS No. 157 defines and codifies the many definitions of fair valueincluded among various other authoritative literature, clarifies and, in someinstances, expands on the guidance for implementing fair value measurements,and increases the level of disclosure required for fair value measurements. AlthoughSFAS No. 157 applies to and amends the provisions of existing FASB andAmerican Institute of Certified Public Accountants (“AICPA”) pronouncements, itdoes not, of itself, require any new fair value measurements, nor does itestablish valuation standards. SFAS No. 157 applies to all otheraccounting pronouncements requiring or permitting fair value measurements,except for: SFAS No. 123R, share-based payment and related pronouncements,the practicability exceptions to fair value determinations allowed by variousother authoritative pronouncements, and AICPA Statements of Position 97-2 and98-9 that deal with software revenue recognition. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. The Company is currentlyassessing the potential effect of SFAS No. 157 on its financialstatements.

 

In February 2007,the FASB issued Statement of Financial Accounting Standards No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”),which provides companies with an option to report selected financial assets andliabilities at fair value. SFAS No. 159’s objective is to reduce bothcomplexity in accounting for financial instruments and the volatility inearnings caused by measuring related assets and liabilities differently.Generally accepted account principles have required different measurementattributes for different assets and liabilities that can create artificial volatilityin earnings. SFAS No. 159 helps to mitigate this type ofaccounting-induced volatility by enabling companies to report related assetsand liabilities at fair value, which would likely reduce the need for companiesto comply with detailed rules for hedge accounting. SFAS No. 159also establishes presentation and disclosure requirements designed tofacilitate comparisons between companies that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159requires companies to provide additional information that will help investorsand other users of financial statements to more easily understand the effect ofthe company’s choice to use fair value on its earnings. SFAS No. 159 alsorequires companies to display the fair value of those assets and liabilitiesfor which the company has chosen to use fair value on the face of the balancesheet. SFAS No. 159 does not eliminate disclosure requirements included inother accounting standards, including requirements for disclosures about fairvalue measurements included in SFAS No. 157 and SFAS No. 107.SFAS No. 159 is effective as of the beginning of a company’s firstfiscal year beginning after November 15, 2007. Early adoption is permittedas of the beginning of the previous fiscal year provided the company makes thatchoice in the first 120 days of that fiscal year and also elects to applythe provisions of SFAS No. 157. The Company is currently assessing thepotential effect of SFAS No. 159 on its financial statements.

 

In December 2007,the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”),which requires an acquirer to recognize in its financial statements as ofthe acquisition date (i) the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree, measured at theirfair values on the acquisition date, and (ii) goodwill as the excess ofthe consideration transferred plus the fair value of any noncontrollinginterest in the acquiree at the acquisition date over the fair values of theidentifiable net assets acquired. Acquisition-related costs, which are the costs an acquirer incurs toeffect a business combination, will be accounted for as expenses in the periodsin which the costs are incurred and the services are received, except thatcosts to issue debt or equity securities will be recognized in accordance withother applicable GAAP. SFAS No. 141(R) makes significant amendmentsto other Statements and other authoritative guidance to provide additionalguidance or to conform the guidance in that literature to that provided in SFASNo. 141(R).  SFAS No. 141(R) alsoprovides guidance as to what information is to be disclosed to enable users offinancial statements to evaluate the nature and financial effects of a businesscombination.  SFAS No. 141(R) iseffective for financial statements issued for fiscal years beginning on orafter December 15, 2008, and early adoption is prohibited. 

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In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements – an amendment of ARB No. 51”(“SFAS No. 160”), which revises the relevance, comparability, andtransparency of the financial information that a reporting entity provides inits consolidated financial statements by establishing accounting and reportingstandards that require (i) the ownership interests in subsidiaries held byparties other than the parent be clearly identified, labeled, and presented inthe consolidated statement of financial position within equity, but separatefrom the parent’s equity, (ii) the amount of consolidated net incomeattributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated statement of income, (iii) changesin a parent’s ownership interest while the parent retains its controllingfinancial interest in its subsidiary be accounted for consistently as equitytransactions, (iv) when a subsidiary is deconsolidated, any retained noncontrollingequity investment in the former subsidiary be initially measured at fair value,with the gain or loss on the deconsolidation of the subsidiary being measuredusing the fair value of any noncontrolling equity investment rather than thecarrying amount of that retained investment, and (v) entities providesufficient disclosures that clearly identify and distinguish between theinterests of the parent and the interests of the noncontrolling owners. SFAS No. 160amends FASB No. 128 to provide that the calculation of earnings per shareamounts in the consolidated financial statements will continue to be based onthe amounts attributable to the parent. SFAS No. 160 is effective forfinancial statements issued for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. Early adoption isprohibited. SFAS No. 160 shall be applied prospectively as of thebeginning of the fiscal year in which it is initially applied, except for thepresentation and disclosure requirements, which shall be appliedretrospectively for all periods presented. The requirements of SFAS No. 160does not apply to the Company as it is currently structured.

 

On March 19,2008—The Financial Accounting Standards Board (FASB) issued FASB Statement No. 161,Disclosures about Derivative Instruments and Hedging Activities. The newstandard is intended to improve financial reporting about derivativeinstruments and hedging activities by requiring enhanced disclosures to enableinvestors to better understand their effects on an entity’s financial position,financial performance, and cash flows. It is effective for financial statementsissued for fiscal years and interim periods beginning after November 15,2008, with early application encouraged. The Company is currently assessing the potential effect of FASB No. 161on its financial statements.

 

3.  ACQUISITION OF MEDIADEFENDER, INC.

 

On July 28, 2005, the Company consummated theacquisition of MediaDefender, Inc., a privately-held Delaware corporation(“MediaDefender”), which is a leading provider of anti-piracy solutions in theInternet-piracy-protection (“IPP”) industry. The stockholders of MediaDefender received aggregate consideration of$42,500,000 in cash, subject to certain holdbacks and adjustments described inthe Merger Agreement.  In order to fundthe acquisition of MediaDefender, the Company completed a $15,000,000 seniorsecured debt transaction and a $30,000,000 convertible subordinated debttransaction, as described at Note 4.

 

In accordance with the Merger Agreement, the Companyacknowledged the terms of Employment Agreements entered into on July 28,2005 by MediaDefender with each of Randy Saaf and Octavio Herrera, confirmingthe terms of their employment.  Mr. Saafand Mr. Herrera each earn a base salary of no less than $350,000 per annumduring the initial term of the agreements, which continue until December 31,2008, and are also each entitled to receive performance bonuses of up to$350,000 if MediaDefender achieves operating earnings before interest, taxes,depreciation and amortization (calculated using the same accounting methods andpolicies as MediaDefender has historically used) exceeding $7,000,000 and$7,500,000 in fiscal 2007 and 2008, respectively.  Mr. Saaf and Mr. Herrera are eachentitled to receive twelve months of severance pay at the rate of 100% of theirmonthly salary and the pro rata portion of the performance bonus referencedabove if they are terminated “without cause”.

 

In conjunction with the acquisition of MediaDefender,effective July 28, 2005, the Company granted stock options to each of Mr. Saafand Mr. Herrera to purchase 200,000 shares of common stock, exercisablefor a period of five years at $3.00 per share, which was in excess of the fairvalue of the common stock issued in the MediaDefender transaction.  These options vest quarterly over three andone-half years.  The fair value of eachof these options, calculated pursuant to the Black-Scholes option-pricingmodel, was determined to be $546,000, which is being recognized as stock-basedcompensation over the vesting period.

 

The Company also acknowledged the terms ofNon-Competition Agreements entered into on July 28, 2005 by MediaDefenderand Mr. Saaf and Mr. Herrera. The Non-Competition Agreements prohibit Mr. Saaf and Mr. Herrerafrom (i) engaging in certain competitive business activities, (ii) solicitingcustomers of MediaDefender or the Company, (iii) soliciting existingemployees of MediaDefender or the Company and (iv) disclosing any confidentialinformation regarding MediaDefender or the Company.  Each agreement has a term of four yearsand shall continue to remain in force and effect in the event theabove-referenced Employment Agreements are terminated prior to the end of thefour-year term of the Non-Competition Agreements.  In consideration, Mr. Saaf and Mr. Herrerawere each entitled to a cash payment of $525,000 from MediaDefender on December 31,2006 (which payments were timely made). As a result of these agreements, effective July 28, 2005, theCompany recorded an asset of $1,050,000 for the non-competition agreements anda related liability of $1,050,000 for the guaranteed payments to MediaDefendermanagement.  The $1,050,000 allocated tonon-competition agreements is being amortized over the term of the employmentagreements.

 

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Mr. Saaf and Mr. Herrera each invested$2,250,000 in the convertible subordinated debt transaction entered into tofund the acquisition of MediaDefender on the same terms and conditions as theother investors in such financing (see Note 4).

 

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to Jonathan Diamond, its Chief Executive Officer,to purchase 2,753,098 shares of common stock, exercisable for a period of fiveyears at $1.55 per share, which was in excess of the fair value of the commonstock issued in the MediaDefender transaction. Options with respect to 1,045,000 shares were scheduled to vest overthree years and options with respect to 1,708,098 shares were scheduled to vestbased on specified performance milestones. The fair value of the time-vested options, calculated pursuant to theBlack-Scholes option-pricing model, was determined to be $2,936,450, which wasbeing recognized as stock-based compensation over the vesting period.   The terms of the time-vesting options weremodified effective March 6, 2008 (see Note 16).

 

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to Robert Weingarten, its Chief FinancialOfficer, to purchase 550,000 shares of common stock, exercisable for a periodof five years at $1.55 per share, which was in excess of the fair value of thecommon stock issued in the MediaDefender transaction.  Options with respect to 275,000 shares werescheduled to vest over three years and options with respect to 275,000 shareswere scheduled to vest based on specified performance milestones.  The fair value of the time-vested options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $772,750, which was being recognized as stock-based compensation over thevesting period.  The terms of the time-vestingoptions were modified effective August 31, 2007 (see Note 16).

 

Upon the closing of the transaction, the Companyissued 1,109,032 shares of common stock and a seven-year warrant to purchase114,985 shares of common stock with an exercise price of $1.55 per share toWNT07 Holdings, LLC (“WNT07”).  Themanagers of WNT07 are Eric Pulier and Teymour Boutros-Ghali, both of whom wereat the time of the issuance of the consideration and currently are members ofthe Company’s Board of Directors.  Theshares and warrants were issued as consideration for services provided by Mr. Pulierand Mr. Boutros-Ghali as consultants to the Company with respect to theMediaDefender acquisition.  Theconsideration issued to WNT07 was approved by the disinterested members of theCompany’s Board of Directors.  The sharesand warrants were issued in reliance upon exemptions from registration pursuantto Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The shares ofcommon stock were valued at $1,585,916 ($1.43 per share) and the warrants werevalued at $83,939, based on a valuation report prepared by an independentvaluation firm.  The aggregate value of$1,669,855 was allocated $333,971 (20%) to a covenant not to compete (asdescribed below) and $1,335,884 (80%) to the costs that the Company incurred toacquire MediaDefender, based on management’s estimate of the relative values,as confirmed by the independent valuation firm.

 

On July 28, 2005,the Company entered into a Non-Competition Agreement with WNT07, Eric Pulierand Teymour Boutros-Ghali (collectively, the “Advisors”).  The Non-Competition Agreement prohibits anyof the Advisors (i) from engaging in certain competitive businessactivities and (ii) from soliciting existing employees of the Company orits subsidiaries.  The covenants not tocomplete or solicit expired on the earlier of April 1, 2007 or the date oftermination of Advisor’s services with the Company.  The amount allocated to the covenant not tocompete was amortized through April 1, 2007.

 

4.  FINANCING TRANSACTIONS WITH RESPECT TOMEDIADEFENDER, INC. ACQUISITION

     (CURRENTLY IN DEFAULT)

 

In conjunction with theacquisition of MediaDefender on July 28, 2005 (see Note 3), the Companycompleted a $15,000,000 senior secured debt transaction (the “Senior Financing”)and a $30,000,000 convertible subordinated debt transaction (the “Sub-DebtFinancing”).

 

The Senior Financing wascompleted in accordance with the terms set forth in the Note and WarrantPurchase Agreement entered into on July 28, 2005 by the Company, each of theinvestors indicated on the schedule of buyers attached thereto and U.S.Bank National Association as Collateral Agent (the “Note Purchase Agreement”).  Pursuant to the terms of the Note PurchaseAgreement, each investor received a note with a term of three years andeleven months that bears interest at the rate of 11.25% per annum (each a “SeniorNote”), payable quarterly, with any unpaid principal and accrued interest dueand payable at maturity.  Termination andpayment of the Senior Notes by the Company prior to maturity does not result ina prepayment fee.  As collateral for the$15,000,000 Senior Financing, the investors received a first priority securityinterest in all existing and future assets of the Company and its subsidiaries,tangible and intangible, including, but not limited to, cash and cashequivalents, accounts receivable, inventories, other current assets, furniture,fixtures and equipment and intellectual property.

 

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In addition, not laterthan ninety days after the close of each fiscal year, the Company is obligatedto apply 60% of its excess cash flow, as defined in the Note Purchase Agreement(the “Annual Cash Sweep”), to prepay the principal amount of the SeniorNotes.  At December 31, 2006, therewas no amount payable for the 2006 Annual Cash Sweep.  At December 31, 2007, there was $313,000payable for the 2007 Annual Cash Sweep, which is included in senior securednotes payable in the balance sheet at December 31, 2007.

 

The Senior Financinginvestors also received five-year warrants to purchase an aggregate of3,250,000 shares of the Company’s common stock at an exercise price of $2.00per share (collectively, the “Senior Warrants”).  The Senior Warrants were valued at $1,982,500based on a valuation report prepared by an independent valuation firm utilizingthe Black-Scholes option-pricing model, and were recorded as a discount to the$15,000,000 of senior secured debt, and are being amortized to interest expenseover the term of the debt.

 

The Senior Warrants weresubject to certain anti-dilution and price reset provisions, as well certainregistration rights obligations requiring the Company to file and maintaineffective a registration statement with the SEC covering the shares of commonstock underlying such warrants, which, if not complied with, subjects theCompany to a cash penalty of 1.5% of the Senior Financing per thirty-dayperiod.  Accordingly, in accordance withEITF 00-19, the fair value of the Senior Warrants was recorded as warrantliability in the Company’s balance sheet at July 28, 2005, and is beingadjusted to reflect any material changes in such liability from the date ofissuance to the end of each subsequent reporting period, with any such changesincluded in other income (expense) in the statement of operations.

 

The Sub-Debt Financingwas completed in accordance with the terms set forth in the Securities PurchaseAgreement entered into on July 28, 2005 by the Company and each of theinvestors indicated on the schedule of buyers attached thereto (the “SecuritiesPurchase Agreement”).  Pursuant to theterms of the Securities Purchase Agreement, each investor received aconvertible subordinated note with a term of four years that bearsinterest at the rate of 4.0% per annum (each a “Sub-Debt Note”), with anyunpaid principal and accrued interest due and payable at maturity.  The interest rate increases to 12.0% perannum during any period in which the Company is in default of its obligationsunder the Sub-Debt Note.  Commencing September 30,2006, interest is payable quarterly in cash or shares of common stock, at theoption of the Company.  Each Sub-DebtNote had an initial conversion price of $1.55 per share, and was subject tocertain anti-dilution, reset and change-of-control provisions.  In addition, each Sub-Debt Note is subject tomandatory conversion by the Company in the event certain trading price targetsfor the Company’s common stock are met.

 

The Sub-Debt Notescontain specific provisions that expressly prohibit the Company from issuingshares to a Sub-Debt Note holder if, after the conversion, such Sub-Debt Noteholder would exceed the respective limit called for in their Sub-Debt Note,either 4.99% or 9.99%, of the Company’s outstanding common shares.

 

Following effectivenessof a registration statement filed by the Company for the securities issued inthe Sub-Debt Financing, two times within any twelve-month period, the Companyhas the right to require the holder of each Sub-Debt Note to convert all or a portionequal to not less than 25% of the note conversion amount (limited to 50% of thenote conversion amount if pursuant to clause (a) below) into shares of theCompany’s common stock in the event that (a) the closing sale price of theCompany’s common stock equals or exceeds $2.32 per share for each of anyfifteen consecutive trading days, with a minimum trading volume of 200,000shares of common stock on each such trading day, (b) the closing saleprice of the Company’s common stock equals or exceeds $3.10 per share on eachtrading day during the fifteen consecutive trading day period, with a minimumtrading volume of 200,000 shares of common stock on each such trading day,subject in both cases to appropriate adjustments for stock splits, stock dividends,stock combinations and other similar transactions after the issuance date, or (c) completionof an equity financing (including the issuance of securities convertible intoequity securities, or long-term debt securities issued as a unit with equitysecurities, of the Company) at a price per share of not less than $2.50generating aggregate gross proceeds of at least $20,000,000 from outside thirdparty investors.

 

The holders of theSub-Debt Notes are entitled to receive any dividends paid or distributions madeto the holders of common stock to the same extent as if such holders hadconverted their Sub-Debt Notes into common stock (without regard to anylimitations on conversion) and had held such shares of common stock on therecord date for such dividend or distribution, with such payment to be madeconcurrently with the payment of the dividend or distribution to the holders ofcommon stock.

 

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The Sub-Debt Financinginvestors also received five-year warrants to purchase an aggregate of1,596,774 shares of common stock at an exercise price of $1.55 per share,subject to certain anti-dilution and price reset provisions (collectively, the “Sub-DebtWarrants”).  The Sub-Debt Warrants werevalued at $1,133,710 based on a valuation report prepared by an independentvaluation firm utilizing the Black-Scholes option-pricing model, and wererecorded as a discount to the $30,000,000 of convertible subordinated debt, andare being amortized to interest expense over the term of the debt.

 

In conjunction with theaforementioned financing transactions, a Subordination Agreement dated July 28,2005 was entered into between the Company, the Senior Financing investors, andthe Sub-Debt Financing investors pursuant to which the Sub-Debt Financinginvestors agreed to subordinate their rights to the investors in the SeniorFinancing in the event of a default under the Senior Financing transactiondocuments and on certain other terms and conditions described therein.

 

Legal fees paid or reimbursed by the Company forservices provided by the respective legal counsels for the lenders wererecorded as a charge to deferred financing costs and are being amortized overthe terms of the related debt.

 

Pursuant to the terms of the Note Purchase Agreementand the Securities Purchase Agreement, the Company was required to amend itsCertificate of Incorporation to increase the number of authorized shares ofcommon stock from 15,000,000 shares to 60,000,000 shares.  The Company obtained the requisite approvalsof the Board of Directors and stockholders and filed a Certificate of Amendmentto the Certificate of Incorporation with the Delaware Secretary of State on November 7,2005 to effect the increase in the authorized shares of common stock.

 

If all of the securitiesissued in the Senior Financing and the Sub-Debt Financing are converted orexercised into shares of the Company’s common stock in accordance with theirrespective terms, it will result in significant dilution to the Company’s existingstockholders and a possible change in control of the Company.  If all of the Company’s outstandingequity-based instruments are converted or exercised into shares of the Company’scommon stock in accordance with their respective terms, including those issuedin conjunction with the acquisition of MediaDefender, there would be a total ofapproximately 38,000,000 shares of the Company’s common stock issued andoutstanding.

 

The securities issued bythe Company in the Senior Financing and the Sub-Debt Financing were offered andsold in reliance upon exemptions from registration pursuant to Section 4(2) underthe Securities Act of 1933, as amended (the “Securities Act”), and Rule 506promulgated thereunder.  Each of theinvestors qualified as an “accredited investor,” as specified in Rule 501under the Securities Act.

 

The Sub-Debt Notes andthe Sub-Debt Warrants were subject to certain registration rights obligationsrequiring the Company to file and maintain effective a registration statementwith the SEC covering the shares of common stock underlying such warrants,which, if not complied with, subjects the Company to a cash penalty of 1.0% ofthe Sub-Debt Financing per thirty-day period. Accordingly, in accordance with EITF 00-19, the fair value of theSub-Debt Warrants was recorded as warrant liability in the Company’s balancesheet at July 28, 2005, and is being adjusted to reflect any materialchanges in such liability from the date of issuance to the end of eachsubsequent reporting period, with any such changes included in other income(expense) in the statement of operations.

 

The Sub-Debt Notescontain reset, anti-dilution and change-in-control provisions that the Companyhas determined caused such debt instruments to be classified as “non-conventional”debt.  Upon evaluation of such debtinstruments under SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS No. 133”), and EITF 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” (“EITF 00-19”), it was determined that the Company wasrequired to bifurcate and value certain rights embedded in the Sub-Debt Noteson the date of issuance (including, specifically, the initial $1.55 per sharefixed conversion feature, which was in excess of the $1.43 per share fairmarket value of the Company’s common stock on the date of issuance) and toclassify such rights as either assets or liabilities.  The fair value of these bifurcatedderivatives as of July 28, 2005, as determined by an independent valuationfirm, was calculated in accordance with SFAS No. 133 Implementation Issue No. B15,“Embedded Derivatives:  SeparateAccounting for Multiple Derivative Features Embedded in a Single HybridInstrument”, using a binomial lattice model utilizing highly subjective andtheoretical assumptions that can materially affect fair values from period toperiod.  The recognition of thesederivative amounts did not have any impact on the Company’s revenues, operatingexpenses or cash flows.  The Companyrecorded an initial embedded derivative liability of $10,534,000, which wasrecorded as a discount to the $31,460,500 of convertible subordinated notes,and is being amortized over the term of the debt.  The carrying value of the embedded derivativeliability is being adjusted to reflect any material changes in such liabilityfrom the date of issuance to the end of each subsequent reporting period, withany such changes included in other income (expense) in the statement ofoperations.  The Company has accountedfor registration rights penalties in accordance with EITF 00-19-2, “Accountingfor Registration Payment Arrangements”, which the Company adopted as of December 31,2006, and SFAS No. 5, “Accounting for Contingencies”.

 

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The Sub-Debt Notescontain several embedded derivative features (both assets and liabilities) thathave been accounted for at fair value. The various embedded derivative features of the Sub-Debt Notes have beenvalued at the date of inception of the Sub-Debt Financing and at the end ofeach reporting period thereafter.  Thematerial derivative features include:  (1) thestandard conversion feature of the debentures, (2) a limitation on theconversion by the holder, and (3) the Company’s right to forceconversion.  An independent valuationfirm valued the embedded derivative features and determined that, except forthe above-noted features, the remaining derivative attributes (both assets andliabilities) were immaterial, both individually and in the aggregate, andeffectively offset each other.  The valueof the embedded derivatives was bifurcated from the Sub-Debt Notes and recordedas derivative liability, with the initial amount recorded as discount on therelated Sub-Debt Notes.  This discount isbeing amortized to interest expense over the life of the Sub-Debt Notes.

 

The Company determinedthat the warrants issued in conjunction with the Senior Financing and theSub-Debt Financing created derivative liabilities in accordance with EITF 00-19because share settlement of these financial instruments was not within thecontrol of the Company, since the Company could not conclude that it hadsufficient authorized but unissued common shares available to satisfy its potentialshare obligations under the warrant agreements. The Company reached this conclusion because:  (1) the Company has an obligation tofile a registration statement with the SEC to register the common stockunderlying warrants, and to have such registration statement declaredeffective, and to maintain effective such registration statement, or to paypenalties in the form of liquidated damages for each thirty-day period thatsuch registration statement is not effective, (2) the warrants containeddilution protection features, with no limit or cap on the number of shares thatcould be issued by the Company pursuant to such provisions, and (3) thewarrants contained certain price reset features.  Because the warrants contain certainanti-dilution and price reset provisions, as well as have registration rights,the fair value of the warrants was accounted for as a derivative and presentedas warrant liability.

 

Pursuant to the terms ofa letter agreement, dated July 15, 2005, by and between the Company andBroadband Capital Management LLC (“Broadband”), effective July 28, 2005,the Company issued to Broadband a Sub-Debt Note in the amount of $1,460,500 (inaddition to the $30,000,000 referred to above) and five-year warrants topurchase 1,516,935 shares of common stock with an exercise price of $1.55 pershare.  The notes and warrants issued toBroadband or its affiliates were issued on the same terms and conditionsgranted to the other Sub-Debt Financing investors.  The securities were issued as partialconsideration for Broadband’s services as the Company’s placement agent in theSub-Debt Financing and the Senior Financing. The securities were issued in reliance upon exemptions from registrationpursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The Broadbandwarrants were valued at $1,077,024 based on a valuation report prepared by anindependent valuation firm utilizing the Black-Scholes option-pricing model.  The aggregate value of the Sub-Debt Note, thewarrants and additional cash payments to Broadband aggregating $299,500 werecharged to deferred financing costs and are being amortized to other expenseover the term of the debt.  Thesecurities issued to Broadband were accounted for in a manner consistent withthe accounting for the Sub-Debt Notes and Sub-Debt Warrants as described above.

 

Pursuant to the terms ofa letter agreement, dated June 21, 2005, by and between the Company andLibra FE, LP (“Libra”), effective July 28, 2005, the Company issued toLibra a seven-year warrant to purchase 237,500 shares of its common stock withan exercise price of $2.00 per share upon the closing of the Senior Financing(the “Libra Warrant”).  The Libra Warrantwas issued as partial consideration for Libra’s services as the Company’s placementagent in the Senior Financing described above. The Company entered into a Registration Rights Agreement with Libra on July 28,2005 (the “Libra Registration Rights Agreement”), pursuant to which the Companywill include the shares underlying the Libra Warrant in the registrationstatement covering the securities issued in the Senior Financing and theSub-Debt Financing described above.  TheLibra Warrant was issued in reliance upon exemptions from registration pursuantto Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The LibraWarrant was valued at $175,750 based on a valuation report prepared by anindependent valuation firm utilizing the Black-Scholes option-pricing model.  The aggregate value of the Libra Warrant andadditional payments to Libra of $450,997 were charged to deferred financingcosts and are being amortized to other expense over the term of the debt.

 

The Libra Warrant wassubject to certain registration rights requiring the Company to file andmaintain effective a registration statement with the SEC covering the shares ofcommon stock underlying such warrant, which if not complied with could subjectthe Company to a cash penalty of $5,000 per thirty-day period.  Inaccordance with EITF 00-19, the fair value of the Libra Warrant was recorded aswarrant liability at July 28, 2005, and was being adjusted to reflect anymaterial changes in such liability from the date of issuance to the end of eachsubsequent reporting period, with any such changes included in other income(expense) in the statement of operations. Effective April 19, 2006, the Libra Warrant was exercised on acashless basis at $2.00 per share, resulting in the issuance of 123,864 sharesof common stock.

 

86

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At the date of exerciseof any of the Senior Warrants, the Sub-Debt Warrants or the Libra Warrant, orthe conversion of Sub-Debt Notes into common stock, the pro rata fair value ofthe related warrant liability and/or embedded derivative liability istransferred to additional paid-in capital.

 

Pursuant to the SeniorFinancing and Sub-Debt Financing documents, the Company is required to complyon a quarterly basis with certain financial covenants, including minimumworking capital, maximum capital expenditures, minimum leverage ratio, minimumEBITDA and minimum fixed charge coverage ratio. These financial covenants are identical in the Senior Financing and theSub-Debt Financing documents.

 

Due to the accountingclassification of the warrants issued in conjunction with the Senior Financingand the Sub-Debt Financing as a current liability in accordance with SFAS No. 133and EITF 00-19, the Company was not in compliance with certain of thesefinancial covenants at December 31, 2005.

 

On April 7, 2006, the lenders providedwaivers with respect to such past events of default under the Senior Notes andamended their loan documents such that the warrant liability and any changethereto in future periods will not affect future covenant and excess cash flowcalculations.  In consideration thereof,the Company offered to temporarily reduce the exercise price of the 3,250,000warrants held by the investors in the Senior Financing from $2.00 to $1.85 pershare through April 30, 2006, and agreed to permanently reduce theexercise price of the 1,596,744 warrants held by the investors in the Sub-DebtFinancing from $1.55 to $1.43 per share on certain terms and conditions. Any exercise of the aforementioned warrants at the reduced exercise price wasrequired to be for cash only.  The conversion price of the Sub-Debt Notesof $1.55 per share was not affected.  The Company also entered intosimilar agreements, as applicable, and provided identical temporary andpermanent reductions to warrant exercise prices, with Broadband CapitalManagement LLC (1,516,935 warrants originally exercisable at $1.55 per share)and Libra FE, LP (237,500 warrants originally exercisable at $2.00 pershare).  The Company also agreed to utilize 25% of the net proceeds fromthe exercise of the warrants held by the investors in the Senior Financing toreduce the respective principal balances on the Senior Notes payable held bysuch exercising investors, and to pay any related unpaid accrued interest onsuch principal payments.  The aforementionedwaivers did not extend to the embedded derivative liabilities associated withthe Sub-Debt.

 

Effective April 27, 2006, certain of theinvestors in the Senior Financing exercised their warrants to purchase2,816,667 shares of common stock at $1.85 per share, resulting in the issuanceof 2,816,667 shares of common stock in exchange for cash proceeds of$5,212,000, of which $1,303,000 was used to reduce the respective principalbalances on the Senior Notes payable held by such exercising investors.  There was no conversion of subordinatedconvertible notes payable during April 2006 in relation to thistransaction.

 

As a result of the $0.15warrant exercise price reduction offered to the investors in the SeniorFinancing in April 2006, the Company recorded a charge to operationsduring the nine months ended September 30, 2006 for the aggregate fairvalue of such exercise price reductions of $423,000 relating to the warrantsheld and exercised by the Senior Financing investors in April 2006.  The Company provided this considerationprimarily in exchange for a waiver of and amendment to certain of the financialcovenants contained in the loan agreements entered into in conjunction with theJuly 2005 acquisition of MediaDefender. The amount charged to operations was calculated by multiplying the $0.15reduction, which represented the fair value of the consideration transferred,by the number of warrants that elected to accept the Company’s offer andexercise, as follows:  $0.15 x 2,816,667= $423,000.  This charge to operationswas presented as reduction in exercise price of warrants and was included inother income (expense) in the statement of operations.

 

As a result of the $0.12warrant exercise price reduction provided to the investors in the Sub-Debt Financingin April 2006, the Company recorded a charge to operations during the ninemonths ended September 30, 2006 for the aggregate fair value of suchexercise price reductions of $218,000 relating to the warrants held by theinvestors in the Sub-Debt Financing in April 2006.  The Company provided this consideration inexchange for a waiver of and amendment to certain of the financial covenantscontained in the loan agreements entered into in conjunction with the July 2005acquisition of MediaDefender.  Thisamount was calculated by determining the difference between the fair value ofthe warrants held by the investors in the Sub-Debt Financing, based on acomparison of updated Black-Scholes calculations using the original $1.55exercise price and the reduced $1.43 exercise price.  The Company utilized revised Black-Scholesinput metrics to reflect updated changes, in particular to estimated life andvolatility.  The result was that theBlack-Scholes value of the Sub-Debt warrants was $3.54, based on the original$1.55 exercise price, as compared to a Black-Scholes value of $3.61, based onthe reduced exercise price of $1.43.  Theamount charged to operations was calculated by multiplying the $0.07 difference($3.61 - $3.54), which represented the fair value of the considerationtransferred, by the number of warrants affected, as follows:  $0.07 x 3,113,709 = $218,000.  This charge to operations was presented asreduction in exercise price of warrants and was included in other income(expense) in the statement of operations.

 

87

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On November 7, 2006,the Company entered into a waiver (the “Sub-Debt Waiver”) with the holders ofthe Sub-Debt Notes.  A provision of the Sub-Debt Notes contains a negativecovenant pertaining to the Company’s Consolidated Fixed Charge Coverage Ratio(as such term is defined in the Sub-Debt Notes), which is to be calculated on aquarterly basis (the “Fixed Charge Covenant”).  The Fixed Charge Covenantas originally drafted did not contemplate that the first cash payment ofaccrued interest was not due and payable to the holders of the Sub-Debt Notesuntil September 30, 2006 (the “First Interest Payment”), an approximatefourteen-month period from the original issuance date of the Sub-Debt Notes. As a result of the Company timely making the First Interest Payment of$1,307,000, the Company was forced to breach the Fixed Charge Covenant. The holders of the Sub-Debt Notes agreed to waive this event of default underthe Sub-Debt Notes that may have been triggered due to a breach of the FixedCharge Covenant resulting from the First Interest Payment.

 

On November 7, 2006,the Company also entered into a waiver (the “Senior Waiver”) with thepurchasers of the Senior Notes originally issued by the Company.  The NotePurchase Agreement contains the same Fixed Charge Covenant that is contained inthe Sub-Debt Notes (the “Senior Fixed Charge Covenant”).  As a result ofthe Company timely making the First Interest Payment of $1,307,000, the Companywas forced to breach the Senior Fixed Charge Covenant.  The holders of theSenior Notes agreed to waive the event of default under the Note PurchaseAgreement that may have been triggered due to a breach of the Senior FixedCharge Covenant resulting from the First Interest Payment.

 

The financing documentsgoverning the terms and conditions of the senior and subordinated indebtednessrequired the Company to maintain an effective registration statement coveringthe resale of shares of common stock underlying the various securities issuedby the Company to each holder.  A resaleregistration statement on Form SB-2, as amended, was declared effective bythe SEC on December 9, 2005.  The Company subsequently filedPost-Effective Amendment No. 1 to the registration statement on Form SB-2,which was declared effective by the SEC on May 1, 2006, and Post-EffectiveAmendment No. 2 to the registration statement on Form SB-2, which wasdeclared effective by the SEC on July 6, 2007.  As a result of thedetermination to restate previously issued financial statements (see Note 1),the Form SB-2 was not available for use by the holders between December 21,2006 and July 6, 2007.

 

The financing documentsspecify that an event of default of the senior and subordinated indebtedness istriggered if a resale registration statement is unavailable for use by theholders for a period of more than ten consecutive trading days after theexpiration of an allowable ten-day grace period.  The Company invoked itsuse of the ten-day allowable grace period on December 21, 2006, whichexpired on December 31, 2006.  The Company delivered notice toholders of its outstanding senior and subordinated indebtedness that, as of December 20,2006, an event of default had been triggered under their respective senior andsubordinated financing documents.

 

As of December 20,2006, the Form SB-2 remained unavailable for use by the holders, and itcontinued to be unavailable for use until July 6, 2007, when Amendment No. 2to the registration statement on Form SB-2 was declared effective by theSEC.  Accordingly, at December 30, 2006, the registration statementcovering the resale of shares of common stock underlying the various securitiesissued by the Company to each holder of the senior and subordinated indebtednesswas not effective.  As a result, an eventof default, among others, with respect to the senior and subordinatedindebtedness was triggered by the unavailability of the Form SB-2 to theholders between December 20, 2006 and July 6, 2007.  The financing documents provide that whilethe Form SB-2 remains unavailable for use, holders of senior indebtednessare entitled to a cash penalty equal to 1.5% of the original Senior Financing,on a pro rata basis, and the holders of subordinated indebtedness are entitledto a cash penalty equal to 1.0% of the original Sub-Debt Financing, on a prorata basis.  These cash penalties are due and payable by the Company atthe end of each thirty-day period while the Form SB-2 remainsunavailable.  The first cash penalty payment was due on January 31,2007, and monthly thereafter.

 

In accordance with EITF00-19-2, which the Company adopted as of December 31, 2006, and SFAS No. 5,the Company accrued seven months liquidated damages (through mid-August 2007)under the registration rights agreements aggregating approximately $3,777,000as a charge to operations at December 31, 2006, which was reduced by$395,000 as a result of the Company’s registration statement being declaredeffective on July 6, 2007, which was earlier than originally estimated,and by an aggregate of $1,000,000 of advance payments made to the holders ofthe Senior Financing during the year ended December 31, 2007 forliquidated damages under the registration rights agreement.  Accordingly, liquidated damages payable underregistration rights agreements were $2,382,000 at December 31, 2007 and$3,777,000 at December 31, 2006, and were reflected as a current liabilityat such dates.  The Company believes thatthe amount of the liquidated damages accrued reflects the undiscounted maximumpotential amount of liquidated damages payable to the holders of the SeniorFinancing and the Sub-Debt Financing since the underlying shares becomegenerally available for resale under an effective registration statement on July 6,2007

 

88

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Since the registrationrights component of the derivative liabilities was not material through September 30,2006, there was no cumulative-effect adjustment recorded as a result of thetransition rules with respect to the adoption of EITF-00-19-2 at December 31,2006.  

 

A summary of theregistration penalty accrual at December 31, 2007 and 2006 is presentedbelow.

 
| ** **                              | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Senior secured  notes payable           |       | $                           | 410,000    |                        | $          | 1,575,000 |   |
| Subordinated  convertible notes payable |       | 1,972 ,000                  |       | 2,202,000                   |       |
| Total  registration penalty accrual     |       | $                           | 2,382,000  |                        | $          | 3,777,000 |   |

 

As of December 31,2007 and 2006, approximately $13,307,000 principal amount was outstanding withrespect to the Senior Financing, and approximately $27,658,000 principal amountwas outstanding with respect to the Sub-Debt Financing.  In addition, at December 31,2007, approximately $410,000 and $1,972,000 was outstanding with respect toaccrued registration delay penalties to the holders of the Senior Financing andthe Sub-Debt Financing, respectively, and approximately $146,000 and $3,206,000was outstanding with respect to accrued interest payable to the holders of theSenior Financing and the Sub-Debt Financing, respectively.  Through December 31, 2007, the Companyhad not paid the registration delay penalties to either the holders of theSenior Notes or the Sub-Debt Notes, although it had made advance payments tothe holders of the Senior Notes aggregating $1,000,000.  As a result of the registration failure, thefailure to pay the registration delay penalties and the various financialcovenant and other breaches of the terms of the Senior Financing and the Sub-DebtFinancing, multiple events of default exist under the Senior Financing and theSub-Debt Financing.  The terms of theSubordination Agreement among the Company and the creditor parties thereto (the“Subordination Agreement”) prevent the Company from making any cash payments tothe Sub-Debt Note holders until the events of default under the SeniorFinancing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of atleast 25% of the outstanding senior indebtedness may declare the outstandingprincipal and accrued interest on all senior notes immediately due and payableupon written notice to the Company, and each holder of outstanding subordinatedindebtedness may only demand redemption of all or any portion of theirrespective notes under certain circumstances as described in the SubordinationAgreement. The Company does not have the capital resources necessary to curethe existing events of default, or to repay any accelerated indebtedness orredemption or penalty amounts.

 

On October 16, 2007,the Company received an Event of Default Redemption Notice from the holders ofapproximately $2,693,000 principal amount of Sub-Debt Notes demanding that theCompany redeem their Sub-Debt Notes.  TheCompany believes and has advised these Sub-Debt Note holders that redemption(including the demand for redemption) is not permitted under the terms of theSubordination Agreement.  On November 1,2007, the Company received a copy of a letter to the Sub-Debt Note holders fromSenior Note holders representing approximately 66% of the Senior Notes.  The letter advised the Sub-Debt Note holdersthat the Subordination Agreement prohibits the Company from redeeming anySub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing anyremedies.

 

All quarterly interest paymentsdue on the outstanding senior and subordinated indebtedness were timely paid bythe Company through December 2006. In addition, the quarterly interest payments due on the outstandingsenior indebtedness in 2007 were timely paid. Pursuant to the terms of the Subordination Agreement, interest on theoutstanding subordinated convertible notes payable cannot be paid as a resultof the existence of the events of default described herein.

 

89

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A summary of accruedinterest payable at December 31, 2007 and 2006 is presented below.

 
| ** **                                   | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Senior secured  notes payable                |       | $                           | 67,000     |                        | $          | 67,000 |   |
| Subordinated  convertible notes payable      |       | 3,034,000                   |       | —                      |       |
| Liquidated  damages payable with respect to: |       |                        |       |                        |       |
| Senior secured  notes payable                |       | 79,000                      |       | —                      |       |
| Subordinated  convertible notes payable      |       | 172,000                     |       | —                      |       |
| Total accrued  interest payable              |       | $                           | 3,352,000  |                        | $          | 67,000 |   |

 

Pursuant to a series of Forbearance and Consent Agreementswith the investors in the Senior Financing, such investors agreed to forbearfrom the exercise of their rights and remedies under the Senior Financingdocuments as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that existed or that could come into existence duringthe forbearance period, from April 17, 2007 through February 20,2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and$494,446 in February 2008.  Thepayments made by the Company under the Forbearance and Consent Agreements werecredited against the registration delay cash penalties and interest on thepenalties resulting from the Company’s default under the various agreementsbetween the Company and the Senior Financing investors.  On March 17, 2008, the Company enteredinto a Forbearance and Consent Agreement with the investors in the Company’sSenior Debt Financing, which was effective as of February 20, 2008,whereby the investors  agreed to forbearfrom exercising any of their rights and remedies under the Senior Financingtransaction documents through December 31, 2008 in exchange for anadjustment in the interest rate associated with the Senior Notes from 11.25% to15%, provided the loan is repaid prior to September 30, 2008 or 16%, ifthe loan remains outstanding subsequent to that date.

 

On August 3, 2007,the Company entered into a Waiver and Forbearance Agreement with the holders ofthe Sub-Debt Financing pursuant to which the holders agreed to waive theirright to charge the 12.0% default interest rate triggered by the Company’sdefaults under the Subordinated Financing transaction documents and insteadcharge the 4.0% standard interest rate on the Sub-Debt Notes for the periodfrom July 16, 2007 through August 31, 2007 (the “Forbearance Period”).  The holders of the Sub-Debt Financing alsoagreed to forbear from exercising any of their other rights and remedies underthe Sub-Debt Financing transaction documents during the Forbearance Period,upon the terms and conditions in the Waiver and Forbearance Agreement.  Effective September 1, 2007, theinterest rate returned to the 12.0% default interest rate.

 

As a result of therequirement to restate previously issued financial statements, which resultedin the recording of an embedded derivative liability, the reclassification ofthe senior and subordinated indebtedness to current liabilities, and therecording of liquidated damages payable under registration rights agreements,the Company was not in compliance with certain of its financial covenants underboth the Senior Financing and the Sub-Debt Financing at December 31,2006.  Notwithstanding such developments,the Company would have been out of compliance with certain of its financialcovenants at December 31, 2007.

 

The registration delaypenalties and ongoing default interest charges are continuing to have asignificant and material negative impact on the Company’s operations and cashflows.  The Company is exploring variousalternatives to resolve the defaults under its senior and secured debtobligations, but is unable to predict the outcome of such negotiations.  On February 7, 2008 the Company retainedthe services of Salem Partners, LLC, to serve as a financial advisor to theCompany in connection with the sale, merger, consolidation, reorganization orother business combination and the restructuring of the material terms of theCompany’s senior notes and/or subordinated convertible notes.  To the extent that the Company is unable tocomplete a sale or merger, or restructure its senior and subordinated debtobligations in a satisfactory manner and/or the lenders begin to exerciseadditional remedies to enforce their rights, the Company will not havesufficient cash resources to maintain its operations.  In such event, the Company may be required toconsider a formal or informal restructuring or reorganization, including afiling under Chapter 11 of the United States Bankruptcy Code.

 

 5.  DERIVATIVE FINANCIAL INSTRUMENTS

 

In conjunction with the financing for the acquisitionof MediaDefender on July 28, 2005 (see Notes 3 and 4), the Companycompleted a $15,000,000 senior secured debt transaction (the “Senior Financing”)and a $30,000,000 convertible subordinated debt transaction (the “Sub-DebtFinancing”).  The Company also issuedvarious warrants in conjunction with such financings.

 

90

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The Sub-Debt Notescontain multiple embedded derivative features (both assets and liabilities)that have been accounted for at fair value as a compound embeddedderivative.  The compound embeddedderivative associated with the Sub-Debt Notes has been valued at the date ofinception of the Sub-Debt Financing and at the end of each reporting periodthereafter.  The compound embeddedderivative includes the following material features:  (1) the standard conversion feature ofthe debentures, (2) a limitation on the conversion by the holder, and (3) theCompany’s right to force conversion.

 

An independent valuationfirm assisted the Company in valuing the various derivative features in thecompound embedded derivative and determined that, except for the above-notedfeatures, the remaining derivative attributes (both assets and liabilities)were immaterial, both individually and in the aggregate, and they effectivelyoffset one another.  The value of thecompound embedded derivative that includes the above-noted features wasbifurcated from the Sub-Debt Notes and recorded as derivative liability.  This initial amount was recorded as adiscount on the related Sub-Debt Notes. This discount is being amortized to interest expense over the life ofthe Sub-Debt Notes.

 

The Company, with theassistance of an independent valuation firm, calculated the fair value of thecompound embedded derivative associated with the Sub-Debt Notes in accordancewith SFAS No. 133 Implementation Issue No. B15, “EmbeddedDerivatives:  Separate Accounting forMultiple Derivative Features Embedded in a Single Hybrid Instrument”, whichrequires that when multiple derivatives (both assets and liabilities) existwithin a financial instrument, they are bundled together as a single hybridcompound instrument.  The calculationmodel utilized a complex, customized, binomial lattice model suitable for thevaluation of path-dependent American options. The model uses the risk neutral binomial methodology to simulate thescenarios and stock price paths.  Themodel also uses backward dynamic programming to value the payoffs at each nodeconsidering all the embedded options simultaneously.  The valuation model used the followingassumptions for the original valuation and for each succeeding quarterlyvaluation:

 
| ** **                                                          | ** ** | **2005** | ** ** | **2006** | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| **Embedded derivatives**                                       | ** ** | **7/28** | ** ** | **9/30** | ** ** | **12/31** | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
| Initial fair  value of common stock                                 |       | $        | 1.43       |     | —     |      | —     |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Fair value of  common stock at each subsequent reporting period end |       | —   |       | $        | 2.50       |      | $          | 3.30 |   | $ | 4.50 |   | $ | 3.50 |   | $ | 3.25 |   | $ | 2.35 |   | $ | 1.90 |   | $ | 2.00 |   | $ | 1.80 |   | $ | 0.38 |   |
| Conversion price                                                    |       | $        | 1.55       |     | $          | 1.55      |       | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   | $ | 1.55 |   |
| Terminal time  period in months                                     |       | 48       |       | 46       |       | 43        |       | 40 |   | 37 |   | 34 |   | 31 |   | 28 |   | 25 |   | 22 |   | 19 |   |
| Expected return                                                     |       | 4.04     | %          | 4.18     | %          | 4.35      | %          | 4.82 | % | 5.10 | % | 4.59 | % | 4.69 | % | 4.58 | % | 4.87 | % | 3.97 | % | 3.05 | % |
| Initial  volatility factor                                          |       | 55       | %          | —   |       | —    |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Volatility factor  for each subsequent reporting period             |       | —   |       | 54       | %          | 59        | %          | 56 | % | 63 | % | 63 | % | 53 | % | 60 | % | 56 | % | 63 | % | 73 | % |
| Triggering events  to forced conversion:                            |       |     |       |     |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Event 1 - stock  price equal or above                               |       | $        | 2.32       |     | $          | 2.32      |       | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   | $ | 2.32 |   |
| Event 2 - daily  share trading volume equal or above                |       | 200,000  |       | 200,000  |       | 200,000   |       | 200,000 |   | 200,000 |   | 200,000 |   | 200,000 |   | 200,000 |   | 200,000 |   | 200,000 |   | 200,000 |   |
| Lack of liquidity  discount for the limitation on conversion        |       | 20       | %          | 20       | %          | 20        | %          | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % |

 

The Company determinedthat the warrants issued in conjunction with the Senior Financing and theSub-Debt Financing created derivative liabilities in accordance with EITF 00-19because share settlement of these financial instruments was not within thecontrol of the Company, since the Company could not conclude that it hadsufficient authorized but unissued common shares available to satisfy itspotential share obligations under the warrant agreements.  The Company reached this conclusionbecause:  (1) the Company has anobligation to file a registration statement with the SEC to register the commonstock underlying warrants, and to have such registration statement declaredeffective, and to maintain effective such registration statement, or to paypenalties in the form of liquidated damages for each thirty-day period thatsuch registration statement is not effective, (2) the warrants containeddilution protection features, with no limit or cap on the number of shares thatcould be issued by the Company pursuant to such provisions, and (3) thewarrants contained certain price reset features.  Because the warrants contain certainanti-dilution and price reset provisions, as well as have registration rights,the fair value of the warrants was accounted for as a derivative and presentedas warrant liability.

 

91

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The Company calculatedthe fair value of the various warrants using the Black-Scholes option-pricingmodel, using the volatility factor determined by the independent valuationfirm.  The valuation model used thefollowing assumptions for the original valuation and for each succeedingquarterly valuation.

 
| ** **                                                          | ** ** | **2005** | ** ** | **2006** | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| **Warrant liability**                                          | ** ** | **7/28** | ** ** | **9/30** | ** ** | **12/31** | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
| Initial fair  value of common stock                                 |       | $        | 1.43       |     | —     |      | —     |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Fair value of  common stock at each subsequent reporting period end |       | —   |       | $        | 2.50       |      | $          | 3.30 |   | $ | 4.50 |   | $ | 3.50 |   | $ | 3.25 |   | $ | 2.35 |   | $ | 1.90 |   | $ | 2.00 |   | $ | 1.80 |   | $ | 0.38 |   |
| Exercise price:                                                     |       |     |       |     |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior warrants                                                     |       | $        | 2.00       |     | $          | 2.00      |       | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   | $ | 2.00 |   |
| Sub-debt warrants                                                   |       | $        | 1.55       |     | $          | 1.55      |       | $ | 1.55 |   | $ | 1.55 |   | $ | 1.43 |   | $ | 1.43 |   | $ | 1.43 |   | $ | 1.43 |   | $ | 1.43 |   | $ | 1.43 |   | $ | 1.43 |   |
| Libra warrants                                                      |       | $        | 2.00       |     | $          | 2.00      |       | $ | 2.00 |   | $ | 2.00 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Time period in  months:                                             |       |     |       |     |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior warrants                                                     |       | 60       |       | 58       |       | 55        |       | 52 |   | 49 |   | 46 |   | 43 |   | 40 |   | 37 |   | 34 |   | 31 |   |
| Sub-debt warrants                                                   |       | 60       |       | 58       |       | 55        |       | 52 |   | 49 |   | 46 |   | 43 |   | 40 |   | 37 |   | 34 |   | 31 |   |
| Libra warrants                                                      |       | 84       |       | 82       |       | 79        |       | 76 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Expected return                                                     |       | 4.04     | %          | 4.18     | %          | 4.35      | %          | 4.82 | % | 5.10 | % | 4.59 | % | 4.69 | % | 4.58 | % | 4.89 | % | 4.03 | % | 3.45 | % |
| Initial  volatility factor                                          |       | 55       | %          | —   |       | —    |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Volatility factor  for each subsequent reporting period             |       | —   |       | 54       | %          | 59        | %          | 56 | % | 63 | % | 63 | % | 53 | % | 60 | % | 56 | % | 63 | % | 73 | % |

 

The Company’sSub-Debt Notes contain compound embedded derivatives (as described above) thatrequired that they be bifurcated from the debt host instrument at the date ofissuance and valued.  The calculation ofthe fair value of the compound embedded derivatives required the use of a moresophisticated valuation model than a Black-Scholes option-pricing model.  Accordingly, the Company retained anindependent valuation firm to calculate the fair value of the compound embeddedderivatives, and the changes in fair value at each subsequent period end.  The Company, with the assistance of theindependent valuation firm, calculated the fair value of the compound embeddedderivatives associated with the Sub-Debt Notes in accordance with SFAS No. 133Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple DerivativeFeatures Embedded in a Single Hybrid Instrument”, by utilizing a complex,customized, binomial lattice model suitable in the valuation of path-dependentAmerican options.  This model utilizedsubjective and theoretical assumptions that can materially affect fair valuesfrom period to period.

 

The independent valuationfirm concluded that the Company’s historical pattern of stock prices as of July 28,2005, and for some time thereafter, would not provide a sufficient indicationof the long-term expected volatility of the Company’s stock going forward forpurposes of the calculation of the fair value of the compound embeddedderivatives, due to the significant changes in the business operations andcapital structure of the Company on July 28, 2005 as a result of theacquisition of MediaDefender and the related financing transactions.  Accordingly, the Company’s independent valuation firmbased its calculation of the Company’s expected stock price volatilities on thevolatility factors of similar public companies. The independent valuation firm identified four companies that weresimilar to the Company in terms of industry, market capitalization, stock priceand profitability:  Easylink ServicesCorporation; Forgent Networks, Inc.; Inforte Corp.; and Think Partnership, Inc.  Using historical stock returns data for aperiod of one year, the independent valuation firm calculated the volatilitiesof these companies at the various reporting dates.  The expected volatilities for the Company asof the reporting dates were calculated based on the average of the volatilitiesof these comparable companies.  Theresulting volatilities were then used to calculate the fair value, and thechanges in fair value, of the Company’s compound embedded derivativeliabilities at each period end.  TheCompany also utilized these volatilities to calculate the fair value, and thechanges in fair value, of the Company’s warrant derivative liabilities at eachperiod end.

 

Paragraph A32 of SFAS No. 123Rlists factors to consider in estimating expected volatility.  The independent valuation firm retained bythe Company to value the compound embedded derivatives contained in theSub-Debt Notes determined that the appropriate methodology to calculatevolatility with respect to the Company’s compound embedded derivatives was to considerthe Company as similar to a newly public company without a trading historybecause of the significant transformative changes resulting from theacquisition and financing of the MediaDefender transaction on July 28,2005.  With reference to newly publiccompanies, section (c) of paragraph A32 of SFAS No. 123R suggeststhat the expected volatility of similar entities be considered.  The independent valuation firm arrived atthis determination due to the Company’s acquisition of MediaDefender on July 28,2005 and the related equity-based financing transactions that provided thecapital to fund the acquisition.

 

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6.  PROPERTY AND EQUIPMENT

 
| ** **                                                                                                                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **Property and equipment are recorded at cost and consist of the following:** | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                                                                                                                           | ** ** | **(in thousands)** | ** ** |
| Computer  equipment and software                                                                                                     |       | $                       | 3,973      |   | $ | 3,744 |   |
| Furniture and  fixtures                                                                                                              |       | 194                     |       | 192 |   |
| Leasehold  improvements                                                                                                              |       | 285                     |       | 261 |   |
|                                                                                                                                 |       | 4,452                   |       | 4,197 |   |
| Less accumulated  depreciation and amortization                                                                                      |       | (2,614                  | )          | (1,729 | ) |
| Property and  equipment, net                                                                                                         |       | $                       | 1,838      |   | $ | 2,468 |   |

 

During the year ended December 31,2007, the Company recorded a charge to operations of $97,000 to write-off thenet book value of obsolete computer equipment that it does not expect to utilizein future periods.

 

At June 30, 2007,the Company evaluated the useful life of certain of its computer equipment anddetermined to reduce the depreciation period from 7 years to 5 years.  The effect of this change in estimate was toincrease depreciation expense by approximately $371,000 for the year ended December 31,2007.  The Company estimates that thischange in estimate will increase depreciation expense by a total ofapproximately $168,000 in 2008 in excess of the amounts that would have been recordedas depreciation expense originally.

 

7.  GOODWILL AND OTHER INTANGIBLE ASSETS

 

IdentifiableIntangible Assets

 

Componentsof the Company’s identifiable intangible assets at December 31, 2007 and2006, all of which were recorded in conjunction with the acquisition ofMediaDefender in July 2005 (see Note 3), are as follows:

 
| ** **                  | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Balance at  End of Year** | ** ** |
|-----------------------------|------------|----------------------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **(in thousands)**                      | ** ** |
| December 31,  2007     |       |                                         |       |                      |       |                                       |       |
| Customer  relationships     |       | $                                            | 1,195      |                      | $          | 755                                        |       | $ | 440 |   |
| Proprietary  technology     |       | 4,012                                        |       | 2,534                     |       | 1,478                                      |       |
| Non-competition  agreements |       | 728                                          |       | 312                       |       | 416                                        |       |
| Total                       |       | $                                            | 5,935      |                      | $          | 3,601                                      |       | $ | 2,334 |   |
|                        |       |                                         |       |                      |       |                                       |       |
| December 31,  2006     |       |                                         |       |                      |       |                                       |       |
| Customer  relationships     |       | $                                            | 1,950      |                      | $          | 755                                        |       | $ | 1,195 |   |
| Proprietary  technology     |       | 6,546                                        |       | 2,534                     |       | 4,012                                      |       |
| Non-competition  agreements |       | 1,191                                        |       | 463                       |       | 728                                        |       |
| Total                       |       | $                                            | 9,687      |                      | $          | 3,752                                      |       | $ | 5,935 |   |

 

Amortizationexpense with respect to intangible assets for the years ended December 31,2007 and 2006 was $3,601,000 and $3,752,000, respectively.  Scheduled amortization expense with respect tointangible assets for the next two succeeding years is as follows (amounts arein thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 2,182      |   |
| 2009                                         |       | 152        |       |
| Total                                        |       | $          | 2,334      |   |

 

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Goodwill

 

Goodwill at December 31,2007 and 2006 was $31,085,000, which was recorded in conjunction with theacquisition of MediaDefender in July 2005 (see Note 3).  Inaccordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, anintangible asset that is not subject to amortization such as goodwill shall betested for impairment at least on an annual basis, and more often under certaincircumstances, and written down when impaired.  An interim impairment testis required if an event occurs or conditions change that would more likely thannot reduce the fair value of the reporting unit below its carrying value.  The first step of the impairment testconsists of a comparison of the total fair value of each reporting unit to thereporting unit’s net assets on the date of the test.  If the fair value isin excess of the net assets, there is no indication of impairment and thus noneed to perform the second step of the impairment test.

 

During the three monthsended September 30, 2007, the Company performed its second annualimpairment test with respect to the goodwill recognized in conjunction with theacquisition of MediaDefender and determined that there was no indication ofimpairment.  Due to the reduced salesactivity in the Company’s anti-piracy business for the year 2007 and internalprojections for 2008, the Company again revisited the impairment work duringour year end review for 2007 and noted that while the test thresholds werenarrower, an adjustment was still not required. The Company plans to closely monitor the sales activity within thissegment during each fiscal quarter of 2008 and, if warranted, will record animpairment loss to adjust downward the carrying value of the segment at thattime.

 

During the weekend of September 15 and 16, 2007,MediaDefender experienced an unlawful online security breach by hackers, whichresulted in approximately 6,000 e-mails, as well as access to otherconfidential information and data, for the period from mid-December 2006through September 10, 2007 being stolen and posted at numerous web-siteson the Internet.  These e-mails containedconfidential information and communications covering a wide variety of internalissues, including personal data, customer data and pricing information, andother sensitive information.  This matterhas been referred to the appropriate federal, state and local law enforcementorganizations and an investigation is ongoing. An internal investigation of this matter is continuing, as a result ofwhich the Company has revised various procedures and policies and enhanced itsonline and Internet security protocols. The Company does not believe that this breach has any impact on theCompany’s accounting and financial controls or reporting systems.

 

As a result of this development, MediaDefenderrecorded approximately $600,000 for service credits to customers, which wererecorded as a reduction to revenues during the year ended December 31,2007.  This amount was determined basedon various factors, including discussions with customers.  MediaDefender also recorded approximately $244,000of legal, consulting and other direct costs related to the breach during theyear ended December 31, 2007.

 

8.   DEFERREDFINANCING COSTS

 

Components of the Company’s deferred financing costsat December 31, 2007 and 2006 are as follows:

 
| ** **                              | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Write-offs  Resulting from  Conversions  and  Repayments  of Debt** | ** ** | **Balance at  End of Year** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **(in thousands)**                      | ** ** |
| Year Ended  December 31, 2007      |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred  financing costs related to:   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated  convertible notes payable |       | $                                            | 1,519      |                      | $          | 607                                                                             |       | $                                          | —     |   | $ | 912 |   |
| Senior secured  notes payable           |       | 565                                          |       | 234                       |       | —                                                                          |       | 331                                        |       |
| Total                                   |       | $                                            | 2,084      |                      | $          | 841                                                                             |       | $                                          | —     |   | $ | 1,243 |   |
|                                    |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Year Ended  December 31, 2006      |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred  financing costs related to:   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated  convertible notes payable |       | $                                            | 2,400      |                      | $          | 618                                                                             |       | $                                          | 263        |   | $ | 1,519 |   |
| Senior secured  notes payable           |       | 900                                          |       | 240                       |       | 95                                                                              |       | 565                                        |       |
| Total                                   |       | $                                            | 3,300      |                      | $          | 858                                                                             |       | $                                          | 358        |   | $ | 2,084 |   |

 

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Amortizationexpense with respect to deferred financing costs for the years ended December 31,2007 and 2006 was $841,000 and $858,000, respectively.  Scheduled amortization expense with respectto deferred financing costs for the next two succeeding years is as follows(amounts are in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 841        |   |
| 2009                                         |       | 402        |       |
| Total                                        |       | $          | 1,243      |   |

 

9.  ALLOWANCE FOR DOUBTFUL ACCOUNTS

 

A summary of the activity with respect to the allowancefor doubtful accounts is as follows:

 
| ** **                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **(in thousands)**                     | ** ** |
| Balance,  beginning of year      |       | $                                           | 421        |   | $ | 177 |   |
| Provision for  doubtful accounts |       | 203                                         |       | 705 |   |
| Amounts charged  off             |       | (206                                        | )          | (461 | ) |
| Balance, end of  year            |       | $                                           | 418        |   | $ | 421 |   |

 

The provision fordoubtful accounts for the years ended December 31, 2007 and 2006 bysegment was as follows:

 
| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| E-commerce                                       |       | $                                           | 10         |   | $ | 34 |   |
| Media                                            |       | 23                                          |       | 317 |   |
| Anti-piracy and  file-sharing marketing services |       | 170                                         |       | 354 |   |
| Total                                            |       | $                                           | 203        |   | $ | 705 |   |

 

10.  ACCRUED EXPENSES

 

Accrued expenses are comprised of the following:

 
| ** **                              | ** ** | **December 31,**   | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Accrued cost of  sales                  |       | $                       | 221        |   | $ | 169 |   |
| Accrued  compensation and related costs |       | 1,096                   |       | 223 |   |
| Accrued  professional fees              |       | 133                     |       | 448 |   |
| Accrued business  and property taxes    |       | 51                      |       | 143 |   |
| Other accrued  expenses                 |       | 384                     |       | 539 |   |
| Total accrued  expenses                 |       | $                       | 1,885      |   | $ | 1,522 |   |

 

95

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11.  INCOME TAXES

 

The components of the provision for income taxes areas follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** ** | ** ** | **(in thousands)**                     | ** ** |
| Current:   |       |                                        |       |   |   |
| Federal    |       | $                                           | —     |   | $ | 660 |   |
| State      |       | 5                                           |       | 178 |   |
|       |       | $                                           | 5          |   | $ | 838 |   |
|       |       |                                        |       |   |   |
| Deferred:  |       |                                        |       |   |   |
| Federal    |       | $                                           | (998       | ) | $ | — |   |
| State      |       | (46                                         | )          | — |   |
|       |       | (1,044                                      | )          | — |   |
| Total      |       | $                                           | (1,039     | ) | $ | 838 |   |

 

Income taxes differ from the amount computed using atax rate of 34% as a result of the following:

 
| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                          | ** ** | **(in thousands)**                     | ** ** |
| Computed expected  tax (tax benefit)                                |       | $                                           | 3,563      |   | $ | (1,388 | ) |
| State and local  income taxes, net of federal income tax benefit    |       | 3                                           |       | 117 |   |
| Amortization of  non-cash financing costs                           |       | 470                                         |       | 861 |   |
| Adjustments to  deferred tax assets                                 |       | 8                                           |       | 1,053 |   |
| Stock-based  compensation                                           |       | 630                                         |       | 656 |   |
| Permanent  adjustments caused by warrant and derivative liabilities |       | (6,878                                      | )          | (1,807 | ) |
| Other                                                               |       | 18                                          |       | 10 |   |
|                                                                |       | (2,186                                      | )          | (498 | ) |
| Valuation  allowance                                                |       | 1,147                                       |       | 1,336 |   |
| Total income tax  (benefit) expense                                 |       | $                                           | (1,039     | ) | $ | 838 |   |

 

The tax effects of temporary differences that giverise to significant portions of the deferred tax assets and liabilities at December 31,2007 and 2006 are as follows:

 
| ** **                        | ** ** | **December 31,**   | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| Deferred tax  liabilities:        |       |                    |       |   |   |
| State income  taxes               |       | 3,644                   |       | $ | 3,311 |   |
| Depreciation                      |       | 45                      |       | 386 |   |
| Total deferred  tax liabilities   |       | 3,689                   |       | 3,697 |   |
|                              |       |                    |       |   |   |
| Deferred tax  assets:             |       |                    |       |   |   |
| Net operating  loss carryforwards |       | 48,660                  |       | 46,722 |   |
| Non-deductible  accrued expenses  |       | 1,282                   |       | 1,776 |   |
| Other                             |       | 179                     |       | 220 |   |
| Total deferred  tax assets        |       | 50,121                  |       | 48,718 |   |
| Valuation  allowance              |       | (46,432                 | )          | (45,285 | ) |
| Net deferred  assets              |       | 3,689                   |       | 3,433 |   |
| Net deferred tax  liabilities     |       | $                       | —     |   | $ | 264 |   |
|                                   |            |                         |            |  |  |  |  |

 

At December 31, 2007, the Company had netoperating loss carryforwards of approximately $112,000,000 for Federal incometax purposes expiring beginning in 2019 and California state net operating losscarryforwards of approximately $118,000,000 expiring beginning in 2009.

 

96

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In assessing the potential realization of deferred taxassets, management considers whether it is more likely than not that someportion or all of the deferred tax assets will be realized.  The ultimate realization of deferred taxassets (primarily net operating loss carryforwards) is dependent upon theCompany attaining future taxable income during the periods in which thosetemporary differences become deductible. As of December 31, 2007 and 2006, management was unable todetermine if it is more likely than not that the Company’s deferred tax assetswill be realized, and has therefore recorded an appropriate valuation allowanceagainst deferred tax assets at such dates.

 

Due to the restrictionsimposed by Internal Revenue Code Section 382 regarding substantial changesin the stock ownership of companies with loss carryforwards, the utilization ofthe Company’s federal net operating loss carryforward was severely limited as aresult of the change in the effective stock ownership of the Company resultingfrom the debt financings arranged in conjunction with the acquisition ofMediaDefender.

 

The Company recorded abenefit for income taxes of $1,039,000 for the year ended December 31,2007, as a result of the carryback of 2007 tax losses to 2005 and 2006.  As a result of the profitable operations ofMediaDefender, the non-deductibility of certain non-cash charges for taxreporting purposes, and permanent limitations on the Company’s ability toutilize its net operating loss carry-forwards, the Company recorded a provisionfor income taxes of $838,000 for the year ended December 31, 2006.

 

As of December 31,2007, the Company’s 2005 U.S. federal income tax return was undergoingexamination by the Internal Revenue Service. The Internal Revenue Service has proposed various adjustments to theCompany’s 2005 taxable income.  Estimatedtaxes and interest relating to such adjustments have been accrued as incometaxes payable in the accompanying financial statements at December 31,2007.  As the Internal Revenue Servicehas not completed its examination, the Company is currently unable to predictthe final outcome of the examination.

 

The Company adopted theprovisions of FIN48 on January 1, 2007, and has identified unrecognized taxbenefits related to the deductibility of certain interest expense onsubordinated debt.  However, there wouldbe no additional accrual required due to available net operating losses.  The following table provides a reconciliationof the Company’s unrecognized tax benefits at December 31, 2007:

 
| Unrecognized tax benefits at January 1, 2007                     |   | $        | — |   |
|------------------------------------------------------------------|--------|----------|--------|--------|
| Increase based upon tax positions taken prior to  2007           |   | 300,000  |   |
| Increase based upon tax positions taken in 2007                  |   | 600,000  |   |
| Decrease based upon net operating loss arising in  2007          |   | (600,000 | )      |
| Decrease based upon net operating loss carryback to  prior years |   | (300,000 | )      |
| Unrecognized tax benefits at December 31, 2007                   |   | $        | — |   |

 

12.  RELATED PARTY TRANSACTIONS

 

Transactions InvolvingOfficers and Directors

 

Effective as of January 1,2006, the Company entered into a one-year consulting agreement with EricPulier, a director of the Company, through WNT Consulting Group, a Californialimited liability company wholly-owned by Mr. Pulier (“WNT”).  The consulting agreement was approved by thedisinterested members of the Company’s Board of Directors.  Effective January 12, 2007, the partiesmutually agreed to terminate this consulting agreement, which had automaticallyrenewed for a second one-year term through December 31, 2007.  Underthe terms of the original consulting agreement, Mr. Pulier received a basefee of $10,000 per month, certain other mandatory payments, and was alsoeligible to receive cash bonuses on the achievement of certain specifiedmilestones.  Mr. Pulier had also agreed to waive all stock optionsand other stock-based compensation granted to outside members of the Company’sBoard of Directors during the term of his original consulting agreement.  The termination agreement provided for aone-time cash payment to Mr. Pulier (through WNT) in the amount of$100,000 (which was paid in January 2007), in consideration for thetermination of the consulting agreement and an acknowledgement and completerelease of any and all claims related to unpaid compensation, bonus amounts orother out-of-pocket expenses (in cash or otherwise) that may have been owed bythe Company as of January 12, 2007. The termination agreement was approved by the Compensation Committee ofthe Company’s Board of Directors.  Mr. Puliercontinues to serve as a member of the Company’s Board of Directors.

 

97

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On January 12, 2007,the Company entered into a new consulting agreement with Mr. Pulier(through WNT).  During the term of the new consulting agreement, whichcommenced January 12, 2007 and continues in effect until any partyprovides ten days prior written notice to the other parties of its intention toterminate, Mr. Pulier will provide non-exclusive consulting and advisoryservices to the Company outside of the ordinary course of his services as amember of the Board of Directors.  In consideration, Mr. Pulier(through WNT) is entitled to receive hourly compensation at the rate of $500per hour.  Any consulting request made by the Company must be approved inadvance by all parties prior to commencement of services.  The newconsulting agreement was approved by the Compensation Committee of the Company’sBoard of Directors.  During the yearended December 31, 2007, Mr. Pulier (through WNT) did not earn anyfees under the new consulting agreement.

 

On November 28,2006, the Company acknowledged the terms of a release of claims (the “Release”)entered into by Nicholas Turner, the Company’s former Vice President, BusinessDevelopment.  Pursuant to the terms of the Release, Mr. Turner hasagreed to fully waive any and all claims that he may have against the Company,including any such claims related to the terms of his employment or otherwise,if any, that may have arisen prior to the execution date of the Release. The Company further acknowledged that the effective date of Mr. Turner’sresignation as the Company’s Vice President, Business Development was August 31,2006.

 

The Company and Mr. Turneralso entered into an independent contractor agreement dated November 28,2006 (the “Contractor Agreement”), in order to provide for Mr. Turner’stemporary continued services with the Company.  The Contractor Agreementwas scheduled to remain in effect for a period of eight months, commencing asof September 1, 2006 (the “Term”); provided, that, the ContractorAgreement could be terminated prior to the end of the Term by Mr. Turnerfor any reason or by the Company (i) for “cause,” (ii) the death ordisability of Mr. Turner or (iii) for any reason at its optioneffective as of December 31, 2006 by making a one-time cash payment to Mr. Turnerof $30,000 in the aggregate (the “Early Termination Option”).  TheContractor Agreement prohibited Mr. Turner from engaging in certaincompetitive business activities and from soliciting existing employees,customers, clients or vendors of the Company or its subsidiaries.  The covenants not to compete or solicitexpired on April 30, 2007.  Inconsideration, Mr. Turner was entitled to receive from the Company a basefee of $12,500 for the first four-month period (comprised of $5,000 in cash and$7,500 in the form of a short-term loan, which would be forgiven on April 30,2007 if Mr. Turner has complied with the provisions of the covenants notto compete or solicit) and $7,500 per month during the second four-month period(including a recoupable advance), as well as certain commission and bonusamounts, assuming achievement of specified milestones.  The Contractor Agreement was approved by theCompensation Committee of the Company’s Board of Directors.

 

Effective December 31,2006, the Company elected to exercise its Early Termination Option under theContractor Agreement and made the one-time cash payment to Mr. Turner of$30,000.  No further amounts are owed bythe Company to Mr. Turner under the terms of the Contractor Agreement.

 

For the year ended December 31,2007, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000, and a grant of 10,000 stock options having a value(based upon the appropriate Black-Scholes option valuation methodology) equal to$16,200.  In addition, each director thatserves on a Committee of the Board of Directors received, for each committeeserved, an additional cash retainer of $10,000, and a grant of 5,000 stockoptions having a value equal to $8,100, having the same terms and conditions asoptions granted to all non-employee members of the Board of Directorsgenerally.  The effective date of theabove stock options was June 29, 2007, a total of 80,000 shares weregranted under the 2006 Equity plan, having an aggregate Black-Scholes value of$129,600.  The options are exercisablethrough June 29, 2012 at $2.00 per share, the fair market value on thedate of grant.  The options vested 50% onJune 30, 2007 and 25% each on September 30, 2007 and December 31,2007.  In addition, to their normal boardfees, two directors also served on the Special Committee related torestructuring matters and received additional cash compensation of $60,000 eachduring 2007.

 

For the year ended December 31,2006, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000, and (excluding Mr. Pulier) a grant of stockoptions having a value (based upon the appropriate Black-Scholes optionvaluation methodology) equal to $35,000.  The strike price for the optionswas set on the date of grant and the options vested entirely on December 31,2006.  In addition, each director that serves on a Committee of the Boardof Directors received, for each committee served, an additional cash retainerof $10,000, and (excluding Mr. Pulier) a grant of stock options having avalue equal to $15,000, having the same terms and conditions as options grantedto all non-employee members of the Board of Directors generally.  The stock option grants were made on July 7,2006 under the 2006 Equity Plan (see Note 13).

 

98

----

 

Fred Davis, who joinedthe Company’s Board of Directors in November 2005, and who did not receiveany board compensation in 2005, was considered a new director in 2006, and receiveda one-time grant of stock options having a value equal to $25,000, a three-yearvesting term and otherwise having the same terms and conditions as optionsgranted to all non-employee members of the Board of Directors generally.

 

During the years ended December 31,2007 and 2006, the Company incurred legal fees of approximately $16,000 and$45,000, respectively, to Davis Shapiro Lewit & Hayes, LLP, a law firmin which Fred Davis, a director of the Company, is a partner.

 

See Notes 3, 13 and 16for information with respect to additional related party transactions.

 

13. STOCKHOLDERS’ EQUITY (DEFICIENCY)

 

Amendments to Certificate of Incorporation:

 

On June 26, 2006, the Company filed with theSecretary of State of the State of Delaware a Certificate of Amendment of itsCertificate of Incorporation to eliminate 5,000,000 shares of authorized butunissued shares of preferred stock.  As aresult, the Company has no authorized shares of preferred stock.

 

Stock-Based Transactions- Year Ended December 31, 2007

 

During the year ended December 31,2007, the Company issued 23,076 shares of common stock, pursuant to aconsulting agreement (see Note 16), and options to purchase 480,000 shares ofcommon stock, including options to purchase 350,000 shares to management, asdiscussed below.

 

Effective February 2,2007, the Company issued to Rene L. Rousselet, the Company’s CorporateController and Chief Accounting Officer, a stock option to purchase 50,000shares of common stock exercisable through February 2, 2012 at $1.50 pershare, the fair market value on the date of grant.  The stock option vests and becomesexercisable in equal installments on March 31, 2007, June 30, 2007, September 30,2007 and December 31, 2007.  Thefair value of the stock option, determined pursuant to the Black-Scholesoption-pricing model, was $60,000, which was charged to operations during theyear ended December 31, 2007.

 

Effective February 2,2007, the Company issued to its newly-appointed Vice President of WorldwideSales, a stock option to purchase 300,000 shares of common stock exercisablethrough February 2, 2012 at $1.50 per share, the fair market value on thedate of grant.  The option with respectto 175,000 shares vests in seven equal quarterly installments on June 30,2007, September 30, 2007, December 31, 2007, March 31, 2008, June 30,2008, September 30, 2008 and December 31, 2008, and the option withrespect to 125,000 shares vests on the achievement of performance targets to bemutually determined by the parties.  Thefair value of the time-vested portion of this stock option, determined pursuantto the Black-Scholes option-pricing model, was $208,000, of which $89,000 wascharged to operations during the year ended December 31, 2007.

 

Effective June 29,2007, the Company issued to its six non-officer directors stock options topurchase an aggregate of 80,000 shares exercisable through June 29, 2012at $2.00 per share, the fair market value on the date of grant.  The options vested 50% on June 30, 2007and 25% each on September 30, 2007 and December 31, 2007.   The fair value of these stock options,determined pursuant to the Black-Scholes option-pricing model, was $129,600,which was charged to operations during the year ended December 31, 2007.

 

99

----

 

The assumptions used inthe Black-Scholes option-pricing model to calculate the fair value of theaforementioned options were as follows:

 
| Stock price on  date of grant           |   | $1.50 – $2.30  |   |
|-----------------------------------------|--------|---------------------|--------|
| Risk-free  interest rate                |   | 4.84 – 5.06%   |   |
| Volatility                              |   | 1.065 – 1.116% |   |
| Dividend yield                          |   | 0%                  |   |
| Weighted average  expected life (years) |   | 5                   |   |
| Weighted average  fair value of option  |   | $1.19 – $1.76  |   |

 

As a result of theresignation of the Company’s former Chief Financial Officer effective August 31,2007 (see Note 16), the Company agreed to amend certain provisions of stockoptions previously granted to the former Chief Financial Officer, including theaccelerated vesting of certain options. The Company recorded the fair value of these grants, calculated pursuantto the Black-Scholes option-pricing model, of $215,000 as a charge tooperations in 2007.  The assumptions usedin the Black-Scholes option-pricing model to calculate the fair value of theamendments to the options were as follows:

 
| Stock price on  date of grant           |   | $     | 3.00   |   |
|-----------------------------------------|--------|-------|--------|--------|
| Risk-free  interest rate                |   | 5.0   | %      |
| Volatility                              |   | 146.3 | %      |
| Dividend yield                          |   | 0     | %      |
| Weighted average  expected life (years) |   | 5     |   |
| Weighted average  fair value of option  |   | $     | 2.81   |   |

 

100

----

 

Stock-Based Transactions - Year Ended December 31,2006

 

On May 6, 2005, theCompany issued to a consultant a stock option to purchase an aggregate of22,000 shares of the Company’s common stock pursuant to the Company’s 1999Employee Stock Option Plan, exercisable for a period of five years at $1.00 pershare, the market price on the date of the grant, pursuant to a short-termconsulting agreement.  The option was subject to milestones, one of whichwas partially attained during the year ended December 31, 2006, as aresult of which 10,000 shares vested during such period.  The fair valueof the vested portion of this option of $35,000, calculated pursuant to theBlack-Scholes option-pricing model, was charged to operations during the yearended December 31, 2006.

 

During the year ended December 31,2006, the Company issued 97,287 shares of common stock upon the exercise ofstock options previously issued to employees and consultants, and received cashproceeds of approximately $80,000.

 

During the year ended December 31, 2006, theCompany provided short-term extensions of the exercise period for options heldby two former employees.  The fair valueof such extensions of $44,000, calculated pursuant to the Black-Scholesoption-pricing model, was charged to operations during the year ended December 31,2006.

 

During the year ended December 31, 2006, theCompany issued to a consultant stock options on a monthly basis to purchase35,000 shares of the Company’s common stock pursuant to the Company’s 2006Equity Incentive Plan, exercisable for a period of five years at prices rangingfrom $2.35 to $2.95 per share, the market price on the date of each grant,pursuant to a short-term consulting agreement. The options were fully vested at the date of issuance.  The aggregate fair value of the options of$76,000, calculated pursuant to the Black-Scholes option-pricing model, wascharged to operations during the year ended December 31, 2006.  The assumptions used in the Black-Scholesoption-pricing model to calculate the fair value of the options were asfollows:

 
| Stock price on  date of grant           |   | $2.35 – 2.90  |   |
|-----------------------------------------|--------|--------------------|--------|
| Risk-free  interest rate                |   | 4.89 – 4.97%  |   |
| Volatility                              |   | 99.8 – 102.1% |   |
| Dividend yield                          |   | 0%                 |   |
| Weighted average  expected life (years) |   | 4.92 – 5.00   |   |
| Weighted average  fair value of option  |   | $1.79 – 2.25  |   |

 

During the year ended December 31,2006, the Company issued 2,203,870 shares of common stock upon the conversionof $3,416,000 of subordinated convertible notes payable.  As a result,$1,345,000 was charged to operations during the year ended December 31,2006, consisting of related deferred financing costs of $263,000 and debtdiscount costs of $1,082,000.

 

Effective April 19,2006, Libra FE, LP exercised its warrants on a cashless basis at $2.00 pershare, resulting in the issuance of 123,864 shares of common stock.

 

Effective April 27,2006, certain of the investors in the Senior Financing exercised their warrantsto purchase 2,816,667 shares of common stock at $1.85 per share, resulting inthe issuance of 2,816,667 shares of common stock in exchange for cash proceedsof $5,212,000, of which $1,303,000 was used to reduce the respective principalbalances on the Senior Notes payable held by such exercising investors.

 

On October 19, 2006,an investor in the Sub-Debt financing exercised a portion of its warrants topurchase 79,839 shares of common stock at $1.43 per share, resulting in theissuance of 79,839 shares of common stock in exchange for cash proceeds of$114,170.

 

During 2006, as a resultof the exercise by the warrant holders of certain warrants, $9,483,000 ofwarrant liability was transferred to additional paid-in capital.  During 2006, as a result of the conversion ofSub-Debt into common stock, $4,053,000 of embedded derivative liability wastransferred to additional paid-in capital.

 

As a result of the $0.15warrant exercise price reduction offered to the investors in the SeniorFinancing, the Company recorded a charge to operations for the aggregate fairvalue of such exercise price reductions of $423,000 relating to the warrantsheld and exercised by the Senior Financing investors in April 2006.

 

101

----

 

As a result of the $0.12warrant exercise price reduction provided to the investors in the Sub-DebtFinancing, the Company recorded a charge to operations for the aggregate fairvalue of such exercise price reductions of $218,000 relating to the warrantsheld by the investors in the Sub-Debt Financing.

 

On July 7, 2006, in conjunction with thepreviously adopted 2006 board compensation program, the Company granted stockoptions under the 2006 Equity Plan approved by the Company’s stockholders atits 2006 Annual Meeting to five non-officer members of its Board of Directorsto acquire an aggregate of 91,551 shares of common stock, exercisable for a periodof five years at $3.35 per share, the closing price of the Company’s commonstock as quoted on the OTC Bulletin Board on the date of grant.  The stockoptions were fully vested on December 31, 2006.  The aggregate fair value of such stockoptions, calculated pursuant to the Black-Scholes option-pricing model, was$260,000, which was charged to operations during the year ended December 31,2006.  The assumptions used in theBlack-Scholes option-pricing model to calculate the fair value of the optionswere as follows:

 
| Stock price on  date of grant           |   | $     | 3.35   |   |
|-----------------------------------------|--------|-------|--------|--------|
| Risk-free  interest rate                |   | 5.05  | %      |
| Volatility                              |   | 122.0 | %      |
| Dividend yield                          |   | 0     | %      |
| Weighted average  expected life (years) |   | 5.0   |   |
| Weighted average  fair value of option  |   | $     | 2.84   |   |

 

On October 9, 2006,the Company entered into an eighteen-month non-exclusive consulting agreementwith Wood River Ventures, LLC and Jonathan Dolgen for consulting and advisoryservices with respect to the business and operations of the Company (see Note16).  The consulting agreement provides for a stock award valued at$112,500, consisting of 34,615 shares of common stock based on the Company’sclosing stock price on October 10, 2006 of $3.25 per share to be issuedunder the Company’s 2006 Equity Incentive Plan.  The shares vest pro rataover the eighteen-month period of the consulting agreement, beginning on October 10,2006 and thereafter monthly on the first day of each month of the term of theconsulting agreement through March 2008. In accordance with ETIF 96-18, “Accounting for Equity Instruments ThatAre Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services”, the shares granted under this consulting agreementare valued each month based on the closing market price on the first day of eachmonth to determine the amount to be recorded as a charge to operations over theeighteen-month term of the consulting agreement.  Accordingly, during the years ended December 31,2007 and 2006, the Company issued 23,076 shares and 5,769 shares of commonstock under this consulting agreement and recorded a related charge tooperations of $75,000 and $19,000, respectively.

 

Sufficiency of Authorizedbut Unissued Shares

 

The Company has concluded, for the reasons described below, that it ishighly probable that the Companywill have sufficient shares available to satisfy its existing option andwarrant obligations to officers, directors, employees, consultants, advisorsand others for the foreseeable future (excluding the warrants issued inconjunction with the financing of the MediaDefender transaction described atNote 4, which are accounted for as a derivative liability).

 

Paragraphs 28 to 35 of SFAS No. 123R describe thetypes of equity awards that should be classified as a liability, including anoption (or similar instrument) that could require the employer to pay anemployee cash or other assets, unless cash settlement is based on a contingentevent that is (a) not probableand (b) outside the control of the employee.  The Company has concluded that any cashsettlement obligation represented by its outstanding options and warrantsissued to employees, officers and directors would be triggered only by acontingent event that is both notprobable and is outside the control of the equity holder.

 

Most of the Company’s outstanding options and warrantswere issued to employees, officers and directors in compensatory transactionsaccounted for under SFAS No. 123R. Of the 5,749,740 options and warrants outstanding at December 31,2007, 5,331,553 were issued to employees, officers and directors.  The Company believes that potential impactpursuant to EITF 00-19-2 of the remaining 418,187 options and warrants issuedto consultants, advisors and others is not material to the consolidatedfinancial statements.  With respect tothe 418,187 options and warrants, 222,000 are exercisable at $0.50 per shareand the remaining 196,187 are exercisable at prices ranging from $1.00 pershare to $7.50 per share; all such exercise prices are in excess of the currentmarket value of the Company’s common stock.

 

102

----

 

The Company currently has 60,000,000 shares of commonstock authorized, of which 10,338,896 shares of common stock were issued at December 31,2007, resulting in 49,661,104 unissued shares at such date.  If all of the Company’s equity-basedinstruments were converted or exercised into shares of common stock inaccordance with their respective original terms, without regard to whether suchinstruments have vested or are in-the-money, approximately 28,000,000additional shares would be issued, resulting in a total of approximately38,000,000 shares of common stock issued and outstanding.  Accordingly, this calculation results inapproximately 22,000,000 shares of common stock available for issuance, inexcess of all equity commitments that the Company currently has outstanding.

 

The Company has approximately $27,658,000 of Sub-DebtNotes outstanding at December 31, 2007, which are convertible into commonstock at $1.55 per share and which represent the single largest component ofsuch potential dilution (approximately 17,850,000 shares).  However, the financing agreements containprovisions that expressly prohibit the Company from issuing shares to aSub-Debt Note holder if after the conversion, such Sub-Debt Note holder wouldexceed the respective limit called for in their Sub-Debt Note, either 4.99% or9.99% of the Company’s outstanding common shares, thus the Company believesthat it is very unlikely that all of the 17,850,000 shares issuable to theholders of the Sub-Debt Notes would be issued at one time or even in a shortperiod of time.

 

Accordingly, based on the foregoing analysis and theCompany’s current capital structure, the Company has concluded that it ishighly probable that the Companywill have sufficient shares available to satisfy its existing option andwarrant obligations for the foreseeable future. The Company will continue to evaluate this issue and if it becomesprobable that there are insufficient authorized shares, the Company willconsider alternative accounting treatment at that time.

 

14.  STOCK-BASED PLANS

 

2004 Consultant Stock Plan

 

Effective September 29, 2004, the Company’s Boardof Directors adopted the ARTISTdirect, Inc. 2004 Consultant Stock Plan(the “Consultant Plan”) in order for the Company to be able to compensateconsultants, at the option of the Company, who provide bona fide services tothe Company not in connection with capital raising or promotion of the Company’ssecurities.  The Consultant Plan willexpire on September 29, 2014, and provides for the issuance of up to500,000 shares of common stock to consultants at fair market value.  On January 13, 2005, the Company filed aRegistration Statement on Form S-8 with the Securities and ExchangeCommission to register the 500,000 shares of common stock for future issuanceunder the Consultant Plan.  As of December 31,2007, no shares had been issued under the Consultant Plan.

 

2006 Equity Incentive Plan

 

The Company’sstockholders approved the ARTISTdirect, Inc. 2006 Equity Incentive Plan(the “2006 Equity Plan”) at the Company’s Annual Meeting of Stockholders heldon June 19, 2006 (the “Annual Meeting”).  The Board of Directors ofthe Company had previously approved the 2006 Equity Plan in April 2006. A total of 1,500,000 new shares of the Company’s common stock have initiallybeen reserved for issuance under the 2006 Equity Plan.  Awards under the2006 Equity Plan may be granted to any of the Company’s employees, directors,officers, consultants or those of the Company’s affiliates.  Awards mayconsist of stock options (both incentive stock options and non-statutory stockoptions), stock awards, stock appreciation rights and cash awards.  Anincentive stock option may be granted under the 2006 Equity Plan only to aperson who, at the time of the grant, is an employee of the Company or a parentor subsidiary of the Company.  During theyear ended December 31, 2006, the Company issued 34,615 shares of commonstock pursuant to a consulting agreement (see Notes 13 and 16) and options topurchase 126,551 shares of common stock. During the year ended December 31, 2007, the Company issued optionsto purchase 480,000 shares of common stock. As of December 31, 2007, 863,834 shares remained available forfuture option grant.

 

103

----

 

A summary of stock optionactivity under the 2006 Equity Plan during the years ended December 31,2006 and 2007 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2005 |       | —                       |       | $ | — |   |
| Granted                                        |       | 126,551                      |       | 3.20 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | —                       |       | — |   |
| Options  outstanding at December 31, 2006 |       | 126,551                      |       | 3.20 |   |
| Granted                                        |       | 480,000                      |       | 1.63 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (5,000                       | )          | 1.50 |   |
| Options  outstanding at December 31, 2007 |       | 601,551                      |       | $ | 1.96 |   |
| Options  exercisable at December 31, 2007 |       | 376,551                      |       | $ | 2.24 |   |

 

The following table summarizes information regardingoptions outstanding and options exercisable at December 31, 2007 under the2006 Equity Plan:

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|                     |       |                         |       |                         |       |   |   |   |   |   |   |   |   |
|                     | $          | 1.50                         |       |                         | 350,000    |   | 4.09 |   | $ | 1.50 |   | 125,000 |   | $ | 1.50 |   |
|                     | $          | 1.55                         |       |                         | 5,000      |   | 3.92 |   | $ | 1.55 |   | 5,000 |   | $ | 1.55 |   |
|                     | $          | 1.80                         |       |                         | 5,000      |   | 3.92 |   | $ | 1.80 |   | 5,000 |   | $ | 1.80 |   |
|                     | $          | 1.90                         |       |                         | 5,000      |   | 3.92 |   | $ | 1.90 |   | 5,000 |   | $ | 1.90 |   |
|                     | $          | 2.00                         |       |                         | 10,000     |   | 3.92 |   | $ | 2.00 |   | 10,000 |   | $ | 2.00 |   |
|                     | $          | 2.00                         |       |                         | 80,000     |   | 4.50 |   | $ | 2.00 |   | 80,000 |   | $ | 2.00 |   |
|                     | $          | 2.15                         |       |                         | 5,000      |   | 3.92 |   | $ | 2.15 |   | 5,000 |   | $ | 2.15 |   |
|                     | $          | 2.20                         |       |                         | 5,000      |   | 3.92 |   | $ | 2.20 |   | 5,000 |   | $ | 2.20 |   |
|                     | $          | 2.25                         |       |                         | 5,000      |   | 3.92 |   | $ | 2.25 |   | 5,000 |   | $ | 2.25 |   |
|                     | $          | 2.30                         |       |                         | 5,000      |   | 3.92 |   | $ | 2.30 |   | 5,000 |   | $ | 2.30 |   |
|                     | $          | 2.35                         |       |                         | 5,000      |   | 3.92 |   | $ | 2.35 |   | 5,000 |   | $ | 2.35 |   |
|                     | $          | 2.90                         |       |                         | 30,000     |   | 3.92 |   | $ | 2.90 |   | 30,000 |   | $ | 2.90 |   |
|                     | $          | 3.35                         |       |                         | 91,551     |   | 3.52 |   | $ | 3.35 |   | 91.551 |   | $ | 3.35 |   |
|                     | $          | 1.50-$3.35                   |       |                         | 601,551    |   | 4.03 |   | $ | 1.96 |   | 376,551 |   | $ | 2.24 |   |

 

The weighted averagegrant date fair value of stock options issued during the years ended December 31,2006 and 2007 was $2.66 per share and $1.63 per share, respectively.

 

The intrinsic value ofexercisable but unexercised in-the-money options at December 31, 2007 was$0.

 

104

----

 

The following tablesummarizes information regarding the Company’s non-vested options under the2006 Equity Plan as of December 31, 2006 and 2007, and the changes duringsuch years:

 
| ** **                                                  | ** ** | **Number   of Shares** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| Options  outstanding but unvested at December 31, 2005 |       | —                           |       |
| Granted                                                     |       | 126,551                          |       |
| Vested                                                      |       | (126,551                         | )          |
| Forfeited                                                   |       | —                           |       |
| Expired                                                     |       | —                           |       |
| Options  outstanding but unvested at December 31, 2006 |       | —                           |       |
| Granted                                                     |       | 480,000                          |       |
| Vested                                                      |       | (250,000                         | )          |
| Forfeited                                                   |       | (5,000                           | )          |
| Expired                                                     |       | —                           |       |
| Options  outstanding but unvested at December 31, 2007 |       | 225,000                          |       |

 

As of December 31,2007, unrecognized compensation cost related to unvested stock options underthe 2006 Equity Plan will be charged to operations as follows (amounts are inthousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 119        |   |
| Total                                        |       | $          | 119        |   |

 

1999 Employee Stock Option Plan

 

In October 1999, the Company implemented the 1999Employee Stock Option Plan (the “Employee Plan”).  The Employee Plan was not approved by thepublic stockholders of the Company.  TheEmployee Plan has currently reserved 1,185,504 shares of the Company’s commonstock for issuance to employees, non-employee members of the board of directorsand consultants.  This share reserveautomatically increases on the first trading day in January each calendaryear by an amount equal to 2% of the total number of shares of the Company’scommon stock outstanding on the last trading day of December in the priorcalendar year, but in no event will this annual increase exceed 87,500shares.  No option may have a termin excess of ten years.  The optionsgenerally vest within three years.  As ofDecember 31, 2007, 234,765 shares remained available for future optiongrant.

 

A summary of stock option activity under the EmployeePlan during the years ended December 31, 2006 and 2007 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options outstanding  at December 31, 2005 |       | 968,618                      |       | $ | 3.57 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | (97,287                      | )          | 0.79 |   |
| Cancelled/expired                              |       | (6,569                       | )          | 0.79 |   |
| Options  outstanding at December 31, 2006 |       | 864,762                      |       | 3.88 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | (35,375                      | )          | 0.79 |   |
| Cancelled/expired                              |       | (11,310                      | )          | 91.41 |   |
| Options  outstanding at December 31, 2007 |       | 818,077                      |       | $ | 2.81 |   |
| Options  exercisable at December 31, 2007 |       | 694,267                      |       | $ | 2.77 |   |

 

105

----

 

The following table summarizes information regardingoptions outstanding and options exercisable at December 31, 2007 under theEmployee Plan:

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|                     |       |                         |       |                         |       |   |   |   |   |   |   |   |   |
|                     | $          | 0.79                         |       |                         | 66,558     |   | 4.24 |   | $ | 0.79 |   | 66,558 |   | $ | 0.79 |   |
|                     | $          | 1.00                         |       |                         | 82,500     |   | 2.35 |   | $ | 1.00 |   | 82,500 |   | $ | 1.00 |   |
|                     | $          | 1.95                         |       |                         | 170,000    |   | 4.69 |   | $ | 1.95 |   | 170,000 |   | $ | 1.95 |   |
|                     | $          | 3.00                         |       |                         | 400,000    |   | 2.57 |   | $ | 3.00 |   | 276,190 |   | $ | 3.00 |   |
|                     | $          | 4.80                         |       |                         | 33,332     |   | 1.78 |   | $ | 4.80 |   | 33,332 |   | $ | 4.80 |   |
|                     | $          | 5.10                         |       |                         | 10,000     |   | 1.77 |   | $ | 5.10 |   | 10,000 |   | $ | 5.10 |   |
|                     | $          | 7.50                         |       |                         | 55,687     |   | 0.88 |   | $ | 7.50 |   | 55,687 |   | $ | 7.50 |   |
|                     | $          | 0.79-$7.50                   |       |                         | 818,077    |   | 2.97 |   | $ | 2.81 |   | 694,267 |   | $ | 2.77 |   |

 

The intrinsic value ofexercisable but unexercised in-the-money options at December 31, 2007 was$0. The intrinsic value of options exercised during the years ended December 31,2007 and 2006 was $45,000 and $283,000, respectively.

 

The following tablesummarizes information regarding the Company’s non-vested options under theEmployee Plan as of December 31, 2006 and 2007, and the changes duringsuch years:

 
| ** **                                                  | ** ** | **Number  of Shares** | ** ** |
|-------------------------------------------------------------|------------|----------------------------|------------|
| Options  outstanding but unvested at December 31, 2005 |       | 427,333                    |       |
| Vested                                                      |       | (182,669                   | )          |
| Forfeited                                                   |       | (6,130                     | )          |
| Expired                                                     |       | (439                       | )          |
| Options  outstanding but unvested at December 31, 2006 |       | 238,095                    |       |
| Vested                                                      |       | (114,285                   | )          |
| Forfeited                                                   |       | —                     |       |
| Expired                                                     |       | —                     |       |
| Options  outstanding but unvested at December 31, 2007 |       | 123,810                    |       |

 

As of December 31,2007, unrecognized compensation cost related to unvested stock options underthe Employee Plan will be charged to operations as follows (amounts are inthousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 312        |   |
| 2009                                         |       | 26         |       |
| Total                                        |       | $          | 338        |   |

 

1999 Artist and Artist Advisor Option Plan

 

In June 1999, and as amended in October 1999and March 2000, the Company adopted the 1999 Artist and Artist AdvisorStock Option Plan (the “Advisor Plan”). The Advisor Plan was not approved by the public stockholders of theCompany.  The Advisor Plan has currentlyreserved 439,659 shares of common stock for issuance to artists for whom theCompany entered into agreements related to online and e-commerce activities andtheir agents, business managers, attorneys and other advisors.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to1% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 37,500 shares.  As of December 31, 2007, 439,659 sharesremained available for future option grants. The options expire seven years from the date of grant and vesting generallyvaries between one to three years.  Nonew option grants under this plan were made during 2006 or 2007.

 

106

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A summary of stock option activity under the AdvisorPlan during the years ended December 31, 2006 and 2007 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2005 |       | 35,536                       |       | $ | 123.29 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (5,672                       | )          | 39.00 |   |
| Options  outstanding at December 31, 2006 |       | 29,864                       |       | 139.28 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (29,864                      | )          | 139.28 |   |
| Options  outstanding at December 31, 2007 |       | —                       |       | $ | — |   |

 

1999 Artist Stock Plan

 

In June 1999, and as amended in October 1999,the Company adopted the 1999 Artist Stock Plan (the “Artist Plan”).  The Artist Plan was not approved by thepublic stockholders of the Company.  TheArtist Plan currently has reserved 935,504 shares of common stock for issuanceto artists for whom the Company entered into agreements related to their onlineand e-commerce activities.  This sharereserve automatically increases on the first trading day in January eachcalendar year by an amount equal to 2% of the total number of shares of theCompany’s common stock outstanding on the last trading day of December inthe prior calendar year, but in no event will this annual increase exceed87,500 shares.  As of December 31,2007, 935,504 shares remained available for future option grants.  The options expire seven years from the dateof grant and vesting generally varies between one to three years.  No new option grants under this plan weremade during 2006 or 2007.

 

A summary of stock option activity under the ArtistPlan during the years ended December 31, 2006 and 2007 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2005 |       | 23,874                       |       | $ | 83.15 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (13,499                      | )          | 40.00 |   |
| Options  outstanding at December 31, 2006 |       | 10,375                       |       | 139.28 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (10,375                      | )          | 139.28 |   |
| Options  outstanding at December 31, 2007 |       | —                       |       | $ | — |   |

 

As of December 31,2007, unrecognized compensation cost related to all unvested stock options(plan and non-plan) will be charged to operations as follows (amounts are inthousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 1,002      |   |
| 2009                                         |       | 26         |       |
| Total                                        |       | $          | 1,028      |   |

 

107

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1999 Employee Stock Purchase Plan

 

In October 1999, the Company adopted the 1999Employee Stock Purchase Plan that initially reserved 50,000 shares of commonstock for issuance under this plan.  Asof December 31, 2007, this plan had 225,000 shares reserved for issuance,of which 212,831 shares remained available for future issuances.  This share reserve automatically increases onthe first trading day in January each calendar year, by an amount equal to1% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 25,000 shares.  Terms of the plan permit eligible employeesto purchase common stock through payroll deduction of up to 15% of eachemployee’s compensation.  The accumulateddeductions are applied to the purchase of shares on each semi-annual purchasedate at a purchase price per share equal to 85% of the fair market value pershare on the participant’s entry date into the offering period or thesemi-annual purchase date, whichever is lower. During the years ended December 31, 2006 and 2007, no shares wereissued under this plan.

 

Non-Plan OptionsOutstanding

 

Effective September 29,2003, the Company issued to Jonathan V. Diamond, the Company’s Chief ExecutiveOfficer, a non-plan, non-qualified stock option to purchase 259,659 shares ofcommon stock exercisable through August 15, 2010 at $0.85 per share, whichwas the approximate fair market value of the common stock on the date ofgrant.  The option vested over a periodof three years from the date of grant, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $221,000, ofwhich $36,000 was charged to operations in 2006.

 

Effective March 29,2004, the Company issued to Robert N. Weingarten, the Company’s Chief FinancialOfficer, a non-plan, non-qualified stock option to purchase 120,000 shares at$0.50 per share, which was not less than the fair market value on the date ofgrant, exercisable through March 29, 2011. The option vested and became exercisable in a series of thirty-sixsuccessive equal monthly installments from March 29, 2004 through March 29,2007.  The fair value of the stockoption, determined pursuant to the Black-Scholes option-pricing model, was$42,000, of which $3,500 and $14,000 was charged to operations in 2007 and2006, respectively.

 

Effective May 31,2001, the Company issued to Frederick W. (Ted) Field, the Company’s Chairmanand former Chief Executive Officer, a non-qualified stock option to purchase302,370 shares of common stock exercisable at $7.50 per share through May 30,2008.  The option vested over a period offive years from June 29, 2001, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $2,006,000,of which $201,000 was charged to operations in 2006.

 

15.  401(K) PLAN

 

The Company has adopted the Cash or Deferred ProfitSharing Plan and Trust under Section 401(k) of the Internal RevenueCode (the “401(k) Plan”).  Under the401(k) Plan, participating employees may defer a percentage (not toexceed 15%) of their eligible pretax earnings up to the Internal RevenueService’s annual contribution limit.  Allemployees of the Company who are 21 years or older and who complete threemonths of service are eligible to participate in the 401(k) Plan.  The Company does not match contributions byparticipants to the 401(k) Plan. Accordingly, there is no related expense for the years ended December 31,2007 and 2006.

 

16.  COMMITMENTSAND CONTINGENCIES

 

Lease Commitments

 

On January 30, 2006, the Company entered into asub-lease agreement for office facilities in Santa Monica, California, effectiveFebruary 2, 2006 through November 30, 2011, to house the operationsof ADI and MediaDefender.  In connectionwith the sub-lease agreement, the Company provided an irrevocable standby bankletter of credit for $180,000 as security for the Company’s obligations underthe sub-lease agreement, which was secured by cash of $180,000, which wasclassified as restricted cash in the Company’s balance sheet.  Pursuant to the terms of the sub-leaseagreement, the letter of credit was reduced to $90,000 during February 2007.

 

This lease containspredetermined fixed increases in the minimum rental rate during the initiallease term.  The Company began torecognize the related rent expense on a straight-line basis on the effectivedate of the lease.  The Company recordsthe difference between the amount charged to expense and the rent paid asdeferred rent on the Company’s balance sheet.

 

108

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Future cash payments under such operating lease are asfollows (amounts are in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| ** **                                   | ** ** | ** ** | ** ** |
| 2008                                         |       | $          | 470        |   |
| 2009                                         |       | 485        |       |
| 2010                                         |       | 499        |       |
| 2011                                         |       | 471        |       |
|                                         |       | $          | 1,925      |   |

 

Rent expense under operating leases for the yearsended December 31, 2007 and 2006 was $441,000 and $468,000.

 

Employment Agreements

 

On July 28, 2005,the Company entered into an Employment Agreement with Jonathan Diamond to serveas the Company’s Chief Executive Officer. During the term of the EmploymentAgreement through December 31, 2008, Mr. Diamond’s base salary wouldbe no less than $350,000 per annum, plus certain specified perquisites thatinclude a monthly car allowance. Mr. Diamond was also eligible to receivean annual discretionary bonus of up to 100% of base salary, as determined bythe Compensation Committee of the Board of Directors or, if none, the Board ofDirectors, and an annual performance bonus of up to 100% of base salary if theCompany achieved defined earnings before interest, taxes, depreciation andamortization in fiscal 2007 ($12,000,000 - $14,400,000) and fiscal 2008 ($15,000,000- $18,000,000). Mr. Diamond was also entitled to receive stock options atthe discretion of the Company’s Board of Directors. In the event Mr. Diamondwas terminated “without cause,” he would be entitled to receive 12 monthsof severance pay at the rate of 100% of his monthly salary, any performancebonus due for the year in which termination occurs and all stock optionssubject to time vesting shall be deemed fully vested and exercisable.  On October 14, 2005, February 3,2006, June 19, 2006 and July 31, 2006, the Company entered intoagreements with Mr. Diamond to incorporate non-material modifications intothe Employment Agreement.

 

Pursuant to an Amendedand Restated Services Agreement dated as of March 6, 2008 (the “ServicesAgreement”) between the Company and Mr. Diamond, Mr. Diamond’semployment as Chief Executive Officer was ended and he was elected as theCompany’s Chairman of the Board of Directors (the “Chairman”) effective March 6,2008.  Under the Services Agreement, in consideration of Mr. Diamond’swaiver of his rights contained in the Employment Agreement dated as of July 28,2005 (the “Prior Agreement”), the execution by Mr. Diamond of a generalrelease in favor of the Company and its affiliates, and his agreement to serveas Chairman, the Company agreed to (a) pay Mr. Diamond a severancepayment of $350,000 payable in semi-monthly installments for a period of sixmonths, (b) accelerate the vesting of Mr. Diamond’s “Time Vesting”options, (c) accelerate the vesting of Mr. Diamond’s options grantedin 2004 to purchase 259,659 shares (the “2004 Options”), (d) extend to February 5,2011 the exercisability of the Time Vesting Options and to March 29, 2011for the 2004 Options, and (e) pay Mr. Diamond his accrued base salarythrough February 29, 2008 and 40 days of accrued vacation time.

 

On July 28, 2005,the Company entered into an Employment Agreement with Robert Weingarten toserve as the Company’s Chief Financial Officer. During the term of theEmployment Agreement through December 31, 2008, Mr. Weingarten’s basesalary would be no less than $195,000 per annum, plus certain specifiedperquisites that include a monthly car allowance. Mr. Weingarten was alsoeligible to receive an annual discretionary bonus of up to 100% of base salary,as determined by the Compensation Committee of the Board of Directors or, ifnone, the Board of Directors, and an annual performance bonus of up to 100% ofbase salary if the Company achieved defined earnings before interest, taxes,depreciation and amortization in fiscal 2007 ($12,000,000 - $14,400,000) andfiscal 2008 ($15,000,000 - $18,000,000). Mr. Weingarten was also entitledto receive stock options at the discretion of the Company’s Board of Directors.In the event Mr. Weingarten was terminated “without cause,” he would beentitled to receive 12 months of severance pay at the rate of 100% of hismonthly salary, any performance bonus due for the year in which terminationoccurs and all stock options subject to time vesting shall be deemed fullyvested and exercisable.  On February 3,2006, June 19, 2006 and July 31, 2006, the Company entered intoagreements with Mr. Weingarten to incorporate non-material modificationsinto the Employment Agreement.

 

Effective August 31,2007, Mr. Weingarten resigned from all positions he held with theCompany.  The Company and Mr. Weingarten entered into a SeparationAgreement and Release dated August 31, 2007, whereas the Company and Mr. Weingartenmutually agreed to terminate their employment relationship as of August 31,2007 and the parties released each other from any and all claims.  As a result of this resignation, the Companyand Mr. Weingarten entered into an Agreement for Consulting Services (the “ConsultingAgreement”) dated August 31, 2007 whereas Mr. Weingarten would beretained as a consultant for a twelve-month period, unless sooner terminatedpursuant to the terms of the Consulting Agreement, and shall be paid a baseconsulting fee of $16,250 per month.

 

109

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In addition, the Companyand Mr. Weingarten entered into an Omnibus Stock Option AmendmentAgreement (the “Option Agreement”) dated August 31, 2007 whereas theCompany agreed to amend certain provisions of stock options previously grantedto Mr. Weingarten (see Note 13).  Mr. Weingartenwould be allowed to exercise the 120,000 stock options granted to him in 2004until the original expiration date of March 29, 2011 without regard to hisresignation from the Company.  Pursuantto the Option Agreement, the vesting of time-vesting options to acquire 275,000shares will be accelerated provided he does not breach the Consulting Agreementsuch that the remaining unvested time-vesting options became fully vested andexercisable as of August 31, 2007.  The vesting of theperformance-vesting options to acquire 275,000 shares will occur only upon theclosing of a sale, merger or other “change of control” transaction at a priceabove $3.10 per share occurring prior to August 31, 2008 provided he doesnot breach the Consulting Agreement.  In addition, Mr. Weingartenwill be able to exercise the time-vesting options and the performance-vestingoptions, if vested, until August 5, 2010, without regard to hisresignation provided he does not breach the Consulting Agreement.

 

In accordance with theMediaDefender transaction, the Company acknowledged the terms of EmploymentAgreements entered into on July 28, 2005 by MediaDefender with each ofRandy Saaf, who serves as Chief Executive Officer of MediaDefender, and OctavioHerrera, who serves as President of MediaDefender. Mr. Saaf and Mr. Herrerawill each earn a base salary of no less than $350,000 per annum during theinitial term of the agreements, which shall continue until December 31,2008, and are also each entitled to receive performance bonuses of up to$350,000 if MediaDefender achieves defined operating earnings before interest,taxes, depreciation and amortization (calculated using the same accountingmethods and policies as MediaDefender has historically used) exceeding$7,000,000 and $7,500,000 in fiscal 2007 and fiscal 2008, respectively.  Mr. Saaf and Mr. Herrera are eachentitled to receive twelve months of severance pay at the rate of 100% of theirmonthly salary and the pro rata portion of the performance bonus referencedabove if they are terminated “without cause.” The Company has determined to paythe performance bonuses to Mr. Saaf and Mr. Herrera for 2007, and hastherefore recorded a charge to general and administrative expense and anaccrued liability of $700,000 during the year ended December 31, 2007.

 

In addition, the Companygranted stock options to purchase 200,000 shares of common stock to each of Mr. Saafand Mr. Herrera, exercisable for a period of five years at $3.00 per shareand vesting quarterly over a period of three and one-half years.  On July 28, 2006, the Company enteredinto agreements with Mr. Saaf and Mr. Herrera to incorporatenon-material modifications into the Employment Agreements.

 

Future payments under employment agreements are as follows(amounts are in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| ** **                                   | ** ** | ** ** | ** ** |
| 2008                                         |       | $          | 1,490      |   |
| 2009                                         |       | 33         |       |
|                                         |       | $          | 1,523      |   |

 

Consulting Agreements

 

On October 9, 2006,the Company entered into an eighteen-month non-exclusive consulting agreementwith Wood River Ventures, LLC and Jonathan Dolgen for consulting and advisoryservices with respect to the business and operations of the Company.  Theconsulting agreement provided for an aggregate cash fee of $187,500, payablequarterly in six installments of $31,250, and a stock award valued at $112,500,consisting of 34,615 shares of common stock based on the Company’s closingstock price on October 10, 2006 of $3.25 per share to be issued under theCompany’s 2006 Equity Incentive Plan.  The shares vest pro rata over theeighteen-month period of the consulting agreement, beginning on October 10,2006 and thereafter monthly on the first day of each month of the term of theconsulting agreement through March 2008. Accordingly, during the years ended December 31, 2007 and 2006, theCompany issued 23,076 shares and 5,769 shares of common stock under thisconsulting agreement with a fair value of $75,000 and $19,000, which wascharged to operations (see Note 13).

 

On October 1, 2006, the Company entered into aone-year non-exclusive consulting agreement with an entity for businessdevelopment consulting services.  Theconsulting agreement provides for an aggregate cash fee of $108,000, consistingof an initial payment of $18,000 and a base fee payable monthly in twelveinstallments of $7,500, and stock options, consisting of an initial award ofoptions to acquire 25,000 shares of common stock, and subsequent awards ofoptions to acquire 5,000 shares of common stock on the last day of each monthof the term of the consulting agreement through September 30, 2007.  

 

110

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The stock options are fully vested when issued.  Accordingly, during the years ended December 31,2007 and 2006, the Company issued options to acquire 45,000 shares and 35,000shares of common stock under this consulting agreement pursuant to the Company’s2006 Equity Incentive Plan, exercisable through November 30, 2011, atprices ranging from $1.55 to $2.30 per share, the market price on the date ofgrant.  The aggregate fair value of theoptions, calculated pursuant to the Black-Scholes option-pricing model was$71,000 and $76,000, respectively, which was charged to operations (see Note13).

 

Legal Matters

 

The Company is periodically subject to various pendingand threatened legal actions that arise in the normal course of business.  The Company’s management believes that theimpact of any such litigation will not have a material adverse impact on theCompany’s financial position or results of operations.

 

As a result of therestatement of our financial statements and the other events describedelsewhere in this Annual Report on Form 10-KSB, we have triggered variousevents of default under our senior debt and subordinated debt financingdocuments.  We could be subject to futureclaims under our financing documents.

 

17.  REPORTABLESEGMENTS

 

Information with respect to the Company’s operatingsegments for the years ended December 31, 2007 and 2006 is presentedbelow.  During the years ended December 31,2007 and 2006, the Company’s operations consisted of three reportablesegments:  e-commerce, media andanti-piracy and file-sharing marketing services.

 

The factors for determining reportable segments werebased on services and products.  Eachsegment is responsible for executing a unique marketing and businessstrategy.  The accounting policies of thesegments are as described in the summary of significant accountingpolicies.  The Company evaluatesperformance based on, among other factors, earnings or loss before interest,taxes, depreciation and amortization (“Adjusted EBITDA”).  Adjusted EBITDA also excludes stock-basedcompensation, changes in the fair value of warrant liability and derivativeliability, and other non-cash write-offs and charges.  Included in Adjusted EBITDA are directoperating expenses for each segment.

 

The table shown below summarizes net revenue andAdjusted EBITDA by operating segment for the years ended December 31, 2007and 2006.  Corporate expenses consist ofgeneral operating expenses that are not directly related to the operations ofthe segments.  A reconciliation of NetIncome (Loss) to Adjusted EBITDA is also provided.

 
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | **(in thousands)**                     | ** ** |
| Net Revenue:                                             |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | 1,497      |   | $ | 2,649 |   |
| Media                                                    |       | 7,500                                       |       | 5,670 |   |
| Anti-piracy and  file-sharing marketing services         |       | 15,174                                      |       | 15,743 |   |
|                                                     |       | $                                           | 24,171     |   | $ | 24,062 |   |
|                                                     |       |                                        |       |   |   |
| Adjusted EBITDA:                                         |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | (218       | ) | $ | 6 |   |
| Media                                                    |       | 2,604                                       |       | 1,919 |   |
| Anti-piracy and  file-sharing marketing services         |       | 5,304                                       |       | 8,935 |   |
|                                                     |       | 7,690                                       |       | 10,860 |   |
| Corporate:                                               |       |                                        |       |   |   |
| General and  administrative expenses                     |       | (4,824                                      | )          | (4,672 | ) |
| Liquidated  damages under registration rights agreements |       | 395                                         |       | (3,777 | ) |
|                                                     |       | $                                           | 3,261      |   | $ | 2,411 |   |

 

111

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| ** **                                                                                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Reconciliation  of Adjusted EBITDA to Net Income (Loss):                                                                                                                                             |       |                                        |       |   |   |
| Adjusted EBITDA  per segments                                                                                                                                                                        |       | $                                           | 3,261      |   | $ | 2,411 |   |
| Stock-based  compensation                                                                                                                                                                            |       | (2,110                                      | )          | (2,281 | ) |
| Depreciation and  amortization                                                                                                                                                                       |       | (1,015                                      | )          | (554 | ) |
| Amortization of  intangible assets                                                                                                                                                                   |       | (3,602                                      | )          | (3,752 | ) |
| Amortization of  deferred financing costs                                                                                                                                                            |       | (841                                        | )          | (858 | ) |
| Reduction in  exercise price of warrants                                                                                                                                                             |       | —                                      |       | (641 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs resulting from  principal payments on senior secured notes payable and conversion of  subordinated convertible notes payable |       | —                                      |       | (1,624 | ) |
| Interest income                                                                                                                                                                                      |       | 211                                         |       | 126 |   |
| Other income                                                                                                                                                                                         |       | —                                      |       | 57 |   |
| Write-off of  fixed assets                                                                                                                                                                           |       | (97                                         | )          | — |   |
| Interest  expense, including amortization of discount on debt of $3,081 and $3,142 in  2007 and 2006, respectively                                                                                   |       | (7,923                                      | )          | (5,852 | ) |
| Change in fair  value of warrant liability                                                                                                                                                           |       | 4,551                                       |       | 1,124 |   |
| Change in fair  value of derivative liability                                                                                                                                                        |       | 18,043                                      |       | 7,792 |   |
| Tax benefit (provision)  for income taxes                                                                                                                                                            |       | 1,039                                       |       | (838 | ) |
| Net income (loss)                                                                                                                                                                                    |       | $                                           | 11,517     |   | $ | (4,890 | ) |

 

The following table summarizes assets as of December 31,2007 and 2006.  Assets by segment arethose assets used in or employed by the operations of each segment.  Corporate assets are principally made up ofcash and cash equivalents, prepaid expenses, computer equipment, leaseholdimprovements and other assets.

 
| ** **                                       | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| ** **                                       | ** ** | ** **              | ** ** | ** ** | ** ** |
| Assets:                                          |       |                    |       |   |   |
| Corporate                                        |       | $                       | 3,144      |   | $ | 2,791 |   |
| E-commerce                                       |       | 248                     |       | 1,383 |   |
| Media                                            |       | 2,419                   |       | 3,730 |   |
| Anti-piracy and  file-sharing marketing services |       | 44,923                  |       | 47,068 |   |
|                                             |       | $                       | 50,734     |   | $ | 54,972 |   |

 

 

112

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18.  SUBSEQUENTEVENTS (UNAUDITED)

 

Engagement of InvestmentBanking Firm:

 

On February 7, 2008,the Company entered into an Engagement Letter (“Engagement Letter”) with SalemPartners LLC (“Salem Partners”).  Under the terms of the EngagementLetter, Salem Partners has been engaged as financial advisor to the Company onan exclusive basis for a period of twelve months (a) in connection with anM&A transaction involving the Company and (b) to render an opinion, ifrequested, in a transaction involving the restructuring of the material termsof the Company’s senior secured notes payable and/or subordinated convertiblenotes payable.

 

# As compensation for itsservices, Salem Partners will be paid a retainer fee for the first fourmonths of service, which shall be credited against any M&A transaction fee,the amount of which will be based on the consideration associated with thetransaction.  A separate fee will beearned if Salem Partners provides an opinion regarding the transaction.

#  

Forbearance and Consent Agreement:

 

On March 17, 2008, the Company entered into aForbearance and Consent Agreement with the investors in the Company’s SeniorDebt Financing, which was effective as of February 20, 2008, whereby theinvestors  agreed to forbear fromexercising any of their rights and remedies under the Senior Financingtransaction documents through December 31, 2008 in exchange for anadjustment in the interest rate associated with the Senior Notes from 11.25% to15%, provided the loan is repaid prior to September 30, 2008 or 16%, ifthe loan remains outstanding subsequent to that date.

 

Management and DirectorChanges:

 

On February 25,2008, the company announced that Mr. Neil McCarthy, provided notice thathe was resigning as Interim Chief Financial Officer of the Company effective March 31,2008.

 

Effective March 6,2008, the Company announced that, Mr. Jon Diamond’s employment as ChiefExecutive Officer had ended and he was appointed Chairman of the Board ofDirectors.  Mr. Fredrick W. Field,who had been serving as the Company’s Chairman, agreed to continue serving as aDirector of the Company.  Mr. DimitriVillard, who had been serving as a Director and Member of the Company’s Auditand Compensation Committees agreed, in addition to those duties, to serve asInterim Chief Executive Officer.

 

On March 24, 2008, Mr. JamesLane advised the Company that he would no longer serve as a Director and memberof the Audit Committee.  As Mr. Lanewas, at that time, the only independent member of the Audit Committee and asthe Company under securities regulations is not required to have an AuditCommittee,  the Company has suspended theactivities of the Audit Committee until a new independent director isnominated. In the interim, the functions of the Audit Committee have beenassumed by the Board of Directors.

 

113

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INDEX TO EXHIBITS

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                    |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                               |
| 2.1                 |       | Agreement and Plan of  Merger, dated July 28, 2005, by and among ARTISTdirect, Inc.,  ARTISTdirect Merger Sub, Inc. and MediaDefender, Inc. (incorporated  by reference to current report on Form 8-K filed on August 5,  2005).                                     |
|                |       |                                                                                                                                                                                                                                                                                               |
| 3.1                 |       | Fourth Amended and  Restated Certificate of Incorporation of ARTISTdirect, Inc.  (incorporated by reference to Exhibit 3.1 to current report on  Form 8-K filed on June 22, 2006).                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                               |
| 3.2                 |       | Amended and Restated  Bylaws of ARTISTdirect, Inc. (incorporated by reference to current  report on Form 8-K filed on April 18, 2006).                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.1                 |       | Form of 11.25%  Senior Note Due July 28, 2009 issued to each of the Senior Financing  investors dated July 28, 2005 (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                                                   |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.2                 |       | Form of Warrant to  Purchase Common Stock issued to each of the Senior Financing investors dated  July 28, 2005 (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                                            |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.3                 |       | Registration Rights  Agreement, dated July 28, 2005, by and among ARTISTdirect, Inc. and  each of the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                                           |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.4                 |       | Form of Convertible  Subordinated Note issued to each of the Sub-debt investors dated  July 28, 2005 (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.5                 |       | Form of Sub-Debt  Financing Warrant issued July 28, 2005 (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.6                 |       | Registration Rights  Agreement, dated July 28, 2005, by and among ARTISTdirect, Inc. and  each of the Sub-Debt Financing investors (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                         |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.7                 |       | Warrant issued to Libra  FE, LP on July 28, 2005 (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.8                 |       | Registration Rights  Agreement, dated July 28, 2005, by and among ARTISTdirect, Inc. and  Libra FE, LP. (incorporated by reference to current report on Form 8-K  filed on August 3, 2005).                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.9                 |       | Warrant issued to  WNT07, LLC on July 28, 2005 (incorporated by reference to current report  on Form 8-K filed on August 3, 2005).                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.10                |       | Waiver of Registration  Rights Agreement, dated November 25, 2005, by and among  ARTISTdirect, Inc. and certain of the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  November 30, 2005).                                      |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.1                 |       | Waiver of Registration  Rights Agreement, dated November 25, 2005, by and among  ARTISTdirect, Inc. and certain of the Sub-Debt Financing investors  (incorporated by reference to current report on Form 8-K filed on  November 30, 2005).                                    |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.12                |       | Omnibus Amendment to  Note and Warrant Purchase Agreement and Warrants to Purchase Common Stock by  and between ARTISTdirect, Inc. and the Senior Financing investors dated  April 7, 2006 (incorporated by reference to current report on  Form 8-K filed on April 10, 2006). |
|                |       |                                                                                                                                                                                                                                                                                               |
| 4.13                |       | Amendment No.1 to  Registration Rights Agreement by and between ARTISTdirect, Inc. and the  Senior Financing investors dated April 7, 2006 (incorporated by  reference to current report on Form 8-K filed on April 10, 2006).                                                 |

 

E-1

----

 
| 4.14   |   | Omnibus Amendment and  Waiver to Notes and Warrants Issued Pursuant to Securities Purchase Agreement  by and between ARTISTdirect, Inc. and the Senior Financing investors  dated April 7, 2006 (incorporated by reference to current report on  Form 8-K filed on April 10, 2006).                                                                                                                                                                                          |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.15   |   | Amendment No.1 to  Registration Rights Agreement executed by ARTISTdirect, Inc. and CCM  Master Qualified Fund dated April 7, 2006 (incorporated by reference to  current report on Form 8-K filed on April 10, 2006).                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.16   |   | Amendment No.1 to  Registration Rights Agreement executed by ARTISTdirect, Inc. and DKR  SoundShore Oasis Holding Funding, Ltd. dated April 7, 2006 (incorporated  by reference to current report on Form 8-K filed on April 10,  2006).                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.17   |   | Amendment and Waiver to  Convertible Subordinated Note executed by ARTISTdirect, Inc. and CCM  Master Qualified Fund dated April 7, 2006 (incorporated by reference to  current report on Form 8-K on April 10, 2006).                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.18   |   | Amendment and Waiver to  Convertible Subordinated Note executed by ARTISTdirect, Inc. and DKR  SoundShore Oasis Holding Fund, Ltd. dated April 7, 2006 (incorporated by  reference to current report on Form 8-K on April 10, 2006).                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.19   |   | Amendment and Waiver  entered into by and between ARTISTdirect, Inc. and Libra FE, LP dated  April 7, 2006 (incorporated by reference to current report on  Form 8-K on April 10, 2006).                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.20   |   | Amendment No.1 to  Registration Rights Agreement entered into by and between  ARTISTdirect, Inc. and Libra FE, LP April 7, 2006 (incorporated by  reference to current report on Form 8-K filed on April 10, 2006).                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.21   |   | Waiver to Convertible  Subordinated Notes by and among ARTISTdirect, Inc. and the holders  identified on the signature page thereto, entered into as of November 7,  2006 (incorporated by reference to Exhibit 10.1 to current report on  Form 8-K filed on November 13, 2006).                                                                                                                                                                                   |
| 4.22   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   | Forbearance and Consent  Agreement dated as of April 17, 2007 by and among the Registrant, U.S.  Bank National Association, JMB Capital Partners, L.P., JMG Capital Partners,  L.P., JMG Triton Offshore Fund, Ltd., and CCM Master Qualified Fund, Ltd.  (incorporated by reference to Exhibit 4.1 to current report on  Form 8-K filed on April 20, 2007).                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.23   |   | Notice of Extension of  Forbearance Period dated May 31, 2007 to U.S. Bank National Association,  as Collateral Agent, by JMB Capital Partners, L.P., JMP Capital Partners,  L.P., JMG Triton Offshore Fund, Ltd., and CCM Master Qualified Fund, Ltd.  (incorporated by reference to Exhibit 99.1 to current report on  Form 8-K filed on June 4, 2007).                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.24   |   | Amendment No. 1  dated June 25, 2007 to the Forbearance and Consent Agreement dated as of  April 17, 2007 by and among the Registrant, U.S. Bank National  Association, as Collateral Agent, JMB Capital Partners, L.P., JMG Capital  Partners, L.P., JMG Triton Offshore Fund, Ltd., and CCM Master Qualified  Fund, Ltd. (incorporated by reference to Exhibit 4.1 to current report  on Form 8-K filed on June 28, 2007).                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.25   |   | Waiver and Forbearance  Agreement, dated as of August 3, 2007, by and among the Registrant, DKR  Soundshore Oasis Holding Fund, Ltd., CCM Master Qualified Fund, Ltd., Cliff  Chapman, Longview Fund, LP, Longview Equity Fund, LP, Longview International  Equity Fund, LP, Randy Saaf, Octavio Herrera, Michael Rapp, Philip Wagenheim,  Karl Brenza and Jeffrey Meshel (incorporated by reference to Exhibit 4.1  to current report on Form 8-K filed on August 8, 2007). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.26   |   | Amendment No. 2 dated  November 30, 2007 to the Forbearance and Consent Agreement dated as of April  17, 2007 by and among the Registrant, U.S. Bank National Association, as  Collateral Agent, JMB Capital Partners, L.P., JMG Capital Partners, L.P., JMG  Triton Offshore Fund, Ltd., and CCM Master Qualified Fund, Ltd. (incorporated  by reference to Exhibit 4.1 to current report on Form 8-K filed on December  5, 2007).                                                              |

 

E-2

----

 
| 4.27   |   | Forbearance and Consent  Agreement dated as of January 31, 2008 by and among the Registrant, U.S.  Bank National Association, as Collateral Agent, JMB Capital Partners, L.P.,  JMG Capital Partners, L.P., JMG Triton Offshore Fund, Ltd., and CCM Master  Qualified Fund, Ltd. (incorporated by reference to Exhibit 4.1 to  current report on Form 8-K filed on February 14, 2008). |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.28   |   | Forbearance and Consent  Agreement dated as of February 20, 2008 by and among the Registrant,  U.S. Bank National Association, as Collateral Agent, JMB Capital Partners,  L.P., JMG Capital Partners, L.P., JMG Triton Offshore Fund, Ltd., and CCM  Master Qualified Fund, Ltd. (incorporated by reference to Exhibit 4.1 to  current report on Form 8-K filed on March 20, 2008).   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.1   |   | Notice of Grant of  Stock Option dated as of September 29, 2003 by and between  ARTISTdirect, Inc. and Jon Diamond (incorporated by reference to  quarterly report on Form 10-Q filed on November 14, 2003).                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.2   |   | Settlement, Release and  Termination of Lease Agreement dated as of September 8, 2003, by and  between 5670 Wilshire L.P. and ARTISTdirect, Inc. (incorporated by  reference to quarterly report on Form 10-Q filed on November 14,  2003).                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.3   |   | Form of Director  Indemnification Agreement (incorporated by reference to registration  statement on Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.4   |   | Form of Officer  Indemnification Agreement (incorporated by reference to registration  statement on Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.5   |   | ARTISTdirect, Inc.  1999 Employee Stock Option Plan (incorporated by reference to registration  statement on Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.6   |   | ARTISTdirect, Inc.  Artist Plan (incorporated by reference to registration statement on  Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.7   |   | ARTISTdirect, Inc.  Artist and Artist Advisor Plan (incorporated by reference to registration statement  on Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.8   |   | ARTISTdirect, Inc.  2004 Consultant Stock Plan (incorporated by reference to registration  statement on Form S-8 filed on January 13, 2005).                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.9   |   | Notice of Grant of  Stock Option dated as of March 29, 2004 by and between  ARTISTdirect, Inc. and Robert N. Weingarten (incorporated by  reference to quarterly report on Form 10-Q filed on August 20,  2004).                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.10  |   | ARTISTdirect, Inc.  2006 Equity Incentive Plan (incorporated by reference to definitive proxy  statement on Schedule 14A filed on May 8, 2006).                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.11  |   | Employment,  Confidentiality and Noncompetition Agreement, dated July 28, 2005, by  and between MediaDefender, Inc. and Randy Saaf (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.12  |   | Employment,  Confidentiality and Noncompetition Agreement, dated July 28, 2005, by  and between MediaDefender, Inc. and Octavio Herrera (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.13  |   | Non-Competition  Agreement, dated July 28, 2005, entered into between  MediaDefender, Inc. and Randy Saaf (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.14  |   | Non-Competition  Agreement, dated July 28, 2005, entered into between  MediaDefender, Inc. and Octavio Herrera (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.15  |   | Note and Warrant  Purchase Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc., the investors indicated on the schedule of buyers  thereto and U.S. Bank National Association, as Collateral Agent for the  Senior Financing investors (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                |

 

E-3

----

 
| 10.16  |   | Security Agreement,  dated July 28, 2005, by and among ARTISTdirect, Inc. and its  subsidiaries and U.S. Bank National Association, as Collateral Agent for the  Senior Financing investors (incorporated by reference to current report on  Form 8-K filed on August 3, 2005)                                               |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.17  |   | Pledge Agreement, dated  July 28, 2005, by and among ARTISTdirect, Inc. and U.S. Bank  National Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.18  |   | Form of Copyright  Security Agreement (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.18  |   | Patent Security  Agreement, dated July 28, 2005, by and among MediaDefender, Inc.  and U.S. Bank National Association, as Collateral Agent for the Senior  Financing investors (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.19  |   | Trademark Security  Agreement, dated July 28, 2005, by and among ARTISTdirect, Inc. and  U.S. Bank National Association, as Collateral Agent for the benefit of the  Senior Financing investors (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.20  |   | Subsidiary Guaranty,  dated July 28, 2005, made by ARTISTdirect, Inc. and its  subsidiaries in favor of U.S. Bank National Association, as Collateral Agent  for the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.21  |   | Securities Purchase  Agreement, dated July 28, 2005, entered into by and among  ARTISTdirect, Inc. and the Sub-debt Financing investors (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.22  |   | Subordination  Agreement, dated July 28, 2005, among ARTISTdirect, Inc., and  certain of its subsidiaries, the Sub-debt Financing investors and U.S. Bank  National Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005). |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.23  |   | Non-Competition  Agreement, dated July 28, 2005, entered into between  ARTISTdirect, Inc. and WNT07, LLC (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.24  |   | Employment Agreement,  dated July 28, 2005, entered into between ARTISTdirect, Inc. and  Jon Diamond (incorporated by reference to current report on Form 8-K  filed on August 3, 2005).                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.25  |   | Employment Agreement,  dated July 28, 2005, entered into between ARTISTdirect, Inc. and  Robert Weingarten (incorporated by reference to current report on  Form 8-K filed on August 3, 2005).                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.26  |   | Amendment No. 1 to  Employment Agreement, dated October 11, 2005), entered into between  ARTISTdirect, Inc. and Jon Diamond (incorporated by reference to current  report on Form 8-K filed on October 14, 2005).                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.27  |   | Acknowledgement and  Amendment regarding Employment Agreement by and between  ARTISTdirect, Inc. and Jon Diamond dated February 3, 2006  (incorporated by reference to current report on Form 8-K filed on  February 3, 2006).                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.28  |   | Acknowledgement and  Amendment regarding Employment Agreement by and between  ARTISTdirect, Inc. and Robert Weingarten dated February 3, 2006  (incorporated by reference to current report on Form 8-K filed on  February 3, 2006).                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.29  |   | Sublease by and between  Sapient Corporation and ARTISTdirect, Inc. dated January 26, 2006  (incorporated by reference to current report on Form 8-K filed on  February 3, 2006).                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.30  |   | Amendment No.1 and  Waiver to Note and Warrant Purchase Agreement entered into by and between  ARTISTdirect, Inc. and the Senior Financing investors dated  April 7, 2006 (incorporated by reference to current report on  Form 8-K filed on April 10, 2006).                                                                |

 

E-4

----

 
| 10.31  |   | Consulting Agreement  entered into as of May 15, 2006 by and between ARTISTdirect, Inc.,  WNT Consulting Group and Eric Pulier (incorporated by reference to current  report on Form 8-K filed on May 17, 2006).                                                                                                                                     |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.32  |   | Acknowledgement and  Amendment No. 2 to Employment Agreement dated June 19, 2006 by and  between ARTISTdirect, Inc. and Jonathan V. Diamond (incorporated by  reference to Exhibit 10.1 to current report on Form 8-K filed on  June 22, 2006).                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.33  |   | Acknowledgement and  Amendment No. 2 to Employment Agreement dated June 19, 2006 by and  between ARTISTdirect, Inc. and Robert N. Weingarten (incorporated  by reference to Exhibit 10.2 to current report on Form 8-K filed on  June 22, 2006).                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.34  |   | Amendment, dated  July 28, 2006, to Employment, Confidentiality and Non-Competition  Agreement by and between ARTISTdirect, Inc. and Randy Saaf (incorporated  by reference to Exhibit 10.1 to current report on Form 8-K filed on  August 1, 2006).                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.35  |   | Amendment, dated  July 28, 2006, to Employment, Confidentiality and Non-Competition  Agreement by and between ARTISTdirect, Inc. and Octavia Herrera  (incorporated by reference to Exhibit 10.2 to current report on  Form 8-K filed on August 1, 2006).                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.36  |   | Amendment No. 3,  dated July 31, 2006, to Employment Agreement by and between  ARTISTdirect, Inc. and Jonathan V. Diamond (incorporated by  reference to Exhibit 10.3 to current report on Form 8-K filed on  August 1, 2006).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.37  |   | Amendment No. 2,  dated July 31, 2006, to Employment Agreement by and between  ARTISTdirect, Inc. and Robert N. Weingarten (incorporated by  reference to Exhibit 10.4 to current report on Form 8-K filed on  August 1, 2006).                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.38  |   | Waiver to Note and  Warrant Purchase Agreement by and among ARTISTdirect, Inc. and the  purchasers identified on the signature page thereto, entered into as of  November 7, 2006 (incorporated by reference to Exhibit 10.1 to  current report on Form 8-K filed on November 13, 2006).                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.39  |   | Assignment by and  between ARTISTdirect, Inc., JLF Partners I, LP, JLF Partners II, LP and  JLF Offshore Fund, Ltd. and The Longview Fund, LP, effective as of  November 8, 2006, and as acknowledged by Grushko & Mittman, PC  (incorporated by reference to Exhibit 10.2 to current report on  Form 8-K filed on November 13, 2006). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.40  |   | Supplemental Agreement  and Acknowledgement by and between ARTISTdirect, Inc. and The Longview  Fund, LP, effective as of November 8, 2006 (incorporated by reference to  Exhibit 10.3 to current report on Form 8-K filed on November 13,  2006.                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.41  |   | Release of Claims dated  as of November 28, 2006 by Nicholas Turner (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on  November 30, 2006).                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.42  |   | Independent Contractor  Agreement dated as of November 28, 2006 by and between  ARTISTdirect, Inc. and Nicholas Turner (incorporated by reference to  Exhibit 10.2 to current report on Form 8-K filed on  November 30, 2006).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.43  |   | Consulting Agreement  entered into as of January 12, 2007 by and between  ARTISTdirect, Inc., WNT Consulting Group and Eric Pulier (incorporated  by reference to Exhibit 10.1 to current report on Form 8-K filed on  January 17, 2007).                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.44  |   | Termination Agreement  entered into as of January 12, 2007 by and between ARTISTdirect, Inc.,  WNT Consulting Group and Eric Pulier (incorporated by reference to  Exhibit 10.2 to current report on Form 8-K filed on  January 17, 2007).                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.45  |   | Offer of Employment  between ARTISTdirect, Inc. and Rene Rousselet approved as of  February 2, 2007 (incorporated by reference to Exhibit 10.1 to  current report on Form 8-K filed on February 6, 2007).                                                                                                                                       |

 

E-5

----

 
| 10.46   |   | Letter Agreement dated  July 2, 2007, between the Registrant and Neil McCarthy (incorporated by  reference to Exhibit 10.1 to current report on Form 8-K filed on  September 7, 2007).                                         |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                               |
| 10.47   |   | Agreement for  Consulting Services dated August 31, 2007, between the Registrant and  Robert N. Weingarten (incorporated by reference to Exhibit 10.68 to  quarterly report on Form 10-QSB filed on November 14, 2007).        |
|    |   |                                                                                                                                                                                                                                               |
| 10.48   |   | Omnibus Stock Option  Amendment Agreement dated August 31, 2007, between the Registrant and  Robert N. Weingarten (incorporated by reference to Exhibit 10.69 to  quarterly report on Form 10-QSB filed on November 14, 2007). |
|    |   |                                                                                                                                                                                                                                               |
| 10.49   |   | Separation Agreement  and Release dated August 31, 2007, between the Registrant and Robert N.  Weingarten (incorporated by reference to Exhibit 10.70 to quarterly  report on Form 10-QSB filed November 14, 2007).            |
|    |   |                                                                                                                                                                                                                                               |
| 10.50   |   | Engagement Letter,  dated as of February 7, 2008, by and between the Registrant and Salem  Partners LLC (incorporated by reference to Exhibit 10.1 to current  report on Form 8-K filed on February 14, 2008).                 |
|    |   |                                                                                                                                                                                                                                               |
| 10.51   |   | Amended and Restated  Services Agreement dated as of March 6, 2008 between the Company and Jon  Diamond (incorporated by reference to Exhibit 10.1 to current report on  Form 8-K filed March 12, 2008).                       |
|    |   |                                                                                                                                                                                                                                               |
| 14.1    |   | Code of Business  Conduct and Ethics (incorporated by reference to current report on  Form 8-K filed on June 22, 2006).                                                                                                                  |
|    |   |                                                                                                                                                                                                                                               |
| 14.2    |   | ARTISTdirect, Inc.  Audit Committee Charter (incorporated by reference to definitive proxy  statement on Schedule 14A filed on May 8, 2006).                                                                                             |
|    |   |                                                                                                                                                                                                                                               |
| 21.1    |   | Subsidiaries of  ARTISTdirect, Inc. (incorporated by reference to registration statement  on Form SB-2 filed on November 10, 2005).                                                                                                 |
|    |   |                                                                                                                                                                                                                                               |
| 23.1    |   | Consent of Gumbiner  Savett Inc., independent registered public accounting firm, with respect to  ARTISTdirect, Inc. and subsidiaries.                                                                                                        |
|    |   |                                                                                                                                                                                                                                               |
| 24.1    |   | Power of Attorney (see  signature page).                                                                                                                                                                                                           |
|    |   |                                                                                                                                                                                                                                               |
| 31.1    |   | Certifications of the  Interim Chief Executive Officer under Section 302 of the Sarbanes-Oxley  Act.                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                               |
| 31.2    |   | Certifications of the  Interim Chief Financial Officer under Section 302 of the Sarbanes-Oxley  Act.                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                               |
| 31.2(a) |   | Certifications of the  Principal Accounting Officer under Section 302 of the Sarbanes-Oxley  Act.                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                               |
| 32.1    |   | Certifications of the  Interim Chief Executive Officer under Section 906 of the Sarbanes-Oxley  Act.                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                               |
| 32.2    |   | Certifications of the  Interim Chief Financial Officer under Section 906 of the Sarbanes-Oxley  Act.                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                               |
| 32.2(a) |   | Certifications of the  Principal Accounting Officer under Section 906 of the Sarbanes-Oxley  Act.                                                                                                                                             |

 

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