**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

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**FORM10-KSB/A**

**AmendmentNo. 4**

**(Mark One)**
| **x**      | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)  OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
|------------|------------|-------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                      |
| ** ** | ** ** | **For the fiscal year ended December 31, 2005**                                                 |
| ** ** | ** ** | ** **                                                                                      |
| **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 Small BusinessIssuer 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, California 90404-4082**(Address of Principal ExecutiveOffices, including Zip Code)

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

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Securities registered pursuant to Section 12(b) ofthe Act:** None**Securities registered pursuant to Section 12(g) of the Act:**  common stock,$0.01 par value**

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Check whether theissuer is not required to file reports pursuant to Section 13 or 15(d) ofthe Exchange Act. o

Check whether theissuer (1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes xNo o

Check if there isno disclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best of theregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes oNo ý

State issuer’srevenues for its most recent fiscal year. $13,971,000.

As of March 29,2006, the aggregate market value of the voting common stock held by non-affiliatesof the registrant was approximately $25,981,540, based on the closing price pershare of $4.47 for the registrant’s common stock as reported on theOver-the-Counter Bulletin Board on such date.

As of March 29,2006, there were 6,921,457 shares of the registrant’s common stock, par value$0.01 per share, issued and outstanding.

**Documentsincorporated by reference****: **None.

 

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**ExplanatoryNote**

This Amendment No. 4 onForm 10-KSB/A (the “Form 10-K/A”) to our Annual Report on Form 10-KSB for theyear ended December 31, 2005, initially filed with the Securities and ExchangeCommission (“SEC”) on April 13, 2006, Amendment No. 1 filed on April 20, 2006,Amendment No. 2 filed on April 25, 2006, and Amendment No. 3 filed on April 28,2006 (the “Original Amended Filings”), is being filed to restate our 2005consolidated financial statements, certain notes to our 2005 consolidatedfinancial statements and other financial information as a result of changes inthe accounting treatment of certain of the Company’s embedded derivativescontained in instruments issued by the Company in July 2005 in connection withthe financing of the MediaDefender acquisition.

The information containedin this Form 10-KSB/A, including the financial statements and notes thereto,amends Item 6 (Management’s Discussion and Analysis or Plan of Operation), andItem 7 (Financial Statements) of Part II of our Original Amended Filings.Except as amended hereby, this Amendment No. 4 does not amend, update or changeany other information contained in the Original Amended Filings.

The senior notes andsubordinated convertible notes (“Notes”) issued in conjunction with the financingof the MediaDefender acquisition (as described in Note 9 to the financialstatements) have a combination of attributes, most notably, conversionfeatures, registration rights and other aspects which have been identified asderivatives and are treated as liabilities in accordance with Financial Accounting Standards Board (“FASB”)Statement No.133, “Accounting for Derivative Instruments and Hedging Activities”(“FASB 133”) and related Emerging Issues Task Force (“EITF”), Issue No. 00-19 “Accountingfor Derivative Financial Instruments Indexed to and Potentially Settled in, aCompany’s Own Stock” (“ETIF 00-19”), as described in Note 9 to thefinancial statements.

In addition to theadjustments for the embedded derivatives associated with the Notes (see Note 9to the financial statements), the Company recalculated the earning per share (“EPS”)and adopted the “Two Class Method” of EPS presentation to reflect thedetermination that the sub-debt notes had a dividend participation feature,which in accordance with SFAS No. 128, “EarningsPer Share,” as clarified by EITF Issue No. 03-6, “Participating Securities and the Two-ClassMethod,” requires the Two Class Method.

A summary of thesignificant adjustments recorded to restate the financial statements as of andfor the year ended December 31, 2005 is presented below. The restatementdid not have an impact on the Company’s cash flows for the year endedDecember 31, 2005.

(a)                                  Theinitial fair value of the derivative liability was bifurcated from the Sub-Debt Notes and was recorded as adiscount to the Sub-Debt Notes, and was amortized to interest expense over thelife of the related debt.

(b)                                 Thederivative liability was revalued at each quarter end, with the resultingchange in fair value reflected in the statement of operations.

(c)                                  Theinitial fair value of the warrants issued in the Senior Financing and theSub-Debt Financing was revised, resulting in revisions to deferred financingcosts and debt discount amounts, and in the related amortization of suchamounts to operations.

(d)                                 Thewarrants issued in conjunction with the Senior Financing and the Sub-DebtFinancing were revalued at each quarter end, with the resulting change in fairvalue reflected in the statement of operations.

(e)                                  Thepro rata portion of warrant liability and derivative liability associated withthe conversion of the sub-debt into common stock was transferred to additionalpaid-in capital.

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The following tablepresents the impact of the restatement on the effected balance sheet categoriesat December 31, 2005(amounts in thousands):
| ** **                                          | ** ** | **As Previously  Reported** | ** ** | **Restatement  Adjustments** | ** ** | **Adjustment  Legend** | ** ** | **As Restated** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------------|------------|----------------------|------------|
| Deferred financing  costs                           |       | $                                | 3,063      |                         | $          | 237                    |       | (c)                  |       | $ | 3,300 |   |
| Warrant liability                                   |       | 3,260                            |       | 11,844                       |       | (c),  (d)              |       | 15,104               |       |
| Derivative liability                                |       | —                           |       | 30,202                       |       | (a),  (b)              |       | 30,202               |       |
| Discount on senior  secured notes payable           |       | 1,245                            |       | 521                          |       | (c),  (d)              |       | 1,766                |       |
| Discount on subordinated  convertible notes payable |       | 774                              |       | 9,494                        |       | (a),  (b), (c)         |       | 10,268               |       |
| Additional paid-in  capital                         |       | 207,832                          |       | 375                          |       | (e)                    |       | 208,207              |       |
| Accumulated deficit                                 |       | (205,926                         | )          | (32,169                      | )          | (a), (b), (c), (d)     |       | (238,095             | )          |
|                                                     |            |                                  |            |                              |            |                        |            |                      |            |  |  |  |

 

The following table presentsthe impact of the restatement on the statements of operations for the yearended December 31, 2005 (amounts in thousands):
| ** **                                                                                                                           | ** ** | **As Previously  Reported** | ** ** | **Restatement  Adjustments** | ** ** | **Adjustment  Legend** | ** ** | **As Restated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------------|------------|----------------------|------------|
| Income from  operations                                                                                                              |       | $                                | 1,397      |                         | $          | —                 |       |                 |       | $ | 1,397 |   |
| Interest income                                                                                                                      |       | 29                               |       | —                       |       |                   |       | 29                   |       |
| Interest expense                                                                                                                     |       | (1,517                           | )          | (1,356                       | )          | (a),  (c)              |       | (2,873               | )          |
| Amortization of  deferred financing costs                                                                                            |       | (373                             | )          | (29                          | )          | (c)                    |       | (402                 | )          |
| Change in fair value  of warrant liability                                                                                           |       | —                           |       | (10,735                      | )          | (c),  (d)              |       | (10,735              | )          |
| Change in fair  value of derivative liability                                                                                        |       | —                           |       | (20,043                      | )          | (a),  (b)              |       | (20,043              | )          |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable |       | (39                              | )          | (6                           | )          | (a),  (c)              |       | (45                  | )          |
| Loss from  continuing operations before income taxes                                                                                 |       | (503                             | )          | (32,169                      | )          |                   |       | (32,672              |       |
| Provision for  income taxes                                                                                                          |       | (241                             | )          | —                       |       |                   |       | (241                 | )          |
| Income from  discontinued operations                                                                                                 |       | 20,808                           |       | —                       |       |                   |       | 20,808               |       |
| Net income (loss)                                                                                                                    |       | $                                | 20,064     |                         | $          | (32,169                | )          |                 |       | $ | (12,105 | ) |
|                                                                                                                                 |       |                             |       |                         |       |                   |       |                 |       |
| Net income  (loss) per share – basic                                                                                            |       | $                                | 5.06       |                         |       |                   |       |                 | $          | (3.05 | ) |
| Net income (loss) per  share – diluted                                                                                          |       | $                                | 1.45       |                         |       |                   |       |                 | $          | (3.05 | ) |

 

The restatement didnot have an impact on cash flows.

 

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**ARTISTDIRECT INC.ANNUAL REPORT ON FORM 10-KSB/A**

**TABLE OF CONTENTS**
|                   | ** ** | ** **                                                                                                             | ** ** | **Page** |
|-------------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I.           |       |                                                                                                                   |       | 1        |
|              |       |                                                                                                                   |       |     |
| ITEM 1.           |       | DESCRIPTION OF  BUSINESS                                                                                               |       | 1        |
|              |       |                                                                                                                   |       |     |
| ITEM 2.           |       | DESCRIPTION OF  PROPERTY                                                                                               |       | 13       |
|              |       |                                                                                                                   |       |     |
| ITEM 3.           |       | LEGAL  PROCEEDINGS                                                                                                     |       | 13       |
|              |       |                                                                                                                   |       |     |
| ITEM 4.           |       | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS                                                                   |       | 13       |
|              |       |                                                                                                                   |       |     |
| PART II           |       |                                                                                                                   |       | 14       |
|              |       |                                                                                                                   |       |     |
| ITEM 5.           |       | MARKET FOR  COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS  PURCHASES OF EQUITY SECURITIES      |       | 14       |
|              |       |                                                                                                                   |       |     |
| ITEM 6.           |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OR PLAN OF OPERATION                                                        |       | 14       |
|              |       |                                                                                                                   |       |     |
| ITEM 7.           |       | FINANCIAL STATEMENTS                                                                                                   |       | 40       |
|              |       |                                                                                                                   |       |     |
| ITEM 8.           |       | CHANGES IN AND  DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                                  |       | 40       |
|              |       |                                                                                                                   |       |     |
| ITEM 8A.          |       | CONTROLS AND PROCEDURES                                                                                                |       | 40       |
|              |       |                                                                                                                   |       |     |
| ITEM 8B.          |       | OTHER INFORMATION                                                                                                      |       | 41       |
|              |       |                                                                                                                   |       |     |
| PART III          |       |                                                                                                                   |       | 41       |
|              |       |                                                                                                                   |       |     |
| ITEM 9.           |       | DIRECTORS,  EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH  SECTION 16(A) OF THE EXCHANGE ACT |       | 41       |
|              |       |                                                                                                                   |       |     |
| ITEM 10.          |       | EXECUTIVE  COMPENSATION                                                                                                |       | 45       |
|              |       |                                                                                                                   |       |     |
| ITEM 11.          |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                       |       | 48       |
|              |       |                                                                                                                   |       |     |
| ITEM 12.          |       | CERTAIN  RELATIONSHIPS AND RELATED PARTY TRANSACTIONS                                                                  |       | 52       |
|              |       |                                                                                                                   |       |     |
| ITEM 13.          |       | EXHIBITS                                                                                                               |       | 52       |
|              |       |                                                                                                                   |       |     |
| ITEM 14.          |       | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                                |       | 53       |
|              |       |                                                                                                                   |       |     |
| SIGNATURES        |       | 54                                                                                                                     |
|              |       |                                                                                                                   |
| POWER OF ATTORNEY |       |                                                                                                                   |

 

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**NOTE CONCERNING FORWARD-LOOKING STATEMENTS**

*Inaddition to historical information, this Annual Report on Form 10-KSB/A (“AnnualReport”) for ARTISTdirect, Inc. (“ARTISTdirect,” the “Company,” “we,” “our”  or “us”) contains “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended(the “Exchange Act”), including statements that include the words “may,” “will,”“believes,” “expects,” “anticipates,” or similar expressions. These forwardlooking statements may include, among others, statements concerning ourexpectations regarding our business, growth prospects, revenue trends,operating costs, working capital requirements, competition, results of operationsand other statements of expectations, beliefs, future plans and strategies,anticipated events or trends, and similar expressions concerning matters thatare not historical facts. The forward-looking statements in this Annual Reportinvolve known and unknown risks, uncertainties and other factors that couldcause our actual results, performance or achievements to differ materially fromthose expressed or implied by the forward-looking statements contained herein.*

*Eachforward-looking statement should be read in context with, and with anunderstanding of, the various disclosures concerning our business madeelsewhere in this Annual Report, as well as other public reports filed by uswith the United States Securities and Exchange Commission. Investors should notplace undue reliance on any forward-looking statement as a prediction of actualresults of developments. Except as required by applicable law or regulation, weundertake no obligation to update or revise any forward-looking statementcontained in this Annual Report.*

**PART I**

**ITEM1.****                             DESCRIPTIONOF BUSINESS**

**General**

Incorporated underthe laws of the****State of Delawarein July 1999, we are a digital media entertainment company that is home to anon-line music network. Through our acquisition of MediaDefender, Inc., aDelaware corporation (“MediaDefender”), in July 2005, we are also a provider ofanti-piracy solutions in the Internet piracy protection industry. Below is anoverview of our three business segments:

·                  *Media.*Our media operations include ourcontent-oriented web-sites, a network of third party music sites and ourentertainment 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 42% and 38% of our revenue duringthe fiscal years ended December 31, 2004 and 2005, respectively. Refer to “ARTISTdirectOverview-Media and E-Commerce Segments” below for additional information.

·                  *E-Commerce.*E-commerce operations consistof the sale of recorded music and artist-related merchandise on our web-sites.Most of our sales come from our ARTISTdirect shopping area, which offers acomprehensive selection of music CDs and broad range of artist and lifestylemerchandise. Our e-commerce segment accounted for 58% and 19% of our revenueduring the fiscal years ended December 31, 2004 and 2005, respectively.Refer to “ARTISTdirect Overview-Media and E-Commerce Segments” below foradditional information.

·                  *Internet Piracy Prevention.*Our Internetpiracy prevention (“IPP”) segment is currently operated by MediaDefender, as awholly-owned subsidiary of ARTISTdirect. MediaDefender’s proprietary suite ofIPP solutions offers significant levels of protection on the 15 majorpeer-to-peer (“P2P”) file-sharing networks, as well as on Internet Relay Chat (“IRC”)and Usenet. MediaDefender’s uber-level solutions are capable of providing up to95% effectiveness in preventing unauthorized downloads of customer-specifiedcontent. Although MediaDefender was acquired by us in the third quarter offiscal 2005, our IPP segment accounted for 43% of our revenue during the fiscalyear ended December 31, 2005. Refer to “MediaDefender Overview-InternetAnti-Piracy Segment” and “Media Defender Acquisition” below for additionalinformation.

At December 31,2005, we employed 57 full-time employees and eight part-time consultants, noneof whom are covered by a collective bargaining agreement. We believe that ourrelationship with our employees is good.

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**MediaDefenderAcquisition**

We consummated theacquisition of MediaDefender in July 2005. The aggregate consideration for theacquisition was $42.5 million in cash, subject to a holdback of $4.25 millionwhich was placed into an escrow account to cover certain indemnification claimsfor a limited period of time ($2.0 million of which has been released to formerMediaDefender stockholders since the closing of the acquisition). Concurrentwith the consummation of the acquisition, we completed a $15.0 million seniorsecured debt transaction and a $30.0 million convertible subordinated debt transaction.Refer to “Management’s Discussion and Analysis or Plan of Operation” foradditional information related to the financing transactions.

**ARTISTdirectOverview – Media and E-Commerce Segments**

The ARTISTdirectnetwork (www.artistdirect.com) is a network of web-sites offering multi-mediacontent, music news and information, community around shared music interests,advertising sponsorships, music-related specialty commerce and digital musicservices.

Our networkconsists of our music search engine and database containing information on morethan 100,000 artists, retail goods, e-commerce offering a wide selection ofartist merchandise and music, our proprietary music guide that enables users tobrowse music by artist, genre or time period, a music-oriented online communityand the ability for users to download and listen to music and view musicvideos.

*Technology*.Our infrastructure is designed to be integrated, scalable, reliable and secure.The software that we use supports the acquisition, management and publicationof content on our web-sites. During fiscal 2005, the management of ourweb-sites and servers for content, applications, database and electroniccommerce was handled internally. Our servers are maintained at IX2 Networks,LLC, a co-location facility in Los Angeles, California. Our operations dependon our and IX2’s ability to protect our systems against fire, power loss,telecommunications failure, break-ins and other events. All web-sites, servers,and systems are monitored and periodic backups are stored at our data center.

Our currente-commerce system is based on systems, analysis and program (“SAP”) developmentsoftware with certain enhancements provided to us by Pandesic, LLC, (“Pandesic”)a joint venture between Intel and SAP that wound up operations inJanuary 2001. Upon Pandesic’s cessation of operations, we received thesource code and executables for the e-commerce system that had been providedpreviously by Pandesic, implemented SAP’s software in house under a two-yearlicense from SAP. In December 2002, our two-year license expired and weentered into a perpetual license agreement with SAP.

*OrderProcessing and Fulfillment.*Our web-sites include an orderingsystem that is designed to facilitate convenient online purchasing of pre-recordedmusic and merchandise. Customers can add items to their “shopping cart” whilesurfing our web-sites. At any time they can securely “checkout,” at which timethey need to register (if they are new customers), or enter their registeredusername and password to retrieve previously saved billing, shipping and creditcard information. We verify orders submitted for credit card payment for frauddetection and sufficient funds before we release the order for fulfillment. Wealso accept alternative modes of payment, such as checks and money orders.Credit card numbers are encrypted, and all customer, commerce and transactionaldata are stored in secure databases protected by firewalls. The transmission ofinformation over the Internet uses Secure Socket Layer security technologyverified by VeriSign, an industry leader in online security.

·                  Wehave a month-to-month agreement with Alliance Entertainment Corp. (“Alliance”)to be the primary supplier of our music and music-related information. Alliancefulfills compact discs ordered by our customers and we pay Alliance thewholesale cost plus a fulfillment fee. In addition, Alliance provides warehousespace and fulfillment services pursuant to an oral agreement that Alliance mayterminate at any time for a majority of the music-related merchandise that weoffer which allows the consolidated shipping of customer orders for both musicand merchandise.

·                  Wehave a month-to-month agreement with Benn Co., LLC (“Benn Co.”) for it to be awholesale supplier of music-related merchandise and provide fulfillmentservices for the products for which it sells to us.

If we are unableto continue our agreements with these suppliers our business could be adverselyaffected.

*CustomerService.*We have a month-to-month agreement with Alliance toprovide customer support services for our web-sites’ consumers and respond tocustomer inquiries, orders and other requests made by phone, fax, e-mail andregular mail.

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*Salesand 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 ofmethods to create awareness of the ARTISTdirect network designed to drivetraffic to our web-sites. We have focused much of our marketing activity one-mail direct marketing to communicate with registered users about specificartists and the ARTISTdirect network. Campaigns have included directnotification of special merchandise offers, contests, promotions andavailable music downloads. To the extent our registered users in thefuture opt out of e-mails or use technology to block marketinge-mails, our operating results could be adversely affected. Ad-blockingtechnologies may be used to limit the effectiveness of web advertising.

*Customers.*During the year ended December 31, 2005, one customeraccounted for $1.79 million, or 33.0% of our total media revenue. During theyear ended December 31, 2004, one customer accounted for $245,000, or 12.0% oftotal media revenue. No other customer accounted for more than 10.0% of ourmedia or e-commerce revenue during 2005 or 2004.

*Competition.*The market for the online promotion and distribution of musicand music-related products and services is relatively new, highly competitiveand rapidly changing. There are a large number of web-sites competing for theattention and spending of consumers and advertisers, and we expect that numberto increase, because there are few barriers to entry to Internet commerce. Inaddition, the competition for advertising revenue, both on web-sites and inmore traditional media, is intense. We compete as follows:

·                  formusic consumers and advertisers with providers of music information, communityand content such as MTV, America Online, MSN, Yahoo!, Listen.com and variousother companies;

·                  withmajor online music retailers such as Amazon.com and iTunes Music Store inselling music and merchandise;

·                  formusic consumers and artist relationships with traditional music industry companies,including Sony BMG Music Entertainment, EMI Music, a unit of EMI Group, WarnerMusic Group, and Universal Music Group, a unit of Vivendi. Some of thesecompanies have recently established online presences to promote and distributethe music and tours of their respective artists;

·                  formusic consumers and advertisers with publishers and distributors of traditionalmedia, such as television, radio and print, including MTV, CMT, Rolling Stoneand Spin and their Internet affiliates; and

·                  withtraditional retailers targeting music consumers, including Tower Records andVirgin Megastore and their Internet affiliates, in selling music andmerchandise.

Our competitorshave worked together to offer music over the Internet, and we may faceincreased competitive pressures as a result. For instance, RealNetworks, TimeWarner, Bertelsmann AG and EMI Group formed MusicNet, a digital musicsubscription platform featuring on-demand downloads and streaming. Variousretailers such as BestBuy have cooperated to distribute music through theiTunes platform. We believe that we are able to compete effectively on thebasis of:

·                  thebreadth and quality of our search, database and the community features of oursite;

·                  thevariety, availability and price of music-related merchandise on our sites; and

·                  theease of use and consumer acceptance of the ARTISTdirect network.

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Competition islikely to increase significantly as new companies enter the market and currentcompetitors expand their services. Many of our current and potentialcompetitors in the Internet and music entertainment businesses may havesubstantial competitive advantages over us, including:

·                  longeroperating histories;

·                  significantlygreater financial, technical and marketing resources;

 

·                  greaterbrand name recognition;

·                  largerexisting customer bases; and

·                  morepopular content or artists.

These competitorsmay be able to respond more quickly to new or emerging technologies, regulatorydevelopments and changes in customer requirements and to devote greater resourcesto the development, promotion and sale of their products or services than wecan. Web-sites maintained by our existing and potential competitors may beperceived by consumers, artists, talent management companies and othermusic-related vendors or advertisers as being superior to ours. In addition, wemay not be able to maintain or increase our web-site traffic levels, purchaseinquiries and number of click-through on our online advertisements. Further,our competitors may experience greater growth in these areas than we do.Increased competition could result in advertising price reduction, reducedmargins or loss of market share, any of which could materially harm ourbusiness.

*GovernmentalRegulation*. The laws and regulations that govern our businesschange rapidly. Although our operations are currently based in California, theUnited States government and the governments of other states and foreignjurisdictions have attempted to regulate activities on the Internet. Thefollowing are some of the evolving areas of law that are relevant to ourbusiness:

*ContentRegulation.*Federal, state and foreign governments haveadopted and proposed laws governing the content of material transmitted overthe Internet. These include laws relating to obscenity, indecency, libel anddefamation. For example, the Child Online Protection Act, or “COPA,” prohibitsand imposes criminal penalties and civil liability on anyone communicatingmaterial harmful to minors through the Internet for commercial purposes, unlessaccess to such material is blocked to minors under age 17. The Third U.S.Circuit Court of Appeals has upheld a preliminary injunction precludingenforcement of COPA. In June 2004, the U.S. Supreme Court upheld the injunctionand remanded the case to the District Court. We could be liable if theinjunction against COPA is lifted and if content delivered by us or placed onour web-sites violates COPA.

*PrivacyLaw.*The state of privacy law is unsettled, and rapidlychanging. Current and proposed federal, state and foreign privacy regulationsand other laws restricting the collection, use and disclosure of personalinformation could limit our ability to use the information in our databases togenerate revenues. In late 1998, the Children’s Online Privacy Protection Act,or “COPPA,” was enacted, mandating that measures be taken to safeguard minorsunder the age of 13. The Federal Trade Commission (“FTC”) promulgatedregulations implementing COPPA on October 21, 1999, which became effectiveon April 21, 2000.

The principalCOPPA requirement is that individually identifiable information about minorsunder the age of 13 not be collected, used, displayed or otherwise collectedwithout first obtaining informed parental consent that is verifiable in lightof present technology. The FTC final regulations create a “sliding scale” ofpermissible methods for obtaining such consent based on how the informationwill be used. Consent for internal use of the individually identifiableinformation of children under the age of 13 can be obtained through e-mail plusan additional safeguard, such as confirming consent with a delayed e-mail,telephone call, or letter.

We comply with theCOPPA requirements by not collecting or displaying the individually identifyinginformation of users who, when attempting to register on the web-sites, entertheir birth date indicating they are under the age of 13. Complying with theCOPPA requirements is costly and may dissuade some of our potential customers.

Because we haveposted a privacy policy pertaining to all users and visitors to our web-site,we are subject the jurisdiction of the FTC. California also passed theCalifornia Online Privacy Protection Act, which took effect July 1, 2004 andmandates content and posting requirements for web-sites privacy policies ofweb-sites that collect personal information from California residents. While weare attempting to be fully compliant with the FTC and California requirements,our efforts may not be entirely successful. In addition, at times we rely uponoutside vendors to maintain data-collection software, and there can be noassurance that they will at all times comply with our instructions to complywith COPPA, our Privacy Policy and FTC and California requirements. If ourmethods of complying with these requirements are inadequate, we may facelitigation with the FTC, California governmental authorities or individuals,which would adversely affect our business. Should any of our business practicesbe found to differ from our privacy policy, we could be subject to sanctionsand penalties from the FTC or injunctions and penalties from Californiagovernmental authorities. It is also possible that users or visitors could tryto recover damages in a civil action as well. Attorney Generals in variousStates also have in the past sought to enforce posted privacy policies and maycontinue to do so in the future.

4

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*LawsGoverning Sending of Unsolicited Commercial E-mail.*Wetypically provide our customers and other visitors to our web-sites with anopportunity to “opt-in,” or agree to receive e-mail from us. The federalgovernment signed the Controlling the Assault of Non-Solicited Pornography andMarketing Act of 2003 (CAN-SPAM) designed to limit unsolicited commerciale-mail commonly referred to as “spam.” In addition, California and a number ofother states regulate the sending of e-mails for commercial purposes to thirdparties where there is no preexisting business relationship. Further, severalstates give Internet service providers (“ISPs”) a private right of actionagainst those who send large e-mailings across their servers in contraventionof the ISP’s posted policy. There is no guarantee that we will always be fullycompliant in all of our communications at all times. Our failure to comply withapplicable laws regarding these types of e-mails could result in significantfines, actual or statutory damages, and injunctive actions.

*Conformanceto E-Commerce Statutory Requirements for Formation of Contracts.*Weconduct e-commerce on our web-sites, and through affiliated web-sites. Theapplicable law on online formation of contracts has been unsettled and isevolving. On June 30, 2000, the federal government enacted the “E-Sign”statute, which in limited cases permits online formation of contracts.Similarly, on January 1, 2000, California adopted a version of the UniformElectronic Transactions Act (“UETA”), which also permits electronic signaturesand record-keeping for certain types of contracts. Only the States of Georgia,Illinois, New York and Washington have not adopted a version of UETA. The StateUETA statutes have not been tested in the courts to determine whether theyconform to E-Sign provisions that allow States to adopt UETA and other lawsregarding electronic contracts and electronic signatures. We attempt to complywith these laws, but there is no guarantee that we will be successful. Judicialinterpretation of their application could result in customer contracts beingset aside or modified. In that case, our e-commerce revenue could be materiallyadversely affected.

*SalesTax.*The tax treatment of goods sold over the Internet iscurrently unsettled. We collect sales taxes for goods shipped to California andFlorida, where we have a physical presence (i.e., a “nexus”). A number ofproposals have been made at the state and local level that would imposeadditional taxes on the sale of goods through the Internet. Such proposals, ifadopted, could substantially impair the growth of electronic commerce and couldadversely affect our opportunity to derive financial benefit from electroniccommerce. The Internet Tax Freedom Act (ITFA), which placed a moratorium on newstate and local taxes on Internet commerce, expired on November 1, 2003,but has since been reinstated through November 2007 as part of the Internet TaxNondiscrimination Act.

*OnlineContests and Sweepstakes.*We conduct online promotionalcontests and sweepstakes. No purchase is necessary to participate. Our officialrules, with material terms and conditions, eligibility restrictions, dates ofparticipation, methods of entry, prize descriptions and restrictions, and oddsof winning, are posted on our web-sites. To avoid having to register and bondour online promotions in the states of New York and Florida, the approximateretail value of the prizes we offer is generally less than $5,000 for a singlepromotion. Although we structure our promotions in a way that attempts tocomply with applicable statutes as currently interpreted and enforced in allfifty states, 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.

*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, France, Germany, Japan, Mexico, Panama, Peru, theUnited Kingdom and Venezuela. Given the cost of filing, maintaining andprotecting federal registrations, we may choose not to register or enforce ourcopyrights or other innovations or certain of our trademarks that later turnout to be important. Despite our efforts, it is possible that the scope ofprotection gained from seeking trademark registration will be insufficient orthat the registration may be deemed invalid or unenforceable.

We seek to protectmany of our innovations as trade secrets and principally rely upon trade secretand contract 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 proprietary information.For example, where consultants develop copyrighted content for us, our generalpolicy is to use written agreements prior to content creation to obtainownership of that content.

5

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The following sets fortha schedule of our active trademarks:

FederalTrademark Filings
| **MARK**                    | ** ** | **APPL. NO.** | ** ** | **REG. DATE**       |
|-----------------------------|------------|---------------|------------|---------------------|
|                        |       |          |       |                |
| ARTISTDIRECT                |       | 75927362      |       | July 29, 2003       |
| CORPORATE LOGO              |       | 76072567      |       | September 16,  2003 |
| CORPORATE LOGO              |       | 76072566      |       | June 5, 2001        |
| CORPORATE LOGO              |       | 76072563      |       | July 17, 2001       |
| CORPORATE LOGO              |       | 76072562      |       | July 31, 2001       |
| CORPORATE LOGO              |       | 76072561      |       | July 31, 2001       |
| CORPORATE LOGO              |       | 76072560      |       | January 1, 2002     |
| BORN ON THE  WORLD WIDE WEB |       | 75768869      |       | September 5,  2000  |
| BORN ON THE  WORLD WIDE WEB |       | 75768868      |       | September 5,  2000  |
| BORN ON THE  WORLD WIDE WEB |       | 75768011      |       | September 5,  2000  |
| THE ULTIMATE  BAND LIST     |       | 75306059      |       | November 28,  2000  |
| ARTISTDIRECT                |       | 75418187      |       | June 6, 2000        |
| ARTISTDIRECT                |       | 75061781      |       | October 19, 1999    |

 

StateTrademark Filings
| **MARK**                | ** ** | **STATE**   | ** ** | **REG. NO.** | ** ** | **REG. DATE**        |
|-------------------------|------------|-------------|------------|--------------|------------|----------------------|
|                    |       |        |       |         |       |                 |
| THE ULTIMATE  BAND LIST |       | Puerto Rico |       | 50161        |       | April 30,  2002 |
| ARTISTDIRECT            |       | Puerto Rico |       | 50159        |       | April 30,  2002 |
| ARTISTDIRECT            |       | Puerto Rico |       | 49609        |       | March 31,  2002 |
| UBL                     |       | Puerto Rico |       | 49616        |       | March 31,  2002 |
| UBL                     |       | Puerto Rico |       | 49615        |       | March 31,  2002 |
| THE ULTIMATE  BAND LIST |       | Puerto Rico |       | 49614        |       | March 31,  2002 |
| THE ULTIMATE  BAND LIST |       | Puerto Rico |       | 49613        |       | March 31,  2002 |
| THE ULTIMATE  BAND LIST |       | Puerto Rico |       | 49612        |       | March 31,  2002 |
| UBL                     |       | Puerto Rico |       | 50158        |       | April 30,  2002 |
| UBL                     |       | Puerto Rico |       | 50157        |       | April 30,  2002 |

 

InternationalFilings
| **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     |       | *            |       |          |
| A & Design |       | Australia      |       | 908102        |       | 908102       |       | 3/28/2002     |
| A & Design |       | Brazil         |       | 824492609     |       | *            |       |          |
| A & Design |       | Brazil         |       | 822892340     |       | *            |       |          |
| A & Design |       | Brazil         |       | 822892359     |       | *            |       |          |
| 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     |

6

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| 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            |   | Brazil         |   | 821955756     |   | *        |   |       |
| ARTISTDIRECT            |   | Brazil         |   | 821955764     |   | *        |   |       |
| ARTISTDIRECT            |   | Brazil         |   | 821955730     |   | *        |   |       |
| ARTISTDIRECT            |   | Brazil         |   | 821955748     |   | *        |   |       |
| ARTISTDIRECT            |   | Brazil         |   | 824492625     |   | *        |   |       |
| 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  |
| 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         |   | 820399078     |   | *        |   |       |
| 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  |

 

7

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| 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  |
| 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    |   | *        |   |       |
| 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 thatregistration is pending.

8

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Despite ourefforts to protect our proprietary rights from unauthorized use or disclosure,our efforts may not be sufficient or successful. It may be possible that someof our innovations 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 givesthe owner 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.

Our web-sites,depending upon the specific musical work, may offer audio streaming of part orall of an entire song or “Web casting,” or the downloading of an entire song inMP3 or other compressed audio formats. Full-length streaming only occurs inspecial instances after obtaining a license from the record label or bandmanager for the “sound recording.” In that case, an ASCAP or BMI blanket musiclicense is also 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 “soundrecordings” offered for download, we seek to clear rights in musicalcomposition in one or more of the following three ways:

·                  alicense agreement with the publisher, writer or other owner of such copyrightin the “musical composition”;

·                  awaiver of any fees 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 thatthe foregoing 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.

For example, theCopyright Office recently opined that additional royalties, besides thosecollected for musical compositions by ASCAP or BMI, are due for webcasted musicthat is selected by or on behalf of the recipient pursuant to 17 U.S.C. Section2114(j)(7). If upheld, that ruling would prevent us from expanding our serviceto permit users to play a requested song via our web-site without payingadditional royalties.

9

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*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.

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

**MediaDefenderOverview- Internet Anti-Piracy Segment**

MediaDefender wasincorporated under the laws of the State of Delaware in July 2000 and is aprovider of anti-piracy solutions in the high-growth IPP industry. We completedthe 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.

*Internet-BasedPiracy.*Piracy has long been a problem for the global contentindustries. The International Intellectual Property Alliance (“IIPA”) estimatesthat commercial piracy alone costs the U.S. content industries approximately$20 billion to $22 billion in lost sales each year. Historically, most consumerparticipation in piracy required a transaction with a third-party vendor. Theadvance of new technologies has served to make anonymous the illegaldistribution and consumption of content. This has been followed by afundamental shift in consumer behavior; piracy in the Internet age is nowviewed as an acceptable activity that millions of people around the world nolonger consider illegal or immoral. In the past five years, Internet-based P2Pfile-sharing networks have emerged as the greatest threat to the future ofcontent companies.

Due to therelatively small size of MP3 files, music was the first industry to be impactedby Internet piracy. From 1999 to 2003, total music sales in the U.S. declinedby approximately 25%, or $3.7 billion. The 2.3% increase in 2004 album salesmay be partially attributed to the increased use of anti-piracy solutions bymusic companies. The growth of broadband Internet access is now making larger-sizedfiles, such as movies, software and video games, similarly vulnerable toInternet-based piracy. Already, the majority of motion pictures are availablein some form on the Internet before theatrical release.

To date, attemptsto limit Internet-piracy have been largely unsuccessful. Litigation,legislation, education, commercial innovation, packaged media and digitalrights management (“DRM”) anti-piracy technologies have been employed withlimited impact. For example, despite the litigation that forced the closure ofNapster, then the most widely used P2P forum for illegal downloads, in July2001, P2P file-sharing networks continue to evolve and thrive.

*IPPSolutions.*MediaDefender employs a wide array of technicalcountermeasures on P2P networks to frustrate users’ attempts to find, copy andshare unauthorized copyrighted materials. MediaDefender’s customers specify thetiming, duration, scope and level of effectiveness of desired protection on atrack-by-track, album-by-album or movie-by-movie basis. Users of P2P networksattempting  to download a file that issuccessfully protected by MediaDefender either cannot begin the downloadingprocess, download the specified file to find that it is not the content forwhich they were searching, or download a file to find that it works for thefirst few seconds and then reverts to white noise or static. By making it moredifficult for P2P users to access unauthorized content on the Internet,MediaDefender induces consumers to pay for content distributed through legitimatemeans, such as Apple Corporation’s iTunes.

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MediaDefender’ssuite of IPP solutions currently covers the 15 major P2P file-sharing networksthat constitute over 95% of all P2P file-sharing activity, as well as IRC andUsenet and consists of  spoofing,decoying, interdiction, counterposting and queuing. MediaDefender’s IPPsolutions are typically deployed together, in degrees that vary according tocustomer preference.

*Suiteof Solutions.*MediaDefender’s solutions are a practical andproven 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’ssolutions hinder illegal Internet file-sharing and downloading include:

·                  *Spoofing*. Spoofs are false signals thatrepresent themselves as legitimate content.

·                  *Swarming*. Swarms are corrupt data packetsegments that are spliced into existing copies and subsequent downloads ofillegitimate files of specified titles.

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

·                  *Interdiction*. Interdiction creates longlines that inhibit would-be pirates from obtaining access to protectedcopyrighted materials.

·                  *Counter-posting*. Counter-posting is amethod of protection that operates on UseNet.

·                  *Queuing*. Queuing is used on IRC to preventP2P users from accessing protected content by taking up space in the line todownload that content.

*Monitoring.*In addition to providing IPP solutions, MediaDefender alsotracks attempts by P2P users to access files illegally and provides suchinformation to its customers in the form of weekly monitoring reports. Bycontinuously monitoring the Internet to detect leaks of copyrighted material,MediaDefender is able to advise its customers concerning the origination ofsuch leaks and help determine when MediaDefender’s IPP solutions are needed.Customers often employ MediaDefender’s monitoring capabilities in anticipationof executing a full-scale IPP solutions contract. This early monitoring allowsits customers to observe the level of piracy affecting their copyrightedmaterials and has proven to be an effective marketing tool for MediaDefender’sIPP solutions.

MediaDefendercontinuously monitors Internet activity for leaks of any new customer-ownedcontent. In addition to an automated web crawler device that monitors leaks 24hours per day, 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 leaksimmediately 24 hours per day seven days per week. This awareness enablescustomers to better manage their relationships with creative talent bydemonstrating control and knowledge of the situation. Monitoring reportscontain information that allows customers to determine:

·                  Thepiracy problem’s size and nature for each individual release;

·                  Whenparticular copyrighted materials should be protected;

·                  TheIP addresses of individuals who are downloading copyrighted content;

·                  Howoften a specific title is requested;

·                  Howoften a title is illegally shared; and

·                  Demographicsof illegal sharers.

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*AncillarySolutions.*MediaDefender can provide ancillary solutions tocustomers to achieve a number of different goals. MediaDefender has assistedcustomers in identifying the IP address responsible for the origination ofillegal content on P2P networks allowing customers to pursue legal actionagainst the source of the piracy.

*Next-GenerationSolutions.*Due to the rapidly evolving nature of the P2Penvironment, MediaDefender must continually adapt its technologies in order tooffer 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.

*PatentPending Technology.*MediaDefender’s IPP solutions utilizeproprietary software and a robust, scalable IT platform of approximately 1,852servers and 6.0 gigabytes of bandwidth capacity. This patent-pendingcombination of software and IT was created over time and based upon the successesand failures of real-world trials. Computer equipment and software is monitoredand maintained on a 24/7 basis. The use of back-up and redundant systems,combined with constant monitoring, allows MediaDefender to provide continuouscoverage and rapidly address potential technical problems.

*IntellectualProperty.*In December 2002, MediaDefender filed an umbrellapatent that covers a variety of its concept and back-end technologies, which isstill pending. Due to the evolving nature of P2P networks, these technologiesare not based on any one service, but rather have the fluidity to betransferred to any P2P network. The claims in the patent filing arepredominantly methods for managing a large array of computers for the purposeof preventing piracy on P2P networks.

*Salesand Marketing.*MediaDefender’s sales process isrelationship-based with a relatively long sales cycle that results in extremelyloyal customers. Initial customer relationships were with music and movieindustry clients, targeted due to the impact of piracy on these businesses.MediaDefender management has invested significant time in buildingrelationships with its clients, which has resulted in word-of-mouth referrals.

*Customersand Target Markets.*MediaDefender’s current customers includefour major record labels and six major movie studios. Two customers accountedfor 35.0% and 29.0%, respectfully, of MediaDefender’s revenues during the fivemonths ended December 31, 2005.

*MarketShare and Competition.*Management believes that MediaDefenderhas a majority of the growing IPP solution market. Its two major competitors,MediaSentry, Inc. and Macrovision, have been in the IPP market for two and fiveyears, respectfully, without gaining significant market share.

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**ITEM2.****                             DESCRIPTIONOF PROPERTY**

The followingtable provides a schedule of corporate offices and facilities leased by us:
| **Location**                                     | ** ** | **Primary Function**                      | ** ** | **Square Footage** | ** ** | **Lease Term** |
|--------------------------------------------------|------------|-------------------------------------------|------------|--------------------|------------|----------------|
| ** **                                       | ** ** | ** **                                | ** ** | ** **         | ** ** | ** **     |
| Santa Monica,  California                        |       | Corporate headquarters for ARTISTdirect   |       | 14,817             |       | 6 years        |
|                                             |       |                                      |       |               |       |           |
| Marina del Rey,  California                      |       | Corporate headquarters for MediaDefender* |       | 3,600              |       | 5 months       |
|                                             |       |                                      |       |               |       |           |
| IX2 Co-Location  Room  Los Angeles, California   |       | 70 Servers and 2X100 Mbps Bandwidth       |       | NA                 |       | 1 year         |
|                                             |       |                                      |       |               |       |           |
| Co-Location  Facility 1  Los Angeles, California |       | 1394 Servers and 5X1 Gbps Bandwidth       |       | NA                 |       | 1 year         |
|                                             |       |                                      |       |               |       |           |
| Co-Location  Facility 2  Los Angeles, California |       | 167 Servers and 5X100 Mbps Bandwidth      |       | NA                 |       | 1 year         |
|                                             |       |                                      |       |               |       |           |
| Co-Location  Facility 3  Los Angeles, California |       | 214 Servers and 1X1 Gbps Bandwidth        |       | NA                 |       | monthly        |
|                                             |       |                                      |       |               |       |           |
| Co-Location  Facility 4  Los Angeles, California |       | 52 Servers                                |       | NA                 |       | monthly        |
|                                             |       |                                      |       |               |       |           |
| Co-Location  Facility 5  Los Angeles, California |       | 25 Servers                                |       | NA                 |       | monthly        |

 

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*To relocate toSanta Monica, California location in April 2006.

We believe thatall real property and facilities leased by us are in good repair and adequatefor our purposes for the next 12 months.

**ITEM3.****                             LEGALPROCEEDINGS**

We areperiodically subject to various pending and threatened legal actions, whicharise in the normal course of business. Our management currently believes thatthe impact of any such litigation will not have a material adverse impact onour financial position or results of operations.

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

There were nomatters submitted to a vote of our stockholders during the fourth quarter ofthe fiscal year ended December 31, 2005.

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**PART II**
| **ITEM 5** | **MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER  MATTERS AND SMALL BUSINESS ISSUERS PURCHASES OF EQUITY SECURITIES** |
|------------|----------------------------------------------------------------------------------------------------------------------|

 

*MarketInformation*

Our common stockhas been listed for quotation on the Over-the-Counter Bulletin Board under thesymbol “ARTD.OB” since May 9, 2003. Prior to that, our common stock was listedon The Nasdaq National Market. The following table sets forth the high and lowsales prices for our common stock, as reported by the Over-the-Counter BulletinBoard for fiscal 2004 and 2005, respectively:
|                | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------|------------|------------|------------|------------|------------|
| **2004**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter  |       | $          | 0.35       |       | $          | 0.25 |   |
| Second Quarter |       | $          | 0.62       |       | $          | 0.32 |   |
| Third Quarter  |       | $          | 0.45       |       | $          | 0.40 |   |
| Fourth Quarter |       | $          | 0.40       |       | $          | 0.26 |   |
|           |       |       |       |       |       |
| **2005**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter  |       | $          | 1.25       |       | $          | 0.22 |   |
| Second Quarter |       | $          | 1.85       |       | $          | 0.94 |   |
| Third Quarter  |       | $          | 4.00       |       | $          | 1.47 |   |
| Fourth Quarter |       | $          | 3.30       |       | $          | 1.65 |   |

 

The closing priceof our common stock on March 29, 2006 was $4.47 per share, as reported onthe Over-The-Counter Bulletin Board.

*Holdersof Record*

As ofMarch 29, 2006, we had 289 holders of record of our common stock,excluding shares held in “street name” by brokerage firms and other nomineeswho hold shares for multiple investors.

*Dividends*

We have notdeclared or paid any cash dividends on our common stock, and we currentlyintend to retain future earnings, if any, to finance the expansion of ourbusiness, and we do not expect to pay any cash dividends in the foreseeablefuture. The decision whether to pay cash dividends on our common stock will bemade by our Board of Directors, in their discretion, and will depend on ourfinancial position, operating results, capital requirements and other factors thatthe Board of Directors considers significant.

*EquityCompensation Plan Information*

Refer toItem 11 below for information with respect to our equity compensationplans.

*AdditionalInformation*

Copies of ourAnnual 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 of thedate of the document in which the statement is included, and we do not assumeor undertake any obligation to update any of those statements unless we arerequired to do so by law.

**ITEM6.****                             MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

**Overview**

We conduct ourmedia and e-commerce business operations through an online music networkappealing to music fans, artists and marketing 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.

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**Acquisitionof MediaDefender and Related Transactions**

On July 28, 2005,we consummated the acquisition of MediaDefender in accordance with the termsset forth in an agreement and plan of merger entered into by and amongARTISTdirect, ARTISTdirect Merger Sub, Inc., a Delaware corporation and ourwholly-owned subsidiary (“Merger Sub”), and MediaDefender (the “MergerAgreement”). Under the terms of the Merger Agreement, Merger Sub merged withand into MediaDefender, the separate corporate existence of Merger Sub ceasedand MediaDefender survived as our wholly-owned subsidiary. The stockholders ofMediaDefender received aggregate consideration of $42.5 million in cash,subject to a holdback of $4.25 million that was placed into an escrow accountat closing, $2.0 million of which has been subsequently released, to cover anyindemnification claims under the Merger Agreement by the parties for a limitedperiod of time. This transaction was accounted for as a purchase in accordancewith SFAS No. 141, “Business Combinations,” and the operations of the twocompanies have been consolidated commencing August 1, 2005.

Concurrent withthe consummation of the acquisition described above, we completed a $15.0million senior secured debt transaction (the “Senior Financing”) and a $30.0million convertible subordinated debt transaction (the “Sub-Debt Financing”).Legal fees paid or reimbursed by us for services provided by legal counsel forthe lenders was recorded as a charge to deferred financing costs and is beingamortized over the terms of the related debt.

The SeniorFinancing was completed in accordance with the terms set forth in a note andwarrant purchase agreement entered into by us on July 28, 2005 (the “NotePurchase Agreement”). Pursuant to the Note Purchase Agreement, each investorreceived a note with a term of three years and 11 months that bears interest atthe rate of 11.25% per annum (each a “Senior Note”), payable quarterly, withany unpaid principal and accrued interest due and payable at maturity.Termination and payment of the Senior Notes by us prior to maturity will notresult in a prepayment fee. As collateral for the $15.0 million SeniorFinancing, the investors received a first priority security interest in all ofour existing and future assets, tangible and intangible, including but notlimited to, cash and cash equivalents, accounts receivable, inventories, othercurrent assets, furniture, fixtures and equipment and intellectual property. Weare required to comply with certain financial covenants, including minimumworking capital, maximum capital expenditures, minimum leverage ratio, minimumEBITDA and minimum fixed charge coverage ratio.

In addition, weare obligated to apply 60% of our annual cash flow, as defined, to prepay theprincipal amount of the Senior Notes, which we have determined to be $390,000,and which has been shown as a current liability at December 31, 2005.

In addition, theinvestors received five year warrants to purchase up to an aggregate of3,250,000 shares of our common stock at an exercise price of $2.00 per share,subject to certain anti-dilution adjustments (collectively, the “Senior WarrantShares”). The Senior warrants were valued at $1,982,500 based on a valuationreport prepared by an independent valuation firm and were recorded as adiscount to the $15.0 million Senior Financing debt, and are being amortizedover the term of the debt.  The Senior WarrantShares are subject to certain registration rights requiring the Company to fileand maintain effective a registration statement with the SEC covering theshares of common stock underlying the warrants.

The Sub-DebtFinancing was completed in accordance with the terms set forth in a securitiespurchase agreement entered into by us on July 28, 2005 (the “SecuritiesPurchase Agreement”). Pursuant to the Securities Purchase Agreement, eachinvestor received a convertible subordinated note with a term of four yearsthat bears interest at the rate of 4.00% per annum (each a “Sub-Debt Note”),with any unpaid principal and accrued interest due and payable at maturity.Interest is payable quarterly in cash or shares of our common stock, at ouroption, with payments beginning September 30, 2006. Each Sub-Debt Note has aninitial conversion price of $1.55 per share, subject to certain anti-dilutionand change-of-control adjustments. In addition, each Sub-Debt Note is subjectto mandatory conversion by us in the event certain trading price targets forour common stock are met following effectiveness of a registration statementfiled by us for the resale of the securities issued in the Sub-Debt Financing.We are required to comply with certain financial covenants, including minimumworking capital, maximum capital expenditures, minimum leverage ratio, minimumEBITDA and minimum fixed charge coverage ratio.

In addition, theSub-Debt Financing investors received five year warrants to purchase up to1,596,774 shares of our common stock at an exercise price of $1.55 per share,subject to certain anti-dilution adjustments. The Sub-debt warrants were valued at $1,133,710 based on a valuationreport prepared by an independent valuation firm and were recorded as adiscount to the $30.0 million Sub-Debt Financing debt, and are being amortizedover the term of the debt.  The Sub-debtwarrant shares are subject to certain registration rights requiring the Companyto file and maintain effective a registration statement with the SEC coveringthe shares of common stock underlying the warrants.

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The Sub-debt Financing in addition to containingcertain registration rights which required the Company to file and maintaineffective a registration statement with the SEC covering the shares of commonstock underlying the debt and the associated warrants also has other conversionfeatures which in accordance with FAS 133 and related ETIF 00-19 requires the Company to valuethese warrants and rights as embedded derivatives (“derivatives”).  The bifurcated value of these obligations, asdetermined by an independent consultant as of July 2005, was calculated using alattice (binomial) valuation model.  TheCompany recorded $10,534,000 as a derivative liability as of July 28, 2005,along with an associated discount against the liability equal to the initialvaluation.  The discount is amortizedover the original term of the underlying Sub-debt notes (48 months) as interestexpense.  The Company is also required torevalue this derivative liability at the end of each reporting period.  The fair value of the derivatives will beadjusted to reflect any changes in the fair value of the derivatives from thedate of issuance to the end of each reporting period, and any such changes willbe included in the statement of operations as other income (expense).  If the fair value of the derivatives ishigher at the subsequent reporting date, the Company will record anon-operating, non-cash charge. If the fair value of the derivatives is lowerat the subsequent reporting date, the Company will record non-operating,non-cash income.

Pursuant to theterms of the Note Purchase Agreement and the Securities Purchase Agreement, wewere required to amend our Certificate of Incorporation to increase the numberof authorized shares of our common stock from 15,000,000 shares to 60,000,000shares. We obtained the requisite Board and stockholder approval and filed aCertificate of Amendment to our Certificate of Incorporation with the DelawareSecretary of State on November 7, 2005 to effect the increase.

Pursuant to theterms of a letter agreement, dated July 15, 2005, between us and BroadbandCapital Management LLC (“Broadband”), we issued to Broadband a Sub-Debt Note inthe amount of $1,460,500 (in addition to the $30.0 million referred to above)and warrants to purchase up to 1,516,935 shares of our common stock with anexercise price of $1.55 per share. The notes and warrants issued to Broadbandor its affiliates were issued on the same terms and conditions granted to theother Sub-Debt Financing investors. The securities were issued as partialconsideration for Broadband’s services as our placement agent in the Sub-DebtFinancing and the Senior Financing. The securities were issued in reliance uponexemptions from registration pursuant to Section 4(2) under the Securities Actand Rule 506 promulgated thereunder. The Broadband warrants were valued at$1,077,024 as of July 2005, based on a valuation report prepared by anindependent valuation firm. 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 over the term ofthe debt.

Pursuant to theterms of a letter agreement, dated June 21, 2005, between us and Libra FE, LP (“Libra”),we issued Libra Warrant Shares to purchase up to 237,500 shares of our commonstock with an exercise price of $2.00 per share upon the closing of the SeniorFinancing (the “Libra Warrant Shares”). The Libra Warrant Shares were issued aspartial consideration for Libra’s services as our placement agent in the SeniorFinancing described above. We entered into a Registration Rights Agreement withLibra on July 28, 2005 (the “Libra Registration Rights Agreement”), pursuant towhich we included the Libra Warrant in the registration statement covering thesecurities issued in the Senior Financing and the Sub-Debt Financing describedabove. The Libra Warrant Shares were issued in reliance upon exemptions fromregistration pursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder. The Libra Warrant Shares were valued at $175,750 as ofJuly 2005, based on a valuation report prepared by an independent valuationfirm. The aggregate value of the warrants and additional payments to Libra of$450,997 were charged to deferred financing costs and are being amortized overthe term of the debt.

The Senior warrants, Sub-Debt warrants, Broadbandwarrants and Libra warrant shares (collectively “Warrants”) contain certainregistration rights requiring the Company to file and maintain effective aregistration statement with the SEC covering the shares of common stockunderlying the Warrants.  In accordancewith FAS 133 and EITF 00-19 the fair value of the warrants, as determined by anindependent consultant asof July 28, 2005, was calculated by using the Black-Scholes method.  The Company recorded a Warrant liability aswell as associated deferred financing costs and additional paid in capital of$4,369,000 equal to the initial valuation as of July 28, 2005.  These costs will be amortized over the termof the associated notes to interest expense and amortization of deferredfinancing costs as other (expense) on the statement of operations.  The carrying value of the Warrants will beadjusted to reflect any changes in the fair value of the warrants from the dateof issuance to the end of each reporting period, and any such changes will beincluded in the statement of operations as other income (expense).  Any change in fair value will be recorded asa non-operating, non-cash income or expense at each reporting date.  If the fair value of Warrants is higher atthe subsequent reporting date, the Company will record a non-operating,non-cash charge. If the fair value of the Warrants is lower at the subsequentreporting date, the Company will record non-operating, non-cash income.  The fair value of these Warrants wasdetermined, at the inception date, utilizing the Black-Scholes model.

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Due to theclassification of the Warrants as a current liability on our financialstatements, we were not in compliance with certain financial covenantscontained in the Note Purchase Agreement at December 31, 2005.  The investors provided waivers with respect toany past technical default of the financial covenants related to the accountingtreatment of the above-referenced warrant liability booked in accordance withFAS No.133 and EITF 00-19.  However, thewaiver provided does not extend to the embedded derivative liabilitiesassociated with the Sub-debt, which resulted in this restatement (see RecentDevelopments section).

In connection withour obligations under the Note Purchase Agreement and the Securities PurchaseAgreement, we filed a resale registration statement on Form SB-2 with the SECthat was declared effective on December 9, 2005.

To induce theSenior Financing investors to participate in the above transaction, theSub-Debt Financing investors entered into a subordination agreement for thebenefit of the Senior Financing investors, pursuant to which the Sub-DebtFinancing investors agreed to subordinate in right of payment all of theindebtedness owed to them by us to the final payment of all senior indebtednessowed by us.

If all of thesecurities issued in the Senior Financing and the Sub-Debt Financing areconverted or exercised into shares of our common stock in accordance with theirrespective terms, it will result in significant dilution to our existingstockholders. If all of our outstanding equity-based instruments are convertedor exercised into shares of our common stock in accordance with theirrespective terms, there will be a total of approximately 38,000,000 shares ofour common stock issued and outstanding.

A change incontrol could occur as a result of the Senior Financing and the Sub-DebtFinancing. Assuming maximum conversion of the securities issued in the SeniorFinancing and Sub-Debt Financing occurs, the Senior Financing investors wouldown approximately 9% of our voting stock, on a fully diluted basis, and theSub-Debt investors would own approximately 55% of our voting stock, on a fullydiluted basis.

The securitiesissued by us in the Senior Financing and the Sub-Debt Financing were offeredand sold in reliance upon exemptions from registration pursuant to Section 4(2)under the Securities Act of 1933, as amended (the “Securities Act”), and Rule506 promulgated thereunder. Each of the investors qualified as an “accreditedinvestor,” as specified in Rule 501 under the Securities Act.

Upon the closingof the acquisition, we issued 1,109,032 shares of our common stock and awarrant to purchase up to 114,985 shares of our common stock with an exerciseprice of $1.55 per share to WNT07 Holdings, LLC. The managers of WNT07Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both members of ourBoard of Directors. The shares and warrants were issued as consideration forservices provided by Messrs. Pulier and Boutros-Ghali as consultants to us inconnection with the acquisition. The issuance of the shares and warrants to WNTO7Holdings, LLC were approved by the independent members of our Board ofDirectors. The shares and warrants were issued in reliance upon exemptions fromregistration pursuant to 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, for an aggregate value of $1,669,855, of which $333,971 wasallocated to the covenant not to compete and the remaining $1,335,884 wasincluded in total costs that we incurred to acquire MediaDefender.

On April 7, 2006,we entered into amendments to certain of the transaction documents governingthe terms of the Senior Financing and the Sub-Debt Financing to amend theirrespective registration rights agreements and to amend and waive certainfinancial covenants. In consideration, we agreed to temporarily reduce theexercise price of the 3,250,000 Senior Warrant Shares held by the SeniorFinancing investors from $2.00 per share to $1.85 per share through April 30,2006 and to permanently reduce the exercise price of the 1,596,744 Sub-DebtWarrant Shares held by the Sub-Debt Financing investors and 1,516,935 Sub-DebtWarrant Shares held by Broadband affiliates from $1.55 per share to $1.43 pershare. Any exercise of these warrants at the reduced exercise price shall befor cash only.  The conversion price ofthe Sub-Debt Notes of $1.55 per share was not impacted by theseamendments.  We also entered into asimilar agreement with Libra to temporarily reduce the exercise price of the237,500 Libra Warrant Shares from $2.00 per share to $1.85 per share throughApril 30, 2006.

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Due to therestrictions imposed by Internal Revenue Code Section 382 regarding substantialchanges in the stock ownership of companies with loss carry-forwards, theutilization of our federal net operating loss carry-forward was severelylimited as a result of the change in our effective stock ownership resulting fromthe financings arranged in conjunction with the acquisition of MediaDefender.

This acquisitionof MediaDefender 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. The following table summarizes theassets acquired and liabilities assumed of MediaDefender at July 28, 2005. Thefair value of the intangible assets acquired and their respective amortizationperiods was determined by an independent valuation firm.
|                                                | ** ** | **(in thousands)** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
|                                           |       |                    |       |
| Assets Acquired:                               |       |                    |       |
| Cash                                           |       | $                       | 1,365      |   |
| Accounts  receivable                           |       | 2,499                   |       |
| Deferred income  tax                           |       | 116                     |       |
| Prepaid expenses  and other current assets     |       | 91                      |       |
| Property and  equipment                        |       | 1,749                   |       |
| Deposits                                       |       | 3                       |       |
|                                           |       |                    |       |
| Total assets  acquired                         |       | 5,823                   |       |
|                                           |       |                    |       |
| Liabilities  Assumed:                          |       |                    |       |
| Accounts payable                               |       | 41                      |       |
| Accrued expenses                               |       | 87                      |       |
| Income taxes  payable                          |       | 230                     |       |
| Due to  ARTISTdirect, Inc.                     |       | 930                     |       |
| Deferred revenue                               |       | 38                      |       |
| Deferred income  tax                           |       | 338                     |       |
|                                           |       |                    |       |
| Total  liabilities assumed                     |       | 1,664                   |       |
|                                           |       |                    |       |
| Net assets  acquired                           |       | 4,159                   |       |
|                                           |       |                    |       |
| Intangible  assets acquired:                   |       |                    |       |
| Customer  relationships                        |       | 2,264                   |       |
| Proprietary  technology                        |       | 7,602                   |       |
| Goodwill                                       |       | 31,085                  |       |
|                                           |       |                    |       |
| Total assets  acquired                         |       | $                       | 45,110     |   |
|                                           |       |                    |       |
| Total purchase  consideration paid as follows: |       |                    |       |
| Cash paid to MediaDefender stockholders        |       | $                       | 42,500     |   |
| Transaction costs incurred                     |       | 2,610                   |       |
|                                           |       |                    |       |
| Total purchase  consideration                  |       | $                       | 45,110     |   |

 

18

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**ProForma Information**

The following proforma operating data presents the results of operations for the years endedDecember 31, 2004 and 2005, respectively, as if the acquisition had occurred onthe first day of each such period. Discontinued operations, impairment lossesand non-recurring items for the years ended December 31, 2004 and 2005 are notincluded. The pro forma results are not necessarily indicative of the financialresults that might have occurred had the acquisition actually taken place onthe respective dates, or of future results of operations.
|                                                     | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| **Pro Forma**                                  | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                     | ** ** |
| ** **                                          | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Net revenue                                         |       | $                                           | 15,665     |   | $ | 20,637 |   |
|                                                |       |                                        |       |   |   |
| Net loss                                            |       | $                                           | (37,120    | ) | $ | (35,222 | ) |
|                                                |       |                                        |       |   |   |
| Adjusted EBITDA                                     |       | $                                           | 4,033      |   | $ | 7,095 |   |
|                                                |       |                                        |       |   |   |
| Net loss per  common share – basic and diluted |       | $                                           | (8.05      | ) | $ | (7.64 | ) |
|                                                |       |                                        |       |   |   |
| Weighted average common  shares outstanding         |       | 4,611,149                                   |       | 4,611,149 |   |

 

Our presentationof financial results includes “Adjusted EBITDA” as a financial measure, whichis not a measure of performance calculated in accordance with accountingprinciples generally accepted in the United States (“GAAP”). Adjusted EBITDA isa non-GAAP financial measure that represents income or loss from continuingoperations before net interest expense, provision for income taxes,depreciation and amortization, as well as certain other items, includingstock-based compensation, impairment losses, and non-recurring gains.Management excludes these items in assessing financial performance, primarilydue to their non-operational nature or because they are outside of our normaloperations. We have provided this information because management believes thatit is useful to investors in understanding our financial condition and resultsof operations.

A reconciliationof Net Loss to Adjusted EBITDA is shown below.
|                                                                                                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **Pro Forma**                                                                                                                                     | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                             | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Net loss                                                                                                                                               |       | $                                           | (37,120    | ) | $ | (35,222 | ) |
|                                                                                                                                                   |       |                                        |       |   |   |
| Add (deduct):                                                                                                                                          |       |                                        |       |   |   |
| Interest income                                                                                                                                        |       | (32                                         | )          | (47 | ) |
| Interest expense                                                                                                                                       |       | 2,971                                       |       | 2,971 |   |
| Amortization of discount on debt                                                                                                                       |       | 1,956                                       |       | 1,956 |   |
| Amortization of deferred financing costs                                                                                                               |       | 900                                         |       | 900 |   |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable into common stock |       | 45                                          |       | 45 |   |
| Amortization of intangible assets                                                                                                                      |       | 3,749                                       |       | 3,749 |   |
| Depreciation                                                                                                                                           |       | 569                                         |       | 397 |   |
| Change in fair value of warrant liability                                                                                                              |       | 10,735                                      |       | 10,735 |   |
| Change in fair value of derivative liability                                                                                                           |       | 20,043                                      |       | 20,043 |   |
| Income taxes                                                                                                                                           |       | 210                                         |       | 1,495 |   |
| Stock-based compensation                                                                                                                               |       | 7                                           |       | 73 |   |
|                                                                                                                                                   |       |                                        |       |   |   |
| Adjusted EBITDA                                                                                                                                        |       | $                                           | 4,033      |   | $ | 7,095 |   |

 

19

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**CriticalAccounting Policies**

The discussion andanalysis of our financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities. On anongoing basis, we evaluate our estimates, including those related to accountsreceivable, tangible and intangible assets, income taxes, and contingencies andlitigation, among others. We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions. We believe that the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of its consolidated financial statements:   accounts receivable, revenue recognition,stock-based compensation, impairment of long-lived assets and goodwill, andincome taxes.

*RevenueRecognition*. We comply with the provisions of StaffAccounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,”as amended by SAB No. 104, and recognizes revenue when all four of thefollowing criteria are met:  (i)persuasive evidence that an arrangement exists; (ii) delivery of the productsand/or services has occurred; (iii) the selling price is both fixed anddeterminable; and (iv) collectibility is 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. We record e-commercerevenue on a gross basis as we enter into sale transactions with customers,establish the prices of our products, choose the suppliers of our products,assume the risk of inventory loss and collect all amounts from the customersand assumes the credit risk. E-commerce revenue is subject to amounts due tothe respective artists based on their contracts, and such expense is recordedas part of cost of e-commerce revenue.

Anti-piracyservices revenue is recognized on a monthly basis as services are provided tocustomers. Deferred revenue is recorded for customers who prepay the full, orany portion, of their respective contracts.

Media revenueconsists primarily of the sale of advertisements and sponsorships, both onlineand offline, under short-term contracts. To date, the duration of ouradvertising and sponsorship commitments has generally averaged from one tothree months, with certain programs lasting up to six months. Our onlineobligations typically include the guarantee of a minimum number of times (“impressions”)that an advertisement appears in pages viewed by the users of our onlineproperties. Online advertising revenue is generally recognized as theimpressions are served during the period in which the advertisement isdisplayed, provided that no significant obligations remain and collection ofthe resulting receivable is reasonably assured. To the extent that minimumguaranteed page deliveries are not met, recognition of the corresponding revenueis deferred until the guaranteed impressions are delivered.

We recognizerevenue for sponsorship arrangements, both online and offline, over the periodduring which the advertising is provided, generally on a straight-line basis.If the sponsorship arrangement is for the sponsorship of a specific event, werecognize revenue when the event occurs. We recognize revenue separately foreach element of integrated entertainment marketing packages that offeradvertisers a combination of offline concert and tour sponsorships that aresupported by online banner advertising, web-page sponsorships, e-mails to ourcustomers and custom content. We determine the fair value of each deliverablebased on the relative fair value of the different deliverables when sold on astand-alone basis. We recognize revenue for each deliverable as the servicesare provided. We recognize revenue for the banner impression deliverable as thebanner impressions are delivered. We recognize revenue for the customer e-mailswhen the e-mails are sent. We recognize revenue for web-page sponsorships on astraight-line basis over the term of the sponsorship. We recognize revenue forcustom content when the content is provided to the customer.

*Stock-BasedCompensation*. We account for stock-based employeecompensation in accordance with the provisions of Accounting Principles Board (“APB”)Opinion No. 25 and FASB Interpretation No. 44 “Accounting for CertainTransactions Involving Stock Compensation” (“FIN 44”)  and complies with the disclosure requirementsof SFAS No. 123, “Accounting for Stock-Based Compensation.”  Under APB No. 25, compensation expense isrecorded based on the difference, if any, between the fair value of our stockand the exercise price on the measurement date. We account  for stock issued to non-employees inaccordance with SFAS No. 123, which requires entities to recognize as expenseover the service period the fair value of all stock-based awards on the date ofgrant and EITF No. 96-18, “Accounting for Equity Investments that are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices,” which addresses the measurement date and recognition approach forsuch transactions.

We recognizecompensation expenses related to variable awards in accordance with FASBInterpretation No. 28, “Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans” (“FIN 28”). For fixed awards, werecognize expense over the vesting period or the period of service.

20

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In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004), “Share Based Payment” (“SFAS No. 123R”), a revision to SFAS No. 123, “Accountingfor Stock-Based Compensation.”  SFAS No.123R supercedes Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.”  SFAS No. 123R requires that we measure thecost of employee services received in exchange for equity awards based on thegrant date fair value of the awards. The cost will be recognized ascompensation expense over the vesting period of the awards. We are required toadopt SFAS No. 123R effective January 1, 2006. Under this method, we will beginrecognizing compensation cost for equity-based compensation for all new ormodified grants after the date of adoption. The pro forma disclosurespreviously permitted under SFAS No. 123 will no longer be an alternative tofinancial statement recognition. In addition, we will recognize the unvestedportion of the grant date fair value of awards issued prior to adoption basedon the fair values previously calculated for disclosure purposes over theremaining vesting period of the outstanding options and warrants.

Public companiesare permitted to adopt the requirements of SFAS No. 123R using one of twomethods:

(1) A “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123R for all awards granted to employees prior to theeffective date of SFAS No. 123R that remain unvested on the effective date.

(2) A “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes of proforma disclosures for either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.

We adopted SFASNo. 123R effective January 1, 2006 and will use the modified prospective methodin which compensation cost is recognized beginning with the effective date (a)based on the requirements of SFAS No. 123R for all share-based payments grantedafter the effective date and (b) based on the requirements of SFAS No. 123R forall awards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date. Although the expense for stockoptions that may be vested or granted in future periods cannot be determined atthis time due to the uncertainty of the vesting or timing of future grants, ourfuture stock price, and the related fair value calculation, the adoption ofSFAS No. 123R will have a material effect on our future financial statements.

*Goodwilland Other Intangible Assets*. Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No.142”), requires purchased intangible assets other than goodwill to be amortizedover their useful lives unless these lives are determined to beindefinite.  Asset allocations andamortization periods with respect to the MediaDefender transaction weredetermined by an independent valuation firm.

SFAS No. 142 requiresgoodwill to be tested for impairment on an annual basis and under certaincircumstances, and written down when impaired. An interim impairment test isrequired if an event occurs or conditions change that would more likely thannot reduce the fair value of the reporting unit below the carrying value.

We evaluate therecoverability of goodwill by estimating the future discounted cash flows ofthe businesses to which the goodwill relates. We use a rate corresponding toour cost of capital, risk adjusted where appropriate, in determining discountedcash flows. Estimated cash flows will be determined by disaggregating thebusiness segments to a reporting level for which meaningful identifiable cashflows can be determined. When estimated future discounted cash flows are lessthan the carrying value of the net assets (tangible and identifiableintangibles) and related goodwill, we will perform an impairment test tomeasure the amount of the impairment loss, if any. Impairment losses, limitedto the carrying value of goodwill, represent the excess of the carrying amountof a reporting unit’s goodwill over the implied fair value of that goodwill. Indetermining the estimated future cash flows, we will consider current andprojected future levels of income based on management’s plans for thatbusiness, as well as business trends, prospects and market and economicconditions.

*Impairmentof Long-Lived Assets*. We account for the impairment oflong-lived assets, such as property and equipment and intangible assets, underthe provisions of Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment of Long-Lived Assets” (“SFAS No. 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 SFASNo. 144, we periodically evaluate, at least annually, whether facts orcircumstances indicate that the carrying value of our depreciable assets to beheld and used may not be recoverable. If such circumstances are determined toexist, an estimate of undiscounted future cash flows produced by the long-livedasset, or the appropriate grouping of assets, is compared to the carrying valueto determine whether impairment exists. In the event that the carrying amountof long-lived assets exceeds the undiscounted future cash flows, then thecarrying amount of such assets is adjusted to their fair value. We report animpairment cost as a charge to operations at the time it is recognized.

21

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*DerivativeInstruments. *Statement of Financial Accounting Standard (“SFAS”)No. 133, “Accounting for Derivative Instruments and Hedging Activities,” asamended, requires all derivatives to be recorded on the balance sheet at fairvalue.  These derivatives include embeddedderivatives in our Convertible Subordinated Debentures (“Sub-debt”) and theassociated warrants (“Warrants”) issued in connection with the financing of theMediaDefender acquisition are separately valued and accounted for on ourbalance sheet. The bifurcated value of these obligations, as determinedby an outside consultant as of July 28, 2005, was calculated using a lattice(binomial) valuation model.

InSeptember 2000, the Emerging Issues Task Force (“EITF”) issued EITF 00-19, “Accountingfor Derivative Financial Instruments Indexed to and Potentially Settled in, aCompany’s Own Stock,” (“EITF 00-19”) which requires freestanding contracts thatare settled in a company’s own stock, including common stock warrants, to bedesignated as an equity instrument, asset or a liability. Under the provisionsof EITF 00-19, a contract designated as an asset or a liability must be carriedat fair value on a company’s balance sheet, with any changes in fair valuerecorded in the company’s results of operations.****For the year ended December 31, 2005 the financial statementsreflect the fair value of these Warrants and the Sub-debt embedded derivativesfeatures on our balance sheet and the unrealized changes in the values of thesewarrants and derivatives in our consolidated statement of operations as “Changein Fair Value of Warrants and Derivative liability.”

Wedetermined that the Sub-debt and the Warrants created derivative liabilities inaccordance with EITF 00-19,  because share settlement of these Sub-debtand Warrants are not within the control of the Company as a result of the factsthat: (1) the Company has an obligation to register the common stock underlyingthe Sub-debt and Warrants or is  requiredto make  payment of penalties each monthuntil the shares are registered and must remain registered pursuant to aneffective registration statement and (2) the Sub-debt and Warrants containeddilution protection features, with no limit or cap on the number of shares thatcould be issued under the Sub-debt and Warrants.  Therefore, we could not conclude that we hadsufficient authorized and unissued shares to issue the number of sharespotentially issuable under the Sub-debt and Warrants.  As a result, we determined that theseSub-debt and Warrants should be treated as derivative liabilities inaccordance with EITF 00-19.

The Sub-debt contains morethan one embedded derivative feature required to be accounted for as assets or liabilities.The various embedded derivative features of the Sub-debt have been valued atthe date of inception of the Sub-debt and at each reporting periodthereafter.  The derivative featuresinclude: (1) the standard conversion feature of the debentures, (2) limitationon the conversion, and (3) the Company’s right to force conversion, as well asthe reset feature and the obligation to maintain a continuously effectiveregistration statement, among others. The independent consultant valued all the significant features of theSub-debt, however a determination was made by the Company, that with theexception of the above features, the remaining attributes offset and wereimmaterial.  The value of the derivativeliabilities were bifurcated from the Sub-debt and the Company recorded aDerivative liability, with the initial carrying amount (as unamortizeddiscount) of the related debenture as an additional discount to the Sub-debtliability. The unamortized discount is being amortized to interest expense overthe life of the debenture.  Because theWarrants contain certain registration rights, penalties and price resets theWarrants issued were also classified as derivatives and recorded as a Warrantliability.

Valuation of the Derivatives

The Company with the assistanceof Independent valuation consultants valued the Embedded Derivatives within the ConvertibleSubordinated Debt Issued on July 28, 2005 using a Binomial Lattice OptionPricing Model. The model used the following assumptions for the originalvaluation and similar assumptions for each succeeding valuation:

·              Stock price: $1.43;

·              The Exercise/conversion price: $1.55

·              Terminal Time Period: convertible subordinateddebt matures on July 2009 for a time of 3 years and 11 months.

·              Time Step: Period between each price movement(monthly)

·              Expected Return: 4.04%: The risk-free rateswere based on the rate of treasury securities with the same term as theConvertible Subordinated Note as of the specified valuation date

·              Volatility: 55%

Thewarrants were valued using a Black Scholes option pricing model by the Companywith the assistance of the Independent valuation consultants. The model usedthe following assumptions for the original valuation and similar assumptionsfor each succeeding valuation:

·              Stock price: $1.43;

·              The Senior warrants Exercise price: $2.00 /Sub-debt warrants Exercise price: $1.55

·              Time Period: Senior warrants 7 years /Sub-debt warrants 5 years

·              Expected Return: 4.04%: The risk-free rateswere based on the rate of treasury securities with the same term as thewarrants as of the specified valuation date

·              Volatility: 55%

22

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*IncomeTaxes*. We account for income taxes under Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFASNo. 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 andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in the statement of operations in the periodthat includes the enactment date. A valuation allowance is established, whennecessary, to reduce deferred tax assets to the amount expected to be realized.

*AccountsReceivable*. We grant credit to our customers generally in theform of short-term trade accounts receivable. Accounts receivable are stated atthe amount management expects to collect from outstanding balances. Whenappropriate, management provides for probable uncollectible amounts through aprovision for doubtful accounts and an adjustment to a valuation allowance.Management primarily determines the allowance based on the aging of accountsreceivable balances, historical write-off experience, customer concentrations,customer creditworthiness and current industry and economic trends. Balancesthat are still outstanding after management has used reasonable collectionefforts are written off through a charge to the valuation allowance and acredit to accounts receivable.

Concentrations ofcredit risk with respect to trade receivables generated by our operations aregenerally limited. However, MediaDefender’s customers consist primarily oflarge reputable companies in the music and entertainment industries.

**RecentlyIssued Accounting Pronouncements and Developments**

In May 2005, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No.154”). SFAS No. 154 is a replacement of APB Opinion No. 20, “Accounting Changes”and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements –(an Amendment of APB Opinion No. 28)” and provides guidance on the accountingfor and reporting of accounting changes and error corrections. SFAS No. 154establishes retrospective application as the required method for reporting achange in accounting principle, and provides guidance for determining whetherretrospective application of a change in accounting principle is impracticableand for reporting a change when retrospective application is impracticable.Retrospective application is the application of a different accountingprinciple to a prior accounting period as if that principle had always beenused or as the adjustment of previously issued financial statements to reflecta change in the reporting entity. SFAS No. 154 also addresses the reporting ofthe correction of an error by restating previously issued financial statements.We will adopt the provisions of SFAS No. 154 effective January 1, 2006.

On September 22,2005, the SEC issued rules to delay by one-year the required reporting bymanagement on internal controls over financial reporting for non-acceleratedfilers. The new SEC rule extends the compliance date for such registrants tofiscal years ending on or after July 15, 2007. Accordingly, we qualify for thedeferral until its year ending December 31, 2007 to comply with the internalcontrol reporting requirements.

In September 2005,the Emerging Issues Task Force (“EITF”) tabled discussions with respect toIssue No. 05-04 “The Effect of a Liquidated Damages Clause on a FreestandingFinancial Instrument subject to EITF 00-19” (EITF 05-04).  EITF 05-04 addresses the treatment ofpotential penalties, in the event that the Company fails to meet certainregistration rights associated with the common stock underlying the Notes andWarrants.  As of December 31, 2005, theCompany did not anticipate any registration issues and given the status of EITF05-04, no registration penalties are reflected in the December 31, 2005financial statements.

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**Resultsof Operations - Years Ended December 31, 2004 and 2005**

The followingtable presents information with respect to our consolidated statements ofoperations, excluding income (loss) from discontinued operations, and as apercentage of total net revenue, for the years ended December 31, 2004 and2005. As a result of our acquisition of MediaDefender effective July 28, 2005,we have consolidated the operations of MediaDefender for the five months endedDecember 31, 2005. Accordingly, our result of operations for the year endedDecember 31, 2005 are not directly comparable to our results of operations forthe year ended December 31, 2004.

Consolidated Statementsof Operations ($000)
| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | **$**                                       | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                                                                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | **(RESTATED)** | ** ** | **(RESTATED)** | ** ** |
| Net revenue:                                                                                                                         |       |                                        |       |   |   |   |   |   |   |
| E-Commerce                                                                                                                           |       | $                                           | 2,994      |   | 58.2 | % | $ | 2,665 |   | 19.1 | % |
| Media                                                                                                                                |       | 2,149                                       |       | 41.8 | % | 5,297 |   | 37.9 | % |
| Anti-piracy services                                                                                                                 |       | —                                      |       | — | % | 6,009 |   | 43.0 | % |
| Total net revenue                                                                                                                    |       | 5,143                                       |       | 100.0 | % | 13,971 |   | 100.0 | % |
| Cost of revenue:                                                                                                                     |       |                                        |       |   |   |   |   |   |   |
| E-Commerce                                                                                                                           |       | 2,631                                       |       | 51.2 | % | 2,400 |   | 17.2 | % |
| Media                                                                                                                                |       | 1,144                                       |       | 22.2 | % | 2,745 |   | 19.7 | % |
| Anti-piracy services                                                                                                                 |       | —                                      |       | — | % | 2,659 |   | 19.0 | % |
| Total cost of revenue                                                                                                                |       | 3,775                                       |       | 73.4 | % | 7,804 |   | 55.9 | % |
| Gross profit                                                                                                                         |       | 1,368                                       |       | 26.6 | % | 6,167 |   | 44.1 | % |
| Operating  expenses:                                                                                                                 |       |                                        |       |   |   |   |   |   |   |
| Sales and marketing                                                                                                                  |       | 167                                         |       | 3.3 | % | 527 |   | 3.8 | % |
| General and administrative                                                                                                           |       | 2,676                                       |       | 52.0 | % | 4,065 |   | 29.1 | % |
| Provision for doubtful accounts                                                                                                      |       | 110                                         |       | 2.2 | % | 105 |   | 0.7 | % |
| Stock-based compensation                                                                                                             |       | 7                                           |       | 0.1 | % | 73 |   | 0.5 | % |
| Total operating costs                                                                                                                |       | 2,960                                       |       | 57.6 | % | 4,770 |   | 34.1 | % |
| Income (loss) from operations                                                                                                        |       | (1,592                                      | )          | (31.0 | )% | 1,397 |   | 10.0 | % |
| Interest income                                                                                                                      |       | 29                                          |       | 0.6 | % | 29 |   | 0.2 | % |
| Interest expense                                                                                                                     |       | —                                      |       | — | % | (2,873 | ) | (20.6 | )% |
| Change in fair value of warrant liability                                                                                            |       | —                                      |       | — | % | (10,735 | ) | (76.7 | )% |
| Change in fair value of embedded liability                                                                                           |       | —                                      |       | — | % | (20,043 | ) | (143.5 | )% |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable |       | —                                      |       | — | % | (45 | ) | (0.3 | )% |
| Amortization of deferred financing costs                                                                                             |       | —                                      |       | — | % | (402 | ) | (2.9 | )% |
| Gain from sale of tradename                                                                                                          |       | 500                                         |       | 9.7 | % | — |   | — | % |
| Loss from continuing operations before taxes                                                                                         |       | (1,063                                      | )          | (20.7 | )% | (32,672 | ) | (233.8 | )% |
| Provision for  income taxes                                                                                                          |       | —                                      |       | — | % | 241 |   | 1.7 | % |
| Net loss                                                                                                                             |       | $                                           | (1,063     | ) | (20.7 | )% | $ | (32,913 | ) | (235.5 | )% |

 

24

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We evaluateperformance based on, among other factors, Adjusted EBITDA. Included inAdjusted EBITDA are direct operating expenses for each segment. The followingtable summarized net revenue and Adjusted EBITDA by operating segment for theyears ended December 31, 2004 and 2005, respectively. Corporate expensesconsist of general operating expenses that are not directly related to theoperations of the segments. A reconciliation of Net Income (Loss) to AdjustedEBITDA is also provided.
|                      | ** ** | **Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **           | ** ** | **(in thousands)**                     | ** ** |
| ** **           | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
|                 |       |                                        |       |   |   |
| Net Revenue:         |       |                                        |       |   |   |
| E-commerce           |       | $                                           | 2,994      |   | $ | 2,665 |   |
| Media                |       | 2,149                                       |       | 5,297 |   |
| Anti-piracy services |       | —                                      |       | 6,009 |   |
|                 |       | $                                           | 5,143      |   | $ | 13,971 |   |
| Adjusted EBITDA:     |       |                                        |       |   |   |
| E-commerce           |       | $                                           | 293        |   | $ | 157 |   |
| Media                |       | 789                                         |       | 2,198 |   |
| Anti-piracy services |       | —                                      |       | 3,851 |   |
|                 |       | 1,082                                       |       | 6,206 |   |
| Corporate            |       | (1,944                                      | )          | (2,969 | ) |
|                 |       | $                                           | (862       | ) | $ | 3,237 |   |

 
|                                                                                                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                             | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Reconciliation  of Adjusted EBITDA to Net Income (Loss):                                                                                               |       |                                        |       |   |   |
| Adjusted EBITDA per segments                                                                                                                           |       | $                                           | (862       | ) | $ | 3,237 |   |
| Stock-based compensation                                                                                                                               |       | (7                                          | )          | (73 | ) |
| Depreciation                                                                                                                                           |       | (223                                        | )          | (205 | ) |
| Amortization of intangible assets                                                                                                                      |       | —                                      |       | (1,562 | ) |
| Amortization of deferred financing costs                                                                                                               |       | —                                      |       | (402 | ) |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable into common stock |       | —                                      |       | (45 | ) |
| Interest income                                                                                                                                        |       | 29                                          |       | 29 |   |
| Interest expense                                                                                                                                       |       | —                                      |       | (2,873 | ) |
| Change in fair value of warrant liability                                                                                                              |       | —                                      |       | (10,735 | ) |
| Change in fair value of derivative liability                                                                                                           |       | —                                      |       | (20,043 | ) |
| Provision for income taxes                                                                                                                             |       | —                                      |       | (241 | ) |
| Loss from discontinued operations -                                                                                                                    |       |                                        |       |   |   |
| – ARTISTdirect Records, LLC                                                                                                                       |       | (2,111                                      | )          | (271 | ) |
| – iMusic record label                                                                                                                             |       | (137                                        | )          | — |   |
| Gain from sale of ARTISTdirect Records, LLC                                                                                                            |       | —                                      |       | 21,079 |   |
| Net income  (loss)                                                                                                                                     |       | $                                           | (3,311     | ) | $ | (12,105 | ) |

 

Adjusted EBITDA isa non-GAAP financial measure that represents earnings before net interestexpense, provision for income taxes, depreciation and amortization, as well ascertain other charges, including stock-based compensation and impairment losses.Management excludes these items in assessing financial performance, primarilydue to their non-operational nature or because they are outside of our normaloperations. We have provided this information because management believes thatit is useful to investors in understanding our financial condition and resultsof operation.

Managementbelieves that Adjusted EBITDA enhances an overall understanding of ourfinancial performance by investors because it is frequently used by securitiesanalysts and other interested parties in evaluating companies in our industrysegment. In addition, management believes that Adjusted EBITDA is useful inevaluating  our operating performancecompared to that of other companies in our industry segment because the calculation of Adjusted EBITDAeliminates the accounting effects of financing costs, income taxes and capitalspending, which items may vary for different companies for reasons unrelated tooverall operating performance.

25

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However, AdjustedEBITDA is not a recognized measurement under GAAP, and when analyzing  our operating performance, investors shoulduse EBITDA in addition to, and not as an alternative for, income (loss) fromoperations, income (loss) before income taxes, and net income (loss), or anyother measure utilized in determining the Company’s operating performance thatis calculated in accordance with GAAP. Because Adjusted EBITDA is notcalculated in accordance with GAAP, it may not be comparable tosimilarly-titled measures utilized by other companies. Furthermore, AdjustedEBITDA is not intended to be a measure of our free cash flow, as it does not consider certain ongoing cashrequirements, such as a required debt service payments and income taxes.

*NetRevenue*. Our net revenue increased by $8,828,000 or 171.7%,to $13,971,000 for the year ended December 31, 2005, as compared to $5,143,000for the year ended December 31, 2004, primarily as a result of an increase inmedia revenue of $3,148,000 and the acquisition of MediaDefender, whichprovided revenue of $6,009,000 from its anti-piracy services since itsacquisition on July 28, 2005. MediaDefender’s revenue accounted for 43.0% ofour total net revenue for the year ended December 31, 2005. We expect thatrevenues from MediaDefender will represent a significant proportion of ourtotal revenues in the foreseeable future.

E-commerce revenuedecreased by $329,000, or 11.0%, to $2,665,000 for the year ended December 31,2005, as compared to $2,994,000 for the year ended December 31, 2004, primarilydue to a decrease in sales of products related to a single music merchandisingentity.

During the yearsended December 31, 2005 and 2004, approximately 67% and 70%, respectively, ofrevenues frome-commerce were generated from the products related to one music merchandisingentity. During the years ended December 31, 2004 and 2005, most of our mediarevenues were generated by a single outside sales organization whichrepresented us with respect to advertising and sponsorship sales on ourweb-site and through affiliated web-sites.

Media revenueincreased by $3,148,000, or 146.5%, to $5,297,000 for the year ended December31, 2005, as compared to $2,149,000 for the year ended December 31, 2004, as aresult of an increase in the number of online advertisers, an increase in thecost per thousand (“CPM”) amounts earned from the sales of impression andnon-impression based advertising and the expansion of our affiliations withother web-sites for which we both market advertising and participate inadvertising revenues. A short-term program with a major advertiser/sponsorduring the three months ended June 30, 2005 contributed approximately$1,786,000 of the increase in media revenue during the year ended December 31,2005. The program ended June 30, 2005 and, as designed, did not continue.

We market and selladvertising on a CPM basis to advertising agencies and directly to variouscompanies as part of our marketing program. We also market and sellsponsorships for various portions of the ARTISTdirect Network. Customers maypurchase advertising space on the entire ARTISTdirect Network, or they maytailor advertising based on music genre or functionality. We intend to continueto focus on increasing revenue from our media operations business segment,which generates revenues from the sale of online advertising and sponsorshipsto companies seeking to reach one or more of the distinct demographic audiencesviewing content in the ARTISTdirect Network.

*Costof Revenue*. Our total cost of revenue increased by$4,029,000, or 106.7%, to $7,804,000 for the year ended December 31, 2005,as compared to $3,775,000 for the year ended December 31, 2004, primarily as aresult of an increase in media revenue and the acquisition of MediaDefender.MediaDefender’s cost of revenue accounted for $2,659,000, or 44.3%, of its net revenue. Depreciation of property andequipment is included in cost of revenue for all business segments.

Included inMediaDefender’s cost of revenue for the year ended December 31, 2005 was theamortization of proprietary technology acquired in the MediaDefendertransaction of $1,056,000.

E-commerce cost ofrevenue decreased by $231,000, or 8.8%, to $2,400,000 for the year endedDecember 31, 2005, as compared to $2,631,000 for the year ended December31, 2004, primarily as a result of the decrease in e-commerce revenues.

Media cost ofrevenue increased by $1,601,000 or 139.9% to $2,745,000 for the year endedDecember 31, 2005, as compared to $1,144,000 for the year ended December 31,2004, as a result of an increase in impressions being delivered by affiliateweb-sites with which we have revenue-sharing arrangements, advertising servingcosts, and sales commissions paid to a third party in conjunction withincreased media revenues.

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As a result of theforegoing, gross profit was $6,167,000 for the year ended December 31, 2005, ascompared to $1,368,000 for the year ended December 31, 2004, reflecting grossmargins of 44.1% and 26.6%, respectively. The significant improvement in grossmargin for the year ended December 31, 2005, as compared to the year endedDecember 31, 2004, was due to a change in the business mix, reflecting anincrease in revenues from higher margin segments. A summary of gross profit andgross margin by segment is as follows ($000):
|                      | ** ** | **Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| **Segment:**         | ** ** | **Gross  Profit**                           | ** ** | **Gross  Margin** | ** ** | **Gross  Profit** | ** ** | **Gross  Margin** | ** ** |
| E-commerce           |       | $                                           | 363        |   | 12.1 | % | $ | 265 |   | 9.9 | % |
| Media                |       | 1,005                                       |       | 46.8 | % | 2,552 |   | 48.2 | % |
| Anti-piracy services |       | —                                      |       | — |   | 3,350 |   | 55.7 | % |
| Totals               |       | $                                           | 1,368      |   | 26.6 | % | $ | 6,167 |   | 44.1 | % |

 

*Salesand Marketing*. Our sales and marketing expense increased by$360,000, or 215.6%, to $527,000 for the year ended December 31, 2005, ascompared to $167,000 for the year ended December 31, 2004, primarily as aresult of the amortization of customer relationships acquired in theMediaDefender transaction of $314,000.

*Generaland Administrative*. Our general and administrative expenseincreased by $1,389,000, or 51.9%, to $4,065,000 for the year ended December31, 2005, as compared to $2,676,000 for the year ended December 31, 2004, inpart as a result of the acquisition of MediaDefender and increased compensationof senior management effective with the closing of the MediaDefenderacquisition. Included in general and administrative expenses for the year endedDecember 31, 2005 was the amortization of non-compete agreements of $192,000.Also included in general and administrative expenses were $152,000 and $204,000of costs related to business development activities for the years ended December31, 2005 and 2004, respectively. Significant components of general andadministrative expenses consist of management compensation, personnel andpersonnel-related costs, insurance, legal and accounting fees, consulting feesand occupancy costs.

The increase ingeneral and administrative expense in 2005, as compared to 2004, was in partattributable to the awarding of discretionary cash bonuses to certain of oursenior executives, as described below.

In March 2005, weawarded discretionary cash bonuses to our Chief Executive Officer and ChiefFinancial Officer aggregating $125,000, which were paid during 2005. We awardedsuch bonuses as consideration for management successfully completing ourcorporate restructuring during the three months ended March 31, 2005. Inparticular, management restructured our internet operations, which hadsustained losses since inception, into a growing, profitable business segment;negotiated the extinguishment of our $12.0 million funding obligation toARTISTdirect Records; and disposed of our investment in ARTISTdirect Recordseffective February 28, 2005, which resulted in the elimination of $19.137million of liabilities from our consolidated balance sheet at that date. Suchbonuses were reviewed and approved by our Board of Directors. We also awarded adiscretionary cash bonus to our Vice President — Business Development of$40,000, which was reviewed and approved by the Compensation Committee of ourBoard of Directors, and was accrued at December 31, 2005 and we accrued $100,000in board fees to two independent directors at December 31, 2005.

*Provisionfor Doubtful Accounts*. Our provision for doubtful accountsdecreased by $5,000, or 4.5%, to $105,000 for the year ended December 31, 2005,as compared to $110,000 for the year ended December 31, 2004.

*Stock-BasedCompensation*. Our stock-based compensation was $73,000 forthe year ended December 31, 2005, as compared to $7,000 for the year endedDecember 31, 2004, reflecting the fair value of options and warrants issued toconsultants.

*InterestIncome*. Our interest income was $29,000 for the years endedDecember 31, 2005 and 2004, respectively.

*InterestExpense*. Our interest expense for the year ended December 31,2005 of $2,873,000 relates to $15.0 million of secured notes payable issued inthe Senior Financing, which bear interest at 11.25% per annum, and $30.0million of subordinated convertible notes, which bear interest at 4.0% perannum, both issued to finance the acquisition of MediaDefender in July 2005.

27

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Additional considerationin the form of warrants issued to the lenders was accounted for at fair valueand recorded as a reduction to the carrying amount of the debt, and is beingamortized to interest expense over the term of the debt. Accordingly, theamortization of discount on debt included in interest expense for the yearended December 31, 2005 was $337,000. We did not have any interest expense forthe year ended December 31, 2004.

In accordance withEITF No. 00-19, the fair value of the embedded derivatives, which werebifurcated from the subordinated convertible notes issued in connection withthe financing of the MediaDefender acquisition in July 2005 is recorded as aderivative liability and a contra-liability is established and amortized overthe term of the associated note, which is 48 months.  The amortization of the contra liabilityassociated with the derivative liability is included in interest expense.   For the year ended December 31, 2005, theCompany amortized $1,266,000 of the embedded derivative contra-liability andthere was no contra-liability amortization for the year ended December 31,2004.

*Warrant Liability fair value adjustment. *In accordance with EITF No.00-19, the fair value of the warrants, which were bifurcated from the seniorand subordinated convertible notes issued in connection with the financing ofthe MediaDefender acquisition in July 2005 is recorded as warrantliability.  The carrying value of thewarrants is adjusted to reflect any changes in the fair value of the warrantsfrom the date of issuance to the end of each reporting period, and any suchchanges are included in the statement of operations as other income(expense).   For the year ended December31, 2005, the Company recorded a non-operating (non-cash) charge to income of$10,735,000 to reflect an increase in warrant liability from the inception dateof the liability.  There were nooutstanding warrants as of 2004 and accordingly no liability adjustment.

* Derivative Liabilityfair value adjustment.* In accordance with EITF No. 00-19, the fair value of the derivatives,which were bifurcated from the subordinated convertible notes issued inconnection with the financing of the MediaDefender acquisition in July 2005, isrecorded as a derivative liability.  Thecarrying value of the derivatives is adjusted to reflect any changes in thefair value of the derivatives from the date of issuance to the end of eachreporting period, and any such changes are included in the statement ofoperations as other income (expense).  For the year ended December 31, 2005, the Company recorded anon-operating (non-cash) charge to income of $20,043,000 to reflect an increasein derivative liability from the inception date of the liability.  There were no embedded derivatives in 2004and accordingly no liability adjustment.

*Write-Offof Unamortized Discount on Debt and Deferred Financing Costs Due to Conversionof Subordinated Convertible Notes Payable*. Our deferredfinancing costs and debt discount costs aggregating $45,000 were charged tooperations as a result of the conversion of subordinated convertible notespayable aggregating $387,500 into 250,000 shares of our common stock inDecember 2005.

*Amortizationof Deferred Financing Costs*. Amortization of deferredfinancing costs was $401,000 for the year ended December 31, 2005. Deferredfinancing costs consist of consideration paid to third parties with respect tothe acquisition and financing of the MediaDefender transaction, including cashpayments, subordinated notes payable and the fair value of warrants issued forlegal fees and placement agent fees, which were deferred and are beingamortized over the term of the related debt. We did not have any amortizationof deferred financing costs for the year ended December 31, 2004.

*Gainfrom Sale of Tradename*. Effective November 23, 2004, pursuantto a trademark assignment and purchase agreement dated as of November 12, 2004,we sold all of our rights, title and interest in and to certain trademarks,service markets and trade names, in certain countries of the world, thatconsist of or incorporate the term “iMusic” (the “Marks”), including domainnames that consist of or incorporate the term iMUSIC (the “Domain Names”) andgoodwill related to such marks or trade names, to Apple Computer, Inc. for acash payment of $500,000. As the Marks and Domain Names that we sold did nothave any carrying value on our books, we recorded a gain from sale of $500,000for the year ended December 31, 2004.

*Lossfrom Continuing Operations Before Income Taxes*. As a resultof the aforementioned factors, the loss from continuing operations was $32,913,000for the year ended December 31, 2005, as compared to a loss from continuingoperations of $1,063,000 for the year ended December 31, 2004.

*Provisionfor Income Taxes*. As a result of the profitable operations ofMediaDefender for the period that it was consolidated with our operationsduring the year ended December 31, 2005, the non-deductibility of certainnon-cash charges for tax reporting purposes, and permanent limitations on ourability to utilize our net operating loss carry-forwards, we recorded aprovision for income taxes of $241,000 for the year ended December 31, 2005. Wedid not record a provision for income taxes for the year ended December 31,2004.

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*DiscontinuedOperations*. On February 28, 2005, we completed the sale of100% of the common stock of ARTISTdirect Recordings to Radar Records pursuantto a transfer agreement for a cash payment of $115,000, as a result of which weno longer had any equity or other economic interest in ARTISTdirect Records,and Radar Records became the owner of a majority of the membership interests inARTISTdirect Records and also acquired the receivable reflecting the $33.0million of loan advances previously provided to ARTISTdirect Records by us. Inconjunction with this transaction, at February 28, 2005, we wrote-off theinter-company balance due from ARTISTdirect Records of $80,000, which waseliminated in consolidation. Radar Records acquired the common stock ofARTISTdirect Recordings subject to the rights of BMG. Radar Records also agreedto offer to investors who had provided bridge funding to ARTISTdirect Records,excluding Frederick W. Field and entities related or controlled by him, theright to acquire proportional shares (based on the amount of bridge fundingmade by each bridge investor in ARTISTdirect Records) of the common stock ofARTISTdirect Recordings on the same terms and conditions as set forth in thetransfer agreement.

The amount ofconsideration received by us was determined with reference to various factors,including, but not limited to, our future business plans and intention to focuson our Internet and web-site operations, ARTISTdirect Records’ current limited capitalresources and substantially reduced level of operations, ARTISTdirect Records’future business plans and capital requirements and the likelihood of obtainingsuch capital on a timely basis and under reasonable terms and conditions, theunpaid costs that we had advanced ARTISTdirect Records to date and would berequired to continue to advance ARTISTdirect Records in the future, and theprobability of us obtaining a return on our investment to date of $33.0 millionin ARTISTdirect Records.

As a result of theexistence of various conflicts of interest with respect to this transaction,full disclosure of these conflicts of interest was made to our Board ofDirectors and the required approval by the disinterested members of our Boardof Directors was obtained prior to the closing of the transaction.

As a result of thesale of all of our interest in ARTISTdirect Recordings to Radar Recordseffective February 28, 2005, we accounted for our interest in ARTISTdirectRecords as a discontinued operation for all periods presented in accordancewith SFAS No. 144, and the assets and liabilities of ARTISTdirect Recordswere classified as “held for sale” through February 28, 2005.

As a result of thedisposition of our interest in ARTISTdirect Records effective February 28,2005, we recognized a net gain (primarily non-cash) in its consolidatedstatement of operations for the year ended December 31, 2005 of $21.079million, primarily as a result of the elimination of the liabilities ofARTISTdirect Records.

A summary of theloss from discontinued operations for the years ended December 31, 2005 and2004, respectively, is presented below. No information with respect to ourdiscontinued operations of the iMusic record label for the year endedDecember 31, 2005 is included, as our iMusic record label was discontinuedduring December 2004 and did not have any business operations during 2005.

Loss fromDiscontinued Operations ($000)
|                                      | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| ** **                           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **ArtistDirect  Records, LLC**         | ** ** | **iMusic  Record Label** | ** ** | **Total** | ** ** | **ArtistDirect  Records, LLC** | ** ** |
| Net revenue                          |       | $                                           | (19        | ) | $ | (136 | ) | $ | (155 | ) | $ | — |   |
| Cost of revenue                      |       | 986                                         |       | (1 | ) | 985 |   | 14 |   |
| Gross loss                           |       | (1,005                                      | )          | (135 | ) | (1,140 | ) | (14 | ) |
| Operating  expenses:                 |       |                                        |       |   |   |   |   |   |   |
| Sales and marketing                  |       | 285                                         |       | 2 |   | 287 |   | 18 |   |
| General and administrative           |       | 393                                         |       | — |   | 393 |   | 25 |   |
| Depreciation and amortization        |       | 22                                          |       | — |   | 22 |   | 1 |   |
| Total operating expenses             |       | 700                                         |       | 2 |   | 702 |   | 44 |   |
| Loss from operations                 |       | (1,705                                      | )          | (137 | ) | (1,842 | ) | (58 | ) |
| Other income  (expense):             |       |                                        |       |   |   |   |   |   |   |
| Minority interest                    |       | 759                                         |       | — |   | 759 |   | 116 |   |
| Interest expense                     |       | (649                                        | )          | — |   | (649 | ) | (128 | ) |
| Forgiveness of debt                  |       | 482                                         |       | — |   | 482 |   | — |   |
| Amortization of bridge note warrants |       | (998                                        | )          | — |   | (998 | ) | (201 | ) |
|                                 |       | (406                                        | )          | — |   | (406 | ) | (213 | ) |
| Net loss                             |       | $                                           | (2,111     | ) | $ | (137 | ) | $ | (2,248 | ) | $ | (271 | ) |

 

*NetLoss*. As a result of the foregoing factors, net loss was$12,105,000 for the year ended December 31, 2005, as compared to a net loss of$3,311,000 for the year ended December 31, 2004.

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**Liquidityand Capital Resources**

*Overview*.Until the acquisition of MediaDefender effective July 28, 2005, we primarilyfinanced our continuing operations from the sale of our equity securities.

As of December 31,2005 and 2004, we had $3,102,000 and $1,156,000 of unrestricted cash and cashequivalents, respectively.  At December31, 2005, the Company hada working capital deficiency of $41,985,000 (including $15,104,000 of warrantliability and net embedded derivative liability of $30,201), as comparedto a working capital deficiency of $18,438,000 at December 31, 2004. Excludingthe warrant and net embeddedderivative liabilities, our working capital would have been $3,320,000 atDecember 31, 2005. The improvement in our cash and working capital positions atDecember 31, 2005 was attributable primarily to the acquisition ofMediaDefender and the disposition of ARTISTdirect Records.

Concurrent withthe acquisition of MediaDefender in July 2005, we completed the $15.0 millionSenior Financing and the $30.0 million Sub-Debt Financing, which generatedapproximately $1.0 million for general working capital purposes. In addition,MediaDefender had working capital of $2,745,000 at the acquisition date. The Company anticipates positive cash flowsfrom this business.

We sold our  interest in ARTISTdirect Records in fiscal2005. We had consolidated ARTISTdirect Records at December 31, 2004, which hadcurrent liabilities of $18,770,000 at such date. Effective February 28, 2005,we sold 100% of our interest in ARTISTdirect Records for a cash payment of$115,000, as a result of which we no longer have any equity or other economicinterest in ARTISTdirect Records. As a result of the sale of our interest inARTISTdirect Records effective February 28, 2005, the liabilities ofARTISTdirect Records were eliminated from our balance sheet at that date.

As a result of thegeneral improvement in our media operations and the expected positive impactfrom the acquisition of MediaDefender, we believe that available cash resourcesare likely to be sufficient to meet anticipated working capital requirementsfor at least the next 12 months. However, we may seek additional funding forpossible acquisitions, expansion of existing operations or other purposes, orto the extent that our operations do not generate sufficient levels ofprofitability and cash flow. Should we seek to raise additional capital, therecan be no assurances that such capital can be raised on terms satisfactory, ona timely basis, or at all.

If all of ouroutstanding equity-based instruments are converted or exercised into shares ofcommon 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 our common stock issued and outstanding.

*Operating*.Net cash provided by operating activities was $1,486,000 for the year endedDecember 31, 2005, as compared to net cash used in operating activities of$3,473,000 for the year ended December 31, 2004. Net cash provided bycontinuing operations was $1,524,000 for the year ended December 31, 2005, ascompared to net cash used in continuing operations of $625,000 for the yearended December 31, 2004. The improvement in net cash provided by continuingoperations in 2005, as compared to 2004, was primarily a result of the decreasein net loss and an increase in accrued liabilities. Net cash used indiscontinued operations was $38,000 and $2,848,000 for the years ended December31, 2005 and 2004, respectively.

*Investing*.Net cash used in investing activities was $43,368,000 for the year endedDecember 31, 2005, which consisted of $42,500,000 paid to acquireMediaDefender, costs incurred with respect to the MediaDefender acquisition of$1,115,000 and purchases of property and equipment of $303,000, reduced by cashacquired in the MediaDefender transaction of $435,000 and the proceeds from thesale of ARTISTdirect Records of $115,000. Net cash provided by investing activities was $957,000 for the yearended December 31, 2004, which consisted of the sale/maturity of short-terminvestments of $1,012,000, reduced by purchases of property and equipment of$55,000.

*Financing*.Net cash provided by financing activities was $43,828,000 for the year endedDecember 31, 2005, which consisted of the proceeds from the $15.0 millionSenior Financing and the $30.0 million Sub-Debt Financing, and the issuance ofbridge notes by ARTISTdirect Records of $37,000 during the two months endedFebruary 28, 2005, reduced by payments for deferred financing costs of$1,025,000 and an increase in restricted cash of $184,000. Net cash provided byfinancing activities was $2,953,000 for year ended December 31, 2004, whichconsisted of the issuance of bridge notes by ARTISTdirect Records of $2,778,000and a decrease in restricted cash of $175,000.

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**ContractualObligations**

As ofDecember 31, 2005, our principal commitments for the next five fiscal yearperiods consisted of contractual commitments as summarized below. The summaryshown below assumes that the senior secured notes payable and the subordinated convertiblenotes payable are outstanding for their full terms, without any early reductionof the principal balances based on cash flows, except for a 2006 scheduledprincipal payment on the senior secured notes payable of $390,000.
| ** **                                              | ** ** | **Payments Due by Year** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**                 | ** ** |
| **Contractual cash obligations**              | ** ** | **Total**                               | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
| Employment contracts                                    |       | $                                       | 3,942      |   | $ | 1,414 |   | $ | 1,264 |   | $ | 1,264 |   | $ | — |   | $ | — |   |
| Guaranteed payments to  MediaDefender management        |       | 1,050                                   |       | 1,050 |   | — |   | — |   | — |   | — |   |
| Lease obligations                                       |       | 2,261                                   |       | 343 |   | 464 |   | 470 |   | 485 |   | 499 |   |
| Senior secured notes  payable                           |       | 15,000                                  |       | 390 |   | — |   | — |   | 14,610 |   | — |   |
| Interest on senior  secured notes payable               |       | 5,826                                   |       | 1,604 |   | 1,666 |   | 1,666 |   | 890 |   | — |   |
| Subordinated  convertible notes payable (1)             |       | 27,954                                  |       | — |   | — |   | — |   | 27,954 |   | — |   |
| Interest on  subordinated convertible notes payable (2) |       | 4,537                                   |       | 1,661 |   | 1,118 |   | 1,118 |   | 640 |   | — |   |
| Total contractual cash  obligations                     |       | $                                       | 60,570     |   | $ | 6,462 |   | $ | 4,512 |   | $ | 4,518 |   | $ | 44,579 |   | $ | 499 |   |

 

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(1)  Subordinated convertible notes payablereflects $3,506,000 of subordinated debt principal converted into shares of ourcommon stock as of March 31, 2006.

(2)  In 2006, $68,000 has been paid in cash as ofMarch 31, 2006 due to conversion of subordinated debt principal into shares ofour common stock. The remaining interest payments are calculated in theordinary course.

*CapitalExpenditures*. We estimate that we will have capitalexpenditures aggregating $1,300,000 for the year ending December 31, 2006 as aresult of the relocation and consolidation of our offices to new facilities andthe planned expansion of the MediaDefender operations.

**Off-BalanceSheet Arrangements**

AtDecember 31, 2005, we did not have any transactions, obligations orrelationships that could be considered off-balance sheet arrangements.

**RecentDevelopments**

On January 30, 2006, the Company entered into a sub-lease agreement for new office facilities in Santa Monica, California through November 30, 2011.

During the periodfrom January 1, 2006 through April 27, 2006, the Company issued2,113,000 shares of common stock upon the conversion of $3,275,000 ofsubordinated convertible notes payable.

Effective April 7, 2006, the Company entered intovarious agreements with the investors in its Senior Financing and Sub-DebtFinancing to amend their respective registration rights agreements and to amendand waive certain financial covenants contained in the various agreementsunderlying the Senior Financing and Sub-Debt Financing In considerationthereof, the Company agreed to temporarily reduce the exercise price of the3,250,000 warrants held by the investors in the Senior Financing from$2.00 to $1.85 per share through April 30, 2006, and agreed to permanentlyreduce the exercise price of the 1,596,744 warrants held by the investorsin the Sub-Debt Financing from $1.55 to $1.43 per share.  The amendments provided that any exercise ofthe aforementioned warrants at the reduced exercise price shall be for cashonly.  The conversion price of theSub-Debt Notes of $1.55 per share was not affected by these amendments.  The Company also entered into similaragreements, as applicable, and provided identical temporary and permanentreductions to warrant exercise prices, with Broadband Capital Management LLC (1,516,935warrants originally exercisable at $1.55 per share) and Libra FE, LP(237,500 warrants originally exercisable at $2.00 per share).  The Company also agreed to utilize 25% of thenet proceeds from the exercise of the warrants held by the investors in theSenior Financing to reduce the respective principal balances on the notespayable held by such exercising investors, and to pay any related unpaidaccrued interest on such principal payments.

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Effective April 19, 2006, Libra FE, LPexercised its warrants on a cashless basis at $2.00 per share, resulting in theissuance of 123,864 shares of common stock. Effective April 27, 2006, certain of the investors in the SeniorFinancing exercised their warrants to purchase 2,816,667 shares of common stockat $1.85 per share, resulting in the issuance of 2,816,667 shares of commonstock in exchange for cash proceeds of $5,211,000, of which $1,303,000 was usedto reduce the respective principal balances on the notes payable held by suchexercising investors.

As previously reported on a Current Report onForm 8-K filed by the Company with the SEC on December 27, 2006, theCompany’s Audit Committee determined that the Company would restate itspreviously issued financial statements for the annual period endedDecember 31, 2005 and the quarterly periods ended September 30, 2005,March 31, 2006, June 30, 2006 and September 30, 2006.  As a result of the pending restatements, theRegistration Statement on Form SB-2, as amended  (Reg. No.333-129626, (the “Form SB-2”)) has not been available for use by theholders of the underlying securities since December 21, 2006.  The financing documents governing the termsand conditions of the Senior and Sub-Debt Financing require the Company tomaintain an effective registration statement covering the resale of shares ofcommon stock underlying the various securities issued by the Company to eachholder.

As previously reported on a Current Report on Form 8-Kfiled on January 18, 2007, the financing documents for the Senior Financing andSub-Debt Financing specify that an event of default of the senior andsubordinated indebtedness is triggered if the Form SB-2 is unavailable for useby the holders of the underlying securities for a period of more than 10consecutive trading days after the expiration of an allowable 10 day graceperiod.  The Company invoked its use ofthe 10 day allowable grace period on December 21, 2006, which expired onDecember 31, 2006.  Thereafter,an event of default was triggered on January 18, 2007.  As of the date of this filing, theForm SB-2 remained unavailable for use by the holders of the underlyingsecurities, and it will continue to be unavailable for use until the Companyprepares and files a post-effective amendment to the Form SB-2 withrestated financial statements, as appropriate, which is then declared effectiveby the staff of the SEC.

Upon the occurrence of an event of default, holders ofat least 25% of the outstanding senior indebtedness, approximately $13,307,000,may declare the outstanding principal and accrued interest on all senior notesimmediately due and payable upon written notice to the Company.  Holders of outstanding subordinatedindebtedness may demand redemption of all or any portion of their respectivenotes, approximately $27,658,000 on certain terms and conditions, as describedin the subordinated financing documents. As of the date of this filing, the Company had not received a request toaccelerate or redeem any portion of the outstanding indebtedness from anysenior or subordinated holder.  TheCompany does not have the capital resources necessary to repay any acceleratedindebtedness or redemption.

**RISK FACTORS**

Our actual resultsmay differ materially from those anticipated in these forward-lookingstatements. We operate in a market environment that is difficult to predict andthat involves significant risks and uncertainties, many of which will be beyondour control. Refer also to “Special Note Regarding Forward-Looking Statements.”

**RISKS RELATED TO OUR BUSINESS**

***It is difficult to evaluate our business and prospectsbecause we have a limited operating history and a rapidly evolving business.***

We wereincorporated under the laws of the state of Delaware in July 1999. Our limitedoperating history and rapidly evolving business make it difficult to evaluateour prospects or to accurately predict our future revenue or results ofoperations. Our revenue and income potential are unproven, and our businessmodel is constantly and rapidly evolving. In particular, the Internet isconstantly changing and we may need to modify our business model to adapt tothese changes.

***The loss of key personnel could adversely affect ourbusiness because these individuals are important to our business.***

Our future successdepends to a significant extent on the continued services of our seniormanagement, including Jonathan V. Diamond, Randy Saaf and Octavio Herrera. Theloss of any of these individuals would likely have an adverse effect on ourbusiness. Competition for personnel throughout our industry is intense and wemay be unable to retain these key employees or attract, integrate or retainother highly qualified employees in the future. We have in the pastexperienced, and we expect to continue to experience, difficulty in hiring andretaining highly skilled employees with appropriate qualifications. If we donot succeed in attracting new personnel or retaining and motivating our currentpersonnel, our business could be adversely affected. Recent changes incorporate governance and securities laws and regulations, such as the Sarbanes-OxleyAct of 2002, could make it more difficult for us to attract and retainqualified executive officers or qualified members of our Board of Directors,particularly individuals to serve on our audit committee.

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***We have substantial debt obligations, which could materiallyand adversely affect our business.***

To obtainsufficient cash resources to fund the acquisition of MediaDefender, we incurredapproximately $45.0 million worth of indebtedness. We will require substantialamounts of cash to fund scheduled payments of interest on the notes issued inthe debt transactions, payment of the principal amount of the notes, futurecapital expenditures, payments on our leases and any increased working capitalrequirements due to the acquisition. If we are unable to meet our cashrequirements out of cash flow from operations, there can be no assurance thatwe will be able to obtain alternative financing. The degree to which we arefinancially leveraged could materially and adversely affect our ability toobtain financing for working capital, acquisitions or other purposes and couldmake us more vulnerable to industry downturns and competitive pressures. In theabsence of such financing, our ability to respond to changing business andeconomic conditions, to make future acquisitions, to absorb adverse operatingresults or to fund capital expenditures or increased working capitalrequirements would be significantly reduced. Our ability to meet our debtservice obligations will be dependent upon our future performance, which willbe subject to financial, business and other factors affecting our operations,some of which are beyond our control.

***The success of our newly-acquired Internet piracy preventionsegment depends in part on the continued success of MediaDefender’s contentprotection technology.***

If currentMediaDefender customers, which include major movie studios and record labels,determine that the benefits of MediaDefender’s technology do not justify theexpense, or other competitive technologies are superior than those provided byMediaDefender, demand for its IPP technology would decline and our operatingresults would be harmed.

***Our relationships with entertainment industry participantsare particularly important to our newly-acquired Internet piracy prevention segment,and if we fail to maintain such relationships fostered by MediaDefender ourbusiness prospects could be materially harmed.***

If we fail tomaintain and expand MediaDefender’s relationships with a broad range ofparticipants throughout the entertainment industry, including movie studios andrecord labels, our business prospects could be materially harmed. Relationshipshave historically played an important role in the entertainment industries thatMediaDefender serves. If we fail to maintain and strengthen theserelationships, these entertainment industry participants may not purchase oruse our technologies, which could materially harm our business and businessprospects. In addition, if major entertainment industry participants formstrategic relationships that exclude us, our business and business prospectscould be materially adversely affected.

***Global sales of recorded music have recently declined andthis trend may continue in the future.***

Based on datacompiled by The Recording Industry Association of America, or RIAA, the numberof CDs shipped from record companies to retail distribution channels fellapproximately 8% in 2005, as compared to the previous year. Dollar value alsofell substantially from 11.4 billion to 10.5 billion in 2005 from 2004. Thisdecline represents the greatest drop since 2002, when shipped units and dollarvalue fell by 8.9% and 6.7%, respectively. According to the RIAA, the decline,in sales had been due in part, to widespread copying and illegal Internetdownloading of music. If the overall trend continues, it may affect oure-commerce business and have a material affect on our revenues.

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***If we are unable to grow our online advertisingsignificantly in the near future, our business may be adversely affected.***

If we do not increaseadvertising revenue in our media and e-commerce segments, our business will beadversely affected. Increasing our advertising revenue depends upon manyfactors, including our ability to:

·                  respond to andanticipate fluctuations in the demand for, and pricing of, online advertising;

·                  develop andmaintain key advertising relationships and compete for advertisers withInternet and traditional media companies;

·                  conductsuccessful selling and marketing efforts aimed at advertising agencies anddirect marketing departments;

·                  successfullydevelop, sell and execute entertainment marketing solutions;

·                  increase thesize of our audience and the amount of time that our audience spends on ourweb-sites;

·                  accuratelymeasure the size and demographic characteristics of our audience;

·                  offeradvertisers the means to effectively target their advertisements to ouraudience; and

·                  increase theamount of revenue per advertisement.

Our failure toachieve one or more of these objectives could impair our ability to increaseadvertising revenue, which could adversely affect our business. In addition tothe above factors, general economic conditions, as well as economic conditionsspecific to online advertising, electronic commerce and the music industry,could affect our ability to increase our advertising revenue.

***We may not be able to develop or obtain sufficientlycompelling content to attract and retain our target audience.***

For our media ande-commerce segments to be successful, we must provide content and services thatattract consumers who will purchase music and related merchandise online. Wemay not be able to provide consumers with an acceptable mix of products,services, information and community to attract them to our web-sites or toencourage them to remain on our web-sites for an extended period of time. Ifour audience determines that our content does not reflect its tastes, then ouraudience size could decrease or the demographic characteristics of our audiencecould change and we may be unable to react to those changes effectively or in atimely manner. Any of these results would adversely affect our ability toattract advertisers and sell music and other related merchandise. Our abilityto provide compelling content could be impaired by any of the following:

·                  reduced accessto content controlled by record labels, music publishers and artists;

·                  diminishedtechnical expertise and creativity of our production staff; and

·                  inability toanticipate and capitalize on trends in music.

***If we do not build and maintain strong brands, we may not beable to attract a significant number of users to our web-sites.***

To attract userswe must develop a brand identity for ARTISTdirect and increase public awarenessof the ARTISTdirect network; however, to conserve cash we have significantlydecreased the amounts we have spent and plan to spend on our offline and onlineadvertising and promotional efforts to increase brand awareness, traffic andrevenue. Accordingly, our marketing activities may not result in increasedrevenue and, even if they do, any increased revenue may not offset the expenseswe incur in building our brands. Moreover, despite these efforts we may beunable to increase public awareness of our brands, which would have an adverseeffect on our results of operations.

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***The market for online promotion and distribution of musicand related merchandise is highly competitive and we may not be able to competesuccessfully against our current and future competitors.***

The market for theonline promotion and distribution of music and related merchandise is highlycompetitive and rapidly changing. There are a significant number of web-sitespromoting and distributing music and related merchandise that compete for theattention and spending of consumers, advertisers and users. We face competitivepressures from numerous actual and potential competitors. Our competitorsinclude America Online, MSN, Yahoo!, Amazon.com, MTV, myspace.com, mp3.com,billboard.com and other web-sites and traditional music companies.

Competition islikely to increase significantly as new companies enter the market and currentcompetitors expand their services. Some of our competitors have entered intoagreements to work together to offer music over the Internet, and we may faceincreased competitive pressures as a result. Many of our current and potentialcompetitors in the Internet and music entertainment businesses may havesubstantial competitive advantages relative to us, including:

·                  longer operatinghistories;

·                  significantlygreater financial, technical and marketing resources;

·                  greater brandname recognition;

·                  larger existingcustomer bases; and

·                  more popularcontent or artists.

These competitorsmay be able to respond more quickly to new or emerging technologies and changesin customer requirements and devote greater resources to develop, promote andsell their products or services than we can. Consumers, artists, talentmanagement companies and other music-related vendors or advertisers mayperceive web-sites maintained by our existing and potential competitors asbeing superior to ours. In addition, increased competition could result inreduced advertising rates and margins and loss of market share, any of whichcould harm our business.

***We depend on a limited number of suppliers for music merchandise,fulfillment and distribution and if we cannot secure alternate suppliers, ourbusiness may be harmed.***

We rely to a largeextent on timely distribution by third parties. During 2005, we relied on twovendors, Alliance Entertainment, and Benn Co. to fulfill and distribute ourorders for music and related merchandise. During the year endedDecember 31, 2005, approximately 94% and 6%, respectively, of our totalcustomer orders were fulfilled by Alliance and Benn Co., respectively. Wepurchase a significant portion of our artist-licensed merchandise from Benn Co.and most all of our compact discs from Alliance. Our contracts with Allianceand Benn Co. are both on a month-to-month basis. Our business could besignificantly disrupted if Alliance or Benn Co. were to terminate or breachtheir agreements or suffer adverse developments that affect their ability tosupply products to us. If, for any reason, Alliance, Benn Co. or other vendorsare unable or unwilling to supply products to us in sufficient quantities andin a timely manner, we may not be able to secure alternative suppliers, onacceptable terms, in a timely manner or at all.

***We depend on third party inventory and financial systems andcarrier services.***

Because we rely onthird parties to fulfill orders, we depend on their systems for trackinginventory and financial data. If our distributors’ systems fail or are unableto scale or adapt to changing needs, or if we cannot integrate our informationsystems with the systems of any new distributors, we may not have adequate,accurate or timely inventory or financial information. We also rely onthird-party carriers for shipments to and from distribution facilities. We aretherefore subject to the risks, including employee strikes and inclementweather, associated with our carriers’ ability to provide delivery services tomeet our distribution and shipping needs. In the past, we have occasionallyexperienced an unusually high volume of orders, which resulted in shippingdelays to our customers. These delays did not have a material adverse effect,however, our failure to deliver products to our customers in a timely andaccurate manner in the future could harm our reputation, our relationship withcustomers, the ARTISTdirect brand and our results of operations.

***Our media and e-commerce segments are subject toseasonality, which could adversely affect our operating results.***

We haveexperienced and expect to continue to experience seasonal fluctuations in ouronline sales. These seasonal patterns will cause quarterly fluctuations in ouroperating results. In particular, a disproportionate amount of our online saleshave been realized during the fourth calendar quarter and during the summermonths, traditionally when artists go on tour. Due to our limited operatinghistory, it is difficult to predict the seasonal pattern of our online salesand the impact of such seasonality on our business and operating results. Ourseasonal online sales patterns may become more pronounced, strain ourpersonnel, warehousing, and order shipment activities and cause our operatingresults to be significantly less than expected for any given period. This wouldlikely cause our stock price to fall.

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***We may be subject to system disruptions, which could reduceour revenue.***

Our ability to attractand retain artists, users, advertisers and merchants for our online networkdepends on the performance, reliability and availability of our web-sites andnetwork infrastructure. Our own staff performs the maintenance and operation ofsubstantially all of our Internet communications hardware and servers. We haveperiodic maintenance windows, and we experience outages from time to timecaused by temporary problems in our own systems or software. While we haveimplemented procedures designed to improve the reliability of our systems,these interruptions may continue to occur from time to time. Our users alsodepend on third party Internet service providers and web-site operators foraccess to our web-sites. These entities have experienced significant outages inthe past, and could experience outages, delays and other difficulties due tosystem failures in the future which are unrelated to our systems, but whichcould nonetheless adversely affect our business.

***If we are unable to protect our intellectual propertyrights, our competitive position could be harmed or we could be required toincur expenses to enforce our rights.***

We rely upon theregistered trademark rights in the United States for our commercial use of theARTISTdirect, UBL, Ultimate Band List and other brand names and theirrespective associated domain names, and the ARTISTdirect logo. We seek toprotect some of our trademarks by registration and other means and copyrightsand other proprietary rights through confidentiality requirements and othermeans, but these actions may be inadequate. It may be possible that some of ourinnovations may not be protectable. We have trademark applications pending inseveral jurisdictions, but our registrations may not be accepted or may bepreempted by third parties and/or we may not be able to register our trademarksin all jurisdictions in which we intend to do business. We generally enter intoconfidentiality or license agreements with our employees, consultants andcorporate partners, and generally attempt to control access to and distributionof our proprietary information.

The steps we havetaken may not prevent misappropriation of our proprietary rights, or disclosureof trade secrets, particularly in foreign jurisdictions where laws or lawenforcement practices may not protect our proprietary rights as fully as thosein the United States. Confidentiality may be compromised intentionally oraccidentally by contractors, customers, other third parties or our employees.If third parties were to use or otherwise misappropriate our copyrightedmaterials, trademarks or other proprietary rights without our consent orapproval, our competitive position could be harmed, or we could become involvedin litigation to enforce our rights. In addition, policing unauthorized use ofour content, trademarks and other proprietary rights could be very expensive,difficult or impossible, particularly given the global nature of the Internet,and we may not be able to determine the existence or extent of any unauthorizeduse. We also cannot be certain that others will not develop independentlyequivalent or superior technology or intellectual property rights.

***Our access to copyrighted content depends upon thewillingness of content owners to make their content available.***

The music contentavailable on the ARTISTdirect network is typically comprised of copyrightedworks owned or controlled by multiple third parties. Most of the content on ourartist-specific web-sites is either owned or licensed by the artist. On otherparts of the ARTISTdirect network, depending on the nature of the content andhow we use the music content, we typically license such rights from publishers,record labels, performing rights societies or artists. We frequently either donot have written contracts or have short-term contracts with copyright owners,and, accordingly, our access to copyrighted content depends upon thewillingness of such parties to continue to make their content available. If thefees for music content increase substantially or if significant music contentbecomes unavailable, our ability to offer music content could be materiallylimited. We have not obtained a license for some of the content offered on theARTISTdirect network, including links to other music-related sites andthirty-second streamed song samples, because we believe that a license is notrequired under existing law. However, this area of law remains uncertain andmay not be resolved for a number of years. When this area of law is resolved,we may be required to obtain licenses for such content, alter or remove thecontent from our web-sites and be forced to pay potentially significantfinancial damages for past conduct.

***Intellectual property claims against us could be costly andcould result in the loss of significant rights.***

Third parties mayassert and have asserted trademark, copyright, patent and other types ofinfringement or unfair competition claims against us. If we are forced todefend against any such claims, whether they are with or without merit or aredetermined in our favor, we may face costly litigation, loss of access to, anduse of, content, diversion of technical and management personnel, or productshipment delays. As a result of such a dispute, we may have to developnon-infringing technology, enter into royalty or licensing agreements, ceaseusing certain technology or content or pay damages, any of which may increaseour operating expenses and harm our business. Such royalty or licensingagreements, if required, may be unavailable on terms acceptable to us, or atall. While we have resolved all such disputes in the past, we may not be ableto do so in the future.

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***If our online security measures fail, we could lose visitorsto our sites and could be subject to claims for damage from our users, contentproviders, advertisers and merchants.***

Our relationshipswith consumers would be adversely affected and we may be subject to claims fordamages if the security measures that we use to protect their personalinformation, especially credit card numbers, are ineffective. We rely onsecurity and authentication technology that we license from third parties toperform real-time credit card authorization and verification with our bank. Wecannot predict whether events or developments will result in a compromise orbreach of the technology we use to protect a customer’s personal information.Our infrastructure may be vulnerable to unauthorized access, physical orelectronic computer break-ins, computer viruses and other disruptive problems.Internet service providers have experienced, and may continue to experience,interruptions in service as a result of the accidental or intentional actionsof Internet users, current and former employees and others. Anyone who is ableto circumvent our security measures could misappropriate proprietaryinformation or cause interruptions in our operations. Security breachesrelating to our activities or the activities of third-party contractors thatinvolve the storage and transmission of proprietary information could damageour reputation and our relationships with our content providers, advertisersand merchants. We also could be liable to our content providers, advertisersand merchants for the damages caused by such breaches or we could incursubstantial costs as a result of defending claims for those damages. We mayneed to expend significant capital and other resources to protect against suchsecurity breaches or to address problems caused by such breaches. Our securitymeasures may not prevent disruptions or security breaches.

***We may be subject to liability if private informationprovided by our users were misused.***

Our privacy policydiscloses how we use individually identifiable information that we collect.This policy is displayed and accessible throughout the ARTISTdirect network. Despitethis policy, however, if third persons were able to penetrate our networksecurity or otherwise misappropriate our users’ personal information or creditcard information, we could be subject to liability. We could also be subject toliability for claims for unauthorized purchases with credit card information,impersonation or other similar fraud claims, or other misuses of personalinformation, such as for unauthorized marketing purposes. These claims couldresult in costly and time-consuming litigation.

While we attemptto be fully compliant with our privacy policy, our efforts may not be entirelysuccessful. In addition, at times we rely upon outside vendors to maintaindata-collection software, and there can be no assurance that they will at alltimes comply with our instructions to comply with our privacy policy. If ourmethods of complying with our privacy policy are inadequate, or our businesspractices be found to differ from our privacy policy, we may face litigationwith the FTC, California and other State’s governmental authorities orindividuals, which would adversely affect our business. It is also possiblethat users or visitors could try to recover damages in a civil action as well.

***We may be sued for content available or posted on our web-sitesor products through our web-sites or for linking and framing of third-partyweb-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. We also could be exposed to these typesof claims for content that may be accessed from our web-sites or via links toother web-sites or for products sold through our web-site. While we haveresolved all of these types of claims made against us in the past, we may notbe able to do so in the future. We intend to implement measures to reduceexposure to these types of claims, but such measures may not be successful andmay require us to expend significant resources. Any litigation as a result ofdefending these types of claims could result in substantial costs and damages.Our insurance may not adequately protect us against these types of claims orthe costs of their defense or payment of damages. 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 the rightof publicity may be asserted against us as a result. The law regarding linkingand framing remains unsettled; it is uncertain as to how existing laws,especially trademark and copyright law, will be applied by the judiciary to theInternet. Also, Congress is increasingly active in passing new laws related tothe Internet, and there is uncertainty as to the impact of future potentiallaws, especially those involving domain names, databases and privacy.

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**RISKS RELATED TO OUR CAPITAL STRUCTURE**

***Our stock price is volatile and could decline in the future.***

The price of ourcommon stock may fluctuate in the future. The stock market, in general, and themarket price for shares of technology companies in particular, have experiencedextreme stock price fluctuations. In some cases, these fluctuations have beenunrelated to the operating performance of 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 numberof factors, both within and outside of our control, could cause the price ofour common stock to fluctuate, perhaps substantially. Factors such as thefollowing could have a significant adverse impact on the market price of ourcommon stock:

·                  announcements oftechnological innovations or new products by us or our competitors;

·                  U.S. and foreigngovernmental actions;

·                  developmentsconcerning our patent or other proprietary rights or our competitors (includinglitigation);

·                  our ability toobtain additional financing and, if available, the terms and conditions of thefinancing;

·                  our financialposition and results of operations;

·                  period-to-periodfluctuations in our operating results;

·                  changes inestimates of our performance by any securities analysts;

·                  marketconditions for technology stocks in general; and

·                  marketconditions of securities traded on the Over-the-Counter Bulletin Board.

***The limited trading market may cause volatility in themarket price of our common stock.***

Our common stockis currently traded on a limited basis on the Over-the-Counter Bulletin Boardunder 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 stockis thus subject to volatility. In the absence of an active trading market:

·                  investors mayhave difficulty buying and selling or obtaining market quotations;

·                  marketvisibility for our common stock may be limited; and

·                  a lack ofvisibility for our common stock may have a depressive effect on the market forour common stock.

***Our common stock is considered a “penny stock” and may bedifficult to sell.***

Our common stockis considered to be a “penny stock” since it meets one or more of thedefinitions in Rules 15g-2 through 15g-6 promulgated under Section 15(g)of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Theseinclude but are not limited to the following: (i) the stock trades at aprice less than $5.00 per share; (ii) it is NOT traded on a “recognized”national exchange; (iii) it is NOT quoted on the NASDAQ Stock Market, oreven if so, has a price less than $5.00 per share; or (iv) is issued by acompany with net tangible assets less than $2.0 million, if in businessmore than a continuous three years, or with average revenues of less than$6.0 million for the past three years. The principal result or effect ofbeing 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 Act and Rule 15g-2 promulgated thereunder by the SECrequire broker-dealers dealing in penny stocks to provide potential investorswith a document disclosing the risks of penny stocks and to obtain a manuallysigned and dated written receipt of the document before effecting anytransaction in a penny stock for the investor’s account.

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Potentialinvestors in our common stock are urged to obtain and read such disclosurecarefully before purchasing any shares that are deemed to be “penny stock.”Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approvethe account of any investor for transactions in such stocks before selling anypenny stock to that investor. This procedure requires the broker-dealer to(i) obtain from the investor information concerning his or her financialsituation, investment experience and investment objectives;(ii) reasonably determine, based on that information, that transactions inpenny stocks are suitable for the investor and that the investor has sufficientknowledge and experience as to be reasonably capable of evaluating the risks ofpenny stock transactions; (iii) provide the investor with a writtenstatement setting forth the basis on which the broker-dealer made thedetermination in (ii) above; and (iv) receive a signed and dated copyof such statement from the investor, confirming that it accurately reflects theinvestor’s financial situation, investment experience and investmentobjectives. Compliance with these requirements may make it more difficult forholders of our common stock to resell their shares to third parties or tootherwise dispose of them in the market or otherwise.

***Standards for compliance with Section 404 of theSarbanes-Oxley Act of 2002 are uncertain, and if we fail to comply in a timelymanner, our business could be harmed and our stock price could decline.***

Rules adopted bythe SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 requireannual assessment of our internal control over financial reporting, andattestation of the assessment by our independent registered public accountants.This requirement will first apply to our annual report for fiscal 2007. 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 detailed standards.We may encounter problems or delays in completing activities necessary to makean assessment of our internal control over financial reporting. We have previouslydisclosed in our periodic filings with the SEC the determination of ourprincipal executive officer and principal financial officer that we presentlyhave material weakness in our internal controls. We are currently attempting toaddress these issues by reviewing and revising our internal accounting policiesand procedures. In addition, the attestation process by our independentregistered public accountants is new and we may encounter problems or delays incompleting the implementation of any requested improvements and receiving anattestation of the assessment by our independent registered public accountants.If we cannot assess our internal control over financial reporting as effective,or our independent registered public accountants are unable to provide anunqualified attestation report on such assessment, investor confidence andshare value may be negatively impacted. We may also incur additional accountingrelated expenses associated with compliance with Section 404.

**SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS**

In addition tohistorical information, this Annual Report contains statements relating to ourfuture business and/or results, including, without limitation, the statementsunder the captions “Risk Factors,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and “Description of Business.”These statements include certain projections and business trends that are “forward-looking”within the meaning of the United States Private Securities Litigation ReformAct 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 differ materially, from projected results as a result of certain risksand uncertainties. These risks and uncertainties include, without limitation,those described under “Risk Factors” and those detailed from time to time inour filings with the SEC, and include, among others, the following:

·                  Our limitedoperating history;

·                  Our ability toprotect our intellectual property rights;

·                  Our ability tosuccessfully develop and commercialize our proposed products;

·                  The degree andnature of our competition;

·                  Our ability toemploy and retain qualified employees;

·                  The limitedtrading market for our common stock; and

·                  The otherfactors referenced in this report, including, without limitation, under thesections entitled “Risk Factors,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” and “Description of Business.”

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These risks arenot exhaustive. Other sections of this Annual Report may include additionalfactors which could adversely impact our business and financial performance.Moreover, we operate in a very competitive and rapidly changing environment.New risk factors emerge from time to time and it is not possible for ourmanagement to predict all risk factors, nor can we assess the impact of allfactors on our business or to the extent to which any factor, or combination offactors, may cause actual results to differ materially from those contained inany forward-looking statements. Given these risks and uncertainties, investorsshould not place undue reliance on forward-looking statements as a predictionof actual results. These forward-looking statements are made only as of thedate of this Annual Report. Except for our ongoing obligation to disclosematerial information as required by federal securities laws, we do not intendto update you concerning any future revisions to any forward-looking statementsto reflect events or circumstances occurring after the date of this AnnualReport.
| **ITEM 7.** | **FINANCIAL STATEMENTS** |
|-------------|--------------------------|

 

Our consolidatedfinancial statements appear in a separate section of this Annual Report. Suchinformation is incorporated herein by reference.
| **ITEM 8.** | **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

 

Effective February6, 2004, we dismissed KPMG LLP (“KPMG”) as our independent accountant. Thedismissal was recommended by our Audit Committee and approved by our Board ofDirectors.

KPMG’s reports onour financial statements for the years ended December 31, 2001 and 2002 did notcontain an adverse opinion or a disclaimer of opinion, nor were they qualifiedor modified as to uncertainty, audit scope, or accounting principles, exceptthat KPMG’s report, dated February 14, 2003, for the years ended December 31,2002 and 2001 contained an explanatory paragraph stating that “the Company hasincurred substantial operating losses and negative cash flows from operationsto date and has funding commitments related to its record label joint venture.The Company needs additional capital to fund its operations and the operationsof the record label joint venture. These conditions raise substantial doubtabout the Company’s ability to continue as a going concern. Management’s plansin regard to these matters are also described in note 1. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.”

During the yearsended December 31, 2001 and 2002, and the period from January 1, 2003 throughFebruary 6, 2004, there were no disagreements with KPMG on any matter ofaccounting principles or practices, financial statement disclosure, or auditingscope or procedure, which disagreements, if not resolved to the satisfaction ofKPMG, would have caused KPMG to make reference to the subject matter of thedisagreements in connection with its reports on the our financial statements.In addition, none of the events described in Item 304(a)(1)(iv) of RegulationS-K occurred during such periods.

Effective February17, 2004, we retained Gumbiner Savett Inc. (“GS”) as our independentaccountant. The retention of GS was recommended by our Audit Committee andapproved by our Board of Directors.

During the yearsended December 31, 2002 and 2003, and the subsequent interim period fromJanuary 1, 2004 through February 16, 2004, we did not, nor did anyone on ourbehalf, consult with GS regarding either: (i) the application of accountingprinciples to a specified transaction, either completed or proposed; or thetype of audit opinion that might be rendered on our financial statements, andno written report or oral advice was provided that GS concluded was an importantfactor considered by us in reaching a decision as to the accounting, auditingor financial reporting issue; or (ii) any matter that was either the subject ofa disagreement as defined at Item 304(a)(1)(iv) or a reportable event asdefined at Item 304(a)(1)(v) of Regulation S-K.
| **ITEM 8A.** | **INTERNAL CONTROLS OVER FINANCIAL REPORTING** |
|--------------|------------------------------------------------|

 

**Evaluationof Disclosure Controls and Procedures.**Under the supervisionand with the participation of management, our Chief Executive Officer and our ChiefFinancial Officer, have carried out an evaluation of the effectiveness of ourdisclosure controls and procedures, as such term is defined underRule 13a-15(e) promulgated under the Securities Exchange Act of 1934,as amended.  Based upon that evaluation, our Chief Executive Officer andour Chief Financial Officer concluded that there were material weaknesses inour internal controls over financial reporting as of the end of the periodcovered by this report. Our Chief Executive Officer and Chief Financial Officeridentified weaknesses related to the segregation of duties and the review,approval and reconciliation of accounting data and entries. We are addressingthese issues by reviewing and revising our internal accounting policies andprocedures, expanding the resources allocated to our accounting department andreviewing and revising our accounting and management information systemssoftware. We expect resolution of these issues to take several months.

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**Changesin Internal Controls Over Financial Reporting.**Under thesupervision and with the participation of management, our Chief ExecutiveOfficer and Chief Financial Officer also conducted an evaluation of ourinternal controls over financial reporting to determine whether any changesoccurred during the fourth quarter of 2005 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting. Based on that evaluation, there has been no such change during thefourth quarter of 2005.
| **ITEM 8B.** | **OTHER INFORMATION** |
|--------------|-----------------------|

 

None.

**PART III**
| **ITEM 9.** | **DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND  CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT** |
|-------------|---------------------------------------------------------------------------------------------------------------------------|

 

**Directorsand Executive Officers**

Thefollowing sets forth the name and position of each of our current executiveofficers and directors. Each of our directors are subject to re-election at our2006 annual meeting of stockholders.
| **Name**              | ** ** | **Age** | ** ** | **Position**                                    |
|-----------------------|------------|---------|------------|-------------------------------------------------|
| Frederick W. Field    |       | 53      |       | Chairman of the Board of Directors              |
| Jonathan V. Diamond   |       | 47      |       | President, Chief Executive Officer and Director |
| Robert N. Weingarten  |       | 54      |       | Chief Financial Officer and Secretary           |
| Teymour Boutros-Ghali |       | 50      |       | Director                                        |
| Eric Pulier           |       | 40      |       | Director                                        |
| Dimitri Villard       |       | 62      |       | Director                                        |
| James N. Lane         |       | 54      |       | Director                                        |
| Fred Davis            |       | 46      |       | Director                                        |
| Randy Saaf            |       | 29      |       | Chief Executive Officer of MediaDefender        |
| Octavio Herrera       |       | 29      |       | President of MediaDefender                      |
| Nicholas Turner       |       | 46      |       | Vice President, Business Development            |

 

*Frederick W. Field*. Mr. Field hasserved as our Chairman of the Board since June 2001 and served as ourChief Executive Officer from June 2001 until September 2003.Mr. Field also currently serves as Chief Executive Officer of ARTISTdirectRecords, LLC and as Chairman of the Board and Chief Executive Officer of RadarPictures, Inc., a film production company. From 1990 to 2001, Mr. Fieldserved as Co-Chairman of Interscope Records, a music production company. From1979 to 1997, Mr. Field served as Chairman of the Board and ChiefExecutive Officer of Interscope Communications, Inc.

*Jonathan V. Diamond*. Mr. Diamond hasserved as our Chief Executive Officer and director since September 2003.From January 2003 to the present, he has also served as the Chairman,Chief Executive Officer and a director of YouthStream Media Networks, Inc., apublicly-traded company (YSTM. PK). He was the co-founder of N2K, Inc. andserved as its Vice Chairman and Chief Executive Officer through its 1999 mergerwith CDnow, Inc., an e-commerce company. He continued to serve as Chairman ofthe combined company until its sale to Bertelsmann Music Group inAugust 2000. Mr. Diamond was a co-founder of GRP Records, anindependent music label acquired by MCA in 1990. Mr. Diamond holds anM.B.A. from the Columbia University Graduate School of Business and a B.A. inEconomics and Music from the University of Michigan Honors College.

*Robert N. Weingarten*. Mr. Weingartenhas served as our Chief Financial Officer and Secretary sinceJanuary 2004. From July 1992 to present, Mr. Weingarten has beenthe sole shareholder of Resource One Group, Inc., a financial consulting andadvisory company. From February 2003 to present, he has served as theChief Financial Officer of YouthStream Media Networks, Inc., a publicly tradedcompany (YSTM. PK). Since 1979, Mr. Weingarten has served as a consultantto numerous public companies in various stages of development, operation orreorganization. Mr. Weingarten received an M.B.A. Degree in Finance fromthe University of Southern California in 1975 and a B.A. Degree in Accountingfrom the University of Washington in 1974. Mr. Weingarten currentlyserves as a director of Resource Ventures, Inc., which is a non-trading publiccompany.

*Teymour Boutros-Ghali*. Mr. Boutros-Ghali hasserved as director since January 2005. From January 2002 to the present, Mr.Boutros-Ghali has served as Managing Partner of Monitor Ventures, anearly-stage venture capital firm. From January 2000 to January 2002, he servedas an angel investor and 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 Massachusetts Instituteof Technology and his BA from Cambridge University.

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*Eric Pulier*. Mr. Pulier has served asa director since November 2004. Currently, Mr. Pulier serves as theFounder and Executive Chairman of SOA Software, Inc., a position which he hasheld since 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, and the Center forTelecommunications Management. Mr. Pulier has been a pioneer in thesoftware and digital interactive industries for over 15 years. He has beeninstrumental in establishing ground-breaking companies in several sectorsincluding corporate communications, professional services, security andenterprise software. Mr. Pulier is a Magna Cum Laude graduate of Harvard University.

*Dimitri Villard*. Mr. Villard has served asa director since January 2005. Mr. Villard has also served as President and adirector of Pivotal BioSciences, Inc., a biotechonology company, sinceSeptember 1998. In addition, since January 1982 to present, he has served asPresident and director of Byzantine Productions, Inc. Previously, Mr. Villardwas a director at the investment banking firm of SG Cowen and affiliatedentities, a position he held from January 1997 to July 1999. Mr. Villard currentlyserves as Chairman of the Board of Dax Solutions, Inc., (“Dax”) anentertainment industry digital asset management venture. He has served as adirector of Dax since May 2004. He is also a member of the Executive Committeeof the Los Angeles chapter of the Tech Coast Angels, a private venture capitalgroup. Mr. Villard received a B.A. Degree in Government from Harvard Universityin 1964 and also received a Master of Science degree from China InternationalMedical University.

*James N. Lane*. Mr. Lane has served asa director since May 2005. Mr. Lane has also served as Chairman andChief Executive Officer of Devonwood Capital Partners, a private equity firmsince 2002. From 1997-2002, Mr. Lane was Chairman and Chief ExecutiveOfficer of SG Capital Partners, a private equity firm affiliated with SocieteGeneral and SG Cowen Securities, managing over $800 million of capital.Prior to establishing SG Capital Partners, Mr. Lane’s career spannedapproximately 20 years at Goldman Sachs, & Co. He was a former GeneralPartner and founding member and Co-Head of Goldman Sachs’ Principal InvestmentArea, which invested and managed several billion dollars of the firm’s andclients’ money in private equity investments. Mr. Lane’s responsibilitiesincluded managing the Leveraged Finance group in New York and the EuropeanCorporate Finance and Merchant Banking businesses in London. Mr. Lane earnedhis B.A. degree, cum laude, from Wheaton College and his M.B.A., with highesthonors, from Columbia University.

*Fred Davis.*Mr. Davis has served as adirector since November 2005. Mr. Davis currently serves as a partner at themusic law firm of Davis, Shapiro, Lewit, Montone & Hayes (formerly Davis& Shapiro), which he co-founded in 1997. Prior to 1997, Mr. Davis served asan Executive Vice President at EMI Records. Mr. Davis received his bachelorsdegree from Tufts University and his J.D. degree from Fordham School of Law.

*Randy Saaf*. Mr. Saaf currently servesas Chief Executive Officer of our wholly-owned subsidiary MediaDefender, whichwas acquired on July 28, 2005. Mr. Saaf previously served as bothPresident and Chief Executive Officer of MediaDefender since he co-founded thecompany in July 2000. Mr. Saaf received his Bachelor of Sciencedegree in Engineering from Harvey Mudd College in 1998.

*Octavio Herrera*. Mr. Herreracurrently serves as President of our wholly-owned subsidiary MediaDefender,which was acquired on July 28, 2005. Mr. Herrera previously served as VP,Business Development and Chief Financial Officer of MediaDefender since heco-founded the company in July 2000. Mr. Herrera received his Bachelor ofScience degree in Physics from Occidental College in 1998.

*Nicholas Turner*. Mr. Turner hasserved as our Vice President, Business Development sinceJanuary 2006.  Mr. Turner previouslyserved as Executive Vice President, Business Development from January 2005 toDecember 2005. Mr. Turner has over 20 years experience as a seniorlevel executive and entrepreneur in the entertainment and new media industries.Mr. Turner has been a professional recording musician, artist manager, recordproducer, new media pioneer and record label marketing executive, as well ascharity event creator and fundraiser. Mr. Turner has extensive expertisein guiding companies through the transition from the analog to digital world.During the last 10 years, Mr. Turner has held senior executivepositions with various companies, including N2K, Inc. and CDnow, Inc., withresponsibility for marketing and revenue generation activities.

*Family Relationships*

None.

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***AuditCommittee***

The Board re-established an Audit Committee inNovember 2005. The Audit Committee’s responsibilities include, but are notlimited to:

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

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

·                  discussing oursystems of internal control over financial reporting, and

·                  meetingindependently with the independent registered public accounting firm andmanagement.

The AuditCommittee currently consists of James N. Lane and Dimitri Villard, both of whomare “independent” under the listing standards of the American Stock Exchange.As the Company’s stock is traded on the OTC Bulletin Board, the Company haschosen to use the definition of “independent” under the listing standards ofthe American Stock Exchange. Mr. Lane qualifies as a “financial expert”under Item 401 of Regulation S-B of the Securities and Exchange Act of 1934, asamended.

***Consideration of Director-Nominees***

*Stockholder Nominees.*   TheBoard will consider nominees to the Board proposed by stockholders, althoughthe Board has no formal policy with regard to stockholder nominees as itconsiders all nominees on their merits as discussed below. Any stockholdernominations proposed for consideration should include the nominee’s name andqualifications for Board membership and should be addressed to the attention ofSecretary, ARTISTdirect, Inc., 1601 Cloverfield Boulevard, Suite 400South, Santa Monica, California 90404-4082.

Stockholderswho wish to submit a director-nominee for consideration at the next annualmeeting of stockholders, but who do not wish to submit the nominee forinclusion in our proxy statement, must, in accordance with our bylaws, deliverthe information no earlier than the close of business on the 120th day prior tothe first anniversary of the mailing of our proxy statement from the prioryear. In the event that the date of the annual meeting of stockholders isadvanced by more than 30 days or delayed by more than 60 days from the firstanniversary of the preceding year’s annual meeting of stockholders, then noticemust be delivered not earlier than the 90th day prior to such annual meetingand no later than the close of business on the later of the 60th day prior tosuch annual meeting of stockholders or the tenth day following the day on whichpublic announcement of the date of such meeting is first made. With respect toeach person whom the stockholder proposes to nominate for election orreelection as a director, the proposing stockholder must provide the following:

(a)                                  allinformation relating to such person that is required to be disclosed pursuantto Regulation 14A under the Exchange Act of 1934, as amended (including suchperson’s written consent to being named in the proxy statement as a nominee andto serving as a director if elected);

(b)                                 thename and address of the stockholder who intends to make the nomination and ofthe person or persons to be nominated;

(c)                                  arepresentation that the stockholder is a holder of record of stock of theCompany entitled to vote at such meeting and intends to appear in person or byproxy at the meeting and nominate the person or persons specified in thenotice;

(d)                                 adescription of all arrangements or understandings between the stockholder andeach nominee and any other person or persons (naming such person or persons)pursuant to which the nomination or nominations are to be made by the stockholder;and such other information regarding each nominee proposed by such stockholderas would be required to be included in a proxy statement filed pursuant to theproxy rules of the Securities and Exchange Commission had the nominee beennominated, or intended to be nominated, by the Board.

Theproposing stockholder and the beneficial owner, if any, on whose behalf thenomination is made must also provide (a) the name and address of suchstockholder, as it appears on the Company’s books, and of such beneficial ownerand (b) the number of shares of each class of stock of the Company thatare owned beneficially and of record by such stockholder and such beneficialowner.

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*Selection and Evaluationof Director Candidates.**  *TheBoard is responsible for identifying candidates for membership on the Board andmakes determinations as to whether to recommend such candidates nomination tothe Board based on such nominee’s character, judgment, and business andfinancial experience, as well as their ability to add to the Board’s existingstrengths. This assessment typically includes issues of expertise in industriesimportant to us, functional expertise in areas such as marketing, humanresources, operations, finance, and information technology and an assessment ofan individual’s abilities to work constructively with the existing Board andmanagement, all in the context of an assessment of the perceived needs of theBoard at that point in time. The Board does not have any written specificminimum qualifications or skills that a candidate must meet in order to serveon the Board. The Board identifies nominees by first evaluating the currentmembers of the Board qualified and willing to continue in service. Currentmembers of the Board with skills and experience that are relevant to ourbusiness and who are willing to continue in service are considered forre-nomination, balancing the value of continuity of service by existing membersof the Board with that of obtaining a new perspective. If any member of theBoard does not to wish to continue in service or if the majority of the Boarddecides not to re-nominate a member for re-election, the Board identifies thedesired skills and experience of a new nominee in light of the following criteria.When identifying and evaluating new directors, the Board considers thediversity and mix of the existing Board, including, but not limited to, suchfactors as: employment experience, public interest considerations and theimplementation of our strategic plan. Among other things, when examining aspecific candidate’s qualifications, the Board considers: the ability torepresent our best interests, existing relationships with us, interest in theaffairs and our purpose, the ability to fulfill director responsibilities,leadership skill, integrity, business and financial judgment, ability todevelop business for us and the ability to work as a member of a team.

In fiscal 2005,directors Teymour Boutros-Ghali, Dimitri Villard, James N. Lane and Fred Davis wererecommended as director-nominees by our Chief Executive Officer.

**Section 16(a) Beneficial Ownership Complianc*e***

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 of ownership andchanges in ownership with the Securities and Exchange Commission. The ReportingPersons are required by Securities and Exchange Commission regulation tofurnish our with copies of all Section 16(a) forms they file.

To ourknowledge, based solely on our review of the copies of such forms received byus, or written representations from the Reporting Persons, the followingSection 16(a) forms were not timely filed during fiscal 2005:
| Name                  | ** ** | **Date of Earliest  Transaction** | ** ** | **Date of  Signature** | ** ** | **Form** |
|-----------------------|------------|---------------------------------------------|------------|-----------------------------|------------|----------|
| Teymour Boutros-Ghali |       | 7/28/05                                     |       | 11/07/05                    |       | 4        |
| Jonathan V. Diamond   |       | 7/28/05                                     |       | 11/10/05                    |       | 4        |
| James N. Lane         |       | 09/09/05                                    |       | 09/19/05                    |       | 4        |
| Dimitri Villard       |       | 09/09/05                                    |       | 09/19/05                    |       | 4        |
| WNT07 Holdings, LLC   |       | 07/28/05                                    |       | 08/26/05                    |       | 3        |
| Eric Pulier           |       | 07/27/05                                    |       | 08/03/05                    |       | 4        |
| James N. Lane         |       | 07/27/05                                    |       | 08/03/05                    |       | 4        |
| James N. Lane         |       | 05/12/05                                    |       | 06/01/05                    |       | 3        |
| Nicholas Turner       |       | 01/01/05                                    |       | 05/18/05                    |       | 3        |

 

**Codeof Ethics**

Wehave adopted a Code of Ethics that applies to each of our employees, executiveofficers and directors. A copy is available free of charge on the Internet atwww.sec.gov. The Code of Ethics was filed as Exhibit 14.1 to our annualreport for the fiscal year ended December 31, 2003. Any amendment to orwaiver of the Code of Ethics will be disclosed promptly following the date ofsuch amendment or waiver in a Current Report on Form 8-K filing with theSecurities and Exchange Commission.

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** **
| **ITEM 10.** | **EXECUTIVE COMPENSATION** |
|--------------|----------------------------|

 

Thefollowing table provides certain summary information concerning thecompensation earned by our Chief Executive Officer and each of our four othermost highly compensated executive officers whose salary and bonus for the 2005fiscal year was in excess of $100,000, for services rendered in all capacitiesfor the fiscal years ended December 31, 2003, 2004 and 2005, respectively.No other executive officers who would have otherwise been includable in suchtable on the basis of salary and bonus earned for the fiscal year has beenexcluded by reason of his or her termination of employment or change inexecutive status during that year. The listed individuals shall be hereinafterreferred to as the “named executive officers.”

**SUMMARYCOMPENSATION TABLE**
|                                                         | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Long-Term Compensation Awards** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------------------------|------------|---------------------------------------------|------------|
| **Name and   Principal Positions**       | ** ** | **Year**   | ** ** | **Salary ($)**          | ** ** | **Bonus ($)**                          | ** ** | **Other  Annual  Compensation  ($) (2)** | ** ** | **Restricted  Stock  Awards  ($)** | ** ** | **Securities  Underlying  Options/  SARs(#)** | ** ** | **LTIP  Payouts  ($)** | ** ** | **All  Other  Compensation  ($)** | ** ** |
|                                                    |       |       |       |                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Jonathan V. Diamond                                     |       | 2005       |       | 267,250                      |       | 75,000                                      | (1)        | 8,550 |   |   |   | 2,753,098 |   |   |   |   |   |
| Chief Executive Officer                                 |       | 2004       |       | 185,000                      |       |                                        |       | 7,800 |   |   |   |   |   |   |   |   |   |
|                                                         |       | 2003       |       | 46,250                       |       | 4,315                                       |       | 1,950 |   |   |   | 259,659 |   |   |   |   |   |
| Robert N. Weingarten                                    |       | 2005       |       | 147,250                      |       | 50,000                                      | (1)        | 4,000 |   |   |   | 550,000 |   |   |   |   |   |
| Chief Financial  Officer                                |       | 2004       |       | 120,000                      |       |                                        |       |   |   |   |   | 120,000 |   |   |   |   |   |
|                                                    |       | 2003       |       |                         |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Nicholas Turner                                         |       | 2005       |       | 137,500                      |       | 40,000                                      | (1)        |   |   |   |   | 92,000 |   |   |   |   |   |
| VP, Business Development                                |       | 2004       |       | 47,000                       | (3)        |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Randy Saaf  Chief Executive Officer, MediaDefender |       | 2005       |       | 147,880                      | (4)        |                                        |       | 1,000 |   |   |   | 200,000 |   |   |   |   |   |
| Octavio Herrera  President, MediaDefender               |       | 2005       |       | 147,880                      | (4)        |                                        |       | 1,926 |   |   |   | 200,000 |   |   |   |   |   |

 

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(1)          Representsdiscretionary cash bonuses awarded to our Chief Executive Officer and ChiefFinancial Officer. We awarded such bonuses as consideration for managementsuccessfully completing our corporate restructuring during the three monthsended March 31, 2005. Such bonuses were paid in fiscal 2005. We alsoawarded a discretionary cash bonus to our VP, Business Development of $40,000,which was reviewed and approved by the Compensation Committee of our Board ofDirectors, and was accrued at December 31, 2005.

(2)          Consists ofcar allowance.

(3)          Served as aconsultant in fiscal 2004.

(4)          Retainedeffective July 28, 2005.

Thefollowing table sets forth certain information regarding stock options grantedto our named executive officers during the year ended December 31, 2005.

**OPTIONS/ SAR GRANTS IN LAST FISCALYEAR**
| ** **           | ** ** | **Number of  Securities  Underlying  Options** | ** ** | **Percent of  Total Options  Granted to  Employees in** | ** ** | **Exercise  Price per** | ** ** | **Expiration** | ** ** |
|----------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|------------------------------|------------|----------------|------------|
| **Name**             | ** ** | **Granted**(1)                                      | ** ** | **2004**(2)                                                                 | ** ** | **Share ($)**           | ** ** | **Date**       | ** ** |
| Jonathan V. Diamond  |       | 2,753,098                                           |       | 72.5                                                                        | %          | $                            | 1.55       |           | 08/05/10   |   |
| Robert N. Weingarten |       | 550,000                                             |       | 14.5                                                                        | %          | $                            | 1.55       |           | 08/05/10   |   |
| Nicholas Turner      |       | 92,000                                              |       | 2.4                                                                         | %          | $                            | 0.79       |           | 01/01/12   |   |
| Randy Saaf           |       | 200,000                                             |       | 5.3                                                                         | %          | $                            | 3.00       |           | 07/28/12   |   |
| Octavio Herrera      |       | 200,000                                             |       | 5.3                                                                         | %          | $                            | 3.00       |           | 07/28/12   |   |

 

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(1)          Each option representsthe right to purchase one share of common stock.

(2)          During the year endedDecember 31, 2005, we granted options to management and employees topurchase an aggregate of 3,795,098 shares of common stock with exercise pricesranging from $0.79 - $3.00 per share.

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Thefollowing table provides information, with respect to the named executiveofficers, concerning unexercised stock options held by them atDecember 31, 2005. None of the named executive officers exercised anystock options during 2005.

**AGGREGATED OPTION FISCAL YEAR-ENDVALUES**
|                      | ** ** | **Shares  Acquired on** | ** ** | ** **                       | ** ** | **Number of Securities  Underlying Unexercised  Options at  Fiscal Year End** | ** ** | **Value of Unexercised  In-the-Money  Options at  Fiscal Year End ($)(1)** | ** ** |
|----------------------|------------|------------------------------|------------|----------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| **Name**             | ** ** | **Exercise (#)**        | ** ** | **Value Realized ($)** | ** ** | **Exercisable**                                                                                             | ** ** | **Unexercisable**                                                                                        | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Jonathan V. Diamond  |       | —                       |       | —                           |       | 210,973                                                                                                     |       | 2,801,784                                                                                                |       | 516,884 |   | 4,937,202 |   |
| Robert N. Weingarten |       | —                       |       | —                           |       | 70,000                                                                                                      |       | 600,000                                                                                                  |       | 196,000 |   | 1,102,500 |   |
| Nicholas Turner      |       | —                       |       | —                           |       | 92,000                                                                                                      |       | —                                                                                                   |       | 230,920 |   | — |   |
| Randy Saaf           |       | —                       |       | —                           |       | 23,810                                                                                                      |       | 176,190                                                                                                  |       | 7,143 |   | 52,857 |   |
| Octavio Herrera      |       | —                       |       | —                           |       | 23,810                                                                                                      |       | 176,190                                                                                                  |       | 7,143 |   | 52,857 |   |

 

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(1)          Basedon December 30, 2005 closing stock price of $3.30 per share. December 30thwas the last trading day in fiscal 2005.

**CurrentEmployment Contracts and Termination of Employment, Change-in-ControlAgreements**

OnJuly 28, 2005, we entered into an Employment Agreement with Jonathan V.Diamond, our Chief Executive Officer. During the term of the EmploymentAgreement, which shall continue through December 31, 2008,Mr. Diamond will earn a base salary of no less than $350,000 per annum,plus certain specified perquisites that include a monthly car allowance. He isalso eligible to receive a discretionary bonus of up to 100% of base salary, asdetermined by the Compensation Committee of the Board of Directors or, if none,the Board, and a performance bonus of up to 100% of base salary if we achievespecified earnings targets in fiscal 2007 and 2008. Mr. Diamond shall alsobe entitled to receive stock options at the discretion of the Board ofDirectors. In the event Mr. Diamond is terminated “without cause,” he shall 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.

OnJuly 28, 2005, we entered into an Employment Agreement with Robert N.Weingarten, our Chief Financial Officer. During the term of the EmploymentAgreement, which shall continue through December 31, 2008,Mr. Weingarten will earn a base salary of no less than $195,000 per annum,plus certain specified perquisites that include a monthly car allowance. He isalso eligible to receive a discretionary bonus of up to 100% of base salary, asdetermined by the Compensation Committee of the Board of Directors or, if none,the Board, and a performance bonus of up to 100% of base salary if we achievespecified earnings targets in fiscal 2007 and 2008. Mr. Weingarten shallalso be entitled to receive stock options at the discretion of the Board ofDirectors. In the event Mr. Weingarten is terminated “without cause,” he shallbe entitled to receive 12 months of severance pay at the rate of 100% ofhis monthly 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.

Inaccordance with the Merger Agreement, we acknowledged the terms of EmploymentAgreements entered into on July 28, 2005 by MediaDefender with each ofRandy Saaf, who will serve as Chief Executive Officer of MediaDefender, andOctavio Herrera, who will serve as President of MediaDefender. Each ofMessrs. Saaf and Herrera will earn a base salary of no less than $350,000per annum during the initial term of the agreements, which shall continue untilDecember 31, 2008. Both are also entitled to receive performance bonusesof up to $350,000 if MediaDefender achieves specified earnings targets infiscal 2007 and 2008. Each are entitled to receive 12 months of severancepay at the rate of 100% of his monthly salary and the pro-rata portion of theperformance bonus referenced above if they are terminated “without cause.”Additionally, we granted stock options to purchase up to 200,000 shares ofcommon stock to each of Messrs. Saaf and Herrera.

EffectiveJanuary 1, 2005, we entered into a one-year agreement with Nicholas Turner toserve as our Executive Vice President with a base annual salary of $120,000 peryear, plus certain perquisites benefits. In conjunction with the consultingagreement, the Company granted Mr. Turner a non-plan, non-qualified stockoption to purchase 92,000 shares of Common Stock at an exercise price of $0.79per share, which was the approximate fair market value of the Common Stock onthe date of grant, vesting monthly over a period of two years. We are currentlynegotiating an extension to this agreement with Mr. Turner to serve as VicePresident, Business Development.

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**Director Compensation**

***Fiscal 2005***

Messrs. Villard and Lane received $50,000 in cashcompensation for services rendered as “independent” members of the Board infiscal 2005.

Messrs. Field,Diamond, Pulier, Boutros-Ghali and Davis received no compensation for servicesrendered as members of the Board in fiscal 2005.

***Fiscal 2006***

Directors who are not our employees will receive thefollowing compensation in fiscal 2006:

·                  *Cash:* a cash retainer of $15,000, payable in equalinstallments of $7,500 in the third and fourth quarter of fiscal 2006; and

·                  *Equity*: a grant of stock options having a value (based uponappropriate Black-Scholes option valuation methodology) equal to $35,000. Thestrike price for the options will be set on the date of grant and the optionwill vest entirely on December 31, 2006.

Inaddition, each director that serves on a Committee of the Board will receivethe following compensation in fiscal 2006:

·                  *Cash:* for each committee served, an additional cash retainerof $10,000, payable in equal installments of $5,000 in the third and fourthquarter of fiscal 2006; and

·                  *Equity:* grant of stock options having a value equal to$15,000, and having the same terms and conditions as options granted to allnon-employee Board members generally.

Anynew directors joining the Board in fiscal 2006 will receive a one-time grant ofstock options having a value equal to $25,000, a three-year vesting term andotherwise having the same terms and conditions as options granted to allnon-employee Board members generally. Mr. Davis will be considered a newdirector for purposes of the foregoing.

Mr. Diamond,our President and Chief Executive Officer, will not be entitled to anyadditional compensation for services rendered as a member of the Board infiscal 2006.

All directors arereimbursed for reasonable out-of-pocket expenses incurred in attending meetingsof the Board or any committee of the Board.

47

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| **ITEM 11.** | **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS  AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS** |
|--------------|-----------------------------------------------------------------------------------------------------|

 

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

Thefollowing table provides information as of December 31, 2005 regardingcompensation plans (including individual compensation arrangements) under whichequity securities of our company are authorized for issuance.
| **Plan Category**                                      | ** ** | **Number of Securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                              | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                          | ** ** |
| Equity compensation  plans approved by security holders     |       | 302,370                                                                                                                                              |       | $                                                                                                           | 7.50       |                                                                                                                                                                                                             | 142,110    |   |
| Equity compensation  plans not approved by security holders |       | 4,765,379                                                                                                                                            |       | $                                                                                                           | 3.22       |                                                                                                                                                                                                             | 1,942,731  |   |
| Total                                                       |       | 5,067,749                                                                                                                                            |       | $                                                                                                           | 3.46       |                                                                                                                                                                                                             | 2,084,841  |   |

 

*The 1999 Employee Stock OptionPlan*

The 1999 EmployeeStock Option 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.

The 1999 EmployeeStock Option Plan is a non-stockholder approved plan under which optionsmay 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 2% of the total number of shares of our common stock outstanding on the lasttrading day in December in the immediately preceding calendar year,provided that no annual increase shall exceed 87,500.

All option grantsunder the 1999 Employee Stock Option Plan will have an exercise price per shareequal to the fair market value per share of our common stock on the grant date,subject to certain adjustments for stock splits, recapitalizations and similartransactions. Each option will vest in installments over the optionee’s periodof service with us. The options will vest on an accelerated basis in the eventwe are acquired and those options are not assumed or replaced by the acquiringentity. The options that were granted while we were a limited liabilitycompany, however, will terminate in the event we are acquired and those optionsare not assumed by the acquiring entity (unless their vesting is accelerated byour Compensation Committee). Each option will have a maximum term (not to exceed10 years) set by the plan administrator at the time of grant, subject toearlier termination following the optionee’s cessation of employment. Alloptions are non-statutory options under the Federal tax law, unless they areincentive stock options granted to employees.

*The 1999 Artist Plan*

The 1999 ArtistPlan became effective on October 6, 1999 in connection with our conversionfrom ARTISTdirect, LLC into ARTISTdirect, Inc. All options to purchasemembership units in the limited liability company which were outstanding at thetime of such conversion were assumed by the corporation and converted intooptions for shares of our common stock. The number of shares subject to eachassumed and converted option was equal to the number of membership units in thelimited liability company which were subject to that option immediately priorto the conversion, and the exercise price per share remained the same as theper unit exercise price in effect under the option at the time of conversion.Except for the conversion of the securities subject to the option into sharesof our common stock, each option will continue to be governed by the terms ofthe agreement evidencing that option at the time of our conversion into acorporation.

48

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The 1999 ArtistPlan is a non-stockholder approved plan under which options were granted toperforming artists who provided products and services through the ARTISTchannelWeb sites we operate and maintain for them pursuant to ARTISTchannel agreements.The number of shares of common stock issuable over the term of the 1999 ArtistPlan was initially 400,000 shares and automatically increases each year by 2%of the total number of shares of our common stock outstanding on the lasttrading day in December in the immediately preceding calendar year,provided that no annual increase shall exceed 87,500.

All option grantsunder the 1999 Artist Plan have an exercise price per share equal to the fairmarket value per share of our common stock on the grant date. Each option vestsin installments over the period the optionee’s ARTISTchannel agreement remainsin effect. The options will vest on an accelerated basis in the eventARTISTdirect is acquired and those options are not assumed or replaced by theacquiring entity. Each option has a maximum term (not to exceed 10 years)set by the plan administrator (our Compensation Committee) at the time ofgrant, subject to earlier termination following the termination of the optionee’sARTISTchannel agreement. All options are non-statutory options under the Federaltax law.

*The 1999 Artist and ArtistAdvisor Plan*

The 1999 Artistand Artist Advisor Plan became effective on October 6, 1999 in connectionwith our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc. Alloptions 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.

The 1999 Artistand Artist Advisor Plan is a non-stockholder approved plan under which optionswere granted to performing artists and their attorneys, business managers,agents and other advisors who provided services to us. The number of shares ofcommon stock issuable over the term of the 1999 Artist and Artist Advisor StockOption Plan was initially 185,000 shares and increased by 37,500 shares onJanuary 1, 2001 and 2002, respectively to a total of 260,000 as ofDecember 31, 2002 (subject to adjustment for certain changes in ourcapital structure). The share reserve will automatically increase on the firsttrading day in January each calendar year by an amount equal to 1% of thetotal number of shares of our common stock outstanding on the last trading dayin December in the immediately preceding calendar year, but in no eventwill any such annual increase exceed 37,500 shares.

All option grantsunder the 1999 Artist and Artist Advisor Stock Option Plan have an exerciseprice per share equal to the fair market value per share of our common stock onthe grant date. Each option vests in installments over the optionee’s period ofservice with us. The options will vest on an accelerated basis in the event weare acquired and those options are not assumed or replaced by the acquiringentity. Each option has a maximum term (not to exceed 10 years) set by theplan administrator at the time of grant, subject to earlier terminationfollowing the termination of the optionee’s service for cause. All options arenon-statutory options under the Federal tax law.

Share issuancesunder the 1999 Employee Stock Option Plan, the 1999 Artist Plan and the 1999Artist and Artist Advisor Plan will not reduce or otherwise affect the numberof shares of common stock available for issuance under the 1999 Employee StockPurchase Plan, and share issuances under 1999 Employee Stock Purchase Plan willnot reduce or otherwise affect the number of shares of common stock availablefor issuance under the 1999 Employee Stock Option Plan, the 1999 Artist Planand the 1999 Artist and Artist Advisor Plan.

*2004 Consultant 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 onSeptember 29, 2014, and provides for the issuance of up to 500,000 sharesof common stock to consultants at fair market value. The 2004 Consultant StockPlan is a non-stockholder approved plan.

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

On September 23,2003, we issued Jonathan Diamond, our President and Chief Executive Officer, anon-plan, non-qualified stock option to purchase 259,659 shares of common stockexercisable at $0.85 per share, which was the approximate fair market value ofthe common stock on the date of grant, through August 15, 2010.

49

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On January 9,2004, we issued Keith Yokomoto, our former President and Chief OperatingOfficer, two non-plan, non-qualified stock options to purchase 10,000 sharesand 50,000 shares of common stock, respectively, both exercisable at $0.50 pershare, which was not less than the fair market value on the date of grant,through January 9, 2011. The option for 10,000 shares was immediately vestedupon issuance. The option for 50,000 shares was scheduled to vest in incrementsof 10,000 shares on February 1, 2004, March 31, 2004, June 30, 2004, September30, 2004 and December 31, 2004, based on the accomplishment of certainmilestones by each respective date, which were not attained. Accordingly, theoption for 50,000 shares did not vest and thus expired.

On March 29, 2004,we issued Robert Weingarten, our Chief Financial Officer, a non-plan,non-qualified stock option to purchase 120,000 shares of common stockexercisable at $0.50 per share, which was not less than the fair market valueon the date of grant, through March 29, 2011. The option vests and becomesexercisable in a series of 36 successive equal monthly installments upon theoptionee’s completion of service measured from March 29, 2004.

On January 1, 2005we issued Nicholas Turner, our Vice President, Business Development, anon-plan, non-qualified stock option to purchase 92,000 shares of common stockat an exercise price of $0.79 per share, which was the approximate fair marketvalue of the common stock on the date of grant, vesting monthly over a periodof two years.

On August 25,2005, 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 fair marketvalue of the common stock on the date of grant, through August 25, 2010.  Approximately 38 percent of such stockoptions vests at the rate of 1/3rd per year over a three-year period and theremaining approximately 62 percent vests upon the achievement of certainfinancial milestones by ARTISTdirect.

On August 25, 2005,we issued Robert Weingarten, our Chief Financial Officer, a non-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 stock option vests at the rate of 1/3 per year over athree year period and one half will vest upon the achievement of certainfinancial milestones by ARTISTdirect.

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

**BeneficialOwnership**

Thefollowing table sets forth information with respect to the following:(i) each person who beneficially owns more than five percent (5%) of ourvoting securities, (ii) each of our executive officers and directors and(iii) all of our executive officers and directors as a group. Percentagesare based on 6,921,457 shares of our common stock outstanding as of April 1,2006.
| **Beneficial Owner(1)**                                                                                                         | ** ** | **Title of Class  of Stock** | ** ** | **Amount and Nature  of Beneficial  Ownership(2)** | ** ** | **Percent  of Class** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------|------------|
| *5% Stockholders:*                                                                                                                   |       |                                        |       |                                                              |       |                       |       |
| JMB Capital Partners,  L.P.  1999 Avenue of the Stars, Suite 2040  Los Angeles, California 90067                                |       | Common                                      |       | 2,166,667                                                         | (3)        | 23.8                       |       |
|                                                                                                                                 |       |                                        |       |                                                              |       |                       |       |
| WNTO7 Holdings, LLC  c/o Wayne, Gaynor, Umanoff & Pollack, LLP  6100 Center Drive, Suite 950  Los Angeles, California 90045 |       | Common                                      |       | 1,224,017                                                         | (4)        | 17.4                       |       |
|                                                                                                                                 |       |                                        |       |                                                              |       |                       |       |
| CCM Master Qualified Fund,  Ltd.  One North Wacker Drive, Suite 4725  Chicago, Illinois 60606                                   |       | Common                                      |       | 725,268                                                           | (5)        | 9.5                        | (6)        |
|                                                                                                                                 |       |                                        |       |                                                              |       |                       |       |
| Act II Master Fund,  Ltd.  444 Madison Avenue  New York, New York 10022                                                              |       | Common                                      |       | 465,300                                                           | (7)        | 6.7                        |       |
|                                                                                                                                 |       |                                        |       |                                                              |       |                       |       |
| Rick Rubin c/o Alan S. Halfon & Company  9595 Wilshire Boulevard, Suite 505  Beverly Hills, California 90212                |       | Common                                      |       | 362,022                                                           |       | 5.2                        |       |

 

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| **Beneficial Owner(1)**                                         | ** ** | **Title of Class  of Stock** | ** ** | **Amount and Nature  of Beneficial  Ownership(2)** | ** ** | **Percent  of Class** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------|------------|
| *Current Executive Officers and  Directors:*                         |       |                                        |       |                                                              |       |                       |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Frederick W. Field                                                   |       | Common                                      |       | 302,370                                                           | (8)        | 4.1                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Jonathan V. Diamond                                                  |       | Common                                      |       | 238,021                                                           | (8)        | 3.3                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Robert N. Weingarten                                                 |       | Common                                      |       | 86,666                                                            | (8)        | 1.2                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Teymour Boutros-Ghali                                                |       | Common                                      |       | 183,603                                                           | (9)        | 2.6                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Eric Pulier                                                          |       | Common                                      |       | 1,040,414                                                         | (10)       | 14.8                       |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Dimitri Villard                                                      |       | Common                                      |       | 85,000                                                            | (8)        | 1.2                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| James N. Lane                                                        |       | Common                                      |       | 85,000                                                            | (8)        | 1.2                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Fred Davis                                                           |       | Common                                      |       | 0                                                                 |       |                       | *          |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Randy Saaf                                                           |       | Common                                      |       | 167,377                                                           | (11)       | 2.3                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Octavio Herrera                                                      |       | Common                                      |       | 167,377                                                           | (11)       | 2.3                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| Nicholas Turner                                                      |       | Common                                      |       | 92,000                                                            | (9)        | 1.3                        |       |
|                                                                 |       |                                        |       |                                                              |       |                       |       |
| All current directors and executive officers as a group (11 Persons) |       | Common                                      |       | 2,447,828                                                         | (12)       | 29.6                       |       |

 

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*                 Indicates lessthan 1.0%

(1)          Unless otherwiseindicated, the address for each of the individuals listed in the table is c/oARTISTdirect, Inc., 1601 Cloverfield Boulevard, Suite 400 South, Santa Monica,California, 90404-4082.

(2)          Unless otherwiseindicated by footnote, the persons named in the table have sole voting and soleinvestment power with respect to all shares of common stock shown asbeneficially owned by them, subject to applicable community property laws.

(3)          Consists solely of awarrant to purchase 2,166,667 shares of common stock that may be exercisedwithin 60 days of April 1, 2006. We received an exercise election formfrom this holder dated as of April 27, 2006 to purchase the entire amount.

(4)          Includes 114,985 sharesof common stock that may be exercised within 60 days of April 1, 2006pursuant to a warrant. Members of WNT07 Holdings, LLC include TeymourBoutros-Ghali and FDT Trust-2005. Teymour Boutros-Ghali and Eric Pulier, bothmembers of our Board of Directors are the managing members and have votingpower with respect to the shares.

(5)          Consists solely ofwarrants to purchase shares of common stock that may be exercised within60 days of April 1, 2006.

(6)          CCM Master QualifiedFund, Ltd. was also issued a $13,000,000 principal amount convertiblesubordinated note and a warrant to purchase 691,935 shares of common stock inthe Sub-debt Financing. Both contain a limitation on exercise provision thatprevents CCM Master Qualified Fund, Ltd. from holding more than 9.99% of ouroutstanding common stock.

(7)          Based on a Schedule 13Gfiled on April 4, 2006.

(8)          Consists solely of stockoptions to purchase shares of common stock that are exercisable within60 days of April 1, 2006.

(9)          Refer to footnote(4) above. Mr. Boutros-Ghali holds a 15% economic interest in WNT07Holdings, LLC.

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(10)    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 MyronPulier, the father of Eric Pulier, as determined by Greg Pulier.

(11)    Consists of a warrant topurchase 119,758 shares of common stock and options to purchase47,619 shares of common stock that may be exercised within 60 days ofApril 1, 2006. Messrs. Saaf and Herrera each elected to invest $2,250,000 inthe Sub-Debt Financing. Neither anticipate converting any portion of theirrespective promissory notes within 60 days of April 1, 2006, nor doesmanagement anticipate any conversion shares or interest shares being issued toMr. Saaf or Mr. Herrera within 60 days of April 1, 2006.

(12)    Refer to footnotes(4) and (8)-(11) above.

Beneficialownership is determined in accordance with the Rule 13d-3(a) of theExchange Act and generally includes voting or investment power with respect tosecurities. Except as subject to community property laws, where applicable, theperson named above has sole voting and investment power with respect to allshares of common stock shown as beneficially owned by him/her.

Achange-in-control has not occurred since the beginning of our last fiscal yearend. A change-in-control may occur as a result of the conversion or exercise ofall of the equity-based securities issued in the Senior Financing and theSub-Debt Financing completed by us on July 28, 2005. Assuming maximumconversion or exercise of the equity-based securities issued in these financingtransactions occur, the Senior Financing investors will own approximately 9% ofour common stock, on a fully diluted basis, and the Sub-Debt Financinginvestors will own approximately 55% of our common stock, on a fully dilutedbasis.

**ITEM12.****                       CERTAINRELATIONSHIPS AND RELATED PARTY TRANSACTIONS**

Ourformer administrative offices are located in an office leased by RadarPictures, Inc., a company owned by Frederick W. Field, our Chairman of theBoard, pursuant to a month-to-month arrangement. For the year endedDecember 31, 2005, we paid $90,000 to Radar Pictures, Inc. as rent andfacilities usage expense. The month-to-month arrangement was terminated inMarch 2006.

OnFebruary 28, 2005, we sold our 100% of our interest in ARTISTdirectRecords, Inc. to Radar Records, a company owned by Frederick W. Field, ourChairman of the Board of Directors, for $115,000.

Weissued 1,109,032 shares of common stock and a warrant to purchase up to 114,985shares of common stock with an exercise price of $1.55 per share to WNT07Holdings, LLC upon the closing of the acquisition of MediaDefender. Themanagers of WNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, bothmembers of our Board of Directors. The shares and warrants were issued asconsideration for services provided by Mr. Pulier andMr. Boutros-Ghali as our consultants in connection with the acquisition ofMediaDefender.

RandySaaf and Octavio Herrera, formerly principals and stockholders of MediaDefenderand now both executive officers of our wholly-owned subsidiary MediaDefender,each elected to invest $2,250,000 in the Sub-Debt Financing on the same termsand conditions as the other Sub-Debt Financing investors.

Duringfiscal 2005, we completed the implementation of a new business initiative tocreate global awareness of the ARTISTdirect brand and increase traffic to ourweb-site. Through relationships previously developed by our senior managementin the music and entertainment industry, we began to develop opportunities formajor corporations to sponsor cause-based programs in various parts of theworld in conjunction with music and entertainment celebrities. During the yearended December 31, 2005, we received a fee advance of $35,000 from aninternational non-profit organization with respect to the first such project.This fee advance was budgeted to fund initial planning and oversight andaccordingly, one-half was paid to Jonathan V. Diamond, our Chief ExecutiveOfficer, and one-half was paid to Nicholas Turner, our Executive VicePresident, as a co-producer’s fee.

**ITEM13.****                       EXHIBITS**

The informationrequired by this Item is set forth in the section of this Annual Reportentitled “EXHIBIT INDEX” and is incorporated herein by reference.

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**ITEM14.****                      PRINCIPALACCOUNTANT FEES AND SERVICES**

Aggregatefees billed by GS, our current independent registered public accounting firm,and where indicated, by KPMG, our predecessor independent registered publicaccounting firm, for the years ended December 31, 2005 and 2004,respectfully, are as follows:
|                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
| Audit Fees         |       | $        | 149,585    |     | $          | 161,190 | (2) |
| Audit-Related Fees |       | $        | 85,250     | (1)      | $          | 54,780 | (3) |
| Tax Fees           |       | $        | 48,930     |     | $          | 55,840 |   |
| All Other Fees     |       | $        | 172,350    |     | $          | 0 |   |

 

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(1)          $25,050billed by KPMG.

(2)          $16,000billed by KPMG.

(3)          $1,800billed by KPMG.

Referto ITEM 8 above for information regarding the dismissal of KPMG and thesubsequent hiring of GS as our independent registered public accounting firm.

**Audit Fees; 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.

**All Other Fees**

Allother fees consist of fees for audit-related fees and the audit of financialstatements for MediaDefender.

***Policy on Accounting Matters;Pre-Approval of Audit and Non-Audit Services of Independent Registered PublicAccounting Firm***

Theprimary purpose of the Audit Committee is to assist the Board in monitoring(i) the integrity of our financial statements and disclosures, includingoversight of the accounting and financial reporting processes and the audits ofour financial statements (ii) the compliance by us with our legal, ethicaland regulatory requirements and (iii) the independence and performance ofour independent registered public accounting firm.

TheAudit Committee’s policy is to pre-approve all audit and non-audit services,other than *de minimis* non-audit services, providedby the independent registered public accounting firm. These services mayinclude, among others, audit services, audit-related services, tax services andother services. Pre-approval is generally provided for up to one year and anypre-approval is detailed as to particular service or category of services andis generally subject to a specific budget. The independent registered publicaccounting firm and management are required to periodically report to the fullBoard regarding the extent of services provided by the independent registeredpublic accounting firm in accordance with this pre-approval, and the fees forthe services performed to date.

The AuditCommittee has considered the provision of non-audit services provided by ourindependent registered public accounting firm to be compatible with maintainingtheir independence. The Audit Committee will continue to approve all audit andpermissible non-audit services provided by our independent registered publicaccounting firm. These services may include audit services and relatedservices, tax services, and other services.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|        | ** **     | **ARTISTdirect, Inc.** |
|--------|----------------|------------------------|
|   | ** **     | ** **             | ** ** |
| Date:  | April 16, 2007 | By:                    | /s/ JONATHAN V. DIAMOND |
|   |           |                   | Jonathan V. Diamond |
|   |           |                   | Chief Executive Officer (Principal Executive  Officer) |
|   |           |                   |   |
| Date:  | April 16, 2007 | By:                    | /s/ ROBERT N. WEINGARTEN |
|   |           |                   | Robert N. Weingarten |
|   |           |                   | Chief Financial Officer (Principal Financial  Officer) |

 

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/ FREDERICK W. FIELD    |       | Chairman of the Board of Directors                                    |       | April 16, 2007 |
| Frederick W. Field        |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       | President, Chief Executive Officer and Director                       |       |           |
| /s/ JONATHAN V. DIAMOND   |       | (Principal Executive Officer)                                         |       | April 16, 2007 |
| Jonathan V. Diamond       |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
| /s/ ROBERT N. WEINGARTEN  |       | Chief Financial Officer and Secretary  (Principal Accounting Officer) |       | April 16, 2007 |
| Robert N. Weingarten      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
| /s/ TEYMOUR BOUTROS-GHALI |       | Director                                                              |       | April 16, 2007 |
| Teymour Boutros-Ghali     |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
| /s/ FRED DAVIS            |       | Director                                                              |       | April 16, 2007 |
| Fred Davis                |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
|                      |       |                                                                  |       |           |
| /s/ JAMES LANE            |       | Director                                                              |       | April 16, 2007 |
| James Lane                |       |                                                                  |       |           |

 

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|                     |   |     |   |           |
|---------------------|--------|----------|--------|----------------|
|                |   |     |   |           |
| /s/ ERIC PULIER     |   | Director |   | April 16, 2007 |
| Eric Pulier         |   |     |   |           |
|                |   |     |   |           |
|                |   |     |   |           |
| /s/ DIMITRI VILLARD |   | Director |   | April 16, 2007 |
| Dimitri Villard     |   |     |   |           |
|                |   |     |   |           |
|                |   |     |   |           |

 

 

55

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ARTISTDIRECT, INC.AND SUBSIDIARIES

INDEX TOCONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDEDDECEMBER 31, 2004 AND 2005

**Table of Contents**
| Report of Independent  Registered Public Accounting Firm:                                                      |   |   |
|----------------------------------------------------------------------------------------------------------------|--------|--------|
| Gumbiner  Savett Inc.                                                                                          |   | 57     |
|                                                                                                           |   |   |
| Consolidated Financial Statements:                                                                             |   |   |
| Balance  Sheets — December 31, 2004 and 2005                                                              |   | 58     |
| Statements of Operations —  Years Ended December 31, 2004 and 2005                                        |   | 60     |
| Statements of Comprehensive  Income (Loss) — Years Ended December 31, 2004 and 2005                       |   | 61     |
| Statements of Changes in  Stockholders’ Equity (Deficiency) — Years Ended December 31, 2004 and 2005 |   | 62     |
| Statements of Cash Flows —  Years Ended December 31, 2004 and 2005                                        |   | 63     |
| Notes to  Consolidated Financial Statements — Years Ended December 31, 2004 and 2005                      |   | 65     |

 

56

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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, 2004 and 2005 and the related consolidatedstatements of operations, comprehensive loss, stockholders’ equity (deficiency)and cash flows for the years then ended. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

We conducted ouraudits in accordance with standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudits to obtain reasonable assurance about whether the consolidated financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the consolidatedfinancial statements, an audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall consolidated financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion,the financial statements referred to above present fairly, in all materialrespects, the consolidated financial position of ARTISTdirect, Inc. andsubsidiaries as of December 31, 2004 and 2005, and the consolidated results oftheir operations and their cash flows for the years then ended, in conformitywith accounting principles generally accepted in the United States of America.

As more fullydescribed in Notes 1, 9 and 22, the 2005 consolidated financial statements havebeen restated to adjust the warrant liability and to reflect the recording ofcertain embedded derivatives in the Company’s subordinated debentures.  As such, an event of default has occurredunder its senior and subordinated indebtedness. This could cause a request for accelerated payment of the debt. TheCompany does not have the capital resources necessary to repay acceleratedindebtedness or redemption of the debt. The Company is uncertain regarding the outcome of this default.
| /s/ GUMBINER SAVETT INC.                                                                              |   |   |   |
|-------------------------------------------------------------------------------------------------------|--------|--------|--------|
|                                                                                                  |   |   |
| Santa Monica, California                                                                              |   |   |
| March 30, 2006, except for Notes 1, 6, 9, 14, 20 ,  21, and 22 as to which the date is March 15, 2007 |   |   |

 

57

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedBalance Sheets

(amounts inthousands, except for share data)
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | ** **            | ** ** | **(RESTATED)** | ** ** |
| Assets                                     |       |                  |       |   |   |
| Current assets:                            |       |                  |       |   |   |
| Cash and cash  equivalents                 |       | $                     | 1,156      |   | $ | 3,102 |   |
| Restricted cash                            |       | 175                   |       | 359 |   |
| Accounts  receivable, net                  |       | 751                   |       | 3,667 |   |
| Income taxes  refundable                   |       | —                |       | 1,211 |   |
| Finished goods  inventory, net             |       | 138                   |       | 303 |   |
| Prepaid expenses  and other current assets |       | 58                    |       | 85 |   |
| Assets of  discontinued operations         |       | 16                    |       | — |   |
| Total current  assets                      |       | 2,294                 |       | 8,727 |   |
|                                       |       |                  |       |   |   |
| Property and equipment                     |       | 9,441                 |       | 3,120 |   |
| Less accumulated  depreciation             |       | (9,342                | )          | (1,175 | ) |
| Property and  equipment, net               |       | 99                    |       | 1,945 |   |
|                                       |       |                  |       |   |   |
| Other assets:                              |       |                  |       |   |   |
| Intangible  assets:                        |       |                  |       |   |   |
| Customer  relationships, net               |       | —                |       | 1,950 |   |
| Proprietary  technology, net               |       | —                |       | 6,546 |   |
| Non-compete  agreements, net               |       | —                |       | 1,191 |   |
| Goodwill                                   |       | —                |       | 31,085 |   |
| Total intangible  assets, net              |       | —                |       | 40,772 |   |
| Deferred  financing costs, net             |       | —                |       | 3,300 |   |
| Deposits                                   |       | 20                    |       | 25 |   |
| Total other  assets                        |       | 20                    |       | 44,097 |   |
|                                       |       | $                     | 2,413      |   | $ | 54,769 |   |

 

(continued)

58

----

 
| ** **                                                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                      | ** ** | ** **            | ** ** | **(RESTATED)** | ** ** |
| Liabilities and  Stockholders’ Equity (Deficiency)                                                                                                                                         |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                            |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                |       | $                     | 538        |   | $ | 911 |   |
| Accrued expenses                                                                                                                                                                                |       | 1,274                 |       | 1,923 |   |
| Accrued interest  payable                                                                                                                                                                       |       | —                |       | 607 |   |
| Current portion  of senior secured notes payable                                                                                                                                                |       | —                |       | 390 |   |
| Deferred revenue                                                                                                                                                                                |       | —                |       | 377 |   |
| Warrant  liability                                                                                                                                                                              |       | —                |       | 15,104 |   |
| Derivative  liability                                                                                                                                                                           |       | —                |       | 30,202 |   |
| Guaranteed  payments to MediaDefender management                                                                                                                                                |       | —                |       | 1,050 |   |
| Liabilities of  discontinued operations                                                                                                                                                         |       | 18,920                |       | 149 |   |
| Total current  liabilities                                                                                                                                                                      |       | 20,732                |       | 50,713 |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Long-term liabilities:                                                                                                                                                                          |       |                  |       |   |   |
| Senior secured  notes payable, net of discount of $1,766, less current portion                                                                                                                  |       | —                |       | 12,844 |   |
| Subordinated  convertible notes payable, net of discount of $10,268                                                                                                                             |       | —                |       | 20,806 |   |
| Deferred income  taxes                                                                                                                                                                          |       | —                |       | 264 |   |
| Total long-term  liabilities                                                                                                                                                                    |       | —                |       | 33,914 |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Minority interest –  discontinued operations                                                                                                                                               |       | 1,940                 |       | — |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Commitments and  contingencies                                                                                                                                                                  |       |                  |       |   |   |
|                                                                                                                                                                                            |       |                  |       |   |   |
| Stockholders’ equity  (deficiency):                                                                                                                                                        |       |                  |       |   |   |
| Preferred stock,  $0.01 par value -  Authorized - 5,000,000 shares  Issued and outstanding – none                                                                                          |       | —                |       | — |   |
| Common stock,  $0.01 par value -  Authorized – 60,000,000 shares  Issued and Outstanding – 3,502,117 shares at December 31, 2004 and  4,861,149 shares at December 31, 2005 |       | 38                    |       | 49 |   |
| Treasury stock, 322,902  shares at December 31, 2004 and 0 shares at December 31, 2005, at  cost                                                                                      |       | (3,442                | )          | — |   |
| Additional  paid-in-capital                                                                                                                                                                     |       | 209,135               |       | 208,207 |   |
| Deferred  compensation                                                                                                                                                                          |       | —                |       | (19 | ) |
| Accumulated  deficit                                                                                                                                                                            |       | (225,990              | )          | (238,095 | ) |
| Total  stockholders’ equity (deficiency)                                                                                                                                                   |       | (20,259               | )          | (29,858 | ) |
|                                                                                                                                                                                            |       | $                     | 2,413      |   | $ | 54,769 |   |

 

Seeaccompanying notes to consolidated financial statements.

59

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Operations

(amounts in thousands, except for share data)
| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Net revenue:                                                                                                                         |       |                                        |       |   |   |
| E-commerce                                                                                                                           |       | $                                           | 2,994      |   | $ | 2,665 |   |
| Media                                                                                                                                |       | 2,149                                       |       | 5,297 |   |
| Anti-piracy  services                                                                                                                |       | —                                      |       | 6,009 |   |
| Total net  revenue                                                                                                                   |       | 5,143                                       |       | 13,971 |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Cost of revenue:                                                                                                                     |       |                                        |       |   |   |
| E-Commerce                                                                                                                           |       | 2,631                                       |       | 2,400 |   |
| Media                                                                                                                                |       | 1,144                                       |       | 2,745 |   |
| Anti-piracy  services                                                                                                                |       | —                                      |       | 2,659 |   |
| Total cost of  revenue                                                                                                               |       | 3,775                                       |       | 7,804 |   |
| Gross profit                                                                                                                         |       | 1,368                                       |       | 6,167 |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Operating expenses:                                                                                                                  |       |                                        |       |   |   |
| Sales and  marketing                                                                                                                 |       | 167                                         |       | 527 |   |
| General and  administrative                                                                                                          |       | 2,676                                       |       | 4,065 |   |
| Provision for doubtful  accounts                                                                                                     |       | 110                                         |       | 105 |   |
| Stock-based  compensation                                                                                                            |       | 7                                           |       | 73 |   |
| Total operating  costs                                                                                                               |       | 2,960                                       |       | 4,770 |   |
| Income (loss)  from operations                                                                                                       |       | (1,592                                      | )          | 1,397 |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Other income (expense):                                                                                                              |       |                                        |       |   |   |
| Interest income                                                                                                                      |       | 29                                          |       | 29 |   |
| Interest expense                                                                                                                     |       | —                                      |       | (2,873 | ) |
| Change in fair  value of warrant liabilty                                                                                            |       | —                                      |       | (10,735 | ) |
| Change in fair  value of derivative liability                                                                                        |       | —                                      |       | (20,043 | ) |
| Amortization of  deferred financing costs                                                                                            |       | —                                      |       | (402 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable |       | —                                      |       | (45 | ) |
| Gain from sale  of tradename                                                                                                         |       | 500                                         |       | — |   |
| Loss from  continuing operations before income taxes                                                                                 |       | (1,063                                      | )          | (32,672 | ) |
| Provision for  income taxes                                                                                                          |       | —                                      |       | 241 |   |
| Loss from  continuing operations                                                                                                     |       | (1,063                                      | )          | (32,913 | ) |
|                                                                                                                                 |       |                                        |       |   |   |
| Income (loss)  from discontinued operations:                                                                                         |       |                                        |       |   |   |
| Income (loss)  from operations:                                                                                                      |       |                                        |       |   |   |
| ARTISTdirect  Records, LLC                                                                                                           |       | (2,111                                      | )          | (271 | ) |
| iMusic record  label                                                                                                                 |       | (137                                        | )          | — |   |
| Gain from sale  of interest in ARTISTdirect Records, LLC (substantially all non-cash)                                                |       | —                                      |       | 21,079 |   |
| Income (loss)  from discontinued operations                                                                                          |       | (2,248                                      | )          | 20,808 |   |
| Net loss                                                                                                                             |       | $                                           | (3,311     | ) | $ | (12,105 | ) |
|                                                                                                                                 |       |                                        |       |   |   |
| Net income (loss) per  common share – basic and diluted:                                                                        |       |                                        |       |   |   |
| From continuing  operations                                                                                                          |       | $                                           | (0.30      | ) | $ | (8.29 | ) |
| From  discontinued operations                                                                                                        |       | (0.64                                       | )          | 5.24 |   |
| Net loss                                                                                                                             |       | $                                           | (0.94      | ) | $ | (3.05 | ) |
|                                                                                                                                 |       |                                        |       |   |   |
| Weighted average common  shares outstanding:                                                                                         |       |                                        |       |   |   |
| Basic & Diluted                                                                                                                  |       | 3,502,117                                   |       | 3,969,145 |   |

 

Seeaccompanying notes to consolidated financial statements.

60

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatements of Comprehensive Loss

(amounts inthousands)
| ** **                                        | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Net loss                                          |       | $                                           | (3,311     | ) | $ | (12,105 | ) |
| Other comprehensive  loss:                        |       |                                        |       |   |   |
| Unrealized loss  on available for sale securities |       | (10                                         | )          | — |   |
| Comprehensive income loss                         |       | $                                           | (3,321     | ) | $ | (12,105 | ) |

 

Seeaccompanying notes to consolidated financial statements.

61

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatement of Stockholders’ Equity (Deficiency)

(amounts inthousands, except for share data)
| ** **                                                                                                                           | ** ** | ** **            | ** ** | ** **   | ** ** | ** **  | ** ** | **Additional** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------|------------|----------------|------------|
| ** **                                                                                                                           | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Paid-In** | ** ** |
| ** **                                                                                                                           | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**   | ** ** | **Capital**    | ** ** |
| Balance at  December 31, 2003                                                                                                   |       | 3,502,117             |       | $            | 38         |        | $          | (3,442         | )          | $ | 209,128 |   |
| Unrealized loss  on available for sale securities                                                                                    |       | —                |       | —       |       | —      |       | —         |       |
| Issuance of  warrants as settlement and for services rendered                                                                        |       | —                |       | —       |       | —      |       | 7              |       |
| Net loss                                                                                                                             |       | —                |       | —       |       | —      |       | —         |       |
| Balance at  December 31, 2004                                                                                                   |       | 3,502,117             |       | 38           |       | (3,442      | )          | 209,135        |       |
| Stock options  issued for consulting services                                                                                        |       | —                |       | —       |       | —      |       | 92             |       |
| Amortization of  deferred compensation                                                                                               |       | —                |       | —       |       | —      |       | —         |       |
| Issuance of  shares upon conversion of subordinated convertible notes payable                                                        |       | 250,000               |       | 3            |       | —      |       | 385            |       |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —                |       | —       |       | —      |       | 375            |       |
| Warrants issued  to consultants in conjunction with financing of MediaDefender acquisition                                           |       | —                |       | —       |       | —      |       | 84             |       |
| Common stock  issued to consultants in conjunction with financing of MediaDefender  acquisition                                      |       | 1,109,032             |       | 11           |       | —      |       | 1,575          |       |
| Cancellation of  outstanding shares of treasury stock                                                                                |       | —                |       | (3           | )          | 3,442       |       | (3,439         | )          |
| Net income                                                                                                                           |       | —                |       | —       |       | —      |       | —         |       |
| Balance at December 31, 2005                                                                                                    |       | 4,861,149             |       | $            | 49         |        | $          | —         |       | $ | 208,207 |   |

 
| ** **                                                                                                                           | ** ** | ** **       | ** ** | ** **      | ** ** | **Unrealized**        | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|-----------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                           | ** ** | ** **       | ** ** | ** **      | ** ** | **Gain (Loss)**  | ** ** | **Total**              | ** ** |
| ** **                                                                                                                           | ** ** | ** **       | ** ** | ** **      | ** ** | **on Available** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                           | ** ** | **Deferred**     | ** ** | **Accumulated** | ** ** | **for Sale**     | ** ** | **Equity**             | ** ** |
| ** **                                                                                                                           | ** ** | **Compensation** | ** ** | **Deficit**     | ** ** | **Securities**        | ** ** | **(Deficiency)**       | ** ** |
| ** **                                                                                                                           | ** ** | ** **       | ** ** | **(RESTATED)**  | ** ** | ** **            | ** ** | **(RESTATED)**         | ** ** |
| Balance at  December 31, 2003                                                                                                   |       | $                | —     |            | $          | (222,679              | )          | $                      | 10         |   | $ | (16,945 | ) |
| Unrealized loss  on available for sale securities                                                                                    |       | —           |       | —          |       | (10                   | )          | (10                    | )          |
| Issuance of  warrants as settlement and for services rendered                                                                        |       | —           |       | —          |       | —                |       | 7                      |       |
| Net loss                                                                                                                             |       | —           |       | (3,311          | )          | —                |       | (3,311                 | )          |
| Balance at  December 31, 2004                                                                                                   |       | —           |       | (225,990        | )          | —                |       | (20,259                | )          |
| Stock options  issued for consulting services                                                                                        |       | (92              | )          | —          |       | —                |       | —                 |       |
| Amortization of  deferred compensation                                                                                               |       | 73               |       | —          |       | —                |       | 73                     |       |
| Issuance of  shares upon conversion of subordinated convertible notes payable                                                        |       | —           |       | —          |       | —                |       | 388                    |       |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —           |       | —          |       | —                |       | 375                    |       |
| Warrants issued  to consultants in conjunction with financing of MediaDefender acquisition                                           |       | —           |       | —          |       | —                |       | 84                     |       |
| Common stock  issued to consultants in conjunction with financing of MediaDefender  acquisition                                      |       | —           |       | —          |       | —                |       | 1,586                  |       |
| Cancellation of  outstanding shares of treasury stock                                                                                |       | —           |       | —          |       | —                |       | —                 |       |
| Net income                                                                                                                           |       | —           |       | (12,105         | )          | —                |       | (12,105                | )          |
| Balance at December 31, 2005                                                                                                    |       | $                | (19        | )               | $          | (238,095              | )          | $                      | —     |   | $ | (29,858 | ) |

 

Seeaccompanying notes to consolidated financial statements.

62

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatements of Cash Flows

(amounts inthousands)
| ** **                                                                                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                         | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Cash flows from  operating activities:                                                                                                                             |       |                                        |       |   |   |
| Net income  (loss)                                                                                                                                                 |       | $                                           | (3,311     | ) | $ | (12,105 | ) |
| Income (loss)  from discontinued operations                                                                                                                        |       | 2,248                                       |       | (20,808 | ) |
| Loss from  continuing operations                                                                                                                                   |       | (1,063                                      | )          | (32,913 | ) |
| Adjustments to  reconcile net loss from continuing operations to net cash provided by (used  in) continuing operating activities:                                  |       |                                        |       |   |   |
| Depreciation and  amortization                                                                                                                                     |       | 223                                         |       | 3,210 |   |
| Provision for  doubtful accounts                                                                                                                                   |       | 110                                         |       | 105 |   |
| Stock-based  compensation                                                                                                                                          |       | 7                                           |       | 73 |   |
| Deferred income  taxes                                                                                                                                             |       | 9                                           |       | 42 |   |
| Adjustment as a  result of reclassification of assets and liabilities of ARTISTdirect, LLC to  assets and liabilities of discontinued operations held for disposal |       | 9                                           |       | — |   |
| Change in assets  and liabilities, net of effect from acquisition of MediaDefender:                                                                                |       |                                        |       |   |   |
| (Increase)  decrease in -                                                                                                                                          |       |                                        |       |   |   |
| Accounts  receivable                                                                                                                                               |       | (574                                        | )          | (510 | ) |
| Finished goods  inventory                                                                                                                                          |       | 34                                          |       | (165 | ) |
| Prepaid expenses  and other current assets                                                                                                                         |       | 59                                          |       | 64 |   |
| Income taxes  refundable                                                                                                                                           |       | —                                      |       | (1,211 | ) |
| Other Assets                                                                                                                                                       |       | (5                                          | )          | (1 | ) |
| Increase  (decrease) in -                                                                                                                                          |       |                                        |       |   |   |
| Accounts payable                                                                                                                                                   |       | 323                                         |       | 333 |   |
| Accrued expenses                                                                                                                                                   |       | 261                                         |       | 410 |   |
| Accrued interest  payable                                                                                                                                          |       | —                                      |       | 607 |   |
| Change in fair  value of warrant liability                                                                                                                         |       | —                                      |       | 10,735 |   |
| Change in fair  value of derivative liability                                                                                                                      |       | —                                      |       | 20,403 |   |
| Deferred revenue                                                                                                                                                   |       | (9                                          | )          | 320 |   |
| Other                                                                                                                                                              |       | —                                      |       | 22 |   |
| Net cash  provided by (used in) continuing operations                                                                                                              |       | (625                                        | )          | 1,524 |   |
| Net cash used in  discontinued operations                                                                                                                          |       | (2,848                                      | )          | (38 | ) |
| Net cash  provided by (used in) operating activities                                                                                                               |       | (3,473                                      | )          | 1,486 |   |
|                                                                                                                                                               |       |                                        |       |   |   |
| Cash flows from  investing activities:                                                                                                                             |       |                                        |       |   |   |
| Purchases of  property and equipment                                                                                                                               |       | (55                                         | )          | (303 | ) |
| Proceeds from  sale of interest in ARTISTdirect Records, LLC                                                                                                       |       | —                                      |       | 115 |   |
| Acquisition of  MediaDefender                                                                                                                                      |       | —                                      |       | (42,500 | ) |
| Costs incurred  in MediaDefender acquisition                                                                                                                       |       | —                                      |       | (1,115 | ) |
| Cash acquired in  connection with MediaDefender acquisition, net of adjustments and amount due  to ADI                                                             |       | —                                      |       | 435 |   |
| Sale/maturity of  short-term investments, net                                                                                                                      |       | 1,012                                       |       | — |   |
|                                                                                                                                                               |       |                                        |       |   |   |
| Net cash  provided by (used in) investing activities                                                                                                               |       | 957                                         |       | (43,368 | ) |
|                                                                                                                                                               |       |                                        |       |   |   |
| Cash flows from  financing activities:                                                                                                                             |       |                                        |       |   |   |
| Proceeds from  senior and subordinated debt financings                                                                                                             |       | —                                      |       | 45,000 |   |
| Payments for  deferred financing costs                                                                                                                             |       | —                                      |       | (1,025 | ) |
| Increase  (decrease) in restricted cash                                                                                                                            |       | 175                                         |       | (184 | ) |
| Net cash provided  by discontinued operations –                                                                                                               |       |                                        |       |   |   |
| Proceeds from  issuance of bridge notes by ARTISTdirect Records, LLC during the year ended  December 31, 2004 and two months ended February 28, 2005          |       | 2,778                                       |       | 37 |   |
|                                                                                                                                                               |       |                                        |       |   |   |
| Net cash  provided by financing activities                                                                                                                         |       | 2,953                                       |       | 43,828 |   |
|                                                                                                                                                               |       |                                        |       |   |   |
| Cash and cash  equivalents:                                                                                                                                        |       |                                        |       |   |   |
| Net increase                                                                                                                                                       |       | 437                                         |       | 1,946 |   |
| Balance at  beginning of year                                                                                                                                      |       | 719                                         |       | 1,156 |   |
| Balance at end of year                                                                                                                                             |       | $                                           | 1,156      |   | $ | 3,102 |   |

 

Seeaccompanying notes to consolidated financial statements.

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| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Supplemental disclosure  of cash flow information:                                                                                   |       |                                        |       |   |   |
| Cash paid for -                                                                                                                      |       |                                        |       |   |   |
| Interest                                                                                                                             |       | $                                           | —     |   | $ | 657 |   |
| Income taxes                                                                                                                         |       | $                                           | —     |   | $ | 1,637 |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Non-cash investing and  financing activities:                                                                                        |       |                                        |       |   |   |
| Issuance of  subordinated convertible note payable to placement agent                                                                |       | $                                           | —     |   | $ | 1,460 |   |
| Issuance of  warrants to holders of senior secured notes payable                                                                     |       | $                                           | —     |   | $ | 1,983 |   |
| Issuance of  warrants to holders of subordinated convertible notes payable                                                           |       | $                                           | —     |   | $ | 1,134 |   |
| Issuance of  embedded derivatives to holders of subordinated convertible notes payable                                               |       | $                                           | —     |   | $ | 10,534 |   |
| Issuance of  common stock to directors as consulting fee in conjunction with MediaDefender  acquisition                              |       | $                                           | —     |   | $ | 1,586 |   |
| Issuance of  warrants to directors as consulting fee in conjunction with MediaDefender  acquisition                                  |       | $                                           | —     |   | $ | 84 |   |
| Issuance of  shares upon conversion by subordinated convertible note payable                                                         |       | $                                           | —     |   | $ | 388 |   |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | $                                           | —     |   | $ | 375 |   |
| Issuance of  warrants to placement agent for senior secured notes payable                                                            |       | $                                           | —     |   | $ | 176 |   |
| Issuance of  warrants to placement agent for senior secured notes payable and subordinated  convertible notes payable                |       | $                                           | —     |   | $ | 1,077 |   |
| Guaranteed  payments to MediaDefender management accounted for as non-compete agreements                                             |       | $                                           | —     |   | $ | 1,050 |   |
| Accrued expenses  related to MediaDefender acquisition                                                                               |       | $                                           | —     |   | $ | 160 |   |
| Assets acquired  in MediaDefender transaction, excluding cash and intercompany payable:                                              |       |                                        |       |   |   |
| Assets acquired                                                                                                                      |       | $                                           | —     |   | $ | 4,458 |   |
| Liabilities  assumed                                                                                                                 |       | $                                           | —     |   | $ | 734 |   |
| Customer  relationships                                                                                                              |       | $                                           | —     |   | $ | 2,264 |   |
| Proprietary  technology                                                                                                              |       | $                                           | —     |   | $ | 7,602 |   |
| Goodwill                                                                                                                             |       | $                                           | —     |   | $ | 31,085 |   |

 

Seeaccompanying notes to consolidated financial statements.

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ARTISTDIRECT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2004 AND 2005

1.   BASIS OF PRESENTATION

ORGANIZATION ANDBUSINESS ACTIVITIES

ARTISTdirect, Inc.,a Delaware corporation (“ADI”), was formed on October 6, 1999 upon itsmerger with ARTISTdirect, LLC. The merger was only a change in the form ofownership of ADI. ARTISTdirect, LLC was organized as a California limitedliability company and commenced operations on August 8, 1996.ARTISTdirect, LLC has a 99% ownership interest in ARTISTdirect Agency LLC,Kneeling Elephant Records, LLC and ARTISTdirect New Media, LLC, all of whichare currently inactive, and has consolidated their results since inception. TheCompany is headquartered in Santa Monica, California.

On May 31,2001, the Company, through its wholly-owned subsidiary, ARTISTdirectRecordings, Inc., a Delaware corporation (“ARTISTdirect Recordings”),entered into an agreement to acquire a 50% equity interest in a co-venture withRadar Records Holdings, LLC (“Radar Records”), an entity owned by Frederick W.(Ted) Field, the Company’s Chairman, to form a new record label,ARTISTdirect Records, LLC (“ARTISTdirect Records”). This transaction becameeffective as of June 29, 2001.

EffectiveSeptember 30, 2004, the Company reorganized its operating structure bytransferring its media and e-commerce business operations to a wholly-ownedsubsidiary, ARTISTdirect Internet Group, Inc., a Delaware corporation.This reorganization did not have any effect on the Company’s businessoperations or consolidated financial statements. The Company conducts thesebusiness operations through an online music network appealing to music fans,artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com)is a network of web-sites offering multi-media content, music news andinformation, communities organized around shared music interests, music-relatedspecialty commerce and digital music services.

DuringDecember 2004, the Company discontinued the operations of its iMusicrecord label and has therefore accounted for the operations of iMusic as adiscontinued operation for all periods presented (see Note 13).

OnFebruary 28, 2005, the Company completed the sale of all of its interestin ARTISTdirect Recordings to Radar Records (see Note 11). In accordance withSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets”, the Company has determined that it complied with the provisions ofSFAS No. 144 at December 31, 2004 with respect to the classificationof the operations of ARTISTdirect Records as a discontinued operation.Accordingly, the Company has accounted for its interest in ARTISTdirect Recordsas a discontinued operation for all periods presented, and the assets andliabilities of ARTISTdirect Records were classified as “held for sale” throughFebruary 28, 2005.

On July 28,2005, the Company completed the acquisition of MediaDefender, Inc., aprivately-held Delaware corporation (“MediaDefender”) (see Note 9).MediaDefender was founded in July 2000 and is headquartered in Marina delRey, California. This transaction was accounted for as a purchase in accordancewith SFAS No. 141, “Business Combinations”, and the operations of the twocompanies have been consolidated commencing August 1, 2005. MediaDefenderis one of the leading providers of anti-piracy solutions in the high-growthInternet-piracy-protection (“IPP”) industry and offers services designed tothwart Internet piracy and encourage consumers to pay for online content.

OnNovember 7, 2005, the Company filed with the Secretary of State of theState of Delaware a Certificate of Amendment of its Certificate ofIncorporation to increase the authorized number of shares of its common stockfrom 15,000,000 shares to 60,000,000 shares.

Unless the contextindicates otherwise, ARTISTdirect, Inc. and its subsidiaries are referredto herein as the “Company”.

RESTATEMENT OFFINANCIAL STATEMENTS

The Company hasrestated its financial statements as of and for the year ended December 31,2005 and the quarterly information as shown in Note 21.  The Company’s determination to restate thesefinancial statements was made after discussions with the Securities andExchange Commission regarding the accounting for embedded derivatives containedin various instruments issued by the Company in July 2005 in conjunction withits acquisition of MediaDefender, as required under Financial AccountingStandards Board (“FASB”) Statement No.133, Accounting for DerivativeInstruments and Hedging Activities (“FAS 133”) and related Emerging Issues TaskForce (“EITF”)  Issue No. 00-19Accounting for Derivative Financial Instruments Indexed to and PotentiallySettled in, a Company’s Own Stock (“ETIF 00-19”).

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The SubordinatedConvertible Debentures (“Sub-debt”)issued in conjunction with the financing of the MediaDefender acquisition (asdescribed in Note 9) has a combination of attributes, most notably, conversionfeatures, registration rights and other aspects which were identified asembedded derivatives and are treated as liabilities as described in Note 9.

In addition to theadjustment for the embedded derivatives associated with the subordinatedconvertible notes, an initial valuation of the warrants issued in conjunctionwith the senior and subordinated debentures (“Warrants”) issued in connectionwith the acquisition of MediaDefender have been revalued at inception (see Note9).

Asummary of the significant adjustments recorded to restate the financialstatements as of and for the year ended December 31, 2005 is presentedbelow.  The restatement did not have animpact on the Company’s cash flows for the year ended December 31, 2005.

(a)                                  Theinitial fair value of the derivative liability was bifurcated from the Sub-Debt Notes and was recorded as adiscount to the Sub-Debt Notes, and was amortized to interest expense over thelife of the related debt.

(b)                                 Thederivative liability was revalued at each quarter end, with the resultingchange in fair value reflected in the statement of operations.

(c)                                  Theinitial fair value of the warrants issued in the Senior Financing and theSub-Debt Financing was revised, resulting in revisions to deferred financingcosts and debt discount amounts, and in the related amortization of suchamounts to operations.

(d)                                 Thewarrants issued in conjunction with the Senior Financing and the Sub-DebtFinancing were revalued at each quarter end, with the resulting change in fairvalue reflected in the statement of operations.

(e)                                  Thepro rata portion of warrant liability and derivative liability associated withthe conversion of the sub-debt into common stock was transferred to additionalpaid-in capital.

The following tablepresents the impact of the restatement on the effected balance sheet categoriesat December 31, 2005 (amounts in thousands): 
| ** **                                          | ** ** | **As Previously  Reported** | ** ** | **Restatement  Adjustments** | ** ** | **Adjustment  Legend** | ** ** | **As Restated** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                          | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **             | ** ** | ** **           | ** ** |
| Deferred financing  costs                           |       | $                                | 3,063      |                         | $          | 237                    |       | (c)                  |       | $ | 3,300 |   |
| Warrant liability                                   |       | 3,260                            |       | 11,844                       |       | (c),  (d)              |       | 15,104               |       |
| Derivative liability                                |       | —                           |       | 30,202                       |       | (a),  (b)              |       | 30,202               |       |
| Discount on senior  secured notes payable           |       | 1,245                            |       | 521                          |       | (c),  (d)              |       | 1,766                |       |
| Discount on  subordinated convertible notes payable |       | 774                              |       | 9,494                        |       | (a),  (b), (c)         |       | 10,268               |       |
| Additional paid-in  capital                         |       | 207,832                          |       | 375                          |       | (e)                    |       | 208,207              |       |
| Accumulated deficit                                 |       | $                                | (205,926   | )                            | $          | (32,169                | )          | (a), (b), (c), (d)   |       | $ | (238,095 | ) |

 

The following tablepresents the impact of the restatement on the statements of operations for theyear ended December 31, 2005 (amounts in thousands): 
| ** **                                                                                                                           | ** ** | **As Previously  Reported** | ** ** | **Restatement  Adjustments** | ** ** | **Adjustment  Legend** | ** ** | **As Restated** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|------------------------|------------|----------------------|------------|
|                                                                                                                                 |       |                             |       |                         |       |                   |       |                 |       |
| Income from  operations                                                                                                              |       | $                                | 1,397      |                         | $          | —                 |       |                 |       | $ | 1,397 |   |
| Interest income                                                                                                                      |       | 29                               |       | —                       |       |                   |       | 29                   |       |
| Interest expense                                                                                                                     |       | (1,517                           | )          | (1,356                       | )          | (a),  (c)              |       | (2,873               | )          |
| Amortization of  deferred financing costs                                                                                            |       | (373                             | )          | (29                          | )          | (c)                    |       | (402                 | )          |
| Change in fair  value of warrant liability                                                                                           |       | —                           |       | (10,735                      | )          | (c),  (d)              |       | (10,735              | )          |
| Change in fair  value of derivative liability                                                                                        |       | —                           |       | (20,043                      | )          | (a),  (b)              |       | (20,043              | )          |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable |       | (39                              | )          | (6                           | )          | (a),  (c)              |       | (45                  | )          |
| Loss from  continuing operations before income taxes                                                                                 |       | (503                             | )          | (32,169                      | )          |                   |       | (32,672              | )          |
| Provision for  income taxes                                                                                                          |       | (241                             | )          | —                       |       |                   |       | (241                 | )          |
| Income from  discontinued operations                                                                                                 |       | 20,808                           |       | —                       |       |                   |       | 20,808               |       |
| Net income  (loss)                                                                                                                   |       | $                                | 20,064     |                         | $          | (32,169                | )          |                 |       | $ | (12,105 | ) |
|                                                                                                                                 |       |                             |       |                         |       |                   |       |                 |       |
| Net income  (loss) per share — basic                                                                                            |       | $                                | 5.06       |                         |       |                   |       |                 | $          | (3.05 | ) |
| Net income (loss) per  share — diluted                                                                                          |       | $                                | 1.45       |                         |       |                   |       |                 | $          | (3.05 | ) |

 

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PRINCIPLES OFCONSOLIDATION

The accompanyingfinancial statements include the consolidated accounts of ADI and itssubsidiaries in which it has controlling financial interests. All intercompanyaccounts and transactions have been eliminated for all periods presented. ADIrecorded 100% of the losses attributable to ARTISTdirect Records fromMay 31, 2001 through April 30, 2002 based on ADI’s commitment to fund100% of ARTISTdirect’s operations during that period of time. From May 1,2002 through December 31, 2002, ADI recorded approximately 83% of thelosses of ARTISTdirect Records as a result of BMG’s equity purchase and from anassumption of a portion of ADI’s funding commitment to the record label. Forthe year ended December 31, 2003, ADI recorded approximately 73% of thelosses of ARTISTdirect Records. However, as ADI did not have voting oroperational control, even with its majority ownership position in ARTISTdirectRecords, through December 31, 2003, ADI accounted for this investmentusing the equity method of accounting.

InFebruary 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN46”), which addresses the consolidation by business enterprises of variableinterest entities. FIN 46 defines when a company should evaluate “controllingfinancial interest”, and thus consolidation, based on factors other than votingrights, and requires that a new “risks and rewards” model be applied in thesesituations. ADI adopted FIN 46 as of December 31, 2003. As a result of theadoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidatedbeginning as of December 31, 2003, and the operations of ARTISTdirectRecords were consolidated beginning with the year ended December 31, 2004(see Note 10). There was no change in the operating or business relationshipbetween ADI and ARTISTdirect Records as a result of the adoption of FIN 46.

As a result of thesale of all of the Company’s interest in ARTISTdirect Records effectiveFebruary 28, 2005 (see Note 11), ARTISTdirect Records was accounted for asa discontinued operation for all periods presented, and the assets andliabilities of ARTISTdirect Records were classified as “held for sale” throughFebruary 28, 2005.

For the year endedDecember 31, 2004, ADI recorded 70% of the losses (after intercompanyeliminations) of ARTISTdirect Records. Since Ted Field owned 30% ofARTISTdirect Records, 30% of the losses (after intercompany eliminations) wereoffset against the minority interest of Ted Field. This minority interestresulted from the beneficial conversion feature related to the Bridge Notes(see Note 12).

2.   SIGNIFICANT ACCOUNTING POLICIES

CASH EQUIVALENTS

Cash equivalentsconsist of investments, which are readily convertible into cash and havematurities of three months or less at the time of purchase.

RESTRICTED CASH

As ofDecember 31, 2004 and 2005, restricted cash consisted of a bankcertificate of deposit with balances of $175,000 and $179,000, respectively,securing a bank letter of credit provided as security for charge-backs to theCompany’s e-commerce credit card processor. In addition, at December 31,2005, the Company had classified $180,000 of cash as restricted cash as suchcash was pledged to secure an irrevocable bank stand-by letter of credit issuedin conjunction with the Company’s new office lease which commences inFebruary 2006.

ACCOUNTSRECEIVABLE

The Company grantscredit to its customers generally in the form of short-term trade accountsreceivable. Accounts receivable are stated at the amount management expects tocollect 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 theallowance based on the aging of accounts receivable balances, historicalwrite-off experience, customer concentrations, customer creditworthiness andcurrent 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.

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PROPERTY ANDEQUIPMENT

Expenditures formajor renewal and betterments that extend the useful lives of property andequipment are capitalized. Expenditures for maintenance and repairs are chargedto expense as incurred. When property and equipment is sold or otherwise disposedof, the assets and related accumulated depreciation accounts are relieved, andany gain or loss is included in operations.

Depreciation iscomputed on the straight-line method based on the estimated useful lives of theassets, which is generally three years for computer equipment and software andseven years for furniture and fixtures.

GOODWILL,INTANGIBLE ASSETS 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, withrespect to the MediaDefender transaction, non-compete agreements are beingamortized over the life of the respective non-compete agreements, ranging from20 months to 4 years, and customer relationships and proprietary technology arebeing amortized over 3 years.  Assetallocations and amortization periods with respect to the MediaDefendertransaction were determined by an independent valuation firm.

SFAS No. 142requires goodwill to be tested for impairment on an annual basis and undercertain circumstances, and written down when impaired. An interim impairmenttest is required if an event occurs or conditions change that would more likelythan not reduce the fair value of the reporting unit below the carrying value.

The Companyevaluates the recoverability of goodwill by estimating the future discountedcash flows of the businesses to which the goodwill relates. The Company uses arate corresponding to its cost of capital, risk adjusted where appropriate, indetermining discounted cash flows. Estimated cash flows will be determined bydisaggregating the business segments to a reporting level for which meaningfulidentifiable cash flows can be determined. When estimated future discountedcash flows are less than the carrying value of the net assets (tangible andidentifiable intangibles) and related goodwill, the Company willperform an impairment test to measure the amount of the impairment loss,if any. Impairment losses, limited to the carrying value of goodwill, representthe excess of the carrying amount of a reporting unit’s goodwill over theimplied fair value of that goodwill. In determining the estimated future cashflows, the Company will consider 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.

The Companyaccounts for the impairment of long-lived assets, such as property andequipment and intangible assets, under the provisions of Statement of FinancialAccounting Standards No. 144, “Accounting for the Impairment of Long-LivedAssets” (“SFAS No. 144”). SFAS No. 144 establishes the accounting forimpairment of long-lived tangible and intangible assets other than goodwill andfor 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 such circumstances are determined to exist, anestimate of undiscounted future cash flows produced by the long-lived asset, orthe appropriate grouping of assets, is compared to the carrying value todetermine 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 animpairment cost as a charge to operations at the time it is recognized.

DERIVATIVE INSTRUMENTS

SFAS No. 133  as amended, requires all derivatives to berecorded on the balance sheet at fair value. These derivatives, include embedded derivatives in our ConvertibleSubordinated Debentures (“Sub-debt”) and the associated warrants (“Warrants”)issued in connection with the MediaDefender acquisition financing, areseparately valued and accounted for on the Company’s balance sheet. Thebifurcated value of these obligations, as determined by an outside independentconsultant as of July 28, 2005, was calculated using a lattice (binomial) valuationmodel.

InSeptember 2000, the EITF issued EITF 00-19, which requires freestandingcontracts that are settled in a company’s own stock, including common stockwarrants, to be designated as an equity instrument, asset or a liability. Underthe provisions of EITF 00-19, a contract designated as an asset or a liabilitymust be carried at fair value on a company’s balance sheet, with any changes infair value recorded in the company’s results of operations.****For the year ended December 31, 2005, thefinancial statements reflect the fair value of these Warrants and the Sub-debtembedded derivatives features on the Company’s balance sheet and the unrealizedchanges in the values of these warrants and derivatives in the Company’sconsolidated statement of operations as “Change in Fair Value of Warrants andDerivative liability.”

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TheCompany determined that the Sub-debt and the Warrants created derivativeliabilities in accordance with EITF00-19,  because share settlement of theseSub-debt and Warrants are not within the control of the Company as a result ofthe facts that: (1) the Company has an obligation to register the common stockunderlying the Sub-debt and Warrants or is required to make  payment ofpenalties each month until the shares are registered and must remain registeredpursuant to an effective registration statement, and (2) the Sub-debt andWarrants contained dilution protection features, with no limit or cap on thenumber of shares that could be issued under the Sub-debt and Warrants.  Therefore, we could not conclude that we hadsufficient authorized and unissued shares to issue the number of sharespotentially issuable under the Sub-debt and Warrants.  As a result, we determined that theseSub-debt and Warrants should be treated as derivative liabilities inaccordance with EITF 00-19.

TheSub-debt contains more than one embedded derivative feature required to beaccounted for as assets or liabilities. The various embedded derivativefeatures of the Sub-debt have been valued at the date of inception of theSub-debt and at each reporting period thereafter.  The derivative features include: (1) thestandard conversion feature of the debentures, (2) limitation on the conversion,and (3) the Company’s right to force conversion, as well as the reset featureand the obligation to maintain a continuously effective registration statement,among others.  The independent consultantvalued all the significant features of the Sub-debt, however a determinationwas made by the Company, that with the exception of the above features, theremaining attributes offset and were immaterial.  The value of the derivative liabilities werebifurcated from the Sub-debt and the Company recorded a Derivative liability,with the initial carrying amount (as unamortized discount) of the relateddebenture as an additional discount to the Sub-debt liability. The unamortizeddiscount is being amortized to interest expense over the life of thedebenture.  Because of the Warrantscontain certain registration rights, penalties and price resets the Warrantsissued were also classified as derivatives and recorded as a Warrant liability.

Valuation of the Derivatives

The Company with the assistance of Independent valuationconsultants valued the Embedded Derivatives within the ConvertibleSubordinated Debt Issued on July 28, 2005 using a Binomial Lattice OptionPricing Model. The model used the following assumptions for the originalvaluation and similar assumptions for each succeeding valuation:

·              Stockprice: $1.43;

·              TheExercise/conversion price: $1.55

·              TerminalTime Period: convertible subordinated debt matures on July 2009 for a time of 3years and 11 months.

·              Time Step: Periodbetween each price movement (monthly)

·              ExpectedReturn: 4.04%: The risk-free rates were based on the rate of treasurysecurities with the same term as the Convertible Subordinated Note as of thespecified valuation date

·              Volatility:55%

The warrants were valuedusing a Black Scholes option pricing model by the Company with the assistanceof the Independent valuation consultants. The model used the followingassumptions for the original valuation and similar assumptions for eachsucceeding valuation:

·              Stockprice: $1.43;

·              The Senior warrantsExercise price: $2.00 / Sub-debt warrants Exercise price: $1.55

·              Time Period: Seniorwarrants 7 years / Sub-debt warrants 5 years

·              ExpectedReturn: 4.04%: The risk-free rates were based on the rate of treasurysecurities with the same term as the warrants as of the specified valuationdate

·              Volatility:55%

DEFERRED FINANCINGCOSTS

Deferred financingcosts consist of consideration paid to third parties with respect to theacquisition and financing of the MediaDefender transaction, including cashpayments, the fair value of warrants issued for legal fees and placement agentfees. Such costs are being deferred and amortized over the term of the relateddebt. Upon conversion of subordinated convertible notes payable into commonstock, any related unamortized deferred financing costs are charged tooperations.

DISCOUNT ON DEBT

Additionalconsideration in the form of warrants issued to lenders and placementagents was accounted for at fair value based on a report prepared by anindependent valuation firm. The fair value of such warrants was recorded as areduction to the carrying amount of the debt, and is being amortized tointerest expense over the term of the debt, with the offsetting entry beingrecorded as warrant liability on the balance sheet.  In addition to the warrants, pursuant to FAS133 and EITF No. 00-19. the Company bifurcated the value of the embeddedderivatives associated with the Sub-debt and booked a discount against theSub-debt liability at the time of issuance. The embedded derivative discount is being amortized to interest expenseover the term of the debt.  Uponconversion of subordinated convertible notes payable into common stock, anyrelated unamortized discount on debt is charged to operations.

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REVENUERECOGNITION

The Companycomplies with the provisions of Staff Accounting Bulletin (“SAB”) No. 101,“Revenue Recognition in Financial Statements”, as amended by SAB No. 104,and recognizes revenue when 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) collectibility is 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 recordse-commerce revenue on a gross basis as the Company enters into the sale transactionswith customers, establishes the prices of the products, chooses the suppliersof the products, assumes the risk of inventory loss and collects all amountsfrom the customers and assumes the credit risk. E-commerce revenue is subjectto amounts due to the respective artists based on their contracts, and suchexpense is recorded as part of cost of e-commerce revenue.

The Companyrecords amounts charged to customers for shipping and handling in accordancewith Emerging Issues Task Force No. 00-10, “Accounting for Shipping andHandling Fees and Costs” (“EITF No. 00-10”). Pursuant to EITFNo. 00-10, the Company records amounts charged to customers for shippingand handling as revenue, and records the related costs incurred for shippingand handling to direct cost of product sales in the consolidated statements ofoperations. For the years ended December 31, 2004 and 2005, the Companyrecorded $705,000 and $629,000, respectively, as revenue for shipping andhandling fees charged to customers. For the years ended December 31, 2004and 2005, the Company recorded $434,000 and $361,000, respectively, of shippingand handling costs as direct cost of product sales in the consolidatedstatements of operations.

Media revenueconsists primarily of the sale of advertisements and sponsorships, both onlineand offline, under short-term contracts. To date, the duration of the Company’sadvertising and sponsorship commitments has generally averaged from one tothree months, with certain programs lasting up to six months. The Company’sonline obligations typically include the guarantee of a minimum number of times(“impressions”) that an advertisement appears in pages viewed by the usersof the Company’s online properties. Online advertising revenue is generallyrecognized as the impressions are served during the period in which theadvertisement is displayed, provided that no significant obligations of theCompany remain and collection of the resulting receivable is reasonablyassured. To the extent that minimum guaranteed page deliveries are notmet, recognition of the corresponding revenue is deferred until the guaranteedimpressions are delivered.

Anti-piracyservices revenue is recognized on a monthly basis as services are provided tocustomers. Deferred revenue is recorded for customers who prepay the full, orany portion, of their respective contracts.

The Companyrecognizes revenue for sponsorship arrangements, both online and offline, overthe period during which the advertising is provided, generally on a straight-linebasis. If the sponsorship arrangement is for the sponsorship of a specificevent, the Company recognizes revenue when the event occurs. The Companyrecognizes revenue separately for each element of integrated entertainmentmarketing packages that offer advertisers a combination of offline concert andtour sponsorships that are supported by online banner advertising,web-page sponsorships, e-mails to the Company’s customers and customcontent. The Company determines the fair value of each deliverable based on therelative fair value of the different deliverables when sold on a stand-alonebasis. The Company recognizes revenue for each deliverable as the services areprovided. The Company recognizes revenue for the banner impression deliverableas the banner impressions are delivered. The Company recognizes revenue for thecustomer e-mails when the e-mails are sent. The Company recognizes revenue forweb-page sponsorships on a straight-line basis over the term of thesponsorship. The Company recognizes revenue for custom content when the contentis provided to the customer.

Record labelrevenue consisted of the sale of compact discs by artists under contract to theiMusic record label and to ARTISTdirect Records in 2004. The Company recognizedrevenues upon the shipment of compact discs from its distributor to retailersand independent wholesalers and records estimated reserves for product returns.At the time of the shipment of the product, the following criterion underStatement of Financial Accounting Standards No. 48, “Revenue RecognitionWhen Right of Return Exists”, had been met: the seller’s price to the buyer wassubstantially fixed or determinable at the date of sale; the buyer had paid theseller, or the buyer was obligated to pay the seller, and the obligation wasnot contingent on resale of the product; the buyer’s obligation to the sellerwould not have been changed in the event of theft or physical destruction ordamage of the product; the buyer acquiring the product for resale had economicsubstance apart from that provided by the seller; the seller did not havesignificant obligations for future performance to directly bring about resaleof the product by the buyer; and the amount of future returns could bereasonably estimated.

The Company estimatedthe provision for returns on a quarterly basis by album based on the amount oftime since the initial album release, the actual returns to date, the trend ofsales activity (sales by the retailers and wholesalers) and the number ofunsold units at retailers and wholesalers. Returns to the Company’s distributorare deemed to be returns to the Company. Returns in excess of the estimatedcurrent provision were charged to revenue.

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COST OF REVENUE

Cost of productsales consists of amounts payable to artists related to e-commerce sales, whichincludes the cost of merchandise sold and the share of net proceeds due toartists, and online commerce transaction costs, including credit card fees,fulfillment charges and shipping costs. Manufacturing costs consist of the costof pressing compact discs, manufacturing printed booklets and packagingmaterials and a provision for the obsolescence of finished goods andcomponents. Distribution expenses consist of various distribution costs,including the cost of processing returns and warehousing inventory.

Media cost ofrevenue consists primarily of web-site hosting and maintenance costs, onlinecontent programming costs, online advertising serving costs, sales commissions,payments to affiliated web-sites, and payroll and related expenses for staffinvolved with the web-site. Costs related to the web-site are recognizedimmediately when incurred.  Anti-piracyservices cost of revenue consists primarily of bandwidth and labor costs. Amortizationof proprietary technology is included in anti-piracy services cost of revenue.

Depreciationexpense is included in the related cost of revenue category.

DISCONTINUEDOPERATIONS

The Company hasaccounted for its iMusic record label and its interest in ARTISTdirect Records,LLC as discontinued operations for all periods presented in accordance withSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets” (see Notes 11 and 13).

INVENTORIES

Inventories, netof a provision for obsolescence of $103,000, consist of compact discsmaintained in the warehouse of the Company’s distributor and music-relatedmerchandise. Inventories are stated at the lower of cost or net realizablevalue. Cost is determined using the first-in, first-out method.

INCOME TAXES

The Company accountsfor income taxes under Statement of Financial Accounting StandardsNo. 109, “Accounting for Income Taxes” (“SFAS No. 109”). SFASNo. 109 requires recognition of deferred tax assets and liabilities forthe expected future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin the statement of operations in the period that includes the enactment date.A valuation allowance is established, when necessary, to reduce deferred taxassets to the amount expected to be realized.

WEB-SITEDEVELOPMENT COSTS

Web-sitedevelopment costs consist primarily of third-party development costs andpayroll and related expenses for in-house web-site development costs incurredin the start-up and production of the Company’s content and services. Thesecosts are expensed as incurred.

ADVERTISING COSTS

Advertising costsare included in selling and marketing expense and charged to expense as incurred,and totaled $0 and $22,000 during the years ended December 31, 2004 and2005, respectively.

CONCENTRATION OFRISK

Financialinstruments that potentially subject the Company to significant concentrationsof credit risk consist principally of cash, short-term investments and tradeaccounts receivable. The Company places its cash and short-term investments inhigh credit quality instruments. Cash balances at certain financialinstitutions may exceed the FDIC insurance limits. The Company performsongoing credit evaluations of its customers but does not require collateral.Exposure to losses on receivables is principally dependent on each customer’sfinancial condition. The Company monitors its exposure to credit losses andmaintains allowances for anticipated losses.

Concentrations ofcredit risk with respect to trade receivables generated by the Company’soperations are generally limited. However, the customers of MediaDefenderconsist primarily of large reputable companies in the music and entertainmentindustries.

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The Companypurchases 94% of its music-related merchandise inventory from one supplier. TheCompany is subject to risk in the event that any of the suppliers is unable tofulfill its orders. However, there are a number of different suppliers who canprovide such products to the Company.

During the yearsended December 31, 2004 and 2005, approximately 70% and 67%, respectively,of e-commerce revenues were generated from the products related to a singlemusic merchandising entity.

During the yearended December 31, 2004, one customer accounted for $245,000 or 12% oftotal media revenue, of which $34,000 was due from this customer atDecember 31, 2004. During the year ended December 31, 2005, one majoradvertiser/sponsor accounted for $1,786,000 or 34% of total media revenue, allof which was paid during 2005.

During the yearended December 31, 2004 and 2005, the Company’s media revenues weregenerated primarily by a single outside sales organization which representedthe Company with respect to advertising and sponsorship sales on the Company’sweb-site.

During the year ended December 31, 2005,approximately 64% of MediaDefender’s consolidated revenues were from twocustomers, with one customer accounting for 35% and the other customeraccounting for 29%. At December 31, 2005, the amounts due from suchcustomers were $420,000 and $835,000, respectively, which were included inaccounts receivable.

During the year ended December 31, 2005,MediaDefender purchased approximately 87% of its bandwidth from threesuppliers. At December 31, 2005, amounts payable to one of these supplierswas $22,000. Although there are other suppliers of bandwidth, a change insuppliers would cause delays, which could adversely affect operations in theshort-term.

Information with respect to the year endedDecember 31, 2005 relating to MediaDefender reflects only the five-monthperiod in which MediaDefender has been included in the Company’s consolidatedresults of operations.

FAIR VALUE OFFINANCIAL INSTRUMENTS

The carryingamounts of financial instruments, which includes cash and cash equivalents,short-term investments, accounts receivable, accounts payable, accruedexpenses, warrant liability and derivative liability approximate fair valuebecause of the short maturity of these instruments.

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NET INCOME (LOSS)PER COMMON SHARE

The Companycalculates net income (loss) per share in accordance with SFAS No. 128,Earnings Per Share (“EPS”), as clarified by EITF Issue No. 03-6, ParticipatingSecurities and the Two-Class Method Under FASB Statement No. 128, “Earnings PerShare.”  EITF Issue No. 03-6 clarifiesthe use of the “two-class” method of calculating earnings per share asoriginally prescribed in SFAS No. 128 and provides guidance on how to determinewhether a security should be considered a “participating security”. The Companyhas determined that the convertible subordinated notes issued in connectionwith the Media Defender acquisition (see Note 9) are a participatingsecurity as each note holder is entitled to receive dividends as if the notehad converted into common stock on the record date and therefore has adoptedthe provisions of EITF Issue No. 03-6.

Under thetwo-class method, basic net income (loss) per share is computed by dividing thenet income (loss) applicable to common stockholders by the weighted-averagenumber of common shares outstanding for the reporting period.  Diluted net income (loss) per share iscomputed using the more dilutive of (a) the two-class method or (b) theif-converted method.  Net losses can not beallocated to the subordinated convertible notes.  Diluted net income (loss) per share giveseffect to all potentially dilutive securities, including stock options, seniorand sub-debt warrants and convertible subordinated notes in the event theinclusion is dilutive.

A reconciliationof the numerator and denominator used in the calculation of basic and dilutednet (loss) income per share is as follows:
|                                                                                                                           | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2004**                                | ** ** | **2005** | ** ** |
| ** **                                                                                                                | ** ** | ** **                              | ** ** | **(RESTATED)** | ** ** |
| **Numerator:**                                                                                                            |       |                                    |       |   |   |
| Net loss, as reported                                                                                                     |       | $                                       | (3,311     | ) | $ | (12,105 | ) |
|                                                                                                                      |       |                                    |       |   |   |
| Allocation of net loss:                                                                                                   |       |                                    |       |   |   |
| **Basic:**                                                                                                                |       |                                    |       |   |   |
| Net loss applicable to convertible sub-debt notes                                                                         |       | $                                       | —     |   | $ | — |   |
| Net loss applicable to common stockholders                                                                                |       | (3,311                                  | )          | (12,105 | ) |
|                                                                                                                      |       |                                    |       |   |   |
| Net loss                                                                                                                  |       | $                                       | (3,311     | ) | $ | (12,105 | ) |
|                                                                                                                      |       |                                    |       |   |   |
| **Diluted:**                                                                                                              |       |                                    |       |   |   |
| Net loss applicable to sub-debt notes holders                                                                             |       | $                                       | —     |   | $ | — |   |
| Net loss applicable to common stockholders                                                                                |       | (3,311                                  | )          | (12,105 | ) |
|                                                                                                                      |       |                                    |       |   |   |
| Net loss                                                                                                                  |       | $                                       | (3,311     | ) | $ | (12,105 | ) |
| ** Denominator:**                                                                                                    | ** ** | ** **                              | ** ** | ** ** | ** ** |
| Weighted-average shares of common stock outstanding                                                                       |       | 3,502,117                               |       | 3,969,145 |   |
| Weighted-average shares attributable to subordinated  notes                                                               |       | —                                  |       | — |   |
| Less: Weighted-average number of unvested restricted  common shares outstanding                                           |       | —                                  |       | — |   |
| Weighted-average number of common shares used in  calculating basic net loss per common shares                            |       | 3,502,117                               |       | 3,969,145 |   |
| Weighted-average number of shares issuable upon  exercise of outstanding stock options based on the treasury stock method |       | —                                  |       | — |   |
| Weighted-average number of shares issuable upon  exercise of senior warrants, based on the treasury stock method          |       | —                                  |       | — |   |
| Weighted-average number of shares assuming  conversion of subordinated notes, based on the as if converted method         |       | —                                  |       | — |   |
|                                                                                                                      |       |                                    |       |   |   |
| Weighted-average  number of common shares used in computing diluted net loss per common share                             |       | 3,502,117                               |       | 3,969,145 |   |

 

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|                                                                                                 | ** ** | **Year Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                             | ** ** | **(RESTATED)** | ** ** |
| **Calculation  of net loss per common share:**                                                  |       |                                   |       |   |   |
| **Basic:**                                                                                      | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss applicable to common stockholders                                                      |       | $                                      | (3,311     | ) | $ | (12,105 | ) |
|                                                                                            |       |                                   |       |   |   |
| Weighted-average number of common shares used in  calculating basic net loss per common share   |       | 3,502,117                              |       | 3,969,145 |   |
| Net loss per  share applicable to common stockholders:                                          |       | $                                      | (0.94      | ) | $ | (3.05 | ) |
|                                                                                            |       |                                   |       |   |   |
| **Diluted:**                                                                                    | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss applicable to common stockholders                                                      |       | $                                      | (3,311     | ) | $ | (12,105 | ) |
|                                                                                            |       |                                   |       |   |   |
| Weighted-average number of common shares used in  calculating diluted net loss per common share |       | 3,502,117                              |       | 3,969,145 |   |
| Net loss per share  applicable to common stockholders:                                          |       | $                                      | (0.94      | ) | $ | (3.05 | ) |

 

The Company hasdetermined that the convertible subordinated notes are a participating securityas each note holder is entitled to receive dividends as if the note hadconverted into common stock on the record date. The participatory shares areincluded in the weighted average as of the beginning of the period incalculating the basic weighted average shares outstanding. The calculation ofdiluted weighted average common shares outstanding for the year ended December31, 2004 and December 31, 2005 is based on the average of the closing price ofthe Company’s common stock during each respective period. The calculation ofdiluted loss per share excluded anti-dilutive conversion of subordinated convertiblenotes, stock options, senior and sub-debt warrants of approximately 23,769,149shares and 1,159,000 shares of common stock for the years endedDecember 31, 2005 and 2004, since their effect would have beenanti-dilutive.

STOCK-BASEDCOMPENSATION

The Companyaccounts for stock-based employee compensation in accordance with theprovisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASBInterpretation No. 44 (“FIN 44”), “Accounting for Certain TransactionsInvolving Stock Compensation”, and complies with the disclosure requirements ofSFAS No. 123, “Accounting for Stock-Based Compensation”. Under APBNo. 25, compensation expense is recorded based on the difference, if any,between the fair value of the Company’s stock and the exercise price on themeasurement date. The Company accounts for stock issued to non-employees inaccordance with SFAS No. 123, which requires entities to recognize asexpense over the service period the fair value of all stock-based awards on thedate of grant and EITF No. 96-18, “Accounting for Equity Investments thatare Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services”, which addresses the measurement date andrecognition approach for such transactions.

The Company recognizescompensation expense related to variable awards in accordance with FASBInterpretation No. 28, “Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans” (“FIN 28”). For fixed awards, the Companyrecognizes expense over the vesting period or the period of service.

 InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123 (revised 2004), “Share Based Payment” (“SFAS No. 123R”),a revision to SFAS No. 123, “Accounting for Stock-Based Compensation”.SFAS No. 123R supercedes Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”, and amends SFAS No. 95, “Statement of CashFlows”. SFAS No. 123R requires that the Company measure the cost ofemployee services received in exchange for equity awards based on the grantdate fair value of the awards. The cost will be recognized as compensationexpense over the vesting period of the awards. The Company was required toadopt SFAS No. 123R effective January 1, 2006. Under thismethod, the Company will begin recognizing compensation cost for equity-basedcompensation for all new or modified grants after the date of adoption. The proforma disclosures previously permitted under SFAS No. 123 will no longerbe an alternative to financial statement recognition. In addition, the Companywill recognize the unvested portion of the grant date fair value of awardsissued prior to adoption based on the fair values previously calculated fordisclosure purposes over the remaining vesting period of the outstandingoptions and warrants.

Public companies are permitted to adopt therequirements of SFAS No. 123R using one of two methods:

(1)          A “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123R for all awards granted to employees prior tothe effective date of SFAS No. 123R that remain unvested on the effectivedate.

(2)          A “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures for either (a) all prior periods presented or(b) prior interim periods of the year of adoption.

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The Company adopted SFAS No. 123R effectiveJanuary 1, 2006 and will use the modified prospective method in whichcompensation cost is recognized beginning with the effective date(a) based on the requirements of SFAS No. 123R for all share-basedpayments granted after the effective date and (b) based on therequirements of SFAS No. 123R for all awards granted to employees prior tothe effective date of SFAS No. 123R that remain unvested on the effectivedate. Although the expense for stock options that may be vested or grantedin future periods cannot be determined at this time due to the uncertainty ofthe vesting or timing of future grants, the Company’s future stock price, andthe related fair value calculation, the adoption of SFAS No. 123R willhave a material effect on the Company’s future financial statements.

Pro forma information regarding net loss per share isrequired by SFAS No. 123, and has been determined as if the Company hadaccounted for its employee stock options under the fair value method of suchstatement. The fair value for these options was estimated at the date of grantusing either the Black-Scholes option-pricing model or the report of anindependent valuation firm. The assumptions used in the model and the weightedaverage fair value of each option granted for 2004 and 2005 are as follows:
| ** **                              | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                              | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
|                                    |       |                                        |       |   |   |
| Risk-free interest  rate                |       | 4.00                                        | %          | 5.00 | % |
| Volatility                              |       | 388                                         | %          | 170 | % |
| Dividend yield                          |       | 0                                           | %          | 0 | % |
| Weighted average  expected life (years) |       | 7                                           |       | 5 |   |
| Weighted average fair  value of option  |       | $                                           | 0.35       |   | $ | 3.21 |   |
|                                         |            |                                             |            |  |  |  |  |

 

For the purpose of pro forma disclosures, theestimated fair value of the options is amortized to operations over the vestingperiod of the options or the expected period of benefit. The Company’s proforma information is as follows:
| ** **                                                                                                      | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2004**                                                           | ** ** | **2005** | ** ** |
| ** **                                                                                                      | ** ** | **(in thousands, except for share data)** | ** ** |
| ** **                                                                                                      | ** ** | ** **                                                         | ** ** | **(RESTATED)** | ** ** |
| Net loss — as  reported                                                                                    |       | $                                                                  | (3,311     | ) | $ | (12,105 | ) |
| Less:  Stock-based employee compensation expense determined under fair value methods  not charged to operations |       | (473                                                               | )          | (859 | ) |
| Net loss — pro  forma                                                                                      |       | $                                                                  | (3,784     | ) | $ | (12,964 | ) |
|                                                                                                            |       |                                                               |       |   |   |
| Net loss per share  — basic and diluted:                                                                   |       |                                                               |       |   |   |
| As reported                                                                                                     |       | $                                                                  | (0.94      | ) | $ | (3.05 | ) |
| Pro forma                                                                                                       |       | $                                                                  | (1.08      | ) | $ | (3.27 | ) |

 

COMPREHENSIVEINCOME (LOSS)

The Company hasadopted the provisions of Statement of Financial Accounting StandardsNo. 130, “Reporting Comprehensive Income” (“SFAS No. 130”). SFASNo. 130 establishes standards for the reporting and display ofcomprehensive income, its components and accumulated balances in a full set ofgeneral purpose financial statements. SFAS No. 130 defines comprehensiveincome (loss) to include all changes in equity except those resulting frominvestments by owners and distributions to owners, including adjustments tominimum pension liabilities, accumulated foreign currency translation, andunrealized gains or losses on marketable securities.

The Company’s onlycomponent of other comprehensive loss is the unrealized loss on available forsale securities, consisting of a loss of $10,000 for the year endedDecember 31, 2004. This amount has been recorded as a separate componentof stockholders’ equity (deficiency).

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ESTIMATES

In preparingfinancial statements in conformity with generally accepted accountingprinciples, management is required to make estimates and assumptions thataffect the reported amounts of assets and liabilities and the disclosure ofcontingent assets and liabilities at the date of the financial statements andrevenues and expenses during the reporting period. Some of the more significantestimates include allowances for bad debts and sales returns, impairment oflong-lived assets, impairment of fixed assets, stock-based compensation and thevaluation allowance on deferred tax assets. Actual results could differ fromthose estimates.

RECLASSIFICATION

Certain amountshave been reclassified in 2004 to conform to the presentation in 2005.Such reclassifications did not have any effect on income (loss) from operationsor net income (loss).

3.   RECENT ACCOUNTING PRONOUNCEMENTS ANDDEVELOPMENTS

In May 2005, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 154, “Accounting Changes and ErrorCorrections” (“SFAS No. 154”). SFAS No. 154 is a replacement of APBOpinion No. 20, “Accounting Changes” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements – (an Amendment of APBOpinion No. 28)” and provides guidance on the accounting for and reportingof accounting changes and error corrections. SFAS No. 154 establishesretrospective application as the required method for reporting a change inaccounting principle, and provides guidance for determining whetherretrospective application of a change in accounting principle is impracticableand for reporting a change when retrospective application is impracticable.Retrospective application is the application of a different accountingprinciple to a prior accounting period as if that principle had always beenused or as the adjustment of previously issued financial statements to reflecta change in the reporting entity. SFAS No. 154 also addresses thereporting of the correction of an error by restating previously issuedfinancial statements. The Company will adopt the provisions of SFASNo. 154 effective January 1, 2006.

On September 22, 2005, the SEC issuedrules to delay by one-year the required reporting by management oninternal controls over financial reporting for non-accelerated filers. The newSEC rule extends the compliance date for such registrants to fiscal yearsending on or after July 15, 2007. Accordingly, the Company qualifies forthe deferral until its year ending December 31, 2007 to comply with theinternal control reporting requirements.

4.   PROPERTY AND EQUIPMENT

Property andequipment are recorded at cost and consist of the following:
|                                  | ** ** | **December 31,**   | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2004**                | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Computer  equipment and software |       | $                       | 8,735      |   | $ | 2,977 |   |
| Furniture and  fixtures          |       | 706                     |       | 143 |   |
|                             |       | 9,441                   |       | 3,120 |   |
| Less accumulated  depreciation   |       | (9,342                  | )          | (1,175 | ) |
| Property and  equipment, net     |       | $                       | 99         |   | $ | 1,945 |   |

 

AtDecember 31, 2005, the Company reclassified $8.372 million of property andequipment against the related accumulated deprecation accounts to reflect theretirement of such property and equipment.

Impairment offixed assets is monitored on a continuing basis, and is assessed based on theundiscounted cash flows generated by the underlying assets. In the event thecarrying amount of fixed assets exceeds the undiscounted future cash flows,then the carrying amount of such assets is adjusted to their fair value.

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5.   GOODWILLAND OTHER INTANGIBLE ASSETS

Components of the Company’sidentifiable amortizable intangible assets at December 31, 2005 are asfollows:
|                        | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|------------------------|------------|---------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **(in thousands)**         | ** ** |
|                   |       |                            |       |                          |       |                          |       |
| Customer relationships |       | $                               | 2,264      |                          | $          | 314                           |       | $ | 1,950 |   |
| Proprietary technology |       | 7,602                           |       | 1,056                         |       | 6,546                         |       |
| Non-compete agreement  |       | 1,384                           |       | 193                           |       | 1,191                         |       |
| Total                  |       | $                               | 11,250     |                          | $          | 1,563                         |       | $ | 9,687 |   |

 

Amortization expense ofintangible assets for the year ended December 31, 2005 was $1.563 million.There was no amortization of intangible assets for the year endedDecember 31, 2004. Amortization expense of intangible assets for the nextfour succeeding years is as follows:
| **Years Ending December 31,** | ** ** | **Amortization  Expense** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **(in thousands)**   | ** ** |
|                                         |       |                      |       |
| 2006                                         |       | $                         | 3,752      |   |
| 2007                                         |       | 3,601                     |       |
| 2008                                         |       | 2,182                     |       |
| 2009                                         |       | 152                       |       |
| Total                                        |       | $                         | 9,687      |   |

 

In accordance with SFAS No. 142, “Goodwill andOther Intangible Assets”, an intangible asset that is not subject toamortization such as goodwill shall be, at a minimum, tested for impairmentannually. The first of the impairment tests consists of a comparison of thetotal fair value of the Company based upon the closing stock price and theCompany’s net assets on the date of the test. If the fair value is in excess ofthe net assets, there is no indication of impairment and no need toperform the second tier impairment test. The Company expects toperform this test as of July 31, 2006, the one year anniversary ofthe acquisition of MediaDefender, which resulted in the recording of thegoodwill carried on the Company’s books.

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6.   DEFERREDFINANCING COSTS

Components of the Company’sdeferred financing costs at December 31, 2005 are as follows:
|                                                                             | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Write-off  Related to  Conversion of  Subordinated  Convertible  Notes Payable  into Shares of  Common  Stock** | ** ** | **Net  Carrying  Amount** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                  | ** ** | **(in thousands)**     | ** ** |
| ** **                                                                  | ** ** | **(RESTATED)**              | ** ** | **(RESTATED)**                | ** ** | ** **                                                                                                                                 | ** ** | **(RESTATED)**            | ** ** |
| Deferred financing  costs related to subordinated convertible notes payable |       | $                           | 2,722      |                          | $          | 291                                                                                                                                        |       | $                         | 31         |   | $ | 2,400 |   |
| Deferred financing  costs related to senior secured notes payable           |       | 1,011                       |       | 111                           |       | —                                                                                                                                     |       | 900                       |       |
| Total                                                                       |       | $                           | 3,733      |                          | $          | 402                                                                                                                                        |       | $                         | 31         |   | $ | 3,300 |   |

 

Amortization expense ofdeferred financing costs for the next four succeeding years is as follows:
| **Years Ending December 31,** | ** ** | **Amortization  Expense** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **(in thousands)**   | ** ** |
| ** **                                   | ** ** | **(RESTATED)**            | ** ** |
| 2006                                         |       | $                         | 928        |   |
| 2007                                         |       | 928                       |       |
| 2008                                         |       | 928                       |       |
| 2009                                         |       | 516                       |       |
| Total                                        |       | $                         | 3,300      |   |

 

7.   ALLOWANCEFOR DOUBTFUL ACCOUNTS AND RESERVE FOR SALES RETURNS

A summary of theactivity with respect to the allowance for doubtful accounts is as follows:
| ** **                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| **Continuing Operations**   | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(in thousands)**                     | ** ** |
|                             |       |                                        |       |   |   |
| Balance, beginning of  year      |       | $                                           | 88         |   | $ | 171 |   |
| Provision for doubtful  accounts |       | 110                                         |       | 105 |   |
| Amounts charged off              |       | (27                                         | )          | (99 | ) |
| Balance, end of year             |       | $                                           | 171        |   | $ | 177 |   |

 
| ** **                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| **Discontinued Operations** | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(in thousands)**                     | ** ** |
|                             |       |                                        |       |   |   |
| Balance, beginning of  year      |       | $                                           | 55         |   | $ | 39 |   |
| Provision for doubtful  accounts |       | (16                                         | )          | (39 | ) |
| Balance, end of year             |       | $                                           | 39         |   | $ | — |   |

 

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A summary of theactivity with respect to the reserve for sales returns is as follows:
| ** **                     | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|
| **Continuing Operations** | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                     | ** ** | **(in thousands)**                     | ** ** |
|                           |       |                                        |       |   |   |
| Balance, beginning of  year    |       | $                                           | 12         |   | $ | — |   |
| Amounts charged off            |       | (12                                         | )          | — |   |
| Balance, end of year           |       | $                                           | —     |   | $ | — |   |

 
| ** **                                            | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|
| **Discontinued Operations**                      | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                     | ** ** |
|                                                  |       |                                        |       |   |   |
| Balance, beginning of  year                           |       | $                                           | 255        |   | $ | 199 |   |
| Provision for sales  returns                          |       | 597                                         |       | — |   |
| Reclassification to  accrued expenses                 |       | —                                      |       | (48 | ) |
| Adjustment attributable  to ARTISTdirect Records, LLC |       | —                                      |       | (109 | ) |
| Amounts charged off                                   |       | (653                                        | )          | (30 | ) |
| Balance, end of year                                  |       | $                                           | 199        |   | $ | 12 |   |

 

8.   ACCRUEDEXPENSES

Accrued expensesare comprised of the following:
| ** **                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2004**                | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| Accrued cost of sales                |       | $                       | 239        |   | $ | 265 |   |
| Accrued compensation  and related    |       | 124                     |       | 670 |   |
| Accrued professional  fees           |       | 180                     |       | 467 |   |
| Accrued business and  property taxes |       | 250                     |       | 168 |   |
| Accrued rent                         |       | 224                     |       | — |   |
| Other accrued expenses               |       | 257                     |       | 353 |   |
| Total accrued expenses               |       | $                       | 1,274      |   | $ | 1,923 |   |

 

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9.   ACQUISITIONOF MEDIADEFENDER, INC.

On July 28,2005, the Company consummated the acquisition (the “Acquisition”) ofMediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”),pursuant to the terms of an Agreement and Plan of Merger (the “Merger Agreement”)entered into by and among the Company, ARTISTdirect Merger Sub, Inc., aDelaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”),and MediaDefender. Under the terms of the Merger Agreement, Merger Sub mergedwith and into MediaDefender, the separate corporate existence of Merger Subceased and MediaDefender survived as a wholly-owned subsidiary of the Company.The stockholders of MediaDefender received aggregate consideration of $42.5million in cash, subject to a holdback of $4.25 million which has beenplaced into an escrow account through June 30, 2006 to cover anyindemnification claims under the Merger Agreement by the parties. The amount ofconsideration paid by the Company upon the closing of the Acquisition wasdetermined in arm’s-length negotiations among the parties thereto. Prior toentering into the agreement discussed above, there were no materialrelationships between or among the Company or any of its affiliates, officersor directors, or associates of any such officers or directors, on the one hand,and MediaDefender or any of its affiliates, officers or directors, orassociates of any such officers or directors, on the other.

MediaDefender is aprovider of anti-piracy solutions in the high-growth Internet-piracy-protection(“IPP”) industry and offers services designed to thwart Internet piracy andencourage consumers to pay for online content.

In accordance with the Merger Agreement, the Company acknowledgedthe terms 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 of MediaDefender.Mr. Saaf and Mr. Herrera will each earn a base salary of no less than$350,000 per annum during the initial term of the agreements, which shallcontinue until December 31, 2008, and are also entitled to receiveperformance bonuses of up to $350,000 if MediaDefender achieves specifiedearnings targets in fiscal 2007 and 2008. Mr. Saaf and Mr. Herreraare each entitled to receive 12 months of severance pay at the rate of 100% oftheir monthly salary and the pro-rata portion of the performance bonusreferenced above if they are terminated “without cause”. In addition, theCompany granted stock options to purchase up to 200,000 shares of common stockto each of Mr. Saaf and Mr. Herrera, exercisable for a period of 5years at $3.00 per share.

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 prohibitMr. Saaf and Mr. Herrera from (i) engaging in certaincompetitive business activities, (ii) soliciting customers ofMediaDefender or the Company, (iii) soliciting existing employees ofMediaDefender or the Company and (iv) disclosing any confidentialinformation regarding MediaDefender or the Company. Each agreement has a termof 4 years and shall continue to remain in force and effect in the eventthe above-referenced Employment Agreements are terminated prior to the end ofthe 4 year term of the Non-Competition Agreements. In consideration,Mr. Saaf and Mr. Herrera are each entitled to a cash payment of $525,000from MediaDefender to be paid on December 31, 2006.

As a result of these agreements, effectiveJuly 28, 2005, the Company recorded an asset of $1,050,000 for thenon-compete agreements and a related liability of $1,050,000 for the guaranteedpayments to MediaDefender management. The $1,050,000 allocated to non-competeagreements is being amortized over the life of the employment agreements.

Mr. Saaf and Mr. Herrera have each electedto invest $2,250,000 in the convertible subordinated debt transaction describedbelow on the same terms and conditions as the other investors in suchfinancing, as described below.

Concurrent with the consummation of the Acquisitiondescribed above, the Company completed a $15 million senior secured debttransaction (the “Senior Financing”) and a $30 million convertiblesubordinated debt transaction (the “Sub-Debt Financing”) (collectively “Notes”).Legal fees paid or reimbursed by the Company for services provided by therespective legal counsels for the lenders were recorded as a charge to deferredfinancing costs and are being amortized over the terms of the related debt.

The Senior Financing was completed in accordance withthe terms set forth in the Note and Warrant Purchase Agreement entered into onJuly 28, 2005 by the Company, each of the investors indicated on theschedule of buyers attached thereto and U.S. Bank National Association asCollateral Agent (the “Note Purchase Agreement”). Pursuant to the terms of theNote Purchase Agreement, each investor received a note with a term of threeyears and eleven months that bears interest at the rate of 11.25% perannum (each a “Senior Note”), payable quarterly, with any unpaid principal andaccrued interest due and payable at maturity. Termination and payment of theSenior Notes by the Company prior to maturity will not result in a prepaymentfee. As collateral for the $15 million Senior Financing, the investorsreceived a first priority security interest in all existing and future assetsof the Company and its subsidiaries, tangible and intangible, including but notlimited to, cash and cash equivalents, accounts receivable, inventories, othercurrent assets, furniture, fixtures and equipment and intellectual property.

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The Company is required to comply with certainfinancial covenants, including minimum working capital, maximum capitalexpenditures, minimum leverage ratio, minimum EBITDA and minimum fixed chargecoverage ratio. In addition, not later than ninety days after the close of eachfiscal year, the Company is obligated to apply 60% of its excess cash flow, asdefined, to prepay the principal amount of the Senior Notes, which the Companyhas determined to be $390,000 and has been shown as a current liability atDecember 31, 2005. The Company was not in compliance with certain of thesefinancial covenants at December 31, 2005. On April 7, 2006, thelenders provided waivers with respect to such events of default under the Notesand amended their loan documents such that the warrant liability and any changethereto in future periods (as described below) will not affect future covenantand excess cash flow calculations. The investors provided waivers with respectto any past technical default of the financial covenants related to theaccounting treatment of the above-referenced warrant liability booked inaccordance with FAS No.133 and EITF 00-19. However, the waiver provided does not extend to the embedded derivativeliabilities associated with the Sub-debt, which resulted in this restatement(see Note 22. Subsequent events).

In addition, the investors received five year warrantsto purchase up to an aggregate of 3,250,000 shares of the Company’s commonstock at an exercise price of $2.00 per share, subject to certain anti-dilutionadjustments (collectively, the “Senior Warrant Shares”). The Senior warrantswere valued at $1,982,500 based on a valuation report prepared by anindependent valuation firm and were recorded as a discount to the $15 millionsenior secured debt, and are being amortized over the term of the debt.

The Sub-Debt Financing was completed in accordancewith the terms set forth in the Securities Purchase Agreement entered into onJuly 28, 2005 by the Company and each of the investors indicated on theschedule of buyers attached thereto (the “Securities Purchase Agreement”).Pursuant to the terms of the Securities Purchase Agreement, each investorreceived a convertible subordinated note with a term of four years thatbears interest at the rate of 4.00% per annum (each a “Sub-Debt Note”), withany unpaid principal and accrued interest due and payable at maturity. Interestis payable quarterly in cash or shares of common stock, at the option of theCompany, with payments commencing September 30, 2006. Each Sub-Debt Notehas an initial conversion price of $1.55 per share, subject to certainanti-dilution and change-of-control adjustments. In addition, each Sub-DebtNote is subject to mandatory conversion by the Company in the event certaintrading price targets for the Company’s common stock are met following effectivenessof a registration statement filed by the Company for the securities issued inthe Sub-Debt Financing.

The Company is required to comply with certainfinancial covenants, including minimum working capital, maximum capitalexpenditures, minimum leverage ratio, minimum EBITDA and minimum fixed chargecoverage ratio. The Company was not in compliance with certain of thesefinancial covenants at December 31, 2005. On April 7, 2006, the lendersprovided waivers with respect to such events of default under the Notes andamended their loan documents such that the warrant liability and any changethereto in future periods (as described below) will not affect future covenantcalculations.  The investors providedwaivers with respect to any past technical default of the financial covenantsrelated to the accounting treatment of the above-referenced warrant liabilitybooked in accordance with FAS No.133 and EITF 00-19.  However, the waiver provided does not extendto the embedded derivative liabilities associated with the Sub-debt, whichresulted in this restatement (see Note 22. Subsequent events).

In addition, the Sub-Debt Financing investors receivedfive year warrants to purchase up to 1,596,774 shares of common stock atan exercise price of $1.55 per share, subject to certain anti-dilutionadjustments (collectively, the “Sub-Debt Warrant Shares”). The Sub-debtwarrants were valued at $1,133,710 based on a valuation report prepared by anindependent valuation firm and were recorded as a discount to the $30 millionof convertible subordinated debt, and are being amortized over the term of thedebt.

The subordinated convertibledebentures (“Sub-debt”) in addition to containing certainregistration rights which required the Company to file and maintain effective aregistration statement with SEC covering the shares of common stock underlyingthe debt and the associated warrants, also has other conversion features whichin accordance with FASB No.133 and EITF 00-19, and SEC rules requires theCompany to value these warrants and rights as embedded derivatives (“derivatives”).  The bifurcated value of these obligations, asdetermined by an independentconsultant as of July 2005, was calculated using a lattice (binomial)valuation model.  The Company recorded $10,534,000 as aderivative liability along with an associated discount against the liability equal to the initial valuation asof July 2005.  The discount is amortized over the original term of theunderlying Sub-debt notes (48 months) as interest expense.  The Companyis also required to revalue this derivative liability at the end of eachreporting period.  In accordance withEITF 00-19, the fair value of the derivatives will be adjusted to reflect anychanges in the fair value of the derivatives from the date of issuance to theend of each reporting period, and any such changes will be included in thestatement of operations as other income (expense).  If the fair value of the derivatives ishigher at the subsequent reporting date, the Company will record a non-operating,non-cash charge. If the fair value of the derivatives is lower at thesubsequent reporting date, the Company will record non-operating, non-cashincome.

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Pursuant to the terms of the Senior RegistrationRights Agreement and the Sub-Debt Registration Rights Agreement, the Companywas obligated to have a registration statement covering the securities issuedin the Senior Financing and the Sub-Debt Financing on file with and declaredeffective by the Securities and Exchange Commission within one hundred eightydays of July 28, 2005. In connection therewith, the Company’s RegistrationStatement on Form SB-2, as amended, was declared effective by theSecurities and Exchange Commission on December 9, 2005.

To induce the Senior Financing investors to participatein the above referenced transaction, the Sub-Debt Financing investors enteredinto a Subordination Agreement for the benefit of the Senior Financinginvestors pursuant to which the Sub-Debt Financing investors agreed tosubordinate their rights to the holders of the senior debt.

If all of the securities issued in the SeniorFinancing and the Sub-Debt Financing are converted or exercised into shares ofthe Company’s common stock in accordance with their respective terms, it willresult in significant dilution to the Company’s existing stockholders. If allof the Company’s outstanding equity-based instruments are converted orexercised into shares of the Company’s common stock in accordance with theirrespective terms, including those issued in conjunction with the Acquisition,there will be a total of approximately 38,000,000 shares of the Company’scommon stock issued and outstanding.

A change in control of the Company could occur as aresult of the Senior Financing and the Sub-Debt Financing. Assuming maximumconversion of the securities issued in the Senior Financing and Sub-DebtFinancing occurs, the Senior Financing investors would own approximately 9% ofthe Company’s voting stock, on a fully diluted basis, and the Sub-Debtinvestors would own approximately 55% of the Company’s voting stock, on a fullydiluted basis.

The securities issued by the Company in the SeniorFinancing and the Sub-Debt Financing were offered and sold in reliance uponexemptions from registration pursuant to Section 4(2) under theSecurities Act of 1933, as amended (the “Securities Act”), and Rule 506promulgated thereunder. Each of the investors qualified as an “accreditedinvestor,” as specified in Rule 501 under the Securities Act.

Pursuant to the terms of a letter agreement, datedJuly 15, 2005, by and between the Company and Broadband Capital ManagementLLC (“Broadband”), the Company issued to Broadband a Sub-Debt Note in theamount of $1,460,500 (in addition to the $30 million referred to above)and warrants to purchase up to 1,516,935 shares of common stock with anexercise price of $1.55 per share. The notes and warrants issued to Broadbandor its affiliates were issued on the same terms and conditions granted to theother 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 inreliance upon exemptions from registration pursuant toSection 4(2) under the Securities Act and Rule 506 promulgatedthereunder. The Broadband warrants were valued at $1,077,024 as of July 2005,based on a valuation report prepared by an independent valuation firm. Theaggregate value of the Sub-Debt Note, the warrants and additional cash paymentsto Broadband aggregating $299,500 were charged to deferred financing costs andare being amortized over the term of the debt.

Pursuant to the terms of a letter agreement, datedJune 21, 2005, by and between the Company and Libra FE, LP (“Libra”), theCompany issued Libra Warrant Shares to purchase up to 237,500 shares of itscommon stock with an exercise price of $2.00 per share upon the closing of theSenior Financing (the “Libra Warrant Shares”). The warrants were issued aspartial consideration for Libra’s services as the Company’s placement agent inthe Senior Financing described above. The Company entered into a RegistrationRights Agreement with Libra on July 28, 2005 (the “Libra RegistrationRights Agreement”), pursuant to which the Company will include the LibraWarrant Shares in the registration statement covering the securities issued inthe Senior Financing and the Sub-Debt Financing described above. The LibraWarrant Shares were issued in reliance upon exemptions from registration pursuantto Section 4(2) under the Securities Act and Rule 506promulgated thereunder. The Libra Warrant Shares were valued at $175,750 as ofJuly 2005, based on a valuation report prepared by an independent valuationfirm. The aggregate value of the warrants and additional payments to Libra of$450,997 were charged to deferred financing costs and are being amortized overthe term of the debt.

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The Senior warrants,Sub-Debt warrants, Broadband warrants and Libra Warrant Shares collectively (“Warrants”)contain certain registration rights requiring the Company to file and maintaineffective a registration statement with the SEC covering the shares of commonstock underlying the Warrants.  Inaccordance with FAS 133 and EITF 00-19 the fair value of the warrants, asdetermined by an independentconsultant as of July 2005, was calculated by using the Black-Scholesmethod.  The Company recorded a Warrantliability as well as associated deferred financing costs and additional paid incapital of $4,369,000 equal to the initial valuation as of July 2005.  These costs will be amortized over the termof the associated notes to interest expense and amortization of deferredfinancing costs as other (expense) on the statement of operations.  The carrying value of the Warrants will beadjusted to reflect any changes in the fair value of the warrants from the dateof issuance to the end of each reporting period, and any such changes will beincluded in the statement of operations as other income (expense).  Any change in fair value will be recorded asa non-operating, non-cash income or expense at each reporting date.  If the fair value of warrants is higher atthe subsequent reporting date, the Company will record a non-operating,non-cash charge. If the fair value of the warrants is lower at the subsequentreporting date, the Company will record non-operating, non-cash income.  The fair value of these warrants wasdetermined, at the inception date, utilizing the Black-Scholes model.

Upon the closingof the Acquisition, the Company issued 1,109,032 shares of common stock and awarrant to purchase up to 114,985 shares of common stock with an exercise priceof $1.55 per share to WNT07 Holdings, LLC, which was approved by thedisinterested members of the Company’s Board of Directors. The managers ofWNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both members ofthe Company’s Board of Directors. The shares and warrants were issued asconsideration for services provided by Mr. Pulier andMr. Boutros-Ghali as consultants to the Company in connection with theAcquisition. The shares and warrants were issued in reliance upon exemptionsfrom registration pursuant to Section 4(2) under the Securities Actand Rule 506 promulgated thereunder.

On July 28, 2005, the Company entered into aNon-Competition Agreement with WNT07 Holdings, LLC, Eric Pulier and TeymourBoutros-Ghali (collectively, the “Advisors”). The Non-Competition Agreementprohibits any of the Advisors (i) from engaging in certain competitivebusiness activities and (ii) from soliciting existing employees of theCompany or its subsidiaries. The covenants not to complete or solicit expire onthe earlier of April 1, 2007 or the date of termination of Advisor’sservices with the Company.

The shares of common stock were valued at $1,585,916($1.43 per share) and the warrants were valued at $83,939, based on a valuationreport prepared by an independent valuation firm, for an aggregate value of$1,669,855, of which $333,971 was allocated to the covenant not to compete and theremaining $1,335,884 was included in total costs that the Company incurred toacquire MediaDefender. The amount allocated to the covenant not to compete isbeing amortized through April 1, 2007.

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This transaction was accounted for as a purchase inaccordance with SFAS No. 141, “Business Combinations”, and the operationsof the two companies have been consolidated commencing August 1, 2005. Thefollowing table summarizes the assets acquired and liabilities assumed ofMediaDefender at July 28, 2005. The fair value of the intangible assetsacquired and their respective amortization periods was determined by anindependent valuation firm.

|                                                | ** ** | **(in thousands)** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
|                                           |       |                    |       |
| Assets Acquired:                               |       |                    |       |
| Cash                                           |       | $                       | 1,365      |   |
| Accounts receivable                            |       | 2,499                   |       |
| Deferred income tax                            |       | 116                     |       |
| Prepaid expenses and  other current assets     |       | 91                      |       |
| Property, plant and  equipment                 |       | 1,749                   |       |
| Deposits                                       |       | 3                       |       |
| Total assets acquired                          |       | 5,823                   |       |
|                                           |       |                    |       |
| Liabilities Assumed:                           |       |                    |       |
| Accounts payable                               |       | 41                      |       |
| Accrued expenses                               |       | 87                      |       |
| Income taxes payable                           |       | 230                     |       |
| Due to  ARTISTdirect, Inc.                |       | 930                     |       |
| Deferred revenue                               |       | 38                      |       |
| Deferred income tax                            |       | 338                     |       |
|                                           |       |                    |       |
| Total liabilities  assumed                     |       | 1,664                   |       |
|                                           |       |                    |       |
| Net assets acquired                            |       | 4,159                   |       |
|                                           |       |                    |       |
| Intangible assets  acquired:                   |       |                    |       |
| Customer relationships                         |       | 2,264                   |       |
| Proprietary technology                         |       | 7,602                   |       |
| Goodwill                                       |       | 31,085                  |       |
|                                           |       |                    |       |
| Total assets acquired                          |       | $                       | 45,110     |   |
|                                           |       |                    |       |
| Total purchase  consideration paid as follows: |       |                    |       |
| Cash paid to  MediaDefender stockholders       |       | $                       | 42,500     |   |
| Transaction  costs incurred                    |       | 2,610                   |       |
|                                           |       |                    |       |
| Total purchase consideration                   |       | $                       | 45,110     |   |

 

The following pro forma operating data presents theresults of operations for the years ended December 31, 2004 and 2005, asif the acquisition had occurred on the first day of each such period.Discontinued operations, impairment losses and non-recurring items for theyears ended December 31, 2004 and 2005 are not included. The pro formaresults are not necessarily indicative of the financial results that might haveoccurred had the acquisition actually taken place on the respective dates, orof future results of operations.
|                                                     | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                 | ** ** |
| ** **                                          | ** ** | ** **                              | ** ** | **(RESTATED)** | ** ** |
| Net revenue                                         |       | $                                       | 15,665     |   | $ | 20,637 |   |
|                                                |       |                                    |       |   |   |
| Net loss                                            |       | $                                       | (37,120    | ) | $ | (35,222 | ) |
|                                                |       |                                    |       |   |   |
| Net loss per common  share – basic and diluted |       | $                                       | (8.05      | ) | $ | (7.64 | ) |
|                                                |       |                                    |       |   |   |
| Weighted average common shares outstanding          |       | 4,611,149                               |       | 4,611,149 |   |

 

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10. INVESTMENT IN ANDADVANCES TO ARTISTDIRECT RECORDS, LLC

In May 2001,ADI, through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., aDelaware corporation (“ARTISTdirect Recordings”), entered into an agreementwith Radar Records Holdings, LLC (“Radar Records”), a company owned byFrederick W. (Ted) Field, to form a new record label, ARTISTdirectRecords, LLC (“ARTISTdirect Records”), as a 50/50 co-venture between ADI andRadar Records. On June 29, 2001, ADI’s stockholders approved theemployment of Mr. Field as Chairman and Chief Executive Officer of ADI andthe formation of the ARTISTdirect Records record label. Mr. Field is theChief Executive Officer of ARTISTdirect Records.

ARTISTdirectRecords, headquartered in Los Angeles, California, was in the business ofdeveloping new musical artists and producing and distributing their recordingsas an independent label utilizing both traditional channels and emergingInternet distribution channels.

ADI initiallycommitted to fund a total of $50.0 million to ARTISTdirect Records over fiveyears at the rate of $15.0 million per year, subject to a limit of $33.0million in any three year period. Any funding in excess of these amountsrequired the approval of ADI’s Board of Directors. ADI funded $33.0 millionthrough December 31, 2003.

InNovember 2001, ARTISTdirect Records agreed in principle to enter into apreliminary North America distribution agreement and worldwide licenseagreement with BMG Music, a wholly-owned partnership of Bertelsmann MusicGroup, Inc., the global music division of Bertelsmann AG (“BMG”). Underthe terms of the agreement, BMG agreed to distribute the label’s releases inNorth America, and BMG licensed ARTISTdirect Records’ repertoire in territoriesthroughout the world. In April 2002, the agreements with BMG werefinalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Recordsfrom ADI. As part of this transaction, BMG agreed to advance certainmonies against net sales proceeds under the agreements and also assumed $5.0million of ADI’s funding commitment to ARTISTdirect Records. As a result of theBMG equity purchase, ADI’s funding commitment was reduced to $45.0 million. ADI’scommitment to fund ARTISTdirect Records was subject to a guaranty for thebenefit of BMG. If ADI failed to meet its commitment, BMG had the right tochoose to enforce the guaranty or provide substitute financing that could haveresulted in dilution of ADI’s interest in ARTISTdirect Records.

InDecember 2002, BMG exercised its option to extend the term of thedistribution and license agreement until September 2004. BMG did not renewits distribution agreement and license agreement upon its expiration inSeptember 2004.

Under thedistribution and license agreements, BMG made non-refundable advances toARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002 and $5.0million in 2003 that were recoupable from net sales proceeds from ARTISTdirectRecords’ artist repertoire pursuant to a defined calculation on a monthlybasis. As of December 31, 2003 and 2004, the unrecouped balances relatedto distribution advances from BMG were $8.7 million and $8.9 million,respectively.

InAugust 2002, ADI’s Board of Directors approved an agreement (the “AcceleratedFunding Agreement”) to accelerate up to $10.0 million of its funding commitmentto ARTISTdirect Records. This funding was in addition to the $15.0 million thatADI was obligated to advance to ARTISTdirect Records in 2002 as part ofthe initial $50.0 million funding commitment. During 2002, ADI funded its $15.0million commitment plus the additional $10.0 million bridge loan for totaladvances to the record label of $25.0 million in 2002 and $30.25 million fromthe inception of the record label through December 31, 2002. The $10.0million of accelerated funding was credited toward the satisfaction of ADI’soverall funding commitment and funding obligation for 2003, resulting in aremaining funding commitment of $2.75 million for 2003 and $12.0 million for2004. ADI advanced the $2.75 million during 2003.

As consideration for entering into the Accelerated Funding Agreement,ADI received an additional 20% interest in ARTISTdirect Records from RadarRecords, the entity through which Mr. Field owned his interest inARTISTdirect Records, which resulted in an increase in ADI’s ownership share ofARTISTdirect Records from 45% to 65% and a decrease in Mr. Field’sownership share from 50% to 30%. The Accelerated Funding Agreement alsoprovided that any dilution from the issuance of equity interests inARTISTdirect Records that would have been borne solely by ADI would be borneboth by Radar Records and ADI pro rata with their then respective ownershipinterests. Furthermore, the Accelerated Funding Agreement provided for RadarRecords to guarantee a 25% minimum annual compounded return to be realized fromADI’s advances and equity interests in ARTISTdirect Records. Due to theuncertainty with respect to the realization of such rate of return, ADI did notrecord any amounts related to the 25% minimum annual compounded return in itsconsolidated financial statements.

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Because ADI didnot have voting or operating control of ARTISTdirect Records, even with itsmajority ownership position, through December 31, 2003 it did notconsolidate the results of ARTISTdirect Records; ADI recorded its share oflosses based on the equity method of accounting as loss from equity investmentsin its consolidated statements of operations. Prior to the completion of BMG’spurchase of a 5% interest in ARTISTdirect Records in April 2002 and BMG’sassumption of 10% of ADI’s total funding commitment, ADI had committed to fund100% of the operations of ARTISTdirect Records and had recorded 100% of thelosses attributable to that venture from the inception of ARTISTdirect Recordsto April 30, 2002. From May 1, 2002 through December 31, 2003,ADI has recorded only its proportionate share, on the basis of remainingrelative funding commitments, of any losses of ARTISTdirect Records. ADI fundeda total of $33.0 million of its funding commitment. ADI recognized $8.6million, $29.2 million and $9.3 million of equity loss from ARTISTdirectRecords for the years ended December 31, 2001, 2002 and 2003, respectively.The loss for ARTISTdirect Records for the year ended December 31, 2004 was$4.881 million before intercompany interest elimination of $2.011 million. Theloss for ARTISTdirect Records for the two months ended February 28, 2005was $802,000 before intercompany interest elimination of $416,000. The lossesof ARTISTdirect Records for 2004 and 2005 were included in ADI’s results ofoperations for the respective periods.

InFebruary 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN46”), which addresses the consolidation by business enterprises of variableinterest entities. FIN 46 defines when a company should evaluate “controllingfinancial interest”, and thus consolidation, based on factors other than votingrights, and requires that a new “risks and rewards” model be applied in thesesituations. ADI adopted FIN 46 as of December 31, 2003. As a result of theadoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidatedbeginning as of December 31, 2003, and the operations of ARTISTdirectRecords were consolidated beginning with the year ended December 31, 2004.There was no change in the operating or business relationship between ADI andARTISTdirect Records as a result of the adoption of FIN 46.

ThroughDecember 31, 2003, ADI continued to record the losses of ARTISTdirectRecords. ADI recorded its loan advances to ARTISTdirect Records as additionalequity investments. As of December 31, 2003 and 2004, the Companyconsolidated the balance sheets of ARTISTdirect Records.

ADI has norecorded investment in its loans to ARTISTdirect Records, as the carryingamount of the loans had been reduced to zero as a result of ADI recording itsshare of losses of ARTISTdirect Records during the year ended December 31,2003. ADI did not record interest income on the loans to ARTISTdirect Records.The interest expense of ARTISTdirect Records is eliminated in consolidation. Assuch, interest expense related to ADI was not included in allocating losses tothe minority interest in ARTISTdirect Records.

The loan advancesprovided to ARTISTdirect Records by ADI and BMG bore interest at a rate ofLIBOR plus 4% and the principal and interest were not repayable untilDecember 31, 2015 or upon such time as ARTISTdirect Records achievedcertain defined levels of excess cash flow and available cash. As ofDecember 31, 2003 and 2004, ARTISTdirect Records had loans payable to ADIof $33.0 million, which were eliminated in consolidation, and to BMG of $4.75million. In addition, as of December 31, 2003 and 2004, ARTISTdirectRecords had accrued interest payable to ADI of $3.0 million and $5.0 million,respectively, which were eliminated in consolidation, and to BMG of $447,000and $747,000, respectively.

During the threemonths ended September 30, 2003, ARTISTdirect Records significantlyreduced its overhead costs and operating activities and laid off the majorityof its staff while it continued to restructure its operations and seek additionalcapital. During 2003, ARTISTdirect Records relied on a loan advance from ADI of$2.75 million and bridge loans from Mr. Field and outside investorsaggregating $2.048 million to fund its operations. As of December 31,2003, ARTISTdirect Records did not have sufficient working capital resources toconduct operations. During 2004 and the two months ended February 28,2005, ARTISTdirect Records relied on bridge loans from Mr. Field of $2.778million and $36,500, respectively, to fund its reduced level of operations.Through February 28, 2005, Mr. Field had provided bridge funding toARTISTdirect Records aggregating $3.713 million, including $898,000 in 2003,$2.778 million in 2004 and $36,500 in 2005 (see Note 12).

EffectiveJuly 30, 2004, ADI entered into a Termination Agreement with BMG andARTISTdirect Records which extinguished all of ADI’s obligations under itsfunding guaranty, including the remaining $12.0 million funding obligation toARTISTdirect Records.

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11. DISCONTINUEDOPERATIONS — ARTISTDIRECT RECORDS, LLC

OnFebruary 28, 2005, ADI completed the sale of 100% of the common stock ofARTISTdirect Recordings to Radar Records pursuant to a Transfer Agreement for acash payment of $115,000, as a result of which ADI no longer had any equity orother economic interest in ARTISTdirect Records, and Radar Records became theowner of a majority of the membership interests in ARTISTdirect Records andalso acquired the receivable reflecting the $33.0 million of loan advancespreviously provided to ARTISTdirect Records by ADI. In conjunction with thistransaction, at February 28, 2005, ADI wrote-off the intercompany balancedue from ARTISTdirect Records of $80,000, which was eliminated inconsolidation. Radar Records acquired the common stock of ARTISTdirect Recordingssubject to the rights of BMG. Radar Records also agreed to offer to investorswho had provided bridge funding to ARTISTdirect Records (see Note 12),excluding Frederick W. Field and entities related or controlled by him, theright to acquire proportional shares (based on the amount of bridge fundingmade by each bridge investor in ARTISTdirect Records) of the common stock ofARTISTdirect Recordings on the same terms and conditions as set forth in theTransfer Agreement.

The amount ofconsideration received by ADI was determined with reference to various factors,including, but not limited to, ADI’s future business plans and intention tofocus on its internet and web-site operations, ARTISTdirect Records’ currentlimited capital resources and substantially reduced level of operations,ARTISTdirect Records’ future business plans and capital requirements and thelikelihood of obtaining such capital on a timely basis and under reasonableterms and conditions, the unpaid costs that ADI has advanced ARTISTdirectRecords to date and would be required to continue to advance ARTISTdirectRecords in the future, and the probability of ADI obtaining a return on itsinvestment to date of $33.0 million in ARTISTdirect Records.

As a result of theexistence of various conflicts of interest with respect to this transaction,full disclosure of these conflicts of interest was made to ADI’s Board ofDirectors and the required approval by the disinterested members of ADI’s Boardof Directors was obtained prior to the closing of the transaction.

As a result of thesale of all of ADI’s interest in ARTISTdirect Recordings to Radar Recordseffective February 28, 2005, ADI accounted for its interest inARTISTdirect Records as a discontinued operation for all periods presented in accordancewith SFAS No. 144, and the assets and liabilities of ARTISTdirect Recordswere classified as “held for sale” through February 28, 2005.

A summary of theassets and liabilities of ARTISTdirect Records, which were classified asdiscontinued operations on ADI’s balance sheets at December 31, 2004 andFebruary 28, 2005, is as follows:

 
| ** **                                        | ** ** | **December  31, 2004** | ** ** | **February  28, 2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **(in thousands)**     | ** ** |
| Assets                                            |       |                        |       |                        |       |
| Current assets                                    |       |                        |       |                        |       |
| Cash                                              |       | $                           | —     |                        | $          | — |   |
| Property and  equipment, net                      |       | 16                          |       | 15                          |       |
| Total assets – discontinued  operations      |       | 16                          |       | 15                          |       |
|                                              |       |                        |       |                        |       |
| Liabilities                                       |       |                        |       |                        |       |
| Current  liabilities                              |       |                        |       |                        |       |
| Bank overdraft                                    |       | 2                           |       | —                      |       |
| Accounts payable  and accrued expenses            |       | 399                         |       | 421                         |       |
| Net liability to  BMG                             |       | 8,862                       |       | 8,866                       |       |
| Current portion  of bridge notes payable -        |       |                        |       |                        |       |
| Outside  investors                                |       | 1,136                       |       | 1,198                       |       |
| Minority  investor — Ted Field               |       | 836                         |       | 1,821                       |       |
| Total current  liabilities                        |       | 11,235                      |       | 12,306                      |       |
| Non-current  liabilities                          |       |                        |       |                        |       |
| Loan due to BMG                                   |       | 5,498                       |       | 5,558                       |       |
| Non-current  portion of bridge notes payable -    |       |                        |       |                        |       |
| Outside  investors                                |       | —                      |       | —                      |       |
| Minority investor  – Ted Field               |       | 2,037                       |       | 1,273                       |       |
| Total liabilities —  discontinued operations |       | 18,770                      |       | 19,137                      |       |
|                                              |       |                        |       |                        |       |
| Members’ deficit                             |       | $                           | (18,754    | )                           | $          | (19,122 | ) |

 

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A summary of theresults of operations of ARTISTdirect Records for the year endedDecember 31, 2004 and the two months ended February 28, 2005 is asfollows:
|                                      | ** ** | **Year Ended  December 31, 2004** | ** ** | **Two Months  Ended February  28, 2005** |   |
|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------|--------|
| ** **                           | ** ** | **(in thousands)**                          |       |
|                                 |       |                                             |       |                                                    |   |
| Net revenue                          |       | $                                                | (19        | )                                                       | $      | — |   |
| Cost of revenue                      |       | 986                                              |       | 14                                                      |   |
| Gross loss                           |       | (1,005                                           | )          | (14                                                     | )      |
| Operating  expenses:                 |       |                                             |       |                                                    |   |
| Sales and marketing                  |       | 285                                              |       | 18                                                      |   |
| General and administrative           |       | 393                                              |       | 25                                                      |   |
| Depreciation and amortization        |       | 22                                               |       | 1                                                       |   |
| Total operating expenses             |       | 700                                              |       | 44                                                      |   |
| Loss from operations                 |       | (1,705                                           | )          | (58                                                     | )      |
| Interest expense                     |       | (649                                             | )          | (128                                                    | )      |
| Amortization of bridge note warrants |       | (998                                             | )          | (201                                                    | )      |
| Forgiveness of debt                  |       | 482                                              |       | —                                                  |   |
| Minority interest                    |       | 759                                              |       | 116                                                     |   |
| Net loss                             |       | $                                                | (2,111     | )                                                       | $      | (271 | ) |

 

As a result of thedisposition of ADI’s interest in ARTISTdirect Records effectiveFebruary 28, 2005, ADI recognized a gain (primarily non-cash) in itsconsolidated statement of operations for the year ended December 31, 2005of $21.079 million, primarily as a result of the elimination of the liabilitiesof ARTISTdirect Records.

|                                                                              | ** ** | **(in thousands)** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
|                                                                         |       |                    |       |
| Liabilities disposed  of:                                                    |       |                    |       |
| Current  liabilities                                                         |       |                    |       |
| Accounts payable  and accrued expenses                                       |       | $                       | 421        |   |
| Net liability to  BMG, principal distributor                                 |       | 8,866                   |       |
| Current portion  of bridge notes payable -                                   |       |                    |       |
| Outside  investors                                                           |       | 1,198                   |       |
| Minority  investor - Ted Field                                               |       | 1,821                   |       |
| Total current  liabilities                                                   |       | 12,306                  |       |
| Non-current  liabilities                                                     |       |                    |       |
| Loan due to BMG,  principal distributor                                      |       | 5,558                   |       |
| Non-current  portion of bridge notes payable - Minority investor - Ted Field |       | 1,273                   |       |
| Total  liabilities disposed of                                               |       | 19,137                  |       |
| Minority interest  relieved                                                  |       | 1,842                   |       |
| Cash proceeds  received                                                      |       | 115                     |       |
| Total                                                                        |       | 21,094                  |       |
| Less: Assets disposed  of Property and equipment, net                        |       | (15                     | )          |
| Net gain from sale                                                           |       | $                       | 21,079     |   |

 

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12. BRIDGE NOTES PAYABLE

As ofDecember 31, 2003 and 2004, and February 28, 2005, ARTISTdirectRecords had outstanding loans of $898,000, $3.676 million and $3.713 million,respectively, due to Ted Field and $1.150 million of loans due to outsideinvestors (including $100,000 from Jonathan V. Diamond, the Company’s Presidentand Chief Executive Officer). These loans were obtained through the issuance ofconvertible promissory notes (the “Bridge Notes”). The Bridge Notes accruedinterest at 8% per annum, were due two years from the date of issuance, andwere convertible into new preferred equity of ARTISTdirect Records aspart of its next equity financing. The Bridge Notes payable toMr. Field and to outside investors were included in liabilities ofdiscontinued operations held for disposal in the consolidated balance sheets atDecember 31, 2003 and 2004.

The holders of theBridge Notes also received warrants with a term of five years to purchaseadditional equity of ARTISTdirect Records at $0.01 per unit equivalent to thenumber of units of new equity into which their Bridge Notes were ultimatelyconverted. The aggregate relative fair value of the warrants issued was $2.431million as of February 28, 2005 (one-half of the amount funded by the investorsin the Bridge Notes), which was recorded as a reduction to the carrying amountof the Bridge Notes and a credit to capital, and was being charged tooperations as interest expense over the specified term of the Bridge Notes.

The Bridge Noteswere convertible into equity based on their face amount, which resulted in abeneficial conversion feature with a relative fair value of $2.431 million.Since the commitment date for the beneficial conversion feature was contingentupon the completion of ARTISTdirect Record’s next equity financing, the fairvalue of the beneficial conversion feature was to be charged to operations overthe remaining life of the Bridge Notes at that time.

During the yearsended December 31, 2003 and 2004 and the two months endedFebruary 28, 2005, ARTISTdirect Records recognized $203,000, $998,000 and$183,000, respectively, as interest expense with respect to the amortization ofthe fair value of the warrants. Additional interest expense of approximately$1.2 million was scheduled to be recognized ratably over the remainder of 2005and 2006 over the remaining term of the Bridge Notes. As of December 31,2004 and February 28, 2005, the carrying amount of the Bridge Notes,including accrued interest of $396,000 and $459,000, respectively, was $4.009million and $4.292 million, respectively.

A reconciliationof Bridge Notes payable issued by ARTISTdirect Records during 2003 and 2004 toamounts included in liabilities of discontinued operations in the consolidatedbalance sheets at December 31, 2003 and 2004 is presented below. Duringthe years ended December 31, 2003 and 2004 and the two months endedFebruary 28, 2005, ARTISTdirect Records recorded costs with respect tosuch bridge notes as summarized below.
| ** **                                                   | ** ** | **Outside  Investors**  | ** ** | **Ted Field** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|--------------------|------------|
| ** **                                                   | ** ** | **(in thousands)** | ** ** |
|                                                         |       |                    |       |               |       |
| Gross amount funded  during 2003                             |       | $                       | 1,150      |               | $          | 898 |   |
| Deduct:                                                      |       |                    |       |               |       |
| Fair value of  warrants                                      |       | (575                    | )          | (449               | )          |
| Add:                                                         |       |                    |       |               |       |
| Accrued interest                                             |       | 44                      |       | 23                 |       |
| Amortization of  fair value of warrants in 2003              |       | 136                     |       | 67                 |       |
| Net liability at  December 31, 2003                     |       | 755                     |       | 539                |       |
| Gross amount funded  during 2004                             |       | —                  |       | 2,778              |       |
| Deduct:                                                      |       |                    |       |               |       |
| Fair value of warrants                                       |       | —                  |       | (1,389             | )          |
| Add:                                                         |       |                    |       |               |       |
| Accrued interest                                             |       | 94                      |       | 235                |       |
| Amortization of  fair value of warrants in 2004              |       | 287                     |       | 710                |       |
| Net liability at  December 31, 2004                     |       | 1,136                   |       | 2,873              |       |
| Gross amount funded  during 2005 (two months)                |       | —                  |       | 37                 |       |
| Add:                                                         |       |                    |       |               |       |
| Accrued interest  (two months)                               |       | 15                      |       | 48                 |       |
| Amortization of  fair value of warrants in 2005 (two months) |       | 47                      |       | 136                |       |
| Net liability at  February 28, 2005                     |       | 1,198                   |       | 3,094              |       |
| Less:                                                        |       |                    |       |               |       |
| Amounts due  within one year                                 |       | (1,198                  | )          | (1,821             | )          |
| Amounts due after one  year                                  |       | $                       | —     |               | $          | 1,273 |   |

 

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13. DISCONTINUEDOPERATIONS — iMUSIC

During 2002, theCompany began operating a record label under the brand name iMusic through itswholly-owned subsidiary, ARTISTdirect Digital, Inc. Operations consistedprimarily of the sale of compact discs by artists signed to the iMusic recordlabel. During the three months ended June 30, 2003, management of theCompany decided to scale back the activity of its iMusic label in order toconserve capital. During the three months ended September 30, 2003, theCompany executed an agreement with GC Music, pursuant to which the Companyassigned its rights and obligations to six unreleased artists in exchange for acash payment of $100,000 as a reduction to prior advances related to the sixartists and a profit interest in the projects. GC Music was partially owned bya former officer and director of the Company. The Company retained thedistribution rights to the albums previously released under the original termsof its distribution agreements with its other signed artists, but did notintend to sign any additional artists or release any additional albumsdomestically or internationally under the iMusic label and therefore expectedvery minimal sales activity subsequent to the transaction. At December 31,2004 and 2005, the Company has provided a sufficient reserve for remainingcontract obligations and estimated product returns.

EffectiveNovember 23, 2004, pursuant to a Trademark Assignment and Purchase Agreementdated as of November 12, 2004, the Company sold all of its rights, titleand interest in and to certain trademarks, service markets and trade names, incertain countries of the world, that consist of or incorporate the term “iMusic”(the “Marks”), including domain names that consist of or incorporate the termiMUSIC (the “Domain Names”) and goodwill related to such marks or trade names,to Apple Computer, Inc. for a cash payment of $500,000. The Marks andDomain Names that the Company sold did not have any carrying value on theCompany’s books.

As a result of theforegoing, during December 2004, the Company ceased the sale of productsunder the iMusic label and discontinued the operations of the iMusic recordlabel. Accordingly, the Company has accounted for the operations of iMusic as adiscontinued operation for all periods presented to reflect the termination ofthe business operations of iMusic.

A summary of theliabilities of iMusic, which were classified as discontinued operations on theCompany’s balance sheets at December 31, 2004 and 2005, is shown below.iMusic did not have any assets at December 31, 2004 or 2005.

 
| ** **                                        | ** ** | **December 31,**   | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **2004**                | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | **(in thousands)** | ** ** |
|                                              |       |                    |       |   |   |
| Liabilities                                       |       |                    |       |   |   |
| Current liabilities                               |       |                    |       |   |   |
| Net liability to BMG                              |       | $                       | 41         |   | $ | 12 |   |
| Net liability to GC Music                         |       | —                  |       | 88 |   |
| Accounts payable and accrued expenses             |       | 49                      |       | 49 |   |
| Reserve for product returns                       |       | 60                      |       | — |   |
| Total current liabilities                         |       | 150                     |       | 149 |   |
| Total  liabilities – discontinued operations |       | 150                     |       | 149 |   |
| Net deficit                                       |       | $                       | (150       | ) | $ | (149 | ) |

 

A summary of theoperations of the iMusic record label for the years ended December 31,2004 and 2005 is as follows:
| ** **               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(in thousands)**                     | ** ** |
|                     |       |                                        |       |   |   |
| Net revenue              |       | $                                           | (136       | ) | $ | — |   |
| Cost of revenue          |       | (1                                          | )          | — |   |
| Gross profit (loss)      |       | (135                                        | )          | — |   |
| Operating  expenses:     |       |                                        |       |   |   |
| Sales and marketing      |       | 2                                           |       | — |   |
| Total operating expenses |       | 2                                           |       | — |   |
| Net loss                 |       | $                                           | (137       | ) | $ | — |   |

 

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14. INCOME TAXES

The components of the provision for income taxes areas follows:
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** ** | ** ** | **(in thousands)**                     | ** ** |
| Current:   |       |                                        |       |   |   |
| Federal    |       | $                                           | —     |   | $ | 158 |   |
| State      |       | —                                      |       | 40 |   |
|       |       | $                                           | —     |   | $ | 198 |   |
|       |       |                                        |       |   |   |
| Deferred:  |       |                                        |       |   |   |
| Federal    |       | $                                           | —     |   | $ | 12 |   |
| State      |       | —                                      |       | 31 |   |
|       |       | —                                      |       | 43 |   |
| Total      |       | $                                           | —     |   | $ | 241 |   |

 

Income taxesdiffer from the amount computed using a tax rate of 35% as a result of thefollowing:
| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                          | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Computed  expected tax expense (benefit)                            |       | $                                           | (1,145     | ) | $ | (4,105 | ) |
| State and local  income taxes, net of federal income tax benefit    |       | 19                                          |       | 25 |   |
| Amortization of  non-cash financing costs                           |       | 648                                         |       | 1,108 |   |
| Adjustments to  deferred tax assets                                 |       | 2,058                                       |       | 6,688 |   |
| Permament  adjustments caused by warrant and derivative liabilities |       | —                                      |       | 10,641 |   |
| Other                                                               |       | 20                                          |       | 25 |   |
|                                                                |       | 1,600                                       |       | 14,382 |   |
| Valuation  allowance                                                |       | (1,600                                      | )          | (14,141 | ) |
| Total income tax  expense                                           |       | $                                           | —     |   | $ | 241 |   |

 

The tax effects oftemporary differences that give rise to significant portions of the deferredtax assets and liabilities at December 31, 2004 and 2005 are as follows:
| ** **                        | ** ** | **December 31,**   | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **2004**                | ** ** | **2005** | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| Deferred tax  liabilities:        |       |                    |       |   |   |
| State income taxes                |       | $                       | 4,056      |   | $ | 3,237 |   |
| Depreciation                      |       | —                  |       | 63 |   |
| Total deferred tax liabilities    |       | 4,056                   |       | 3,300 |   |
|                              |       |                    |       |   |   |
| Deferred tax  assets:             |       |                    |       |   |   |
| Net operating loss carryforwards  |       | 58,152                  |       | 48,022 |   |
| Amortization of intangible assets |       | —                  |       | 640 |   |
| Depreciation                      |       | 615                     |       | — |   |
| Other                             |       | 5,376                   |       | 320 |   |
| Total deferred tax assets         |       | 64,143                  |       | 48,982 |   |
| Less: valuation allowance         |       | (60,087                 | )          | (45,946 | ) |
| Net deferred assets               |       | 4,056                   |       | 3,036 |   |
| Net deferred tax  liabilities     |       | $                       | —     |   | $ | 264 |   |

 

AtDecember 31, 2005, the Company had net operating loss carryforwardstotaling approximately $111 million for Federal income tax purposes expiringbeginning in 2020 and California state net operating loss carryforwards ofapproximately $102 million expiring beginning in 2008. Due to the uncertaintysurrounding the realization of the benefits of the Company’s tax attributes,primarily net operating loss carryforwards as of December 31, 2004 and2005, the Company recorded a 100% valuation allowance against its net deferredtax assets as of December 31, 2004 and 2005.

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In assessing thepotential realization of deferred tax assets, management considers whether itis more likely than not that some portion or all of the deferred tax assetswill be realized. The ultimate realization of deferred tax assets is dependentupon the Company attaining future taxable income during the periods in whichthose temporary differences become deductible. As of December 31, 2005,management is unable to determine if it is more likely than not that thedeferred tax assets will be realized.

Due to the restrictions imposed by Internal RevenueCode Section 382 regarding substantial changes in the stock ownership ofcompanies with loss carryforwards, the utilization of the Company’s federal netoperating loss carryforward was severely limited as a result of the change inthe effective stock ownership of the Company resulting from the debt financingsarranged in conjunction with the acquisition of MediaDefender.

As a result of the profitable operations ofMediaDefender for the period that it was consolidated with the Company’soperations during the year ended December 31, 2005, the non-deductibilityof certain non-cash charges for tax reporting purposes, and the permanentlimitations on the Company’s ability to utilize its net operating losscarryforwards, the Company recorded a provision for income taxes of $241,000for the year ended December 31, 2005. The Company did not record aprovision for income taxes for the year ended December 31, 2004.

15. RELATED PARTYTRANSACTIONS

Since 2003 theCompany’s administrative offices have been located in an office leased by RadarPictures, Inc., a company owned by Ted Field, the Chairman of the Company,pursuant to a month-to-month arrangement. For the years ended December 31,2004 and 2005, the Company paid $168,000 and $90,000, respectively, to RadarPictures, Inc. as rent and facilities usage expense. On February 28,2005, the Company paid Radar Pictures, Inc. accrued rent throughDecember 31, 2004. The Company relocated to new office facilities inMarch 2006.

During 2005, the Company completed the implementationof a new business initiative to create global awareness of the ARTISTdirectbrand and increase traffic to the Company’s web-site. Through relationshipspreviously developed by the Company’s senior management in the music andentertainment industry, the Company has begun to develop opportunities formajor corporations to sponsor cause-based programs in various parts of theworld in conjunction with music and entertainment celebrities. The Companybelieves that this effort would enhance the global reputation of the Companythrough associations with leading performers and entertainers, which could thenbe expected to drive brand awareness and traffic to the Company’s digital mediaproperties. During the year ended December 31, 2005, the Company receiveda fee advance of $35,000 from an international non-profit organization withrespect to the first such project. This fee advance was budgeted to fundinitial planning and oversight and accordingly, one-half was paid to theCompany’s Chief Executive Officer and one-half was paid to the Company’sExecutive Vice President as a co-producer’s fee. During the years endedDecember 31, 2004 and 2005, total costs incurred with respect to this projectwere $204,000 and $46,000, respectively.

In conjunction with the acquisition of MediaDefender,the Company issued 1,109,032 shares of common stock and a warrant to purchaseup to 114,985 shares of common stock with an exercise price of $1.55 per shareto WNT07 Holdings, LLC. The managers of WNT07 Holdings, LLC are Eric Pulier andTeymour Boutros-Ghali, both of whom are members of the Company’s Board ofDirectors. The shares and warrants were issued as consideration for servicesprovided by Mr. Pulier and Mr. Boutros-Ghali as consultants to theCompany with respect to the acquisition of MediaDefender (see Note 9).

On July 28, 2005, the Company entered into aNon-Competition Agreement with WNT07 Holdings, LLC, Eric Pulier and TeymourBoutros-Ghali (collectively, the “Advisors”). The Non-Competition Agreementprohibits any of the Advisors (i) from engaging in certain competitivebusiness activities and (ii) from soliciting existing employees of theCompany or its subsidiaries. The covenants not to complete or solicit expire onthe earlier of April 1, 2007 or the date of termination of Advisor’sservices with the Company.

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 prohibitMr. Saaf and Mr. Herrera from (i) engaging in certaincompetitive business activities, (ii) soliciting customers ofMediaDefender or the Company, (iii) soliciting existing employees ofMediaDefender or the Company and (iv) disclosing any confidentialinformation regarding MediaDefender or the Company. Each agreement has a termof 4 years and shall continue to remain in force and effect in the eventthe above-referenced Employment Agreements are terminated prior to the end ofthe 4 year term of the Non-Competition Agreements. In consideration,Mr. Saaf and Mr. Herrera are each entitled to a cash payment of$525,000 from MediaDefender to be paid on December 31, 2006.

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Randy Saaf and Octavio Herrera, formerly principalsand stockholders of MediaDefender and currently both executive officers of theCompany’s wholly-owned subsidiary, MediaDefender, each elected to invest$2,250,000 in the Sub-Debt Financing on the same terms and conditions as theother Sub-Debt Financing investors (see Note 9).

Effective as of January 1, 2006, the Companyentered into a one-year consulting agreement with Eric Pulier, a director ofthe Company, which provides for annual compensation of $170,000. Thisconsulting agreement was approved by the disinterested members of the Board ofDirectors.

At December 31, 2005, the Company accrued$100,000 with respect to board fees to two independent directors and $40,000with respect to a discretionary bonus to its Vice President – BusinessDevelopment. During the year ended December 31, 2005, the Company paidbonuses of $75,000 and $50,000, respectively, to its Chief Executive Officerand Chief Financial Officer, respectively.

See Notes 10, 11, 12, 13, 16 and 19 for additionalrelated party transactions.

16. STOCKHOLDERS’ EQUITY(DEFICIENCY)

Equity-BasedTransactions During the Year Ended December 31, 2004:

EffectiveJanuary 1, 2004, the Company entered into a one-year consulting agreementwith Keith Yokomoto, the Company’s then director and former President and ChiefOperating Officer (see Note 19). Effective January 9, 2004, the Companyalso issued to Mr. Yokomoto two non-qualified stock options to purchase10,000 shares and 50,000 shares exercisable at $0.50 per share, which was notless than the fair market value on the date of grant, through January 9,2011. The option for 10,000 shares was immediately vested upon issuance. Theoption for 50,000 shares was scheduled to vest in increments of 10,000 shareson February 1, 2004, March 31, 2004, June 30, 2004,September 30, 2004 and December 31, 2004, based on the accomplishmentof certain milestones by each respective date, which were not attained.Accordingly, the option for 50,000 shares did not vest and thus expired. Thefair value of the stock option for 10,000 shares, determined pursuant to theBlack-Scholes option pricing model, was $3,500.

EffectiveMarch 29, 2004, the Company issued to Robert N. Weingarten, the Company’sChief Financial Officer, a non-plan, non-qualified stock option to purchase 120,000shares at $0.50 per share, which was not less than the fair market value on thedate of grant, exercisable through March 29, 2011. The option vests andbecomes exercisable in a series of 36 successive equal monthlyinstallments from March 29, 2004. The fair value of the stock option,determined pursuant to the Black-Scholes option pricing model, was $42,000.

 Effective June 30, 2004, the Companysettled a claim by a real estate broker related to the termination of theCompany’s former office lease by issuing a warrant to purchase 10,000 shares ofcommon stock exercisable for a period of five years at $0.50 per share. Thefair value of the warrant was determined to be $4,000, calculated pursuant tothe Black-Scholes option-pricing model, and was charged to operations during2004.

EffectiveAugust 31, 2004, the Company issued a warrant to a consultant for servicesrendered to purchase 10,000 shares of common stock exercisable for a period offive years at $0.50 per share. The fair value of the warrant was determined tobe $3,000, calculated pursuant to the Black-Scholes option-pricing model, andwas charged to operations during the year ended December 31, 2004.

Equity-Based TransactionsDuring the Year Ended December 31, 2005:

On March 29,2005, the Company issued to its Vice President – Business Development anon-plan, non-qualified stock option to purchase 92,000 shares of the Company’scommon stock exercisable for a period of seven years at $0.79 per share, themarket price on the date of grant. The stock option vested monthly over aperiod of one year commencing January 1, 2005. The fair value of thisoption, calculated pursuant to the Black-Scholes option-pricing model, wasdetermined to be $63,000.

On March 29,2005, the Company issued to its employees stock options to purchase anaggregate of 205,150 shares of the Company’s common stock pursuant to theCompany’s 1999 Employee Stock Option Plan exercisable for a period of sevenyears at $0.79 per share, the market price on the date of grant. The stock optionsare scheduled to vest quarterly through September 30, 2006. The fair valueof these options, calculated pursuant to the Black-Scholes option-pricingmodel, was determined to be $140,000.

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On May 6,2005, the Company issued to three consultants stock options to purchase anaggregate of 78,000 shares of the Company’s common stock pursuant to theCompany’s 1999 Employee Stock Option Plan exercisable for a period of fiveyears at $1.00 per share, the market price on the date of the grant, pursuantto short-term consulting agreements with a duration approximating one year. Thefair value of these options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $79,000, of which $60,000 wascharged to operations during the year ended December 31, 2005 and $19,000was recorded as deferred compensation at December 31, 2005, which is beingamortized to operations through March 31, 2006.

On May 6,2005, the Company issued to a consultant a stock option to purchase anaggregate of 22,000 shares of the Company’s common stock pursuant to theCompany’s 1999 Employee Stock Option Plan exercisable for a period of fiveyears at $1.00 per share, the market price on the date of the grant, pursuantto short-term consulting agreements. The option was subject to milestones, oneof which was partially attained during the year ended December 31, 2005.The fair value of the vested portion of these options, calculated pursuant tothe Black-Scholes option-pricing model, was determined to be $40,000, of which$13,000 was charged to operations during the year ended December 31, 2005.

Effective as ofJuly 28, 2005, the Company agreed to issue to each of its two independentdirectors at that time a stock option to purchase up to 85,000 shares of theCompany’s common stock exercisable for a period of seven years at 85% of theaverage closing price of the Company’s common stock for the 30 trading dayperiod prior to July 28, 2005 and the 30 trading day period subsequent toJuly 28, 2005. The stock options were issued at an exercise price of $1.95per share on September 9, 2005, which was in excess of the fair value ofthe common stock issued in the MediaDefender transaction, and were fully vestedat issuance. The fair value of each of these options, calculated pursuant tothe Black-Scholes option-pricing model, was determined to be $245,650.

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to each of Randy Saaf, MediaDefender’s ChiefExecutive Officer, and Octavio Herrera, Media Defender’s President, to purchaseup to 200,000 shares of common stock to each of Mr. Saaf andMr. Herrera, exercisable for a period of five years at $3.00 per share,which was in excess of the fair value of the common stock issued in theMediaDefender transaction. These options are scheduled to vest quarterly overthree and one-half years. The fair value of each of these options, calculatedpursuant to the Black-Scholes option-pricing model, was determined to be$546,000.

In conjunction with theacquisition of MediaDefender, effective July 28, 2005, the Company grantedstock options to Jonathan Diamond, its Chief Executive Officer, to purchase upto 2,753,098 shares of common stock, exercisable for a period of five years at$1.55 per share, which was in excess of the fair value of the common stockissued in the MediaDefender transaction. Options with respect to 1,045,000shares are scheduled to vest over three years and options with respect to1,708,098 shares are scheduled to vest based on specified performancemilestones. The fair value of the time-vested options, calculated pursuant tothe Black-Scholes option-pricing model, was determined to be $2,936,450.

In conjunction with theacquisition of MediaDefender, effective July 28, 2005, the Company grantedstock options to Robert Weingarten, its Chief Financial Officer, to purchase upto 550,000 shares of common stock, exercisable for a period of five years at$1.55 per share, which was in excess of the fair value of the common stockissued in the MediaDefender transaction. Options with respect to 275,000 sharesare scheduled to vest over three years and options with respect to 275,000shares are scheduled to vest based on specified performance milestones. Thefair value of the time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $772,750.

In conjunctionwith the acquisition of MediaDefender, the Company issued 1,109,032 shares ofcommon stock and a warrant to purchase up to 114,985 shares of common stockwith an exercise price of $1.55 per share to WNT07 Holdings, LLC. The managersof WNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both of whomare members of the Company’s Board of Directors. The shares and warrants wereissued as consideration for services provided by Mr. Pulier andMr. Boutros-Ghali as consultants to the Company with respect to theMediaDefender acquisition. WNT07 Holdings, LLC, Mr. Pulier andMr. Boutros-Ghali entered into a Non-Competition Agreement with theCompany effective July 28, 2005, which prohibits them (i) fromengaging in certain competitive business activities and (ii) fromsoliciting existing employees of the Company or its subsidiaries. The covenantsnot to complete or solicit expire on the earlier of April 1, 2007 or thedate of termination of Advisor’s services with the Company. 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, for an aggregate value of $1,669,855, of which $333,971 wasallocated to covenant not to compete and the remaining $1,335,884 was includedin total costs that the Company incurred to acquire MediaDefender.

The warrants andconvertible securities were issued in conjunction with the acquisition andfinancing of the MediaDefender transaction, and are described at Note 9.

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InDecember 2005, subordinated convertible notes payable aggregating $387,500were converted into 250,000 shares of common stock. As a result, relateddeferred financing costs and debt discount costs aggregating $45,000 werecharged to operations.

EffectiveJuly 29, 2005, the Company cancelled 322,902 shares of common stock heldin treasury with a carrying cost of $3.442 million.

17. STOCK OPTION ANDSTOCK PURCHASE PLANS

CONSULTANT STOCKPLAN

EffectiveSeptember 29, 2004, the Company’s Board of Directors adopted theARTISTdirect, Inc. 2004 Consultant Stock Plan (the “Consultant Plan”) inorder for the Company to be able to compensate consultants, at the option ofthe Company, who provide bona fide services to the Company not in connectionwith capital raising or promotion of the Company’s securities. The ConsultantPlan will expire on September 29, 2014, and provides for the issuance ofup to 500,000 shares of common stock to consultants at fair market value. OnJanuary 13, 2005, the Company filed a Registration Statement onForm S-8 with the Securities and Exchange Commission to register the500,000 shares of common stock for future issuance under the Consultant Plan.As of December 31, 2005, no shares had been issued under the ConsultantPlan.

EMPLOYEE OPTIONPLAN

InOctober 1999, the Company implemented the 1999 Employee Stock Option Plan(the “Employee Plan”) that replaced the 1998 Unit Option Plan. The EmployeePlan was not approved by the public stockholders of the Company. The EmployeePlan has currently reserved 1,010,504 shares of the Company’s common stock forissuance to employees, non-employee members of the board of directors andconsultants. This share reserve automatically increases on the first tradingday in January each calendar year by an amount equal to 2% of the totalnumber of shares of the Company’s common stock outstanding on the last tradingday of December in the prior calendar year, but in no event will thisannual increase exceed 87,500 shares. No option may have a term in excessof ten years. The options generally vest within three years. As ofDecember 31, 2005, 41,886 shares remained available for future optiongrant.

ThroughDecember 31, 2005, the Company has accounted for its Employee Plan inaccordance with the provisions of Accounting Principles Board (APB) OpinionNo. 25, “Accounting for Stock Issued to Employees”, InterpretationNo. 44, and other related interpretations. As such, compensation expensehas been recorded on the date of grant only if the current market price of theunderlying stock exceeded the exercise price.

A summary of stockoption activity under Employee Plan during the years ended December 31,2004 and 2005 is as follows:
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 118,897                      |       | $ | 14.79 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | (7,743                       | )          | 9.11 |   |
| Options  outstanding at December 31, 2004 |       | 111,154                      |       | 15.18 |   |
| Granted                                        |       | 875,150                      |       | 1.74 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | (17,686                      | )          | 1.31 |   |
| Options outstanding at  December 31, 2005 |       | 968,618                      |       | $ | 3.57 |   |

 

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The followingtable summarizes information regarding options outstanding and optionsexercisable at December 31, 2005 under the Employee Plan:

|              | ** **   | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------|--------------|------------------------------|------------|------------------------------|------------|
| ** **   | ** **   | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **   | ** **   | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **   | ** **   | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Exercise** | ** **   | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Prices**   | ** **   | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|         |         |                         |       |                         |       |   |   |   |   |   |   |
| $       | 0.79         |                         |       | 188,250                      |       | 6.24 |   | $ | 0.79 |   | 146,987 |   | $ | 0.79 |   |
| $       | 1.00         |                         |       | 100,000                      |       | 4.35 |   | $ | 1.00 |   | 66,311 |   | $ | 1.00 |   |
| $       | 1.95         |                         |       | 170,000                      |       | 6.69 |   | $ | 1.95 |   | 170,000 |   | $ | 1.95 |   |
| $       | 3.00         |                         |       | 400,000                      |       | 4.57 |   | $ | 3.00 |   | 47,619 |   | $ | 3.00 |   |
| $       | 4.80         |                         |       | 33,332                       |       | 3.78 |   | $ | 4.80 |   | 33,332 |   | $ | 4.80 |   |
| $       | 5.10         |                         |       | 10,000                       |       | 3.77 |   | $ | 5.10 |   | 10,000 |   | $ | 5.10 |   |
| $       | 7.50         |                         |       | 58,603                       |       | 2.74 |   | $ | 7.50 |   | 58,603 |   | $ | 7.50 |   |
| $       | 36.00        |                         |       | 439                          |       | 0.78 |   | $ | 36.00 |   | 439 |   | $ | 36.00 |   |
| $       | 40.00        |                         |       | 1,025                        |       | 1.44 |   | $ | 40.00 |   | 1,025 |   | $ | 40.00 |   |
| $       | 139.28       |                         |       | 6,969                        |       | 1.24 |   | $ | 139.28 |   | 6,969 |   | $ | 139.28 |   |
| $       | 0.79-$139.28 |                         |       | 968,618                      |       | 5.07 |   | $ | 3.57 |   | 541,285 |   | $ | 4.31 |   |

 

ADVISOR OPTION PLAN

In June 1999,and as amended in October 1999 and March 2000, the Company adopted the1999 Artist and Artist Advisor Stock Option Plan (the “Advisor Plan”). TheAdvisor Plan was not approved by the public stockholders of the Company. TheAdvisor Plan has currently reserved 364,659 shares of common stock for issuanceto artists for whom the Company entered into agreements related to online ande-commerce activities and their agents, business managers, attorneys and otheradvisors. This share reserve automatically increases on the first trading dayin January each calendar year by an amount equal to 1% of the total numberof shares of the Company’s common stock outstanding on the last trading day ofDecember in the prior calendar year, but in no event will this annualincrease exceed 37,500 shares. As of December 31, 2005, 329,123 sharesremained available for future option grants. The options expire seven yearsfrom the date of grant and vesting generally varies between one to three years.No new option grants under this plan were made during 2004 or 2005.

A summary of stockoption activity under the Advisor Plan during the years ended December 31,2004 and 2005 is as follows:
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 35,536                       |       | $ | 123.29 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options  outstanding at December 31, 2004 |       | 35,536                       |       | 123.29 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options outstanding at  December 31, 2005 |       | 35,536                       |       | $ | 123.29 |   |

 

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The followingtable summarizes information regarding options outstanding and optionsexercisable under the Advisor Plan at December 31, 2005:
| ** **               | ** **    | **Options Outstanding and Exercisable** | ** ** |
|--------------------------|---------------|--------------------------------------------------------|------------|
| **Exercise Prices** | ** **    | **Number  of Shares**                             | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| ** **               | ** **    | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                        | 36.00         |                                                   |       | 1,250 |   | 0.78 |   | $ | 36.00 |   |
|                     | 40.00         |                                                   |       | 4,422 |   | 0.60 |   | 40.00 |   |
|                     | 139.28        |                                                   |       | 29,864 |   | 1.24 |   | 139.28 |   |
| $                        | 36.00-$139.28 |                                                   |       | 35,536 |   | 1.15 |   | $ | 123.29 |   |

 

ARTIST OPTION PLAN

In June 1999,and as amended in October 1999, the Company adopted the 1999 Artist StockPlan (the “Artist Plan”). The Artist Plan was not approved by the publicstockholders of the Company. The Artist Plan currently has reserved 760,504shares of common stock for issuance to artists for whom the Company enteredinto agreements related to their online and 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, 2005, 736,630 shares remained availablefor future option grants. The options expire seven years from the date of grantand vesting generally varies between one to three years. In December 2001,a majority of the outstanding options under the Advisor plan were rescinded andcancelled. No new option grants under this plan were made during 2004 or 2005.

A summary of stockoption activity under the Artist Plan during the years ended December 31,2004 and 2005 is as follows:
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 23,874                       |       | $ | 83.15 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options  outstanding at December 31, 2004 |       | 23,874                       |       | 83.15 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options outstanding at  December 31, 2005 |       | 23,874                       |       | $ | 83.15 |   |

 

The followingtable summarizes information regarding options outstanding and options exercisableunder the Artist Plan at December 31, 2005:

|                          | ** ** | **Options Outstanding and Exercisable** | ** ** |
|--------------------------|------------|--------------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number  of Shares**                             | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| ** **               | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
|                     | $          | 40.00                                                  |       | 13,499 |   | 0.66 |   | $ | 40.00 |   |
|                     | $          | 139.28                                                 |       | 10,375 |   | 1.20 |   | $ | 139.28 |   |
|                     | $          | 40.00-$139.28                                          |       | 23,874 |   | 0.89 |   | $ | 83.15 |   |

 

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EMPLOYEE STOCK PURCHASEPLAN

InOctober 1999, the Company adopted the 1999 Employee Stock Purchase Planthat initially reserved 50,000 shares of common stock for issuance under thisplan. As of December 31, 2005, this plan had 175,000 shares reserved forissuance, of which 162,831 shares remained available for future issuances. Thisshare reserve automatically increases on the first trading day in January eachcalendar year, by an amount equal to 1% 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 exceed25,000 shares. Terms of the plan permit eligible employees to purchase commonstock through payroll deduction of up to 15% of each employee’s compensation.The accumulated deductions are applied to the purchase of shares on eachsemi-annual purchase date at a purchase price per share equal to 85% of thefair market value per share on the participant’s entry date into the offeringperiod or the semi-annual purchase date, whichever is lower. Pursuant to theprovisions of APB No. 25, shares issued to employees under this plan areconsidered non-compensatory. During the years ended December 31, 2004 and2005, no shares were issued under this plan.

18. 401(K) PLAN

The Company hasadopted the Cash or Deferred Profit Sharing Plan and Trust underSection 401(k) of the Internal Revenue Code (the “401(k) Plan”). Under the401(k) Plan, participating employees may defer a percentage (not to exceed15%) of their eligible pretax earnings up to the Internal Revenue Service’sannual contribution limit. All employees of the Company who are 21 years orolder and who complete three months of service are eligible to participate inthe 401(k) Plan. The Company does not match contributions by participants tothe 401(k) Plan. Accordingly, there is no related expense for the years endedDecember 31, 2004 and 2005.

19. COMMITMENTS ANDCONTINGENCIES

LEASE COMMITMENTS

OnJanuary 30, 2006, the Company entered into a sub-lease agreement for newoffice facilities in Santa Monica, California through November 30, 2011.The effective date of the sub-lease agreement was February 2, 2006. The newoffice facilities will house both ADI and MediaDefender. In connection with thesub-lease agreement, the Company provided an irrevocable standby bank letter ofcredit for $180,000 as security for the Company’s obligations under thesub-lease. The letter of credit will be reduced to $90,000 on the 13th month of the sub-lease, provided the Companyis in compliance with all terms under the sub-lease.

This lease contains predetermined fixed increases inthe minimum rental rate during the initial lease term. The Company willrecognize the related rent expense on a straight-line basis beginning on theeffective date of the lease. The Company will record the difference between theamount charged to expense and the rent paid as deferred rent on the Company’sbalance sheet.

Future cashpayments under operating leases are as follows:
| Years Ending December 31, | ** ** | **(in thousands)** | ** ** |
|------------------------------------------|------------|-------------------------|------------|
|                                     |       |                    |       |
| 2006                                     |       | $                       | 343        |   |
| 2007                                     |       | 464                     |       |
| 2008                                     |       | 470                     |       |
| 2009                                     |       | 485                     |       |
| 2010                                     |       | 499                     |       |
| 2011                                     |       | 471                     |       |
|                                     |       | $                       | 2,732      |   |

 

Rent expense underoperating leases for the years ended December 31, 2004 and 2005 was$173,000 and $100,000, respectively, including $168,000 and $90,000 to arelated party in 2004 and 2005, respectively (see Note 15).

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EMPLOYMENT AGREEMENTS

On July 28, 2005, the Company entered into anEmployment Agreement with Jonathan Diamond, the Company’s Chief ExecutiveOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Diamond will earn a base salary of noless than $350,000 per annum, plus certain specified perquisites that include amonthly car allowance. Mr. Diamond is also eligible to receive an annualdiscretionary bonus of up to 100% of base salary, as determined by theCompensation 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 achieves specified earnings targets in fiscal 2007 and 2008.Mr. Diamond shall also be entitled to receive stock options at the discretionof the Company’s Board of Directors. In the event Mr. Diamond isterminated “without cause,” he shall be entitled to receive 12 months ofseverance pay at the rate of 100% of his monthly salary, any performance bonusdue for the year in which termination occurs and all stock options subject totime vesting shall be deemed fully vested and exercisable.

On July 28, 2005, the Company entered into anEmployment Agreement with Robert Weingarten, the Company’s Chief FinancialOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Weingarten will earn a base salary ofno less than $195,000 per annum, plus certain specified perquisites thatinclude a monthly car allowance. Mr. Weingarten is 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 achieves specified earnings targets in fiscal 2007 and 2008.Mr. Weingarten shall also be entitled to receive stock options at thediscretion of the Company’s Board of Directors. In the eventMr. Weingarten is terminated “without cause,” he shall be entitled to receive12 months of severance pay at the rate of 100% of his monthly salary, anyperformance bonus due for the year in which termination occurs and all stockoptions subject to time vesting shall be deemed fully vested and exercisable.

In accordance with the MediaDefender transaction, theCompany acknowledged the terms of Employment Agreements entered into onJuly 28, 2005 by MediaDefender with each of Randy Saaf, who serves asChief Executive Officer of MediaDefender, and Octavio Herrera, who serves as Presidentof MediaDefender. Mr. Saaf and Mr. Herrera will each earn a basesalary of no less than $350,000 per annum during the initial term of theagreements, which shall continue until December 31, 2008, and are alsoentitled to receive performance bonuses of up to $350,000 if MediaDefenderachieves specified earnings targets in fiscal 2007 and 2008. Mr. Saaf andMr. Herrera are each entitled to receive twelve months of severance pay atthe rate of 100% of their monthly salary and the pro-rata portion of theperformance bonus referenced above if they are terminated “without cause.”  In addition, the Company granted stockoptions to purchase up to 200,000 shares of common stock to each ofMr. Saaf and Mr. Herrera, exercisable for a period of 5 years at$3.00 per share.

EffectiveDecember 31, 2003, Keith Yokomoto, the Company’s former President andChief Operating Officer, entered into a Termination Agreement and MutualGeneral Release. Mr. Yokomoto subsequently resigned as a director of theCompany on October 22, 2004. Effective January 1, 2004, the Companyentered into a one-year consulting agreement with Mr.Yokomoto that provided fortotal compensation of $120,000.

Future paymentsunder employment agreements are as follows:
| Years Ending December 31, | ** ** | ** **              | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** |
| 2006                                     |       | $                       | 1,414      |   |
| 2007                                     |       | $                       | 1,264      |   |
| 2008                                     |       | $                       | 1,264      |   |
|                                     |       | $                       | 3,942      |   |

 

LITIGATION

The Company isperiodically subject to various pending and threatened legal actions whicharise in the normal course of business. The Company’s management believes thatthe impact of any such litigation will not have a material adverse impact onthe Company’s financial position or results of operations.

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20. REPORTABLE SEGMENTS

Information withrespect to the Company’s operating segments for the years endedDecember 31, 2004 and 2005 is presented below. During the year endedDecember 31, 2004, the Company’s continuing operations consisted of tworeportable segments:  e-commerce andmedia. During the year ended December 31, 2005, the Company’s continuingoperations consisted of three reportable segments:  e-commerce, media and anti-piracy services.

The segment datapresented below has been restated for all periods to reflect operationsdiscontinued at December 31, 2004. In December 2004, the Company discontinuedthe operations of its iMusic record label and as a result it has been presentedas a discontinued operation for all periods presented. The Company consolidatedthe operations of ARTISTdirect Records for the year ended December 31,2004. As a result of the sale of the Company’s interest in ARTISTdirect Recordseffective February 28, 2005, the operations of ARTISTdirect Records havebeen presented as a discontinued operation for all periods presented.

Information withrespect to the year ended December 31, 2005 relating to MediaDefenderreflects only the five-month period in which MediaDefender has been included inthe Company’s consolidated results of operations.

The factors fordetermining reportable segments were based on services and products. Eachsegment is responsible for executing a unique marketing and business strategy.The accounting policies of the segments are as described in the summary ofsignificant accounting policies. The Company evaluates performance based on,among other factors, earnings or loss before interest, taxes, depreciation andamortization (“Adjusted EBITDA”). Adjusted EBITDA also excludes stock-basedcompensation and impairment losses. Included in Adjusted EBITDA are directoperating expenses for each segment.

The followingtable summarizes net revenue and Adjusted EBITDA by operating segment for theyears ended December 31, 2004 and 2005. Corporate expenses consist ofgeneral operating expenses that are not directly related to the operations ofthe segments. A reconciliation of Net Income (Loss) to Adjusted EBITDA is alsoprovided.
| ** **           | ** ** | **Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------|------------|
| ** **           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **           | ** ** | **(in thousands)**                     | ** ** |
|                 |       |                                        |       |   |   |
| Net Revenue:         |       |                                        |       |   |   |
| E-commerce           |       | $                                           | 2,994      |   | $ | 2,665 |   |
| Media                |       | 2,149                                       |       | 5,297 |   |
| Anti-piracy services |       | —                                      |       | 6,009 |   |
|                 |       | $                                           | 5,143      |   | $ | 13,971 |   |
| Adjusted EBITDA:     |       |                                        |       |   |   |
| E-commerce           |       | $                                           | 293        |   | $ | 157 |   |
| Media                |       | 789                                         |       | 2,198 |   |
| Anti-piracy services |       | —                                      |       | 3,851 |   |
|                 |       | 1,082                                       |       | 6,206 |   |
| Corporate            |       | (1,944                                      | )          | (2,969 | ) |
|                 |       | $                                           | (862       | ) | $ | 3,237 |   |

 

100

----

 
| ** **                                                                                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                             | ** ** | ** **                                  | ** ** | **(RESTATED)** | ** ** |
| Reconciliation  of Adjusted EBITDA to Net Income (Loss):                                                                                               |       |                                        |       |   |   |
| Adjusted EBITDA per segments                                                                                                                           |       | $                                           | (862       | ) | $ | 3,237 |   |
| Stock-based compensation                                                                                                                               |       | (7                                          | )          | (73 | ) |
| Depreciation                                                                                                                                           |       | (223                                        | )          | (205 | ) |
| Amortization of intangible assets                                                                                                                      |       | —                                      |       | (1,562 | ) |
| Amortization of deferred financing costs                                                                                                               |       | —                                      |       | (402 | ) |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable into common stock |       | —                                      |       | (45 | ) |
| Interest income                                                                                                                                        |       | 29                                          |       | 29 |   |
| Interest expense, including amortization of discount  on debt of $1,486                                                                                |       | —                                      |       | (2,873 | ) |
| Change in fair value to warrant liability                                                                                                              |       | —                                      |       | (10,735 | ) |
| Change in fair value to derivative liability                                                                                                           |       | —                                      |       | (20,043 | ) |
| Provision for income taxes                                                                                                                             |       | —                                      |       | (241 | ) |
| Loss from discontinued operations -                                                                                                                    |       |                                        |       |   |   |
| – ARTISTdirect Records, LLC                                                                                                                       |       | (2,111                                      | )          | (271 | ) |
| – iMusic record label                                                                                                                             |       | (137                                        | )          | — |   |
| Gain from sale of ARTISTdirect Records, LLC                                                                                                            |       | —                                      |       | 21,079 |   |
| Net income  (loss)                                                                                                                                     |       | $                                           | (3,311     | ) | $ | (12,105 | ) |

 

Assets as ofDecember 31, 2004 and 2005 are summarized as follows:
| ** **              | ** ** | **December 31,**   | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **2004**                | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(in thousands)** | ** ** |
|                    |       |                    |       |   |   |
| Assets:                 |       |                    |       |   |   |
| Corporate               |       | $                       | 1,313      |   | $ | 4,963 |   |
| E-commerce              |       | 314                     |       | 941 |   |
| Media                   |       | 772                     |       | 1,931 |   |
| Anti-piracy services    |       | —                  |       | 46,934 |   |
| Discontinued operations |       | 14                      |       | — |   |
|                    |       | $                       | 2,413      |   | $ | 54,769 |   |

 

Assets by segmentare those assets used in or employed by the operations of each segment.Corporate assets are principally made up of cash and cash equivalents,short-term investments, prepaid expenses, computer equipment, leaseholdimprovements and other assets.

101

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21. QUARTERLY RESULTS OFOPERATIONS (UNAUDITED)

The followingtable sets forth unaudited quarterly results of operations for the years endedDecember 31, 2004 and 2005. This unaudited quarterly information has beenderived from the Company’s unaudited financial statements and, in the Company’sopinion, includes all adjustments, including normal recurring adjustments,necessary for a fair presentation of the information for the periods covered.The operating results for any quarter are not necessarily indicative of theoperating results for any future period.

 
| ** **                                                      | ** ** | **Three Months Ended**                                   | ** ** | ** **              | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                      | ** ** | **March 31,  2004**                                           | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** | **Year Ended  December 31, 2004** | ** ** |
| ** **                                                      | ** ** | **(in thousands, except for share data)** | ** ** |
|                                                            |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net revenue                                                     |       | $                                                                  | 963        |                    | $          | 1,180 |   | $ | 1,365 |   | $ | 1,635 |   | $ | 5,143 |   |
| Gross profit                                                    |       | 178                                                                |       | 456                     |       | 567 |   | 390 |   | 1,591 |   |
|                                                            |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Loss from  continuing operations                                |       | (489                                                               | )          | (452                    | )          | (93 | ) | (29 | ) | (1,063 | ) |
| Loss from  discontinued operations                              |       | (223                                                               | )          | (214                    | )          | (435 | ) | (1,376 | ) | (2,248 | ) |
| Net loss                                                        |       | $                                                                  | (712       | )                       | $          | (666 | ) | $ | (528 | ) | $ | (1,405 | ) | $ | (3,311 | ) |
|                                                            |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net loss per  common share - basic and diluted:                 |       |                                                               |       |                    |       |   |   |   |   |   |   |
| From continuing operations                                      |       | $                                                                  | (0.14      | )                       | $          | (0.13 | ) | $ | (0.03 | ) | $ | (0.01 | ) | $ | (0.30 | ) |
| From discontinued operations                                    |       | (0.06                                                              | )          | (0.06                   | )          | (0.12 | ) | (0.39 | ) | (0.64 | ) |
| Total                                                           |       | $                                                                  | (0.20      | )                       | $          | (0.19 | ) | $ | (0.15 | ) | $ | (0.40 | ) | $ | (0.94 | ) |
| Weighted average common  shares outstanding - basic and diluted |       | 3,502,117                                                          |       | 3,502,117               |       | 3,502,117 |   | 3,502,117 |   | 3,502,117 |   |

 
| ** **                                          | ** ** | **Three Months Ended**                                   | ** ** | ** **              | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **March 31,  2005**                                           | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **Year Ended  December 31, 2005** | ** ** |
| ** **                                          | ** ** | **(in thousands, except for share data)** | ** ** |
| ** **                                          | ** ** | ** **                                                         | ** ** | ** **              | ** ** | **(RESTATED)** | ** ** | **(RESTATED)** | ** ** | **(RESTATED)** | ** ** |
| Net revenue                                         |       | $                                                                  | 1,290      |                    | $          | 3,169 |   | $ | 3,852 |   | $ | 5,660 |   | $ | 13,971 |   |
| Gross profit                                        |       | 367                                                                |       | 1,394                   |       | 1,680 |   | 2,726 |   | 6,167 |   |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Income (loss)  from continuing operations           |       | (375                                                               | )          | 604                     |       | (18,364 | ) | (14,778 | ) | (32,913 | ) |
| Income from  discontinued operations                |       | 20,808                                                             |       | —                  |       | — |   | — |   | 20,808 |   |
| Net income  (loss)                                  |       | $                                                                  | 20,433     |                    | $          | 604 |   | $ | (18,364 | ) | $ | (14,778 | ) | $ | (12,105 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income  (loss) per common share – basic:   |       |                                                               |       |                    |       |   |   |   |   |   |   |
| From continuing operations                          |       | $                                                                  | (0.11      | )                       | $          | 0.17 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (8.29 | ) |
| From discontinued operations                        |       | 5.94                                                               |       | 0.00                    |       | 0.00 |   | 0.00 |   | 5.24 |   |
| Total                                               |       | $                                                                  | 5.83       |                    | $          | 0.17 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (3.05 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income (loss)  per common share – diluted: |       |                                                               |       |                    |       |   |   |   |   |   |   |
| From continuing operations                          |       | $                                                                  | (0.11      | )                       | $          | 0.15 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (8.29 | ) |
| From discontinued operations                        |       | 5.94                                                               |       | 0.00                    |       | 0.00 |   | 0.00 |   | 5.24 |   |
| Total                                               |       | $                                                                  | 5.83       |                    | $          | 0.15 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (3.05 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Weighted average  common shares outstanding:        |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Basic                                               |       | 3,502,117                                                          |       | 3,502,117               |       | 4,241,472 |   | 4,611,149 |   | 3,969,145 |   |
| Diluted                                             |       | 3,502,117                                                          |       | 3,927,844               |       | 4,241,472 |   | 4,611,149 |   | 3,969,145 |   |

 

102

----

22. SUBSEQUENT EVENTS(UNAUDITED)

On January 30, 2006, the Company entered into a sub-lease agreement for new office facilities in Santa Monica, California through November 30, 2011, as described at Note 19.

During the period fromJanuary 1, 2006 through April 27, 2006, the Company issued 2,113,000shares of common stock upon the conversion of $3,275,000 of subordinatedconvertible notes payable.

EffectiveApril 7, 2006, the Company entered into various agreements with theinvestors in its Senior Financing and Sub-Debt Financing (see Note 9) toamend their respective registration rights agreements and to amend and waivecertain financial covenants contained in the various agreements underlying theSenior Financing and Sub-Debt Financing In consideration thereof, the Company agreed to temporarily reduce theexercise price of the 3,250,000 warrants held by the investors in theSenior Financing from $2.00 to $1.85 per share through April 30, 2006, andagreed to permanently reduce the exercise price of the 1,596,744 warrantsheld by the investors in the Sub-Debt Financing from $1.55 to $1.43 per share.  The amendments provided that any exercise ofthe aforementioned warrants at the reduced exercise price shall be for cashonly.  The conversion price of theSub-Debt Notes of $1.55 per share was not affected by these amendments.  The Company also entered into similaragreements, as applicable, and provided identical temporary and permanentreductions to warrant exercise prices, with Broadband Capital Management LLC(1,516,935 warrants originally exercisable at $1.55 per share) andLibra FE, LP (237,500 warrants originally exercisable at $2.00 pershare).  The Company also agreed toutilize 25% of the net proceeds from the exercise of the warrants held by theinvestors in the Senior Financing to reduce the respective principal balanceson the notes payable held by such exercising investors, and to pay any relatedunpaid accrued interest on such principal payments.

EffectiveApril 19, 2006, Libra FE, LP exercised its warrants on a cashlessbasis at $2.00 per share, resulting in the issuance of 123,864 shares of commonstock.  Effective April 27, 2006,certain of the investors in the Senior Financing exercised their warrants topurchase 2,816,667 shares of common stock at $1.85 per share, resulting in theissuance of 2,816,667 shares of common stock in exchange for cash proceeds of$5,211,000, of which $1,303,000 was used to reduce the respective principalbalances on the notes payable held by such exercising investors.

Aspreviously reported on a Current Report on Form 8-K filed by the Companywith the SEC on December 27, 2006, the Company’s Audit Committee determinedthat the Company would restate its previously issued financial statements forthe annual period ended December 31, 2005 and the quarterly periods endedSeptember 30, 2005, March 31, 2006, June 30, 2006 andSeptember 30, 2006.  As a result ofthe pending restatements, the Registration Statement on Form SB-2, asamended (Reg. No. 333-129626, (the “Form SB-2”)) has not been available for useby the holders of the underlying securities since December 21, 2006.  The financing documents governing the termsand conditions of the Senior and Sub-Debt Financing require the Company tomaintain an effective registration statement covering the resale of shares ofcommon stock underlying the various securities issued by the Company to eachholder.

Aspreviously reported on a Current Report on Form 8-K filed on January 18, 2007,the financing documents for the Senior Financing and Sub-Debt Financing specifythat an event of default of the senior and subordinated indebtedness istriggered if the Form SB-2 is unavailable for use by the holders of theunderlying securities for a period of more than 10 consecutive trading daysafter the expiration of an allowable 10 day grace period.  The Company invoked its use of the 10 dayallowable grace period on December 21, 2006, which expired onDecember 31, 2006.  Thereafter,an event of default was triggered on January 18, 2007.  As of the date of this filing, theForm SB-2 remained unavailable for use by the holders of the underlyingsecurities, and it will continue to be unavailable for use until the Companyprepares and files a post-effective amendment to the Form SB-2 withrestated financial statements, as appropriate, which is then declared effectiveby the staff of the SEC.

Uponthe occurrence of an event of default, holders of at least 25% of theoutstanding senior indebtedness, approximately $13,307,000, may declare theoutstanding principal and accrued interest on all senior notes immediately dueand payable upon written notice to the Company. Holders of outstanding subordinated indebtedness may demand redemptionof all or any portion of their respective notes, approximately $27,658,000 oncertain terms and conditions, as described in the subordinated financingdocuments.  As of the date of thisfiling, the Company had not received a request to accelerate or redeem anyportion of the outstanding indebtedness from any senior or subordinatedholder.  The Company does not have thecapital resources necessary to repay any accelerated indebtedness orredemption.

103

----

Thebelow proforma table reflects the effect on the Consolidated Balance Sheetsince the Senior and Subordinated Notes repayment is subject to acceleration orredemption and accordingly, are classified as a current liability:

|                                    | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(RESTATED)**        | ** ** | **Proforma** | ** ** |
| Assets                             |       |                  |       |   |   |
| Current assets                     |       | 8,727                 |       | 8,727 |   |
| Property and equipment, net        |       | 1,945                 |       | 1,945 |   |
| Other assets                       |       | 44,097                |       | 44,097 |   |
| Total Assets                       |       | $                     | 54,769     |   | $ | 54,769 |   |
|                               |       |                  |       |   |   |
| Liabilities                        |       |                  |       |   |   |
| Current liabilities                |       | 50,712                |       | 84,362 |   |
| Long-term liabilities              |       | 33,914                |       | 264 |   |
| Total Liabilities                  |       | 84,626                |       | 84,626 |   |
|                               |       |                  |       |   |   |
| Net  shareholders’ deficiency |       | (29,857               | )          | (29,857 | ) |
|                               |       |                  |       |   |   |
|                               |       | $                     | 54,769     |   | $ | 54,769 |   |

 

Inaddition, the financing documents provide that while the registration statementremains unavailable for use, holders of senior indebtedness are entitled to acash penalty equal to 1.5% of the original principal amount issued in theSenior Financing ($15,000,000), on a pro-rata basis, and the holders ofsubordinated indebtedness are entitled to a cash penalty equal to 1.0% of theoriginal principal amount issued in the Sub-Debt Financing ($31,460,500), on apro-rata basis.  These cash penalties aredue and payable by the Company at the end of each 30-day period while the registrationstatement remains unavailable.  The firstcash penalty payment was due on January 30, 2007, however the Company hasnot made any penalty payments.

TheCompany entered into an exclusive agreement with a financial advisor toinitiate discussions with holders of the outstanding senior and subordinatedindebtedness to request a waiver of and amendment to certain of the financingdocuments to address the event of default, the impact of the restatements, thepayment of cash penalties, and various other related matters.  The Company is unable to predict the outcomeof such discussions.

104

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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 August 5, 2005). |
|            |       |                                                                                                                                                                                                                                   |
| 3.1             |       | Amended and Restated Certificate of Incorporation of  ARTISTdirect, Inc. (incorporated by reference to registration statement on  Form S-1/A filed on January 27, 2000).                                                          |
|            |       |                                                                                                                                                                                                                                   |
| 3.2             |       | Amended and Restated Bylaws of ARTISTdirect, Inc.  (incorporated by reference to current report on Form 8-K filed on April  18, 2006).                                                                                            |
|            |       |                                                                                                                                                                                                                                   |
| 3.3             |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (incorporated by reference to quarterly report  on Form 10-Q filed August 14, 2001).                                                           |
|            |       |                                                                                                                                                                                                                                   |
| 3.4             |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (incorporated by reference to quarterly report  on Form 10-Q filed August 14, 2002).                                                      |
|            |       |                                                                                                                                                                                                                                   |
| 3.5             |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (incorporated by reference to current report on  Form 8-K filed November 9, 2005).                                                                  |
|            |       |                                                                                                                                                                                                                                   |
| 4.1             |       | Registration Rights Letter Agreement dated  May 31, 2001 between ARTISTdirect, Inc. and Frederick W. Field  (incorporated by reference to definitive proxy statement filed June 11,  2001).                             |
|            |       |                                                                                                                                                                                                                                   |
| 4.2             |       | 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 August 3,  2005).                    |
|            |       |                                                                                                                                                                                                                                   |
| 4.3             |       | 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 August 3, 2005).                              |
|            |       |                                                                                                                                                                                                                                   |
| 4.4             |       | 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  August 3, 2005).            |
|            |       |                                                                                                                                                                                                                                   |
| 4.5             |       | 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 August 3, 2005).                                         |
|            |       |                                                                                                                                                                                                                                   |
| 4.6             |       | Form of Sub-Debt Financing Warrant issued  July 28, 2005 (incorporated by reference to current report on Form 8-K  filed August 3, 2005).                                                                                    |
|            |       |                                                                                                                                                                                                                                   |
| 4.7             |       | 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  August 3, 2005).          |
|            |       |                                                                                                                                                                                                                                   |
| 4.8             |       | Warrant issued to Libra FE, LP on July 28, 2005  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                                                            |
|            |       |                                                                                                                                                                                                                                   |
| 4.9             |       | 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 August 3, 2005).                                      |
|            |       |                                                                                                                                                                                                                                   |
| 4.10            |       | Warrant issued to WNT07, LLC on July 28, 2005  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                                                              |
|            |       |                                                                                                                                                                                                                                   |
| 4.11            |       | 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 November 30, 2005).  |
|            |       |                                                                                                                                                                                                                                   |
| 4.12            |       | Waiver of Registration Rights Agreement, dated  November 25, 2005, by and among ARTISTdirect, Inc. and                                                                                                                                 |

 

E-1

----

 
|        |   | certain of the Sub-Debt Financing investors  (incorporated by reference to current report on Form 8-K filed November 30,  2005).                                                                                                                                                                                                                |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.13   |   | 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 April 10, 2006).                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.14   |   | 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 April  10, 2006).                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.15   |   | 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 April 10, 2006).                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.16   |   | 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 April 10,  2006).                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.17   |   | 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 April 10, 2006).                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.18   |   | 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 April 10,  2006).                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.19   |   | 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 April 10, 2006).                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.20   |   | 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 April 10, 2006).                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 4.21   |   | 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 April 10,  2006).                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.1   |   | Amendment No. 1 dated February 27, 2002 to  the Agreement dated July 19, 2000 between ARTISTdirect, Inc. and  Ticketmaster (incorporated by reference to quarterly report on Form 10-Q  filed May 15, 2002).                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.2   |   | Escrow Agreement dated March 13, 2002 among  ARTISTdirect, Inc., Ticketmaster and JPMorgan Chase Bank (incorporated by  reference to quarterly report on Form 10-Q filed May 15, 2002).                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.3   |   | Agreement dated October 22, 2001 between  ARTISTdirect, Inc. and Old Glory Boutique Distributing, Inc. (incorporated by  reference to quarterly report on Form 10-Q filed August 14, 2002).                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.4   |   | Letter Agreement, dated as of December 9, 2002,  by and between ARTISTdirect, Inc. and Frederick W. Field to amend the  Employment Agreement dated May 31, 2001 between ARTISTdirect, Inc. and  Mr. Field (incorporated by reference to current report on Form 8-K  filed December 13, 2002).                     |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.5   |   | Letter Agreement, dated as of December 9, 2002,  by and between ARTISTdirect Records, L.L.C. and Frederick W. Field to  amend the Employment Agreement dated May 31, 2001 between ARTISTdirect  Records, L.L.C. and Mr. Field (incorporated by reference to current  report on Form 8-K filed December 13, 2002). |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.6   |   | Letter Agreement, dated as of December 23,  2002, by and between ARTISTdirect, Inc. and Keith Yokomoto to amend the  Employment Agreement dated July 1, 2001 between ARTISTdirect, Inc. and  Mr. Yokomoto (incorporated by reference to quarterly report on  Form 10-Q/A filed December 23, 2002).                     |

 

E-2

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| 10.7       |       | Letter Agreement, dated as of December 23,  2002, by and between ARTISTdirect, Inc. and Marc Geiger to amend the  Employment Agreement dated July 28, 1998, as amended on July 1,  2001, between ARTISTdirect, Inc. and Mr. Geiger (incorporated by  reference to current report on Form 8-K filed December 23, 2002).                                               |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.8       |       | Letter Agreement dated December 11, 2002  between ARTISTdirect, Inc. and Benn Co., LLC consenting to the assignment by  Old Glory Boutique Distributing, Inc. to Benn Co., LLC of the Agreement dated  October 22, 2001 between ARTISTdirect, Inc. and Old Glory Boutique  Distributing, Inc. (incorporated by reference to annual report on  Form 10-K filed March 31, 2003). |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.9       |       | Agreement for Services dated as of June 13,  2002 between ARTISTdirect, Inc. and Frankel & Company (incorporated  by reference to annual report on Form 10-K filed March 31, 2003).                                                                                                                                                                                             |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.10      |       | Letter Agreement, dated as of May 1, 2003, by  and between ARTISTdirect, Inc. and Frederick W. Field to amend the  Employment Agreement dated May 31, 2001 between ARTISTdirect, Inc. and  Mr. Field (incorporated by reference to quarterly report on  Form 10-Q filed August 14, 2003).                                                                            |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.11      |       | Letter Agreement, dated as of May 1, 2003, by  and between ARTISTdirect Records, L.L.C. and Frederick W. Field to amend  the Employment Agreement dated May 31, 2001 between ARTISTdirect  Records, L.L.C. and Mr. Field (incorporated by reference to quarterly  report on Form 10-Q filed August 14, 2003).                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.13      |       | 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  November 14, 2003).                                                                                                                                                                           |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.14      |       | 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).                                                                                                                                     |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.15      |       | Termination Agreement and Mutual Release by Keith  Yokomoto and ARTISTdirect, Inc. dated as of December 31, 2003  (incorporated by reference to annual report on Form 10-K filed on  May 17, 2004).                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.16      |       | Form of Director Indemnification Agreement  (incorporated by reference to registration statement on Form S-1/A                                                                                                                                                                                                                                                                                |
|       |       | filed January 27, 2000).                                                                                                                                                                                                                                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.17      |       | Form of Officer Indemnification Agreement (incorporated  by reference to registration statement on Form S-1/A filed January 27,  2000).                                                                                                                                                                                                                                                       |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.18      |       | ARTISTdirect, Inc. 1999 Employee Stock Option Plan  (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.19      |       | ARTISTdirect, Inc. Artist Plan (incorporated by  reference to registration statement on Form S-1/A filed January 27, 2000).                                                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.20      |       | ARTISTdirect, Inc. Artist and Artist Advisor Plan  (incorporated by reference to registration statement on Form S-1/A filed January  27, 2000).                                                                                                                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.21      |       | ARTISTdirect, Inc. 2004 Consultant Stock Plan  (incorporated by reference to registration statement on Form S-8 filed  January 13, 2005).                                                                                                                                                                                                                                                          |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.22      |       | 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 August 20, 2004).                                                                                                                                                                   |

 

E-3

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| 10.23  |   | Termination Agreement made as of July 30, 2004  among ARTISTdirect, Inc., ARTISTdirect Records, LLC and BMG Music  (incorporated by reference to quarterly report on Form 10-Q filed  August 20, 2004).                                                                                                                        |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.24  |   | Trademark Assignment and Purchase Agreement between  ARTISTdirect, Inc. and Apple Computer, Inc. dated November 12, 2004  (incorporated by reference to current report on Form 8-K filed  November 29, 2004).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.25  |   | Transfer Agreement between ARTISTdirect Recordings,  Inc., ARTISTdirect, Inc. and Radar Records Holdings, Inc. dated as of  December 31, 2004 (incorporated by reference to current report on  Form 8-K filed March 4, 2005).                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.26  |   | 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  August 3, 2005).                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.27  |   | 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 August 3, 2005).                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.28  |   | 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 August 3, 2005).                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.29  |   | 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 August 3, 2005).                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.30  |   | 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 August 3, 2005). |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.31  |   | 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 August 3,  2005)                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.32  |   | 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 August 3, 2005).                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.33  |   | Form of Copyright Security Agreement (incorporated  by reference to current report on Form 8-K filed August 3, 2005).                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.34  |   | 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 August 3, 2005).                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.35  |   | 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 August 3,  2005).                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.36  |   | 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 August 3, 2005).                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                          |
| 10.37  |   | 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  August 3, 2005).                                                                                                            |

 

E-4

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| 10.38  |   | 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 August 3, 2005). |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.39  |   | 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 August 3, 2005).                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.40  |   | 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 August 3, 2005).                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.41  |   | 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 August 3, 2005).                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.42  |   | 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 October 14,  2005).                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.43  |   | 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 February  3, 2006).                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.44  |   | 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 February 3, 2006).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.45  |   | Sublease by and between Sapient Corporation and  ARTISTdirect, Inc. dated January 26, 2006 (incorporated by reference to  current report on Form 8-K filed February 3, 2006).                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.46  |   | Fiscal 2006 Board of Directors Compensation  (incorporated by reference to current report on Form 8-K filed April 4,  2006.)                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 10.47  |   | 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 April 10, 2006).                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 14.1   |   | Code of Business Conduct and Ethics (incorporated by  reference to annual report on Form 10-K filed May 17, 2004).                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 16.1   |   | Letter from KPMG LLP regarding change in certifying  accountants (incorporated by reference to current report on Form 8-K filed  February 12, 2004).                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 21.1   |   | Subsidiaries of ARTISTdirect, Inc. (incorporated by  reference to registration statement on form SB-2 filed 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 (incorporated by reference to  annual report on Form 10-KSB filed April 13, 2006).                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 31.1   |   | Certifications of the Chief Executive Officer under  Section 302 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 31.2   |   | Certifications of the Chief Financial Officer under  Section 302 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 32.1   |   | Certifications of the Chief Executive Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 32.2   |   | Certifications of the Chief Financial Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |

 

E-5

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