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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-K
 
 [X]
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2003OR[  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the transition period from to.
  ARTISTDIRECT, INC.
  
 DELAWARE
    
    95-4760230(State or Other Jurisdiction
    
    (I.R.S. Employer Identification
Number)of Incorporation or Organization)
 10900 Wilshire Boulevard, Suite 1400, Los Angeles, California 90024
  Registrants telephone number, including area code: (310) 443-5360
 
 Securities registered pursuant to Section 12(b) of the Act: None
 Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value
 
 Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [  ] Indicate by check mark whether the disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the Registrants knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K [  ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [  ] No [X] As of April 14, 2004, the aggregate market value of the voting and
non-voting common equity held by non-affiliates was approximately $984,000,
based on the closing price per share of $0.39 for the Registrants common stock
as reported on the OTC Bulletin Board on such date. Indicate the number of shares outstanding of each of the Registrants
classes of common stock, as of the latest practicable date: As of April 14,
2004, there were 3,502,117 shares of the Registrants common stock, par value
$0.01 per share, outstanding. DOCUMENTS INCORPORATED BY
REFERENCE - NONE




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ARTISTDIRECT INC. ANNUAL REPORT ON FORM
10-K  
 TABLE OF CONTENTS PagePART I
    
    
    1ITEM 1. BUSINESS
    
    
    1ITEM 2. PROPERTIES
    
    
    18ITEM 3. LEGAL PROCEEDINGS
    
    
    19ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    19PART II
    
    
    19ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
    
    
    19ITEM 6. SELECTED FINANCIAL DATA
    
    
    20ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    21ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    39ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
    
    
    40ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
    
    
    40ITEM 9A. CONTROLS AND PROCEDURES
    
    
    40PART III
    
    
    41ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
    
    
    41ITEM 11. EXECUTIVE COMPENSATION
    
    
    43ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
    
    
    50ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    
    
    54ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
    
    
    55PART IV
    
    
    56ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
    
    
    56SIGNATURES
    
    
    57EXHIBIT 10.15EXHIBIT 14.1EXHIBIT 23.1EXHIBIT 23.2EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
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This report contains forward-looking statements that include, but are not
limited to, statements concerning projected revenues, expenses, gross profit
and income, the need for additional capital, and the success of pending
litigation. These forward-looking statements are based on our current
expectations, estimates and projections about our industry, managements
beliefs, and certain assumptions made by us. Words such as anticipates,
expects, intends, plans, believes, seeks, estimates, may, will
and variations of these words or similar expressions are intended to identify
forward-looking statements. In addition, any statements that refer to
expectations, projections or other characterizations of future events or
circumstances, including any underlying assumptions, are forward-looking
statements. These statements are not guarantees of future performance and are
subject to certain risks, uncertainties and assumptions that are difficult to
predict. Therefore, our actual results could differ materially and adversely
from those expressed in any forward-looking statements as a result of various
factors. The section entitled Risk Factors set forth at the end of Part I,
Item 1 of this report, the Managements Discussion and Analysis of Financial
Condition and Results of Operations in Part II, Item 7 of this report and
similar discussions in our other filings with the Securities and Exchange
Commission (SEC) discuss some of the important risk factors that may affect
our business, results of operations and financial condition. You should
carefully consider those risks in addition to the other information in this
report and in our other filings with the SEC before deciding to invest in our
company or to maintain or increase your investment. We undertake no obligation
to revise or update publicly any forward-looking statements for any reason. ii




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PART I 
 ITEM 1. BUSINESS OVERVIEW We are a music entertainment company that combines an online music network
and a record label business to provide an integrated offering for music fans,
artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com)
is a network of Web sites offering multi-media content, music news and
information, community around shared music interests, advertising sponsorships,
music-related specialty commerce and digital music services. Through our
co-venture record label, ARTISTdirect Records, we develop new musical artists
and produce and distribute their recordings as an independent label utilizing
traditional channels of distribution. The ARTISTdirect Network consists of our music search engine and database
containing information on more than 100,000 artists, retail e-commerce offering
a wide selection of artist merchandise and music, our proprietary music guide
that enables users to browse music by artist, genre or time period, a
music-oriented online community and the ability for users to download and
listen to music and view music videos.           Our two record labels have significantly reduced their operations in 2003.
iMusic, a record label formed through our wholly-owned subsidiary,
ARTISTdirect Digital, LLC, sold most of its rights regarding unreleased artists
to a third party. There is no plan to add additional artists or release
additional albums through this record label in the future. Our other record label, ARTISTdirect Records, LLC, was formed as a
co-venture between our wholly owned subsidiary, ARTISTdirect Recordings, Inc.,
and Radar Records Holdings, LLC, an entity wholly owned by our Chairman,
Frederick W. (Ted) Field. Mr. Field also serves as the Chief Executive Officer
of ARTISTdirect Records. During 2003, we have significantly downsized the
ARTISTdirect Records operation and currently have no full-time employees. We
are seeking additional financing to restructure the ARTISTdirect Records
business, and will keep its operations minimal until such capital is obtained,
if ever. RECENT EVENTS We underwent significant changes during the fiscal year ended December
31, 2003 as described below: Nasdaq Delisting In May 2003, our common stock was delisted from Nasdaq because we no
longer complied with the stockholders equity, market capitalization and
certain other requirements for continued listing on The Nasdaq National Market
or for 1




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moving our listing to The Nasdaq Small Cap Market. Our common stock now trades
on the Over-The-Counter Bulletin Board under the symbol ARTD. Changes in Accountant In February 2004, we announced that we terminated KPMG LLP as our
independent accountant and retained Gumbiner, Savett, Finkel, Fingleson & Rose,
Inc. to act as our new independent accountant. New Management Since December 31, 2002, our management has undergone significant changes.
In September 2003, Mr. Ted Field resigned as our Chief Executive Officer and
serves solely as our Chairman. We appointed Mr. Jonathan Diamond as Chief Executive
Officer that same month. On May 31, 2003, Mr. Marc Geiger resigned as our
Vice-Chairman and President, Artist Services, and now serves solely as our
director. In June 2003, Mr. James Carroll resigned as our Chief Financial
Officer and he was replaced by Mr. Thomas Fuelling. In January 2004, we
appointed Mr. Robert Weingarten as our Chief Financial Officer after Mr.
Fuelling resigned in November 2003. On December 31, 2003, Mr. Keith Yokomoto
stepped down as our Chief Operating Officer and now acts solely as a director. Record Label Downsizing and Restructuring iMUSIC During 2002, our wholly owned subsidiary ARTISTdirect Digital, Inc. began
operating a record label under the brand name iMusic. We transferred most of
our rights and obligations regarding unreleased artists to a third party. In
2003, we executed an agreement with GC Music in which we assigned our rights and obligations to six unreleased artists in
exchange for a profits interest in any projects GC Music had with such artists.
We retained the distribution right to the albums previously released under the
original terms of our distribution agreements with our other signed artists.
We do not plan to sign any additional artists through our iMusic label or
release any additional albums domestically or internationally and expect very
minimal sales activity in the future, if at all. ARTISTdirect RECORDS In May 2001, we entered into an agreement with veteran entertainment
executive Frederick W. (Ted) Field to become our Chairman and Chief Executive
Officer and form a new record label in partnership with us. On June 29, 2001,
our stockholders approved the employment of Mr. Field and the formation of the
record label, ARTISTdirect Records, LLC, as a 50/50 co-venture between
ARTISTdirect and Mr. Field where we agreed to provide a significant financial
commitment. Through our co-venture record label, we develop new musical
artists and produce and distribute their recordings as an independent label
utilizing both traditional channels and emerging internet distribution
channels. In addition to the formation of the record label and our financial
commitment, we entered into a five-year employment agreement with Mr. Field to
serve as Chairman and Chief Executive Officer. Mr. Field also serves as the
Chief Executive Officer of ARTISTdirect Records. We initially committed to fund a total of $50 million to ARTISTdirect
Records over five years at the rate of $15.0 million per year, subject to a
limit of $33 million in any three year period. Any funding in excess of these
amounts required the approval of our Board of Directors. We have funded a
total of $33.0 million through December 31, 2003. In November 2001, ARTISTdirect Records agreed in principle to enter into a
preliminary North America distribution agreement and worldwide license
agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music
Group, Inc., the global music division of Bertelsmann AG (BMG). Under the
terms of the agreement, BMG agreed to distribute the labels releases in North
America, and BMG licensed ARTISTdirect Records repertoire in territories
throughout the world. In April 2002, the agreements with BMG were finalized,
including BMGs purchase of 5% of the equity of ARTISTdirect Records from us.
As part of this transaction, BMG agreed to advance certain monies against net
sales proceeds under the agreements and also assumed $5.0 million of our
funding commitment to ARTISTdirect Records. As a result of the BMG equity
purchase, our funding commitment was reduced to $45 million. In December 2002,
BMG exercised its option to extend the term of the distribution and license
agreement until September 2004. Under the distribution and license agreements, BMG made non-returnable
advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002
and $5.0 million in 2003 that are recoupable from net sales proceeds from 2




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ARTISTdirect Records artist repertoire. The advances are to be recouped
on a monthly basis based on a defined calculation. As of December 31, 2002 and
2003, the unrecouped balance related to distribution advances from BMG was $4.1
million and $8.7 million, respectively. In August 2002, our Board of Directors approved an agreement (the
Accelerated Funding Agreement) to accelerate up to $10 million of its funding
commitment to ARTISTdirect Records. This funding was in addition to the $15
million that we were obligated to advance to ARTISTdirect Records in 2002 as
part of the initial $50 million funding commitment. During 2002, we funded our
$15 million commitment plus the additional $10 million bridge loan for total
advances to the record label of $25.0 million in 2002 and $30.25 million from
the inception of the record label through December 31, 2002. The $10 million
of accelerated funding was credited toward the satisfaction of our overall
funding commitment and funding obligation for 2003, resulting in a remaining
funding commitment of $2.75 million for 2003 and $12.0 million for 2004. We
advanced the $2.75 million during 2003. Our commitment to fund ARTISTdirect
Records is subject to a guaranty for the benefit of BMG. Should we fail to
meet our commitment, BMG may choose to enforce the guaranty or provide
substitute financing that could result in dilution of our interest in
ARTISTdirect Records. As consideration for entering into the Accelerated Funding Agreement, we
received an additional 20% interest in ARTISTdirect Records from Radar Records
Holdings, L.L.C. (RRH), the entity through which Mr. Field owns his interest
in ARTISTdirect Records, which resulted in an increase in our ownership share
of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Fields ownership
share from 50% to 30%. The Accelerated Funding Agreement also provides that
any dilution from the issuance of equity interests in ARTISTdirect Records that
would have been borne solely by us will be borne both by RRH and us pro rata
with our then respective ownership interests. Furthermore, the Accelerated
Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded
return to be realized from our advances and equity interests in ARTISTdirect
Records. Due to the uncertainty with respect to the realization of such rate
of return, we have not recorded any amounts related to the 25% minimum annual
compounded return in our consolidated financial statements. As of December 31, 2003, ARTISTdirect Records did not have sufficient
working capital resources to conduct operations and accordingly had curtailed
its operations. During the three months ended September 30, 2003, ARTISTdirect
Records significantly reduced its overhead costs and operating activities and
laid off the majority of its staff while it continued to restructure its
operations and seek additional capital. We do not have the resources to meet our remaining $12.0 million funding
commitment to ARTISTdirect Records for 2004. ARTISTdirect Records requires
additional capital in order to continue operations, and therefore we are
continuing to pursue alternatives to raise additional capital for both
ourselves and for ARTISTdirect Records. However, there can be no assurances
that additional capital can be obtained by either our company or by
ARTISTdirect Records on reasonable terms or at all. If additional funds are
raised through the issuance of equity securities of either our company or
ARTISTdirect Records, the percentage ownership of our current stockholders in
our company and/or our companys ownership of ARTISTdirect Records would be
reduced. Failure to raise additional capital could seriously harm the business
of ARTISTdirect Records. In such event, ARTISTdirect Records may seek to
divest all or certain of its assets or we may seek to divest all or a part of
its ownership of ARTISTdirect Records, in order to raise the capital necessary
to sustain business operations of our company and/or ARTISTdirect Records. As of December 31, 2003, ARTISTdirect Records had received $898,000 of
loans from Ted Field and $1,150,000 of loans from outside investors (including
$100,000 from Jonathan V. Diamond, our new President and Chief Executive
Officer). The total loans of $2.048 million during 2003 were obtained through
the issuance of convertible promissory notes (the Bridge Notes). The Bridge
Notes accrue interest at 8% per annum, are due two years from the date of
issuance, and will be converted into new equity of ARTISTdirect Records as part
of its next equity financing. The holders of the Bridge Notes also received warrants with a term of five
years to purchase additional equity of ARTISTdirect Records at $0.01 per unit
equivalent to the number of units of new equity into which their Bridge Notes
are ultimately converted. During the three months ended March 31, 2004, Mr. Field advanced an
additional $1.89 million to ARTISTdirect Records to fund operating expenses and
the settlement of artist contracts. In consideration for such advances, Mr.
Field received Bridge Notes and warrants. 3




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ARTISTdirect Network Downsizing In 2003, because of declining revenue and in response to our liquidity
problems, we reduced our staff handling the ARTISTdirect Network from
eight persons
to three persons. Termination of Office Lease In 2003, we reached an agreement to terminate of our lease for 64,000
square feet of office space with a term through April 2010. In conjunction
with the termination, the landlord drew down the entire remaining $1.35 million
letter of credit that we had provided as a security deposit. We also issued to
the landlord warrants to purchase 200,000 shares of the Companys common stock
exercisable at $0.50 per share through September 8, 2008. ARTISTdirect BUSINESS SEGMENTS During the year ended December 31, 2003, the Company operated primarily
through three reportable segments: Media Operations (Media), E-commerce
operations (E-commerce), and Record Label operations (Record Label) through
its iMusic record label. Media.The ARTISTdirect Network is comprised of our Media and E-commerce
operations. Our Media operations include our content-oriented web sites and our
entertainment marketing initiatives. Revenue from Media operations is generated
from the sale of online and offline advertising and integrated marketing
solutions. We market and sell advertising on a cost-per-impression (CPM) basis
to advertising agencies and to marketing personnel of various companies.
Customers may purchase advertising space for the entire web site, or it may
tailor advertising based on music genre (e.g., jazz, country, rock music) or
based on functionality (e.g., directing advertising to customers using music
download features or broadband-only features of the ARTISTdirect Network).
Since we are increasingly aware of websites outside the ARTISTdirect Network
that are frequently visited by artists and music fans, we have also offered our
customers advertising space on behalf of third party websites. E-Commerce.E-commerce operations includes sale of recorded music and
music-related merchandise. Most of our sales comes from our ARTISTdirect
Shopping area which offers a comprehensive selection of music CDs and broad
range of artist and lifestyle merchandise. Record Labels. We began operating our iMusic record label in 2002. Operations consist
primarily of the sale of compact discs by artists signed to the iMusic record
label. iMusics concept was to focus on the signing of established artists
with a proven sales base and an ability to generally make records less
expensively than developing artists. In addition, we expected that
substantially less would be spent on marketing and promotion of these releases
than on those of new artists. In the second quarter of 2003, our management
decided to scale back the activity of our iMusic label in order to conserve
capital. In the third quarter of 2003, we entered into an agreement with GC
Music, a company in which Marc P. Geiger, a director of the Company, is a
partner, pursuant to which we assigned our rights and obligations to six
unreleased artists in exchange for $100,000 and a profit interest in the
projects. We retain the distribution rights to the albums previously released
under the original terms of its distribution agreements with its other signed
artists. We do not plan to sign any additional artists or release any
additional albums domestically or internationally under the iMusic label and
expects very minimal sales activity in the future. In addition, we have significantly reduced operations of ARTISTdirect
Records until additional financing is obtained. As of December 31, 2003,
ARTISTdirect Records had signed recording agreements with six artists and had
no full-time employees. INFRASTRUCTURE AND OPERATIONS TECHNOLOGY Our infrastructure is designed to be integrated, scalable, reliable and
secure. The software that we use supports the acquisition, management and
publication of content on our Web sites. During 2003, the management of our Web
sites and servers for content, applications, database and electronic commerce
was handled internally. Our servers are maintained at IX2 Networks, LLC, a
co-location facility in Los Angeles, California. Our operations depend on our
and IX2s ability to protect our systems against fire, power loss,
telecommunications failure, break-ins and other events. All Web sites, 4




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servers, and systems are monitored and periodic backups are stored at our
downtown data center. Our current e-commerce system is based on SAP software with certain
enhancements provided to us by Pandesic, LLC, a joint venture between Intel and
SAP that wound up operations in January 2001. Upon Pandesics cessation of
operations, we received the source code and executables for the e-commerce
system that had been provided previously by Pandesic, implemented SAPs
software in house under a two-year license from SAP. In December 2002, our
two-year license expired and we entered into a perpetual license agreement with
SAP. ORDER PROCESSING AND FULFILLMENT Our Web sites include an ordering system that is designed to facilitate
convenient online purchasing of pre-recorded music and merchandise. Customers
can add items to their shopping cart while surfing our Web sites. At any time
they can securely checkout, at which time they need to register (if they are
new customers), or enter a username and password to retrieve previously saved
billing, shipping and credit card information. We verify orders submitted for
credit card payment for fraud detection and sufficient funds before we release
them for fulfillment. We also accept alternative modes of payment, such as
checks and money orders. Credit card numbers are encrypted, and all customer,
commerce and transactional data are stored in secure databases protected by
firewalls. The transmission of information over the Internet uses Secure Socket
Layer security technology verified by VeriSign. Alliance Entertainment. In August 1998, we entered into a five-year agreement
with Alliance Entertainment Corp. to be our primary supplier of music and
music-related information for our ARTISTdirect Superstore. This agreement is
now month-to-month. Alliance owns the All Music Guide, a comprehensive source
of artist and album information that is supplied to our users primarily through
its integration into the UBL. Alliance fulfills compact discs ordered by our
customers and we pay Alliance the wholesale cost plus a fulfillment fee. In
addition, Alliance provides warehouse space and fulfillment services pursuant
to an oral agreement that Alliance may terminate at any time for a majority of
the music-related merchandise that we offer which allows the consolidated
shipping of customer orders for both music and merchandise. We have integrated
our order processing system with Alliances information systems to assist in
fulfillment tracking, inventory management and customer service. We purchase
almost all of the music titles available for sale on our Web sites from
inventory held by Alliance. Benn Co. (formerly Old Glory).In November 2001, we entered into a six-month
agreement with Old Glory Boutique Distributing Inc. (Old Glory) to be a
wholesale supplier of music-related merchandise and provide fulfillment
services for the products for which it sells to us. The agreement was renewed
for a one-year period in May 2002 and automatically renewed for an additional
year in May 2003. In December 2002, this agreement was assigned from Old Glory
to Benn Co., LLC. This agreement is now month-to-month. If
we are unable to continue our agreements with these suppliers, or if Alliance ceases to provide fulfillment
services for merchandise, our business could be adversely affected. CUSTOMER SERVICE In June 2001, we entered into a two-year agreement with AEC One-Stop
Group, Inc. (Alliance Entertainment) to provide customer support services for
our Web sites consumers and respond to customer inquiries, orders and other
requests made by phone, fax, e-mail and regular mail. Prior to entering into
the agreement with Alliance, we provided customer service with an internal
staff of customer service representatives. This agreement is now
month-to-month. SALES AND MARKETING ADVERTISING SALES We sell advertising and sponsorships to advertisers seeking to reach one
or more of the distinct demographic audiences viewing content in the
ARTISTdirect Network. Advertisers may choose single elements such as targeted
or run-of-network banners or sponsorship of fixed placement on our Web sites.
Pricing is negotiated based upon the size of the target audience, the duration
and intensity of the campaign and the size and placement of the advertisement.
For the years ended December 31, 2003 and 2002, advertising represented 20%
and 15%, respectively, of our revenue. AT&T Wireless accounted for 47% and 14%
of our advertising revenues for the year ended December 31, 2003 and 2002,
respectively. 5




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MARKETING AND PROMOTION We use a number of methods to create awareness of the ARTISTdirect Network
and drive traffic to our Web sites. We have focused much of our marketing
activity on e-mail direct marketing to communicate with registered users of
specific artists and the ARTISTdirect Network. Campaigns have included direct
notification of special merchandise offers, contests, promotions and music
downloads. COMPETITION The market for the online promotion and distribution of music and
music-related products and services is relatively new, highly competitive and
rapidly changing. There are a large number of Web sites competing for the
attention and spending of consumers and advertisers, and we expect that number
to increase, because there are few barriers to entry to Internet commerce. In
addition, the competition for advertising revenue, both on Web sites and in
more traditional media, is intense. We compete as follows:  
    
    for music consumers and advertisers with providers of music
information, community and content such as MTV, America Online, MSN,
Yahoo!, Listen.com and various other companies;
    
    with major online music retailers such as Amazon.com and CDnow in
selling music and merchandise;
    
    for music consumers and artist relationships with traditional music
industry companies, including BMG Entertainment, a unit of Bertelsmann
AG, EMI Music, a unit of EMI Group, Sony Music Entertainment, a unit of
Sony Corporation, Warner Music Group, and Universal Music Group, a unit
of Vivendi. Some of these companies have recently established online
presences to promote and distribute the music and tours of their
respective artists;
    
    for music consumers and advertisers with publishers and distributors
of traditional media, such as television, radio and print, including
MTV, CMT, Rolling Stone and Spin and their Internet affiliates; and
    
    with traditional retailers targeting music consumers, including Tower
Records and Virgin Megastore and their Internet affiliates, in selling
music and merchandise. Our competitors have worked together to offer music over the Internet, and
we may face increased competitive pressures as a result. For instance,
RealNetworks, Time Warner, Bertelsmann AG and EMI Group formed MusicNet, a
digital music subscription platform featuring on-demand downloads and
streaming. Sony Connect and various retailers such as BestBuy have cooperated
to distribute music through the iTunes platform. We believe that we are able to compete primarily on the bases of:  
    
    the breadth and quality of our search, database and the community features of our site;
    
    the variety, availability and price of music-related
merchandise on our sites; and
    
    the ease of use and consumer acceptance of the ARTISTdirect Network. Competition is likely to increase significantly as new companies enter the
market and current competitors expand their services. Many of our current and
potential competitors in the Internet and music entertainment businesses may
have substantial competitive advantages over us, including:  
    
    longer operating histories;
    
    significantly greater financial, technical and marketing resources;
    
    greater brand name recognition;
    
    larger existing customer bases; and
    
    more popular content or artists. 6




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These competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements and to devote greater
resources to the development, promotion and sale of their products or services
than we
can. Web sites maintained by our existing and potential competitors may be
perceived by consumers, artists, talent management companies and other
music-related vendors or advertisers as being superior to ours. In addition, we
may not be able to maintain or increase our Web site traffic levels, purchase
inquiries and number of click-throughs 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, reduced
margins or loss of market share, any of which could harm our business. GOVERNMENTAL REGULATION The laws and regulations that govern our business change rapidly. Although
our operations are currently based in California, the United States government
and the governments of other states and foreign countries have attempted to
regulate activities on the Internet. The following are some of the evolving
areas of law that are relevant to our business: CONTENT REGULATION Federal, state and foreign governments have adopted and proposed laws
governing the content of material transmitted over the Internet. These include
laws relating to obscenity, indecency, libel and defamation. For example, the
Child Online Protection Act, or COPA, prohibits and imposes criminal penalties
and civil liability on anyone communicating material harmful to minors through
the Internet for commercial purposes, unless access to such material is blocked
to minors under age 17. The Third U.S. Circuit Court of Appeals has upheld a
preliminary injunction precluding enforcement of COPA. In November 2001, the
U.S. Supreme Court heard an appeal but no decision has been issued yet. We
could be liable if the injunction against COPA is lifted and if content
delivered by us or placed on our Web sites violates COPA. On March 6, 2003, the
Third U.S. Circuit Court of Appeals issued a ruling that COPA restricts free
speech because it is not narrowly focused is enough to only target pornography,
and is therefore unconstitutional. The Department of Justice could appeal this
ruling to the U.S. Supreme Court. PRIVACY LAW The state of privacy law is unsettled, and rapidly changing. Current and
proposed federal, state and foreign privacy regulations and other laws
restricting the collection, use and disclosure of personal information could
limit our ability to use the information in our databases to generate revenues.
In late 1998, the Childrens Online Privacy Protection Act, or COPPA, was
enacted, mandating that measures be taken to safeguard minors under the age of
13. The FTC promulgated regulations implementing COPPA on October 21, 1999,
which became effective on April 21, 2000. The principal COPPA requirement is
that individually identifiable information about minors under the age of 13 not
be collected, used or displayed without first obtaining informed parental
consent that is verifiable in light of present technology. The FTC final
regulations create a sliding scale of permissible methods for obtaining such
consent. Consent for internal use of the individually identifiable information
of children under the age of 13 can be obtained through e-mail plus an
additional safeguard, such as confirming consent with a delayed e-mail,
telephone call, or letter. Obtaining verifiable consent from a childs parent
to share that childs information with a third party or enable the child to
publicly distribute the information by, for example, allowing unrestricted
access to a chat room or message board is significantly more burdensome. While
the temporary sliding scale implementation was due to expire on April 21,
2002, on October 31, 2001, the FTC extended the implementation period through
April 21, 2005. The FTC has required that parental consent for such higher risk activities
be verified by more secure methods than e-mail, such as a credit card in
connection with a transaction, print-and-sign forms, toll-free numbers staffed
by trained operators, or digital signatures. Complying with the new
requirements is costly and will likely dissuade some of our customers. While we
are attempting to be fully compliant with the FTC requirements, our efforts may
not be entirely successful. In addition, at times we rely upon outside vendors
to maintain data-collection software, and there can be no assurance that they
will at all times comply with our instructions to comply with COPPA. If our
methods of complying with COPPA are inadequate, we may face litigation with the
FTC or individuals, which would adversely affect our business. Moreover, we have posted a Private Policy pertaining to all users and
visitors to our Web site. By doing so, we have subjected ourselves to the
jurisdiction of the FTC. Should any of our business practices be found to
differ from our Private Policy, we could be subject to sanctions and penalties
from the FTC. It is also possible that users or visitors could try to recover
damages in a civil action as well. 7




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LAWS GOVERNING SENDING OF UNSOLICITED COMMERCIAL E-MAIL We typically provide our customers and other visitors to our Web sites
with an opportunity to opt-in, or agree to
receive e-mailings from us. The federal government recently signed the
Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003
(CAN-SPAM) designed to limit unsolicited commercial e-mail commonly referred to
as spam. In addition, California and a number of other states regulate the
sending of e-mails for commercial purposes to third parties where there is no
preexisting business relationship. Further, several states give Internet
service providers (ISPs) a private right of action against those who send
large e-mailings across their servers in contravention of the ISPs posted
policy. There is no guarantee that we will always be fully compliant in all of
our communications at all times. Our failure to comply with applicable laws
regarding these types of e-mails could result in significant fines, actual or
statutory damages, and injunctive actions. CONFORMANCE TO E-COMMERCE STATUTORY REQUIREMENTS FOR FORMATION OF
CONTRACTS We conduct e-commerce on our Web sites, and through affiliated Web sites.
The applicable law on online formation of contracts has been unsettled and is
evolving. 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 standard version of the
Uniform Electronic Transactions Act (UETA), which also permits electronic
signatures and record-keeping for certain types of contracts. We attempt to
comply with these laws, but there is no guarantee that we will be successful.
Judicial interpretation of their application could result in customer contracts
being set aside or modified. In that case, our e-commerce revenue could be
materially adversely affected. SALES TAX The tax treatment of goods sold over the Internet is currently unsettled.
We collect sales taxes for goods shipped to California and Florida, where we
have a physical presence. A number of proposals have been made at the state and
local level that would impose additional taxes on the sale of goods through the
Internet. Such proposals, if adopted, could substantially impair the growth of
electronic commerce and could adversely affect our opportunity to derive
financial benefit from electronic commerce. While the Internet Tax Freedom Act
(ITFA) has placed a moratorium on new state and local taxes on Internet
commerce, the tax moratorium expired on November 1, 2003 and has not been
re-enacted. At least some state legislatures that will convene during early
2004 have indicated that they will move to expand their sales taxes to cover
Internet commerce, if the ITFA is not reinstated. Imposing state sales taxes
on Internet-based commerce would adversely affect our business. ONLINE CONTESTS AND SWEEPSTAKES We conduct online promotional contests and sweepstakes. No purchase is
necessary to participate. Our official rules, with all material terms,
conditions of eligibility, dates of participation, methods of entry and
limitations, if any, along with the odds and prize offerings, are posted on our
Web sites. In order to comply with New York and Florida state law, our prizes
are limited in value to less than $5,000, or we must comply with those states
registration and bonding requirements. While we attempt to comply with the law
of all fifty state jurisdictions, we may not be uniformly successful, and
foreign jurisdictions may attempt to regulate or ban our promotional contests.
In that event, we could lose an effective tool for increasing and keeping
visitors to our Web site, and our business could be adversely affected. INTELLECTUAL PROPERTY OUR PROPRIETARY RIGHTS Copyrighted material that we develop, as well as our service marks and
domain names relating to the ARTISTdirect or UBL brands, and other proprietary
rights are important to our business prospects. We seek to protect our
common-law trademarks through federal registration, but these actions may be
inadequate. Where consultants develop copyrighted content for us, our general
policy is to use written agreements prior to content creation to obtain
ownership of that content. In addition, we principally rely upon trademark,
copyright, trade secret and contract law to protect our proprietary rights. We
generally enter into confidentiality agreements, work-made-for-hire contracts
and intellectual property licenses with our employees, consultants and
corporate partners, respectively, as part of our efforts to control access to
and distribution of our technologies, content and other proprietary
information. Despite our efforts to protect our proprietary rights from unauthorized
use or disclosure, parties may attempt to disclose or use our customer lists,
Web site content, service marks, domain names or confidential commercial data.
The steps that we have taken may not prevent misappropriation of our
proprietary rights, particularly in foreign countries where laws or law
enforcement practices may not protect our proprietary rights at all, or as
fully as in the United States. If 8




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third parties were to use or otherwise misappropriate our copyrighted
materials, trademarks or other proprietary rights without our consent or
approval, our competitive position could be harmed, or we could become involved
in costly and distracting litigation to enforce our rights. OUR WEB SITES FEATURE CONTENT THAT IS COPYRIGHTED BY MULTIPLE
THIRD-PARTIES A copyright gives the owner divisible rights, including those of
performance, reproduction and distribution. The music featured by us is
typically comprised of copyrighted works owned, controlled or administered by
multiple third parties, including record labels, artists, songwriters, music
publishers and performance rights and licensing organizations such as The Harry
Fox Agency, Broadcast Music Inc. and the American Society of Composers, Authors
and Publishers. Each song often has multiple copyright owners, who control
rights which may include performance, reproduction and distribution rights in
the musical composition comprised of the lyrics and music, as well as with
the sound recording of the artists interpretation of the musical
composition. In the case of music videos, there are separate copyrights to the
visual content, as well as synchronization rights for integrating the music
and video. We, or our artists, may have different licensing arrangements with
some or all of these parties to perform, reproduce and distribute works
depending 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 or all of an entire song or Web casting, or the downloading
of an entire song in MP3 or other compressed audio formats. Full-length
streaming only occurs in special instances after obtaining an oral license from
the record label or band manager for the sound recording. In that case, an
ASCAP or BMI blanket music license is also obtained by us or by our artists for
rights to perform the associated underlying musical composition. Where we
offer full-length downloads of songs in MP3 or other compressed audio formats,
we seek to obtain the rights to transmit, reproduce and perform the sound
recording in writing from the person or entity owning or controlling
copyrights in such sound recording. With respect to rights in the musical
compositions embodied in such sound recordings offered for download, we seek
to clear rights in musical composition in one of the following three ways:  
    
    a license agreement with the publisher, writer or other owner of such copyright in the musical composition;
    
    a waiver of any fees or royalties that would otherwise be required for such use; or
    
    a representation and warranty from the owner of the copyrights in the
sound recording that no mechanical royalties are owed to any third
parties. In the event that the foregoing steps are insufficient to clear rights, or
we otherwise fail to obtain rights, we could be exposed to claims of copyright
infringement, with attendant disruption to our operations and liability
including potential statutory or actual damages and loss of profits
attributable to infringement, plus payment of attorneys fees to the claimant
and entry of an injunction. There are other situations, 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 forced to obtain additional licenses or may be prevented from third party
content use, and may further be liable to pay actual or statutory damages,
profits attributable to any alleged infringement, as well as attorneys fees.
Our licensing arrangements for third-party content vary from formal contracts
to informal agreements based on the promotional nature of the content. In some
cases we pay a fee to the licensor for use of the sound recording, musical
composition or music video and in other cases the use is free. We also use
other third-party content, including photographs, artist names, likenesses and
concert reviews. While it is our general policy to obtain a written release or
license for such use, in many instances we rely only upon an oral license for
such use. We rely upon our positive working relationships with copyright owners
to obtain licenses on favorable terms. Any changes in the nature or terms of
these arrangements, including any requirement that we pay significant fees for
the use of the content, could have a negative impact on the availability of
content or our business. For example, the Copyright Office recently opined that additional
royalties, besides those collected for musical compositions by ASCAP or BMI,
are due for Webcasted music that is selected by or on behalf of the recipient
pursuant to 17 U.S.C. sec. 114(j)(7). If upheld, that ruling would prevent us
from expanding our service to permit users to play a requested song via our Web
site without paying additional royalties. 9




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LINKING AND FRAMING OF THIRD-PARTY WEB SITES We link to and frame third-party Web sites of our artists without
express written permission to do so. In addition, in
the past we have provided a search feature to allow users to find music
residing elsewhere on the Internet. Those practices are controversial, and
have, in instances not involving us, resulted in litigation. Various claims,
including trademark and copyright infringement, unfair competition, and
commercial misappropriation, as well as infringement of the right 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 to how existing laws,
especially trademark and copyright law, will be applied by the judiciary to the
Internet. Also, Congress is increasingly active in passing new laws related to
the Internet, and there is uncertainty as to the impact of future potential
laws, especially those involving domain names, databases and privacy. DEFAMATION OR CONTRIBUTORY INFRINGEMENT Our Web site features a community area where visitors can post comments We
do not censor such comments and it is possible that a customer could use our
Web sites as a forum to make false, misleading or disparaging remarks about
others. Such on-line comments could lead to claims for defamation or
infringement. As to libel claims brought in the United States, we believe that
we qualify for safe harbor protection for third-party postings under 47 U.S.C.
sec. 230(c)(1). However, other countries, notably the United Kingdom, may
impose such liability, and it is possible we could be sued there for
third-party postings. Separately, our Web sites allow consumers to use our
personal Web publishing tools to post samples of their works. Such postings
could be misused to post unlicensed copyrighted content of others. We have
obtained limited safe-harbor protection under the recently enacted Digital
Millennium Copyright Act against liability for infringing material of which we
do not have control and knowledge. SEASONALITY The seasonality of our e-commerce segment affects our revenue. Our CDs
and other online goods are most often purchased during the holiday season and
also during the summer months, traditionally when artists go on tour. EMPLOYEES As of March 31, 2004, we had 13 full-time employees and four part-time
consultants. None of our employees is represented by a labor union. We have not
experienced any work stoppages and consider our employee relations to be good. RISK FACTORS Before investing in our company or deciding to maintain or increase your
investment, you should carefully consider the risks described below, in
addition to the other information contained in this report and in our other
filings with the Securities and Exchange Commission. The risks and
uncertainties described below are not the only ones facing our company.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial may also affect our business operations. If any of
these risks actually occur, our business, financial condition or results of
operations could be seriously harmed. In that event, the market price for our
common stock could decline and you may lose all or part of your investment. We Face Substantial Doubt About Our Ability to Continue as a Going Concern
Without Additional Restructuring and/or Additional Financing We have incurred losses and negative cash flows from operations in every
fiscal period since inception and have an accumulated deficit of $222.7 million
as of December 31, 2003. For the year ended December 31, 2003, we incurred a
net loss of $21.7 million and negative operating cash flows of $5.4 million.
As of December 31, 2003, we had a net working capital deficiency of $9.5
million and a stockholders deficiency of $16.9 million. Additionally, we have been funding substantially all of the operations of
ARTISTdirect Records. Our operations to date and loans to ARTISTdirect Records
have been funded by the sale of our preferred and common stock. Management
expects our operating losses to continue for the foreseeable future. We do not
currently anticipate that available cash resources will be sufficient to meet
anticipated needs for working capital and capital expenditures over the next
twelve months without additional capital. We are attempting to mitigate our funding obligation and raise additional
funding through various means. However, there can be no assurances that we
will be successful in this regard. If sufficient funding is not available,
then we may not be able to fund our operations or our remaining commitment to
provide funding to ARTISTdirect Records. Failure to 10




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raise additional capital could seriously harm the business of ARTISTdirect
Records and impair the value of our investment in ARTISTdirect Records. We
have reduced our operations and have divested certain of our assets in order to
attempt to raise the capital necessary to sustain business operations. To the
extent that we are unable to successfully restructure our funding obligation
and/or obtain the capital necessary to fund our future cash requirements on a
timely basis and under acceptable terms and conditions, we will not have
sufficient cash resources to maintain operations, and may consider a formal or
informal restructuring or reorganization. Due to our current financial condition, our auditors have included an
explanatory paragraph in their 2003 report on the financial statements of
ARTISTdirect, Inc. and ARTISTdirect Records, LLC stating that there is
substantial doubt about our ability to continue as a going concern. Our
financial statements do not include any adjustments that might result from the
outcome of this uncertainty. It Is Difficult To Evaluate Our Business And Prospects Because We Have A
Limited Operating History And Rapidly Evolving Business Our limited operating history and rapidly evolving business make it
difficult to evaluate our prospects or to accurately predict our future revenue
or results of operations. Our revenue and income potential are unproven, and
our business model is constantly and rapidly evolving. In particular, the
Internet is constantly changing and we may need to modify our business model to
adapt to these changes. We Have A History Of Operating Losses And Anticipate Losses And Negative Cash
Flow For The Foreseeable Future To date, we have not been profitable on an annual or quarterly basis and
have incurred accumulated losses of approximately $222.7 million as of December
31, 2003. For the years ended December 31, 2003 and 2002, we incurred net
losses of approximately $21.7 million and $48.2 million, respectively, which
represented approximately 363% and 771%, respectively, of our revenue for those
periods. We expect our operating losses and negative cash flow to continue for
at least the near future. We will need to generate significant additional
revenue to achieve profitability. Consequently, it is possible that we may
never achieve profitability, and even if we do achieve profitability, we may
not sustain or increase profitability on a quarterly or annual basis in the
future. If we do not achieve or sustain profitability in the future, then we
will likely be unable to continue our operations. Global Sales of Recorded Music Have Recently Declined and This Trend May
Continue in the Future Based on data compiled by the International Federation of the Phonographic
Industry (IFPI), global sales of recorded music declined 1.3% in value and 1.2%
in units from 1999 to 2000, declined 5.0% in value and 6.5% in units from 2000
to 2001, and declined 9.2% in value and 11.2% in units in the first half of
2002 compared with the first half of 2001. The IFPI attributes this decline, in
part, to widespread copying and illegal Internet downloading of music. If this
trend continues, it may affect our e-commerce business and have a material
adverse effect on our revenue. Our Prior Management Has Committed Substantial Amount Of Our Available Cash To
The ARTISTdirect Records Co-Venture With Ted Field And, As A Result, The Amount
Of Cash That We Will Have Available To Operate Our Other Businesses Has Been
Substantially Reduced The ARTISTdirect Records co-venture with Mr. Field represented a
significant shift in the planned use of our cash resources. As of December 31,
2003, we had provided $33.0 million to ARTISTdirect Records, and are obligated
to provide an additional $12.0 million in 2004. As of December 31, 2003, we had
unrestricted cash and short-term investments totaling $726,000. Our commitment
to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG.
Should we fail to meet our commitment, BMG may choose to enforce the guaranty
or provide substitute financing that could result in dilution of our interest
in ARTISTdirect Records. Despite the fact that third party investors and Mr. Field advanced $2.05
million of bridge loans to ARTISTdirect Records in 2003, and an additional
$1.89 million during the three months ended March 31, 2004, ARTISTdirect
Records will require additional capital in 2004. We currently anticipate that our available cash resources, including
short-term investments, will not be sufficient to meet our anticipated working
capital requirements during 2004, including our $12.0 million funding
commitment to 11




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ARTISTdirect Records in 2004. We have reduced our operations and have
divested certain of our assets in order to attempt to raise the capital
necessary to sustain business operations, and we are exploring various
alternatives to raise additional capital. There can be no assurance that
additional capital can be obtained by either our company or by ARTISTdirect
Records on reasonable terms, in a timely manner or at all. Failure to raise
additional capital could seriously harm the business of ARTISTdirect Records
and impair the value of our investment in ARTISTdirect Records. If additional funds are raised through the issuance of equity securities
of either our company or ARTISTdirect Records, the percentage ownership of
current stockholders in our company and/or ARTISTdirect Records will be
reduced. If we raise additional funds by issuing debt, we may be subject to
limitations on our operations, including limitations on the payment of
dividends, and any debt issued by ARTISTdirect Records may be senior to the
obligations of ARTISTdirect Records to our company. To the extent that we are
unable to successfully restructure our funding commitment and/or obtain the
capital necessary to fund our future cash requirements on a timely basis and
under acceptable terms and conditions, we will not have sufficient cash
resources to maintain operations, and may consider a formal or informal
restructuring or reorganization. See ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS  Liquidity and Capital Resources for more
information on our liquidity and capital resources. Our Equity Interest In ARTISTdirect Records May Be Significantly Diluted If We
Are Unable To Meet Our Financing Commitment In the event that we fail to provide funding to ARTISTdirect Records as
required under the terms of the operating agreement governing the co-venture,
ARTISTdirect Records then has the right to secure substitute financing. Among
other things, any advances made by us that are outstanding at the time will
become subordinated to repayment of the substitute financing and we can be
forced to divest certain of our equity interest in ARTISTdirect Records should
the issuance of an equity interest to the substitute financier be required as a
condition of the substitute financing. If We are Unable To Grow Our Online Advertising Significantly In The Near
Future, Our Business May Be Adversely Affected. If we do not increase advertising revenue, our business will be adversely
affected. Increasing our advertising revenue depends upon many factors,
including our ability to:  
    
    respond to and anticipate fluctuations in the demand for, and pricing
of, online advertising;
    
    develop and maintain key advertising relationships and compete for
advertisers with Internet and traditional media companies;
    
    conduct successful selling and marketing efforts aimed at advertising
agencies and direct marketing departments;
    
    successfully develop, sell and execute entertainment marketing solutions;
    
    increase the size of our audience and the amount of time that our audience spends on our Web sites;
    
    accurately measure the size and demographic characteristics of our audience;
    
    offer advertisers the means to effectively target their advertisements to our audience; and
    
    increase the amount of revenue per advertisement. Our failure to achieve one or more of these objectives could impair our ability
to increase advertising revenue, which could adversely affect our business. In
addition to the above factors, general economic conditions, as well as economic
conditions specific to online advertising, electronic commerce and the music
industry, could affect our ability to increase our advertising revenue. In
particular, the growth of online advertising has declined since 2000, which has
had, and in the future may continue to have, a significant adverse effect on
our revenue from online advertising. In the past, we have traditionally relied
on a limited number of customers for our advertising revenue. For instance,
during the year ended December 31, 2003, AT&T Wireless accounted for 47% of our
total media revenue. 12




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We May Not Be Able To Develop Or Obtain Sufficiently Compelling Content To
Attract And Retain Our Target Audience For our business to be successful, we must provide content and services
that attract consumers who will purchase music and related merchandise online.
We may not be able to provide consumers with an acceptable mix of products,
services, information and community to attract them to our Web sites or to
encourage them to remain on our Web sites for an extended period of time. If
our audience determines that our content does not reflect its tastes, then our
audience size could decrease or the demographic characteristics of our audience
could change and we may be unable to react to those changes effectively or in a
timely manner. Any of these results would adversely affect our ability to
attract advertisers and sell music and other related merchandise. Our ability
to provide compelling content could be impaired by any of the following:  
    
    reduced access to content controlled by record labels, music publishers and artists;
    
    diminished technical expertise and creativity of our production staff; and
    
    inability to anticipate and capitalize on trends in music. If We Do Not Build And Maintain Strong Brands, We May Not Be Able To Attract A
Significant Number Of Users To Our Web Sites To attract users we must develop a brand identity for ARTISTdirect and
increase public awareness of the ARTISTdirect Network; however to conserve
cash, we have significantly decreased the amounts we have spent and plan to
spend on our offline and online advertising and promotional efforts to increase
brand awareness, traffic and revenue. Accordingly, our marketing activities may
not result in increased revenue and, even if they do, any increased revenue may
not offset the expenses we incur in building our brands. Moreover, despite
these efforts we may be unable to increase public awareness of our brands,
which would have an adverse effect on our results of operations. Our Market Is Highly Competitive And We May Not Be Able To Compete Successfully
Against Our Current And Future Competitors The market for the online promotion and distribution of music and related
merchandise is highly competitive and rapidly changing. There are a significant
number of Web sites promoting and distributing music and related merchandise
that compete for the attention and spending of consumers, advertisers and
users. We face competitive pressures from numerous actual and potential
competitors. Our competitors include America Online, MSN, Yahoo!, Listen.com,
Amazon.com, CDnow, MTV, other web sites and traditional music companies. Competition is likely to increase significantly as new companies enter the
market and current competitors expand their services. Some of our competitors
have announced agreements to work together to offer music over the Internet,
and we may face increased competitive pressures as a result. Many of our
current and potential competitors in the Internet and music entertainment
businesses may have substantial competitive advantages relative to us,
including:  
    
    longer operating histories;
    
    significantly greater financial, technical and marketing resources;
    
    greater brand name recognition;
    
    larger existing customer bases; and
    
    more popular content or artists. These competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements and devote greater resources
to develop, promote and sell their products or services than we can. Consumers,
artists, talent management companies and other music-related vendors or
advertisers may perceive Web sites maintained by our existing and potential
competitors as being superior to ours. In addition, increased competition could
result in reduced advertising rates and margins and loss of market share, any
of which could harm our business. 13




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We Depend On A Limited Number Of Suppliers For Music Merchandise, Fulfillment
And Distribution and If We Cannot Secure Alternate Suppliers, Our Business May
Be Harmed We rely to a large extent on timely distribution by third parties. During
2003, we relied on two vendors, Alliance Entertainment, and Benn Co. (formerly
Old Glory Boutique Distributing, Inc.) to fulfill and distribute our orders for
music and related merchandise. During the year ended December 31, 2003,
approximately 86% and 14%, respectively, of our total customer orders were
fulfilled by Alliance and Benn Co., respectively. We purchase a significant
portion of our artist-licensed merchandise from Benn Co. and most all of our
compact discs from Alliance Our contracts with Alliance and Benn Co. expired in
August 2003 and April 2003, respectively, and we now operate with these vendors
on a month-to-month basis. Our business could be significantly disrupted if
Alliance or Benn Co. were to terminate or breach their agreements or suffer
adverse developments that affect their ability to supply products to us. If,
for any reason, Alliance, Benn Co. or other vendors are unable or unwilling to
supply products to us in sufficient quantities and in a timely manner, we may
not be able to secure alternative suppliers, on acceptable terms, in a timely
manner or at all. We Depend On Third Party Inventory And Financial Systems And Carrier Services Because we rely on third parties to fulfill orders, we depend on their
systems for tracking inventory and financial data. If our distributors systems
fail or are unable to scale or adapt to changing needs, or if we cannot
integrate our information systems with the systems of any new distributors, we
may not have adequate, accurate or timely inventory or financial information.
We also rely on third-party carriers for shipments to and from distribution
facilities. We are therefore subject to the risks, including employee strikes
and inclement weather, associated with our carriers ability to provide
delivery services to meet our distribution and shipping needs. In the past,
both Alliance and we have occasionally experienced an unusually high volume of
orders, which resulted in shipping delays to our customers. These delays did
not have a material adverse effect, however, our failure to deliver products to
our customers in a timely and accurate manner in the future could harm our
reputation, our relationship with customers, the ARTISTdirect brand and our
results of operations. Our Business Is Subject To Seasonality, Which Could Adversely Affect Our
Operating Results We have experienced and expect to continue to experience seasonal
fluctuations in our online sales. These seasonal patterns will cause quarterly
fluctuations in our operating results. In particular, a disproportionate amount
of our online sales have been realized during the fourth calendar quarter and
during the summer months, traditionally when artists go on tour. Due to our
limited operating history, it is difficult to predict the seasonal pattern of
our online sales and the impact of such seasonality on our business and
operating results. Our seasonal online sales patterns may become more
pronounced, strain our personnel, warehousing, and order shipment activities
and cause our operating results to be significantly less than expected for any
given period. This would likely cause our stock price to fall. We May Be Subject To System Disruptions, Which Could Reduce Our Revenue Our ability to attract and retain artists, users, advertisers and
merchants for our online network depends on the performance, reliability and
availability of our Web sites and network infrastructure. Our own staff
performs the maintenance and operation of substantially all of our Internet
communications hardware and servers. We have periodic maintenance windows, and
we experience outages from time to time caused by temporary problems in our own
systems or software. While we have implemented procedures to improve the
reliability of our systems, these interruptions may continue to occur from time
to time. Our users also depend on third party Internet service providers and
Web site operators for access to our Web sites. These entities have experienced
significant outages in the past, and could experience outages, delays and other
difficulties due to system failures in the future which are unrelated to our
systems, but which could nonetheless adversely affect our business. Computer Viruses, Electronic Break-Ins Or Similar Disruptive Events Could
Disrupt Our Online Services Computer viruses, electronic break-ins or similar disruptive events could
disrupt our online services. System disruptions could result in the
unavailability or slower response times of our Web sites, which would reduce
the number of advertisements delivered or commerce conducted on our Web sites
and lower the quality of our users experience. Service disruptions could
adversely affect our revenue and, if they were prolonged, would seriously harm
our business and reputation. Our business interruption insurance may not be
sufficient to compensate us for losses that may occur as a result of these
interruptions. 14




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The
Loss Of Key Personnel, Including Ted Field or Jonathan Diamond, Could Adversely
Affect Our Business Because
These Individuals Are Important To Our Business Our future success depends to a significant extent on the continued
services of our senior management, particularly Ted Field and Jonathan Diamond. The
loss of any of these individuals would likely have an adverse effect on our
business. Competition for personnel throughout our industry is intense and we
may be unable to retain these key employees or attract, integrate or retain
other highly qualified employees in the future. We have in the past
experienced, and we expect to continue to experience, difficulty in hiring and
retaining highly skilled employees with appropriate qualifications. If we do
not succeed in attracting new personnel or retaining and motivating our current
personnel, our business could be adversely affected. Recent changes in
corporate governance and securities laws and regulations, such as the
Sarbanes-Oxley Act of 2002, could make it more difficult for us to attract and
retain qualified executive officers or qualified members of our Board of
Directors, particularly to serve on our audit committee. If We Are Unable To Protect Our Intellectual Property Rights, Our Competitive
Position Could Be Harmed Or We Could Be Required To Incur Expenses To Enforce
Our Rights We rely upon registered trademark rights in the United States for our
commercial use of the ARTISTdirect, UBL, Ultimate Band List, and iMusic brand
names and their respective associated domain names, and the ARTISTdirect logo.
We seek to protect our trademarks, copyrights and other proprietary rights by
registration and other means, but these actions may be inadequate. We have
trademark applications pending in several jurisdictions, but our registrations
may not be accepted or may be preempted by third parties and/or we may not be
able to register our trademarks in all jurisdictions in which we intend to do
business. We generally enter into confidentiality or license agreements with
our employees, consultants and corporate partners, and generally control access
to and distribution of our proprietary information. The steps we have taken may
not prevent misappropriation of our proprietary rights, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States. If third parties were to
use or otherwise misappropriate our copyrighted materials, trademarks or other
proprietary rights without our consent or approval, our competitive position
could be harmed, or we could become involved in litigation to enforce our
rights. In addition, policing unauthorized use of our content, trademarks and
other proprietary rights could be very expensive, difficult or impossible,
particularly given the global nature of the Internet. Our Access To Copyrighted Content Depends Upon The Willingness Of Content
Owners To Make Their Content Available The music content available on the ARTISTdirect Network is typically
comprised of copyrighted works owned or controlled by multiple third parties.
Most of the content on our artist-specific Web sites is either owned or
licensed by the artist. On other parts of the ARTISTdirect Network, depending
on the nature of the content and how we use the music content, we typically
license such rights from publishers, record labels, performing rights societies
or artists. We frequently either do not have written contracts or have
short-term contracts with copyright owners, and, accordingly, our access to
copyrighted content depends upon the willingness of such parties to continue to
make their content available. If the fees for music content increase
substantially or if significant music content becomes unavailable, our ability
to offer music content could be materially limited. We have not obtained a
license for some of the content offered on the ARTISTdirect Network, including
links to other music-related sites and thirty-second streamed song samples,
because we believe that a license is not required under existing law. However,
this area of law remains uncertain and may not be resolved for a number of
years. When this area of law is resolved, we may be required to obtain licenses
for such content, alter or remove the content from our Web sites and be forced
to pay potentially significant financial damages for past conduct. Intellectual Property Claims Against Us Could Be Costly And Could Result In The
Loss Of Significant Rights Third parties may assert trademark, copyright, patent and other types of
infringement or unfair competition claims against us. If we are forced to
defend against any such claims, whether they are with or without merit or are
determined in our favor, we may face costly litigation, loss of access to, and
use of, content, diversion of technical and management personnel, or product
shipment delays. As a result of such a dispute, we may have to develop
non-infringing technology or enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may be unavailable on terms
acceptable to us, or at all. While we have resolved all such disputes in the
past, we may not be able to do so in the future. If there is a successful claim
of infringement against us and we are unable to develop non-infringing
technology or license the infringed or similar technology or content on a
timely basis, it could harm our business. In addition, we rely on third parties
to provide services enabling our online product sales transactions, including
credit card processing, order fulfillment, shipping and customer service. We
could become subject to infringement actions by third parties based upon our
use of intellectual property provided by our third-party providers. It is also
possible that we could become subject to 15




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infringement actions based upon the content licensed from third parties.
Any such claims or disputes could subject us to costly litigation and the
diversion of our financial resources and technical and management personnel.
Further, if our efforts to enforce our intellectual property rights are
unsuccessful or if claims by third parties against ARTISTdirect, the UBL and
iMusic are successful, we may be required to change our trademarks, alter or
remove content, pay financial damages, or alter our business practices. These
changes of trademarks, alteration of content, payment of financial damages or
alteration of practices may adversely affect our business. If Our Online Security Measures Fail, We Could Lose Visitors To Our Sites And
Could Be Subject To Claims For Damage From Our Users, Content Providers,
Advertisers And Merchants Our relationships with consumers would be adversely affected and we may be
subject to claims for damage if the security measures that we use to protect
their personal information, especially credit card numbers, are ineffective. We
rely on security and authentication technology that we license from third
parties to perform real-time credit card authorization and verification with
our bank. We cannot predict whether events or developments will result in a
compromise or breach of the technology we use to protect a customers personal
information. Our infrastructure may be vulnerable to unauthorized access,
physical or electronic 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 actions of Internet users, current and former employees and
others. Anyone who is able to circumvent our security measures could
misappropriate proprietary information or cause interruptions in our
operations. Security breaches relating to our activities or the activities of
third-party contractors that involve the storage and transmission of
proprietary information could damage our reputation and our relationships with
our content providers, advertisers and merchants. We also could be liable to
our content providers, advertisers and merchants for the damages caused by such
breaches or we could incur substantial costs as a result of defending claims
for those damages. We may need to expend significant capital and other
resources to protect against such security breaches or to address problems
caused by such breaches. Our security measures may not prevent disruptions or
security breaches. We May Be Subject To Liability If Private Information Provided By Our Users
Were Misused Our privacy policy discloses how we use individually identifiable
information that we collect. This policy is displayed and accessible throughout
the ARTISTdirect Network. Despite this policy, however, if third persons were
able to penetrate our network security or otherwise misappropriate our users
personal information or credit card information, we could be subject to
liability. We could also be subject to liability for claims for unauthorized
purchases with credit card information, impersonation or other similar fraud
claims, or other misuses of personal information, such as for unauthorized
marketing purposes. These claims could result in costly and time-consuming
litigation. Laws Or Regulations May Adversely Affect Our Ability To Collect Demographic And
Personal Information From Users, Or To Display Certain Content On Our Sites,
And Could Affect Our Ability To Attract Advertisers Legislatures and government agencies have adopted and are considering
adopting additional laws and regulations regarding the collection, use and
disclosure of personal information obtained from individuals when accessing Web
sites. For example, the Childrens Online Privacy Protection Act restricts the
ability of Internet companies to collect information from children under the
age of 13 without their parents consent. In addition, the Federal Trade
Commission and state and local authorities have been investigating Internet
companies regarding their use of personal information. Our privacy programs may
not conform with laws or regulations that are adopted. In addition, these
legislative and regulatory initiatives may adversely affect our ability to
collect demographic and personal information from users, which could have an
adverse effect on our ability to provide advertisers with demographic
information. These initiatives may also affect our ability to conduct
electronic commerce. The European Union has adopted a directive that imposes restrictions on
the collection and use of personal data. The directive imposes restrictions
that are more stringent than current Internet privacy standards in the United
States. If this directive were enforced against us, it could prevent us from
collecting data from users in European Union member countries or subject us to
liability for use of information in contravention of the directive. Other
countries have adopted or may adopt similar legislation. We could incur
additional expenses if new regulations regarding the use of personal
information are introduced or if government authorities choose to investigate
our privacy practices. In addition, legislatures and government agencies have adopted and are
considering adopting additional laws and regulations governing the content of
material transmitted over the Internet. These include laws relating to
obscenity, indecency, libel and defamation. For example, the Child Online
Protection Act, or COPA, prohibits and imposes criminal penalties and civil
liability on anyone communicating material harmful to minors through the
Internet for commercial 16




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purposes, unless access to such material is blocked to minors under age
17. The U.S. Supreme Court has maintained a preliminary injunction precluding
enforcement of COPA, pending the decision on questions of COPAs
constitutionality that the U.S. Supreme Court remanded to the Third U.S.
Circuit Court of Appeals. We could be liable if the injunction against COPA is
lifted and if content delivered by us or placed on our Web sites violates COPA.
Such a result may adversely affect our ability to attract users under age 17
and, consequently, may adversely affect our ability to attract advertisers. We May Continue To Have Contingent Liability Due To Our Issuances Of Certain
Unregistered Securities Prior to our initial public offering, we issued a number of shares and
options to purchase shares of our common stock to our employees and to artists
and their managers and advisors. Due to the nature of the persons who received
these shares and options in addition to our employees and the total number of
shares and options issued to them and our employees, the issuance of some of
these shares and options did not comply with the requirements of Rule 701 under
the Securities Act of 1933, as amended (the Securities Act), or any other available exemptions from
the registration requirements of Section 5 of the Securities Act, and may not
have qualified for any exemption from qualification or registration under
applicable state securities laws either. As a result, in November 2001,we made a rescission offer to all these
persons pursuant to a registration statement filed under the Securities Act and
pursuant to applicable state securities law. In the rescission offer, we
offered to repurchase from these persons all shares purchased by them pursuant
to option exercises before the expiration of the rescission offer for an amount
equal to the purchase or exercise price paid for these purchased shares, plus
interest from the date of purchase until the expiration of the rescission
offer, at the current statutory rate per year mandated by the state in which
the shares were purchased, or at 7% per year if a private placement exemption
was available in a particular state or if the shares were otherwise issued in
compliance with state law (less any amounts received by those persons who had
already sold their shares). We also offered to repurchase all unexercised
options granted to these persons at 20% of the option exercise price times the
number of option shares, plus interest from the date the options were granted
until the rescission offer expires, at the current statutory rate per year
mandated by the state in which the options were granted, or at 7% per year if a
private placement exemption was available in a particular state or if the
options were otherwise granted in compliance with state law. The rescission
offer was completed in December 2001, resulting in 83,403 shares and 636,740
options being tendered in the rescission offer at a cost to us to
repurchase such shares
and options of approximately $10.2 million. The Securities Act does not expressly provide that a rescission offer will
terminate a purchasers right to rescind a sale of stock that was not
registered under the Securities Act as required. Accordingly, we may continue
to be contingently liable under the Securities Act to any offerees that
rejected the rescission offer. In addition, it is possible that offerees may
claim that the consideration offered to them in the rescission offer was
insufficient, in which case we may have additional liability. We May Be Sued For Content Available Or Posted On Our Website Or Products
Through Our Web Sites Or For Linking And Framing Of Third-Party Web Sites We may be liable to third parties for content published on our Web sites and
other Web sites where our syndicated content appears if the music, artwork,
text or other content available violates their copyright, trademark or other
intellectual property rights or if the available content is defamatory, obscene
or pornographic. Similar claims have been brought, sometimes successfully,
against Web site operators in the past. We also may be liable for content
uploaded or posted by our users on our Web sites, such as digitally distributed
music files, postings on our message boards, chat room discussions and
copyrightable works. In addition, we could have liability to some of our
content licensors for claims made against them for content available on our Web
sites. We also could be exposed to these types of claims for content that may
be accessed from our Web sites or via links to other Web sites or for products
sold through our Web site. While we have resolved all of these types of claims
made against us in the past, we may not be able to do so in the future. We
intend to implement measures to reduce exposure to these types of claims, but
such measures may not be successful and may require us to expend significant
resources. Any litigation as a result of defending these types of claims could
result in substantial costs and damages. Our insurance may not adequately
protect us against these types of claims or the 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 do so. In addition, in the past we have
provided a search feature to allow users to find music residing elsewhere on
the Internet. Those practices are controversial, and have, in instances not
involving us, resulted in litigation. Various claims, including trademark and
copyright infringement, unfair competition, and commercial misappropriation, as
well as infringement of the right of publicity may be asserted against us as a
result. The law regarding linking and framing remains unsettled; it is
uncertain as to how existing laws, especially trademark and copyright law, will
be applied by the 17




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judiciary to the Internet. Also, Congress is increasingly active in passing new
laws related to the Internet, and there is uncertainty as to the impact of
future potential laws, especially those involving domain names, databases and
privacy. We May Need To Change The Manner In Which We Conduct Our Business If Government
Regulation Increases There are currently few laws or regulations that specifically regulate
communications or commerce on the Internet. Laws and regulations may be adopted
in the future, however, that address issues such as user privacy, pricing,
taxation, content, copyrights, distribution, security, and the quality of
products and services. Several telecommunications companies have petitioned the
Federal Communications Commission to regulate Internet service providers and
online services providers in a manner similar to long distance telephone
carriers and to impose access fees on these companies. Any imposition of access
fees could increase the cost of transmitting data over the Internet. In
addition, the growth and development of the market for online commerce may lead
to more stringent consumer protection laws, both in the United States and
abroad, that may impose additional burdens on us. The United States Congress
has enacted Internet laws regarding childrens privacy, copyrights, taxation
and the transmission of sexually explicit material. The law of the Internet,
however, remains largely unsettled, even in areas where there has been some
legislative action. Moreover, it may take years to determine the extent to
which existing laws relating to issues such as property ownership, libel and
personal privacy are applicable to the Web. Any new, or modifications to
existing, laws or regulations relating to the Web could adversely affect our
business. Prohibition and restriction of Internet content and commerce could
reduce or slow Internet use, decrease the acceptance of the Internet as a
communications and commercial medium and expose us to liability. Any of these
outcomes could have a material adverse effect on our business, results of
operations and financial condition. The growth and development of the market
for Internet commerce may prompt calls for more stringent consumer protection
laws, both in the United States and abroad, that may impose additional burdens
on companies conducting business over the Internet. The Internet Is Subject To Rapid Changes, Which Could Result In Significant
Additional Costs The market for Internet products and services is characterized by rapid
change, evolving industry standards and frequent introductions of new
technological developments. These new standards and developments could make our
existing or future products or services obsolete. Keeping pace with the
introduction of new standards and technological developments could result in
significant additional costs or prove difficult or impossible for us. The
failure to keep pace with these changes and to continue to enhance and improve
the responsiveness, functionality and features of our Web sites could harm our
ability to attract and retain users. Among other things, we will need to
license or develop leading technologies, enhance our existing services and
develop new services and technologies that address the varied needs of our
users. Our Net Sales Could Be Adversely Affected If We Become Subject To Sales And
Other Taxes If one or more states or any foreign country successfully asserts that we
should collect sales or other taxes on our sale of products over the Internet,
our net sales and results of operations could be harmed. We do not currently
collect sales or other similar taxes for physical shipments of goods into
states other than California and Florida. However, one or more states may seek
to impose sales tax collection obligations on companies, such as ARTISTdirect,
which engage in or facilitate online commerce. A number of proposals have been
made at the state and local level that would impose additional taxes on the
sale of goods and services through the Internet. Such proposals, if adopted,
could substantially impair the growth of electronic commerce and could
adversely affect our opportunity to derive financial benefit from electronic
commerce. Moreover, if any state or foreign country were to successfully assert
that we should collect sales or other taxes on the exchange of merchandise on
its system, our results of operations could be adversely affected. In addition,
any operations in states outside California and Florida could subject our
shipments in such states to state sales taxes under current or future laws.
Congress has enacted legislation limiting the ability of the states to impose
taxes on Internet-based transactions. This legislation, known as the Internet
Tax Freedom Act, imposes a moratorium ending on November 1, 2003 on state and
local taxes on electronic commerce where such taxes are discriminatory and on
Internet access unless such taxes were generally imposed and actually enforced
before October 1, 1998. Failure to renew this legislation in the future would
allow various states to impose taxes on Internet-based commerce. 
 ITEM 2. PROPERTIES Our principal corporate offices are located in Los Angeles, California,
where we sub-lease approximately 2,000 square feet of office space from a
company controlled by our Chairman. During 2003, we terminated the lease of
approximately 64,000 feet of office lease that we previously occupied. 18




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ITEM 3. LEGAL PROCEEDINGS In June 2003, we initiated discussions with our landlord regarding the
potential termination or restructuring of an office lease that had a term
through April 2010. On June 24, 2003, the landlord filed suit against us for
unlawful detainer of our premises and in July 2003 the landlord drew down the
entire remaining $1.35 million letter of credit that we had provided as a
security deposit in conjunction with the execution of the original lease. In
September 2003, we reached an agreement to terminate our lease with the
landlord. In conjunction with the termination, we issued to the landlord
warrants to purchase 200,000 shares of the Companys common stock exercisable
at $0.50 per share through September 8, 2008. In October 2003, the legal proceedings
against the Company were dismissed with prejudice. From time to time, we may be involved in litigation relating to claims
arising out of our ordinary course of business. We are not presently involved
in any material legal proceedings. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 
 PART II 
 ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS MARKET INFORMATION ARTISTdirects common stock is listed for quotation on the
Over-The-Counter Bulletin Board under the symbol ARTD since May 9, 2003 and
was listed on the Nasdaq National Market prior to that date. The following
table sets forth, for the two most recent fiscal years, the high and low
closing sale prices for our common stock as reported by Yahoo! Finance for 2002
and 2003: 2002First Quarter
    
    $
    14.30
    
    
    $
    9.60Second Quarter
    
    
    11.94
    
    
    
    7.60Third Quarter
    
    
    9.99
    
    
    
    4.31Fourth Quarter
    
    
    5.37
    
    
    
    2.152003First Quarter
    
    $
    3.70
    
    
    $
    1.05Second Quarter
    
    
    2.00
    
    
    
    0.10Third Quarter
    
    
    1.20
    
    
    
    0.35Fourth Quarter
    
    
    0.85
    
    
    
    0.12
   (1)
    
    All numbers are adjusted to reflect a one-for-ten reverse stock split in
July 2001. On April 14, 2004, the closing sale price for our common stock as reported
by America Online was $0.39 per share. EQUITY COMPENSATION PLAN INFORMATION See
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS  Equity Compensation Plan
Information for information regarding the number of outstanding and reserved
options, warrants and other derivative securities under our equity compensation
plans. HOLDERS As of April 14, 2004, there were approximately 300 holders of record of
our common stock. DIVIDENDS We have never paid any cash dividends on our common stock and we have no
current plans to do so. 19




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SALES OF UNREGISTERED SECURITIES In September 2003, we issued warrants to purchase 200,000 shares of common
stock at $0.50 per share as partial consideration for an office lease
termination. In December 2003, we issued 40,000 shares of common stock to a
consultant for services rendered which were valued at $0.50 per share. We made
such issuances in reliance upon Section 4(2) of the Securities Act. The
parties to whom securities were issued in connection with the foregoing, made
an informed investment decision based upon negotiation with us and were
provided with access to material information regarding our company. We believe
that the party that acquired our securities pursuant to the foregoing had
knowledge and experience in financial matters such that such party was capable
of evaluating the merits and risks of acquisition of our securities. All
certificates representing the shares issued pursuant to the foregoing bear an
appropriate legend restricting the transfer of such shares, except in
accordance with the Securities Act. In September 2003, we issued an option to purchase 259,659 shares of
common stock at $0.85 per share, the approximate fair market value of the stock
at such time, to Jonathan V. Diamond in connection with his appointment as our
President. The option may be exercisable until August 15, 2010. 75% of the
common stock underlying the options are subject to a repurchase right at $0.85
per share by the Company upon his termination of employment. This repurchase
right lapses in three equal installments such that, the repurchase right will
lapse entirely upon the third anniversary of his employment. We made such
issuance in reliance upon Section 4(2) of the Securities Act. From May 2003 through December 31, 2003, ARTISTdirect Records had issued
and sold from time to time, an aggregate of $2.048 million in convertible notes
(the Bridge Notes) to nine individual investors. $898,000 of these notes
were sold to our Chairman, Ted Field and $100,000 to Jonathan V. Diamond, our
President and Chief Executive Officer. The Bridge Notes accrue interest at 8%
per annum, are due two years from the date of issuance, and will be converted
into new equity of ARTISTdirect Records as part of its next equity financing.
The holders of the Bridge Notes also received warrants with a term of five
years to purchase additional equity of ARTISTdirect Records at $0.01 per unit
equivalent to the number of units of new equity into which their Bridge Notes
are ultimately converted. We made issuances of such notes and warrants in
reliance upon Section 4(2) of the Securities Act. The parties to whom
securities were issued in connection with the foregoing, made an informed
investment decision based upon negotiation with us and were provided with
access to material information regarding our company. We believe that the
party that acquired our securities pursuant to the foregoing had knowledge and
experience in financial matters such that such party was capable of evaluating
the merits and risks of acquisition of our securities. All certificates
representing the shares issued pursuant to the foregoing bear an appropriate
legend restricting the transfer of such shares, except in accordance with the
Securities Act. 
 ITEM 6. SELECTED FINANCIAL DATA The following selected financial data with respect to ARTISTdirects
consolidated statements of operations for the years ended December 31, 1999,
2000, 2001, 2002 and 2003 and consolidated balance sheets as of December 31,
1999, 2000, 2001, 2002 and 2003 are derived from the audited consolidated
financial statements of the Company. The following information should be read
in conjunction with the consolidated financial statements of the Company and
the related notes thereto and Item 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations, which is included elsewhere in
this Annual Report on Form 10-K. TABLE OF SELECTED FINANCIAL DATA Years Ended December 31,1999
    
    2000
    
    2001
    
    2002
    
    2003 (2)(in thousands, except per share data)Net revenue (1)
    
    $
    8,970
    
    
    $
    18,370
    
    
    $
    10,421
    
    
    $
    6,250
    
    
    $
    5,984Loss from continuing
operations
    
    
    (57,826
    )
    
    
    (61,499
    )
    
    
    (69,927
    )
    
    
    (48,339
    )
    
    
    (16,446
    )Net loss
    
    
    (57,804
    )
    
    
    (59,308
    )
    
    
    (69,880
    )
    
    
    (48,192
    )
    
    
    (21,701
    )Net loss attributable
to common
shareholders
    
    
    (59,455
    )
    
    
    (85,178
    ) (5)
    
    
    (70,571
    )
    
    
    (48,192
    )
    
    
    (21,701
    )Loss from continuing
operations per
common share
    
    
    (17.16
    )
    
    
    (27.52
    )
    
    
    (19.50
    )
    
    
    (13.96
    )
    
    
    (4.75
    )
 20




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Years Ended December 31,1999
    
    2000
    
    2001
    
    2002
    
    2003 (2)(in thousands, except per share data)Net loss per common
share
    
    
    (17.14
    )
    
    
    (26.83
    )
    
    
    (19.49
    )
    
    
    (13.92
    )
    
    
    (6.27
    )Total assets
    
    
    97,830
    
    
    
    117,762
    
    
    
    59,873
    
    
    
    15,925
    
    
    
    3,006Long-term obligations
    
    
    112,390
    (3)
    
    
    12,308
    (4)
    
    
    903
    
    
    
    1,117
    
    
    
    6,491Cash dividends
declared per
common share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1)
    
    Net revenue excludes revenue from the agency business, which was
discontinued in December 2001, and which has been classified as a discontinued
operation for all periods presented.(2)
    
    As a result of the adoption by the Company of Financial Accounting
Standards Board Interpretation No. 46, Consolidation of Variable Interest
Entities effective December 31, 2003, the balance sheet of ARTISTdirect
Records was consolidated as of December 31, 2003. The operations of
ARTISTdirect Records will be consolidated beginning January 1, 2004.(3)
    
    Includes $111,707 of redeemable preferred stock and common stock, which
was converted into common stock in 2000 and 2001.(4)
    
    Includes $10,778 of redeemable common stock which was converted into
common stock in 2001.(5)
    
    Includes beneficial conversion feature on redeemable preferred stock of
$24,375. 
 ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following discussion should be read in conjunction with our
consolidated financial statements and the notes to those financial statements
included elsewhere in this Annual Report on Form 10-K. The following
discussion contains forward-looking statements based on our current
expectations, estimates and projections about our industry, managements
beliefs and certain assumptions made by us. Words such as anticipates,
expects, intends, plans, believes, may, will or similar expressions
are intended to identify forward-looking statements. In addition, any
statements that refer to expectations, projections or other characterizations
of future events or circumstances, including any underlying assumptions, are
forward-looking statements. Such statements include, but are not limited to,
statements concerning our business model, increased competition in the
industry, our ability to generate revenues from our record label, online
product sales, advertising and other revenue streams, ability to increase
visits to our web site, ability to attract and retain artists, ability to
adequately fund our operations and financial commitments, ability to offer
compelling content, ability to fulfill on-line music and merchandise orders in
a timely manner, ability to build brand recognition, ability to integrate
acquisitions of technology and other businesses, ability to protect and/or
obtain intellectual property rights, and ability to manage growth. Such
statements are not guarantees of future performance and are subject to risks,
uncertainties and assumptions that are difficult to predict. Therefore, our
actual results could differ materially and adversely from those expressed in
any forward-looking statements as a result of various factors. Factors that
could cause or contribute to the differences are discussed in Risk Factors
and elsewhere in this Annual Report on Form 10-K. We undertake no obligation
to revise or update publicly any forward-looking statements for any reason.
The information contained in this Annual Report on Form 10-K is not a complete
description of our business or the risks associated with an investment in our
common stock. We urge you to carefully review and consider the various
disclosures made by us in this Annual Report on Form 10-K and in our other
filings with the Securities and Exchange Commission that discuss our business. GENERAL OVERVIEW We are a music entertainment company that combines an online music network
and a record label to provide an integrated offering for music fans, artists
and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a
network of Web sites offering multi-media content, music news and information,
community around shared music 21




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interests, music-related specialty commerce and digital music services. In May 2001, we entered into an agreement with veteran entertainment
executive Frederick W. (Ted) Field to become our Chairman and Chief Executive
Officer and form a new record label in partnership with us. On June 29, 2001,
our stockholders approved the employment of Mr. Field and the formation of the
record label, ARTISTdirect Records, LLC, as a 50/50 co-venture between
ARTISTdirect and Mr. Field where we agreed to provide a significant financial
commitment. Through our co-venture record label, we develop new musical
artists and produce and distribute their recordings as an independent label
utilizing both traditional channels and emerging Internet distribution
channels. In addition to the formation of the record label and our financial
commitment, we entered into a five-year employment agreement with Mr. Field to
serve as Chairman and Chief Executive Officer. Mr. Field also serves as the
Chief Executive Officer of ARTISTdirect Records. During the year ended December 31, 2003, we restructured senior operating
management and significantly reduced overhead and operating activities at the
parent company level and laid off the majority of our staff. In conjunction
with this restructuring, effective September 29, 2003, we entered into an
employment agreement with Jonathan V. Diamond to service as our President and
Chief Executive Officer through August 15, 2006. We initially committed to fund a total of $50 million to ARTISTdirect
Records over five years at the rate of $15.0 million per year, subject to a
limit of $33 million in any three year period. Any funding in excess of these
amounts required the approval of our Board of Directors. We have funded a
total of $33.0 million through December 31, 2003. In November 2001, ARTISTdirect Records agreed in principle to enter into a
preliminary North America distribution agreement and worldwide license
agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music
Group, Inc., the global music division of Bertelsmann AG (BMG). Under the
terms of the agreement, BMG agreed to distribute the labels releases in North
America, and BMG licensed ARTISTdirect Records repertoire in territories
throughout the world. In April 2002, the agreements with BMG were finalized,
including BMGs purchase of 5% of the equity of ARTISTdirect Records from us.
As part of this transaction, BMG agreed to advance certain monies against net
sales proceeds under the agreements and also assumed $5.0 million of our
funding commitment to ARTISTdirect Records. As a result of the BMG equity
purchase, our funding commitment was reduced to $45 million. In December 2002,
BMG exercised its option to extend the term of the distribution and license
agreement until September 2004. Under the distribution and license agreements, BMG made non-returnable
advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002
and $5.0 million in 2003 that are recoupable from net sales proceeds from
ARTISTdirect Records artist repertoire. The advances are to be recouped on a
monthly basis based on a defined calculation. As of December 31, 2002 and
2003, the unrecouped balance related to distribution advances from BMG was $4.1
million and $8.7 million, respectively. In August 2002, our Board of Directors approved an agreement (the
Accelerated Funding Agreement) to accelerate up to $10 million of its funding
commitment to ARTISTdirect Records. This funding was in addition to the $15
million that we were obligated to advance to ARTISTdirect Records in 2002 as
part of the initial $50 million funding commitment. During 2002, we funded our
$15 million commitment plus the additional $10 million bridge loan for total
advances to the record label of $25.0 million in 2002 and $30.25 million from
the inception of the record label through December 31, 2002. The $10 million
of accelerated funding was credited toward the satisfaction of our overall
funding commitment and funding obligation for 2003, resulting in a remaining
funding commitment of $2.75 million for 2003 and $12.0 million for 2004. We
advanced the $2.75 million during 2003. Our commitment to fund ARTISTdirect
Records is subject to a guaranty for the benefit of BMG. Should we fail to
meet our commitment, BMG may choose to enforce the guaranty or provide
substitute financing that could result in dilution of our interest in
ARTISTdirect Records. As consideration for entering into the Accelerated Funding Agreement, we
received an additional 20% interest in ARTISTdirect Records from Radar Records
Holdings, L.L.C. (RRH), the entity through which Mr. Field owns his interest
in ARTISTdirect Records, which resulted in an increase in our ownership share
of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Fields ownership
share from 50% to 30%. The Accelerated Funding Agreement also provides that
any dilution from the issuance of equity interests in ARTISTdirect Records that
would have been borne solely by us will be borne both by RRH and us pro rata
with our then respective ownership interests. Furthermore, the Accelerated
Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded
return to be realized from our advances and equity interests in ARTISTdirect
Records. Due to the uncertainty with respect to the realization of such rate
of return, we have not recorded any amounts related to the 25% minimum annual
compounded return in our consolidated financial statements. 22




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Because we did not have voting or operating control of ARTISTdirect
Records, even with our majority ownership
position, through December 31, 2003 we did not consolidate the results of
ARTISTdirect Records; we recorded our share of losses based on the equity
method of accounting as loss from equity investments in our consolidated
statements of operations. Prior to the completion of BMGs purchase of a 5%
interest in ARTISTdirect Records in April 2002 and BMGs assumption of 10% of
our total funding commitment, we had committed to fund 100% of the operations
of ARTISTdirect Records and had recorded 100% of the losses attributable to
that venture from the inception of ARTISTdirect Records to April 30, 2002.
From May 1, 2002 through December 31, 2002, we have recorded only our
proportionate share, on the basis of remaining relative funding commitments, of
any losses of ARTISTdirect Records. We have funded a total of $33.0 million of
our funding commitment. We recognized $8.6 million, $29.3 million and $9.3
million of equity loss from ARTISTdirect Records for the years ended December
31, 2001, 2002 and 2003, respectively. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities. We adopted FIN 46 effective December 31, 2003. As a result
of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was
consolidated as of December 31, 2003, and the operations of ARTISTdirect
Records will be consolidated beginning January 1, 2004. As of December 31, 2003, ARTISTdirect Records did not have sufficient
working capital resources to conduct operations and accordingly had curtailed
its operations. During the three months ended September 30, 2003, ARTISTdirect
Records significantly reduced its overhead costs and operating activities and
laid off the majority of its staff while it continued to restructure its
operations and seek additional capital. We do not have the resources to meet our remaining $12.0 million funding
commitment to ARTISTdirect Records for 2004. ARTISTdirect Records requires
additional capital in order to continue operations, and therefore we are
continuing to pursue alternatives to raise additional capital for both
ourselves and for ARTISTdirect Records. However, there can be no assurances
that additional capital can be obtained by either our company or by
ARTISTdirect Records on reasonable terms or at all. If additional funds are
raised through the issuance of equity securities of either our company or
ARTISTdirect Records, the percentage ownership of our current stockholders in
our company and/or our companys ownership of ARTISTdirect Records would be
reduced. Failure to raise additional capital could seriously harm the business
of ARTISTdirect Records and impair the value of our investment in ARTISTdirect
Records. In such event, ARTISTdirect Records may seek to divest all or certain
of its assets or we may seek to divest all or a part of its ownership of
ARTISTdirect Records, in order to raise the capital necessary to sustain
business operations of our company and/or ARTISTdirect Records. GOING CONCERN We have incurred losses and negative cash flows from operations in every
fiscal period since inception and have an accumulated deficit of $222.7 million
as of December 31, 2003. For the year ended December 31, 2003, we incurred a
net loss of $21.7 million and negative operating cash flows of $5.4 million.
As of December 31, 2003, we had a net working capital deficiency of $9.5
million and a stockholders deficiency of $16.9 million. Additionally, we have been funding substantially all of the operations of
ARTISTdirect Records. Our operations to date and loans to ARTISTdirect Records
have been funded by the sale of our preferred and common stock. Management
expects our operating losses to continue for the foreseeable future. We do not
currently anticipate that available cash resources will be sufficient to meet
anticipated needs for working capital and capital expenditures over the next
twelve months without additional capital. We are attempting to mitigate our funding obligation and raise additional
funding through various means. However, there can be no assurances that we
will be successful in this regard. If sufficient funding is not available,
then we may not be able to fund our operations or our remaining commitment to
provide funding to ARTISTdirect Records. Failure to raise additional capital
could seriously harm the business of ARTISTdirect Records and impair the value
of our investment in ARTISTdirect Records. We have reduced our operations
and have divested certain of our assets in order to attempt to raise the
capital necessary to sustain business operations. To the extent that we are
unable to successfully restructure our funding obligation and/or obtain the
capital necessary to fund our future cash requirements on a timely basis and
under acceptable terms and conditions, we will not have sufficient cash
resources to maintain operations, and may consider a formal or informal
restructuring or reorganization. As a result of the conditions described above, our auditors have included
an explanatory paragraph in their opinion indicating that there is substantial
doubt about our ability to continue as a going concern. Our financial
statements do not include any adjustments that might result from the outcome of
this uncertainty. 23




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A summary of how we conduct our business is presented below. REVENUE We currently generate revenues from three sources: e-commerce, media and
the record label. E-Commerce Revenue. E-Commerce revenue includes the sale of music and
related merchandise, such as apparel, collectibles and accessories, through the
ARTISTdirect shopping mall of our Network. We recognize the gross amount of
product sales and shipping revenue upon shipment of the item and record
appropriate reserves for product returns. We have experienced seasonality with
respect to our online product sales. In particular, our e-commerce sales in the
fourth quarter have, on average, been higher than in other quarters. We believe
that this trend may continue for the foreseeable future. Media Revenue. Media revenue consists primarily of sales of banner
advertisements and sponsorships. In sales of banner advertisements, we
principally earn revenue based on the number of impressions or times an
advertisement appears on pages viewed within our Web sites. Our banner
advertising commitments generally range from one to six months. Banner
advertising revenue is generally recognized as the impressions are served
during the period in which the advertisement is displayed, provided that we
have no significant remaining obligations and collection of the resulting
receivable is probable. We typically guarantee a minimum number of impressions
to the advertiser. To the extent that minimum guaranteed page deliveries are
not met, we defer recognition of the corresponding revenue until the guaranteed
impressions are delivered. We also sell to advertisers the sponsorship of a
Web page or event for a specified period of time. We recognize sponsorship
revenue over the period in which the sponsored page or event is displayed. To
the extent that committed obligations under sponsorship agreements are not met,
revenue recognition is deferred until the obligations are met. Since most of
our sponsorship and advertising contracts are short-term in nature, our
advertising revenue is susceptible to significant fluctuation. Record Label Revenue. iMusic.The iMusic record label generated revenue primarily from the sale
of compact discs by artists signed to the iMusic record label. We recognized
revenues upon the shipment of compact discs to retailers and independent
wholesalers and recorded appropriate reserves for product returns. During the
three months ended June 30, 2003, management of the Company decided to scale
back the activity of its iMusic label in order to conserve capital. During the
three months ended September 30, 2003, the Company executed an agreement with
GC Music, pursuant to which the Company assigned its rights and obligations to
six unreleased artists in exchange for a cash payment of $100,000 as a
reduction to prior advances related to the six artists and a profit interest in
the projects. The Company retains the distribution rights to the albums
previously released under the original terms of its distribution agreements
with its other signed artists. The Company does not plan to sign any
additional artists or release any additional albums domestically or
internationally under the iMusic label and expects very minimal sales activity
in the future. ARTISTdirect Records. ARTISTdirect Records generates revenue primarily
from the sale of compact discs by artists signed to the record label. We have recorded 100% of the losses attributable to that venture from May
31, 2001 through April 30, 2002 based on our commitment to fund 100% of its
operations up to that time. From May 1, 2002 through December 31, 2002, we
recorded approximately 83% of the losses of ARTISTdirect Records as a result of
BMGs equity purchase and their assumption of a portion of our funding
commitment to the record label. For the year ended December 31, 2003, we
recorded approximately 73% of the losses of ARTISTdirect Records. However,
given that we did not have voting or operating control, even with our majority
ownership position in ARTISTdirect Records, through December 31, 2003, we
accounted for this investment under the equity method of accounting as income
(loss) from equity investments in our consolidated statements of operations. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities. We adopted FIN 46 effective December 31, 2003. As a result
of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was
consolidated as of December 31, 2003, and the operations of ARTISTdirect
Records will be consolidated beginning January 1, 2004. As a result of the
consolidation of the balance sheet of ARTISTdirect Records as of December 31,
2003, the Companys balance sheet as of December 31, 2003 is not directly
comparable to its balance sheet as of December 31, 2002. In addition, as a
result of the consolidation of ARTISTdirect Records as of December 31, 2003, we 24




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recorded a one-time charge to operations of $5.255 million in 2003
resulting from the cumulative effect on prior years of this change in
accounting method. COST OF REVENUE Direct cost of product sales consists of the cost of merchandise sold, the
amounts payable to artists for their share of net proceeds, online transaction
costs, including credit card fees, warehousing and fulfillment charges and
shipping costs. Direct cost of product sales also includes manufacturing costs
and distribution fees payable. Other cost of revenue consists primarily of Web
site hosting and maintenance costs, online content programming costs, online
advertising serving costs, record royalties payable to artists and payroll and
related expenses for staff involved with the Web site. Stock-based
compensation included in cost of revenue represents the amortization of
non-cash compensation expense related to vendor warrants and stock options
granted to artists and their advisors in connection with entering into
contractual commitments to operate their online commerce activities.
Historically, our cost of revenue has generally exceeded our net revenue
primarily as a result of the non-cash stock-based compensation expense and also
due to other cost of revenue exceeding media revenues. OPERATING EXPENSE Web Site Development. Web site development expense consists primarily of
expenses incurred to update the content and design of our Web sites and
underlying technology infrastructure. These expenses primarily include
payments to third-party service vendors and personnel costs. Sales and Marketing. Sales and marketing expense consists primarily of
advertising, marketing and promotion expenses incurred to promote our Web
sites, as well as payroll and related expenses for personnel engaged in
marketing and advertising sales activities. General and Administrative. General and administrative expense consists
of payroll and related expenses for executive and administrative personnel,
professional services expenses, facilities expenses, travel and other general
corporate expenses. Provision for Doubtful Accounts. Provision for doubtful accounts consists
of provisions related to uncollectible receivables. Stock-based Compensation. We record stock-based compensation expense
(exclusive of amounts recorded within cost of revenue) in connection with
equity granted to employees, directors, professional firms, artists and artist
advisors during this period. We may grant additional equity securities in the
future to employees, directors and others. We record stock compensation for
employee option grants equal to the excess of the fair value of our common
stock over the exercise price on the grant date. We record the compensation
over the vesting period. For options/warrants granted to non-employees, we
record as stock compensation the fair value of the options/warrants (using the
Black-Scholes option-pricing model) amortized over the related period of
service. Depreciation and Amortization. Depreciation and amortization expense
consists of the depreciation of fixed assets and the amortization of acquired
intangible assets, including goodwill. No intangible assets remained on the
balance sheet at December 31, 2003. Impairment of long-lived assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event that the carrying amount of long-lived assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. Loss from Sale and Abandonment of Property and Equipment.Loss from sale
and abandonment of property and equipment consists of the costs associated with
the sale and abandonment of the property and equipment and leasehold
improvements at our former offices. We determined that these assets were
impaired during 2003 as a result of various factors. Accordingly, we reduced
the carrying amount of these assets to their estimated fair value by recording
a charge to operations during 2003. The leasehold improvements were
subsequently abandoned when the Company vacated the premises, and most of the
remaining assets were sold to third party liquidators for cash. This amount
has been reported as a loss from sale and abandonment of property and equipment
in the consolidated statement of operations for the year ended December 31,
2003. 25




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CRITICAL ACCOUNTING POLICIES We have identified the following as critical accounting policies: revenue
recognition, stock-based compensation, and impairment of long-lived assets and
goodwill. The discussion and analysis of our financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our
estimates, including those related to bad debts, intangible assets, income
taxes, and contingencies and litigation. We base our estimates on historical
experience and on various other assumptions that we believe to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. We believe the following
critical accounting policies affect our more significant judgments and
estimates used in the preparation of our consolidated financial statements. Revenue Recognition E-commerce revenue consists primarily of the gross amount of sales revenue
paid by the customer for recorded music and merchandise sold via the Internet,
including shipping fees, and is recognized when the products are shipped. We
record e-commerce revenue on a gross basis as we enter into sale transactions
with customers, establish the prices of the products, choose the suppliers of
the products, assume the risk of inventory loss and collect all amounts from
the customers and assume the credit risk. E-commerce revenue is subject to
amounts due to the respective artists based on their contracts, and such
expense is recorded as part of direct cost of product sales. We record amounts charged to customers for shipping and handling in
accordance with Emerging Issues Task Force No. 00-10, Accounting for Shipping
and Handling Fees and Costs. Pursuant to EITF No. 00-10, we record amounts
charged to customers for shipping and handling as revenue, and records the
related costs incurred for shipping and handling to direct cost of product
sales in the consolidated statements of operations. Media revenue consists primarily of the sale of advertisements and
sponsorships, both online and offline, under short-term contracts. To date,
the duration of our advertising and sponsorship commitments has generally
averaged from one to three months, with certain programs lasting up to six
months. Our online obligations typically include the guarantee of a minimum
number of times (impressions) that an advertisement appears in pages viewed
by the users of our online properties. Online advertising revenue is generally
recognized as the impressions are served during the period in which the
advertisement is displayed, provided that we have no significant remaining
obligations and collection of the resulting receivable is reasonably assured.
To the extent that minimum guaranteed page deliveries are not met, recognition
of the corresponding revenue is deferred until the guaranteed impressions are
delivered. We recognize revenue for sponsorship arrangements, both online and
offline, over the period during which the advertising is provided, generally on
a straight-line basis. If the sponsorship arrangement is for the sponsorship
of a specific event, we recognize revenue when the event occurs. We recognize
revenue separately for each element of integrated entertainment marketing
packages that offer advertisers a combination of off-line concert and tour
sponsorships that are supported by on-line banner advertising, web page
sponsorships, emails to our customers and custom content. We determine the
fair value of each deliverable based on the fair value of the different
deliverables when sold on a stand-alone basis. We recognize revenue for each
deliverable as the services are provided. We recognize revenue for the banner
impression deliverable as the banner impressions are delivered. We recognize
revenue for the customer emails when the emails are sent. We recognize revenue
for Web page sponsorships on a straight-line basis over the term of the
sponsorship. We recognize revenue for the custom content when the content is
provided to the customer. We recognize revenue for event sponsorships when the
event has occurred. Record label revenue consists primarily of the sale of compact discs by
artists signed to iMusic. We recognize revenue upon the shipment of compact
discs from our distributor to retailers and independent wholesalers and record
appropriate reserves for product returns. At the time of the shipment of the
product, the following criterion under Statement of Financial Accounting
Standards No. 48, Revenue Recognition When Right of Return Exists, have been
met: the sellers price to the buyer is substantially fixed or determinable at
the date of sale; the buyer has paid the seller, or the buyer is obligated to
pay the seller and the obligation is not contingent on resale of the product;
the buyers obligation to the seller 26




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would not be changed in the event of theft or physical destruction or damage of
the product; the buyer acquiring the product for resale has economic substance
apart from that provided by the seller; the seller does not have significant
obligations for future performance to directly bring about resale of the
product by the buyer; and the amount of future returns can be reasonably
estimated. Stock-Based Compensation We account for stock-based employee compensation in accordance with the
provisions of Accounting Principles Board (APB) Opinion No. 25 and FASB
Interpretation No. 44 , Accounting for Certain Transactions Involving Stock
Compensation (FIN 46), and comply with the disclosure requirements of SFAS
No. 123, Accounting for Stock-Based Compensation. Under APB No. 25,
compensation expense is recorded based on the difference, if any, between the
fair value of our stock and the exercise price on the measurement date. We
account for stock issued to non-employees in accordance with SFAS No. 123,
which requires entities to recognize as expense over the service period the
fair value of all stock-based awards on the date of grant and EITF No. 96-18,
Accounting for Equity Investments that are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services, which addresses
the measurement date and recognition approach for such transactions. We recognize compensation expense related to variable awards in accordance
with FIN 28. For fixed awards, we recognize expense over the vesting period or
the period of service. Stock-based compensation included in cost of revenue represents the
amortization of non-cash compensation expense related to vendor warrants and
stock options granted to artists and their advisors in connection with entering
into contractual commitments to operate their online commerce activities. We
record the fair value of options/warrants granted to non-employees as
compensation expense over the period of service. We determine the fair value
of the options/warrants based on the Black-Scholes option-pricing model. Stock-based compensation included in operating expenses represents the
amortization of non-cash compensation expense related to equity instruments
granted to employees, directors, professional firms, artists and artist
advisors. Compensation for equity grants to non-employees is recorded in the
same manner as described above. We record stock compensation for employee
option grants equal to the excess of the fair value of our common stock over
the exercise price on the grant date. We record the compensation over the
vesting period. Impairment of Long-Lived Assets and Goodwill Effective January 1, 2002, we evaluate the impairment of goodwill by
comparing the carrying amount of the goodwill at the reporting unit level to
the fair value of the goodwill. The carrying amount of the goodwill is
adjusted to its fair value in the event the fair value exceeds the carrying
amount. Impairment of long-lived assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event that the carrying amount of long-lived assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. Presented below are the Companys consolidated statements of operations
for the years ended December 31, 2001, 2002 and 2003. 2001
    
    2002
    
    2003Net revenue:E-Commerce
    
    $
    7,542
    
    
    $
    4,713
    
    
    $
    3,459Media
    
    
    2,879
    
    
    
    924
    
    
    
    1,173Record label
    
    
    
    
    
    
    613
    
    
    
    1,352Total net revenue
    
    
    10,421
    
    
    
    6,250
    
    
    
    5,984
 27




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2001
    
    2002
    
    2003Cost of revenue:Direct cost of product sales
    
    
    6,137
    
    
    
    3,969
    
    
    
    3,118Other cost of revenue
    
    
    5,728
    
    
    
    3,687
    
    
    
    1,212Stock-based compensation
    
    
    8,405
    
    
    
    3,084
    
    
    
    33Total cost of revenue
    
    
    20,270
    
    
    
    10,740
    
    
    
    4,363Gross profit (loss)
    
    
    (9,849
    )
    
    
    (4,490
    )
    
    
    1,621Operating expenses:Web site development
    
    
    3,726
    
    
    
    53
    
    
    
    5Sales and marketing
    
    
    5,726
    
    
    
    2,224
    
    
    
    1,220General and administrative
    
    
    13,339
    
    
    
    7,527
    
    
    
    4,230Provision for doubtful accounts
    
    
    1,503
    
    
    
    42
    
    
    
    83Stock-based compensation
    
    
    12,415
    
    
    
    1,897
    
    
    
    527Depreciation and amortization
    
    
    6,512
    
    
    
    2,814
    
    
    
    1,014Loss from impairment of goodwill
    
    
    11,444
    
    
    
    788
    
    
    
    Loss from sale and abandonment of
property and equipment
    
    
    
    
    
    
    
    
    
    
    2,225Total operating costs
    
    
    54,665
    
    
    
    15,345
    
    
    
    9,304Loss from operations
    
    
    (64,514
    )
    
    
    (19,835
    )
    
    
    (7,683
    )Loss from equity investments
    
    
    (8,998
    )
    
    
    (29,252
    )
    
    
    (9,320
    )Interest income, net
    
    
    3,585
    
    
    
    748
    
    
    
    146Forgiveness of debt by officer
    
    
    
    
    
    
    
    
    
    
    411Loss from continuing operations
    
    
    (69,927
    )
    
    
    (48,339
    )
    
    
    (16,446
    )Income from discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Cumulative effect of consolidation of
ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    (5,255
    )Net loss
    
    $
    (69,880
    )
    
    $
    (48,192
    )
    
    $
    (21,701
    )
 RESULTS OF OPERATIONS Overview: During the year ended December 31, 2003, we restructured senior operating
management and significantly reduced overhead and operating activities at the
parent company level and laid off the majority of our staff. In addition,
during the year ended December 31, 2003, ARTISTdirect Records significantly
reduced its overhead costs and operating activities and laid off the majority
of its staff while it continued to restructure its operations and seek
additional capital. This restructuring is expected to continue during 2004.
As of December 31, 2003, ARTISTdirect Records did not have sufficient working
capital resources to conduct operations and accordingly had curtailed its
operations. In addition, at December 31, 2003, the parent company did not have
sufficient resources to fund its remaining $12.0 million capital commitment to
ARTISTdirect Records. Accordingly, for 2004, we are focusing on obtaining
additional capital, both at 28




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the parent company level and at ARTISTdirect Records, as well as enhancing the
operations and margins of the Media business. We do not expect to be able to
make significant further reductions to operating costs in 2004. ARTISTDIRECT, INC. YEARS ENDED DECEMBER 31, 2003 AND 2002 NET REVENUE Net revenue from continuing operations for the year ended December 31,
2003 decreased to $6.0 million, from $6.3 million for the year ended December
31, 2002, which represented a decrease of 4%. E-commerce revenue for the year ended December 31, 2003 decreased to $3.5
million, from $4.7 million for the year ended December 31, 2002, a decrease of
27%, primarily as a result of lower traffic to the Web site, fewer sales orders
and a decline in demand for music and licensed artist merchandise in 2003. Media revenue increased to $1.2 million for the year ended December 31,
2003, from $924,000 for the year ended December 31, 2002, an increase of 27%,
as a result of an increase in the number of online advertisers and an increase
in the CPM amounts earned from the sales of impression and non-impression
based advertising and offline sponsorships. The increase in advertising
revenues in 2003 is a reversal of the revenue decline in media revenues over
the previous years. We expect to focus our efforts on increasing media revenue
during 2004. Record label revenue increased to $1.4 million for the year ended December
31, 2003, from $613,000 for the year ended December 31, 2002, an increase of
121%. This increase of approximately $739,000 is due to an increase in
revenues from the iMusic record label, which was launched in the third quarter
of 2002, due to more releases in 2003. During the three months ended June 30, 2003, management decided to scale
back the activity of its iMusic label in order to conserve capital. During the
three months ended September 30, 2003, we executed an agreement with GC Music,
pursuant to which we assigned our rights and obligations to six unreleased
artists in exchange for a cash payment of $100,000 as a reduction to prior
advances related to the six artists and a profit interest in the projects. We
retain the distribution rights to the albums previously released under the
original terms of its distribution agreements with our other signed artists.
We do not plan to sign any additional artists or release any additional albums
domestically or internationally under the iMusic label and expect very minimal
sales activity in the future. COST OF REVENUE Direct cost of product sales. Direct cost of product sales decreased to
$3.1 million for the year ended December 31, 2003, from $4.0 million for the
year ended December 31, 2002, a decrease of 21%. This decrease of $851,000 is
due primarily to the decrease in E-commerce revenues in 2003. Other cost of revenue. Other cost of revenue decreased to $1.2 million
for the year ended December 31, 2003, from $3.7 million for the year ended
December 31, 2002, a decrease of 67%. This decrease was due primarily to an
approximate $1.7 million decrease in Web site hosting and maintenance costs due
to a reduction in headcount and a restructuring of our third party service
provider agreements, and an approximate $800,000 decrease in iMusic record
label artist advances. Stock-based compensation. For the year ended December 31, 2003, we
recorded non-cash stock-based compensation charges of $33,000 compared to $3.1
million for the year ended December 31, 2002, a decrease of 99%. Stock-based
compensation expense relates primarily to the amortization of the estimated
value of stock options, calculated pursuant to the Black-Scholes option-pricing
model, previously issued to artists and their advisors in connection with the
operation of their stores and is amortized over the life of the associated
contracts. The decrease in stock-based compensation in 2003 is primarily due
to completion of most of the amortization of stock-based compensation during
2002 as a result of the terms of a number of artist agreements expiring during
2002. The $3.1 million in stock-based compensation expense in 2002 consists of
$2.1 million related to option grants to artists and advisors, $900,000 in
compensation expense related to the rescission for which services were being
provided by artists and advisors in 2002, and $79,000 of expense related to
warrants granted to suppliers. 29




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OPERATING EXPENSE Web Site Development. Web site development expense decreased to $5,000
for the year ended December 31, 2003, from $53,000 for the year ended December
31, 2002, a decrease of 91%. This decrease was primarily attributable to lower
fees paid to third party service vendors relating to the enhancement of our Web
site. Sales and Marketing. Sales and marketing expense decreased to $1.2
million for the year ended December 31, 2003, from $2.2 million for the year
ended December 31, 2002, a decrease of 45%. The $1.0 million decrease was due
primarily to an approximately $1.3 million decrease in online advertising
expenditures resulting from the restructuring of our agreement with
Ticketmaster and lower marketing, payroll and related costs, offset in part by
an increase of approximately $350,000 in iMusic record label expenses. General and Administrative. General and administrative expense decreased
to $4.2 million for the year ended December 31, 2003, from $7.5 million for the
year ended December 31, 2002, a decrease of 44%. The $3.3 million decrease was
primarily attributable to a decrease in payroll costs associated with the
reduced headcount of $2.3 million and an approximately $1.0 million decrease in
outside services, facilities and insurance costs. Provision for Doubtful Accounts.Bad debt expense increased to $83,000
for the year ended December 31, 2003, from $42,000 for the year ended December
31, 2002, as a result of higher level of uncollectible accounts receivable
related to advertising revenues in 2003. Stock-based Compensation. We recorded stock-based compensation expense of
$527,000 for the year ended December 31, 2003 in connection with previous
stock-based compensation issued to employees, directors, professional firms,
artists and advisors for promotional services, a decrease of 72% from the $1.9
million expense for the year ended December 31, 2002. Stock-based compensation
represented the remaining amortization of such prepaid compensation paid in
prior years. The decrease in stock-based compensation in 2003 is primarily due
to the amortization period for most of the stock-based compensation being
completed in 2002. Depreciation and Amortization. Depreciation and amortization expense
decreased from $2.8 million for the year ended December 31, 2002 to $1.0
million for the year ended December 31, 2003, a decrease of 64%. This decrease
of $1.8 million was primarily due to the write-down and abandonment of property
and equipment during 2003. Loss from Sale and Abandonment of Property and Equipment and Impairment of
Goodwill. During the year ended December 31, 2003, we recorded a loss from the
sale and abandonment of property and equipment of $2.2 million. This loss was
mainly as a result of vacating our office space following the termination of
our lease. During the year ended December 31, 2002, we recorded a loss on
impairment of goodwill related to the write-off of the remaining goodwill
associated with our online operations of $788,000. This write-down was
recorded due to declines in advertising revenue on the Network and the
determination that there was insufficient basis to support the carrying amounts
of goodwill based upon the projected undiscounted future cash flows related to
the underlying Network assets. LOSS FROM EQUITY INVESTMENTS Loss from equity investments decreased from $29.3 million for the year
ended December 31, 2002 to $9.3 million for the year ended December 31, 2003.
This equity loss related to the operations of ARTISTdirect Records. The
decrease in the loss is due to a reduced level of activity at ARTISTdirect
Records in 2003 as compared to 2002. We recorded as loss from equity
investments 100% of ARTISTdirect Records loss through April 30, 2002 due to
our commitment to fund 100% of its operations. From May 1, 2002 through
December 31, 2002, we recorded approximately 83% of the ventures loss based on
our relative share of the remaining funding commitment to the venture. For the
year ended December 31, 2003, we recorded approximately 73% of the losses of
ARTISTdirect Records. The result of operations of ARTISTdirect Records will be
consolidated beginning January 1, 2004. INTEREST INCOME, NET During the year ended December 31, 2003, net interest income was $146,000,
as compared with net interest income of $748,000 for the year ended December
31, 2002. This net decrease in interest cost of approximately $602,000 is
primarily due to lower average cash balances held during 2003 as compared with
2002. 30




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FORGIVENESS OF DEBT BY OFFICER During 2002, our Chairmans employment agreement was amended whereby he
agreed to defer his future salary until
we raised new debt or equity financing of at least $20 million. During
the three months ended June 30, 2003, our Chairmans employment agreement was
further amended whereby all deferred and any future salary, except a base
amount, would be waived, even if new debt or equity financing is raised.
Accordingly, during the year ended December 31, 2003, $411,000 of accrued
compensation due to our Chairman was recorded as gain from forgiveness of debt
in the consolidated statement of operations. CUMULATIVE EFFECT OF CONSOLIDATION OF ARTISTDIRECT RECORDS, LLC As a result of the consolidation of ARTISTdirect Records as of December
31, 2003, we recorded a one-time charge to operations of $5.255 million in 2003
resulting from the cumulative effect on prior years of the change in accounting
method from equity to consolidation. DISCONTINUED OPERATIONS Income from discontinued operations decreased from $147,000 for the year
ended December 31, 2002 to $0 for the year ended December 31, 2003. The
decrease is due to the completion of the wind down of agency operations in
2002. NET LOSS Net loss decreased to $21.7 million for the year ended December 31, 2003,
as compared to $48.2 million for the year ended December 31, 2002, a decrease
of $26.5 million or 55%. This decrease is primarily attributable to a $6.1
million decrease in gross loss, a $1.0 million decrease in sales and marketing
expense, a $3.3 million decrease in general and administrative expenses, a
$19.9 million decrease in the loss from equity investments, a $1.4 million
decrease in stock-based compensation, and a $1.8 million decrease in
depreciation and amortization, partially offset by a $1.4 million increase in
loss from sale and abandonment of property and equipment and impairment of
goodwill and a cumulative loss adjustment of $5.3 million relating to the
consolidation of ARTISTdirect Records. YEARS ENDED DECEMBER 31, 2002 AND 2001 NET REVENUE Net revenue from continuing operations for the year ended December 31,
2002 decreased to $6.3 million from $10.4 million for the year ended December
31, 2001, a decrease of 40%. The decrease was due to decreases in e-commerce
and media that were partially offset by increase in iMusic record label
revenues. E-commerce revenue for the year ended December 31, 2002 decreased to $4.7
million from $7.5 million for the year ended December 31, 2001, a decrease of
38% primarily as a result of lower traffic to the site, fewer sales orders and
a continued weak sales environment for music and licensed artist merchandise. Advertising and other revenue decreased to $924,000 for the year ended
December 31, 2002 from $2.9 million for the year ended December 31, 2001, a
decrease of 68% as a result of a decrease in the number of online advertisers
and a reduction in the sales of non-impression based advertising and offline
sponsorships. The decrease in advertising revenues is attributed to general
weakness in the United States economy, overall softness in the advertising
market and a specific decline in the demand for online advertising. iMusic record label revenue increased to $613,000 for the year ended
December 31, 2000 from $0 for the year ended December 31, 2001, an increase of
100% as a result of the launch of the iMusic record label in the third quarter
of 2002. COST OF REVENUE Direct cost of product sales. Direct cost of product sales decreased to
$4.0 million for the year ended December 31, 2002 from $6.1 million for the
year ended December 31, 2001, a decrease of 35%. This $2.1 million decrease
corresponded with the decrease in online product sales revenue and was
primarily attributable to a $2.0 million decrease in product costs and a
$600,000 decrease in transaction costs partially offset by iMusic record label
cost of sales of $400,000. Other cost of revenue. Other cost of revenue decreased to $3.7 million
for the year ended December 31, 2002, from $5.7 million for the year ended
December 31, 2001, a decrease of 36%. This $2.0 million decrease was due
primarily to an approximate $900,000 decrease in network payroll costs due to a
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decrease in Web site hosting and maintenance costs due to a restructuring
of our third party service provider agreements, and an approximate $800,000
decrease in entertainment marketing costs due to a reduction in event costs in
connection with a decrease in related advertising revenue, offset partially by
approximately $400,000 of iMusic record label distribution fees and royalty
costs. Stock-based compensation. For the year ended December 31, 2002, we
recorded non-cash stock-based compensation charges of $3.1 million compared to
$8.4 million for the year ended December 31, 2001, a decrease of 63%. The
stock-based compensation expense relates primarily to the amortization of the
estimated value of the options, using the Black-Scholes option- pricing model,
issued to artists and their advisors in connection with the operation of their
stores and is amortized over the life of the associated contracts. The
decrease in stock-based compensation is primarily due to the expense of
approximately $900,000 in 2001 related to the rescission offer and the
completion of the terms of artist agreements during 2002. The $3.1 million in
expense in 2002 consists of $2.1 million related to option grants to artists
and advisors, $900,000 in compensation expense related to the rescission for
which services were being provided by artists and advisors in 2002, and $79,000
of expense related to warrants granted to suppliers. OPERATING EXPENSE Web Site Development. Web site development expense decreased to $53,000
for the year ended December 31, 2002, from $3.7 million for the year ended
December 31, 2001, a decrease of 99%. This decrease was primarily attributable
to a $2.1 million decrease in payroll and related costs in 2002 from the
elimination of our information technology development staff and an approximate
$1.6 million decrease in fees paid to third party service vendors relating to
the development and internal transition of our E-commerce system incurred in
2001. Sales and Marketing. Sales and marketing expense decreased to $2.2
million for the year ended December 31, 2002 from $5.7 million for the year
ended December 31, 2001, a decrease of 61%. The $3.5 million decrease was
primarily attributable to a $1.0 million decrease in our online advertising
expenditures resulting from the restructuring of our agreement with
Ticketmaster, a $1.1 million reduction in payroll and related costs and an
approximate $700,000 reduction in e-mail marketing expenses, publicity costs
and other promotional expenses. General and Administrative. General and administrative expense decreased
to $7.6 million for the year ended December 31, 2002 from $13.3 million for the
year ended December 31, 2001, a decrease of 44%. The $5.8 million decrease was
primarily attributable to a $1.7 million decrease in payroll costs associated
with reduced headcount in staff in 2001, $1.6 million decrease in outside
services due in part to the rescission in 2001, $1.0 million decrease in
facilities expenses, and $1.3 million decrease in travel and entertainment,
communications and other general and administrative expenses. Provision for Doubtful Accounts.Bad debt expense decreased to $42,000
for the year ended December 31, 2002 from $1.5 million for the year ended
December 31, 2001 due to the write-off of a $1.5 million receivable due from
one of the major records labels related to advertising and promotion services
provided. Stock-based Compensation. We recorded stock-based compensation expense of
$1.9 million for the year ended December 31, 2002 in connection with stock
issuances to employees, directors, professional firms, artists and advisors for
promotional services, a decrease of 85% from the $12.4 million expense for the
comparable period in 2001. Stock-based compensation in 2002 represented the
remaining amortization of prepaid compensation paid in 2001 related to the
value of options granted to artists and advisors. The decrease is primarily
due to the expense recorded in 2001 of $6.1 million related to the rescission
of options granted to employees, professional firms, artists and advisors, and
due to the completion of promotion agreements with artists in 2002. Depreciation and Amortization. Depreciation and amortization expense
decreased to $2.8 million for the year ended December 31, 2002 from $6.5
million for the year ended December 31, 2001, a decrease of 57%. This $3.7
million decrease was primarily due to a decrease in the amortization of
intangible assets as a result of the $11.4 write-off of goodwill in 2001 and
goodwill no longer being amortized effective January 1, 2002. Loss from Impairment of Goodwill. During the year ended December 31,
2002, we recorded a loss on impairment of goodwill related to the write-off of
the remaining goodwill associated with our online operations in the amount of
$788,000. During the year ended December 31, 2001 we recorded a loss on
impairment of goodwill related to our acquisitions of Mjuice, iMusic and the
UBL in the amount of $11.4 million. These write-downs were recorded due to
declines in advertising revenue on the Network and the determination that there
was insufficient basis to support the carrying amounts of goodwill based upon
the projected undiscounted future cash flows related to the underlying Network 32




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assets. LOSS FROM EQUITY INVESTMENTS Loss from equity investments increased to $29.3 million for the year ended
December 31, 2002 from $9.0 million for the year ended December 31, 2001. The
increase is due to an increase in the loss of ARTISTdirect Records. We
recorded 100% of the ventures loss through April 30, 2002 due to our
commitment to fund 100% of its operations. From May 1, 2002 through December
31, 2002, we began recording approximately 83% of the ventures loss based on
our relative share of the remaining funding commitment to the venture. INTEREST INCOME, NET Interest income decreased to $748,000 for the year ended December 31, 2002
from $3.6 million for the year ended December 31, 2001, a decrease of 79%.
This $2.9 million decrease is primarily due to lower average cash balances held
during 2002 compared with 2001 and lower interest rates. DISCONTINUED OPERATIONS Income from discontinued operations increased to $147,000 for the year
ended December 31, 2002 from $47,000 for the year ended December 31, 2001. The
increase is due to the timing of touring activity and a reduction of expenses
in 2002 during the wind-down of discontinued operations. NET LOSS Net loss decreased to $48.2 million for the year ended December 31, 2002,
compared to $69.9 million for the year ended December 31, 2001, a decrease of
$21.7 million or 31%. This decrease is primarily attributable to a $5.4
million decrease in the gross loss, a $10.7 million decrease in the loss from
impairment of goodwill, a $10.5 million decrease in stock-based compensation, a
$5.8 million decrease in general and administrative expense, a $3.7 million
decrease in depreciation and amortization, a $3.7 million decrease in Web site
development, a $3.5 million decrease in sales and marketing expense, and a $1.4
million decrease in provision for doubtful accounts, partially offset by a
$20.3 million increase in the loss from equity investments and a $2.8 million
decrease in interest income. ARTISTDIRECT RECORDS, LLC YEARS ENDED DECEMBER 31, 2003 AND 2002 NET REVENUE Net revenue decreased to $1.4 million for the year ended December 31,
2003, as compared to $3.7 million for the year ended December 31, 2002. Net
revenues in 2003 and 2002 are presented net of a provision for actual and
estimated future returns of $888,000 and $1.7 million, respectively. Net
revenue decreased in 2003 as compared to 2002 as a result the reduction in
operating activities as described below. During the year ended December 31, 2003, ARTISTdirect Records
significantly reduced its overhead costs and operating activities and laid off
the majority of its staff while it continued to restructure its operations and
seek additional capital. This restructuring is expected to continue during
2004. As of December 31, 2003, ARTISTdirect Records did not have sufficient
working capital resources to conduct operations and accordingly had curtailed
its operations. In addition, at December 31, 2003, we did not have sufficient
resources to fund our remaining capital commitment to ARTISTdirect Records.
Accordingly, for 2004, ARTISTdirect Records is focusing on obtaining additional
capital. Due to the financial condition of ARTISTdirect Records and the impact
of its restructuring during 2003, it is currently anticipated that revenues
from ARTISTdirect Records will be substantially less in 2004 as compared to
2003. COST OF REVENUE Direct cost of product revenue includes manufacturing costs and
distribution fees payable to BMG and the provision for artist advances and
royalty expense. Manufacturing and distribution expenses for the year ended
December 31, 2003 were $420,000, as compared to $1.3 million for the year ended
December 31, 2002. Artist advances and recording costs relate to signed
artists as well as an advance against future royalties paid to a producer. The
provision for advances and royalties 33




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for the year ended December 31, 2003 was $1.4 million, as compared to $8.8
million for the year ended December 31, 2002. The decrease was due to a
reduction in the level of operating activities in 2003 as compared to 2002. OPERATING EXPENSE Sales and Marketing. Sales and marketing expense represents costs of
sales, marketing, promotion, publicity and video production related to albums
released by ARTISTdirect Records during the period. Sales and marketing
expense for the year ended December 31, 2003 was $3.3 million, as compared to
$12.0 million for the year ended December 31, 2002. The decrease was due to a
reduction in the level of operating activities in 2003 as compared to 2002. General and Administrative.General and administrative expense represents
payroll and related expenses, costs for travel and entertainment, outside legal
fees and general office and communication expenses. General and administrative
expense for the year ended December 31, 2003 was $6.5 million, as compared to
$14.4 million for the year ended December 31, 2002. The decrease was due to
ARTISTdirect Records significantly reducing its overhead costs and operating
activities and laying off the majority of its staff during mid-2003 while it
continued to restructure its operations and seek additional capital. This
restructuring is expected to continue during 2004. It is not expected that
ARTISTdirect Records will be able to make significant further reductions to
operating costs in 2004. Depreciation and Amortization. Depreciation and amortization expense was
$39,000 for the year ended December 31, 2003, as compared to $36,000 for the
year ended December 31, 2002. Loss from Sale and Abandonment of Property and Equipment. During the year
ended December 31, 2003, ARTISTdirect Records recorded a loss from the sale and
abandonment of property and equipment of $100,000. This loss was primarily as
a result of ARTISTdirect Records vacating its office space following the
termination of its lease. INTEREST EXPENSE Interest expense primarily represents the accrual of interest on loan
advances made to ARTISTdirect Records by ARTISTdirect, Inc. and by BMG. Loan
advances aggregated $37.75 million and $35.0 million at December 31, 2003 and
2002, respectively, and bear interest at LIBOR plus 4%. Interest expense for
the year ended December 31, 2003 was $2.4 million, as compared to $1.1 million
for the year ended December 31, 2002. The increase is due primarily to an
increase in the level of advances made during 2003 as compared to 2002. During the year ended December 31, 2003, ARTISTdirect Records also
recognized $203,000 as interest expense with respect to the amortization of the
fair value of Bridge Note warrants (see Liquidity and Capital Resources 
ARTISTdirect Records, LLC below), which was included in the $2.4 million of
interest expense in 2003. NET LOSS Net loss was $12.7 million for the year ended December 31, 2003, and
consisted primarily of a gross loss of $372,000, total operating expenses of
$9.9 million and interest expense of $2.2 million. Net loss was $34.0 million
for the year ended December 31, 2002, and consisted primarily of a gross loss
of $6.4 million, total operating expenses of $26.4 million and interest expense
of $1.1 million. YEAR ENDED DECEMBER 31, 2002 AND PERIOD FROM MAY 31, 2001 (INCEPTION) TO
DECEMBER 31, 2001 NET REVENUE Net revenue increased to $3.7 million for the year ended December 31, 2002
from $0 for the period from May 31, 2001 (inception) to December 31, 2001.
During 2002, ARTISTdirect Records released seven albums. Net revenues in 2002
are presented net of a provision for actual and estimated future returns of
$1.7 million. During 2001, the Company did not release any albums. COST OF REVENUE Direct cost of product revenue includes manufacturing costs and
distribution fees payable to BMG and the provision for artist advances and
royalty expense. Manufacturing and distribution expenses for the year ended
December 31, 2002 were 34




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$1.3 million, as compared with $0 for the period ended December 31, 2001.
Artist advances and recording costs relate to signed artists as well as an
advance against future royalties paid to a producer. The provision for
advances and royalties for the year ended December 31, 2002 was $8.8 million,
as compared with $3.2 million for the period ended December 31, 2001. The
increase was due to an increase in the number of artists signed and the level
of recording activity in 2002 as compared to 2001. OPERATING EXPENSE Sales and Marketing. Sales and marketing expense represents costs of
sales, marketing, promotion, publicity and video production related to albums
released by ARTISTdirect Records during the period, as well as the related
costs for additional expected releases being set up for release during 2003.
Sales and marketing expense for the year ended December 31, 2002 was $12.0
million, compared with $799,000 for the period ended December 31, 2001. General and Administrative.General and administrative expense represents
payroll and related expenses, costs for travel and entertainment, outside legal
fees and general office and communication expenses. General and administrative
expense for the year ended December 31, 2002 was $14.4 million, as compared
with $4.5 million for the period ended December 31, 2001. The increase is due
primarily to a full years amount of expense in 2002 and an increase in
headcount and related activity to support the first releases of the label
during 2002. Depreciation and Amortization. Depreciation and amortization expense was
$36,000 for the year ended December 31, 2002, as compared to $2,000 for the
period ended December 31, 2001. INTEREST EXPENSE Interest expense represents the accrual of interest on loan advances made
to ARTISTdirect Records by ARTISTdirect, Inc. and by BMG. Loan advances
aggregated $35.0 million and $5.25 million at December 31, 2002 and 2001,
respectively, and bear interest at LIBOR plus 4%. Interest expense for the
year ended December 31, 2002 was $1.1 million, as compared with $126,000 for
the period ended December 31, 2001. The increase is due to an increase in the
level of advances made during 2002 and the accrual of a full years interest in
2002 as compared with the prior year. NET LOSS Net loss was $34.0 million for the year ended December 31, 2002, and
consisted primarily of a gross loss of $6.4 million, total operating expenses
of $26.4 million and interest expense of $1.1 million. Net loss for the period
ended December 31, 2001 was $8.7 million, and consisted primarily of a gross
loss of $3.2 million, total operating expenses of $5.4 million and interest
expense of $126,000. LIQUIDITY AND CAPITAL RESOURCES ARTISTDIRECT, INC. We have financed our activities during the past few years from the sale of
our equity securities. As of December 31, 2003, we had $726,000 of
unrestricted cash and cash equivalents and held $1.0 million in short-term
investments. We had a working capital deficiency of $9.5 million at December
31, 2003, primarily because of the net liability to BMG of $8.7 million at such
date (see Note 11 to the ARTISTdirect, Inc. consolidated financial statements
for a further description of the liability to BMG). As of December 31, 2003,
the balance sheet of ARTISTdirect Records was consolidated, resulting in an
increase in long-term debt of $6.5 million. During the year ended December 31, 2003, we restructured senior operating
management and significantly reduced overhead and operating activities and laid
off the majority of our staff. At December 31, 2003, we did not have
sufficient resources to meet our remaining $12.0 million funding commitment to
ARTISTdirect Records. Accordingly, for 2004, we are focusing on obtaining
additional capital, as well as enhancing the operations and margins of the
Media business. We do not expect to be able to make significant further
reductions to operating costs in 2004. Operating.Net cash used in operating activities was $5.4 million, $11.2
million and $22.2 million for the years ended December 31, 2003, 2002 and 2001,
respectively. Net cash used in operating activities for each of these periods
consisted primarily of net losses, partially offset by non-cash items such as
loss from equity investments, stock-based compensation, depreciation and
amortization, and loss from impairment of goodwill and sale and abandonment of
property and equipment. 35




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Investing.Net cash provided by investing activities was $2.4 million for
the year ended December 31, 2003, which consisted primarily of $5.0 million
from the maturity/sale of short-term investments, partially offset by our
advance of $2.75 million to ARTISTdirect Records. Net cash used in investing
activities for the year ended December 31, 2002 was $12.8 million, which
consisted of $25.0 million of advances to ARTISTdirect Records, offset by
approximately $12.3 million of proceeds from the maturity/sale of short-term
investments. Net cash provided by investing activities was $11.6 million for
the year ended December 31, 2001, which consisted primarily of $18.0 million of
proceeds from the maturity/sale of short-term investments, partially offset by
$5.3 million of advances to ARTISTdirect Records. Financing.Net cash provided by financing activities was $1.8 million for
the year ended December 31, 2003, which consisted of a $1.8 million reduction
in restricted cash, of which approximately $1.3 million was paid out to our
landlord in conjunction with the termination of our facilities lease. Net cash
provided by financing activities was $855,000 for the year ended December 31,
2002, which was primarily a result of the release of restricted cash related to
two letters of credit held by third parties related to our office lease and
e-commerce credit card processor. Net cash used in financing activities was
$15.9 million for the year ended December 31, 2001, and consisted of payments
made for the rescission of certain shares and options issued to employees,
artists, advisors and professional firms of $10.2 million, the repurchase of
common stock of $2.7 million, and approximately $3.0 million held as restricted
cash related to our lease agreement for our Los Angeles office and our
E-commerce business. ARTISTDIRECT RECORDS, LLC ARTISTdirect Records has relied primarily on advances from ARTISTdirect,
Inc. and from BMG to fund its operations since inception in 2001. During 2003,
ARTISTdirect Records also received loans aggregating $2.048 million from Ted
Field and from outside investors (see Financing below). At December 31,
2003, ARTISTdirect Records had $7,000 of cash. ARTISTdirect Records had a working capital deficiency of $10.9 million at
December 31, 2003, primarily because of the net liability to BMG of $8.7
million at such date (see Note 8 to the ARTISTdirect Records, LLC financial
statements for a further description of the liability to BMG). As of December 31, 2003, ARTISTdirect Records did not have sufficient
working capital resources to conduct operations and accordingly had curtailed
its operations. ARTISTdirect, Inc. does not have the resources to meet its
remaining $12.0 million funding commitment to ARTISTdirect Records for 2004.
Since ARTISTdirect Records requires additional capital in order to continue
operations, it is continuing to pursue alternatives to raise additional
capital. However, there can be no assurances that additional capital can be
obtained on reasonable terms or at all. Operating.Net cash used in operating activities was $7.1 million, $31.0
million and $5.4 million for the years ended December 31, 2003 and 2002 and the
period ended December 31, 2001, respectively. Net cash used in operating
activities for 2003, 2002 and 2001 consisted primarily of net losses, partially
offset by an increase in the net liability to BMG during 2003, 2002 and 2001 of
$3.7 million, $813,000 and $2.5 million, respectively, relating to certain
recoupable distribution advances in conjunction with its North American
distribution agreement and worldwide license agreement with ARTISTdirect
Records. Under the distribution and license agreements, BMG made non-returnable
advances to ARTISTdirect Records of $5.0 million, $2.5 million and $2.5 million
in 2003, 2002 and 2001, respectively, that are recoupable from net sales
proceeds from ARTISTdirect Records artist repertoire. The advances are to be
recouped on a monthly basis based on a defined calculation. As of December 31,
2003 and 2002, the unrecouped balances related to distribution advances from
BMG were $8.7 million and $4.1 million, respectively. Investing.Net cash provided by investing activities was $52,000 for the
year ended December 31, 2003, and consisted of proceeds from the sale of
property and equipment. Net cash used in investing activities for the year
ended December 31, 2002 and the period ended December 31, 2001 was $246,000 and
$23,000, respectively, which consisted of the purchases of property and
equipment. Financing.Net cash provided by financing activities was $7.0 million for
the year ended December 31, 2003, which consisted of the proceeds from bridge
notes of $2.048 million, an advance from ARTISTdirect, Inc. of $2.75 million,
and a net increase in interest payable of $2.2 million. Net cash provided by
financing activities was $31.1 million for the year ended December 31, 2002,
which consisted primarily of the proceeds from loan advances from ARTISTdirect,
Inc. and BMG of $25.0 million and $4.75 million, respectively, and a net
increase in interest payable of $1.1 million. Net cash provided by financing
activities was $5.5 million for the period ended December 31, 2001, and
consisted primarily of the proceeds from loan advances from ARTISTdirect, Inc.
of $5.25 million. 36




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As of December 31, 2003, ARTISTdirect Records had received $898,000 of
loans from Ted Field and $1,150,000 of loans from outside investors (including
$100,000 from Jonathan V. Diamond, our new President and Chief Executive
Officer). The total loans of $2.048 million during 2003 were obtained through
the issuance of convertible promissory notes (the Bridge Notes). The Bridge
Notes accrue interest at 8% per annum, are due two years from the date of
issuance, and will be converted into new equity of ARTISTdirect Records as part
of its next equity financing. The holders of the Bridge Notes also received warrants with a term of five
years to purchase additional equity of ARTISTdirect Records at $0.01 per unit
equivalent to the number of units of new equity into which their Bridge Notes
are ultimately converted. The relative fair value of the warrants issued was
$1.024 million (one-half of the amount funded by the investors in the Bridge
Notes), which was recorded as a reduction to the carrying amount of the Bridge
Notes and a credit to capital, and is being charged to operations as interest
expense over the specified term of the Bridge Notes. In addition, since the Bridge Notes are convertible into equity based on
their face amount, this results in a beneficial conversion feature with a
relative fair value of $1.024 million. Since the commitment date for the
beneficial conversion feature is contingent upon the completion of
ARTISTdirects next equity financing, the fair value of the beneficial
conversion feature will be charged to operations over the remaining life of the
Bridge Notes at that time. During the year ended December 31, 2003, ARTISTdirect Records recognized
$203,000 as interest expense with respect to the amortization of the fair value
of the Bridge Note warrants. Additional interest expense of $821,000 will be
recognized ratably in 2004 and 2005 over the remaining term of the Bridge
Notes. PRINCIPAL COMMITMENTS  ARTISTDIRECT, INC. AND ARTISTDIRECT RECORDS, LLC As of December 31, 2003, our principal commitments consisted of our
remaining funding obligation to ARTISTdirect Records of $12.0 million due in
2004 and other funding commitments as summarized below. During 2003, our main
operating lease commitment for our office space was terminated. A summary of
our contractual cash obligations, excluding the ARTISTdirect Records funding
commitment, as of December 31, 2003, is as follows: Payments Due by Period (in thousands)Less than
    
    Between
    
    Between
    
    AfterContractual cash obligations
    
    Total
    
    1 year
    
    2-3 years
    
    4-5 years
    
    5 yearsOperating leases
    
    $
    38
    
    
    $
    38
    
    
    $
    
    
    
    $
    
    
    
    $
    Employment contracts
    
    
    606
    
    
    
    305
    
    
    
    301
    
    
    
    
    
    
    
    Artist advances
    
    
    1,500
    
    
    
    1,500
    
    
    
    
    
    
    
    
    
    
    
    Liability to BMG (including accrued
interest)
    
    
    5,197
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,197Bridge Notes (including accrued interest)
    
    
    2,115
    
    
    
    
    
    
    
    2,115
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    9,456
    
    
    $
    1,843
    
    
    $
    2,416
    
    
    $
    
    
    
    $
    5,197
 At December 31, 2003, the Company did not have any material commitments
for capital expenditures or have any transactions, obligations or relationships
that could be considered off-balance sheet arrangements. LIQUIDITY  ARTISTDIRECT, INC. AND ARTISTDIRECT RECORDS, LLC We currently anticipate that our available cash resources, including
short-term investments, will not be sufficient to meet our anticipated working
capital requirements during 2004, including our $12.0 million funding
commitment to ARTISTdirect Records in 2004. We have reduced our operations and
have divested certain of our assets in order to attempt to raise the capital
necessary to sustain business operations, and we are exploring various
alternatives to raise additional capital. There can be no assurance that
additional capital can be obtained by either our company or by ARTISTdirect
Records on reasonable terms, in a timely manner or at all. Failure to raise
additional capital could seriously harm the business of ARTISTdirect Records
and impair the value of our investment in ARTISTdirect Records. If additional funds are raised through the issuance of equity securities
of either our company or ARTISTdirect Records, the percentage ownership of
current stockholders in our company and/or ARTISTdirect Records will be
reduced. If we raise additional funds by issuing debt, we may be subject to
limitations on our operations, including limitations on the payment of
dividends, and any debt issued by ARTISTdirect Records may be senior to the
obligations of ARTISTdirect Records to our company. To the extent that we are
unable to successfully restructure our funding 37




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commitment and/or obtain the capital necessary to fund our future cash
requirements on a timely basis and under acceptable terms and conditions, we
will not have sufficient cash resources to maintain operations, and may
consider a formal or informal restructuring or reorganization. Due to our
current financial condition, our auditors have included an explanatory
paragraph in their 2003 report on the financial statements of ARTISTdirect,
Inc. and ARTISTdirect Records, LLC stating that there is substantial doubt
about our ability to continue as a going concern. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (SFAS No. 143). SFAS No. 143 addresses the diverse
accounting practices for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The Company
adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143
did not have a significant effect on the Companys financial statement
presentation or disclosures. In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of, it retains many
of the fundamental provisions of that statement. The Company adopted SFAS No.
144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a
material impact on the Companys financial statement presentation or
disclosures. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS 4, which required all gains and
losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. Upon
adoption of SFAS No. 145, the Company will be required to apply the criteria in
APB Opinion No. 30, Reporting the Results of Operations  Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions (Opinion No. 30), in
determining the classification of gains and losses resulting from the
extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to
require that certain lease modifications that have economic effects similar to
sale-leaseback transactions to be accounted for in the same manner as
sale-leaseback transactions. The Company adopted SFAS No. 145 effective
January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for
use did not have a material impact on the Companys financial statement
presentation or disclosures. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit and Disposal Activities. SFAS No. 146 nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring). Under EITF Issue No. 94-3, a
liability for an exit cost is recognized at the date of an entitys commitment
to an exit plan. Under SFAS No. 146, the liabilities associated with an exit
or disposal activity will be measured at fair value and recognized when the
liability is incurred and meets the definition of a liability in the FASBs
conceptual framework. SFAS No. 146 is effective for exit or disposal
activities initiated after December 31, 2002. The adoption of SFAS 146 did not
have a material impact on the Companys financial statement presentation or
disclosures. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based CompensationTransition and Disclosurean amendment of SFAS No.
123. SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No.
123 and APB Opinion No. 28, Interim Financial Reporting, to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company implemented SFAS No. 148 effective
December 31, 2002. The Company has determined that it will continue to account
for stock-based employee compensation in accordance with APB No. 25. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and
clarifies under what circumstances a contract with initial investments meets
the characteristics of a derivative and when a derivative contains a financing
component. SFAS No. 149 is effective for contracts entered into or modified
after June 30, 2003. The adoption of SFAS No. 149 did not have a significant
effect on the Companys financial statement presentation or disclosures. 38




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In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for how an issuer classifies and measures in
its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an
issuer classify a financial instrument that is within its scope as a liability
(or an asset in some circumstances) because that financial instrument embodies
an obligation of the issuer. SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003 and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of
a change in accounting principle for financial instruments created before the
issuance date of SFAS No. 150 and still existing at the beginning of the
interim period of adoption. Restatement is not permitted. The adoption of
SFAS No. 150 did not have a significant effect on the Companys financial
statement presentation or disclosures. In November 2002, the FASB issued Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others (FIN 45), an interpretation of FASB
Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.
FIN 45 elaborates on the disclosures to be made by a guarantor in its interim
and annual financial statements about its obligations under guarantees issued.
FIN 45 also clarifies that a guarantor is required to recognize, at inception
of a guarantee, a liability for the fair value of the obligation undertaken.
The initial recognition and measurement provisions of FIN 45 are applicable to
guarantees issued or modified after December 31, 2002. The disclosure
requirements of FIN 45 are effective for financial statements of interim and
annual periods ended after December 15, 2002. The adoption of FIN 45 did not
have a material effect on the Companys financial statement presentation or
disclosures. In November 2002, the FASBs Emerging Issues Task Force (EITF) issued
EITF No. 00-21 Revenue Arrangements with Multiple Deliverables. EITF No.
00-21 addresses certain aspects of the accounting by a vendor for arrangements
under which it will perform multiple revenue-generating activities.
Specifically, EITF No. 00-21 addresses how to determine whether an arrangement
involving multiple deliverables contains more than one unit of accounting. In
applying EITF No. 00-21, separate contracts with the same entity or related
parties that are entered into at or near the same time are presumed to have
been negotiated as a package and should, therefore, be evaluated as a single
arrangement in considering whether there are one or more units of accounting.
That presumption may be overcome if there is sufficient evidence to the
contrary. EITF No. 00-21 also addresses how arrangement consideration should
be measured and allocated to the separate units of accounting in the
arrangement. The guidance in EITF No. 00-21 is effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. The
Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF
No. 00-21 has not had any significant impact on the Companys financial
statement presentation or disclosures. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities, which have one or both of the following characteristics:
(1) the equity investment at risk is not sufficient to permit the entity to
finance its activities without additional financial support from other parties,
or (2) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest: (a) the direct or
indirect ability to make decisions about the entitys activities through voting
or similar rights, (b) the obligation to absorb the expected losses of the
entity if they occur, or (c) the right to receive the expected residual returns
of the entity if they occur. In addition, FIN 46 contains detailed disclosure
requirements. FIN 46 applies immediately to variable interest entities created
after January 31, 2003, and to variable interest entities in which an
enterprise obtains an interest after that date. It applies in the first fiscal
year or interim period ending after March 15, 2004, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. Early adoption is permitted. The Company adopted FIN
46 as of December 31, 2003. The adoption of FIN 46 on such date had a
significant impact on the Companys consolidated balance sheet. The Company
had previously accounted for its investment in ARTISTdirect Records under the
equity method. The Company consolidated the balance sheet of ARTISTdirect
Records as of December 31, 2003, and will consolidate the operations of
ARTISTdirect Records beginning January 1, 2004. 
 ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market rate risk for changes in interest rates is related
primarily to our investment portfolio. We have not used derivative financial
instruments in our investment portfolio. At December 31, 2003, our short-term
investments are comprised of United States corporate and bank debt. Interest
rate fluctuations impact the carrying value of the portfolio. We do not believe
that the future market risks related to the above securities will have material
adverse impact on our financial position, results of operations or liquidity. 39




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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our consolidated financial statements and schedule, as listed under Item
15, appear in a separate section of this Annual Report on Form 10-K beginning
on page 59. 
 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE Effective February 6, 2004, we dismissed KPMG LLP (KPMG) as our
independent accountant. The dismissal of KPMG was recommended by our Audit
Committee and approved by our Board of Directors. KPMGs reports on our financial statements for the years ended December
31, 2001 and 2002 did not contain an adverse opinion or a disclaimer of
opinion, nor were they qualified or modified as to uncertainty, audit scope, or
accounting principles, except that KPMGs report, dated February 14, 2003, for
the years ended December 31, 2002 and 2001 contained an explanatory paragraph
stating that the Company has incurred substantial operating losses and
negative cash flows from operations to date and has funding commitments related
to its record label joint venture. The Company needs additional capital to
fund its operations and the operations of the record label joint venture.
These conditions raise substantial doubt about the Companys ability to
continue as a going concern. Managements plans in regard to these matters are
also described in note 1. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty. During the years ended December 31, 2001 and 2002, and the period from
January 1, 2003 through February 6, 2004, there were no disagreements with KPMG
on any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedure, which disagreements, if not
resolved to the satisfaction of KPMG, would have caused KPMG to make reference
to the subject matter of the disagreements in connection with its reports on
the our financial statements. In addition, none of the events described in
Item 304(a)(1)(v) of Regulation S-K occurred during such periods. Effective February 17, 2004, we retained Gumbiner, Savett, Finkel,
Fingleson & Rose, Inc. (GSFFR) as our independent accountant. The retention
of GSFFR was recommended by our Audit Committee and approved by our Board of
Directors. During the years ended December 31, 2002 and 2003, and the subsequent
interim period from January 1, 2004 through February 16, 2004, we did not, nor
did anyone on our behalf, consult with GSFFR regarding either: (i) the
application of accounting principles to a specified transaction, either
completed or proposed; or the type of audit opinion that might be rendered on
our financial statements, and no written report or oral advice was provided
that GSFFR concluded was an important factor considered by us in reaching a
decision as to the accounting, auditing or financial reporting issue; or (ii)
any matter that was either the subject of a disagreement as defined at Item
304(a)(1)(iv) or a reportable event as defined at Item 304 (a)(1)(v) of
Regulation S-K. 
 ITEM 9A. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures Disclosure controls and procedures are designed to ensure that information
required to be disclosed in the reports filed or submitted under the Exchange
Act of 1934 is recorded, processed, summarized and reported, within the time
periods specified in the rules and forms of the Securities and Exchange
Commission. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed in the reports filed under the Exchange Act of 1934 is accumulated
and communicated to management, including its principal executive and financial
officers, as appropriate, to allow timely decisions regarding required
disclosure. We carried out an evaluation, under the supervision and with the
participation of our management, including its principal executive officer and
financial officer, of the effectiveness of the design and operation of our
disclosure controls and procedures as of the end of the period covered by this
report. Based upon and as of the date of that evaluation, our principal
executive officer and financial officer concluded that our disclosure controls
and procedures are effective to ensure that information required to be
disclosed in the reports we file and submit under the Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commissions rules and forms. 40




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(b) Changes in Internal Controls There were no changes in our internal controls or in other factors that
could have significantly affected those controls subsequent to the date of our
most recent evaluation. 
 PART III 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Directors, Executive Officers and Key Employees The following table sets forth certain information regarding our
directors, executive officers and certain key employees as of April 15, 2004: Name
    
    Age
    
    Positions with ARTISTdirectFrederick W. Field
    
    
    51
    
    
    Chairman of the BoardJonathan V. Diamond
    
    
    44
    
    
    Chief Executive Officer and directorRobert N. Weingarten
    
    
    51
    
    
    Chief Financial Officer and SecretaryMarc P. Geiger
    
    
    41
    
    
    DirectorStephen M. Krupa
    
    
    39
    
    
    DirectorBenjamin S. A. Moody
    
    
    44
    
    
    DirectorKeith K. Yokomoto
    
    
    41
    
    
    Director
 The following is a brief description of the capacities in which each of
our directors, executive officers and key employees has served during the past
five years. Frederick W. Fieldhas served as our Chairman of the Board since June 2001
and served as our Chief Executive Officer from June 2001 until September 2003.
Mr. Field also currently serves as Chief Executive Officer of ARTISTdirect
Records, LLC (a joint venture among ARTISTdirect Recordings, Inc., our
wholly-owned subsidiary, Radar Records, LLC, an entity controlled by Mr. Field,
and BMG Entertainment) and as Chairman of the Board and Chief Executive Officer
of Radar Pictures, Inc., a film production company. From 1990 to 2001, Mr.
Field served as Co-Chairman of Interscope Records, a music production company.
From 1979 to 1997, Mr. Field served as Chairman of the Board and Chief
Executive Officer of Interscope Communications, Inc. Jonathan V. Diamond. Mr. Diamond has served 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., a publicly traded company. He was the
co-founder of N2K, Inc. and served as its Vice Chairman and Chief Executive
Officer through its 1999 merger with CDnow, Inc., an e-commerce company. He
continued to serve as Chairman of the combined company until its sale to
Bertelsmann Music Group in August 2000. Mr. Diamond is a former partner in GRP
Records, an independent music label acquired by MCA in 1990. Mr. Diamond holds
an M.B.A. from the Columbia University Graduate School of Business and a B.A.
in Economics and Music from the University of Michigan. Robert N. Weingarten. Mr. Weingarten was appointed Chief Financial Officer
and Secretary of the Company in January 2004. From July 1992 to present, Mr.
Weingarten has been the sole shareholder of Resource One Group, Inc., a
financial consulting and advisory company. From February 2003 to present, he
has served as the Chief Financial Officer of Youthstream Media Networks, Inc.,
a publicly traded company. Since 1979, Mr. Weingarten has served as a
consultant to numerous public companies in various stages of development,
operation or reorganization. Mr. Weingarten received an M.B.A. Degree in
Finance from the University of Southern California in 1975 and a B.A. Degree in
Accounting from the University of Washington in 1974. Mr. Weingarten currently
serves as President and Chief Financial Officer of Aries Ventures Inc. and
Resource Ventures, Inc., both of which are public companies. Marc P. Geigerco-founded ARTISTdirect, Inc. and has served as a director
since June 2001. He served as our 41




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President, Artist Services and Vice-Chairman of the Board from June 2001
to May 2003. Mr. Geiger served as Chief Executive Officer from our inception to
June 2001 and as our Chairman of the Board from July 1998 to June 2001. From
January 1992 to December 1996, Mr. Geiger was the Senior Vice President of
Marketing, A&R and New Media at American Recordings, Inc. From 1984 to 1991,
Mr. Geiger worked as a talent agent for Regency Artists, that was later
acquired by the William Morris Agency. In 1990, Mr. Geiger co-founded the
Lollapalooza concert tour. Stephen M. Krupahas served as a director since May 1999. Mr. Krupa is a
founding member and Managing Director of Psilos Group Managers, LLC, a private
venture capital fund focused on the digital media, information technology and
health care sectors. Mr. Krupa is currently a director of several private
technology and healthcare companies. From February 1995 to July 1998, Mr. Krupa
held various positions at Wasserstein Perella & Co., most recently as a Vice
President where he specialized in mergers and acquisitions advisory work. Mr.
Krupa received his B.S. in Mechanical Engineering from the University of South
Florida and his M.B.A. from the Wharton School of the University of
Pennsylvania. Benjamin S. A. Moodyhas served as a director since March 2001. Mr. Moody
is the co-founder and Managing Member of Pan American Finance, LLC, an
investment banking firm focused on providing advisory services to companies in
the Latin American, Caribbean and the U.S. Hispanic markets. Mr. Moody
currently serves as a director of several private media and technology
companies. From June 1998 to June 2001, Mr. Moody served as Vice Chairman and
Chief Financial Officer of Cisneros Television Group, a media entertainment
company, as well as Managing Director and Chief Financial Officer of
Ibero-American Media Partners II, Ltd., a joint venture between the Cisneros
Group of Companies and Hicks, Muse, Tate & Furst. From June 1996 to June 1998,
Mr. Moody was a Managing Director of Violy, Byorum and Partners, LLC, a mergers
and acquisitions advisory firm. From June 1992 to June 1996, Mr. Moody was a
Vice President of Citicorp Securities, Inc. Mr. Moody received his B.A. in
English Language and Literature from Saint Benets Hall, Oxford University. Keith K. Yokomotoco-founded ARTISTdirect, Inc. and has served as a
director since July 1998 and as a consultant since January 2004. He served as
our President from July 1999 to December 2003, as Chief Operating Officer from
January 1997 to December 2003. From September 1985 to January 1997, Mr.
Yokomoto was a manager of new ventures and business development and a project
engineer at Hughes Electronics. Mr. Yokomoto received his B.S. in Mechanical
Engineering from the University of California at San Diego and his M.B.A. from
the University of Southern California. Our executive officers are elected by the Board of Directors on an annual
basis and serve until their successors have been duly elected and qualified.
There are no family relationships among any of the directors or executive
officers of ARTISTdirect. Compensation Committee Interlocks and Insider Participation The Compensation Committee of our Board of Directors currently consists of
Messrs. Krupa and Moody. Jerry Rubinstein served as a member of our
Compensation Committee from September 2002 until his resignation in August
2003. None of these individuals was an officer or employee of ARTISTdirect at
any time during the 2003 fiscal year or at any other time. Messrs. Diamond and
Weingarten are also directors and executive officers of Youthstream Media
Networks, Inc., a publicly-traded company. No current executive officer of
ARTISTdirect has ever served as a member of the board of directors or
compensation committee of any other entity that has or has had one or more
executive officers serving as a member of our Board of Directors or
Compensation Committee. Director Compensation Directors who are not employees of ARTISTdirect or one of its subsidiaries
do not currently receive any cash compensation from ARTISTdirect for their
service as members of our Board of Directors or any Board committee. However,
directors are reimbursed for all reasonable travel and lodging expenses
incurred by them in attending Board and committee meetings. All directors are
eligible to participate in the ARTISTdirect 1999 Employee Stock Option Plan. Meetings and Committees of the Board of Directors The
Board of Directors held 10 meetings during the fiscal year ended December 31, 2003 (Fiscal Year 2003).
The Board has an Audit Committee and a Compensation Committee. Each Director
attended or participated in 75% or more of the aggregate of (i) the total
number of meetings of the Board and (ii) the total number of meetings held by
all committees of the Board on which such Director served during Fiscal Year
2003. 42




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The Audit Committee reviews, acts on and reports to the Board of Directors
with respect to various auditing and accounting matters, including the
selection of the Companys independent auditors, the scope of the annual
audits, fees to be paid to the auditors, the performance of the independent
auditors and the Companys accounting practices. The board of directors has
established Audit and Compensation Committees. The Company does not currently have an audit committee financial expert
serving on its Audit Committee, as the Company has limited resources and is
continuing its restructuring efforts. The Company intends to attempt to add a
qualified board member to serve as an audit committee financial expert in the
future. The members of the Audit Committee are Messrs. Moody and Krupa, each
non-employee directors of the Company. The Audit Committee as currently
configured held five meetings during the Fiscal Year 2003. The Compensation Committee reviews and approves the compensation and
benefits of our key executive officers, administers our employee benefit plans
and makes recommendations to the Board regarding such matters. The Compensation
Committee as currently configured held four meetings during the Fiscal Year
2003. Compliance with Section 16(a) of the Securities Exchange Act of 1934 The members of our Board of Directors, our executive officers and persons
who hold more than 10% of our outstanding common stock are subject to the
reporting requirements of Section 16(a) of the Securities Exchange Act of 1934
which require them to file reports with respect to their ownership of our
common stock and their transactions in such common stock. Based upon (i) the
copies of Section 16(a) reports which we received from such persons for their
2003 fiscal year transactions in our common stock and their holdings of our
common stock, and (ii) the written representations received from one or more of
such persons that no annual Form 5 reports were required to be filed by them
for the 2003 fiscal year, Mr. Diamond filed one late Form 4 report covering one
transaction. Other than the foregoing instances, we believe that the reporting
requirements under Section 16(a) for such fiscal year were met in a timely
manner by our other directors, executive officers and greater than ten percent
beneficial owners. 
 ITEM 11. EXECUTIVE COMPENSATION Summary of Cash and Certain Other Compensation The following table provides certain summary information concerning the
compensation earned by ARTISTdirects Chief Executive Officer and each of the
three other most highly compensated executive officers of ARTISTdirect whose
salary and bonus for the 2003 fiscal year was in excess of $100,000, for
services rendered in all capacities to ARTISTdirect and its subsidiaries for
the fiscal years ended December 31, 2000, 2001 and 2003. No other executive
officers who would have otherwise been includable in such table on the basis of
salary and bonus earned for the 2003 fiscal year has been excluded by reason of
his or her termination of employment or change in executive status during that
year. The listed individuals shall be hereinafter referred to as the named
executive officers. 43




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SUMMARY COMPENSATION TABLE Long-TermAnnual Compensation
    
    CompensationAwardsOther Annual
    
    Securities Underlying
    
    All OtherName and Principal Positions
    
    Year
    
    Salary($)
    
    Bonus($)
    
    Compensation($)(1)
    
    Options (#)
    
    Compensation($)Frederick W. Field
    
    
    2003
    
    
    $
    56,160
    (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Chairman
    
    
    2002
    
    
    
    812,500
    (3)
    
    $
    
    (5)
    
    $
    
    
    
    
    
    
    
    
    2001
    
    
    
    750,000
    (4)
    
    
    
    
    
    
    
    
    
    
    444,480
    
    
    
    Jonathan V. Diamond
    
    
    2003
    
    
    $
    46,250
    (6)
    
    $
    4,315
    
    
    
    1,950
    
    
    
    
    
    
    
    Chief Executive Officer
    
    
    2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2001
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Marc P. Geiger
    
    
    2003
    
    
    $
    249,999
    (7)
    
    $
    
    
    
    
    
    
    
    
    
    
    
    $
    4,167
    (6)Vice-Chairman and
    
    
    2002
    
    
    
    458,333
    (8)
    
    
    
    
    
    
    7,800
    
    
    
    
    
    
    
    President, Artist Services
    
    
    2001
    
    
    
    325,000
    
    
    
    350,000
    
    
    
    7,800
    
    
    
    
    
    
    
    Keith K. Yokomoto
    
    
    2003
    
    
    
    597,222
    (9)
    
    
    
    (10)
    
    
    7,800
    
    
    
    
    
    
    $
    76,924
    (9)President, Chief Operating
    
    
    2002
    
    
    
    402,778
    
    
    
    
    
    
    
    7,800
    
    
    
    
    
    
    
    Officer and Director
    
    
    2001
    
    
    
    325,000
    
    
    
    350,000
    
    
    
    7,800
    
    
    
    
    
    
    
    
   (1)
    
    Reflects car allowance.(2)
    
    Includes $28,080 of deferred salary received in connection with Mr.
Fields service as Chief Executive Officer of ARTISTdirect Records, LLC.
ARTISTdirect Records is a co-venture which is indirectly jointly owned by
ARTISTdirect and Mr. Field. See the section below titled Employment
Contracts, Termination of Employment and Change in Control Arrangements
for more information.(3)
    
    Includes $541,667 of salary received in connection with Mr. Fields
service as Chief Executive Officer of ARTISTdirect Records, LLC.
ARTISTdirect Records is a co-venture which is indirectly jointly owned by
ARTISTdirect and Mr. Field. See the section below titled Employment
Contracts, Termination of Employment and Change in Control Arrangements
for more information.(4)
    
    Includes $500,000 of salary received in connection with Mr. Fields
service as Chief Executive Officer of ARTISTdirect Records. ARTISTdirect
Records is a co-venture which is indirectly jointly owned by ARTISTdirect
and Mr. Field. See the section below titled Employment Contracts,
Termination of Employment and Change in Control Arrangements for more
information.(5)
    
    From July 16, 2002, Mr. Field has elected to defer all of his salary
under his employment agreements with ARTISTdirect and ARTISTdirect
Records. During 2002, Mr. Field deferred $229,167 of salary from
ARTISTdirect and $458,334 of salary from ARTISTdirect Records. In May
2003, all deferred salary totaling approximately $411,000 from the Company
and approximately $822,000 from ARTISTdirect Records was waived. See the
section below titled Employment Contracts, Termination of Employment and
Change in Control Arrangements for more information.(6)
    
    Mr. Diamond entered into an employment agreement on September 29, 2003
with the Company in which he earned an annual salary of $185,000, received
a signing bonus of $4,315 and a car allowance $650 per month.(7)
    
    Includes $145,833 in deferred salary and $4,167 in vacation pay which
were paid to Mr. Geiger upon his termination as our employee, net of
applicable tax withholdings, through the cancellation of repayment Mr.
Geigers prepaid bonus of $150,000 upon the termination of Mr. Geigers
employment on May 31, 2003. .(8)
    
    Since November 1, 2002, Mr. Geiger elected to defer 50% of his salary
under his employment agreement with ARTISTdirect.(9)
    
    Includes $412,847 in deferred salary and $76,924 in accrued vacation pay
which were paid to Mr. Yokomoto upon his termination as an employee on
December 31, 2003. $150,000 of this amount was repaid to us for a prepaid
bonus he received. 44




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(10)
    
    From August 1 through August 31, 2002, Mr. Yokomoto elected to defer 33%
of his salary, and from September 1, 2002 until the termination of his
employment contract, Mr. Yokomoto elected to defer 50% of his salary.
During 2002 and 2003, Mr. Yokomoto deferred $97,222 and 315,625 of salary,
respectively. This deferred amount and $76,924 in accrued vacation pay,
net of applicable tax withholdings, was paid in a cash lump sum by upon
the termination of Mr. Yokomotos employment with ARTISTdirect on December
31, 2003. See the section below titled Employment Contracts, Termination
of Employment and Change in Control Arrangements for more information. Stock Options and Stock Appreciation Rights In September 2003, we issued to Mr. Jonathan Diamond, options to purchase
259,659 shares of our common stock at $0.85 per share. These options expire on
August 15, 2010. The options will also terminate if Mr. Diamond is no longer
an employee of the our company. 75% of the shares underlying the options are
subject to repurchase rights upon his termination. These rights expire in
three annual installments such that upon the third anniversary of his
employment, all repurchase rights shall lapse. No stock options or stock appreciation rights were granted to any of the
other named executive officers during the 2003 fiscal year. Aggregated Option.Fiscal Year-End Value The following table provides information, with respect to the named
executive officers, concerning unexercised options held by them at the end of
the 2003 fiscal year. None of the named executive officers exercised any stock
appreciation rights during the 2003 fiscal year and no stock appreciation
rights were held by the named executive officers at the end of such year. AGGREGATED FISCAL YEAR-END OPTION VALUES Value of UnexercisedNumber of Unexercised Options at
    
    in-the-MoneyFiscal Year End (#)
    
    Options at Fiscal Year End ($)Name
    
    Exercisable
    
    Unexercisable
    
    Exercisable
    
    UnexercisableFrederick W. Field
    
    
    302,370
    
    
    
    142,110
    
    
    $
    0
    
    
    $
    0Jon Diamond
    
    
    259,659
    
    
    
    0
    
    
    
    0
    
    
    
    0Marc Geiger
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Keith K. Yokomoto
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
 Employment Contracts, Termination of Employment and Change in Control
Arrangements ARTISTdirect has entered into employment agreements with its named
executive officers. The compensation and dates of employment under the
employment agreements are as follows: Frederick Field In May 2001, ARTISTdirect entered into an employment agreement and stock
option agreements with Frederick Field, its Chairman of the Board and Chief
Executive Officer. The employment agreement generally provides for the
following:  
    
    Mr. Field is paid an annual base salary of $500,000, plus bonus pool participation.
    
    The term of the agreement expires May 31, 2006.
    
    The employment agreement provides that if ARTISTdirect terminates Mr. Fields employment other than for cause, disability
or death, or Mr. Field terminates his employment for good reason, he will receive a lump sum payment equal to the amount of
his annual base salary for:  (1)
    
    50% of the remaining term of the employment agreement if the
termination occurs within the first 3 years of his employment, 45




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(2)
    
    12 months if the termination occurs in the fourth year of his
employment, or(3)
    
    the full remaining term of the employment agreement if the
termination occurs in the fifth year of his employment.  
    
    The above payments also will be made if Mr. Field terminates his
employment by written notice upon the commencement of any arbitration
proceeding to determine whether or not his employment with
ARTISTdirect Records may be terminated for good reason and Mr. Fields
employment with ARTISTdirect Records is terminated for good reason.
    
    If Mr. Field terminates his employment by written notice upon the
commencement of any arbitration proceeding to determine whether or not
his employment with ARTISTdirect Records may be terminated for cause
and Mr. Field remains employed at ARTISTdirect Records because the
arbitrator determines that ARTISTdirect Records is not entitled to
terminate Mr. Fields employment for cause, then the above payments
will be made, but the applicable pay period will be reduced by 50%. ARTISTdirect also granted Mr. Field three non-plan, non-qualified stock
options to purchase 444,480 shares of common stock at an exercise price of
$7.50 per share, under the following stock option agreements:  
    
    One of the stock option agreements generally provides that Mr. Fields
right to purchase 302,370 shares is immediately exercisable subject to
a right of repurchase, and vests in a series of 60 successive equal
monthly installments from June 29, 2001. The vesting fully accelerates
upon a change of control or upon Mr. Fields cessation of service with
ARTISTdirect pursuant to an involuntary termination. An involuntary
termination includes (i) ARTISTdirects termination of Mr. Fields
employment for reasons other than for cause, (ii) a cessation of
services pursuant to Mr. Fields permanent disability or death and
(iii) Mr. Fields voluntary resignation for good reason, as set forth
in the employment agreement. Permanent disability exists if Mr. Field
becomes unable to engage in any substantial gainful activity by reason
of any medically determinable physical or mental impairment that is
expected to result in death or has lasted or can be expected to last
for a continuous period of at least 12 months. In addition, if Mr.
Field terminates his employment upon written notice in connection with
the commencement of any arbitration proceeding to determine whether or
not his employment with ARTISTdirect Records may be terminated for
cause and Mr. Field remains employed at ARTISTdirect Records because
the arbitrator determined that ARTISTdirect Records was not entitled
to terminate Mr. Fields employment for cause, then 50% of the then
unvested option shares will automatically accelerate so that they are
immediately fully vested and exercisable.
    
    A second stock option agreement generally provides that Mr. Fields
right to purchase 75,588 shares vests and becomes exercisable upon
the occurrence prior to June 29, 2004 of any one of the following
events: (i) the 30-day average closing sale price of ARTISTdirects
common stock or the consideration paid per share in an acquisition of
ARTISTdirect reaches a minimum of $35.00 per share; (ii)
ARTISTdirects common stock is re-listed on The Nasdaq National Market
following a delisting; (iii) a change of control occurs; or (iv) Mr.
Fields service with ARTISTdirect ceases pursuant to an involuntary
termination. If none of the foregoing events occurs by June 29, 2004,
then the option will terminate and none of the option shares subject
to the second stock option agreement will vest or become exercisable
by Mr. Field.
    
    The third stock option agreement generally provides that Mr. Fields
right to purchase 66,522 shares vests and becomes exercisable upon the
occurrence prior to June 29, 2004 of any one of the following events:
(i) the 30-day average closing sale price of ARTISTdirects common
stock or the consideration paid per share in an acquisition of
ARTISTdirect reaches a minimum of $70.00 per share; (ii)
ARTISTdirects common stock is re-listed on The Nasdaq National Market
following a delisting; (iii) a change of control occurs; or (iv) Mr.
Fields service with ARTISTdirect ceases pursuant to an involuntary
termination. If none of the foregoing events occurs by June 29, 2004,
then the option will terminate and none of the option shares subject
to the third option agreement will vest or become exercisable by Mr.
Field. All three stock options expire no later than May 30, 2008. All three stock
options may also terminate prior to the expiration date as follows: (i) upon
the later of the 12 month anniversary of Mr. Fields cessation of service or
the expiration of Mr. Fields initial five-year employment term with
ARTISTdirect if Mr. Fields employment with ARTISTdirect ceases pursuant to an
involuntary termination; (ii) upon the earlier of the 12 month anniversary of
Mr. Fields cessation of service or the expiration of Mr. Fields initial
five-year employment term with ARTISTdirect if Mr. Field terminates his
employment pursuant to a termination with justification; (iii) upon the earlier
of the 90-day anniversary of Mr. Fields cessation of service or the expiration
date of the stock option if Mr. Field ceases to remain in ARTISTdirects
service for any reason other than an involuntary termination or a termination
with justification; (iv) immediately if ARTISTdirect 46




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terminates Mr. Fields
employment for cause; (v) upon the earlier of the 12 month anniversary of Mr.
Fields death or the
expiration date of the stock option if Mr. Field ceases to remain in
ARTISTdirects service due to his death; and (vi) upon the latter of the 12
month anniversary of Mr. Fields cessation of service with ARTISTdirect or the
expiration of Mr. Fields initial five-year employment term with ARTISTdirect
if Mr. Field ceases to remain in ARTISTdirects service due to his permanent
disability. In addition, Mr. Field also serves as the Chief Executive Officer of
ARTISTdirect Records. Mr. Field has a five-year employment agreement with
ARTISTdirect Records, pursuant to which he is paid an annual base salary of
$1,000,000 plus certain benefits. If Mr. Field terminates his employment with
ARTISTdirect Records for good reason, he will receive a lump sum payment equal
to the amount of his annual base salary for (i) 50% of the remaining term of
the employment agreement if the termination occurs within the first 3 years of
his employment, (ii) 12 months if the termination occurs in the fourth year of
his employment or (iii) the full remaining term of the employment agreement if
the termination occurs in the fifth year of his employment. ARTISTdirect
Records may not terminate Mr. Fields employment other than for cause or due to
his disability or death. From July 16, 2002, Mr. Field has elected to defer salary that he would
have earned under his employment agreements with ARTISTdirect and ARTISTdirect
Records. In December 2002, ARTISTdirect and ARTISTdirect Records amended Mr.
Fields employment agreements to provide that the amount of Mr. Fields
deferred salary, net of applicable tax withholdings, will be paid in a cash
lump sum by ARTISTdirect and ARTISTdirect Records, respectively, within thirty
days after the consummation of a private financing of at least $20,000,000 or,
if earlier, the occurrence of (i) a merger, consolidation, sale of fifty
percent (50%) or more of the voting securities or sale of all or substantially
all of the assets of ARTISTdirect or ARTISTdirect Records, respectively, (ii)
Mr. Fields attainment of age 65, or (iii) the termination of Mr. Fields
employment with ARTISTdirect or ARTISTdirect Records, respectively. In May 2003, Mr. Field agreed to reduce his annual salary under his
employment agreements with ARTISTdirect and ARTISTdirect Records to $28,080
under each agreement. Mr. Fields employment agreement was further amended
whereby all deferred salary totaling approximately $411,000 and $822,000,
respectively, was waived, even if new debt or equity financing is raised. Jonathan V. Diamond In
September 2003, ARTISTdirect had entered into a two-year employment agreement
with Jonathan V. Diamond, its Chief Executive Officer and director, which
provided for the following:  
    
    Mr. Diamond was paid an annual salary of $185,000 and a discretionary
bonus of up to $50,000 and a formula-based bonus of up to $50,000
determined by the Board, pro rated for any partial fiscal year. Mr.
Diamond also received a signing bonus of $4,315.
    
    The agreement provided for the payment of salary for eighteen months
after the date of termination (or, if a shorter period, the remaining
term under his employment agreement) and full vesting of his stock
option if the termination was:  (1)
    
    other than due to a disability,(2)
    
    other than for cause, such as the commission of a felony,
material dishonesty against ARTISTdirect, or gross negligence in the
performance of duties,(3)
    
    other than due to Mr. Diamonds death, or(4)
    
    for good reason, such as an adverse change of duties, a
reassignment of location, or a material breach of ARTISTdirects
obligations to Mr. Diamond.  
    
    The agreement also provided that if Mr. Diamonds employment was
terminated for cause or disability, or he resigned for other than good
reason, he would be prohibited, for a period of the later of one year
after the early termination of his employment, or the expiration of
the term of his employment agreement, from attempting to hire any
ARTISTdirect employees.
    
    Mr. Diamond also received a stock option to purchase 259,659 shares of
common stock at $0.85 per share, the approximate fair market value of
the stock at such time. The option may be exercisable until August
15, 2010. 75% 47




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0f the common stock underlying the options are subject
to a repurchase right at $0.85 per share by the Company upon
his termination of employment. This repurchase right lapses in three equal
installments such that, the repurchase right will lapse entirely upon the
third anniversary of his employment. Marc Geiger In July 1998, ARTISTdirect had entered into an employment agreement with
Marc Geiger, its Vice-Chairman and President, Artist Services, which provided
for the following:  
    
    Mr. Geiger was paid an annual salary of $150,000 and a guaranteed annual bonus of $100,000.
    
    The agreement provided for the payment of salary and a guaranteed bonus for twelve months after the date of termination if
the termination was:  (1)
    
    other than due to a disability,(2)
    
    other than for cause, such as the commission of a felony,
material dishonesty against ARTISTdirect, or gross negligence in the
performance of duties,(3)
    
    other than due to Mr. Geigers death, or(4)
    
    for good reason, such as an adverse change of duties, a
reassignment of location, or a material breach of ARTISTdirects
obligations to Mr. Geiger.  
    
    The agreement also provided that if Mr. Geigers employment was
terminated for cause or disability, or he resigned for other than good
reason, he would be prohibited, for a period of the later of one year
after the early termination of his employment, or the expiration of the
term of his employment agreement, from competing with ARTISTdirect or
attempting to hire any ARTISTdirect employees. In June 2001, Mr. Geiger resigned his position as Chairman of the Board
and Chief Executive Officer and took the position of Vice Chairman of the Board
and President, Artist Services. Mr. Geiger also executed an agreement with
ARTISTdirect, effective as of April 27, 2001, agreeing that such changes in his
title and duties would not constitute good reason that would entitle him to
the severance pay described above if he chooses to terminate his employment. In July 2001, ARTISTdirect amended Mr. Geigers original employment
agreement to provide for the following:  
    
    Mr. Geiger is paid an annual salary of $500,000 (to be reviewed
annually for any increases by ARTISTdirects Compensation Committee in
consultation with ARTISTdirects Chief Executive Officer), is entitled
to four weeks vacation each year, and is eligible to participate in
ARTISTdirects executive performance bonus pool and in the Artists &
Repertoire Bonus Plan of ARTISTdirect Records, LLC.
    
    The initial term of the amended agreement expires June 30, 2006.
Beginning July 1, 2006, and on each anniversary, the term of the
amended agreement will automatically be extended for an additional
one-year period unless written notice is provided otherwise.
    
    Mr. Geiger is entitled to receive a one-time lump sum advance of
$300,000, representing a pre-payment of $60,000 against any monies
otherwise becoming payable to Mr. Geiger under ARTISTdirects
executive performance bonus pool for each year of the initial
five-year term of the amended agreement.
    
    The amended agreement provides for the payment of $1,000,000 plus one
years salary (or whatever shorter period remains in the term of the
amended agreement) upon the termination of Mr. Geigers employment if
the termination was:  (1)
    
    other than due to a disability,(2)
    
    other than for cause, such as the commission of a felony,
fraud or embezzlement, gross negligence or willful misconduct in the
performance of duties, material breach of the amended agreement, or
misappropriation of a corporate opportunity, 48




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(3)
    
    other than due to Mr. Geigers death, or(4)
    
    for good reason, such as a material and substantial reduction
in title, responsibilities or duties, a reassignment of location, or
a material breach of ARTISTdirects obligations to Mr. Geiger.  
    
    If Mr. Geigers employment is terminated for cause or he resigns for
other than good reason, he must repay ARTISTdirect within 30 days the
amount, if any, by which the $300,000 advance exceeds the lesser of
(1) the amount earned by him under the executive performance bonus
pool or (2) the product of $5,000 and the number of full months that
have elapsed between July 1, 2001 and the employment termination date.  
    
    The amended agreement provides that prior to the termination of his
employment, Mr. Geiger is prohibited from competing with ARTISTdirect.
In addition, for a period of one year after the expiration of the
amended agreement, Mr. Geiger is prohibited from hiring any of
ARTISTdirects employees. From November 1, 2002, Mr. Geiger has elected to defer 50% of the salary
that he would have earned under his employment agreement with ARTISTdirect. In
December 2002, ARTISTdirect amended Mr. Geigers employment agreement to
provide that the amount of Mr. Geigers deferred salary, net of applicable tax
withholdings, will be paid in a cash lump sum by ARTISTdirect within thirty
days after the consummation of a private financing of at least $20,000,000 or,
if earlier, the occurrence of (i) a merger, consolidation, sale of fifty
percent (50%) or more of the voting securities or sale of all or substantially
all of the assets of ARTISTdirect, (ii) Mr. Geigers attainment of age 65, or
(iii) the termination of Mr. Geigers employment with ARTISTdirect. Effective May 31, 2003, Mr. Geiger resigned as an officer of the Company,
although he remains as a director of the Company. Mr. Geigers July 2001
amended employment agreement, which had an initial term extending through June
30, 2006, provided for an annual salary of $500,000 plus certain benefits. The
amended employment agreement also provided that under certain conditions, Mr.
Geiger would receive a payment of $1,000,000 plus one years salary upon the
termination of his employment with the Company. In February 2001, the Company
loaned Mr. Geiger $150,000, with interest at 7%. The term of the loan was
initially one year, but was extended in September 2001 to five years
commensurate with the amendment of Mr. Geigers employment agreement in July
2001. Mr. Geiger was obligated to repay the loan in five equal annual
principal payments of $30,000, along with accrued interest to date, beginning
in September 2002. In consideration for Mr. Geiger terminating his employment
agreement effective as of the date of his resignation and waiving all rights to
compensation under the employment agreement, we paid Mr. Geiger his accrued
compensation and benefits of approximately $184,000, and Mr. Geiger repaid the
$150,000 loan plus accrued interest. Keith Yokomoto In July 2001, ARTISTdirect entered into an employment agreement with Keith
Yokomoto, its President and Chief Operating Officer, which provides for the
following:  
    
    Mr. Yokomoto is paid an annual salary of $500,000 (to be reviewed
annually for any increases by ARTIST directs Compensation Committee
in consultation with ARTISTdirects Chief Executive Officer), is
entitled to four weeks vacation each year, and is eligible to
participate in ARTISTdirects executive performance bonus pool and in
the Artists & Repertoire Bonus Plan of ARTISTdirect Records, LLC.  
    
    The initial term of the agreement expires June 30, 2006. Beginning
July 1, 2006, and on each anniversary, the term of the agreement will
automatically be extended for an additional one-year period unless
written notice is provided otherwise.  
    
    Mr. Yokomoto is entitled to receive a one-time lump sum advance of
$300,000, representing a pre-payment of $60,000 against any monies
otherwise becoming payable to Mr. Yokomoto under the executive
performance bonus pool for each year of the initial five-year term of
the agreement.  
    
    Mr. Yokomoto also is entitled to receive a performance-based stock
option to purchase shares of ARTISTdirects common stock at a per
share exercise price equal to the fair market value of its common
stock on the date of the option grant. The exact number of shares and
terms of the stock option will be determined by the Compensation
Committee in consultation with ARTISTdirects Chief Executive Officer.  
    
    The agreement provides for the payment of $350,000 plus one years
salary (or whatever shorter period remains in the 49




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term of the
agreement) upon the termination of Mr. Yokomotos employment if the
termination was:  (1)
    
    other than due to a disability,(2)
    
    other than for cause, such as the commission of a felony,
fraud or embezzlement, gross negligence or willful misconduct in the
performance of duties, material breach of the agreement, or
misappropriation of a corporate opportunity,(3)
    
    other than due to Mr. Yokomotos death, or(4)
    
    for good reason, such as a material and substantial
reduction in title, responsibilities or duties, a reassignment of
location, or a material breach of ARTISTdirects obligations to Mr.
Yokomoto.  
    
    If Mr. Yokomotos employment is terminated for cause or he resigns for
other than good reason, he must repay ARTISTdirect within 30 days the
amount, if any, by which the $300,000 advance exceeds the lesser of
(1) the amount earned by him under the executive performance bonus
pool or (2) the product of $5,000 and the number of full months that
have elapsed between July 1, 2001 and the employment termination date.  
    
    The agreement provides that prior to the termination of his
employment, Mr. Yokomoto is prohibited from competing with
ARTISTdirect. In addition, for a period of one year after the
expiration of the agreement, Mr. Yokomoto is prohibited from hiring
any of ARTISTdirects employees. From August 1, 2002 through August 31, 2002, Mr. Yokomoto has elected to
defer 33% of the salary that he would have earned under his employment
agreement with ARTISTdirect, and from September 1, 2002, Mr. Yokomoto has
elected to defer 50% of the salary that he was due to receive. In December
2002, ARTISTdirect amended Mr. Yokomotos employment agreement to provide that
the amount of Mr. Yokomotos deferred salary, net of applicable tax
withholdings, will be paid in a cash lump sum by ARTISTdirect within thirty
days after the consummation of a private financing of at least $20,000,000 or,
if earlier, the occurrence of (i) a merger, consolidation, sale of fifty
percent (50%) or more of the voting securities or sale of all or substantially
all of the assets of ARTISTdirect, (ii) Mr. Yokomotos attainment of age 65, or
(iii) the termination of Mr. Yokomotos employment with ARTISTdirect. Effective December 31, 2003, Mr. Yokomoto entered into a Termination
Agreement and Mutual General Release. Mr. Yokomoto remains as a director of
the Company. Mr. Yokomotos July 2001 employment agreement, which had an
initial term extending through June 30, 2006, provided for an annual salary of
$500,000 plus certain benefits, and a commencement advance of $300,000,
representing a pre-payment of $60,000 against any monies that would otherwise
become payable to Mr. Yokomoto under the Companys executive performance bonus
pool for each year of the initial five-year term of the employment agreement.
The employment agreement also provided that under certain conditions, Mr.
Yokomoto would receive a payment of $350,000 plus one years salary upon the
termination of his employment with the Company. In consideration for Mr.
Yokomoto terminating his employment agreement effective as of December 31, 2003
and waiving all rights to $1.25 million of remaining compensation under the
employment agreement, we paid Mr. Yokomoto his accrued but unpaid salary at the
rate of $500,000 per year through December 31, 2003 aggregating $412,847 and
his accrued but unused vacation pay through December 31, 2003 aggregating
$76,924, and Mr. Yokomoto repaid us the unearned portion of the commencement
advance of $150,000. Effective January 1, 2004, we entered into a one-year consulting agreement
with Mr. Yokomoto. Under this consulting agreement, we will pay Mr. Yokomoto
$120,000 per year in twelve equal installments in exchange for 20 hours of
services per week as determined by the Company but consisting of assistance in
connection with business development and corporate strategy, efforts to secure
financing, implementation of a digital music initiative, and coordinating
advertising and sales activities. Mr. Yokomoto also receives 10,000
immediately exerciseable options and 50,000 options which become exerciseable
upon accomplishing certain milestones. These options are exerciseable at $0.50
per share. Mr Yokomoto also agreed, prior to the date that is one year after
the termination of this Agreement, not to hire or offer to hire any officer,
employee, agent, client, performer or songwriter of the Company to discontinue
his or her relationship with the Company. 
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS The following table sets forth certain information known to ARTISTdirect
with respect to the beneficial ownership of ARTISTdirects common stock as of
April 23, 2004 by (i) all persons who are beneficial owners of five percent
(5%) or 50




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more of ARTISTdirects common stock, (ii) each current director, (iii) the
executive officers named in the Summary Compensation Table of the Executive
Compensation section of this Form 10-K/A and (iv) all current directors and
executive officers as a group. As of April 23, 2004, there were 3,502,117
shares of common stock outstanding. Unless otherwise indicated, each of the
stockholders has sole voting and investment power with respect to the shares
beneficially owned, subject to community property laws, where applicable. PercentageShares
    
    of SharesBeneficially
    
    BeneficiallyBeneficial Owner
    
    Owned
    
    Owned (1)Entities
affiliated with Constellation Venture Capital, L.P. (2)575
Lexington AvenueNew York, New York 10022
    
    
    275,113
    
    
    
    7.9
    %Universal
Music Group, Inc.2220 Colorado AvenueSanta Monica, California 90404
    
    
    312,500
    
    
    
    8.9
    %Donald P. Muller c/o Creative Artists Agency 9830 Wilshire Blvd
Beverly Hills, California 90212
    
    
    329,177
    
    
    
    9.4
    %Rick Rubin c/o Alan S. Halfon & Company 9595 Wilshire Boulevard,
Suite 505Beverly Hills, California 90212
    
    
    362,022
    
    
    
    10.3
    %Coghill Capital Management, L.L.COne North Wacker Drive, Suite 4725
Chicago, Illinois 60606
    
    
    263,165
    
    
    
    7.5
    %Frederick W. Field (3)
    
    
    302,370
    
    
    
    8.6
    %Jonathan V. Diamond (4)
    
    
    259,659
    
    
    
    6.9
    %Marc P. Geiger
    
    
    337,740
    
    
    
    9.6
    %Keith K. Yokomoto (5)
    
    
    188,905
    
    
    
    5.3
    %Stephen M. Krupa (6)
    
    
    88,746
    
    
    
    2.5

    %Benjamin S. A. Moody (7)
    
    
    10,150
    
    
    
    *All current directors and executive officers as a group (7 persons) (8)
    
    
    1,190,284
    
    
    
    29.3
    %
   *
    
    Represents less than 1%.  (1)
    
    Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and includes voting or investment power
with respect to the securities. Common stock subject to options or
warrants that are currently exercisable or exercisable within 60 days of
March 17, 2003 are deemed to be outstanding and to be beneficially owned
by the person or group holding such options or warrants for the purpose of
computing the percentage ownership of such person or group but are not
treated as outstanding for the purpose of computing the percentage
ownership of any other person or group. Unless otherwise indicated, the
address for each of the individuals listed in the table is care of
ARTISTdirect, Inc., 10900 Wilshire Boulevard, Suite 1400, Los Angeles,
California, 90024. Unless otherwise indicated by footnote, the persons
named in the table have sole voting and sole investment power with respect
to all shares of ARTISTdirect common stock shown as beneficially owned by
them, subject to applicable community property laws. Percentage of
beneficial ownership is based on 3,502,117 shares of common stock
outstanding as of April 23, 2004 and reflects the effect of ARTISTdirects
rescission offer that was consummated in December 2001, pursuant to which
ARTISTdirect purchased approximately 83,403 shares of its common stock, as
well as the effect of ARTISTdirects one-for-ten reverse stock split
effected in July 2001.(2)
    
    Consists of (a) 226,379 shares held by Constellation Venture Capital,
L.P. and (b) 48,734 shares held by Constellation Ventures (BVI), Inc. One
of ARTISTdirects former directors, Clifford Friedman, is President and
Chief Executive Officer of Constellation Ventures (BVI), Inc. and a member
of Constellation Ventures Management, LLC, the general partner of
Constellation Venture Capital, L.P. As such, Mr. Friedman may be deemed to
exercise voting and investment power over such shares. Mr. Friedman
disclaims beneficial ownership of such shares, except to the extent of his
proportionate interest therein.(3)
    
    Consists of 302,370 shares subject to immediately exercisable options.(4)
    
    Consists of 259,659 shares subject to immediately exercisable options.(5)
    
    Includes (a) 37,102 shares held by Mr. Yokomoto as trustee of the Geiger
Childrens Trust, (b) 37,102 shares held by Mr. Yokomoto as trustee of the
Muller Childrens Trust and (c) 10,000 shares subject to immediately
exercisable options. Mr. Yokomoto has sole voting and dispositive power
over these shares. Mr. Yokomoto disclaims beneficial ownership of these shares. 51




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(6)
    
    Consists of (a) 78,353 shares held by Psilos Group Partners, L.P., (b)
393 shares held by Psilos Group Investors, LLC and (c) 10,000 shares
subject to immediately exercisable options. Mr. Krupa is a member of
Psilos Group Investors, LLC, which is the general partner of Psilos Group
Partners, L.P. As such, Mr. Krupa may be deemed to exercise voting and
investment power over such shares. Mr. Krupa disclaims beneficial
ownership of such shares, except to the extent of his proportionate
interest therein.(7)
    
    Includes 10,000 shares subject to immediately exercisable options.(8)
    
    Includes the information set forth in notes 3-7 above. Equity Compensation Plan Information The following table provides information as of December 31, 2003 with
respect to the shares of our common stock that may be issued under our existing
equity compensation plans. The table does not include information with respect
to shares subject to outstanding options granted under equity compensation
plans assumed by ARTISTdirect in connection with mergers and acquisitions of
the companies that originally granted those options. Footnote (6) to the table
sets forth the total number of shares of our common stock issuable upon the
exercise of those assumed options as of December 31, 2003, and the weighted
average exercise price of those options. We do not intend to grant further
options under those assumed plans. A
    
    B
    
    CNumber of Securities RemainingAvailable for Future IssuanceNumber of Securities to be
    
    Weighted Average
    
    Under Equity CompensationIssued Upon Exercise of
    
    Exercise Price of
    
    Plans (Excluding SecuritiesOutstanding Options
    
    Outstanding Options
    
    Reflected in Column A)Equity Compensation
Plans Approved by
Shareholders (1)
    
    
    444,480
    (3)
    
    $
    7.50
    
    
    
    112,831
    (4)Equity Compensation
Plans Not Approved
by Shareholders (2)
    
    
    430,997
    
    
    $
    3.82
    
    
    
    1,614,119
    (5)Total
    
    
    875,477
    
    
    $
    5.69
    
    
    
    1,726,950
   (1)
    
    Consists solely of the 1999 Employee Stock Purchase Plan and the stock
options granted to our Chairman and former Chief Executive Officer,
Frederick Field, as part of an individual compensation arrangement in
connection with his initial employment agreement with ARTISTdirect.(2)
    
    Consists solely of the 1999 Employee Stock Option Plan, the 1999 Artist
Stock Option Plan, the 1999 Artist and Artist Advisor Stock Option Plan
and the stock options granted to our current Chief Executive Officer,
Jonathan Diamond, as part of an individual compensation arrangement in
connection with his initial employment agreement with ARTISTdirect..(3)
    
    Excludes purchase rights accruing under ARTISTdirects 1999 Employee
Stock Purchase Plan that has a shareholder approved initial reserve of
50,000 shares. Under the Purchase Plan, each eligible employee may
purchase up to 75 shares of common stock at semi-annual intervals on the
last business day of April and October each year at a purchase price per
share equal to 85% of the lower of (i) the fair market value per share of
common stock on the employees entry date into the two-year offering
period in which that semi-annual purchase date occurs or (ii) the fair
market value per share on the semi-annual purchase date.(4)
    
    Consists of shares available for future issuance under the 1999 Employee
Stock Purchase Plan. As of December 31, 2003, an aggregate of 112,831
shares of common stock were available for issuance under the 1999 Employee
Stock Purchase Plan. The number of shares of common stock available for
issuance under the 1999 Employee Stock Purchase Plan automatically
increases on the first trading day of January each calendar year by an
amount equal to 1.0% of the total number of shares of common stock
outstanding on the last trading day of December in the immediately
preceding calendar year, but in no event will any such annual increase
exceed 25,000 shares of common stock.(5)
    
    Consists of shares available for future issuance under the 1999 Employee
Stock Option Plan, the 1999 Artist Stock Option Plan and the 1999 Artist
and Artist Advisor Stock Option Plan. As of December 31, 2003, an
aggregate of 52




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758,492 shares of common stock were available for issuance under the 1999
Employee Stock Option Plan, 596,546 shares of common stock were available for
issuance under the 1999 Artist Stock Option Plan and 259,081 shares of common
stock were available for issuance under the 1999 Artist and Artist Advisor
Stock Option Plan. The number of shares of common stock available for
issuance under each of the 1999 Employee Stock Option Plan and the 1999
Artist Stock Option Plan automatically increases on the first trading day of
January each calendar year by an amount equal to 2.0%, respectively, of the
total number of shares of common stock outstanding on the last trading day of
December in the immediately preceding calendar year, but in no event will any
such annual increase exceed 87,500 shares of common stock, respectively. The
number of shares of common stock available for issuance under the 1999 Artist
and Artist Advisor Stock Option Plan automatically increases on the first
trading day of January each calendar year by an amount equal to 1.0% of the
total number of shares of common stock outstanding on the last trading day of
December in the immediately preceding calendar year, but in no event will any
such annual increase exceed 37,500 shares of common stock. We do not intend
to grant further options under the 1999 Artist Stock Option Plan or the 1999
Artist and Artist Advisor Stock Option Plan.(6)
    
    The table does not include information for the Audio Explosion 1998 Stock
Option Plan and the Mjuice.com, Inc. 1999 Stock Option Plan that we
assumed in connection with our August 2000 acquisition of Mjuice.com, Inc.
As of December 31, 2003, no shares of our common stock were issuable upon
exercise of outstanding options under those assumed plans. We do not
intend to grant further options under those assumed plans. The 1999 Employee Stock Option Plan The 1999 Employee Stock Option Plan became effective on October 6, 1999 in
connection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc.
All options to purchase membership units in the limited liability company which
were outstanding at the time of such conversion were assumed by the corporation
and converted into options for shares of our common stock. The number of shares
subject to each assumed and converted option was equal to the number of
membership units in the limited liability company which were subject to that
option immediately prior to the conversion, and the exercise price per share
remained the same as the per 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 shares of our common stock, each option will continue to be
governed by the terms of the agreement evidencing that option at the time of
our conversion into a corporation. The 1999 Employee Stock Option Plan is a non-shareholder approved plan
under which options may be granted to employees, non-employee members of our
Board of Directors, and consultants and other independent advisors in our
employ or service. The number of shares of common stock issuable over the term
of the 1999 Employee Stock Option Plan was initially 650,000 shares and
increased by 75,592 shares and 69,235 shares on January 1, 2002 and 2003,
respectively, for a total of 870,420 on December 31, 2003 (subject to
adjustment for certain changes in our capital structure). The share reserve
will automatically increase on the first trading day in January each calendar
year by an amount equal to 2.0% of the total number of shares of our common
stock outstanding on the last trading day in December in the immediately
preceding calendar year, but in no event will any such annual increase exceed
87,500 shares. All option grants under the 1999 Employee Stock Option Plan will have an
exercise price per share equal to the fair market value per share of our common
stock on the grant date. Each option will vest in installments over the
optionees period of service with ARTISTdirect. The options will vest on an
accelerated basis in the event ARTISTdirect is acquired and those options are
not assumed or replaced by the acquiring entity. The options that were granted
while we were a limited liability company, however, will terminate in the event
ARTISTdirect is acquired and those options are not assumed by the acquiring
entity (unless their vesting is accelerated by our Compensation Committee).
Each option will have a maximum term (not to exceed 10 years) set by the plan
administrator (our Compensation Committee) at the time of grant, subject to
earlier termination following the optionees cessation of employment. All
options are non-statutory options under the Federal tax law, unless they are
incentive stock options granted to employees. The 1999 Artist Stock Option Plan The 1999 Artist Stock Option Plan became effective on October 6, 1999 in
connection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc.
All options to purchase membership units in the limited liability company which
were outstanding at the time of such conversion were assumed by the corporation
and converted into options for shares of our common stock. The number of shares
subject to each assumed and converted option was equal to the number of
membership units in the limited liability company which were subject to that
option immediately prior to the conversion, and the exercise price per share
remained the same as the per 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 shares of our common stock, 53




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each option will continue to be governed by the terms of the agreement
evidencing that option at the time of our conversion into a corporation. The 1999 Artist Stock Option Plan is a non-shareholder approved plan under
which options were granted to performing artists who provided products and
services through the ARTISTchannel Web 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 Artist Stock Option Plan was initially
400,000 shares and increased by 75,592 shares and 69,235 shares on January 1,
2002 and 2003, respectively, for a total of 620,420 as of December 31, 2003
(subject to adjustment for certain changes in our capital structure). The share
reserve will automatically increase on the first trading day in January each
calendar year by an amount equal to 2.0% of the total number of shares of our
common stock outstanding on the last trading day in December in the immediately
preceding calendar year, but in no event will any such annual increase exceed
87,500 shares. All option grants under the 1999 Artist Stock Option Plan have an exercise
price per share equal to the fair market value per share of our common stock on
the grant date. Each option vests in installments over the period the
optionees ARTISTchannel agreement remains in effect. The options will vest on
an accelerated basis in the event ARTISTdirect is acquired and those options
are not assumed or replaced by the acquiring entity. Each option has a maximum
term (not to exceed 10 years) set by the plan administrator (our Compensation
Committee) at the time of grant, subject to earlier termination following the
termination of the optionees ARTISTchannel agreement. All options are
non-statutory options under the Federal tax law. The 1999 Artist and Artist Advisor Stock Option Plan The 1999 Artist and Artist Advisor Stock Option Plan became effective on
October 6, 1999 in connection with our conversion from ARTISTdirect, LLC into
ARTISTdirect, Inc. All options to purchase membership units in the limited
liability company which were outstanding at the time of such conversion were
assumed by the corporation and converted into options for shares of our common
stock. The number of shares subject to each assumed and converted option was
equal to the number of membership units in the limited liability company which
were subject to that option immediately prior to the conversion, and the
exercise price per share remained the same as the per 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 shares of our common stock, each
option will continue to be governed by the terms of the agreement evidencing
that option at the time of our conversion into a corporation. The 1999 Artist and Artist Advisor Stock Option Plan is a non-shareholder
approved plan under which options were granted to performing artists and their
attorneys, business managers, agents and other advisors who provided services
to us. The number of shares of common stock issuable over the term of the 1999
Artist and Artist Advisor Stock Option Plan was initially 185,000 shares and
increased by 37,500 and 34,617 shares on January 1, 2002 and 2003, respectively
to a total of 294,617 as of December 31, 2003 (subject to adjustment for
certain changes in our capital structure). The share reserve will automatically
increase on the first trading day in January each calendar year by an amount
equal to 1.0% of the total number of shares of our common stock outstanding on
the last trading day in December in the immediately preceding calendar year,
but in no event will any such annual increase exceed 37,500 shares. All option grants under the 1999 Artist and Artist Advisor Stock Option
Plan have an exercise price per share equal to the fair market value per share
of our common stock on the grant date. Each option vests in installments over
the optionees period of service with ARTISTdirect. The options will vest on an
accelerated basis in the event ARTISTdirect is acquired and those options are
not assumed or replaced by the acquiring entity. Each option has a maximum term
(not to exceed 10 years) set by the plan administrator (our Compensation
Committee) at the time of grant, subject to earlier termination following the
termination of the optionees service for cause. All options are non-statutory
options under the Federal tax law. Share issuances under the 1999 Employee Stock Option Plan, the 1999 Artist
Stock Option Plan and the 1999 Artist and Artist Advisor Stock Option Plan will
not reduce or otherwise affect the number of shares of common stock available
for issuance under the 1999 Employee Stock Purchase Plan, and share issuances
under 1999 Employee Stock Purchase Plan will not reduce or otherwise affect the
number of shares of common stock available for issuance under the 1999 Employee
Stock Option Plan, the 1999 Artist Stock Option Plan and the 1999 Artist and
Artist Advisor Stock Option Plan. 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Since January 1, 2003 there has not been any transaction or series of
similar transactions to which ARTISTdirect was or is a party in which the
amount involved exceeded or exceeds $60,000 and in which any director,
executive officer, 54




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holder of more than 5% of any class of our voting securities, or any
member of the immediate family of any of the foregoing persons had or will have
a direct or indirect material interest, other than as set forth above under
Executive Compensation or as described below. Sublease with Frederick Field Affiliate We relocated our administrative offices to a site leased by a company
owned by Ted Field. We sub-lease these offices on a month-to-month basis.
During the year ended December 31, 2003, we accrued $56,000 as rent expense,
which represents occupancy costs for September through December 2003. ARTISTdirect Records Financing As of December 31, 2003, ARTISTdirect Records had received $898,000 and
$100,000 of loans from Ted Field and Jonathan V. Diamond, respectively. The
Notes accrue interest at 8% per annum, are due two years from the date of
issuance, and will be converted into new equity of ARTISTdirect Records as part
of its next equity financing. Mr. Field and Mr. Diamond also received warrants
with a term of five years to purchase additional equity of the Company at $0.01
per unit equivalent to the number of units of new equity into which their
Bridge Notes are ultimately converted. Diamond Employment Agreement In September 2003, we entered into an employment agreement with Jonathan
Diamond in connection with his appointment as our chief executive officer. See
the section above titled Employment Contracts, Termination of Employment and
Change in Control Arrangements for information on these agreements. Termination Agreements In the 2003 fiscal year, we entered into agreements with Keith Yokomoto
and Marc Geiger to terminate their officer positions. See the section above
titled Employment Contracts, Termination of Employment and Change in Control
Arrangements for information on these agreements. Yokomoto Consulting Agreement. On January 1, 2004, we entered into a consulting agreement with a
director, Keith Yokomoto, to provide services on a part-time basis for one
year. See the section above titled Employment Contracts, Termination of
Employment and Change in Control Arrangements for information on these
agreement. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Audit and Audit Related Fees: KPMG LLP (KPMG) was our independent accountant for the year ended
December 31, 2002 and for the interim periods ended September 30, 2003.
Services provided to us by KPMG with respect to such periods consisted
primarily of the audit of our financial statements and the financial statements
of ARTISTdirect Records, LLC and limited reviews of the Form 10-QSB Quarterly
Reports for the interim periods included therein pursuant to Statement on
Auditing Standards No. 100. Charges by KPMG with respect to these matters
aggregated approximately $42,000 and $217,500, respectively, for the years
ended December 31, 2003 and 2002. Gumbiner,
Savett, Finkel, Fingleson & Rose, Inc. (GSFFR) was our
independent accountant in preparing financial statements for the year
ended December 31, 2003. Services provided to us by GSFFR with
respect to such periods consisted primarily of the audit of our
financial statements and the financial statements of ARTISTdirect
Records, LLC. Charges billed to date by GSFFR with respect to these
matters aggregated approximately $47,060 for the year ended
December 31, 2003. Tax Fees: KPMG prepared the corporate income tax returns for our company and for
ARTISTdirect Records for the year ended December 31, 2002. Charges by KPMG
with respect to these matters aggregated approximately $24,250 for the year
ended December 31, 2002. Charges
billed to date by GSFFR for tax matters was $1,155 for the year ended
December 31, 2003. Pre-Approval Policies and Procedures: The Audit Committee meets periodically to review and approve the scope of
the services to be provided to us by our independent accountant, as well to
review and discuss any issues that may arise during an engagement. The Audit
Committee considers various issues with respect to the services to be provided
by our independent accountant, including the complexity of any engagement, its expected cost, the knowledge and
expertise of the independent accountants staff, any complex accounting or
disclosure issues, new accounting pronouncements, and the capability of our
financial staff. 55




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PART IV 
 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1). FINANCIAL STATEMENTS ARTISTdirect financial statements appear in a separate section of this
Annual Report on Form 10-K beginning on the pages referenced below: ARTISTdirect, Inc. and Subsidiaries Consolidated Financial Statements  Independent Auditors Report
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Changes in Stockholders Deficiency
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
    59
60
61
63
64
65 (2) FINANCIAL STATEMENT SCHEDULES Financial statement schedules have been omitted as they are not
applicable, not required, or the information is included in the consolidated
financial statements or the notes thereto. (3) EXHIBITS A list of exhibits required to be filed as part of this Annual Report on
Form 10-K is set forth in the Index to Exhibits, which immediately precedes
such exhibits, and is incorporated herein by reference. (b) REPORTS ON FORM 8-K  (1)
    
    A Form 8-K was filed on February 20, 2004 to report that we retained
Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. as our independent accountant.(2)
    
    A Form 8-K was filed on February 12, 2004 to report that we
dismissed KPMG LLP as our independent accountant. 56




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized. ARTISTDIRECT, INC.Date: May 13, 2004By:      /s/ Jonathan V.
DiamondJonathan V. DiamondChief Executive Officer
 We, the undersigned officers and directors of ARTISTdirect, Inc., do
hereby constitute and appoint Jon Diamond and Robert Weingarten and each of
them, our true and lawful attorneys-in-fact and agents, each with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all amendments to this Report, and to
file the same, with exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite or necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all that each of said
attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do
or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated. Signature
    
    Title
    
    DateChairman of the Board
    
    May 13, 2004/s/  Frederick W. FieldFrederick W. FieldPresident and Chief Executive Officer and Director
    
    May 13, 2004/s/  Jonathan V. DiamondJonathan V. DiamondChief Financial Officer
    
    May 13, 2004/s/  Robert N. WeingartenRobert N. WeingartenDirector
    
    May 13, 2004/s/  Marc P. GeigerMarc P. GeigerDirector
    
    May 13, 2004/s/  Keith YokomotoKeith YokomotoDirector
    
    May 13, 2004/s/  Stephen KrupaStephen KrupaDirector
    
    May 13, 2004/s/  Benjamin MoodyBenjamin Moody
 57




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ARTISTDIRECT, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003 PAGEIndependent Auditors Report- Gumbiner, Savett, Finkel, Fingleson & Rose, Inc.
    
    
    59Consolidated Balance Sheets  December 31, 2002 and 2003
    
    
    60Consolidated Statements of Operations  Years Ended December 31, 2001, 2002 and 2003
    
    
    61Consolidated Statements of Comprehensive Loss  Years Ended December 31, 2001, 2002 and 2003
    
    
    62Consolidated Statements of Changes in Stockholders Equity (Deficiency)  Years Ended December 31, 2001, 2002 and 2003
    
    
    63Consolidated Statements of Cash Flows  Years Ended December 31, 2001, 2002 and 2003
    
    
    64Notes to Consolidated Financial Statements  Years Ended December 31, 2001, 2002 and 2003
    
    
    65
 58




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INDEPENDENT AUDITORS REPORT To the Board of Directors
ARTISTdirect, Inc. We have audited the accompanying consolidated balance sheet of ARTISTdirect,
Inc. and subsidiaries (the Company) as of December 31, 2003 and the related
consolidated statements of operations, comprehensive income (loss),
stockholders equity (deficiency) and cash flows for the year then ended.
These financial statements are the responsibility of the Companys management.
Our responsibility is to express an opinion on these consolidated financial
statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of ARTISTdirect,
Inc. and subsidiaries as of December 31, 2003 and the consolidated results of
their operations and their cash flows for the year then ended, in conformity
with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, as of December
31, 2003 the Company changed its method of accounting for its investment in its
record label joint venture, ARTISTdirect Records, LLC. The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note 1,
the Company has incurred substantial operating losses and negative cash flows
from operations to date. The Company needs additional capital to fund its
operations. As of December 31, 2003, the Company has a net working capital
deficiency of $9,464,000 and stockholders deficiency of $16,945,000. These
conditions raise substantial doubt about the Companys ability to continue as a
going concern. Managements plans in regard to these matters are also
described in Note 1. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty. /s/ GUMBINER, SAVETT, FINKEL, FINGLESON & ROSE, INC. Santa Monica, California
April 6, 2004 59




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ARTISTDIRECT, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR SHARE DATA) December 31,
    
    December 31,2002
    
    2003 (see Note 1)AssetsCurrent assets:Cash and cash equivalents
    
    $
    1,910
    
    
    $
    726Restricted cash
    
    
    2,157
    
    
    
    350Short-term investments
    
    
    6,124
    
    
    
    1,022Accounts receivable, net
    
    
    426
    
    
    
    297Prepaid expenses and other current assets
    
    
    1,220
    
    
    
    289Total current assets
    
    
    11,837
    
    
    
    2,684Property and equipment, net
    
    
    3,629
    
    
    
    307Investments in affiliated companies
    
    
    64
    
    
    
    Other assets
    
    
    395
    
    
    
    15$
    15,925
    
    
    $
    3,006Liabilities and Stockholders Equity (Deficiency)Current liabilities:Accounts payable
    
    $
    493
    
    
    $
    1,116Accrued expenses
    
    
    3,018
    
    
    
    2,283Net liability to BMG
    
    
    
    
    
    
    8,749Deferred revenue
    
    
    144
    
    
    
    Total current liabilities
    
    
    3,655
    
    
    
    12,148Non-current liabilities:Liability associated with record label joint venture
    
    
    7,699
    
    
    
    Deferred rent and other long-term liabilities
    
    
    1,117
    
    
    
    Bridge notes
payable - outside investors
    
    
    
    
    
    
    755Bridge notes payable - related party
    
    
    
    
    
    
    539Loan due to BMG, a distributor and a related party
    
    
    
    
    
    
    5,197Total liabilities
    
    
    12,471
    
    
    
    18,639Minority
interest
    
    
    
    
    
    
    1,312Commitments
interestStockholders equity (deficiency):Preferred stock, $0.01 par value Authorized  5,000,000Issued and outstanding - none
    
    
    
    
    
    
    Common stock, $0.01 par value -Authorized - 15,000,000 shares;Issued - 3,784,644 shares and 3,825,019 shares
in 2002 and 2003, respectivelyOutstanding - 3,461,742 shares and 3,502,117
shares in 2002 and 2003, respectively
    
    
    38
    
    
    
    38Treasury stock, 322,902 shares, at cost
    
    
    (3,442
    )
    
    
    (3,442
    )Additional paid-in-capital
    
    
    208,208
    
    
    
    209,128Unearned compensation
    
    
    (440
    )
    
    
    Accumulated deficit
    
    
    (200,978
    )
    
    
    (222,679
    )Unrealized gain on available for sale investments
    
    
    68
    
    
    
    10Total stockholders equity (deficiency)
    
    
    3,454
    
    
    
    (16,945
    )$
    15,925
    
    
    $
    3,006
 See accompanying notes to consolidated financial statements. 60




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ARTISTDIRECT, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR SHARE DATA) Years Ended December 31,2001
    
    2002
    
    2003 (see Note 1)Net revenue:E-Commerce
    
    $
    7,542
    
    
    $
    4,713
    
    
    $
    3,459Media
    
    
    2,879
    
    
    
    924
    
    
    
    1,173Record label
    
    
    
    
    
    
    613
    
    
    
    1,352Total net revenue
    
    
    10,421
    
    
    
    6,250
    
    
    
    5,984Cost of revenue:Direct cost of product sales
    
    
    6,137
    
    
    
    3,969
    
    
    
    3,118Other cost of revenue
    
    
    5,728
    
    
    
    3,687
    
    
    
    1,212Stock-based compensation
    
    
    8,405
    
    
    
    3,084
    
    
    
    33Total cost of revenue
    
    
    20,270
    
    
    
    10,740
    
    
    
    4,363Gross profit (loss)
    
    
    (9,849
    )
    
    
    (4,490
    )
    
    
    1,621Operating expenses:Web site development
    
    
    3,726
    
    
    
    53
    
    
    
    5Sales and marketing
    
    
    5,726
    
    
    
    2,224
    
    
    
    1,220General and administrative
    
    
    13,339
    
    
    
    7,527
    
    
    
    4,230Provision for doubtful accounts
    
    
    1,503
    
    
    
    42
    
    
    
    83Stock-based compensation
    
    
    12,415
    
    
    
    1,897
    
    
    
    527Depreciation and amortization
    
    
    6,512
    
    
    
    2,814
    
    
    
    1,014Loss from impairment of goodwill
    
    
    11,444
    
    
    
    788
    
    
    
    Loss from sale and abandonment of
property and equipment
    
    
    
    
    
    
    
    
    
    
    2,225Total operating costs
    
    
    54,665
    
    
    
    15,345
    
    
    
    9,304Loss from operations
    
    
    (64,514
    )
    
    
    (19,835
    )
    
    
    (7,683
    )Loss from equity investments
    
    
    (8,998
    )
    
    
    (29,252
    )
    
    
    (9,320
    )Interest income, net
    
    
    3,585
    
    
    
    748
    
    
    
    146Forgiveness of debt by officer
    
    
    
    
    
    
    
    
    
    
    411Loss from continuing operations
    
    
    (69,927
    )
    
    
    (48,339
    )
    
    
    (16,446
    )Income from discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Loss before cumulative effect of change in accounting
principles
    
    
    (69,880
    )
    
    
    (48,192
    )
    
    
    (16,446
    )Cumulative effect of consolidation of ARTISTdirect
Records, LLC
    
    
    
    
    
    
    
    
    
    
    (5,255
    )Net loss
    
    
    (69,880
    )
    
    
    (48,192
    )
    
    
    (21,701
    )Interest on rescission offer
    
    
    691
    
    
    
    
    
    
    
    Net loss attributable to common stockholders
    
    $
    (70,571
    )
    
    $
    (48,192
    )
    
    $
    (21,701
    )Net income (loss) per common share  basic and diluted:From continuing operations
    
    $
    (19.50
    )
    
    $
    (13.96
    )
    
    $
    (4.75
    )From discontinued operations
    
    
    0.01
    
    
    
    0.04
    
    
    
    From cumulative effect of consolidation of ARTISTdirect
Records, LLC
    
    
    
    
    
    
    
    
    
    
    (1.52
    )Net loss
    
    $
    (19.49
    )
    
    $
    (13.92
    )
    
    $
    (6.27
    )Weighted average number of common shares outstanding
    
    
    3,620,161
    
    
    
    3,461,057
    
    
    
    3,461,992Pro forma amounts, assuming the consolidation of
ARTISTdirect Records, LLC was applied retroactively:Loss from continuing operations
    
    $
    (69,927
    )
    
    $
    (52,106
    )
    
    $
    (17,934
    )Income from discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Net loss
    
    $
    (69,880
    )
    
    $
    (51,959
    )
    
    $
    (17,934
    )Net income (loss) per common share  basic and diluted:From continuing operations
    
    $
    (19.50
    )
    
    $
    (15.05
    )
    
    $
    (5.18
    )From discontinued operations
    
    
    0.01
    
    
    
    0.04
    
    
    
    Net loss
    
    $
    (19.49
    )
    
    $
    (15.01
    )
    
    $
    (5.18
    )
 See accompanying notes to consolidated financial statements. 61




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##### Table of Contents



ARTISTDIRECT, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(IN THOUSANDS) Years Ended December 31,20032001
    
    2002
    
    (see Note 1)NET LOSS
    
    $
    (69,880
    )
    
    $
    (48,192
    )
    
    $
    (21,701
    )Other comprehensive income (loss):Unrealized gain (loss) on
available for sale securities
    
    
    146
    
    
    
    (78
    )
    
    
    (58
    )COMPREHENSIVE LOSS
    
    $
    (69,734
    )
    
    $
    (48,270
    )
    
    $
    (21,759
    )
 See accompanying notes to consolidated financial statements. 62




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##### Table of Contents



ARTISTDIRECT, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIENCY)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS) Common Stock
    
    Treasury
    
    AdditionalPaid-InShares
    
    Amount
    
    Stock
    
    CapitalBalance at December 31, 2000
    
    
    3,779,608
    
    
    $
    38
    
    
    $
    
    
    
    $
    201,031Cancellation of options/warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,362
    )Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Reclassification of unearned
compensation to prepaid
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Repurchase of common stock
    
    
    (239,499
    )
    
    
    
    
    
    
    (2,734
    )
    
    
    Issuance of securities for employee
stock purchase plan
    
    
    3,902
    
    
    
    
    
    
    
    
    
    
    
    17Completion of rescission offer
    
    
    (83,403
    )
    
    
    
    
    
    
    (708
    )
    
    
    9,487Unrealized gain on available for
sale investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2001
    
    
    3,460,608
    
    
    
    38
    
    
    
    (3,442
    )
    
    
    208,173Issuance of options/warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of securities for employee
stock purchase plan
    
    
    1,134
    
    
    
    
    
    
    
    
    
    
    
    4Unrealized loss on available for
sale investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2002
    
    
    3,461,742
    
    
    
    38
    
    
    
    (3,442
    )
    
    
    208,208Issuance of warrants for legal
Settlement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    100Issuance of common stock for
services
    
    
    40,000
    
    
    
    
    
    
    
    
    
    
    
    20Amortization of unearned
Compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of securities for employee
stock purchase plan
    
    
    375
    
    
    
    
    
    
    
    
    
    
    
    Unrealized loss on available for sale
Securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Adjustment resulting from change to
consolidation from equity
accounting for ARTISTdirect
Records, LLC effective December
31, 2003
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    800Net lossBalance at December 31, 2003
(see Note 1)
    
    
    3,502,117
    
    
    $
    38
    
    
    $
    (3,442
    )
    
    
    209,128
   [Continued from above table, first column(s) repeated] Unrealized Gain(Loss) onAvailable
    
    TotalUnearned
    
    Accumulated
    
    for Sale
    
    EquityCompensation
    
    Deficit
    
    Securities
    
    (Deficiency)Balance at December 31, 2000
    
    $
    (20,364
    )
    
    $
    (82,906
    )
    
    $
    
    
    
    $
    97,799Cancellation of options/warrants
    
    
    2,362
    
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    14,547
    
    
    
    
    
    
    
    
    
    
    
    14,547Reclassification of unearned
compensation to prepaid
    
    
    2,710
    
    
    
    
    
    
    
    
    
    
    
    2,710Repurchase of common stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,734
    )Issuance of securities for employee
stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17Completion of rescission offer
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,779Unrealized gain on available for
sale investments
    
    
    
    
    
    
    
    
    
    
    146
    
    
    
    146Net loss
    
    
    
    
    
    
    (69,880
    )
    
    
    
    
    
    
    (69,880
    )Balance at December 31, 2001
    
    
    (745
    )
    
    
    (152,786
    )
    
    
    146
    
    
    
    51,384Issuance of options/warrants
    
    
    (31
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    336
    
    
    
    
    
    
    
    
    
    
    
    336Issuance of securities for employee
stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4Unrealized loss on available for
sale investments
    
    
    
    
    
    
    
    
    
    
    (78
    )
    
    
    (78
    )Net loss
    
    
    
    
    
    
    (48,192
    )
    
    
    
    
    
    
    (48,192
    )Balance at December 31, 2002
    
    
    (440
    )
    
    
    (200,978
    )
    
    
    68
    
    
    
    3,454Issuance of warrants for legal
Settlement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    100Issuance of common stock for
services
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    20Amortization of unearned
Compensation
    
    
    440
    
    
    
    
    
    
    
    
    
    
    
    440Issuance of securities for employee
stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Unrealized loss on available for sale
Securities
    
    
    
    
    
    
    
    
    
    
    (58
    )
    
    
    (58
    )Adjustment resulting from change to
consolidation from equity
accounting for ARTISTdirect
Records, LLC effective December
31, 2003
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    800Net loss
    
    
    
    
    
    
    (21,701
    )
    
    
    
    
    
    
    (21,701
    )Balance at December 31, 2003
(see Note 1)
    
    $
    
    
    
    $
    (222,679
    )
    
    $
    10
    
    
    $
    (16,945
    )
 See accompanying notes to consolidated financial statements. 63




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##### Table of Contents



ARTISTDIRECT, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS) Years Ended December 31,20032001
    
    2002
    
    (see Note 1)Cash flows from operating activities:Net loss
    
    $
    (69,880
    )
    
    $
    (48,192
    )
    
    $
    (21,701
    )Income from discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Loss from continuing operations
    
    
    (69,927
    )

    
    
    (48,339
    )
    
    
    (21,701
    )Adjustments to reconcile net loss to net cash used in operating activities:Cumulative effect of consolidation of ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    5,255Depreciation and amortization
    
    
    6,512
    
    
    
    2,814
    
    
    
    1,014Loss from equity investments
    
    
    8,998
    
    
    
    29,252
    
    
    
    9,320Forgiveness of debt by officer
    
    
    
    
    
    
    
    
    
    
    (411
    )Loss from impairment of goodwill
    
    
    11,444
    
    
    
    788
    
    
    
    Loss from sale and abandonment of property and equipment
    
    
    34
    
    
    
    
    
    
    
    2,225Provision for doubtful accounts and sales returns
    
    
    1,131
    
    
    
    226
    
    
    
    778Stock-based compensation
    
    
    20,820
    
    
    
    4,981
    
    
    
    560Changes in operating assets and liabilities, net of effects
from consolidation of ARTISTdirect Records, LLC:(Increase) decrease in -Accounts receivable
    
    
    647
    
    
    
    (306
    )
    
    
    (649
    )Prepaid expenses and other current assets
    
    
    328
    
    
    
    356
    
    
    
    886Other assets
    
    
    241
    
    
    
    (390
    )
    
    
    380Increase (decrease) in -Accounts payable, accrued expenses and other liabilities
    
    
    (2,449
    )
    
    
    (798
    )
    
    
    (2,929
    )Deferred revenue
    
    
    2
    
    
    
    108
    
    
    
    (144
    )Net cash used in continuing operations
    
    
    (22,219
    )
    
    
    (11,308
    )
    
    
    (5,416
    )Net cash provided by discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Net cash used in operating activities
    
    
    (22,172
    )
    
    
    (11,161
    )
    
    
    (5,416
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (840
    )
    
    
    (381
    )
    
    
    Proceeds from the sales of equipment
    
    
    60
    
    
    
    15
    
    
    
    123Sale/maturity of short-term investments, net
    
    
    17,996
    
    
    
    12,316
    
    
    
    5,045Loss from investments in affiliated companies
    
    
    (279
    )
    
    
    
    
    
    
    Advances to and investment in ARTISTdirect Records, LLC
    
    
    (5,300
    )
    
    
    (25,000
    )
    
    
    (2,750
    )Sale of equity interest in ARTISTdirect Records, LLC
    
    
    
    
    
    
    250
    
    
    
    Distribution of earnings from equity investment
    
    
    5
    
    
    
    
    
    
    
    Consolidation of ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    7Net cash provided by (used in) investing activities
    
    
    11,642
    
    
    
    (12,800
    )
    
    
    2,425Cash flows from financing activities:Repurchase of common stock
    
    
    (2,734
    )
    
    
    
    
    
    
    Rescission purchases of common stock and options
    
    
    (10,186
    )
    
    
    
    
    
    
    Change in restricted cash
    
    
    (3,008
    )
    
    
    851
    
    
    
    1,807Proceeds from employee stock purchase plan
    
    
    17
    
    
    
    4
    
    
    
    Net cash provided by (used in) financing activities
    
    
    (15,911
    )
    
    
    855
    
    
    
    1,807Cash and cash equivalents:Net decrease
    
    
    (26,441
    )
    
    
    (23,106
    )
    
    
    (1,184
    )At beginning of year
    
    
    51,457
    
    
    
    25,016
    
    
    
    1,910At end of year
    
    $
    25,016
    
    
    $
    1,910
    
    
    $
    726Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    11
    
    
    $
    
    
    
    $
    Cash paid for income taxes
    
    $
    
    
    
    $
    
    
    
    $
    
 See accompanying notes to consolidated financial statements. 64




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##### Table of Contents



ARTISTDIRECT, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003 1. BASIS OF PRESENTATION ORGANIZATION ARTISTdirect, Inc. (ADI) was formed on October 6, 1999 upon its merger
with ARTISTdirect, LLC (the Capital Reorganization). The Capital
Reorganization was only a change in the form of ownership of ADI. ARTISTdirect,
LLC was organized as a California limited liability company and commenced
operations on August 8, 1996. ARTISTdirect, LLC had a 99% ownership interest
in ARTISTdirect Agency LLC, Kneeling Elephant Records, LLC and ARTISTdirect New
Media, LLC (the Affiliated Companies) and has consolidated their results
since inception. On May 31, 2001, the Company, through its wholly-owned subsidiary,
ARTISTdirect Recordings, Inc., entered into an agreement to acquire a 50%
equity interest in a co-venture with Frederick W. (Ted) Field to form a new
record label, ARTISTdirect Records, LLC (ARTISTdirect Records). This
transaction became effective as of June 29, 2001. In April 2002, ADIs
ownership position in ARTISTdirect Records decreased to 45% as a result of a
sale of a 5% interest to BMG (see Note 11). However, ADIs ownership position
increased to 65% during 2002, as a result of ADIs agreement to accelerate its
funding commitment to ARTISTdirect Records in 2002 (see Note 11). Unless the context indicates otherwise, ARTISTdirect, Inc. and its
subsidiaries are referred to herein as the Company. BUSINESS ACTIVITIES The Company is a music entertainment company, headquartered in Los
Angeles, California, that combines an on-line music network and a record label
to provide an integrated offering for music fans, artists and marketing
partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web
sites offering multi-media content, music news and information, community
around shared music interests, music-related specialty commerce and digital
music services. Through the Companys subsidiary, ARTISTdirect Records, the
Company develops new musical artists and produces and distributes their
recordings as an independent label utilizing both traditional channels and
emerging Internet distribution channels. PRINCIPLES OF CONSOLIDATION The accompanying financial statements include the consolidated accounts of
ADI and its subsidiaries in which it has controlling interests. All
significant intercompany accounts and transactions have been eliminated for all
periods presented. ADI has recorded 100% of the losses attributable to
ARTISTdirect Records from May 31, 2001 through April 30, 2002 based on ADIs
commitment to fund 100% of ARTISTdirects operations during that time. From
May 1, 2002 through December 31, 2002, ADI recorded approximately 83% of the
losses of ARTISTdirect Records as a result of BMGs equity purchase and from an
assumption of a portion of ADIs funding commitment to the record label. For
the year ended December 31, 2003, ADI recorded approximately 73% of the losses
of ARTISTdirect Records. However, given that ADI did not have voting or
operational control, even with its majority ownership position in ARTISTdirect
Records, through December 31, 2003, ADI accounted for this investment under the
equity method of accounting as income (loss) from equity investments in the
consolidated statements of operations. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities. ADI adopted FIN 46 as of December 31, 2003. As a result of
the adoption of FIN 46, the balance sheet of ARTISTdirect Records was
consolidated as of December 31, 2003, and the operations of ARTISTdirect
Records will be consolidated beginning January 1, 2004 (see Notes 2 and 11). As a result of the consolidation of the balance sheet of ARTISTdirect
Records as of December 31, 2003, the Companys balance sheet as of December 31,
2003 is not directly comparable to its balance sheet as of December 31, 2002.
The cumulative effect of this change on prior years was to increase the loss
for 2003 by $5.3 million ($1.52 per share). The financial statements for 2002
have not been restated, and the cumulative effect of the change of $5.3 million
($1.52 per share) is shown as a one-time charge to operations in the 2003
statement of operations. 65




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##### Table of Contents



GOING CONCERN The Company has incurred losses and negative cash flows from operations in
every fiscal period since inception and has an accumulated deficit of $222.7
million as of December 31, 2003. For the year ended December 31, 2003, the
Company incurred a net loss of $21.7 million and negative operating cash flows
of $5.4 million. As of December 31, 2003, the Company had a net working
capital deficiency of $9.5 million and a stockholders deficiency of $16.9
million. Additionally, ADI has been funding substantially all of the
operations of ARTISTdirect Records. ADIs operations to date and loans to
ARTISTdirect Records have been funded by the sale of its preferred and common
stock. Management expects the Companys operating losses to continue for the
foreseeable future. The Company does not currently anticipate that its
available cash resources will be sufficient to meet anticipated capital needs
over the next twelve months without additional capital. The Company
restructured its operations, laid off most of its staff and reduced operating
costs during 2003, and is attempting to mitigate its funding obligation and
raise additional funding through various means. However, there can be no
assurances that the Company will be successful in this regard. If sufficient
capital is not available, then the Company may not be able to fund its
operations or its remaining funding commitment to ARTISTdirect Records.
Failure to raise additional capital could seriously harm the business of
ARTISTdirect Records and impair the value of the Companys investment in
ARTISTdirect Records. To the extent that the Company is unable to
successfully restructure its funding obligation and/or obtain the capital
necessary to fund its future cash requirements on a timely basis and under
acceptable terms and conditions, the Company will not have sufficient cash
resources to maintain operations, and may consider a formal or informal
restructuring or reorganization. The conditions described above raise
substantial doubt about the Companys ability to continue as a going concern.
The financial statements do not include any adjustments that might result from
the outcome of this uncertainty. 2. SIGNIFICANT ACCOUNTING POLICIES CASH EQUIVALENTS Cash equivalents consist of investments, which are readily convertible
into cash and have maturities of three months or less at the time of purchase. RESTRICTED CASH As of December 31, 2002, restricted cash consisted of a letter of credit
posted for the benefit of the Companys landlord of approximately $1.8 million
and a letter of credit posted for the benefit of the Companys e-commerce
credit card processor of $350,000. As of December 31, 2003, restricted cash
consisted of the letter of credit related to the e-commerce credit card
processor. SHORT-TERM INVESTMENTS The Company classifies its short-term investments as available-for-sale
and has recorded the investments at fair value, with the difference between
amortized cost and fair value being recorded as a component of stockholders
equity (deficiency). The Company invests primarily in fixed income securities
with maturities of one year or less at the time of purchase. DEPRECIATION Depreciation is provided using the straight-line method over the following
estimated useful lives as follows: Computer equipment and software
    
    3 yearsFurniture and fixtures
    
    7 yearsLeasehold improvements
    
    Lesser of estimated useful
life or term of lease (10 years)
 REVENUE RECOGNITION E-commerce revenue consists primarily of the gross amount of sales revenue
paid by the customer for recorded music and merchandise sold via the Internet,
including shipping fees, and is recognized when the products are shipped. The
Company records e-commerce revenue on a gross basis as the Company enters into
the sale transactions with customers, establishes the prices of the products,
chooses the suppliers of the products, assumes the risk of inventory loss and
collects all amounts from the customers and assumes the credit risk.
E-commerce revenue is subject to amounts due to the respective artists based on
their contracts, and such expense is recorded as part of direct cost of product
sales. 66




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The Company records amounts charged to customers for shipping and handling
in accordance with Emerging Issues Task Force No. 00-10, Accounting for
Shipping and Handling Fees and Costs (EITF No. 00-10). Pursuant to EITF No.
00-10, the Company records amounts charged to customers for shipping and
handling as revenue, and records the related costs incurred for shipping and
handling to direct cost of product sales in the consolidated statements of
operations. For the years ended December 31, 2001, 2002 and 2003, the Company
recorded $1.5 million, $1.0 million and $806,000, respectively, as revenue for
shipping and handling fees charged to customers. For the years ended December
31, 2001, 2002 and 2003, the Company recorded $1.1 million, $736,000 and
$523,000, respectively, of shipping and handling costs as direct cost of
product sales in the consolidated statements of operations. Media revenue consists primarily of the sale of advertisements and
sponsorships, both online and offline, under short-term contracts. To date,
the duration of the Companys advertising and sponsorship commitments has
generally averaged from one to three months with certain programs lasting up to
six months. The Companys online obligations typically include the guarantee
of a minimum number of times (impressions) that an advertisement appears in
pages viewed by the users of the Companys online properties. Online
advertising revenue is generally recognized as the impressions are served
during the period in which the advertisement is displayed, provided that no
significant obligations of the Company remain and collection of the resulting
receivable is reasonably assured. To the extent that minimum guaranteed page
deliveries are not met, recognition of the corresponding revenue is deferred
until the guaranteed impressions are delivered. The Company recognizes revenue for sponsorship arrangements, both online
and offline, over the period during which the advertising is provided,
generally on a straight-line basis. If the sponsorship arrangement is for the
sponsorship of a specific event, the Company recognizes revenue when the event
occurs. The Company recognizes revenue separately for each element of
integrated entertainment marketing packages that offer advertisers a
combination of off-line concert and tour sponsorships that are supported by
on-line banner advertising, web page sponsorships, emails to the Companys
customers and custom content. The Company determines the fair value of each
deliverable based on the fair value of the different deliverables when sold on
a stand-alone basis. The Company recognizes revenue for each deliverable as
the services are provided. The Company recognizes revenue for the banner
impression deliverable as the banner impressions are delivered. The Company
recognizes revenue for the customer emails when the emails are sent. The
Company recognizes revenue for web page sponsorships on a straight-line basis
over the term of the sponsorship. The Company recognizes revenue for the
custom content when the content is provided to the customer. The Company
recognizes revenue for event sponsorships when the event has occurred. Record label revenue consists primarily of the sale of compact discs by
artists under contract with the Company through the iMusic record label. The
Company recognizes revenues upon the shipment of compact discs from its
distributor to retailers and independent wholesalers and records appropriate
reserves for product returns. At the time of the shipment of the product, the
following criterion under Statement of Financial Accounting Standards No. 48,
Revenue Recognition When Right of Return Exists, have been met: the sellers
price to the buyer is substantially fixed or determinable at the date of sale;
the buyer has paid the seller, or the buyer is obligated to pay the seller, and
the obligation is not contingent on resale of the product; the buyers
obligation to the seller would not be changed in the event of theft or physical
destruction or damage of the product; the buyer acquiring the product for
resale has economic substance apart from that provided by the seller; the
seller does not have significant obligations for future performance to directly
bring about resale of the product by the buyer; and the amount of future
returns can be reasonably estimated. The Company estimates the provision for returns on a quarterly basis by
album based on the amount of time since the initial album release, the actual
returns to date, the trend of sales activity (sales by the retailers and
wholesalers) and the number of unsold units at retailers and wholesalers.
Returns to the Companys distributor are deemed to be returns to the Company. COST OF REVENUE Direct cost of product sales consists of amounts payable to artists
related to e-commerce sales, which includes the cost of merchandise sold and
the artists share of net proceeds, and online commerce transaction costs,
including credit card fees, fulfillment charges and shipping costs. Direct cost of product sales also includes manufacturing costs and
distribution fees payable. Manufacturing costs consist of the cost of
pressing compact discs, manufacturing printed booklets and packaging materials
and a provision for the obsolescence of finished goods and components.
Distribution expenses consist of various distribution costs, including the cost
of processing returns and warehousing inventory. Artist advances and royalty
expenses consist of payments made to artists and others in connection with the
recording of an album. 67




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Other cost of revenue consists primarily of Web site hosting and
maintenance costs, online content programming costs, online advertising serving
costs, record royalties payable and payroll and related expenses for staff
involved with the Website. Stock-based compensation expense relates to
non-cash charges in connection with options issued to artists and their
advisors for the right to operate their stores and warrants issued to vendors.
Amounts payable to artists and transaction costs are recognized upon shipment.
Web site-related costs are recognized immediately when incurred. Payroll and related expenses are recognized in the period incurred.
Non-cash stock-based compensation charges are recognized over the period of the
related agreements. ARTIST ADVANCES Artist advances consists of the amounts advanced to artists in connection
with the recording of their albums. In addition, included in artist advances
are costs expended for producer fees, musician fees, engineering and studio
costs, equipment costs, mastering and remix costs, sample clearances and artist
living expenses during recording. Artist advances are typically recoupable
from artist royalties earned from the sale of compact discs. The Company
expenses these advances when incurred as the Companys artists have limited or
no history of album sales. DISCONTINUED OPERATIONS The Company has accounted for its agency division as a discontinued
operation in accordance with Accounting Principles Board (APB) No. 30,
Accounting for Discontinued Operations, and recorded the net results of this
business segment in a single line entitled income from discontinued operations
in the consolidated statements of operations for the years ended December 31,
2001 and 2002. The classification of the agency division as a discontinued
operation was made prior to the initial application of SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. INVENTORIES Inventories, net of a provision for obsolescence, are included in prepaid
expenses and other current assets, and consist of compact discs maintained in
the warehouse of the Companys distributor and music-related merchandise.
Inventories are stated at the lower of cost or net realizable value. Cost is
determined using the first-in, first-out method. INCOME TAXES The Company accounts for income taxes under the asset and liability method
whereby deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred
tax assets and liabilities of a change in tax rates is recognized in the
statement of operations in the period that includes the enactment date. A
valuation allowance is recognized if management cannot determine that it is
more likely than not that some portion or all of the tax asset will be
realized. WEB SITE DEVELOPMENT COSTS Web site development costs consist primarily of third-party development
costs and payroll and related expenses for in-house Web site development costs
incurred in the start-up and production of the Companys content and services.
These costs are expensed as incurred. ADVERTISING COSTS Advertising costs are expensed as incurred and totaled $2.7 million, $1.0
million and $333,000 during the years ended December 31, 2001, 2002 and 2003,
respectively. IMPAIRMENT OF LONG-LIVED ASSETS AND GOODWILL Prior to January 1, 2002, the Company periodically reviewed the carrying
amount of long-lived assets and goodwill to determine whether current events or
circumstances warranted adjustments to such carrying amounts. An impairment
adjustment was necessary 68




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in the event the net book value of such long-lived assets and goodwill
exceeded the future undiscounted cash flows attributable to such assets. In
such an event, the loss would be measured by the amount that the carrying value
of such assets exceeded their fair value, as determined based on estimated
discounted cash flows. In 2001, the Company determined that the remaining goodwill associated
with the acquisition of Mjuice was fully impaired due to the Companys decision
to wind down the related operation and recorded a loss from impairment of $4.5
million. In addition, due to the decline in advertising revenues, the Company
determined that there was insufficient basis to support the entire carrying
amount of goodwill associated with the 1999 acquisitions of iMusic and UBL
based upon the projected undiscounted future cash flows related to the
underlying assets of these goodwill amounts and recorded a loss from impairment
of $7.0 million based on the estimated discounted cash flows. For the year
ended December 31, 2001, the Company recorded an aggregate $11.4 million loss
from impairment of goodwill. Both of these write-downs were reflected in the
Media segment operations. Prior to January 1, 2002, the Company amortized goodwill, which represents
the excess of the purchase price over the net assets acquired in business
acquisitions, over 5 years. In January 2002, the Company adopted SFAS No. 142,
Goodwill and Other Intangible Assets, and as a result ceased to amortize
goodwill. Instead, the Company was required to perform a transitional
impairment review of its goodwill as of January 1, 2002 and an annual
impairment review thereafter. The Company evaluated the impact of the adoption
of SFAS No. 142 and determined that no impairment charge was required upon
adoption of this standard. The impairment test was performed through
comparison of the fair value of the reporting units with the carrying value of
their assets. During the three months ended June 30, 2002, the Company
determined the remaining goodwill associated with the iMusic and UBL
acquisitions of $788,000 was impaired due to a continuing decline in e-commerce
and advertising revenues, and recorded a loss from impairment of that amount.
This write-down was reflected in the Media segment operations. The fair value
of the reporting unit to which the goodwill impairment related was determined
based on the discounted estimated future cash flows. The discount rate used in
the discounted cash flow analysis was determined based on the estimated cost of
capital in the industry in which the Media segment operates. As of December
31, 2002, no goodwill or intangible assets remained on the Companys balance
sheet. Impairment of long-lived assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event that the carrying amount of long-lived assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. See Note 7 for write-downs in 2003 with respect to the Companys property
and equipment. CONCENTRATION OF RISK Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash, short-term
investments and trade accounts receivable. The Company places its cash and
short-term investments in high credit quality instruments. Cash balances at
certain financial institutions may exceed the FDIC insurance limits. The
Company performs ongoing credit evaluations of its customers but does not
require collateral. Exposure to losses on receivables is principally dependent
on each customers financial condition. The Company monitors its exposure to
credit losses and maintains allowances for anticipated losses. The Company purchases a large percentage of its music-related merchandise
inventory from a limited number of suppliers. The Company is subject to risk
in the event that any of the suppliers is unable to fulfill their orders.
However, there are a number of different suppliers who can provide
manufacturing services for the Company. During the year ended December 31, 2003, AT&T Wireless accounted for
$550,000 or 47% of total media revenue. No other advertiser accounted for more
than 10% of the Companys media revenue during 2002 or 2003. There were no
amounts due from AT&T Wireless at December 31, 2003. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of financial instruments, which include cash and cash
equivalents, short-term investments, accounts receivable, accounts payable and
accrued expenses, approximate fair value because of the short maturity of these
instruments. The carrying amount of the Bridge Notes payable approximates fair value as
the related effective interest rate (including the discount) approximates rates
currently available to the Company. 69




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LIABILITY ASSOCIATED WITH INVESTMENTS IN AFFILIATED COMPANIES Investments in affiliated companies in which ADIs voting interest is
greater than 20% and does not have a controlling financial interest, or in
which ADI is able to exert significant influence in instances where the voting
interest is less than 20%, are accounted for under the equity method of
accounting. Under this method, the investment, originally recorded at cost, is
adjusted to recognize ADIs share of the net earnings or losses of the
affiliates as they occur rather than as dividends or other distributions are
received. ADIs share of losses is generally limited to the extent of its
investment in and advances to the investee. However, ADI recorded losses in
excess of its investment when funding commitments exist. Through December 31,
2003, ADI accounted for its investment in ARTISTdirect Records on the equity
method of accounting since ADI did not have voting or operational control of
the investee. ADI had committed to fund 100% of the operations of ARTISTdirect
Records and recorded 100% of the losses attributable to that venture from May
31, 2001 to April 30, 2002. From May 1, 2002 to December 31, 2003, ADIs
funding commitment was reduced by the sale of 5% of the equity of ARTISTdirect
Records to BMG and therefore ADI recorded only its proportionate share, on the
basis of relative funding commitments, of the losses of ARTISTdirect Records. ADI has not recorded a valuation allowance for its loans to ARTISTdirect
Records as the carrying amount of the loans has been reduced to zero as a
result of ADI recording its share of losses of ARTISTdirect Records during the
years ended December 31, 2001, 2002 and 2003. See Notes 2 and 11 with respect to consolidation of ARTISTdirect Records
as of December 31, 2003. LOSS PER COMMON SHARE The Company computes net loss per share in accordance with SFAS No. 128,
Earnings per Share and Securities and Exchange Commission Staff Accounting
Bulletin No. 98 (SAB 98). SFAS No. 128 requires companies with complex
capital structures to present basic and diluted EPS. Basic EPS is measured as
the income or loss available to common shareholders divided by the weighted
average outstanding common shares for the period. Diluted EPS is similar to
basic EPS but presents the dilutive effect on a per share basis of potential
common shares (e.g., convertible securities, options and warrants) as if they
had been converted at the beginning of the periods presented. Potential common
shares that have an anti-dilutive effect (i.e., those that increase income per
share or decrease loss per share) are excluded from the calculation of diluted
EPS. During the year ended December 31, 2001, interest on the rescission offer
balance was added to the net loss in determining the net loss attributable to
common shareholders. The calculation of diluted loss per share excludes approximately 820,000,
780,000 and 1,111,000 of potential common shares for the years ended December
31, 2001, 2002 and 2003, respectively, since the effect would be anti-dilutive. STOCK-BASED COMPENSATION The Company accounts for stock-based employee compensation in accordance
with the provisions of Accounting Principles Board (APB) Opinion No. 25 and
FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions
Involving Stock Compensation, and complies with the disclosure requirements of
SFAS No. 123, Accounting for Stock-Based Compensation. Under APB No. 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 the measurement
date. The Company accounts for stock issued to non-employees in accordance
with SFAS No. 123, which requires entities to recognize as expense over the
service period the fair value of all stock-based awards on the date of grant
and EITF No. 96-18, Accounting for Equity Investments that are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services, which addresses the measurement date and recognition approach for
such transactions. The Company recognizes compensation expense related to variable awards in
accordance with FIN 28. For fixed awards, the Company recognizes expense over
the vesting period or the period of service. In
addition to stock-based compensation classified as cost of revenue,
stock-based compensation is comprised of sales and marketing expense of
$6.3 million, $1.9 million and $0 for the years ended December 31, 2001, 2002
and 2003, respectively, and general and administrative expense of $6.1 million,
$31,000 and $527,000 for the years ended December 31, 2001, 2002 and 2003,
respectively. Prior to the Companys initial public offering in March 2000, the Company
issued shares or options to purchase shares to employees, artists and advisors.
The issuance of these shares or options did not fully comply with certain
requirements under the Securities Act, or available exemptions thereunder, and
as a result the Company made a rescission offer to all these persons pursuant
to a registration statement filed under the Securities Act and pursuant to
California securities law. 70




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As a result of completing the rescission offer in December 2001, the
Company incurred stock-based compensation expense for the repurchase of
unexercised stock options held by employees and non-employees and shares of
common stock held by employees and non-employees pursuant to the exercise of
stock options. The compensation expense recorded for the repurchase of
unexercised stock options (vested and unvested) from employees was the sum of
the intrinsic value at the original measurement date (less any expense related
to the intrinsic value recorded up to the acceptance of the rescission offer)
and the amount of cash paid to the holder that exceeds the lesser of the
intrinsic value at the original measurement date or upon the completion of the
rescission offer. Such amount was recorded as expense immediately upon the
completion of the rescission offer. The compensation expense recorded for the repurchase of unexercised
non-employee options (vested and unvested) was calculated as the difference
between the amount of cash paid for the repurchase of the options and the fair
value of the options on the closing date of the rescission offer. This
compensation expense was recorded over the period over which the non-employee
provided services to the Company pursuant to a contract. The fair value of the
options was determined using the Black-Scholes option-pricing model over the
remaining life of the options. Any unamortized expense at the time of
repurchase related to the initial grant of the options to the non-employees
continued to be amortized over the remaining service period related to the
original option grants. The key assumptions used in the Black-Scholes
option-pricing model for the purpose of the calculation were: a risk free rate
of 6%; a volatility factor of 98%; no expected dividends; and an expected life
which was equal to the remaining contractual life of the options as of December
31, 2001. The compensation expense for the repurchase of shares issued pursuant to
the exercise of options (by employees and non-employees) was calculated as the
difference between the amount of cash paid for the repurchase of the shares and
the fair value of the shares on the date the repurchase. The compensation
expense related to the repurchase of shares from employees was recorded at the
time of repurchase, and the compensation expense related to the repurchase of
shares from non-employees was recorded over the period over which services were
being provided. Pro forma information regarding net loss per share is required by SFAS
123, and has been determined as if the Company had accounted for its employee
stock options under the fair value method of such statement. The fair value
for these options was estimated at the date of grant using the Black-Scholes
option-pricing model. The assumptions used in the model and the weighted
average fair value of each option granted for 2001, 2002 and 2003 are as
follows: 2001
    
    2002
    
    2003Risk free interest rate
    
    
    6.38
    %
    
    
    4.00
    %
    
    
    3.00
    %Volatility
    
    
    180
    %
    
    
    120
    %
    
    
    388
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Weighted average expected life (years)
    
    
    5
    
    
    
    5
    
    
    
    7Weighted average fair value of option
    
    $
    6.05
    
    
    $
    6.13
    
    
    $
    0.89
 For purpose of pro forma disclosures, the estimated fair value of the options
is amortized to operations over the vesting period of the options or the
expected period of benefit. The Companys pro forma information follows (in
thousands, except per share amount): Years Ended December 31,2001
    
    2002
    
    2003(in thousands, except for share data)Net loss as reported attributable to common shareholders
    
    $
    70,571
    
    
    $
    48,192
    
    
    $
    21,701Add: Stock-based employee compensation expense
reported in net loss attributable to common stockholders
    
    
    3,558
    
    
    
    31
    
    
    
    Deduct: Total stock-based employee compensation
expense determined under fair value methods for all awards
    
    
    10,991
    
    
    
    995
    
    
    
    2,263Pro forma net loss
    
    $
    78,004
    
    
    $
    49,156
    
    
    $
    23,964Net loss per share:Basic and diluted  as reported
    
    $
    (19.49
    )
    
    $
    (13.92
    )
    
    $
    (6.27
    )Basic and diluted  pro forma
    
    $
    (21.54
    )
    
    $
    (14.20
    )
    
    $
    (6.92
    )
 COMPREHENSIVE LOSS The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 130, Reporting Comprehensive Income (SFAS No.
130). SFAS No. 130 establishes standards for the reporting and display of
comprehensive income, its components and accumulated balances in a full set of
general purpose financial statements. SFAS No. 130 defines comprehensive 71




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income (loss) to include all changes in equity except those resulting from
investments by owners and distributions to owners, including adjustments to
minimum pension liabilities, accumulated foreign currency translation, and
unrealized gains or losses on marketable securities. The Companys only component of other comprehensive income is the
unrealized gain (loss) on available for sale securities, consisting of a gain
of $146,000 for the year ended December 31, 2001 and a loss of $78,000 and
$58,000 for the years ended December 31, 2002 and 2003, respectively. These
amounts have been recorded as a separate component of stockholders equity
(deficiency). ESTIMATES In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosures
of contingent assets and liabilities at the date of the financial statements
and revenues and expenses during the reporting period. Some of the more
significant estimates include allowances for bad debts, impairment of
long-lived assets and goodwill, impairment of fixed assets, stock-based
compensation and the valuation allowance on deferred tax assets. Actual
results could differ from those estimates. 3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (SFAS No. 143). SFAS No. 143 addresses the diverse
accounting practices for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The Company
adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143
did not have a significant effect on the Companys financial statement
presentation or disclosures. In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of, it retains many
of the fundamental provisions of that statement. The Company adopted SFAS No.
144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a
material impact on the Companys financial statement presentation or
disclosures. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS 4, which required all gains and
losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. Upon
adoption of SFAS No. 145, the Company will be required to apply the criteria in
APB Opinion No. 30, Reporting the Results of Operations  Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions (Opinion No. 30), in
determining the classification of gains and losses resulting from the
extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to
require that certain lease modifications that have economic effects similar to
sale-leaseback transactions to be accounted for in the same manner as
sale-leaseback transactions. The Company adopted SFAS No. 145 effective
January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for
use did not have a material impact on the Companys financial statement
presentation or disclosures. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit and Disposal Activities. SFAS No. 146 nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring). Under EITF Issue No. 94-3, a
liability for an exit cost is recognized at the date of an entitys commitment
to an exit plan. Under SFAS No. 146, the liabilities associated with an exit
or disposal activity will be measured at fair value and recognized when the
liability is incurred and meets the definition of a liability in the FASBs
conceptual framework. SFAS No. 146 is effective for exit or disposal
activities initiated after December 31, 2002. The adoption of SFAS 146 did not
have a material impact on the Companys financial statement presentation or
disclosures. 72




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In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based CompensationTransition and Disclosurean amendment of SFAS No.
123. SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No.
123 and APB Opinion No. 28, Interim Financial Reporting, to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company implemented SFAS No. 148 effective
December 31, 2002. The Company has determined that it will continue to account
for stock-based employee compensation in accordance with APB No. 25. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and
clarifies under what circumstances a contract with initial investments meets
the characteristics of a derivative and when a derivative contains a financing
component. SFAS No. 149 is effective for contracts entered into or modified
after June 30, 2003. The adoption of SFAS No. 149 did not have a significant
effect on the Companys financial statement presentation or disclosures. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for how an issuer classifies and measures in
its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an
issuer classify a financial instrument that is within its scope as a liability
(or an asset in some circumstances) because that financial instrument embodies
an obligation of the issuer. SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003 and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of
a change in accounting principle for financial instruments created before the
issuance date of SFAS No. 150 and still existing at the beginning of the
interim period of adoption. Restatement is not permitted. The adoption of
SFAS No. 150 did not have a significant effect on the Companys financial
statement presentation or disclosures. In November 2002, the FASB issued Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others (FIN 45), an interpretation of FASB
Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.
FIN 45 elaborates on the disclosures to be made by a guarantor in its interim
and annual financial statements about its obligations under guarantees issued.
FIN 45 also clarifies that a guarantor is required to recognize, at inception
of a guarantee, a liability for the fair value of the obligation undertaken.
The initial recognition and measurement provisions of FIN 45 are applicable to
guarantees issued or modified after December 31, 2002. The disclosure
requirements of FIN 45 are effective for financial statements of interim and
annual periods ended after December 15, 2002. The adoption of FIN 45 did not
have a material effect on the Companys financial statement presentation or
disclosures. In November 2002, the FASBs Emerging Issues Task Force (EITF) issued
EITF No. 00-21 Revenue Arrangements with Multiple Deliverables. EITF No.
00-21 addresses certain aspects of the accounting by a vendor for arrangements
under which it will perform multiple revenue-generating activities.
Specifically, EITF No. 00-21 addresses how to determine whether an arrangement
involving multiple deliverables contains more than one unit of accounting. In
applying EITF No. 00-21, separate contracts with the same entity or related
parties that are entered into at or near the same time are presumed to have
been negotiated as a package and should, therefore, be evaluated as a single
arrangement in considering whether there are one or more units of accounting.
That presumption may be overcome if there is sufficient evidence to the
contrary. EITF No. 00-21 also addresses how arrangement consideration should
be measured and allocated to the separate units of accounting in the
arrangement. The guidance in EITF No. 00-21 is effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. The
Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF
No. 00-21 has not had any significant impact on the Companys financial
statement presentation or disclosures. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities, which have one or both of the following characteristics:
(1) the equity investment at risk is not sufficient to permit the entity to
finance its activities without additional financial support from other parties,
or (2) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest: (a) the direct or
indirect ability to make decisions about the entitys activities through voting
or similar rights, (b) the obligation to absorb the expected losses of the
entity if they occur, or (c) the right to receive the expected residual returns
of the entity if they occur. In addition, FIN 46 contains detailed disclosure
requirements. FIN 46 applies immediately to variable interest entities created
after January 31, 2003, and to variable interest entities in which an
enterprise obtains an interest after that date. It applies in the first fiscal
year or interim period ending after March 15, 2004, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. Early adoption is permitted. The Company adopted FIN
46 as of December 31, 2003. The adoption of FIN 46 on such date had a
significant impact on the Companys consolidated balance sheet. The Company
had previously accounted for its investment in ARTISTdirect Records under the
equity method. The Company 73




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consolidated the balance sheet of ARTISTdirect Records as of December 31,
2003, and will consolidate the operations of ARTISTdirect Records beginning
January 1, 2004. 4. SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS Significant non-cash investing and financing activities are as follows: Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Securities subject to potential rescission offer
    
    $
    691
    
    
    $
    
    
    
    $
    Issuance/cancellation of options/warrants
    
    
    (2,362
    )
    
    
    31
    
    
    
    Cumulative effect of consolidation of
ARTISTdirect Records, LLC:Losses previously allocated to minority
members of ARTISTdirect Records, LLC,
resulting in an increase in loans payable
    
    
    
    
    
    
    
    
    
    
    (5,255
    )
 The following is the adjustment resulting from the change to consolidation
from equity accounting for ARTISTdirect Records, LLC effective December 31,
2003: Cash
    
    $
    7Other assets
    
    
    40Accounts payable
    
    
    (901
    )Accrued expenses
    
    
    (1,212
    )Due to ARTISTdirect, Inc.
    
    
    (45
    )Net liability to BMG
    
    
    (8,749
    )Bridge notes payable  outside investors
    
    
    (755
    )Bridge notes payable  minority interest
    
    
    (481
    )Liability associated with record label joint venture
    
    
    14,208Minority interest
    
    
    (1,312
    )Adjustment resulting from change to consolidation
from equity accounting for ARTISTdirect Records, LLC
    
    
    (800
    )$
    
 As a result of the consolidation of ARTISTdirect Records effective
December 31, 2003, the Company recorded a credit to additional paid-in capital
of $800,000, which consisted of the net 65% majority interest portion of the
total debt forgiven in 2003 by the Chairman of ARTISTdirect Records of $534,000
($822,000 x 65%), and other adjustments aggregating $266,000. 5. SHORT-TERM INVESTMENTS The Companys short-term investments consist of the following: December 31, 2002
    
    December 31, 2003Fair
    
    
    
    
    
    FairMarket

    
    Amortized
    
    Market
    
    AmortizedValue
    
    Cost
    
    Value
    
    Cost(in thousands)United States corporate and bank debt
    
    $
    6,124
    
    
    $
    6,056
    
    
    $
    1,022
    
    
    $
    1,012
 6. ARTIST ADVANCES As of December 31, 2003, ARTISTdirect Records had signed recording
agreements with six artists and had advanced a total of $1.238 million through
such date with respect to these artists. The amount of these advances is
recoupable against royalties to be 74




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earned by the artists based on sales. However, given that most of the
artists signed by the record label have no previous track record, the advances
have been expensed by ARTISTdirect Records as incurred. As of December 31,
2003, ARTISTdirect Records is contractually committed to additional minimum
artist advances of approximately $1.5 million, all of which is payable in 2004. 7. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost and consist of the following: December 31,2002
    
    2003(in thousands)Computer equipment and software
    
    $
    8,680
    
    
    $
    8,750Furniture and fixtures
    
    
    1,737
    
    
    
    734Leasehold improvements
    
    
    2,674
    
    
    
    13,091
    
    
    
    9,484Less accumulated depreciation
    
    
    (9,462
    )
    
    
    ( 9,177
    )Property and equipment, net
    
    $
    3,629
    
    
    $
    307
 In June 2003, the Company initiated discussions with its landlord
regarding the potential termination or restructuring of its office lease that
had a term through April 2010. On June 24, 2003, the landlord filed suit
against the Company for unlawful detainer of its premises and in July 2003 the
landlord drew down the entire remaining $1.35 million letter of credit that the
Company had provided as a security deposit in conjunction with the execution of
the original lease. In September 2003, the Company reached an agreement to
terminate its lease with the landlord. In conjunction with the termination,
the Company issued to the landlord warrants to purchase 200,000 shares of the
Companys common stock exercisable at $0.50 per share through September 8,
2008. In October 2003, the legal proceedings against the Company were dismissed
with prejudice. As a result, the Company recorded an expense of $429,000,
comprised of $1.35 million under the letter of credit which was funded by the
Company, plus $100,000 of expense related to the issuance of the warrants to
the landlord, calculated pursuant to the Black-Scholes option-pricing model,
offset by deferred rent obligations and other credits of $1.021 million. Impairment of fixed assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event the carrying amount of fixed assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. There was no impairment of long-lived assets as
of December 31, 2002, as undiscounted expected cash flows exceeded net book
value. During the three months ended June 30, 2003, the Company determined
that its fixed assets were impaired due to continuing losses, going concern
issues, the delisting of its common stock from the NASDAQ Stock Market, and the
likelihood that the majority of these assets would likely be abandoned in the
near future. The Company determined that these factors were indicators of
impairment and thus reduced the carrying amount of the fixed assets to their
estimated fair value by recording a write-off of $2.225 million during the
three months ended June 30, 2003. The leasehold improvements were subsequently
abandoned when the Company vacated the premises, and most of the Companys
remaining property and equipment was subsequently sold to third party
liquidators for cash. This amount has been reported as a loss from sale and
abandonment of property and equipment in the consolidated statement of
operations for the year ended December 31, 2003. 8. ALLOWANCES FOR DOUBTFUL ACCOUNTS AND SALES RETURN RESERVE A summary of the activity with respect to the allowance for doubtful
accounts is as follows: Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Balance, beginning of period
    
    $
    389
    
    
    $
    1,584
    
    
    $
    40Provision for doubtful accounts
    
    
    1,503
    
    
    
    42
    
    
    
    83Amounts charged off
    
    
    (308
    )
    
    
    (1,586
    )
    
    
    (35
    )Adjustment resulting from
change to consolidation
from equity accounting for
ARTISTdirect Records
effective December 31, 2003
    
    
    
    
    
    
    
    
    
    
    55Balance, end of period
    
    $
    1,584
    
    
    $
    40
    
    
    $
    143
 75




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A summary of the activity with respect to the reserve for sales returns is
as follows: Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Balance, beginning of period
    
    $
    75
    
    
    $
    11
    
    
    $
    282Provision for sales returns
    
    
    248
    
    
    
    403
    
    
    
    695Amounts charged off
    
    
    (312
    )
    
    
    (132
    )
    
    
    (870
    )Adjustment resulting from
change to consolidation
from equity accounting for
ARTISTdirect Records
effective December 31, 2003
    
    
    
    
    
    
    
    
    
    
    160Balance, end of period
    
    $
    11
    
    
    $
    282
    
    
    $
    267
 9. GOODWILL The Company adopted SFAS No. 142 in January 2002. The following table
reconciles the reported net loss for the year ended December 31, 2001 to the
adjusted amount, excluding previously reported goodwill amortization expense,
which is no longer recorded under the provisions of SFAS No. 142. The Company
did not record any goodwill amortization expense in the years ended December
31, 2002 or 2003. Year EndedDecember 31, 2001(in thousands,except share data)Reported net loss attributable to common shareholders
    
    $
    (70,571
    )Goodwill amortization
    
    
    2,786Adjusted net loss
    
    $
    (67,785
    )Basic and diluted loss per share:Reported net loss
    
    $
    (19.49
    )Goodwill amortization
    
    
    0.77Adjusted net loss
    
    $
    (18.72
    )
 While not contemplated by the disclosure requirements of SFAS No. 142, the
elimination of goodwill amortization in the year ended December 31, 2001 would
have increased the related recorded balances of goodwill in this period and
accordingly would have increased the loss from impairment of goodwill in 2002
by an aggregate amount equal to the eliminated goodwill amortization. 10. ACCRUED EXPENSES Accrued expenses are comprised of the following: December 31,2002
    
    2003(in thousands)Accrued cost of sales
    
    $
    905
    
    
    $
    480Accrued payroll and related
    
    
    881
    
    
    
    960Accrued professional fees
    
    
    445
    
    
    
    273Sublease rent loss
    
    
    119
    
    
    
    Accrued advertising costs
    
    
    9
    
    
    
    Other accrued expenses
    
    
    659
    
    
    
    570Total accrued expenses
    
    $
    3,018
    
    
    $
    2,283
 76




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11. INVESTMENT IN ARTISTDIRECT RECORDS, LLC In May 2001, ADI entered into an agreement with Frederick W. (Ted) Field
to become Chairman and Chief Executive Officer of ADI and through its
wholly-owned subsidiary, ARTISTdirect Recordings, Inc., to form a new record
label, ARTISTdirect Records, LLC (ARTISTdirect Records), in partnership with
ADI. On June 29, 2001, ADIs stockholders approved the employment of Mr. Field
and the formation of the ARTISTdirect Records record label. ARTISTdirect
Records was formed as a 50/50 co-venture between ADI and Mr. Field. Mr. Field
is the Chief Executive Officer of ARTISTdirect Records. The primary business
activity of ARTISTdirect Records is the sale of compact discs by artists signed
to the record label. ADI initially committed to fund a total of $50 million to ARTISTdirect
Records over five years at the rate of $15.0 million per year, subject to a
limit of $33 million in any three year period. Any funding in excess of these
amounts required the approval of ADIs Board of Directors. ADI has funded
$33.0 million through December 31, 2003. In November 2001, ARTISTdirect Records agreed in principle to enter into a
preliminary North America distribution agreement and worldwide license
agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music
Group, Inc., the global music division of Bertelsmann AG (BMG). Under the
terms of the agreement, BMG agreed to distribute the labels releases in North
America, and BMG licensed ARTISTdirect Records repertoire in territories
throughout the world. In April 2002, the agreements with BMG were finalized,
including BMGs purchase of 5% of the equity of ARTISTdirect Records from ADI.
As part of this transaction, BMG agreed to advance certain monies against net
sales proceeds under the agreements and also assumed $5.0 million of ADIs
funding commitment to ARTISTdirect Records. As a result of the BMG equity
purchase, ADIs funding commitment was reduced to $45 million. In December
2002, BMG exercised its option to extend the term of the distribution and
license agreement until September 2004. Under the distribution and license agreements, BMG made non-returnable
advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002
and $5.0 million in 2003 that are recoupable from net sales proceeds from
ARTISTdirect Records artist repertoire. The advances are to be recouped on a
monthly basis based on a defined calculation. As of December 31, 2002 and
2003, the unrecouped balance related to distribution advances from BMG was $4.1
million and $8.7 million, respectively. In August 2002, ADIs Board of Directors approved an agreement (the
Accelerated Funding Agreement) to accelerate up to $10 million of its funding
commitment to ARTISTdirect Records. This funding was in addition to the $15
million that ADI was obligated to advance to ARTISTdirect Records in 2002 as
part of the initial $50 million funding commitment. During 2002, ADI funded
its $15 million commitment plus the additional $10 million bridge loan for
total advances to the record label of $25.0 million in 2002 and $30.25 million
from the inception of the record label through December 31, 2002. The $10
million of accelerated funding was credited toward the satisfaction of ADIs
overall funding commitment and funding obligation for 2003, resulting in a
remaining funding commitment of $2.75 million for 2003 and $12.0 million for
2004. ADI advanced the $2.75 million during 2003. ADIs commitment to fund
ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should
ADI fail to meet its commitment, BMG may choose to enforce the guaranty or
provide substitute financing that could result in dilution of ADIs interest in
ARTISTdirect Records. As consideration for entering into the Accelerated Funding Agreement, ADI
received an additional 20% interest in ARTISTdirect Records from Radar Records
Holdings, L.L.C. (RRH), the entity through which Mr. Field owns his interest
in ARTISTdirect Records, which resulted in an increase in ADIs ownership share
of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Fields ownership
share from 50% to 30%. The Accelerated Funding Agreement also provides that
any dilution from the issuance of equity interests in ARTISTdirect Records that
would have been borne solely by ADI will be borne both by RRH and ADI pro rata
with their then respective ownership interests. Furthermore, the Accelerated
Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded
return to be realized from ADIs advances and equity interests in ARTISTdirect
Records. Due to the uncertainty with respect to the realization of such rate
of return, ADI has not recorded any amounts related to the 25% minimum annual
compounded return in its consolidated financial statements. Because ADI did not have voting or operating control of ARTISTdirect
Records, even with its majority ownership position, through December 31, 2003
it did not consolidate the results of ARTISTdirect Records; ADI recorded its
share of losses based on the equity method of accounting as loss from equity
investments in its consolidated statements of operations. Prior to the
completion of BMGs purchase of a 5% interest in ARTISTdirect Records in April
2002 and BMGs assumption of 10% of ADIs total funding commitment, ADI had
committed to fund 100% of the operations of ARTISTdirect Records and had
recorded 100% of the losses attributable to that venture from the inception of
ARTISTdirect Records to April 30, 2002. From May 1, 2002 through December 31,
2003, ADI has recorded only its proportionate share, on the basis of remaining
relative funding commitments, of any losses of ARTISTdirect Records. ADI has
funded a total of $33.0 million of its funding commitment. ADI recognized $8.6
million, $29.3 million and $9.3 million of equity loss from ARTISTdirect
Records for the years ended December 31, 2001, 2002 and 2003, 77




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respectively. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities. The Company adopted FIN 46 effective December 31, 2003. As
a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records
was consolidated as of December 31, 2003, and the operations of ARTISTdirect
Records will be consolidated beginning January 1, 2004. ADI charged ARTISTdirect Records $200,000, $1.35 million and $563,000 in
2001, 2002 and 2003, respectively, for the reimbursement of overhead costs,
including rent and other occupancy costs, telephone and internet services, and
the services of certain ADI personnel primarily in the areas of accounting,
legal, information technology, human resources and administration. These
amounts are reflected as a reduction to general and administrative expense in
ADIs consolidated statements of operations for such periods. The carrying amount of ADIs investment in ARTISTdirect Records at
December 31, 2002 represents the difference between ADIs investment and
advances and ADIs share of losses from ARTISTdirect Records. Through December
31, 2003, ADI continued to record the losses of ARTISTdirect Records. ADI
recorded its loan advances to ARTISTdirect Records as additional equity
investments. As of December 31, 2002, ADIs share of losses exceeded the
amount of ADIs investment and advances at that date, resulting in a credit
balance of approximately $7.7 million, which was classified as a liability on
ADIs consolidated balance sheet at December 31, 2002. As of December 31,
2003, the Company consolidated the balance sheet of ARTISTdirect Records. ADI had no recorded investment in its loans to ARTISTdirect Records, as
the carrying amount of the loans had been reduced to zero as a result of ADI
recording its share of losses of ARTISTdirect Records during the years ended
December 31, 2001, 2002 and 2003. ADI does not record interest income on the
loans to ARTISTdirect Records. The loan advances provided to ARTISTdirect Records by ADI and BMG bear
interest at a rate of LIBOR plus four percent and the principal and interest
are not repayable until December 31, 2015 or upon such time as ARTISTdirect
Records achieves certain defined levels of excess cash flow and available cash.
As of December 31, 2002 and 2003, ARTISTdirect Records had loans payable to
ADI of $30.25 million and $33.0 million, respectively, which have been
eliminated in consolidation in 2003, and to BMG of $4.75 million. In addition,
as of December 31, 2002 and 2003, ARTISTdirect Records had accrued interest
payable to ADI of $1.1 million and $3.0 million, respectively, and to BMG of
$189,000 and $447,000, respectively. During the year ended December 31, 2003,
Mr. Field loaned $898,000 to ARTISTdirect Records (see Note 13). The $898,000 of loans from Mr. Field has been classified as bridge notes
payable in the consolidated balance sheet at December 31, 2003. A roll forward schedule of ADIs net investment balance for the years
ended December 31, 2002 and 2003 is as follows: December 31,2002
    
    2003(in thousands)Balance, beginning of period
    
    $
    (3,027
    )
    
    $
    (7,699
    )Investment and advances
    
    
    25,000
    
    
    
    2,750Sale of equity interests
    
    
    (250
    )
    
    
    Intercompany activity with
ARTISTdirect Records, LLC
    
    
    (186
    )
    
    
    (3
    )Equity losses recorded
    
    
    (29,236
    )
    
    
    (9,256
    )Consolidation of ARTISTdirect
Records, LLC
    
    
    
    
    
    
    14,208Balance, end of period
    
    $
    (7,699
    )
    
    $
    
 As of December 31, 2003, ARTISTdirect Records did not have sufficient
working capital resources to conduct operations. During the three months ended
September 30, 2003, ARTISTdirect Records significantly reduced its overhead
costs and operating activities and laid off the majority of its staff while it
continued to restructure its operations and seek additional capital. ADI does not have the resources to meet its remaining $12.0 million
funding commitment to ARTISTdirect Records for 2004. ARTISTdirect Records
requires additional capital in order to continue operations, and therefore ADI
is continuing to pursue alternatives to raise additional capital for both
itself and for ARTISTdirect Records. However, there can be no assurance that
additional capital can be obtained by either ADI or by ARTISTdirect Records on
reasonable terms or at all. If additional funds are 78




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raised through the issuance of equity securities of either ADI or
ARTISTdirect Records, the percentage ownership of ADIs current stockholders in
ADI and/or the ADIs ownership of ARTISTdirect Records would be reduced.
Failure to raise additional capital could seriously harm the business of
ARTISTdirect Records and impair the value of ADIs investment in ARTISTdirect
Records. In such event, ARTISTdirect Records may seek to divest all or certain
of its assets or ADI may seek to divest all or a part of its ownership of
ARTISTdirect Records, in order to raise the capital necessary to sustain
business operations of ADI and/or ARTISTdirect Records. Should this fail,
ARTISTdirect Records may consider a formal or informal restructuring or
reorganization, potentially resulting in a total loss of ADIs investment in
ARTISTdirect Records. 12. INVESTMENTS IN OTHER AFFILIATED COMPANIES The Company had a 45% ownership in SnoCore, LLC and accounted for this
investment under the equity method through December 31, 2003. The Company
recorded equity income (loss) of $48,000, $(16,000) and $(64,000) with respect
to this investment for the years ended December 31, 2001, 2002 and 2003,
respectively. Effective December 31, 2003, the Company exchanged its 45%
ownership interest in SnoCore, LLC for a 9% net profits interest. The Company
did not record any gain or loss on this transaction at December 31, 2003. During the year ended December 31, 2000, the Company entered into a joint
venture, ARTISTdirect Latin America, LLC, in which the Company held a 50%
ownership interest. The Company made investments of $250,000 and $395,000
during the years ended December 31, 2000 and 2001, respectively, and recorded
these amounts as its share of losses under the equity method. During the year
ended December 31, 2002, the venture ceased operations and no additional
investment was made or loss recognized by the Company. 13. BRIDGE NOTES PAYABLE As of December 31, 2003, ARTISTdirect Records had received $898,000 of
loans from Ted Field and $1.150 million of loans from outside investors
(including $100,000 from Jonathan V. Diamond, the Companys new President and
Chief Executive Officer). The total loans of $2.048 million during 2003 were
obtained through the issuance of convertible promissory notes (the Bridge
Notes). The Bridge Notes accrue interest at 8% per annum, are due two years
from the date of issuance, and will be converted into new equity of
ARTISTdirect Records as part of its next equity financing. The $1.150 million
of loans from outside investors has been presented as bridge notes payable in
the consolidated balance sheet at December 31, 2003. The holders of the Bridge Notes also received warrants with a term of five
years to purchase additional equity of ARTISTdirect Records at $0.01 per unit
equivalent to the number of units of new equity into which their Bridge Notes
are ultimately converted. The relative fair value of the warrants issued was
$1.024 million (one-half of the amount funded by the investors in the Bridge
Notes), which was recorded as a reduction to the carrying amount of the Bridge
Notes and a credit to capital, and is being charged to operations as interest
expense over the specified term of the Bridge Notes. In addition, since the Bridge Notes are convertible into equity based on
their face amount, this results in a beneficial conversion feature with a
relative fair value of $1.024 million. Since the commitment date for the
beneficial conversion feature is contingent upon the completion of ARTISTdirect
Records next equity financing, the fair value of the beneficial conversion
feature will be charged to operations over the remaining life of the Bridge
Notes at that time. During the year ended December 31, 2003, ARTISTdirect Records recognized
$203,000 as interest expense with respect to the amortization of the fair value
of the warrants. Additional interest expense of $821,000 will be recognized
ratably in 2004 and 2005 over the remaining term of the Bridge Notes. As of
December 31, 2003, the carrying amount of the Bridge Notes, including accrued
interest of $67,000, was $1.294 million. A reconciliation of bridge notes payable issued by ARTISTdirect Records
during 2003 to amounts presented in the consolidated balance sheet at December
31, 2003 is presented below. During the year ended December 31, 2003,
ARTISTdirect Records recorded costs with respect to such bridge notes as
summarized below. 79




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OutsideInvestors
    
    Ted FieldGross amount funded during 2003
    
    $
    1,150
    
    
    $
    898Deduct:Fair value of warrants
    
    
    (575
    )
    
    
    (449
    )Add:Accrued interest
    
    
    44
    
    
    
    23Amortization of fair value
of warrants in 2003
    
    
    136
    
    
    
    67Net liability at December 31, 2003
    
    $
    755
    
    
    $
    539
 14. iMUSIC During 2002, the Companys wholly-owned subsidiary, ARTISTdirect Digital,
Inc., began operating a record label under the brand name iMusic. Operations
consist primarily of the sale of compact discs by artists signed to the iMusic
record label. iMusics concept was to focus on the signing of established
artists with a proven sales base and an ability to generally make records less
expensively than developing artists. In addition, the Company expected that
substantially less would be spent on marketing and promotion of these releases
than on those of new artists. During the three months ended June 30, 2003,
management of the Company decided to scale back the activity of its iMusic
label in order to conserve capital. During the three months ended September
30, 2003, the Company executed an agreement with GC Music, pursuant to which
the Company assigned its rights and obligations to six unreleased artists in
exchange for a cash payment of $100,000 as a reduction to prior advances
related to the six artists and a profit interest in the projects. The Company
retains the distribution rights to the albums previously released under the
original terms of its distribution agreements with its other signed artists.
The Company does not plan to sign any additional artists or release any
additional albums domestically or internationally under the iMusic label and
expects very minimal sales activity in the future. During the years ended
December 31, 2002 and 2003, revenues generated by the iMusic label were
$613,000 and $1,352,000, respectively. At December 31, 2003, accounts
receivable relating to the iMusic label were $106,000. 15. DISCONTINUED OPERATIONS In December 2001, the Company decided to exit the music talent agency
business and as a result this segment has been classified as a discontinued
operation in the consolidated statement of operations for years ended December
31, 2001 and 2002 and its net results are reflected as income from discontinued
operations. The agency business did not have any significant assets or
liabilities associated with it and no gain or loss was recognized related to
its disposal. The wind up of operations of the agency business was completed
during 2002. A summary of the statements of operations of the agency business
segment is as follows: Years Ended December 31,2001
    
    2002(in thousands)Agency commission revenues
    
    $
    1,043
    
    
    $
    259Cost of revenues
    
    
    642
    
    
    
    85Gross profit
    
    
    401
    
    
    
    174General and administrative
    
    
    354
    
    
    
    27Income from discontinued operations
    
    $
    47
    
    
    $
    147
 16. INCOME TAXES Income taxes differ from the amount computed using a tax rate of 35% as a
result of the following: Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Computed expected tax benefit
    
    $
    (24,474
    )
    
    $
    (16,919
    )
    
    $
    (7,595
    )State and local income taxes, net
of federal income tax benefit
    
    
    (3,298
    )
    
    
    (2,311
    )
    
    
    (1,302
    )Goodwill amortization/write-off
    
    
    4,371
    
    
    
    276
    
    
    
    Adjustments to deferred tax assets
    
    
    
    
    
    
    2,172
    
    
    
    28,396Other
    
    
    13
    
    
    
    20
    
    
    
    (23,388
    )
    
    
    (16,762
    )
    
    
    19,499Increase
(decrease) in valuation allowance
    
    
    23,388
    
    
    
    16,762
    
    
    
    (19,499
    )Total tax benefit
    
    $
    
    
    
    $
    
    
    
    $
    
 80




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The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and liabilities at
December 31, 2002 and 2003 are
presented below: December 31,2002
    
    
    2003(in thousands)Deferred tax assets:Net operating loss carryforwards
    
    $
    57,477
    
    $
    60,933Amortization of stock-based compensation
    
    
    27,819
    
    
    2,370Other
    
    
    2,206
    
    
    2,674Total deferred tax assets
    
    
    87,502
    
    
    65,977Less: valuation allowance
    
    
    (81,353
    )
    
    (61,854
    )Net deferred assets
    
    
    6,149
    
    
    4,123Deferred tax liability  state income taxes
    
    
    (6,149
    )
    
    (4,123
    )Net deferred tax assets
    
    $
    
    
    $
    
 At December 31, 2003, the Company had net operating loss carryforwards
totaling approximately $142 million for Federal income tax purposes expiring
beginning in 2020 and California state net operating loss carryforwards of $127
million expiring beginning in 2008. Due to the uncertainty surrounding the
realization of the benefits of its tax attributes, primarily net operating loss
carryforwards as of December 31, 2003, the Company has recorded a 100%
valuation allowance against its net deferred tax assets as of December 31, 2002
and 2003. In assessing the potential realization of deferred tax assets, management
considers whether it is more likely than not that some portion or all of the
deferred tax assets will be realized. The ultimate realization of deferred tax
assets is dependent upon the Company attaining future taxable income during the
periods in which those temporary differences become deductible. In addition, Internal Revenue Code Section 382 substantially restricts the
ability of a corporation to utilize existing net operating losses in the event
of an ownership change. Accordingly, a portion of the Companys net
operating losses for Federal income tax purposes may be limited due to previous
changes in ownership. 17. SIGNIFICANT CONTRACTS In February 2002, the Company amended an existing agreement with
Ticketmaster pursuant to which the Company agreed to purchase online
advertising totaling $2.0 million from Ticketmaster and in conjunction became
entitled to certain non-exclusive opportunities to pre-sell tickets on the
ARTISTdirect website. The Company recognized as sales and marketing expense
the amount paid on a straight-line basis, which approximated how the services
were received, over the amended term of the agreement. The term of the amended
agreement expired in April 2003. In connection with the issuance of Series C Preferred shares in 1999 and
2000, the Company entered into strategic relationships with four record labels.
Under the terms of these agreements, the Company had the right to purchase
certain content related to each of the respective companies artists on terms
generally made available to other online music companies. Under one of the
agreements, the Company provided marketing and promotional services on its
network and recognized advertising and sponsorship revenues of $1,000,000 and
$500,000 in the years ended December 31, 2000 and 2001, respectively. The
Company never received any content as expected under the agreement and during
2001 it determined that the collectibility of this receivable either in the
form of cash or acceptable content was impaired. Consequently, a provision for
doubtful accounts of $1.5 million was recorded in the consolidated statement of
operations during the year ended December 31, 2001. The Company did not
provide or receive any services or benefits from any of the other labels and
did not record any revenues or expenses related to these other agreements. In November 2001, ARTISTdirect Records agreed in principle to enter into a
preliminary North American distribution agreement and worldwide license
agreement with BMG. Under the terms of the agreement, BMG distributes
ARTISTdirect Records releases in North America, and BMG licenses ARTISTdirect
Records repertoire in territories throughout the world. In April 2002, the
agreements with BMG were finalized, including BMGs purchase of 5% of the
equity of ARTISTdirect Records from the Company. In connection with the
purchase of equity, BMG agreed to assume $5.0 million of the Companys funding
commitment to ARTISTdirect Records. This loan advance bears interest at a rate
of LIBOR plus 4%, and the principal and interest are not repayable until
December 31, 2015, or upon such time as ARTISTdirect Records achieves certain
defined levels of excess cash flow and available cash. 81




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Under the distribution and license agreements, BMG made non-returnable
advances to ARTISTdirect Records, of $2.5 million in 2001, $2.5 million in 2002
and $5.0 million in 2003 that are recoupable from net sales proceeds from
ARTISTdirect Records artist repertoire. The advances are to be recouped on a
monthly basis based on a defined calculation. As of December 31, 2002 and
2003, the unrecouped balances related to distribution advances from BMG were
$4.1 million and $8.7 million, respectively. 18. RELATED PARTY TRANSACTIONS For the years ended December 31, 2001, 2002 and 2003, the Company incurred
legal expenses of approximately $364,000, $260,000 and $156,000, respectively,
for legal services provided by Lenard & Gonzalez LLP and its successor firm,
Lenard, Brisbin & Klotz LLP. Allen Lenard, one of the Companys former
directors who resigned from the board in September 2002, was Managing Partner
of Lenard & Gonzalez LLP and is managing partner of Lenard, Brisbin & Klotz
LLP. In addition, during 2001, ADI also paid legal fees of $530,000 to Lenard,
Brisbin & Klotz in connection with the ARTISTdirect Records transaction, which
has been treated as an advance to ARTISTdirect Records under the operating
agreement. During the three months ended September 30, 2003, the Company
significantly reduced its overhead costs and operating activities and laid off
the majority of its staff while it continued to restructure its operations and
seek additional capital. The Company also relocated its administrative offices
to a site leased by a company owned by Ted Field. The Company sub-leases these
offices on a month-to-month basis. During the year ended December 31, 2003,
the Company accrued $56,000 as rent expense, which represents occupancy costs
for September through December 2003. See Notes 11, 13, 19, 20, 21 and 23 for additional related party
transactions. 19. RESCISSION OFFER In December 2001, the Company completed a rescission offer in which it
rescinded the purchase of 83,403 shares of its common stock purchased upon the
exercise of options and the issuance of vested and unvested unexercised options
to purchase 636,740 shares of common stock. The shares of stock were
repurchased at prices ranging from $12.40 to $40.00 per share and the
unexercised options that were rescinded had exercise prices ranging from $12.40
to $140.00 per share. In aggregate, the Company paid $10.2 million to rescind
the shares and options. As a result of the completion of the rescission offer, the Company
recorded stock compensation expense of $6.9 million and $1.9 million in 2001
and 2002, respectively. The $6.9 million of compensation expense recognized in
2001 consisted of $859,000 reflected in cost of revenues and $6.1 million
included in operating expenses as stock-based compensation. The $1.9 million
of compensation expense recognized in 2002 consisted of $900,000 reflected in
cost of revenues and $1.0 million reflected in operating expenses. No
additional compensation expense related to the rescission offer was recorded in
2003. As of December 31, 2001, the Company reclassified $2.7 million of unearned
compensation (related to the original option grants subject to the rescission
offer) to prepaid stock-based compensation in the balance sheet, as the
underlying equity instruments were no longer outstanding as a result of the
rescission of the instruments in December 2001. The Companys Chief Financial Officer at the time of the rescission offer
in December 2001 tendered outstanding options to purchase 45,918 shares of the
Companys common stock in exchange for $390,340, as a result of which the
options were cancelled. The Company did not record any compensation expense related to the shares
and options of those holders who chose not to accept the rescission
offer. The Securities Act of 1933, as amended (the "Securities Act"),
does not expressly provide that a rescission offer will terminate a
purchaser's right to rescind a sale of stock that was not registered
under the Securities Act as required. However, federal courts in the past have ruled that a person who rejects or
fails to accept a rescission offer is precluded from later seeking similar
relief. The Company believes that subsequent to the rescission offer, any
rights to rescind will be contingent upon legal rulings, the outcome of which
are not currently determinable. Accordingly, the Company has accounted for
shares and options that were not rescinded in the rescission offer as if there
is no right of rescission. In the event any rescissions occur subsequent to
the expiration of the rescission offer in December 2001, the Company will
account for those rescissions, if any, in the manner described above at the
time those rescissions are completed. 82




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20. STOCKHOLDERS EQUITY COMMON STOCK In April 2001, the Company completed a tender offer in which it
repurchased 200,000 shares of common stock for a total cost of $2.5 million.
The repurchased shares are reflected as treasury stock in the balance sheets as
of December 31, 2002 and 2003. In May 2001, the Company authorized the purchase of up to $2 million worth
of the Companys common stock. During 2001, the Company repurchased in the open
market or in privately negotiated transactions 39,499 shares of common stock
for an aggregate purchase price of approximately $234,000. This repurchase was
separate from the Companys tender offer described above, and is reflected as
treasury stock in the balance sheets as of December 31, 2002 and 2003. No
shares were repurchased by the Company in 2002 or 2003. On July 5, 2001, the Company effected a 1-for-10 reverse stock split. The
outstanding common securities, options and warrants have been retroactively
adjusted to reflect the reverse stock split. All discussion of equity amounts
in these financial statements reflects the effect of the reverse stock split. During December 2003, the Company issued 40,000 shares of common stock to
a consultant for services rendered which were valued at $0.50 per share,
resulting in a charge to operations of $20,000. WARRANTS During 1999, the Company issued warrants, which were immediately
exercisable, to purchase 35,967 shares of common stock at $40.00 per share to
two vendors from whom it purchased merchandise. None of the warrants had been
exercised as of December 31, 2003. The value of the warrants was $864,000, of
which $322,000, $79,000 and $32,000 was recognized as stock based compensation
in cost of revenues for the years ended December 31, 2001, 2002 and 2003,
respectively. The term of the agreements expired in 2003. The warrants expire
in June 2007. In January 2000, the Company issued warrants to purchase 6,250 shares of
common stock at $139.28 per share in connection with an office lease. The
warrants were exercisable upon grant and expire in January 2005. As of
December 31, 2003, none of these warrants had been exercised. The warrants
were valued at $568,000 and were being amortized over the term of the related
lease. During the years ended December 31, 2001, 2002 and 2003, $57,000,
$57,000 and $379,000, respectively, had been recorded as stock-based
compensation expense with respect to these warrants. As a result of the
termination of this office lease in 2003 (see Note 7), the unamortized portion
of these warrants was written off during 2003. In September 2003, the Company issued warrants to purchase 200,000 shares
of common stock as part of the consideration for an office lease termination
(see Note 7). 21. STOCK OPTION AND STOCK PURCHASE PLANS EMPLOYEE OPTION PLAN In October 1999, the Company implemented the 1999 Employee Stock Option
Plan that replaced the 1998 Unit Option Plan. The plan has currently reserved
870,420 shares of the Companys common stock for issuance to employees,
non-employee members of the board of directors and consultants. This share
reserve automatically increases on the first trading day in January each
calendar year by an amount equal to two percent (2%) of the total number of
shares of the Companys common stock outstanding on the last trading day of
December in the prior calendar year, but in no event will this annual increase
exceed 87,500 shares. No option may have a term in excess of 10 years. The
options generally vest within three years. As of December 31, 2003, 758,492
shares remained available for future option grant. The Company accounts for its employee stock option plan in accordance with
the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees, Interpretation No. 44, and other related
interpretations. As such, compensation expense would be recorded on the date
of grant only if the current market price of the underlying stock exceeded the
exercise price. Summary stock option activity for 1999 Employee Stock Option Plan during
the years ended December 31, 2001, 2002 and 2003 83




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is as follows: Options OutstandingWeightedNumber of
    
    AverageShares
    
    Exercise PriceOutstanding options at December 31, 2000
    
    
    566,304
    
    
    $
    58.36Granted
    
    
    35,687
    
    
    
    7.50Exercised
    
    
    
    
    
    
    Cancelled
    
    
    (418,836
    )
    
    
    44.78Outstanding options at December 31, 2001
    
    
    183,155
    
    
    
    79.51Granted
    
    
    100,000
    
    
    
    5.94Exercised
    
    
    
    
    
    
    Cancelled
    
    
    (35,149
    )
    
    
    17.02Outstanding options at December 31, 2002
    
    
    248,006
    
    
    
    58.43Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    (136,079
    )
    
    
    100.71Outstanding options at December 31, 2003
    
    
    111,927
    
    
    $
    7.04
 The Company recorded stock-based compensation of $2.7 million, $31,000 and
$0 related to stock options granted to employees under the 1999 Employee Stock
Option Plan during the years ended December 31, 2001, 2002 and 2003,
respectively. The following table summarizes information regarding options outstanding
and options exercisable at December 31, 2003: Options OutstandingWeighted
    
    
    
    
    
    Options Exercisableaverageremaining
    
    Weighted
    
    
    
    
    
    WeightedExercise
    
    Number
    
    contractual
    
    average
    
    Number
    
    AveragePrices
    
    of shares
    
    life
    
    exercise price
    
    of shares
    
    exercise price$4.80

    
    
    40,000
    
    
    
    5.78
    
    
    $
    4.80
    
    
    
    26,667
    
    
    $
    4.805.10

    
    
    10,000
    
    
    
    5.77
    
    
    
    5.10
    
    
    
    10,000
    
    
    
    5.107.50

    
    
    58,603
    
    
    
    4.83
    
    
    
    7.50
    
    
    
    58,603
    
    
    
    7.5012.40

    
    
    786
    
    
    
    1.58
    
    
    
    12.40
    
    
    
    786
    
    
    
    12.4030.00

    
    
    450
    
    
    
    3.76
    
    
    
    30.00
    
    
    
    450
    
    
    
    30.0036.00

    
    
    439
    
    
    
    3.76
    
    
    
    36.00
    
    
    
    439
    
    
    
    36.0040.00

    
    
    1,650
    
    
    
    4.44
    
    
    
    40.00
    
    
    
    1,650
    
    
    
    40.00$
4.80-$40.00

    
    
    111,928
    
    
    
    5.22
    
    
    $
    7.04
    
    
    
    98,594
    
    
    $
    7.34
 In May 2001, the Company granted an officer three non-qualified stock
options, which are not part of any stock option plan maintained by the Company,
to purchase 444,480 shares of common stock at an exercise price of $7.50 per
share. Options on 302,370 shares are exercisable immediately (the underlying
shares pursuant to the exercise of this option vests over five years from the
date of the option grant), options on 75,588 shares are exercisable in the
event the 30-day average closing price of the Companys common stock on NASDAQ
equals or exceeds $35.00 per share within three years from the grant date, and
options on 66,522 shares are exercisable in the event the 30-day average
closing price of the Companys common stock on NASDAQ equals or exceeds $70.00
per share within three years of the grant date. The two options that are not
exercisable upon grant shall also become exercisable in the event of a
de-listing of the Companys common stock from NASDAQ and a subsequent
re-listing, a change in control of the Company or an involuntary termination of
the officer (within three years of the date of grant). If not vested by June
29, 2004, the options for 75,588 shares and 66,522 shares will terminate. In September 2001, the Company granted options to purchase 35,687 shares
of its common stock at an exercise price of $7.50 per share to outside legal
counsel. The fair value of the stock options granted to the outside legal
counsel was $171,000 and was recorded as stock based compensation during the
year ended December 31, 2001 as the grant related to past services. ADVISOR OPTION PLAN In June 1999 and as amended in October 1999 and March 2000 the Company
adopted the 1999 Artist and Artist Advisor Stock Option Plan (the Advisor
Plan). The Advisor Plan has currently reserved 294,617 shares of common stock
for issuance to artists for whom the Company entered into agreements related to
online and e-commerce activities and their agents, business managers, attorneys
and other advisors. This share reserve automatically increases on the first
trading day in January each calendar year by an 84




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amount equal to one percent (1%) of the total number of shares of the
Companys common stock outstanding on the last trading day of December in the
prior calendar year, but in no event will this annual increase exceed 37,500
shares. As of December 31, 2003, 259,081 shares remained available for future
option grants. The options expire seven years from the date of grant and
vesting generally varies between one to three years. In December 2001, a
majority of the outstanding options under the Advisor plan were rescinded and
cancelled. No new option grants under this plan were made during 2002 or 2003. Summary stock option activity for the Advisor Plan options during the
years ended December 31, 2001, 2002 and 2002 is as follows: Options OutstandingWeightedNumber
    
    Averageof Shares
    
    Exercise PriceOutstanding options at December 31, 2000
    
    
    119,336
    
    
    $
    67.05Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    (83,800
    )
    
    
    43.23Outstanding options at December 31, 2001
    
    
    35,536
    
    
    
    123.29Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    
    
    
    
    Outstanding options at December 31, 2002
    
    
    35,536
    
    
    
    123.29Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    
    
    
    
    Outstanding options at December 31, 2003
    
    
    35,536
    
    
    $
    123.29
 The weighted average fair value of options granted under the Advisor Plan
was $66.50 per option in 2000 resulting in a total value for options granted of
$2.1 million. Of the $2.1 million, $1.8 million was expensed in 2000 and
$300,000 was expensed in 2001. The following table summarizes information regarding options outstanding
and options exercisable at December 31, 2003: Options Outstanding
    
    Options ExercisableWeightedAverageRemaining
    
    Weighted
    
    
    
    
    
    WeightedNumber
    
    contractual
    
    Average
    
    Number
    
    averageExercise prices
    
    of shares
    
    life
    
    exercise price
    
    of shares
    
    exercise price$36.00
    
    
    1,250
    
    
    
    3.78
    
    
    $
    36.00
    
    
    
    1,250
    
    
    $
    36.0040.00
    
    
    4,422
    
    
    
    3.61
    
    
    
    40.00
    
    
    
    4,422
    
    
    
    40.00139.28
    
    
    29,864
    
    
    
    4.25
    
    
    
    139.28
    
    
    
    29,864
    
    
    
    139.28$36.00-$139.28
    
    
    35,536
    
    
    
    4.15
    
    
    $
    123.29
    
    
    
    35,536
    
    
    $
    123.29
 ARTIST OPTION PLAN In June 1999 and as amended in October 1999, the Company adopted the 1999
Artist Stock Plan (the Artist Plan). The Artist Plan currently has reserved
620,420 shares of common stock for issuance to artists for whom the Company
entered into agreements related to their online and e-commerce activities.
This share reserve automatically increases on the first trading day in January
each calendar year by an amount equal to two percent (2%) of the total number
of shares of the Companys common stock outstanding on the last trading day of
December in the prior calendar year, but in no event will this annual increase
exceed 87,500 shares. As of December 31, 2003, 596,546 shares remained
available for future option grants. The options expire seven years from the
date of grant and vesting generally varies between one to three years. In
December 2001, a majority of the outstanding options under the Advisor plan
were rescinded and cancelled. No new option grants under this plan were made
during 2002 or 2003. 85




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Summary stock option activity for the Artist Option Plan during the years
ended December 31, 2001, 2002 and 2003 is as follows: Options OutstandingWeightedNumber
    
    Averageof Shares
    
    Exercise PriceOutstanding options at December 31, 2000
    
    
    222,375
    
    
    $
    59.86Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    (198,501
    )
    
    
    57.07Outstanding options at December 31, 2001
    
    
    23,874
    
    
    
    83.15Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    
    
    
    
    Outstanding options at December 31, 2002
    
    
    23,874
    
    
    
    83.15Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Cancelled
    
    
    
    
    
    
    Outstanding options at December 31, 2003
    
    
    23,874
    
    
    $
    83.15
 The following table summarizes information regarding options outstanding
and options exercisable at December 31, 2003: Options Outstanding and ExercisableWeightedaverage
    
    WeightedNumber
    
    remaining
    
    AverageExercise prices

    
    of shares
    
    contractual life
    
    exercise price$40.00

    
    
    13,499
    
    
    
    3.66
    
    
    $
    40.00139.28

    
    
    10,375
    
    
    
    4.20
    
    
    
    139.28$40.00-$139.28

    
    
    23,874
    
    
    
    3.90
    
    
    $
    83.15
 Total compensation expense related to the Advisor Plan and the Artist
Option Plan (excluding the impact of the rescission offer) was $10.6 million,
$2.9 million and $540,000 for the years ended December 31, 2001, 2002 and 2003,
respectively, of which $7.2 million, $2.1 million and $33,000, respectively,
was included in cost of revenue, and $3.4 million, $800,000 and $527,000,
respectively, was included in operating expenses. For the year ended December 31, 2001, the decrease in unearned
compensation of $2.4 million was a result of the cancellation of unvested
compensatory employee options. EMPLOYEE STOCK PURCHASE PLAN In October 1999, the Company adopted the 1999 Employee Stock Purchase Plan
that has reserved 100,000 shares of common stock for issuance under this plan.
This share reserve automatically increases on the first trading day in January
each calendar year, by an amount equal to one percent (1%) of the total number
of the Companys common stock outstanding on the last trading day of December
in the prior calendar year, but in no event will this annual increase exceed
25,000 shares. Terms of the plan permit eligible employees to purchase common
stock through payroll deduction of up to 15% of each employees compensation.
The accumulated deductions will be applied to the purchase of shares on each
semi-annual purchase date at a purchase price per share equal to 85% of the
fair market value per share on the participants entry date into the offering
period or the semi-annual purchase date, whichever is lower. Pursuant to the
provisions of APB No. 25, shares issued to employees under this plan are
considered non-compensatory. During the years ended December 31, 2001, 2002
and 2003, 3,902 shares, 1,134 shares and 375 shares, respectively, were issued
under this plan for total proceeds of $17,000, $4,000 and $440, respectively. See Note 23 for a description of non-plan stock options to purchase
259,659 shares of common stock issued to the Companys President and Chief
Executive Officer, and non-plan stock options to purchase 444,480 shares of
common stock issued to the Companys Chairman, who is also the Chief Executive
Officer of ARTISTdirect Records. 22. 401(K) PLAN The Company has adopted the Cash or Deferred Profit Sharing Plan and Trust
under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the
401(k) Plan, participating employees may defer a percentage (not to exceed 15%)
of their eligible pretax earnings up to the Internal Revenue Services annual
contribution limit. All employees of the Company age 21 years or older who
complete three months of service are eligible to participate in the 401(k)
Plan. The Company does not match participants contributions to the 401(k)
Plan. Accordingly, there is no related expense for the years ended December
31, 2001, 2002 and 2003. 86




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23. COMMITMENTS AND CONTINGENCIES LEASE COMMITMENTS Future minimum lease payments under operating leases for certain equipment
are as follows: Year EndedDecember
31,(in thousands)2004
    
    $
    38
 Rent expense under operating leases for the years ended December 31, 2001,
2002 and 2003 was $1,961,000, $1,806,000 and $2,144,000 (including $56,000 to a
related party in 2003), respectively. EMPLOYMENT CONTRACTS Future payments under employment and consulting contracts are as follows: Years EndedDecember
31,(in thousands)2004
    
    $
    3052005
    
    
    1852006
    
    
    116Total
    
    $
    606
 Effective September 29, 2003, the Company entered into an employment
agreement with Jonathan V. Diamond to serve as the Companys President and
Chief Executive Officer through August 15, 2006 with a base annual salary of
$185,000 plus certain benefits. In conjunction with the employment agreement,
the Company granted Mr. Diamond a non-plan, non-qualified stock option to
purchase 259,659 shares of common stock at an exercise price of $0.85 per
share, which was the approximate fair market value of the common stock at the
date of grant. Effective May 31, 2003, Marc P. Geiger, the Companys former Vice Chairman
of the Board of Directors and President  Artist Services, resigned as an
officer of the Company. Mr. Geiger remains as a director of the Company. Mr.
Geigers July 2001 amended employment agreement, which had an initial term
extending through June 30, 2006, provided for an annual salary of $500,000 plus
certain benefits. The amended employment agreement also provided that under
certain conditions, Mr. Geiger would receive a payment of $1,000,000 plus one
years salary upon the termination of his employment with the Company. In
February 2001, the Company loaned Mr. Geiger $150,000, with interest at 7%.
The term of the loan was initially one year, but was extended in September 2001
to five years commensurate with the amendment of Mr. Geigers employment
agreement in July 2001. Mr. Geiger was obligated to repay the loan in five
equal annual principal payments of $30,000, along with accrued interest to
date, beginning in September 2002. In consideration for Mr. Geiger terminating
his employment agreement effective as of the date of his resignation and
waiving all rights to compensation under the employment agreement, the Company
paid Mr. Geiger his accrued compensation and benefits of approximately
$184,000, and Mr. Geiger repaid the $150,000 loan plus accrued interest. Effective December 31, 2003, Keith Yokomoto, the Companys former
President and Chief Operating Officer, entered into a Termination Agreement and
Mutual General Release. Mr. Yokomoto remains as a director of the Company.
Mr. Yokomotos July 2001 employment agreement, which had an initial term
extending through June 30, 2006, provided for an annual salary of $500,000 plus
certain benefits, and a commencement advance of $300,000, representing a
pre-payment of $60,000 against any monies that would otherwise become payable
to Mr. Yokomoto under the Companys executive performance bonus pool for each
year of the initial five-year term of the employment agreement. The employment
agreement also provided that under certain conditions, Mr. Yokomoto would
receive a payment of $350,000 plus one years salary upon the termination of
his employment with the Company. In consideration for Mr. Yokomoto terminating
his employment agreement effective as of December 31, 2003 and waiving all
rights to $1.25 million of remaining compensation under the employment
agreement, the Company paid Mr. Yokomoto his accrued but unpaid salary at the
rate of $500,000 per year through December 31, 2003 aggregating $412,847 and
his accrued but unused vacation pay through December 31, 2003 aggregating
$76,924, and Mr. Yokomoto repaid the Company the unearned portion of the
commencement advance of $150,000. 87




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Effective January 1, 2004, the Company entered into a one-year consulting
agreement with Mr. Yokomoto that provides for total compensation of $120,000.
Effective January 9, 2004, the Company also issued to Mr. Yokomoto two
non-qualified stock options to purchase 10,000 shares and 50,000 shares at
$0.50 per share, which was not less than the fair market value on the date of
grant, exercisable through January 9, 2011. The option for 10,000 shares was
immediately vested upon issuance. The option for 50,000 shares vests in
increments of 10,000 shares on February 1, 2004, March 31, 2004, June 30, 2004,
September 30, 2004 and December 31, 2004, based on the accomplishment of
certain milestones by each respective date. In May 2001, the Company entered into an agreement with Frederick W. (Ted)
Field to serve as Chairman and Chief Executive Officer of the Company and to
form a new record label, ARTISTdirect Records, as a co-venture with the
Company. On June 29, 2001, the Companys stockholders approved the employment
of Mr. Field and the formation of the ARTISTdirect Records record label.
ARTISTdirect Records was formed as a 50/50 co-venture between the Company and
Mr. Field. Mr. Field is the Chief Executive Officer of ARTISTdirect Records.
In conjunction therewith, the Company entered into an employment agreement and
stock option agreement with Mr. Field. Mr. Fields employment agreement, which has an initial term extending
through May 31, 2006, provided for an annual base salary of $500,000 plus
certain benefits. The employment agreement also provided that under certain
conditions, Mr. Field would receive a lump-sum payment equal to his annual base
salary for (i) 50% of the remaining term of the employment agreement if
termination occurs within the first three years of his employment, (ii) his
annual base salary for one year if termination occurs in the fourth year of his
employment, and (iii) his annual base salary for the full remaining term of the
employment agreement if termination occurs in the fifth year of his employment. In May 2001, the Company also granted Mr. Field three non-qualified stock
options, which are not part of any stock option plan maintained by the Company,
to purchase 444,480 shares of common stock at an exercise price of $7.50 per
share. Options on 302,370 shares are exercisable immediately (the underlying
shares pursuant to the exercise of this option vests over five years from the
date of the option grant), options on 75,588 shares are exercisable in the
event the 30-day average closing price of the Companys common stock on NASDAQ
equals or exceeds $35.00 per share within three years from the grant date, and
options on 66,522 shares are exercisable in the event the 30-day average
closing price of the Companys common stock on NASDAQ equals or exceeds $70.00
per share within three years of the grant date. The two options that are not
exercisable upon grant shall also become exercisable in the event of a
de-listing of the Companys common stock from NASDAQ and a subsequent
re-listing, a change in control of the Company or an involuntary termination of
the officer (within three years of the date of grant). If not vested by June
29, 2004, the options for 75,588 shares and 66,522 shares will terminate. During 2002, Mr. Fields employment agreement was amended whereby Mr.
Field agreed to defer his future salary until the Company raised new debt or
equity financing of at least $20 million. During the three months ended June
30, 2003, Mr. Fields employment agreement was further amended whereby all
deferred and any future salary, except a base amount, would be waived, even if
new debt or equity financing is raised. Accordingly, during the year ended
December 31, 2003, $411,000 of accrued compensation due to Mr. Field by the
Company was recorded as gain from forgiveness of debt in the consolidated
statement of operations. LITIGATION The Company is subject to various pending and threatened legal actions
which arise in the normal course of business. The Companys management believes
that the impact of such litigation will not have a material adverse impact on
its financial position or results of operations. 24. REPORTABLE SEGMENTS Information with respect to the Companys operating segments for the years
ended December 31, 2001, 2002 and 2003 is presented below. During the year
ended December 31, 2003, the Company operated primarily through three
reportable segments: E-commerce operations (E-commerce), Media Operations
(Media) and Record Label operations (Record Label). Record label
operations consisted primarily of the iMusic record label. Since the Company
accounted for its interest in ARTISTdirect Records on the equity method of
accounting during 2001, 2002 and 2003, the operations of ARTISTdirect Records
are not included for such periods. 88




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In prior years, the Company also considered its talent agency business to
be a segment, but the Company decided in December 2001 to exit this business
and as a result it has been shown as a discontinued operation in the
consolidated statements of operations. The Company also previously considered
digital music to be a separate segment; however, this business did not develop
as quickly as initially anticipated and it is no longer considered a separate
reportable segment. The segment data below has been restated for all periods
to reflect the current segment structure. E-commerce revenue is generated from the sale of recorded music and
music-related merchandise. Media revenue is generated from the sale of
advertising and sponsorships, both online and offline. Record label revenue is
generated from the sale of recorded music performed by artists signed to the
Companys iMusic record label. The factors for determining reportable segments were based on services and
products. Each segment is responsible for executing a unique marketing and
business strategy. The accounting policies of the segments are the same as
those described in the summary of significant accounting policies. The Company
evaluates performance based on EBITDA (earnings or loss before interest, taxes,
depreciation and amortization, including stock-based compensation, impairment
losses, and minority interest). Included in EBITDA are direct operating
expenses for the segment. The following table summarizes the revenue and
EBITDA by segment for the years ended December 31, 2001, 2002 and 2003.
Corporate expenses consist of general operating expenses that are not directly
related to the operations of the segments. Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Net Revenue:E-commerce
    
    $
    7,542
    
    
    $
    4,713
    
    
    $
    3,459Media
    
    
    2,879
    
    
    
    924
    
    
    
    1,173Record label
    
    
    
    
    
    
    613
    
    
    
    1,352$
    10,421
    
    
    $
    6,250
    
    
    $
    5,984EBITDA:E-commerce
    
    $
    (2,605
    )
    
    $
    (137
    )
    
    $
    553Media
    
    
    (6,908
    )
    
    
    (3,065
    )
    
    
    (576
    )Record label
    
    
    
    
    
    
    (1,396
    )
    
    
    (354
    )(9,513
    )
    
    
    (4,598
    )
    
    
    (377
    )Corporate
    
    
    (16,086
    )
    
    
    (6,654
    )
    
    
    (3,096
    )$
    (25,599
    )
    
    $
    (11,252
    )
    
    $
    (3,473
    )
 Years Ended December 31,2001
    
    2002
    
    2003(in thousands)Reconciliation of EBITDA to Net Loss:EBITDA per Segments
    
    $
    (25,599
    )
    
    $
    (11,252
    )
    
    $
    (3,473
    )Stock-based compensation
    
    
    (20,820
    )
    
    
    (4,981
    )
    
    
    (560
    )Depreciation and amortization
    
    
    (6,512
    )
    
    
    (2,814
    )
    
    
    (1,014
    )Amortization of vendor prepaid
    
    
    (139
    )
    
    
    
    
    
    
    Loss from impairment of goodwill
    
    
    (11,444
    )
    
    
    (788
    )
    
    
    Loss from sale and abandonment of
property and equipment
    
    
    
    
    
    
    
    
    
    
    (2,225
    )Loss from equity investments
    
    
    (8,998
    )
    
    
    (29,252
    )
    
    
    (9,320
    )Interest income (expense), net
    
    
    3,585
    
    
    
    748
    
    
    
    146Income from discontinued operations
    
    
    47
    
    
    
    147
    
    
    
    Cumulative effect of consolidation of
ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    (5,255
    )$
    (69,880
    )
    
    $
    (48,192
    )
    
    $
    (21,701
    )
 Assets as of December 31, 2002 and 2003 are summarized as follows: December 31,2002
    
    2003(in thousands)Assets:Corporate
    
    $
    14,455
    
    
    $
    2,066E-commerce
    
    
    432
    
    
    
    528Media
    
    
    819
    
    
    
    355Record label
    
    
    219
    
    
    
    57$
    15,925
    
    
    $
    3,006
 89




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Assets by segment are those assets used in the Company operations in each
segment. Corporate assets are principally made up of cash and cash
equivalents, short-term investments, prepaid expenses, computer equipment,
leasehold improvements and other assets. As of December 31, 2002 and 2003, the Company had advanced $30.25 million
and $33.0 million to its record label venture, ARTISTdirect Records, and had
recorded losses of approximately $8.6 million, $29.3 million and $9.3 million
with respect to this investment for the years ended December 31, 2001, 2002 and
2003, respectively (see Note 11). 25. QUARTERLY RESULTS OF OPERATIONS The following table sets forth unaudited quarterly results of operations
for the years ended December 31, 2002 and 2003. This unaudited quarterly
information has been derived from the Companys unaudited financial statements
and, in the Companys opinion, 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 the operating results for any future period. March 31,
    
    June 30,
    
    September 30,
    
    December 31,
    
    Year Ended2002
    
    2002
    
    2002
    
    2002
    
    December 31, 2002Net revenue
    
    $
    1,331
    
    
    $
    1,441
    
    
    $
    1,758
    
    
    $
    1,720
    
    
    $
    6,250Gross loss
    
    
    (1,490
    )
    
    
    (1,270
    )
    
    
    (862
    )
    
    
    (868
    )
    
    
    (4,490
    )Loss from continuing operations
    
    
    (13,323
    )
    
    
    (15,201
    )
    
    
    (9,991
    )
    
    
    (9,824
    )
    
    
    (48,339
    )Income (loss) from discontinued operations
    
    
    158
    
    
    
    (11
    )
    
    
    
    
    
    
    
    
    
    
    147Net loss
    
    $
    (13,165
    )
    
    $
    (15,212
    )
    
    $
    (9,991
    )
    
    $
    (9,824
    )
    
    $
    (48,192
    )Basic and diluted loss per share:From continuing operations
    
    $
    (3.85
    )
    
    $
    (4.40
    )
    
    $
    (2.89
    )
    
    $
    (2.84
    )
    
    $
    (13.96
    )From discontinued operations
    
    
    0.05
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.04Total
    
    $
    (3.80
    )
    
    $
    (4.40
    )
    
    $
    (2.89
    )
    
    $
    (2.84
    )
    
    $
    (13.92
    )
 March 31,
    
    June 30,
    
    September 30,
    
    December 31,
    
    Year Ended2003
    
    2003
    
    2003
    
    2003
    
    December 31, 2003Net revenue
    
    $
    1,699
    
    
    $
    1,976
    
    
    $
    879
    
    
    $
    1,430
    
    
    $
    5,984Gross profit
    
    
    163
    
    
    
    758
    
    
    
    131
    
    
    
    569
    
    
    
    1,621Loss from continuing operations
    
    
    (7,131
    )
    
    
    (5,424
    )
    
    
    (1,670
    )
    
    
    (2,221
    )
    
    
    (16,446
    )Cumulative effect of consolidation
of ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,255
    )
    
    
    (5,255
    )Net loss
    
    $
    (7,131
    )
    
    $
    (5,424
    )
    
    $
    (1,670
    )
    
    $
    (7,476
    )
    
    $
    (21,701
    )Basic and diluted loss per share:From continuing operations
    
    $
    (2.06
    )
    
    $
    (1.57
    )
    
    $
    (0.48
    )
    
    $
    (0.64
    )
    
    $
    (4.75
    )From cumulative effect of
consolidation of
ARTISTdirect Records, LLC
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1.52
    )
    
    
    (1.52
    )Total
    
    $
    (2.06
    )
    
    $
    (1.57
    )
    
    $
    (0.48
    )
    
    $
    (2.16
    )
    
    $
    (6.27
    )
 26. SUBSEQUENT EVENTS (UNAUDITED) During the three months ended March 31, 2004, Mr. Field advanced an
additional $1.89 million to ARTISTdirect Records to fund operating expenses and
the settlement of artist contracts. In consideration for such advances, Mr.
Field received Bridge Notes and warrants as described at Note 13. 90




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ARTISTDIRECT RECORDS, LLC INDEX TO FINANCIAL STATEMENTS PAGEIndependent Auditors Report- Gumbiner, Savett, Finkel, Fingleson & Rose, Inc.
    
    
    93Balance Sheets  December 31, 2002 and 2003
    
    
    94Statements of Operations  Period from May 31, 2001 (inception)
to December 31, 2001, and Years Ended December 31, 2002 and 2003
    
    
    95Statements of Members Deficit  Period from May 31, 2001 (inception)
to December 31, 2001, and Years Ended December 31, 2002 and 2003
    
    
    96Statements of Cash Flows  Period from May 31, 2001 (inception) to
December 31, 2001, and Years Ended December 31, 2002 and 2003
    
    
    97Notes to Financial Statements  Period from May 31, 2001 (inception)
to December 31, 2001, and Years Ended December 31, 2002 and 2003
    
    
    98
 91




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INDEPENDENT AUDITORS REPORT The Members
ARTISTdirect Records, LLC We have audited the accompanying balance sheet of ARTISTdirect Records, LLC
(the Company) as of December 31, 2003 and the related statements of
operations, members deficit and cash flows for the year then ended. These
financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audit. We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ARTISTdirect Records, LLC as
of December 31, 2003 and the results of its operations and its cash flows for
the year then ended, in conformity with accounting principles generally
accepted in the United States of America. The accompanying financial statements have been prepared assuming that
ARTISTdirect Records, LLC will continue as a going concern. As more fully
described in Note 1, the Company has incurred substantial operating losses and
negative cash flows from operations to date. The Company needs additional
capital to fund its operations. As of December 31, 2003, the Company has a net
working capital deficiency of $10.9 million and a members deficit of $53.355
million. These conditions raise substantial doubt about the Companys
ability to continue as a going concern. Managements plans in regard to these
matters are also described in Note 1. The financial statements do not include
any adjustments that might result from the outcome of this uncertainty. /s/ GUMBINER, SAVETT, FINKEL, FINGLESON & ROSE, INC. Santa Monica, California
April 6, 2004 92




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ARTISTDIRECT RECORDS, LLC BALANCE SHEETS
(IN THOUSANDS) December 31,
    
    December 31,2002
    
    2003AssetsCurrent assets:Cash
    
    $
    
    
    
    $
    7Accounts receivable, net
    
    
    18
    
    
    
    Inventory, net
    
    
    85
    
    
    
    Prepaid expenses
    
    
    118
    
    
    
    Total current assets
    
    
    221
    
    
    
    7Property and equipment, net
    
    
    231
    
    
    
    40Other assets, net
    
    
    85
    
    
    
    $
    537
    
    
    $
    47Liabilities and Members DeficitCurrent liabilities:Accounts payable
    
    $
    531
    
    
    $
    901Accrued expenses
    
    
    2,122
    
    
    
    1,212Due to ARTISTdirect, Inc., a related party
    
    
    1
    
    
    
    45Net liability to BMG, a distributor and a
related party
    
    
    4,113
    
    
    
    8,749Total current liabilities
    
    
    6,767
    
    
    
    10,907Non-current liabilities:Interest payable
    
    
    1,276
    
    
    
    3,451Loan advances from ARTISTdirect, Inc.,
a related party, and BMG, a distributor
and a related party
    
    
    35,000
    
    
    
    37,750Bridge notes payable  outside investors
    
    
    
    
    
    
    755Bridge notes payable  Chief Executive
Officer and a related party
    
    
    
    
    
    
    539Total liabilities
    
    
    43,043
    
    
    
    53,402Commitments and contingenciesMembers deficit
    
    
    (42,506
    )
    
    
    (53,355
    )$
    537
    
    
    $
    47
 See accompanying notes to financial statements. 93




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ARTISTDIRECT RECORDS, LLC STATEMENTS OF OPERATIONS
(IN THOUSANDS) Period from May 31,2001 (inception) to
    
    Year Ended
    
    Year EndedDecember 31, 2001
    
    December 31, 2002
    
    December 31, 2003Net revenue
    
    $
    
    
    
    $
    3,709
    
    
    $
    1,426Cost of revenue:Manufacturing and distribution expenses
    
    
    
    
    
    
    1,305
    
    
    
    420Advances and royalties, net
    
    
    3,174
    
    
    
    8,788
    
    
    
    1,378Total cost of revenue
    
    
    3,174
    
    
    
    10,093
    
    
    
    1,798Gross loss
    
    
    (3,174
    )
    
    
    (6,384
    )
    
    
    (372
    )Operating expenses:Sales and marketing
    
    
    799
    
    
    
    12,029
    
    
    
    3,287General and administrative
    
    
    4,549
    
    
    
    14,374
    
    
    
    6,450Depreciation and amortization
    
    
    2
    
    
    
    36
    
    
    
    39Loss from sale and abandonment of
property and equipment
    
    
    
    
    
    
    
    
    
    
    100Total operating expenses
    
    
    5,350
    
    
    
    26,439
    
    
    
    9,876Loss from operations
    
    
    (8,524
    )
    
    
    (32,823
    )
    
    
    (10,248
    )Interest expense, net, including
amortization of bridge note
warrants of $203,000 in 2003
    
    
    126
    
    
    
    1,133
    
    
    
    2,447Net loss
    
    $
    (8,650
    )
    
    $
    (33,956
    )
    
    $
    (12,695
    )
 See accompanying notes to financial statements. 94




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ARTISTDIRECT RECORDS, LLC STATEMENTS OF MEMBERS DEFICIT
(IN THOUSANDS) MembersDeficitBalance at May 31, 2001 (inception)
    
    $
    Initial capital contribution upon formation
    
    
    100Net loss
    
    
    (8,650
    )Balance at December 31, 2001
    
    
    (8,550
    )Net loss
    
    
    (33,956
    )Balance at December 31, 2002
    
    
    (42,506
    )Compensation forgiven by Chief Executive
Officer and member
    
    
    822Issuance of bridge note warrants
    
    
    1,024Net loss
    
    
    (12,695
    )Balance at December 31, 2003
    
    $
    (53,355
    )
 See accompanying notes to financial statements. 95




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ARTISTDIRECT RECORDS, LLC STATEMENTS OF CASH FLOWS
(IN THOUSANDS) Period from May 31,2001 (inception) to
    
    Year Ended
    
    Year EndedDecember 31, 2001
    
    December 31, 2002
    
    December 31, 2003Cash flows from operating activities:Net loss
    
    $
    (8,650
    )
    
    $
    (33,956
    )
    
    $
    (12,695
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    2
    
    
    
    36
    
    
    
    39Allowance for obsolescence
    
    
    
    
    
    
    250
    
    
    
    204Allowance for sales returns
    
    
    
    
    
    
    800
    
    
    
    888Amortization of bridge note warrants
    
    
    
    
    
    
    
    
    
    
    203Loss from sale and abandonment of property and equipment
    
    
    
    
    
    
    
    
    
    
    100Changes in operating assets and liabilities:(Increase) decrease in -Accounts receivable
    
    
    
    
    
    
    (18
    )
    
    
    18Prepaid expenses and other current assets
    
    
    (59
    )
    
    
    (394
    )
    
    
    (1
    )Other assets
    
    
    (115
    )
    
    
    30
    
    
    
    85Increase (decrease) in -Accounts payable, accrued expenses and other liabilities
    
    
    738
    
    
    
    1,673
    
    
    
    282Due to ARTISTdirect, Inc., a related party
    
    
    187
    
    
    
    (186
    )
    
    
    44Net liability to BMG, a distributor and a related party
    
    
    2,500
    
    
    
    813
    
    
    
    3,748Net cash used in operating activities
    
    
    (5,397
    )
    
    
    (30,952
    )
    
    
    (7,085
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (23
    )
    
    
    (246
    )
    
    
    Proceeds from sale of property and equipment
    
    
    
    
    
    
    
    
    
    
    52Net cash provided by (used in) investing activities
    
    
    (23
    )
    
    
    (246
    )
    
    
    52Cash flows from financing activities:Proceeds from issuance of bridge notes
    
    
    
    
    
    
    
    
    
    
    2,048Proceeds from loan advances from ARTISTdirect, Inc., a related party
    
    
    5,250
    
    
    
    25,000
    
    
    
    2,750Proceeds from loan advances from BMG, a distributor and a related party
    
    
    
    
    
    
    4,750
    
    
    
    Net increase in interest payable
    
    
    135
    
    
    
    1,141
    
    
    
    2,242Net increase in cash overdraft
    
    
    
    
    
    
    242
    
    
    
    Proceeds from initial capital contributions
    
    
    100
    
    
    
    
    
    
    
    Net cash provided by financing activities
    
    
    5,485
    
    
    
    31,133
    
    
    
    7,040Net increase (decrease) in cash
    
    
    65
    
    
    
    (65
    )
    
    
    7Cash at beginning of period
    
    
    
    
    
    
    65
    
    
    
    Cash at end of period
    
    $
    65
    
    
    $
    
    
    
    $
    7Supplemental disclosure of cash flow information:Cash paid during the period for interest
    
    $
    
    
    
    $
    
    
    
    $
    Cash paid during the period for taxes
    
    $
    
    
    
    $
    
    
    
    $
    
 See accompanying notes to financial statements. 96




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ARTISTDIRECT RECORDS, LLC NOTES TO FINANCIAL STATEMENTS PERIOD FROM MAY 31, 2001 (INCEPTION) TO DECEMBER 31, 2001,
AND YEARS ENDED DECEMBER 31, 2002 AND 2003 1. BASIS OF PRESENTATION ORGANIZATION AND BUSINESS ACTIVITIES ARTISTdirect Records, LLC (the Company) was formed in May 2001 as a
50/50 co-venture between ARTISTdirect, Inc. (ADI) and Radar Records Holdings,
LLC (Radar Records), an entity owned and controlled by Frederick W. (Ted)
Field, the then Chairman and Chief Executive Officer of ADI. At its formation,
the Company issued 10,000,000 membership units for total proceeds of $100,000.
The Company commenced operations in July 2001. The Company, headquartered in
Los Angeles, California, develops new musical artists and produces and
distributes their recordings as an independent label utilizing both traditional
channels and emerging Internet distribution channels. At the time of formation of the Company, ADI committed to provide funding
of up to $50 million over five years at the rate of $15.0 million per year,
subject to a limit of $33 million in any three year period. Any funding in
excess of these amounts required the approval of ADIs Board of Directors. ADI
has funded $33.0 million through December 31, 2003. In November 2001, ADI agreed to sell a 5% equity interest in the Company
to BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the
global music division of Bertelsmann AG (BMG), in connection with entering
into a North American distribution agreement and a worldwide licensing
agreement. In April 2002, these agreements were formally executed. As part of
these transactions, BMG agreed to advance certain monies against net sales
proceeds under the agreements and also assumed $5.0 million of ADIs funding
commitment to the operations of the Company. As a result of the BMG equity
purchase, ADIs funding commitment was reduced to $45 million. In December
2002, BMG exercised its option to extend the term of the distribution and
license agreement until September 2004. In August 2002, ADIs Board of Directors approved an agreement (the
Accelerated Funding Agreement) to accelerate up to $10 million of its funding
commitment to the Company. This funding was in addition to the $15 million
that ADI was obligated to advance to the Company in 2002 as part of the initial
$50 million funding commitment. During 2002, ADI funded its $15 million
commitment plus the additional $10 million bridge loan for total advances to
the record label of $25.0 million in 2002 and $30.25 million from the inception
of the record label through December 31, 2002. The $10 million of accelerated
funding was credited toward the satisfaction of ADIs overall funding
commitment and funding obligation for 2003, resulting in a remaining funding
commitment of $2.75 million for 2003 and $12.0 million for 2004. ADI advanced
the $2.75 million during 2003. ADIs commitment to fund the Company is subject
to a guaranty for the benefit of BMG. Should ADI fail to meet its commitment,
BMG may choose to enforce the guaranty or provide substitute financing that
could result in dilution of ADIs interest in the Company. As consideration for entering into the Accelerated Funding Agreement, ADI
received an additional 20% interest in the Company from Radar Records Holdings,
L.L.C. (RRH), the entity through which Mr. Field owns his interest in the
Company, which resulted in an increase in ADIs ownership share of the Company
from 45% to 65% and a decrease in Mr. Fields ownership share from 50% to 30%.
BMGs ownership percentage remained at 5%. The Accelerated Funding Agreement
also provides that any dilution from the issuance of equity interests in the
Company that would have been borne solely by ADI will be borne both by RRH and
ADI pro rata with their then respective ownership interests. Furthermore, the
Accelerated Funding Agreement provides for RRH to guarantee a 25% minimum
annual compounded return to be realized from ADIs advances and equity
interests in the Company. The loan advances provided to the Company by ADI bear interest at a rate
of LIBOR plus 4% and the principal and interest are not repayable until
December 31, 2015 or upon such time as the Company achieves certain defined
levels of excess cash flow and available cash. As of December 31, 2002 and
2003, the Company had loans payable to ADI of $30.25 million and $33.0 million,
respectively. In addition, as of December 31, 2002 and 2003, the Company had
accrued interest payable to ADI of $1.1 million and $3.0 million, respectively. 97




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GOING CONCERN The Company has incurred losses and negative cash flows from operations
since inception in 2001 and has an accumulated deficit of $53.4 million as of
December 31, 2003. For the year ended December 31, 2003, the Company incurred
a net loss of $12.7 million and had negative working capital of $10.9 million
at December 31, 2003. The Company has relied on loan and distribution advances
to fund its operations to date. During 2003, the Company received loan
advances of $2.75 million from ADI and has received a total of $37.75 million
of loan advances through December 31, 2003. As of December 31, 2003, the
Company did not have sufficient working capital resources to conduct
operations. Management expects the Company to continue to incur operating
losses for the foreseeable future. During the three months ended September 30, 2003, the Company
significantly reduced its overhead costs and operating activities and laid off
the majority of its staff while it continued to restructure its operations and
seek additional capital. During 2003, the Company relied on $898,000 of loans
from Ted Field and $1,150,000 of loans from outside investors to fund
operations. The total loans of $2.048 million during 2003 were obtained
through the issuance of convertible promissory notes (the Bridge Notes) (see
Note 10). ADI does not have the resources to meet its remaining $12.0 million
funding commitment to the Company for 2004. The Company requires additional
capital in order to continue operations, and is therefore continuing to pursue
alternatives to raise additional capital. However, there can be no assurances
that additional capital can be obtained on reasonable terms or at all. Failure
to raise additional capital could seriously harm the Companys business. In
such event, the Company may seek to divest all or certain of its assets in
order to raise the capital necessary to sustain business operations. Should
this fail, the Company may consider a formal or informal restructuring or
reorganization. The conditions described above raise substantial doubt about the Companys
ability to continue as a going concern. The financial statements do not
include any adjustments that might result from the outcome of this uncertainty. 2. SIGNIFICANT ACCOUNTING POLICIES REVENUE RECOGNITION Revenue consists primarily of the sale of compact discs by artists signed
under contract with the Company. The Company recognizes revenues upon the
shipment of compact discs from its distributor to retailers and independent
wholesalers and records appropriate reserves for product returns. At the time
of the shipment of the product, the following criterion under Statement of
Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right
of Return Exists, have been met: the sellers price to the buyer is
substantially fixed or determinable at the date of sale; the buyer has paid the
seller, or the buyer is obligated to pay the seller, and the obligation is not
contingent on resale of the product; the buyers obligation to the seller would
not be changed in the event of theft or physical destruction or damage of the
product; the buyer acquiring the product for resale has economic substance
apart from that provided by the seller; the seller does not have significant
obligations for future performance to directly bring about resale of the
product by the buyer; and the amount of future returns can be reasonably
estimated. The Company estimates the provision for returns on a quarterly basis by
album based on the amount of time since the initial album release, the actual
returns to date, the trend of sales activity (sales by the retailers and
wholesalers) and the number of unsold units at retailers and wholesalers.
Returns to the Companys distributor are deemed to be returns to the Company.
Revenues recorded for the years ended December 31, 2002 and 2003 are net of a
provision for actual and estimated future returns of $1.7 million and $888,000,
respectively. COST OF REVENUE Manufacturing expenses consist of the cost of pressing compact discs,
manufacturing printed booklets and packaging materials, and a provision for the
obsolescence of finished goods and components. Distribution expenses consist
of the distribution fee payable to BMG and other distribution expenses,
including the cost of processing returns and warehousing inventory. Artist
advances and royalty expenses consist of payments made to artists and others in
connection with the recording of an album. ARTIST ADVANCES Artist advances consists of the amounts advanced to artists in connection
with the recording of their albums. In addition, included in artist advances
are costs expended for producer fees, musician fees, engineering and studio
costs, equipment costs, mastering and 98




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remix costs, sample clearances and artist living expenses during
recording. Artist advances are typically recoupable from artist royalties
earned from the sale of compact discs. The Company expenses these advances
when incurred as the Companys artists have limited or no history of album
sales. INVENTORY Inventory, net of a provision for obsolescence, consists of finished
albums maintained in the warehouse of the Companys distributor and is stated
at the lower of cost or net realizable value. Cost is determined using the
first-in, first-out method. Inventory has been fully reserved at December 31,
2003. DEPRECIATION Depreciation is provided using the straight-line method over the following
estimated useful lives: Computer equipment and software
    
    3 yearsFurniture and fixtures
    
    7 yearsStudio equipment
    
    7 years
 INCOME TAXES The Company is treated as a limited liability company for federal and
state income tax reporting purposes whereby its income (loss) is reported in
the individual income tax returns of the Companys members. STOCK-BASED COMPENSATION The Company accounts for stock-based employee compensation in accordance
with the provisions of Accounting Principles Board (APB) Opinion No. 25 and
FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions
Involving Stock Compensation, and complies with the disclosure requirements of
SFAS No. 123, Accounting for Stock-Based Compensation. Under APB No. 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 the measurement
date. The Company accounts for stock issued to non-employees in accordance
with SFAS No. 123, which requires entities to recognize as expense over the
service period the fair value of all stock-based awards on the date of grant
and EITF 96-18, Accounting for Equity Investments that are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services, which addresses the measurement date and recognition approach for
such transactions. The Company recognizes compensation expense related to
variable awards in accordance with FIN 28. For fixed awards, the Company
recognizes expense over the vesting period or the period of service The Company did not record any stock-based compensation expense for the
period ended December 31, 2001 and the years ended December 31, 2002 and 2003. IMPAIRMENT OF LONG-LIVED ASSETS Impairment of long-lived assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event that the carrying amount of long-lived assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. See Note 5 for write-downs in 2003 with respect to the Companys property
and equipment. CONCENTRATION OF CREDIT RISK AND SUPPLIER RISK Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of trade accounts receivable.
The Companys exposure to losses on receivables is dependent upon the
financial condition of its distributor, BMG, which is responsible for credit
losses from retail and wholesale customers. The Company purchases its inventory from a limited number of suppliers.
However, there are a number of alternative suppliers who can provide
manufacturing services for the Company. 99




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FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of financial instruments, which include cash and cash
equivalents, accounts receivable, accounts payable and accrued expenses,
approximate fair value because of the short maturity of these instruments. The carrying amount of the Bridge Notes payable approximates fair value as
the related effective interest rate (including the discount) approximates rates
currently available to the Company. COMPREHENSIVE LOSS The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 130, Reporting Comprehensive Income (SFAS No.
130). SFAS No. 130 establishes standards for the reporting and display of
comprehensive income, its components and accumulated balances in a full set of
general purpose financial statements. SFAS No. 130 defines comprehensive
income (loss) to include all changes in equity except those resulting from
investments by owners and distributions to owners, including adjustments to
minimum pension liabilities, accumulated foreign currency translation, and
unrealized gains or losses on marketable securities. The Company did not have
any items of comprehensive income (loss) during 2001, 2002 or 2003 except the
net loss. ESTIMATES In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosures
of contingent assets and liabilities at the date of the financial statements
and revenues and expenses during the reporting period. Some of the more
significant estimates are the allowance for sales returns and inventory
obsolescence. Actual results could differ from those estimates. 3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (SFAS No. 143). SFAS No. 143 addresses the diverse
accounting practices for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The Company
adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143
did not have a material impact on the Companys financial statement
presentation or disclosures. In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of, it retains many
of the fundamental provisions of that statement. The Company adopted SFAS No.
144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a
material impact on the Companys financial statement presentation or
disclosures. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS 4, which required all gains and
losses from extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of related income tax effect. Upon
adoption of SFAS No. 145, the Company will be required to apply the criteria in
APB Opinion No. 30, Reporting the Results of Operations  Reporting the
Effects of a Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transactions (Opinion No. 30), in
determining the classification of gains and losses resulting from the
extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to
require that certain lease modifications that have economic effects similar to
sale-leaseback transactions to be accounted for in the same manner as
sale-leaseback transactions. The Company adopted SFAS No. 145 effective
January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for
use did not have a material impact on the Companys financial statement
presentation or disclosures. 100




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In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit and Disposal Activities. SFAS No. 146 nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring). Under EITF Issue No. 94-3, a
liability for an exit cost is recognized at the date of an entitys commitment
to an exit plan. Under SFAS No. 146, the liabilities associated with an exit
or disposal activity will be measured at fair value and recognized when the
liability is incurred and meets the definition of a liability in the FASBs
conceptual framework. SFAS No. 146 is effective for exit or disposal
activities initiated after December 31, 2002. The adoption of SFAS 146 did not
have a material impact on the Companys financial statement presentation or
disclosures. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based CompensationTransition and Disclosurean amendment of SFAS No.
123. SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No.
123 and APB Opinion No. 28, Interim Financial Reporting, to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company implemented SFAS No. 148 effective
December 31, 2002. The Company has determined that it will continue to account
for stock-based employee compensation in accordance with APB No. 25. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and
clarifies under what circumstances a contract with initial investments meets
the characteristics of a derivative and when a derivative contains a financing
component. SFAS No. 149 is effective for contracts entered into or modified
after June 30, 2003. The adoption of SFAS No. 149 did not have a material
impact on the Companys financial statement presentation or disclosures. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
SFAS No. 150 establishes standards for how an issuer classifies and measures in
its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an
issuer classify a financial instrument that is within its scope as a liability
(or an asset in some circumstances) because that financial instrument embodies
an obligation of the issuer. SFAS No. 150 is effective for financial
instruments entered into or modified after May 31, 2003 and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of
a change in accounting principle for financial instruments created before the
issuance date of SFAS No. 150 and still existing at the beginning of the
interim period of adoption. Restatement is not permitted. The adoption of
SFAS No. 150 did not have a material impact on the Companys financial
statement presentation or disclosures. In November 2002, the FASB issued Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness to Others (FIN 45), an interpretation of FASB
Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.
FIN 45 elaborates on the disclosures to be made by a guarantor in its interim
and annual financial statements about its obligations under guarantees issued.
FIN 45 also clarifies that a guarantor is required to recognize, at inception
of a guarantee, a liability for the fair value of the obligation undertaken.
The initial recognition and measurement provisions of FIN 45 are applicable to
guarantees issued or modified after December 31, 2002. The disclosure
requirements of FIN 45 are effective for financial statements of interim and
annual periods ended after December 15, 2002. The adoption of FIN 45 did not
have a material impact on the Companys financial statement presentation or
disclosures. In November 2002, the FASBs Emerging Issues Task Force (EITF) issued
EITF No. 00-21 Revenue Arrangements with Multiple Deliverables. EITF No.
00-21 addresses certain aspects of the accounting by a vendor for arrangements
under which it will perform multiple revenue-generating activities.
Specifically, EITF No. 00-21 addresses how to determine whether an arrangement
involving multiple deliverables contains more than one unit of accounting. In
applying EITF No. 00-21, separate contracts with the same entity or related
parties that are entered into at or near the same time are presumed to have
been negotiated as a package and should, therefore, be evaluated as a single
arrangement in considering whether there are one or more units of accounting.
That presumption may be overcome if there is sufficient evidence to the
contrary. EITF No. 00-21 also addresses how arrangement consideration should
be measured and allocated to the separate units of accounting in the
arrangement. The guidance in EITF No. 00-21 is effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. The
Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF
No. 00-21 did not have a material impact on the Companys financial statement
presentation or disclosures. In February 2003, the Financial Accounting Standards Board issued
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), which addresses the consolidation by business enterprises of variable
interest entities, which have one or both of the following characteristics:
(1) the equity investment at risk is not sufficient to permit the entity to
finance its activities without 101




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additional financial support from other parties, or (2) the equity
investors lack one or more of the following essential characteristics of a
controlling financial interest: (a) the direct or indirect ability to make
decisions about the entitys activities through voting or similar rights, (b)
the obligation to absorb the expected losses of the entity if they occur, or
(c) the right to receive the expected residual returns of the entity if they
occur. In addition, FIN 46 contains detailed disclosure requirements. FIN 46
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim
period ending after March 15, 2004, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
Early adoption is permitted. The Company adopted FIN 46 as of December 31,
2003. The adoption of FIN 46 did not have a material impact on the Companys
financial statement presentation or disclosures. However, as a result of the
adoption of FIN 46 by ADI as of December 31, 2003, the Companys balance sheet
was consolidated with ADIs balance sheet at December 31, 2003, and the
Companys operations will be consolidated with ADIs operations beginning
January 1, 2004. ADI previously accounted for the Companys operations under
the equity method of accounting. 4. ARTIST ADVANCES As of December 31, 2003, the Company had signed recording agreements with
six artists and had advanced a total of $1.238 million through such date with
respect to these artists. The amount of these advances is recoupable against
royalties to be earned by the artists based on sales. However, given that most
of the artists signed by the record label have no previous track record, the
advances have been expensed by the Company as incurred. As of December 31,
2003, the Company is contractually committed to additional minimum artist
advances of approximately $1.5 million, all of which is payable in 2004. 5. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost and consist of the following: December 31,2002
    
    2003(in thousands)Computer equipment and software
    
    $
    71
    
    
    $
    58Furniture and fixtures
    
    
    29
    
    
    
    30Studio equipment
    
    
    169
    
    
    
    10269
    
    
    
    98Less accumulated depreciation
    
    
    (38
    )
    
    
    (58
    )Property and equipment, net
    
    $
    231
    
    
    $
    40
 Impairment of fixed assets is monitored on a continuing basis, and is
assessed based on the undiscounted cash flows generated by the underlying
assets. In the event the carrying amount of fixed assets exceeds the
undiscounted future cash flows, then the carrying amount of such assets is
adjusted to their fair value. There was no impairment of long-lived assets as
of December 31, 2002. During the three months ended June 30, 2003, the Company
determined that its fixed assets were impaired due to continuing losses, going
concern issues, and the likelihood that the majority of these assets would
likely be abandoned in the near future. The Company determined that these
factors were indicators of impairment and thus reduced the carrying amount of
the fixed assets to their estimated fair value by recording a write-off of
$100,000 during the three months ended June 30, 2003. Most of the Companys
property and equipment was subsequently sold to third party liquidators for
cash. This amount has been reported as a loss from sale and abandonment of
property and equipment in the statement of operations for the year ended
December 31, 2003. 102




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6. ALLOWANCE FOR SALES RETURN RESERVE A summary of the activity with respect to the reserve for sales returns
for the periods indicated is as follows: Period Ended
    
    Year Ended
    
    Year EndedDecember 31, 2001
    
    December 31, 2002
    
    December 31, 2003(in thousands)Balance, beginning of period
    
    $
    
    
    
    $
    
    
    
    $
    800Provision for sales returns
    
    
    
    
    
    
    1,689
    
    
    
    888Actual returns
    
    
    
    
    
    
    (889
    )
    
    
    (1,528
    )Balance, end of period
    
    $
    
    
    
    $
    800
    
    
    $
    160
 7. ACCRUED EXPENSES Accrued expenses are comprised of the following: December 31,2002
    
    2003(in thousands)Accrued compensation and related
    
    $
    1,082
    
    
    $
    881Accrued sales and marketing
    
    
    530
    
    
    
    Accrued royalties
    
    
    245
    
    
    
    250Other accrued expenses
    
    
    265
    
    
    
    81Total accrued expenses
    
    $
    2,122
    
    
    $
    1,212
 8. SIGNIFICANT CONTRACTS In November 2001, the Company agreed in principle to enter into a
preliminary North American distribution agreement and worldwide license
agreement with BMG Music (BMG), the global music division of Bertelsmann AG.
Under the terms of the agreement, BMG distributes the Companys releases in
North America, and BMG licenses the Companys repertoire in territories
throughout the world. In April 2002, the agreements with BMG were finalized,
including BMGs purchase of 5% of the equity of the Company from ADI. As part
of this transaction, BMG agreed to advance certain monies against net sales
proceeds under the agreements and also assumed $5.0 million of ADIs funding
commitment to the Company, which was advanced during 2002. As a result of the
BMG equity purchase, ADIs funding commitment was reduced to $45 million. In
December 2002, BMG exercised its option to extend the term of the distribution
and license agreement until September 2004. Under the distribution and license agreements, BMG made non-returnable
advances to the Company of $2.5 million in 2001, $2.5 million in 2002 and $5.0
million in 2003 that are recoupable from net sales proceeds from the Companys
artist repertoire. The advances are to be recouped on a monthly basis based on
a defined calculation. As of December 31, 2002 and 2003, the unrecouped
balances related to distribution advances from BMG were $4.1 million and
$8.7 million, respectively. The loan advances provided to the Company by BMG bear interest at a rate
of LIBOR plus 4% and the principal and interest are not repayable until
December 31, 2015 or upon such time as the Company achieves certain defined
levels of excess cash flow and available cash. As of December 31, 2002 and
2003, the Company had loans payable to BMG of $4.75 million. In addition, as
of December 31, 2002 and 2003, the Company had accrued interest payable to BMG
of $189,000 and $447,000, respectively. 9. RELATED PARTY TRANSACTIONS During 2001, ADI paid legal fees of $530,000 to Lenard, Brisbin & Klotz
LLP in connection with the transaction pursuant to which the Company was formed
and capitalized, which has been treated as an advance to the Company under the
operating agreement. Allen Lenard, one of ADIs former directors who resigned
from its board of directors in September 2002, is managing partner of Lenard,
Brisbin & Klotz LLP. During the year ended December 31, 2003, the Company paid
$155,000 of legal fees to Lenard, Brisbin & Klotz LLP. ADI charged the Company $200,000, $1.35 million and $563,000 in 2001, 2002
and 2003, respectively, for the reimbursement of overhead costs, including rent
and other occupancy costs, telephone and internet services, and the services of
certain ADI personnel primarily in the areas of accounting, legal, information
technology, human resources and administration. These amounts were included
in general and administrative expense. During the three months ended September 30, 2003, the Company
significantly reduced its overhead costs and operating activities and laid off
the majority of its staff while it continued to restructure its operations and
seek additional capital. The Company also 103




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relocated its administrative offices to offices leased by a company owned
by Ted Field. The Company sub-leases these offices on a month-to-month basis.
Rent expense for the period September through December 2003 was not material. The Company entered into an employment agreement with Ted Field to serve
as Chief Executive Officer, which had an initial term extending through May 31,
2006, and which provided for an annual base salary of $1,000,000 plus certain
benefits. The employment agreement also provided that under certain
conditions, Mr. Field would receive a lump-sum payment equal to his annual base
salary for (i) 50% of the remaining term of the employment agreement if
termination occurs within the first three years of his employment, (ii) his
annual base salary for one year if termination occurs in the fourth year of his
employment, and (iii) his annual base salary for the full remaining term of the
employment agreement if termination occurs in the fifth year of his employment. During 2002, Mr. Fields employment agreement was amended whereby Mr.
Field agreed to defer his future salary until the Company raised new debt or
equity financing of at least $20 million. During the three months ended June
30, 2003, Mr. Fields employment agreement was further amended whereby all
deferred and any future salary, except a base amount, would be waived, even if
new debt or equity financing is raised. Accordingly, during the year ended
December 31, 2003, $822,000 of accrued compensation due to Mr. Field by the
Company was credited to capital in the statement of members deficit. See Notes 1, 10 and 14 for additional related party transactions. 10. BRIDGE NOTES PAYABLE As of December 31, 2003, the Company had received $898,000 of loans from
Ted Field and $1,150,000 of loans from outside investors (including $100,000
from Jonathan V. Diamond, ADIs new President and Chief Executive Officer).
The total loans of $2.048 million during 2003 were obtained through the
issuance of convertible promissory notes (the Bridge Notes). The Bridge
Notes accrue interest at 8% per annum, are due two years from the date of
issuance, and will be converted into new equity of the Company as part of its
next equity financing. The $1,150,000 of loans from outside investors has been
presented as bridge notes payable in the balance sheet at December 31, 2003.
The $898,000 of loans from Mr. Field has been presented as bridge notes payable
in the balance sheet at December 31, 2003. The holders of the Bridge Notes also received warrants with a term of five
years to purchase additional equity of the Company at $0.01 per unit equivalent
to the number of units of new equity into which their Bridge Notes are
ultimately converted. The relative fair value of the warrants issued was
$1.024 million (one-half of the amount funded by the investors in the Bridge
Notes), which was recorded as a reduction to the carrying amount of the Bridge
Notes and a credit to capital, and is being charged to operations as interest
expense over the specified term of the Bridge Notes. In addition, since the Bridge Notes are convertible into equity based on
their face amount, this results in a beneficial conversion feature with a
relative fair value of $1.024 million. Since the commitment date for the
beneficial conversion feature is contingent upon the completion of the
Companys next equity financing, the fair value of the beneficial conversion
feature will be charged to operations over the remaining life of the Bridge
Notes at that time. During the year ended December 31, 2003, the Company recognized $203,000
as interest expense with respect to the amortization of the fair value of the
warrants. Additional interest expense of $821,000 will be recognized ratably
in 2004 and 2005 over the remaining term of the Bridge Notes. As of December
31, 2003, the carrying amount of the Bridge Notes, including accrued interest
of $67,000, was $1.294 million. A reconciliation of bridge notes payable issued by the Company during 2003
to amounts presented in the balance sheet at December 31, 2003 is presented
below. 104




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OutsideInvestors
    
    Ted FieldGross amount funded during 2003
    
    $
    1,150
    
    
    $
    898Deduct:Fair value of warrants
    
    
    (575
    )
    
    
    (449
    )Add:Accrued interest
    
    
    44
    
    
    
    23Amortization of fair value
of warrants in 2003
    
    
    136
    
    
    
    67Net liability at December 31, 2003
    
    $
    755
    
    
    $
    539
 11. 401(K) PLAN In 2001, the Company adopted ADIs Cash or Deferred Profit Sharing Plan
and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan).
Under the 401(k) Plan, participating employees may defer a percentage (not to
exceed 15%) of their eligible pretax earnings up to the Internal Revenue
Services annual contribution limit. All employees of the Company age 21 years
or older who complete three months of service are eligible to participate in
the 401(k) Plan. The Company does not match contributions by participants to
the 401(k) Plan. Accordingly, there is no related expense for the period from
May 31, 2001 (inception) to December 31, 2001 and the years ended December 31,
2002 and 2003. 12. LITIGATION The Company is subject to various pending and threatened legal actions,
which arise in the normal course of business. The Companys management
believes that the impact of such litigation will not have a material adverse
impact on its financial position or results of operations. 13. SUPPLEMENTAL DISCLOSURES TO STATEMENTS OF CASH FLOWS Significant non-cash investing and financing activities are as follows: Period Ended
    
    Year Ended
    
    Year EndedDecember 31, 2001
    
    December 31, 2002
    
    December 31, 2003(in thousands)Compensation forgiven by
Chief Executive Officer
    
    $
    
    
    
    $
    
    
    
    $
    822Discount related to issuance
of Bridge Note warrants
    
    
    
    
    
    
    
    
    
    
    1,024
 14. SUBSEQUENT EVENTS (UNAUDITED) During the three months ended March 31, 2004, Mr. Field advanced an
additional $1.89 million to the Company to fund operating expenses and the
settlement of artist contracts. In consideration for such advances, Mr.
Field received Bridge Notes and warrants as described at Note 10. 105




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EXHIBIT INDEX EXHIBIT NO.
    
    DESCRIPTION3.1
    
    Amended and Restated Certificate of Incorporation of the
Registrant. Incorporated by reference to Exhibit 3.1 in the
Registrants Registration Statement on Form S-1 initially
filed on September 22, 1999 (Registration No. 333-87547), as
amended by Amendment No.s 1 - 7 thereto.3.2
    
    Amended and Restated Bylaws of the Registrant. Incorporated by
reference to Exhibit 3.2 in the Registrants Registration
Statement on Form S-1 initially filed on September 22, 1999
(Registration No. 333-87547), as amended by Amendment No.s 1
- 7 thereto.3.3
    
    Certificate of Amendment of the Third Amended and Restated
Certificate of Incorporation. Incorporated by reference to
Exhibit 3.3 in the Registrants Quarterly Report on Form 10-Q
filed on August 14, 2001.3.4
    
    Certificate of Amendment, dated June 3, 2002, of the Third
Amended and Restated Certificate of Incorporation.
Incorporated by reference to Exhibit 3.4 in the Registrants
Quarterly Report on Form 10-Q filed on August 14, 2002.4.1
    
    See Exhibits 3.1 and 3.2 for provisions of the Registrants
Certificate of Incorporation and Bylaws determining the rights
of holders of the Registrants common stock.4.2
    
    Specimen common stock certificate. Incorporated by reference
to Exhibit 4.2 in the Registrants Registration Statement on
Form S-1 initially filed on September 22, 1999 (Registration
No 333-87547), as amended by Amendment No.s 1 - 7 thereto.4.3
    
    Registration Rights Letter Agreement dated May 31, 2001
between the Registrant and Frederick W. Field. Incorporated by
reference to Exhibit 3 filed in connection with the
Registrants Definitive Proxy Statement on June 11, 2001.10.1
    
    Amendment No. 1 dated February 27, 2002 to the Agreement dated
July 19, 2000 between the Registrant and Ticketmaster.
Incorporated by reference to Exhibit 10.35 in the Registrants
Quarterly Report on Form 10-Q filed on May 15, 2002.10.2
    
    Escrow Agreement dated March 13, 2002 among the Registrant,
Ticketmaster and JPMorgan Chase Bank. Incorporated by
reference to Exhibit 10.36 in the Registrants Quarterly
Report on Form 10-Q filed on May 15, 2002.10.3
    
    Agreement dated October 22, 2001 between the Registrant and
Old Glory Boutique Distributing, Inc. Incorporated by
reference to Exhibit 10.37 in the Registrants Quarterly
Report on Form 10-Q filed on August 14, 2002.10.4
    
    Letter Agreement, dated as of December 9, 2002, by and between
ARTISTdirect, Inc. and Frederick Field to amend the Employment
Agreement dated May 31, 2001 between ARTISTdirect, Inc. and
Mr. Field. Incorporated by reference to Exhibit 10.38 in the
Registrants Current Report on Form 8-K filed on December 13,
2002.10.5
    
    Letter Agreement, dated as of December 9, 2002, by and between
ARTISTdirect Records, L.L.C. and Frederick Field to amend the
Employment Agreement dated May 31, 2001 between ARTISTdirect
Records, L.L.C. and Mr. Field. Incorporated by reference to
Exhibit 10.39 in the Registrants Current Report on Form 8-K
filed on 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 Amendment
No. 1 to Exhibit 10.40 in the Registrants Quarterly Report on
Form 10-Q/A filed on December 23, 2002.10.7
    
    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 Exhibit 10.41 in the Registrants
Current Report on Form 8-K filed on December 23, 2002.
 106




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EXHIBIT NO.
    
    DESCRIPTION10.8
    
    Letter Agreement dated December 11, 2002 between the Registrant 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 the
Registrant and Old Glory Boutique Distributing, Inc. Incorporated by reference to Exhibit 10.8 to
Registrants Annual Report on Form 10-K filed on March 31, 2003.10.9
    
    Agreement for Services dated as of June 13, 2002 between the Registrant and Frankel & Company. Incorporated
by reference to Exhibit 10.9 to Registrants Annual Report on Form 10-K filed on March 31, 2003.10.10
    
    Letter Agreement, dated as of May 1, 2003, by and between ARTISTdirect, Inc. and Frederick Field to amend the
Employment Agreement dated May 31, 2001 between ARTISTdirect, Inc. and Mr. Field. Incorporated by reference
to Exhibit 10.1 in the Registrants Quarterly Report on Form 10-Q filed on August 14, 2003.10.11
    
    Letter Agreement, dated as of May 1, 2003, by and between ARTISTdirect Records, L.L.C. and Frederick Field to
amend the Employment Agreement dated May 31, 2001 between ARTISTdirect Records, L.L.C. and Mr. Field.
Incorporated by reference to Exhibit 10.2 in the Registrants Quarterly Report on Form 10-Q filed on August
14, 2003.10.12
    
    Employment Agreement dated as of September 29, 2003 by and between the Registrant and Jon Diamond.
Incorporated by reference to Exhibit 10.3 in the Registrants Quarterly Report on Form 10-Q filed on November
14, 2003.10.13
    
    Notice of Grant of Stock Option dated as of September 29, 2003 by and between the Registrant and Jon Diamond.
Incorporated by reference to Exhibit 10.4 in the Registrants Quarterly Report on Form 10-Q filed on 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 the Registrant. Incorporated by reference to Exhibit 10.5 in the Registrants Quarterly
Report on Form 10-Q filed on November 14, 2003.10.15
    
    Termination Agreement and Mutual Release by Keith Yokomoto and the Registrant dated as of December 31, 2003.
Filed herewith.10.16
    
    Form of Director Indemnification
Agreement. Incorporated by reference to Exhibit 10.29 in the
Registrants Registration Statement on Form S-1 filed on
September 22, 1999 (Registration No. 333-87547), as amended by
Amendment No.s 1-7 thereto.10.17
    
    Form of Officer Indemnification
Agreement. Incorporated by reference to Exhibit 10.30 in the
Registrants Registration Statement on Form S-1 filed on
September 22, 1999 (Registration No. 333-87547), as amended by
Amendment No.s 1-7 thereto.14.1
    
    Code of business conduct and ethics21.1
    
    Subsidiaries of the Registrant. Incorporated by reference to Exhibit 21.1 in the Registrants Registration
Statement on Form S-1 initially filed on November 22, 2000 (Registration No 333-50576), as amended by
Amendment No.s 1 - 5 thereto.23.1
    
    Consent of Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. with respect to ARTISTdirect, Inc. and subsidiaries23.2
    
    Consent of Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. with respect to ARTISTdirect Records, LLC24.1
    
    Powers of Attorney. See signature page to this Annual Report on Form 10-K.31.1
    
    Certifications of the Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act31.2
    
    Certifications of the Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act32.1
    
    Certifications of the Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act32.2
    
    Certifications of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act
 107