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

** **

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**FORM 10-K**

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| **x**      | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------|----------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                               |
| ** ** | ** ** | **For the fiscal year ended December 31, 2008**                                                     |
| ** ** | ** ** | ** **                                                                                               |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number: 000-30063**

 

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

 

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

 

**1601 Cloverfield Boulevard, Suite 400 South, SantaMonica, California 90404-4082**(Address of PrincipalExecutive Offices, including Zip Code)

 

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

 

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Securities registered pursuant toSection 12(b) of the Act:  **None**

 

Securities registered pursuant to Section 12(g) ofthe Act:  **Common stock, $0.01 par value**

 

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Check whether the issuer isa well-known seasoned issuer as defined in Rule 405 of the Securities Act.   Yes o No x

 

Check whether the issuer isnot required to file reports pursuant to Section 13 or 15(d) of theExchange Act. Yes o No x

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x No o

 

Check if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-B is not containedherein, and will not be contained, to the best of the registrant’s knowledge,in definitive proxy or information statements incorporated by reference inPart III of this Form 10-K or any amendment to this Form 10-K x

 

Indicate by check mark whether registrant is a “large acceleratedfiler, “accelerated filer,” non-accelerated filer” or “smaller reportingcompany reporting company” as such terms are defined  in Rule 12b-2 of the Exchange Act (checkone):  Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer o  Smaller Reporting Company  x

 

Check whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o No x

 

As of June 30, 2008, theaggregate market value of the voting common stock held by non-affiliates of theregistrant was approximately $1,509,851, based on the closing price per shareof $0.27 for the registrant’s common stock as reported on the Over-the-CounterBulletin Board on such date.

 

As of April 10, 2009, therewere 56,077,158 shares of the registrant’s common stock, par value $0.01 pershare, issued and outstanding.

 

Documentsincorporated by reference:  None.

 

 

 

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**ARTISTDIRECT INC.ANNUAL REPORT ON FORM 10-K**

**TABLE OF CONTENTS**

 
| ** **  | ** **                                                                                        | **Page**   |
|-------------|---------------------------------------------------------------------------------------------------|------------|
| PART I      |                                                                                              |       |
| ITEM 1.     | BUSINESS                                                                                          | 2          |
| ITEM 1A     | RISK FACTORS                                                                                      | 15         |
| ITEM 1B     | UNRESOLVED STAFF  COMMENTS                                                                        | 20         |
| ITEM 2.     | PROPERTIES                                                                                        | 21         |
| ITEM 3.     | LEGAL PROCEEDINGS                                                                                 | 21         |
| ITEM 4.     | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                              | 21         |
|        |                                                                                              |       |
| PART II     |                                                                                              |       |
| ITEM 5.     | MARKET FOR  COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY  SECURITIES |  

22 |
| ITEM 6      | SELECTED  CONSOLIDATED FINANCIAL DATA                                                             | 22         |
| ITEM 7.     | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS       |  

23 |
| ITEM 7A     | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                       | 41         |
| ITEM 8.     | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                      | 42         |
| ITEM 9.     | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE             | 42         |
| ITEM 9A(T). | CONTROLS AND  PROCEDURES                                                                          | 42         |
| ITEM 9B.    | OTHER INFORMATION                                                                                 | 42         |
|        |                                                                                              |       |
| PART III    |                                                                                              |       |
| ITEM 10.    | DIRECTORS,  EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE                                          | 43         |
| ITEM 11.    | EXECUTIVE  COMPENSATION                                                                           | 46         |
| ITEM 12.    | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS  | 52         |
| ITEM 13.    | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                        | 58         |
| ITEM 14.    | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                           | 60         |
| ITEM 15.    | EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES                                                       | 60         |
|        |                                                                                              |       |
| SIGNATURES  |                                                                                              | 61         |

 

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**NOTE CONCERNING FORWARD-LOOKING STATEMENTS**

 

*In addition to historical information, this Annual Report on Form 10-K(“Annual Report”) for ARTISTdirect, Inc. (“ARTISTdirect,” the “Company,”“we,” “our”  or “us”) contains“forward-looking” statements within the meaning of the United States PrivateSecurities Litigation Reform Act of 1995, including statements that include thewords “may,” “will,” “believes,” “expects,” “anticipates,” or similarexpressions. These forward looking statements may include, among others, statementsconcerning our expectations regarding our business, growth prospects, revenuetrends, operating costs, accounting, working capital requirements, competition,results of operations and other statements of expectations, beliefs, futureplans and strategies, anticipated events or trends, and similar expressionsconcerning matters that are not historical facts. The forward-lookingstatements in this Annual Report involve known and unknown risks, uncertaintiesand other factors that could cause our actual results, performance orachievements to differ materially from those expressed or implied by theforward-looking statements contained herein.*

 

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

 

**PART I**

 

**ITEM 1.****                             BUSINESS**

 

**General**

 

Incorporatedunder the laws of the****State ofDelaware in July 1999, we were exclusively an Internet based digital mediacompany that was home to an on-line music website and an affiliate network oflyric websites. Through our acquisition of MediaDefender, Inc., a Delawarecorporation (“MediaDefender”), in July 2005, we also became a provider ofanti-piracy solutions in the Internet piracy protection industry.  Below is an overview of our businesssegments:

 

·                  *Internet Piracy Prevention.*Our Internetpiracy prevention (“IPP”) segment is currently operated by MediaDefender, as awholly-owned subsidiary of ARTISTdirect. MediaDefender’s proprietary suite ofIPP solutions offers significant levels of protection on major peer-to-peer(“P2P”) file-sharing networks. Our IPP segment accounted for approximately 64%and 61% of our revenue during the fiscal years ended December 31, 2008 and2007, respectively.  Refer to“MediaDefender Overview - Internet Anti-Piracy Segment below for moreinformation.

 

·                  *Media.*Our media operations include ourcontent-oriented websites, a network of third party music sites, ouradvertising and other marketing initiatives. Revenue from media operations isgenerated from the sale of online advertising and integrated marketingsolutions. We market and sell advertising on a cost-per-impression basis toadvertising agencies and directly to various companies as part of theirmarketing programs. Customers may purchase advertising space for our flagshipwebsite www.artistdirect.com or the entire ARTISTdirect network, and they maytailor advertising based on music genre (e.g., jazz, country or rock music) orbased on functionality (e.g., directing advertising to customers using musicdownload features or broadband-only features of the ARTISTdirect network). Ourmedia segment accounted for approximately 36% and approximately 33% of ourrevenue during the fiscal years ended December 31, 2008 and 2007,respectively.

 

·                  *E-Commerce.*E-commerce operations consistof the sale of recorded music and artist-related merchandise on our websites.  Most of our sales come from our ARTISTdirectshopping area, which offers a comprehensive selection of music CDs and a rangeof artist and lifestyle merchandise. Effective August 31, 2007, theCompany restructured the relationship with its merchandising partner toeliminate merchandise sales and focus on sales of music CDs. Our e-commercesegment accounted for approximately 3% and approximately 6% of our revenueduring the fiscal years ended December 31, 2008 and 2007, respectively.

 

Refer to “ARTISTdirect Overview-Media and E-Commerce Segments” belowfor additional information.

 

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At December 31,2008, we employed 68 full-time employees, none of whom are covered by acollective bargaining agreement. We believe that our relationship with ouremployees and consultants is good.

 

**RecentDevelopments**

 

*Debt Restructing*

* *

Senior Debt Restructuring

 

EffectiveJanuary 30, 2009, ARTISTdirect, Inc. (the “Company”) entered into aFirst Amendment to Note and Warrant Purchase Agreement dated as ofDecember 31, 2008 (the “Senior Amendment”) with the holders of theCompany’s senior secured debt (the “Senior Note Holders”).  Pursuant tothe Senior Amendment, the Senior Note Holders agreed to extinguish allobligations by the Company under the Note and Warrant Purchase Agreement, datedJuly 28, 2005, and other documents entered into in connection with thesenior secured debt transaction (the “Senior Debt Restructuring”), uponcompletion of the following: (1) $3,500,000 cash payment to the SeniorNote Holders; (2) issuance of new subordinated notes, in the aggregateprincipal amount of $1,000,000, to the Senior Note Holders (the “New Notes”);(3) issuance of 9,000,000 restricted shares of the Company’s common stockto the Senior Note Holders, which are subject to a lock-up period of 12 months;and (4) the conversion of all of the previously issued Subordinated Notes.  The Senior Debt Restructuring was consummatedas of January 30, 2009.

 

The New Notes are unsecuredand bear interest at 6.0% per annum, beginning January 30, 2009. Theprincipal and the interest accrued thereon are payable on the maturity date,January 30, 2014, and are subordinated to the senior indebtedness of theCompany.

 

Additionally, in connectionwith the Senior Debt Restructuring, Trilogy Capital Partners, Inc. agreedto deliver to the Company for cancellation a warrant to purchase up to 433,333shares of the Company’s capital stock at an exercise price of $2.00 pershare.  Fifty percent of such warrants were beneficially owned by DimitriVillard, the Company’s Chief Executive Officer, who had acquired such warrantsas part of the acquisition of 6,190,000 shares from Trilogy CapitalPartners, Inc., which occurred on January 15, 2009.

 

Conversion of SubordinatedNotes

 

Inconnection with the Senior Debt Restructuring, effective January 30, 2009,the Company entered into a Second Amendment to the Convertible SubordinatedNote with holders of the Subordinated Notes representing no less than themajority of the current outstanding aggregate principal amount to provide forthe immediate conversion of the Subordinated Notes (the “SubordinatedAmendment”). The Subordinated Amendment also provides for theextinguishment of all obligations of the Company under the Subordinated Notesand related documents, including the Registration Rights Agreement among theCompany and the holders.  Such obligations included the outstandingprincipal amount and accrued and unpaid interest on the Subordinated Notes,accrued and unpaid late charges and amounts owed under the Registration RightsAgreement with the holders of the Subordinated Notes.  Consummation of the transactions under theSubordinated Amendment occurred as of January 30, 2009.

 

Financing by FactoringAccounts Receivables

 

On January 30, 2009,the Company’s two wholly-owned subsidiaries, ARTISTdirect InternetGroup, Inc. (“ADIG”) and MediaDefender each entered into an AccountsReceivable Purchase & Security Agreement (the “A/R Agreement”) withPacific Business Capital Corporation (“PBCC”), pursuant to which ADIG andMediaDefender agreed to sell and PBCC agreed to purchase qualified accountsreceivable on a recourse basis. On January 30, 2009, PBCC purchased anaggregate of approximately $1,600,000 of unpaid receivables to be acquired byPBCC pursuant to the A/R Agreement, subject to a maximum aggregate amount of$3,000,000. The A/R Agreement is effective for twelve-months and automaticallyrenews for successive 12-month periods unless terminated by written notice byeither party 30 days prior to such successive period.

 

As collateral for thefinancing, PBCC received a first priority interest in all existing and futureassets of the Company, ADIG and MediaDefender, tangible and intangible,including but not limited to, cash and cash equivalents, accounts receivable,inventories, other current assets, furniture, fixtures and equipment and intellectualproperty. In addition to the foregoing, the Company, ADIG and MediaDefenderentered into cross guarantees of their respective obligations under the A/RAgreement.

 

Convertible short-termnote to Director

 

On March 3, 2009, theCompany issued a convertible note (the “Note”) to Frederick W. Field, adirector of the Company.  The Note is in the principal amount of $200,000with the principal amount and accrued interest at the rate of 5% per annum dueon July 31, 2009.  The Note isautomatically convertible into shares of the Company’s Common Stock at a priceof $0.03 per share at such time as the Company has sufficient authorizedshares.

 

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The following table is aproforma presentation of the Consolidated Balance Sheet reflecting the abovedescribed Debt Restructuring as if it had occurred as of December 31, 2008.

 
| ** **                                             | ** ** | **December 31, 2008** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **Audited**                     | ** ** | **Proforma** | ** ** |
| Assets:                                                | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash                                                   |       | $                               | 2,262,000  |   | $ | 12,000 |   |
| Other current assets, net                              |       | 3,480,000                       |       | 3,480,000 |   |
| Property and equipment, net                            |       | 1,201,000                       |       | 1,201,000 |   |
| Other non-current assets, net                          |       | 546,000                         |       | 153,000 |   |
|                                                   |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |
|                                                   |       |                            |       |   |   |
| Liabilities and Stockholders’ Equity (Deficiency) |       |                            |       |   |   |
| Accounts payable and accrued expenses                  |       | $                               | 921,000    |   | $ | 971,000 |   |
| Accrued interest and liquidated damages                |       | 8,890,000                       |       | — |   |
| New credit facility                                    |       | —                          |       | 1,250,000 |   |
| Senior secured notes, net                              |       | 12,817,000                      |       | — |   |
| Subordinated convertible notes, net                    |       | 26,397,000                      |       | — |   |
| Other current liabilities                              |       | 1,228,000                       |       | 1,183,000 |   |
|                                                   |       | 50,253,000                      |       | 3,404,000 |   |
|                                                   |       |                            |       |   |   |
| New subordinated notes, net of discount                |       | —                          |       | 270,000 |   |
| Other long-term liabilities                            |       | 159,000                         |       | 159,000 |   |
|                                                   |       | 159,000                         |       | 429,000 |   |
|                                                   |       |                            |       |   |   |
| Net Stockholders’  Equity (Deficiency), net       |       | (42,923,000                     | )          | 1,013,000 |   |
|                                                   |       |                            |       |   |   |
|                                                   |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |

* *

*Management and Director Changes*

 

EffectiveJanuary 13, 2009, each of Randy Saaf and Octavio Herrera (each, an “Executive”)entered into separate amendments (collectively, the “Amendments”) to theirrespective Employment, Confidentiality and Noncompetition Agreements(collectively, the “Employment Agreements”) dated as of July 28, 2005 withMediaDefender, Inc..  Under each of theAmendments, commencing January 1, 2009 the term of employment between eachExecutive and the MediaDefender were at-will, and either the MediaDefender orthe Executive may terminate the applicable Employment Agreement upon five days’written notice, in which case such Executive shall have a period of 60 daysfrom the effective date of termination to exercise all vested stockoptions.  Effective February 15, 2009,MediaDefender, terminated the employment of Randy Saaf, Chief Executive Officerof MediaDefender, and Octavio Herrera, President of MediaDefender.

 

EffectiveFebruary 1, 2009, Dimitri Villard, the Chairman of the Board of Directors,  pursuant to a three year employmentagreement, was appointed to serve as the Company’s Chief Executive Officer.Prior to that date, Mr. Villard was the Company’s interim Chief ExecutiveOfficer.  Mr. Villard will receive basecompensation equal to $25,000 per month subject to increases as determined bythe Board of Directors, in its sole discretion. Mr. Villard was granted options to purchase 3,920,000 shares of theCompany’s stock at $0.03 per share vesting monthly over 36 months and willreceive a bonus equal to 33% of the amount by which the Company’s EBITDAexceeds a certain threshold amount as determined by the Company’s CompensationCommittee for such fiscal year.

 

EffectiveFebruary 1, 2009, the Company and Rene Rousselet (“Executive”) entered into anEmployment Agreement pursuant to which Mr. Rousselet was employed to continueas the Company’s Corporate Controller and Principal Accounting Officer.  The employment is on an “at will basis.”  Mr. Rousselet will receive a salary of$14,583 per month subject to increases and a bonus as determined by the Boardof Directors, in its sole discretion. Mr. Rousselet was granted options to purchase 560,000 shares of theCommon Stock of the Company at $0.03 per share vesting monthly over 36 monthscommencing February 1, 2009.  If Mr.Rousselet’s employment is terminated without cause, Mr. Rousselet will receivehis salary and vesting of options for an additional period of three months fromthe date of termination.

 

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*Acquisition of MediaSentry*

* *

The Company and its wholly owned subsidiary, MediaDefender entered intoan Asset Purchase Agreement dated as of March 30, 2009 (the “PurchaseAgreement”) pursuant to which the Company through MediaDefender agreed topurchase from SafeNet, Inc. and MediaSentry, Inc. (collectively the“Sellers”), substantially all the assets of the MediaSentry operating unit (the“Acquired Assets”).  In connection with the acquisition, MediaDefenderacquired the receivables, equipment and intellectual property of MediaSentry aswell as assumed substantially all the employees, offices and client contractsrelating to MediaSentry.  The purchase price of the Acquired Assets was$936,000 consisting of $136,000 in cash and a $800,000 one-year promissory noteof the Company.  The acquisition wasconsummated on March 30, 2009.  TheMediaSentry operating unit provides (a) comprehensive business andmarketing intelligence services for digital media measurement and(b) services to globally detect, track and deter the unauthorized distributionof digital content.

 

**MediaDefenderOverview - Internet Anti-Piracy Segment**

 

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

 

*Internet-Based Piracy.*Piracy has long beenand continues to be a problem for the global content industries. TheInternational Intellectual Property Alliance (“IIPA”) estimates that theworldwide cost of music and computer software piracy costs content providers asmuch as $18 billion per year in lost sales. The IIPA provides annual estimates of copyright piracy, but has excludedpiracy of movies, video games and books as this information was not availablefor 2008.  The IIPA 2008 amount indicatesa 9% increase in piracy for the reported categories over 2007.  The MPAA has indicated that copyright piracycould reach new highs during the current economic downturn.  Due to the relatively small size of MP3files, music was the first industry to be severely impacted by Internetpiracy.  Worldwide music sales decreased7% in 2008 which is a decrease in the decline as compared to a 10% drop in2007.  According to the RIAA, thedecline, in sales has been due in part, to widespread copying and illegal Internetdownloading of music.  The growth ofbroadband Internet access is now making larger-sized files, such as movies,software and video games, similarly vulnerable to Internet-based piracy.Already, the majority of motion pictures are available in some form on the Internetbefore theatrical release.

 

To date,attempts to limit internet-piracy have been largely unsuccessful. Litigation,legislation, education, commercial innovation, packaged media and digitalrights management (“DRM”) anti-piracy technologies have been employed withlimited impact.

 

*IPP Solutions.*MediaDefender employs a widearray of technical countermeasures on P2P networks to frustrate users’ attemptsto find, copy and share unauthorized copyrighted materials.  Users of P2P networks attempting  to download content that is successfullyprotected by MediaDefender either cannot begin the downloading process,download the specified file to find that it is not the content for which theywere searching, or download a file to find that it works for the first fewseconds and then reverts to white noise or static. By making it more difficultfor P2P users to access unauthorized content on the Internet, MediaDefenderinduces consumers to pay for content distributed through legitimate means, suchas Apple Corporation’s iTunes.

 

*Next-Generation Solutions.*Due to the rapidlyevolving nature of the P2P environment, MediaDefender must continually adaptits technologies in order to offer customers increasing levels of effectivenessagainst the latest Internet-piracy threats. MediaDefender’s development team isconstantly monitoring advances in peer-to-peer networking and developingsolutions to target new networks.

 

*Advertising.*During 2008 and 2007 MediaDefender worked with severaladvertising agencies and their clients to launch innovative programs whichdistributed branded advertising content on P2P networks. These programs generateancillary incremental revenue which serves to reduce the potential negativeimpact of a reduction in the growth of its IPP solutions services in therecorded music and television area.

 

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* *

*Patent Pending Technology.*MediaDefender’s IPPsolutions utilize proprietary software and a robust, scalable IT platform. Thispatent-pending combination of software and IT was created over time and is basedupon the successes and failures of real-world trials. Computer equipment andsoftware is monitored and maintained on a 24/7 basis. The use of back-up andredundant systems, combined with constant monitoring, allows MediaDefender toprovide continuous coverage and rapidly address potential technical problems.

 

*Intellectual Property.*During 2008 MediaDefenderobtained an umbrella patent that covers some of its concept and back-endtechnologies. Due to the evolving nature of P2P networks, these technologiesare not based on any one service, but rather have the fluidity to be transferredto any P2P network. The claims in the patent filing are predominantly methodsfor managing a large array of computers for the purpose of preventing piracy onP2P networks.

 

*Sales and Marketing.*MediaDefender’s salesprocess is relationship-based with a relatively long sales cycle. Initialcustomer relationships were with music and movie industry clients, targeted dueto the impact of piracy on these businesses, and has since expanded to softwareand gaming clients.

 

*Customers .*MediaDefender’s current principalcustomers include four major record labels and four major motion picturestudios.  Approximately 65% ofMediaDefender’s consolidated revenues were from three customers.  Of those three customers, the respectivecustomers’ percentages were 32%, 21% and 12% of MediaDefender’s revenues duringthe year ended December 31, 2008. During 2007, there were four customers constituting 68% ofMediaDefender’s consolidated revenues, one customer accounted for 21%, twocustomers each were at 18% and one customer accounted for 12%.

 

*Market Share and Competition.*Managementbelieves that MediaDefender has the majority of the IPP solution market. TheCompany recently purchased its major existing competitor, MediaSentry, fromSafenet, Inc.,  and Macrovison, afirm which had been competing in the IPP business, recently stopped offeringthe service due to a lack of performance in the market.

 

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

 

TheARTISTdirect Network is a network of websites anchored by our flagship website www.artistdirect.comoffering multi-media content, music news and information, community aroundshared music interests, advertising sponsorships, music-related specialtycommerce and digital music services.

 

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

 

*Technology*. Our infrastructure is designed tobe integrated, scalable, reliable and secure. The software that we use supportsthe acquisition, management and publication of content on our websites.  During fiscal 2008, the management of our websitesand servers for content, applications, database and electronic commerce washandled internally. Our servers are maintained at three co-location facilitiesin El Segundo and Los Angeles, California, and Phoenix, Arizona. Our operationsdepend on the ability to protect our systems against fire, power loss,telecommunications failure, break-ins and other events. All websites, servers,and systems are monitored and periodic backups are stored at our data center.  The Company has a disaster recovery site inArizona to provide a continued Internet present should the Los Angeles areaexperience a major operational failure.

 

*Order Processing and Fulfillment.*Our websitesinclude an ordering system that is designed to facilitate convenient onlinepurchasing of pre-recorded CD’s and DVD’s. We utilize an outside fulfillment house to verify orders submitted forcredit card payment for fraud detection and sufficient funds before we releasethe order for shipment.  The fulfillmenthouse insures that the credit card numbers are encrypted, and all customer,commerce and transactional data are stored in secure databases protected byfirewalls. The transmission of information over the Internet uses Secure SocketLayer security technology verified by VeriSign, an industry leader in onlinesecurity.

 

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We have anagreement with Alliance Entertainment Corp. (“Alliance”) to be the primarysupplier of our music and movie-related merchandise.  Alliance processes and fulfills the orders byour customers and we pay Alliance the wholesale costs of the merchandise plustransaction fees.  Alliance also providescustomer service and shipping services.  If we are unable to continue our current agreement with Alliance oridentify a suitable alternative fulfillment house, our E-commerce businesscould be adversely affected.

 

*Sales and Marketing.*We sell advertising andsponsorships to companies seeking to reach one or more of the distinctdemographic audiences viewing content in the ARTISTdirect network. Advertisersmay choose single elements such as targeted or run-of-network banners orsponsorship of fixed placement on our websites. Pricing is negotiated basedupon the size of the target audience, the duration and intensity of thecampaign and the size and placement of the advertisement.

 

EffectiveFebruary 1, 2009, we entered into an exclusive agreement with TrafficMarketplace (“TMP”) for the representation and sale of our advertisinginventory for United States users as well as for opt-in email, direct mail andtelemarketing list management and co-registration services. In exchange forsuch exclusive representation, TMP guarantees us a certain level of revenuesubject to our achieving a threshold of unique user visits and page views onour sites and our network affiliates’ sites. 

 

We use anumber of methods to create awareness of the ARTISTdirect network designed todrive traffic to our websites. We have focused much of our marketing activityon e-mail direct marketing to communicate with registered users about specificartists and the ARTISTdirect network. Campaigns have included directnotification of special merchandise offers, contests, promotions and availablemusic downloads. To the extent our registered users in the future opt out ofe-mails or use technology to block marketing e-mails, our operating resultscould be adversely affected. Ad-blocking technologies may be used to limit theeffectiveness of web advertising.

 

*Customers.*During the year ended December 31,2008, one customer accounted for $589,000 or 15% of total media revenue.  During the year ended December 31, 2007,one customer accounted for $1.2 million or 16% of total media revenue.  No other customer accounted for more than10.0% of our media revenue during either year.

 

*Competition.*The market for the online promotionand distribution of music and music-related products and services is highlycompetitive and rapidly changing. There are a large number of websitescompeting for the attention and spending of consumers and advertisers, and weexpect that number to increase, because there are few barriers to entry to Internetcommerce.  In addition, the competitionfor advertising revenue, both on websites and in more traditional media, isintense. We compete as follows:

 

·                  formusic consumers and advertisers with providers of music information, communityand content such as MTV, America Online, MSN, Yahoo!, Listen.com, myspace.com,mp3.com, billboard.com and various other companies;

 

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

 

·                  formusic consumers and artist relationships with traditional music industrycompanies, including Sony BMG Music Entertainment, EMI Music, a unit of EMIGroup, Warner Music Group, and Universal Music Group, a unit of Vivendi. Someof these companies have established online presences to promote and distributethe music and tours of their respective artists;

 

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

 

·                  with traditionalretailers targeting music consumers, including Wal-Mart and Target and their Internetaffiliates, in selling music and merchandise.

 

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Ourcompetitors have worked together to offer music over the Internet, and we mayface increased competitive pressures as a result. We believe that we are ableto compete effectively on the basis of:

 

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

 

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

 

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

 

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

 

·                  longeroperating histories;

 

·                  significantlygreater financial, technical, management capital and marketing resources;

 

·                  greaterbrand name recognition;

 

·                  largerexisting customer bases; and

 

·                  morepopular content or artists.

 

Thesecompetitors may be able to respond more quickly to new or emergingtechnologies, regulatory developments and changes in customer requirements andto devote greater resources to the development, promotion and sale of theirproducts or services than we can. Websites maintained by our existing andpotential competitors may be perceived by consumers, artists, talent managementcompanies and other music-related vendors or advertisers as being superior toours. In addition, we may not be able to maintain or increase our web-site trafficlevels, purchase inquiries and number of click-through on our onlineadvertisements. Further, our competitors may experience greater growth in theseareas than we do. Increased competition could result in advertising pricereduction, reduced margins or loss of market share, any of which couldmaterially harm our business.

 

*Governmental Regulation*. The laws andregulations that govern our business change rapidly. Although our operationsare currently based in California, the United States government and thegovernments of other states and foreign jurisdictions have attempted toregulate activities on the Internet. The following is a general discussion ofsome of the evolving areas of law that are relevant to our business:

 

*Content Regulation and Privacy Law.*The stateof privacy law is unsettled, and rapidly changing. Current and proposedfederal, state and foreign privacy regulations and other laws restricting thecollection, use and disclosure of personal information could limit our abilityto use the information in our databases to generate revenues. In late 1998, theChildren’s Online Privacy Protection Act, or “COPPA,” was enacted, mandatingthat measures be taken to safeguard minors under the age of 13. The FederalTrade Commission (“FTC”) promulgated regulations implementing COPPA on October 21,1999, which became effective on April 21, 2000.

 

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

 

We comply withthe COPPA requirements by not collecting or displaying the individuallyidentifying information of users who, when attempting to register on the websites,enter their birth date indicating they are under the age of 13. Complying withthe COPPA requirements is costly and may dissuade some of our potentialcustomers.

 

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

 

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

 

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

 

*Sales Tax.*The tax treatment of goods soldover the Internet is currently unsettled. We collect sales taxes for goodsshipped to California and Florida, where we have a physical presence (i.e., a“nexus”). A number of proposals have been made at the state and local levelthat would impose additional taxes on the sale of goods through the Internet.Such proposals, if adopted, could substantially impair the growth of electroniccommerce and could adversely affect our opportunity to derive financial benefitfrom electronic commerce.

 

*Online Contests and Sweepstakes.*Weoccasionally conduct online promotional contests and sweepstakes. No purchaseis necessary to participate. Our official rules, with material terms andconditions, eligibility restrictions, dates of participation, methods of entry,prize descriptions and restrictions, and odds of winning, are posted on our websites.To avoid having to register and bond our online promotions in the states of NewYork and Florida, the approximate retail value of the prizes we offer isgenerally less than $5,000 for a single promotion.****Although we structure our promotions in a way that attemptsto comply with applicable statutes as we believe they are currently interpretedand enforced in all fifty states, many of those statutes were drafted longbefore the advent of promotions over the Internet, and different states haveinterpreted substantially similar statutes differently. Thus, our ability toconduct online promotions is subject to the broad discretionary enforcementpowers vested in various authorities. Further, our ability to conduct onlinepromotions may be affected in whole or in part by various business methodpatents that may have been issued. In addition, foreign jurisdictions mayattempt to regulate or ban our promotional contests. Under any of those threescenarios, we could face fines or possible exposure to liability or lose aneffective tool for increasing traffic to and keeping visitors at our websites,and our business could be adversely affected.

 

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* *

*Intellectual Property.*Software,**content and other material that wedevelop, as well as our service marks and domain names relating to theARTISTdirect or UBL brands, and other proprietary rights are important to ourbusiness prospects. Significant impairment of our intellectual property rightscould harm our business. We seek to protect certain of our common-lawtrademarks through Federal registration in the United States of America andState registrations in Puerto Rico. We also have trademark registrations inArgentina, Australia, Brazil, Canada, Chile, Costa Rica, the European Union,Japan, Mexico, Panama, Peru, the United Kingdom and Venezuela. Given the cost offiling, maintaining and protecting federal registrations, we may choose not toregister or enforce certain of our trademarks that later turn out to beimportant. Despite our efforts, it is possible that the scope of protectiongained from seeking trademark registration will be insufficient or that theregistration may be deemed invalid or unenforceable.

 

We seek to protect many of our innovations as trade secrets andprincipally rely upon trade secret and contract law in the Unites States toprotect our proprietary rights. We generally enter into confidentialityagreements, “work-made-for-hire” contracts and intellectual property licenseswith our employees, consultants and corporate partners, respectively, as partof our efforts to control access to and distribution of our technologies,content and other proprietary information. For example, where consultantsdevelop copyrighted content for us, our general policy is to use writtenagreements prior to content creation to obtain ownership of that content.

 

The following sets forth a schedule of our active trademarks:

 

Federal Trademark Filings

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

 

State Trademark Filings

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

 

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InternationalFilings

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

 

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

 

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

 

----

* Indicatesthat application is pending and not yet registered.

 

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

 

A copyright gives the owner divisible rights, including those ofperformance, reproduction and distribution. The music featured by us istypically comprised of copyrighted works owned, controlled or administered bymultiple third parties, including record labels, artists, songwriters, musicpublishers and performance rights and licensing organizations such as (but notlimited to) The Harry Fox Agency, Broadcast Music Inc. (“BMI”) and the AmericanSociety of Composers, Authors and Publishers (“ASCAP”). Each song often hasmultiple copyright owners, who control rights which may include performance,reproduction and distribution rights in the “musical composition” comprised ofthe lyrics and music, as well as with the “sound recording” of the artist’sinterpretation of the “musical composition.” In the case of music videos, thereare separate copyrights to the visual content, as well as “synchronizationrights” for integrating the music and video. We, or our artists, may havedifferent licensing arrangements with some or all of these parties to perform,reproduce and distribute works depending upon how the song or music video isused by us.

 

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Our websites, depending upon the specific musical work, may offer audiostreaming of part or all of an entire song or “Web casting,” or the downloadingof an entire song in MP3 or other compressed audio formats. Full-lengthstreaming only occurs in special instances after obtaining a license from therecord label or band manager for the “sound recording.” In that case, an ASCAPor BMI blanket music license is also obtained by us or by our artists forrights to perform the associated underlying “musical composition.” Where weoffer full-length downloads of songs in MP3 or other compressed audio formats,we seek to obtain the rights to transmit, reproduce and perform the “soundrecording” in writing from the person or entity owning or controllingcopyrights in such “sound recording.” With respect to rights in the “musicalcompositions” embodied in such “sound recordings” offered for download, we seekto clear rights in musical composition in one or more of the following threeways:

 

·                  a licenseagreement with the publisher, writer or other owner of such copyright in the“musical composition”;

 

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

 

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

 

In the event that the foregoing steps are insufficient to clear rights,or we otherwise fail to obtain rights, we could be exposed to claims ofcopyright infringement, with attendant disruption to our operations andliability including potential statutory or actual damages and loss of profitsattributable to infringement, plus payment of attorneys’ fees to the claimantand entry of an injunction against us.

 

There are other situations, such as a limited 30-second sample of asong that is “streamed,” where we use content relying upon a sub-license froman artist’s record label. However, the laws in this area are uncertain, and wemay be obligated to obtain additional licenses or may be prevented from thirdparty content use, and may, in the event proper licenses and clearances havenot been secured, further be liable to pay actual or statutory damages, profitsattributable to any alleged infringement, as well as attorneys’ fees. Ourlicensing arrangements for third-party content vary from formal contracts toinformal agreements based on the promotional nature of the content. In somecases we pay a fee to the licensor for use of the “sound recording,” “musicalcomposition” or music video and in other cases the use is free. We also useother third-party content, including photographs, artist names, likenesses andconcert reviews. While it is our general policy to obtain a written release orlicense for such use, in many instances we rely only upon an oral license forsuch use. We rely upon our positive working relationships with copyright ownersto obtain licenses on favorable terms. Any changes in the nature or terms ofthese arrangements, including any requirement that we pay significant fees forthe use of the content, could have a negative impact on the availability ofcontent or our business.

 

*Linking and Framing of Third-Party websites.*Welink to and “frame” third-party websites of our artists without express writtenpermission to do so. In addition, in the past we have provided a search featureto allow users to find music residing elsewhere on the Internet. Thosepractices are controversial, and have, in instances not involving us, resultedin litigation. Various claims, including trademark and copyright infringement,unfair competition, and commercial misappropriation, as well as infringement ofthe right of publicity may be asserted against us as a result of thesepractices. The law regarding linking and framing remains unsettled; it isuncertain as to how existing laws, especially trademark and copyright law, willbe applied by the judiciary to the Internet. Also, Congress is increasinglyactive in passing new laws related to the Internet, and there is uncertainty asto the impact of future potential laws, especially those involving domainnames, databases and privacy.

 

*Defamation or Contributory Infringement.*Ourweb-site features a community area where visitors can post comments. We do notcensor such comments and it is possible that a customer could use our websitesas a forum to make false, misleading or disparaging remarks about others. Suchon-line comments could lead to claims for defamation or infringement. As tolibel claims brought in the United States, we believe that we qualify for safeharbor protection for third-party postings under 47 U.S.C. Section 230(c)(1).However, other countries, notably the United Kingdom, may impose suchliability, and it is possible we could be sued there for third-party postings.Separately, our websites allow consumers to use our personal web publishingtools to post samples of their works. Such postings could be misused to postunlicensed copyrighted content of others. We have obtained limited safe-harborprotection under the Digital Millennium Copyright Act against liability forinfringing material of which we do not have control and knowledge.

 

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* *

*Seasonality.*Theseasonality of our e-commerce segment affects our revenue. Our CDs and otheronline goods are most often purchased during the winter holiday season and alsoduring the summer months, traditionally when artists go on concert tour.

 

**ITEM 1A.               RISK FACTORS**

** **

**RISK FACTORS**

** **

Ouractual results may differ materially from those anticipated in theseforward-looking statements. We operate in a market environment that isdifficult to predict and that involves significant risks and uncertainties,many of which will be beyond our control. Refer also to “Special Note RegardingForward-Looking Statements.”

 

**RISKS RELATED TO OURBUSINESS**

** **

***It isdifficult to evaluate our business and prospects because we have a limitedoperating history and a rapidly evolving business.***

*** ***

Wewere incorporated under the laws of the state of Delaware in July 1999. Ourlimited operating history and rapidly evolving business make it difficult toevaluate our prospects or to accurately predict our future revenue or resultsof operations. Our revenue and income potential are unproven, and our businessmodel is constantly and rapidly evolving. In particular, the Internet isconstantly changing and we may need to modify our business model to adapt tothese changes.

 

***The musicindustry is under extreme pressure to reduce costs.***

*** ***

Themajor music labels are suffering from significant sales and profitdeterioration and wherever possible are reducing expenditures. This hasnegatively impacted the amount of business that MediaDefender has conductedwith these customers and this trend is expected to continue.

 

***Our inabilityto retain and, as necessary, strengthen our executive management team would bedetrimental to the success of our business.***

*** ***

Werely heavily on a small group of senior executives and retaining their servicesis important to our future success. As we continue to grow the business, theexecutive management team will face increasing challenges and the possible needto supplement or expand the existing team to enable us to put in place anecessary succession plan. Any failures in this regard could impact, amongother factors, our revenues, growth and profitability.

 

***We havesubstantially reduced operating cash as a result of the debt restructuring,(see Recent Developments).***

*** ***

Toobtain sufficient cash resources to affect the payment to the Senior Noteholders and the conversion of the balance of the Senior Debt and theSubordinated Notes, we incurred approximately $1.250 million in principalamount of indebtedness.  We utilizedsubstantial amounts of the Company’s operating cash to accomplish the debtrestructuring and will need to fund interest on the credit facilities, futurecapital expenditures and general working capital requirements out of ongoingoperations. If we are unable to meet our cash requirements out of cash flowfrom operations, there can be no assurance that we will be able to obtainalternative financing or be able to raise additional capital in the currenteconomic environment.

 

***The success ofour Internet piracy prevention segment depends heavily on the continued successof MediaDefender’s content protection technology.***

*** ***

Ifcurrent MediaDefender customers, which include both major motion picturestudios and record labels, determine that the benefits of MediaDefender’stechnology do not justify the expense, or other competitive technologies aresuperior than those provided by MediaDefender, demand for its IPP technologywould decline and our operating results would be significantly harmed.

 

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***Global salesof recorded music have recently declined and this trend may continue in thefuture.***

*** ***

Basedon data compiled by Nielsen SoundScan, total Internet album sales decreased by8.6% in 2008 to 27.1 million units as compared to 30.1 million units in2007.  According to the RIAA, thedecline, in sales had been due in part, to widespread copying and illegalInternet downloading of music.  If theoverall trend continues, it may affect our e-commerce business and have amaterial effect on our revenues.

 

***We may not beable to develop or obtain sufficiently compelling content to attract and retainour target audience.***

*** ***

Forour media and e-commerce segments to be successful, we must provide content andservices that attract consumers who will purchase music and related merchandiseonline. We may not be able to provide consumers with an acceptable mix ofproducts, services, information and community to attract them to our websitesor to encourage them to remain on our websites for an extended period of time.If our audience determines that our content does not reflect its tastes, thenour audience size could decrease or the demographic characteristics of ouraudience could change and we may be unable to react to those changeseffectively or in a timely manner. Any of these results would adversely affectour ability to attract advertisers and sell music and other related merchandise.

 

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

*** ***

During2008, no one customer accounted for more than 10.0% of our media revenue.During the year ended December 31, 2008, approximately 65% of MediaDefender’sconsolidated revenues were from three customers.  Of those three customers, the respectivecustomers’ percentages of revenue were 32%, 21% and 12%.  In January 2008, MediaDefender was notifiedby a customer accounting for 12% of 2007 revenue, that they were discontinuingservice and were evaluating the use of other methods to offset the negativeimpact of piracy.  In June 2008, theCompany was advised that another customer that accounted for 18% ofMediaDefender’s 2007 annual revenues was substantially curtailing its use ofMediaDefender’s anti-piracy services subsequent to the expiration of itscurrent contract with MediaDefender on June 30, 2008, citing uncertainty withrespect to the effectiveness and cost/benefit of anti-piracy services.  Should MediaDefender, lose any of itsremaining major customers, our business and results of operations could beadversely affected.  During 2007, therewere four customers constituting 68% of MediaDefender’s consolidated revenues,one customer accounted for 21%, two customers each were at 18% and one customeraccounted for 12%.

 

***If we do notbuild and maintain strong brands, we may not be able to attract a significantnumber of users to our websites.***

*** ***

Toattract users we must develop a brand identity for ARTISTdirect and increasepublic awareness of the ARTISTdirect network; however, to conserve cash we havenot been able to spend large amounts on offline and online advertising andpromotional 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 inbuilding our brands. Moreover, despite these efforts we may be unable toincrease public awareness of our brands, which would have an adverse effect onour results of operations.

 

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

*** ***

Themarket for the online promotion and distribution of music and relatedmerchandise is highly competitive and rapidly changing. There are a significantnumber of websites promoting and distributing music and related merchandisethat compete for the attention and spending of consumers, advertisers andusers. We face competitive pressures from numerous actual and potentialcompetitors. Our competitors include America Online, MSN, Yahoo!, Amazon.com,MTV, myspace.com, mp3.com, billboard.com and other websites and traditionalmusic companies.

 

Thesecompetitors may be able to respond more quickly to new or emerging technologiesand 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 mayperceive websites maintained by our existing and potential competitors as beingsuperior to ours. In addition, increased competition could result in reducedadvertising rates and margins and loss of market share, any of which could harmour business.

 

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

*** ***

Werely to a large extent on timely distribution by third parties. During 2008, werelied on Alliance Entertainment to fulfill and distribute our orders for CDsand DVDs. Our contract with Alliance ended in July 2008 and we continue tooperate our e-commerce business on a monthly basis in the event that thisarrangement is terminated without a suitable replacement our e-commercebusiness could be adversely affected.

 

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

*** ***

Wehave experienced and expect to continue to experience seasonal fluctuations inour online sales. These seasonal patterns will cause quarterly fluctuations inour operating results. In particular, a disproportionate amount of our onlinesales have been realized during the fourth calendar quarter and during thesummer months, traditionally when artists go on tour. Due to our limitedoperating history, it is difficult to predict the seasonal pattern of ouronline sales and the impact of such seasonality on our business and operatingresults. Our seasonal online sales patterns may become more pronounced, strainour personnel, warehousing, and order shipment activities and cause ouroperating results to be significantly less than expected for any given period.

 

***We may besubject to system disruptions, which could reduce our revenue.***

*** ***

Ourability to attract and retain artists, users, advertisers and merchants for ouronline network depends on the performance, reliability and availability of ourwebsites and network infrastructure. Our own staff performs the maintenance andoperation of substantially all of our Internet communications hardware andservers. We have periodic maintenance windows, and we experience outages fromtime to time caused by temporary problems in our own systems or software. Whilewe have implemented procedures designed to improve the reliability of oursystems, these interruptions may continue to occur from time to time. Our usersalso depend on third party Internet service providers and website operators foraccess to our websites. These entities have experienced significant outages inthe past, and could experience outages, delays and other difficulties due tosystem failures in the future which are unrelated to our systems, but whichcould nonetheless adversely affect our business.

 

***If we areunable to protect our intellectual property rights, our competitive positioncould be harmed or we could be required to incur expenses to enforce ourrights.***

*** ***

Werely upon the registered trademark rights in the United States for ourcommercial use of the ARTISTdirect, Ultimate Band List and other brand namesand their respective associated domain names, and the ARTISTdirect logo. Weseek to protect our trademarks by registration and copyrights and otherproprietary rights through confidentiality requirements and other means, butthese actions may be inadequate. It may be possible that some of ourinnovations may not be protectable. We have trademark applications pending inseveral jurisdictions, but our registrations may not be accepted or may bepreempted by third parties and/or we may not be able to register our trademarksin all jurisdictions in which we intend to do business. We generally enter intoconfidentiality or license agreements with our employees, consultants andcorporate partners, and generally attempt to control access to and distributionof our proprietary information.

 

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

 

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

*** ***

Themusic content available on the ARTISTdirect network is typically comprised ofcopyrighted works owned or controlled by multiple third parties. Most of thecontent on our artist-specific websites is either owned or licensed by theartist. On other parts of the ARTISTdirect network, depending on the nature ofthe content and how we use the music content, we typically license such rightsfrom publishers, record labels, performing rights societies or artists.

 

Wefrequently either do not have written contracts or have short-term contractswith copyright owners, and, accordingly, our access to copyrighted contentdepends upon the willingness of such parties to continue to make their contentavailable. If the fees for music content increase substantially or ifsignificant music content becomes unavailable, our ability to offer musiccontent could be materially limited. We have not obtained a license for some ofthe content offered on the ARTISTdirect network, including links to othermusic-related sites and thirty-second streamed song samples, because we believethat a license is not required under existing law. However, this area of lawremains uncertain and may not be resolved for a number of years. When this areaof law is resolved, we may be required to obtain licenses for such content,alter or remove the content from our websites and be forced to pay potentiallysignificant financial damages for past conduct. We continue to discuss thepotential for license arrangements with many of the major music publishers.

 

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

*** ***

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

 

***We may besubject to liability if private information provided by our users were misused.***

*** ***

Ourprivacy policy discloses how we use individually identifiable information thatwe collect. This policy is displayed and accessible throughout the ARTISTdirectnetwork. Despite this policy, however, if third persons were able to penetrateour network security or otherwise misappropriate our users’ personalinformation or credit card information, we could be subject to liability. Wecould also be subject to liability for claims for unauthorized purchases withcredit card information, impersonation or other similar fraud claims, or othermisuses of personal information, such as for unauthorized marketing purposes.These claims could result in costly and time-consuming litigation.

 

Whilewe attempt to be fully compliant with our privacy policy, our efforts may notbe entirely successful. In addition, at times we rely upon outside vendors tomaintain data-collection software, and there can be no assurance that they willat all times comply with our instructions to comply with our privacy policy. Ifour methods of complying with our privacy policy are inadequate, or ourbusiness practices be found to differ from our privacy policy, we may face litigationwith the FTC, California and other State’s governmental authorities orindividuals, which would adversely affect our business. It is also possiblethat users or visitors could try to recover damages in a civil action as well.

 

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***We may be suedfor content available or posted on our websites or products sold through ourwebsites or for linking and framing of third-party websites.***

*** ***

Wemay be liable to third parties for content published on our websites and otherwebsites where our syndicated content appears if the music, artwork, text orother content available violates their copyright, trademark or other intellectualproperty rights or if the available content is defamatory, obscene orpornographic. Similar claims have been brought, sometimes successfully, againstwebsite operators in the past. We also may be liable for content uploaded orposted by our users on our websites, 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 forclaims made against them for content available on our websites.

 

Wealso could be exposed to these types of claims for content that may be accessedfrom our websites or via links to other websites or for products sold throughour website. While we have resolved all of these types of claims made againstus in the past, we may not be able to do so in the future. Any litigation as aresult of defending these types of claims could result in substantial costs anddamages. Our insurance may not adequately protect us against these types ofclaims or the costs of their defense or payment of damages. We link to and“frame” third-party websites of our artists without express written permissionto do so. In addition, in the past we have provided a search feature to allowusers to find music residing elsewhere on the Internet. Those practices arecontroversial, and have, in instances not involving us, resulted in litigation.Various claims, including trademark and copyright infringement, unfaircompetition, and commercial misappropriation, as well as infringement of theright of publicity may be asserted against us as a result. The law regardinglinking and framing remains unsettled; it is uncertain as to how existing laws,especially trademark and copyright law, will be applied by the judiciary to theInternet. Also, Congress is increasingly active in passing new laws related tothe Internet, and there is uncertainty as to the impact of future potentiallaws, especially those involving domain names, databases and privacy.

 

**RISKS RELATED TO OURCAPITAL STRUCTURE**

** **

***Our stockprice is volatile and could decline in the future.***

*** ***

Theprice of our common stock may fluctuate in the future.  The stock market, in general, and the marketprice for shares of technology companies in particular, have experiencedextreme stock price fluctuations. In some cases, these fluctuations have beenunrelated to the operating performance of the affected companies.  Many companies in the technology and relatedindustries have experienced dramatic volatility in the market prices of theircommon stock.  We believe that a numberof factors, both within and outside of our control, could cause the price ofour common stock to fluctuate, perhaps substantially.

 

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

*** ***

Ourcommon stock is currently traded on a limited basis on the Over-the-CounterBulletin Board under the symbol “ARTD.OB.” The quotation of our common stock on the Over-the-Counter Bulletin Boarddoes not assure that a meaningful, consistent and liquid trading marketcurrently exists, and in recent years such market has experienced extreme priceand volume fluctuations that have particularly affected the market prices ofmany smaller companies like us.  Our commonstock is thus subject to volatility. In the absence of an active tradingmarket:

 

·                  investors may have difficulty buyingand selling or obtaining market quotations;

 

·                  market visibility for our commonstock may be limited; and

 

·                  a lack of visibility for our commonstock may have a depressive effect on the market for our common stock.

 

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***Our commonstock is considered a “penny stock” and may be difficult to sell.***

*** ***

Ourcommon stock is considered to be a “penny stock” since it meets one or more ofthe definitions in Rule 3a51-1 under the Securities Exchange Act of 1934, asamended (the “Exchange Act”).    Theprincipal result or effect of being designated a “penny stock” is thatsecurities broker-dealers cannot recommend the stock but must trade in it on anunsolicited basis.  Section 15(g) of theExchange Act and Rule 15g-2 promulgated thereunder by the SEC requirebroker-dealers dealing in penny stocks to provide potential investors with adocument disclosing the risks of penny stocks and to obtain a manually signedand dated written receipt of the document before effecting any transaction in apenny stock for the investor’s account.

 

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

 

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

*** ***

Rulesadopted by the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002require annual assessment of our internal control over financialreporting.  The standards that must bemet for management to assess the internal control over financial reporting aseffective are new and complex, and require significant documentation, testingand possible remediation to meet the detailed standards.  We may encounter problems or delays incompleting activities necessary to make an assessment of our internal controlover financial reporting.  If we cannotassess our internal control over financial reporting as effective, investorconfidence and share value may be negatively impacted.  We expect to incur additional accountingrelated expenses associated with compliance with Section 404.

 

***The securitiesissued by the Company in connection with the restructuring of our senior andsubordinated debt could have a negative impact on the market price of ourstock.***

*** ***

Inconnection with the Debt Restructuring and debt conversion, 45,732,492 sharesof common stock were issued to the Senior and Subordinated Note holders.  Any sales in the public market of the commonstock issued in connection with the Debt Restructuring and debt conversioncould adversely affect prevailing market prices of our common stock.  Additionally, the existence of these sharescould be perceived as representing a negative overhang on the market for ourstock.

 

***Changes infinancial accounting standards or interpretations of existing standards couldaffect reported results of operation.***

*** ***

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

 

**ITEM1B                UNRESOLVED STAFFCOMMENTS**

** **

**                               **Notapplicable.

 

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**ITEM2.****                             PROPERTIES**

 

The following table provides a schedule of corporate offices andfacilities leased by us:

 
| **Location**             | ** ** | **Primary Function**                                  | ** ** | **Square Footage** | ** ** | **Lease Term**                      |
|--------------------------|------------|------------------------------------------------------------|------------|-------------------------|------------|------------------------------------------|
| ** **               | ** ** | ** **                                                 | ** ** | ** **              | ** ** | ** **                               |
| Santa Monica, California |       | Corporate headquarters for ARTISTdirect and  MediaDefender |       | 14,817                  |       | Lease ends November 30, 2011        |
|                     |       |                                                       |       |                    |       |                                     |
| Morristown, New Jersey   |       | Regional office space                                      |       | 5,000                   |       | Rental agreement ends September 30, 2009 |
|                     |       |                                                       |       |                    |       |                                     |
| Kettering, Ohio          |       | Regional office space                                      |       | 3,932                   |       | Lease ends June 30, 2009                 |
|                     |       |                                                       |       |                    |       |                                     |
| Los Angeles, California  |       | Secured co-location space                                  |       | 300                     |       | Monthly                                  |
|                     |       |                                                       |       |                    |       |                                     |
| Los Angeles, California  |       | Secured co-location facility                               |       | NA                      |       | Lease ends February 2010            |
|                     |       |                                                       |       |                    |       |                                     |
| El Segundo, California   |       | Secured co-location facility                               |       | NA                      |       | Lease ends February 2010            |
|                     |       |                                                       |       |                    |       |                                     |
| Scottsdale, Arizona      |       | Secured co-location facility                               |       | NA                      |       | Lease ends August 2009              |

 

We believe that all real property and facilities leased by us are ingood repair and adequate for our purposes for the next 12 months.

 

**ITEM3.****                             LEGALPROCEEDINGS**

 

We are periodically subject to various pending and threatened legalactions, which arise in the normal course of business. Our management currentlybelieves that the impact of any such litigation will not have a materialadverse impact on our financial position or results of operations.

 

**ITEM 4.****                                                     SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

There were no matters submitted to a vote of our stockholders duringthe fourth quarter of the fiscal year ended December 31, 2008.

 

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**PART II**

 

**ITEM5.****                       MARKETFOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERPURCHASES OF EQUITY SECURITIES**

 

*Market Information*

 

Our common stock has been listed on the Over-the-Counter Bulletin Boardunder the symbol “ARTD.OB” since May 9, 2003.  The following table sets forth the high andlow sales prices for our common stock, as reported by the Over-the-CounterBulletin Board for fiscal 2008 and 2007, respectively:

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2008**       |       |     |       |    |       |
| First Quarter  |       | $        | 0.51       |    | $          | 0.37 |   |
| Second Quarter |       | $        | 0.45       |    | $          | 0.27 |   |
| Third Quarter  |       | $        | 0.27       |    | $          | 0.03 |   |
| Fourth Quarter |       | $        | 0.03       |    | $          | 0.01 |   |
|           |       |     |       |    |       |
| **2007**       |       |     |       |    |       |
| First Quarter  |       | $        | 2.40       |    | $          | 1.40 |   |
| Second Quarter |       | $        | 2.38       |    | $          | 1.75 |   |
| Third Quarter  |       | $        | 2.30       |    | $          | 1.75 |   |
| Fourth Quarter |       | $        | 1.90       |    | $          | 0.38 |   |

 

The closing price of our common stock on March 31, 2009 was $0.01per share, as reported on the Over-The-Counter Bulletin Board.  The Over-the-Counter quotations reflectinter-dealer prices, without retail mark-up, markdown or commission, and maynot represent actual transactions.

 

*Holders of Record*

 

As of March 31, 2009, we had 278 holders of record of our commonstock, excluding shares held in “street name” by brokerage firms and othernominees who hold shares for multiple investors.

 

*Dividends*

 

The Company has not declared or paid any cash dividends on our commonstock since its inception.  The Company’svarious senior and subordinated financing documents prevent the Company frompaying any cash dividends on account of our common stock.  Subject to the Company’s obligations to oursenior and subordinated lenders, the Company intends to retain any futureearnings, if any, to finance the Company’s business, and we do not expect todeclare or pay any cash dividends in the foreseeable future.

 

*Equity Compensation Plan Information*

 

Refer to Item 11 “Security Ownership of Certain Beneficial Ownersand Management and Related Stockholder Matters” below for information withrespect to our equity compensation plans.

 

*Additional Information*

 

Copies of our prior Annual Reports on Form 10-K, QuarterlyReports, Current Reports on Form 8-K, and any amendments to those reports,are available free of charge on the Internet at www.sec.gov. All statementsmade in any of our filings, including all forward-looking statements, are madeas of the date of the document in which the statement is included, and we donot assume or undertake any obligation to update any of those statements unlesswe are required to do so by law.

 

**ITEM6.  SELECTED FINANCIAL DATA**

 

Not applicable.

 

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**ITEM7.****                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Overview:

 

The Companyconducts its media business operations through an online music networkappealing to music fans, artists and marketing partners.  The ARTISTdirect Network is a network of websitesoffering multi-media content, music news and information, communities organizedaround shared music interests, music-related specialty commerce and digitalmusic services.

 

The Companyacquired MediaDefender, Inc., a privately-held Delaware corporation, (“MediaDefender”)in July of 2005, which added media protection services to ArtistDirect’s Internetoperations.  MediaDefender is the leadingprovider of anti-piracy solutions in the Internet-piracy-protection (“IPP”)industry.  Revenues related toanti-piracy activities declined in 2008 from 2007 and management anticipates afurther decline in 2009.  The industrywide reduction in technological anti-piracy services reflects a change by mediaconglomerates to explore alternative online distribution initiatives, includingan ad supported free access to television programming and reduced costs or asubscription based model for digital music downloads.  This decline in industry wide anti-piracy spendingis also a reflection of general economic conditions, whereby media copyrightholders attempt to maintain profitability through general costs cuttingmeasures, which would include anti-piracy programs. 

 

**RecentDevelopments**

 

*Debt Restructing*

* *

Senior Debt Restructuring

 

EffectiveJanuary 30, 2009, ARTISTdirect, Inc. (the “Company”) entered into aFirst Amendment to Note and Warrant Purchase Agreement dated as ofDecember 31, 2008 (the “Senior Amendment”) with the holders of theCompany’s senior secured debt (the “Senior Note Holders”).  Pursuant tothe Senior Amendment, the Senior Note Holders agreed to extinguish allobligations by the Company under the Note and Warrant Purchase Agreement, datedJuly 28, 2005, and other documents entered into in connection with thesenior secured debt transaction (the “Senior Debt Restructuring”), uponcompletion of the following: (1) $3,500,000 cash payment to the SeniorNote Holders; (2) issuance of new subordinated notes, in the aggregateprincipal amount of $1,000,000, to the Senior Note Holders (the “New Notes”);(3) issuance of 9,000,000 restricted shares of the Company’s common stockto the Senior Note Holders, which are subject to a lock-up period of 12 months;and (4) the conversion of all of the previously issued Subordinated Notes.  The Senior Debt Restructuring was consummatedas of January 30, 2009.

 

The New Notes are unsecuredand bear interest at 6.0% per annum, beginning January 30, 2009. Theprincipal and the interest accrued thereon are payable on the maturity date,January 30, 2014, and are subordinated to the senior indebtedness of theCompany.

 

Additionally, in connectionwith the Senior Debt Restructuring, Trilogy Capital Partners, Inc. agreedto deliver to the Company for cancellation a warrant to purchase up to 433,333shares of the Company’s capital stock at an exercise price of $2.00 pershare.  Fifty percent of such warrants were beneficially owned by DimitriVillard, the Company’s Chief Executive Officer, who had acquired such warrantsas part of the acquisition of 6,190,000 shares from Trilogy CapitalPartners, Inc., which occurred on January 15, 2009.

 

Conversion of SubordinatedNotes

 

Inconnection with the Senior Debt Restructuring, effective January 30, 2009,the Company entered into a Second Amendment to the Convertible SubordinatedNote with holders of the Subordinated Notes representing no less than themajority of the current outstanding aggregate principal amount to provide forthe immediate conversion of the Subordinated Notes (the “SubordinatedAmendment”). The Subordinated Amendment also provides for theextinguishment of all obligations of the Company under the Subordinated Notesand related documents, including the Registration Rights Agreement among theCompany and the holders.  Such obligations included the outstandingprincipal amount and accrued and unpaid interest on the Subordinated Notes,accrued and unpaid late charges and amounts owed under the Registration RightsAgreement with the holders of the Subordinated Notes.  Consummation of the transactions under theSubordinated Amendment occurred as of January 30, 2009.

 

Financing by FactoringAccounts Receivables

 

On January 30, 2009,the Company’s two wholly-owned subsidiaries, ARTISTdirect InternetGroup, Inc. (“ADIG”) and MediaDefender each entered into an AccountsReceivable Purchase & Security Agreement (the “A/R Agreement”) withPacific Business Capital Corporation (“PBCC”), pursuant to which ADIG andMediaDefender agreed to sell and PBCC agreed to purchase qualified accounts receivableon a recourse basis. On January 30, 2009, PBCC purchased an aggregate ofapproximately $1,600,000 of unpaid receivables to be acquired by PBCC pursuantto the A/R Agreement, subject to a maximum aggregate amount of $3,000,000. TheA/R Agreement is effective for twelve-months and automatically renews forsuccessive 12-month periods unless terminated by written notice by either party30 days prior to such successive period.

 

As collateral for thefinancing, PBCC received a first priority interest in all existing and futureassets of the Company, ADIG and MediaDefender, tangible and intangible,including but not limited to, cash and cash equivalents, accounts receivable,inventories, other current assets, furniture, fixtures and equipment andintellectual property. In addition to the foregoing, the Company, ADIG andMediaDefender entered into cross guarantees of their respective obligationsunder the A/R Agreement.

 

Convertible short-termnote to Director

 

On March 3, 2009, theCompany issued a convertible note (the “Note”) to Frederick W. Field, adirector of the Company.  The Note is in the principal amount of $200,000with the principal amount and accrued interest at the rate of 5% per annum dueon July 31, 2009.  The Note isautomatically convertible into shares of the Company’s Common Stock at a priceof $0.03 per share at such time as the Company has sufficient authorizedshares.

 

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The following table is aproforma presentation of the Consolidated Balance Sheet reflecting the abovedescribed Debt Restructuring as if it had occurred as of December 31, 2008.

 
| ** **                                              | ** ** | **December 31, 2008** | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **Audited**                     | ** ** | **Proforma** | ** ** |
| Assets:                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash                                                    |       | $                               | 2,262,000  |   | $ | 12,000 |   |
| Other current assets, net                               |       | 3,480,000                       |       | 3,480,000 |   |
| Property and equipment, net                             |       | 1,201,000                       |       | 1,201,000 |   |
| Other non-current assets, net                           |       | 546,000                         |       | 153,000 |   |
|                                                    |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |
|                                                    |       |                            |       |   |   |
| Liabilities and Stockholders’ Equity  (Deficiency) |       |                            |       |   |   |
| Accounts payable and accrued expenses                   |       | $                               | 921,000    |   | $ | 971,000 |   |
| Accrued interest and liquidated damages                 |       | 8,890,000                       |       | — |   |
| New credit facility                                     |       | —                          |       | 1,250,000 |   |
| Senior secured notes, net                               |       | 12,817,000                      |       | — |   |
| Subordinated convertible notes, net                     |       | 26,397,000                      |       | — |   |
| Other current liabilities                               |       | 1,228,000                       |       | 1,183,000 |   |
|                                                    |       | 50,253,000                      |       | 3,404,000 |   |
|                                                    |       |                            |       |   |   |
| New subordinated notes, net of discount                 |       | —                          |       | 270,000 |   |
| Other long-term liabilities                             |       | 159,000                         |       | 159,000 |   |
|                                                    |       | 159,000                         |       | 429,000 |   |
|                                                    |       |                            |       |   |   |
| Net  Stockholders’ Equity (Deficiency), net        |       | (42,923,000                     | )          | 1,013,000 |   |
|                                                    |       |                            |       |   |   |
|                                                    |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |

* *

*Management and Director Changes*

 

EffectiveJanuary 13, 2009, each of Randy Saaf and Octavio Herrera (each, an “Executive”)entered into separate amendments (collectively, the “Amendments”) to theirrespective Employment, Confidentiality and Noncompetition Agreements(collectively, the “Employment Agreements”) dated as of July 28, 2005 withMediaDefender, Inc..  Under each of theAmendments, commencing January 1, 2009 the term of employment between eachExecutive and the MediaDefender were at-will, and either the MediaDefender orthe Executive may terminate the applicable Employment Agreement upon five days’written notice, in which case such Executive shall have a period of 60 daysfrom the effective date of termination to exercise all vested stockoptions.  Effective February 15, 2009,MediaDefender, terminated the employment of Randy Saaf, Chief Executive Officerof MediaDefender, and Octavio Herrera, President of MediaDefender.

 

EffectiveFebruary 1, 2009, Dimitri Villard, the Chairman of the Board of Directors,  pursuant to a three year employmentagreement, was appointed to serve as the Company’s Chief Executive Officer.Prior to that date, Mr. Villard was the Company’s interim Chief ExecutiveOfficer.  Mr. Villard will receive basecompensation equal to $25,000 per month subject to increases as determined bythe Board of Directors, in its sole discretion. Mr. Villard was granted options to purchase 3,920,000 shares of theCompany’s stock at $0.03 per share vesting monthly over 36 months and willreceive a bonus equal to 33% of the amount by which the Company’s EBITDAexceeds a certain threshold amount as determined by the Company’s CompensationCommittee for such fiscal year.

 

EffectiveFebruary 1, 2009, the Company and Rene Rousselet (“Executive”) entered into anEmployment Agreement pursuant to which Mr. Rousselet was employed to continueas the Company’s Corporate Controller and Principal Accounting Officer.  The employment is on an “at will basis.”  Mr. Rousselet will receive a salary of$14,583 per month subject to increases and a bonus as determined by the Boardof Directors, in its sole discretion. Mr. Rousselet was granted options to purchase 560,000 shares of theCommon Stock of the Company at $0.03 per share vesting monthly over 36 monthscommencing February 1, 2009.  If Mr.Rousselet’s employment is terminated without cause, Mr. Rousselet will receivehis salary and vesting of options for an additional period of three months fromthe date of termination.

 

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*Acquisition of MediaSentry*

* *

The Company and its wholly owned subsidiary, MediaDefender entered intoan Asset Purchase Agreement dated as of March 30, 2009 (the “PurchaseAgreement”) pursuant to which the Company through MediaDefender agreed topurchase from SafeNet, Inc. and MediaSentry, Inc. (collectively the“Sellers”), substantially all the assets of the MediaSentry operating unit (the“Acquired Assets”).  In connection with the acquisition, MediaDefenderacquired the receivables, equipment and intellectual property of MediaSentry aswell as assumed substantially all the employees, offices and client contractsrelating to MediaSentry.  The purchase price of the Acquired Assets was$936,000 consisting of $136,000 in cash and a $800,000 one-year promissory noteof the Company.  The acquisition wasconsummated on March 30, 2009.  TheMediaSentry operating unit provides (a) comprehensive business andmarketing intelligence services for digital media measurement and(b) services to globally detect, track and deter the unauthorizeddistribution of digital content.

 

Going Concern:

 

As a result of communications with the Staff of the Securities andExchange Commission in 2006, in particular regarding the application ofaccounting rules and interpretations related to embedded derivativesassociated with the Company’s subordinated convertible notes payable issued in July 2005,the Company determined that it was necessary to restate previously issuedfinancial statements. As a result, in December 2006, the Company wasrequired to suspend the use of its then effective registration statement forthe holders of its senior and subordinated indebtedness.  In addition to this initial default, theCompany has since entered into other events of default which continued to be ineffect as of December 31, 2008.

 

As of December 31, 2008, approximately $12,994,000 principalamount was outstanding with respect to the Senior Financing, and approximately$27,658,000 principal amount was outstanding with respect to the Sub-DebtFinancing.  In addition, at December 31, 2008, approximately$2,415,000 was outstanding with respect to accrued registration delay liabilityto the holders of the Sub-Debt Financing and approximately $6,475,000 wasoutstanding with respect to accrued interest payable to the holders of theSenior Financing and the Sub-Debt Financing.  The Senior Notes and the Subordinated Noteswere due in June and July 2009, respectively.

 

As more fully described in recent developments,the Senior Financing and Sub-Debt Financing have been restructured.  In accordance with the restructure, theCompany paid $3,500,000 to the Senior Note Holders, issued new subordinatednotes in the aggregate principal amount of $1,000,000 to the Senior NoteHolders, issued 9,000,000 restricted shares of the Company's common stock tothe Senior Note Holders, which are subject to a lock-up period of 12 months,and converted the Sub-Debt to equity.  Inorder to obtain funds to accomplish the restructure, and to fund futureoperations, the Company obtained financing by factoring its accountsreceivable.

 

As a result of the successful debtrestructuring, the Company anticipates that it will have sufficient access toworking capital from operations and the factoring of account receivable.  However, because of the Companys’ decliningrevenues, negative working capital, net loss, and uncertainties related toimproving its operating results under current economic conditions, ourindependent auditors, in their report on the Companys’ financial statements forthe year ended December 31, 2008 expressed substantial doubt about the Companys’ability to continue as a going concern. The accompanying consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America, which contemplate continuation of the Company as a goingconcern.  The consolidated financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

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Critical Accounting Policies:

 

The discussion and analysis of the Company’s financial condition andresults of operations is based upon its consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financial statements requires the Company tomake estimates and judgments that affect the reported amounts of assets, liabilities,revenues and expenses, and related disclosure of contingent assets andliabilities.  On an ongoing basis, theCompany evaluates its estimates, including those related to accountsreceivable, tangible and intangible assets, warrant and derivative liabilities,income taxes, and contingencies and litigation, among others.  The Company bases its estimates on historicalexperience and on various other assumptions that it believes to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.  The Companybelieves that the following critical accounting policies affect the moresignificant judgments and estimates used in the preparation of its consolidatedfinancial statements:   revenuerecognition, stock-based compensation, goodwill, intangible assets andlong-lived assets, derivative instruments, income taxes and accountsreceivable.

 

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

 

E-commerce revenue consists primarily of the gross amount of salesrevenue 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 has a contract with a fulfillmenthouse to service its music-related e-commerce activity.  The Company records e-commerce revenue on agross basis as the Company enters into the sale transactions with customers,establishes the prices of the products, chooses the suppliers of the products,assumes the risk of inventory loss and collects all amounts from the customersand assumes the credit risk.  In certaincircumstances, e-commerce revenue is subject to royalties, and such expense isrecorded as part of cost of e-commerce revenue.

 

The Company records amounts charged to customers for shipping andhandling in accordance with EITF 00-10, “Accounting for Shipping andHandling Fees and Costs” (“EITF 00-10”). Pursuant to EITF 00-10, the Company records amounts charged tocustomers for shipping and handling as revenue, and records the related costsincurred for shipping and handling to direct cost of product sales in thestatement of operations.

 

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

 

The Company recognizes revenue for sponsorship arrangements over theperiod during which the advertising is provided, generally on a straight-linebasis.  The Company recognizes revenuefor a banner impression deliverable as the banner impressions aredelivered.  The Company recognizesrevenue for web-page sponsorships on a straight-line basis over the termof the sponsorship.  The Companyrecognizes revenue for custom content when the content is provided to thecustomer.

 

Anti-piracyand file-sharing marketing services revenue is recognized on a monthly basis asservices are provided to customers. Deferred revenue is recorded for customers who prepay the full, or any portion,of their respective contracts.

 

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

 

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

 

Goodwill,Intangible Assets and Long-Lived Assets. Statement of Financial Accounting Standards No. 142, “Goodwill andOther Intangible Assets” (“SFAS No. 142”), requires purchased intangibleassets other than goodwill to be amortized over their useful lives unless theselives are determined to be indefinite.

 

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

 

During theyear ended December 31, 2008, the Company recorded a non-cash charge tooperations aggregating $31,085,000 with respect to the impairment of thegoodwill recognized in conjunction with the acquisition of MediaDefender inJuly 2005.  This charge to operations wasbased on various factors and developments occurring in 2008, includingcontinuing erosion in the demand for MediaDefender’s core Internet anti-piracyservices within the entertainment industry, the unexpected non-renewal byMediaDefender’s largest customer in mid-2008, continuing deterioration ofoperating margins and valuation metrics, and the inability to implement newadvertising initiatives on a large-scale basis. 

 

DerivativeInstruments. Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS No. 133”),requires all derivatives to be recorded on the balance sheet at fairvalue.  When multiple derivatives (both assets and liabilities) existwithin a financial instrument, they are bundled together as a single hybridcompound instrument in accordance with SFAS No. 133 Implementation Issue No. B15,“Embedded Derivatives:  SeparateAccounting for Multiple Derivative Features Embedded in a Single HybridInstrument”.  The calculation of the fairvalue of derivatives utilizes highly subjective and theoretical assumptionsthat can materially affect fair values from period to period.  The change in the fair value of thederivatives from period to period is recorded in other income (expense) in thestatement of operations.  As a result,the Company’s financial statements are impacted quarterly based on factors suchas the price of the Company’s common stock and the principal amount of Sub-DebtNotes converted into common stock. Consequently, the Company’s results of operations and financial positionmay vary from quarter to quarter based on factors other than those directlyassociated with the Company’s operating revenues and expenses.  The recognition of these derivative amounts doesnot have any impact on cash flows.

 

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

 

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

 

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

 

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

 

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

 

Adoption of New Accounting Policies:

 

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

 

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

 

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

 

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Recent AccountingPronouncements:

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards No. 157, “Fair ValueMeasurements” (“SFAS No. 157”), which establishes a formal framework formeasuring fair value under Generally Accepted Accounting Principles (“GAAP”).SFAS No. 157 defines and codifies the many definitions of fair valueincluded among various other authoritative literature, clarifies and, in someinstances, expands on the guidance for implementing fair value measurements,and increases the level of disclosure required for fair value measurements.Although SFAS No. 157 applies to and amends the provisions of existingFASB and American Institute of Certified Public Accountants (“AICPA”)pronouncements, it does not, of itself, require any new fair valuemeasurements, nor does it establish valuation standards. SFAS No. 157applies to all other accounting pronouncements requiring or permitting fairvalue measurements, except for: SFAS No. 123R, share-based payment andrelated pronouncements, the practicability exceptions to fair valuedeterminations allowed by various other authoritative pronouncements, and AICPAStatements of Position 97-2 and 98-9 that deal with software revenuerecognition. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. 

 

InFebruary 2007, the FASB issued Statement of Financial Accounting StandardsNo. 159, “The Fair Value Option for Financial Assets and FinancialLiabilities” (“SFAS No. 159”), which provides companies with an option toreport selected financial assets and liabilities at fair value. SFASNo. 159’s objective is to reduce both complexity in accounting forfinancial instruments and the volatility in earnings caused by measuringrelated assets and liabilities differently. Generally accepted accountprinciples have required different measurement attributes for different assets andliabilities that can create artificial volatility in earnings. SFASNo. 159 helps to mitigate this type of accounting-induced volatility byenabling companies to report related assets and liabilities at fair value,which would likely reduce the need for companies to comply with detailedrules for hedge accounting. SFAS No. 159 also establishespresentation and disclosure requirements designed to facilitate comparisonsbetween companies that choose different measurement attributes for similartypes of assets and liabilities. SFAS No. 159 requires companies toprovide additional information that will help investors and other users offinancial statements to more easily understand the effect of the company’schoice to use fair value on its earnings. Management has determined thatSFAS No. 157 does not have a material impact on our financialposition.

 

SFASNo. 159 also requires companies to display the fair value of those assetsand liabilities for which the company has chosen to use fair value on the faceof the balance sheet. SFAS No. 159 does not eliminate disclosurerequirements included in other accounting standards, including requirements fordisclosures about fair value measurements included in SFAS No. 157 andSFAS No. 107. SFAS No. 159 is effective as of the beginning of acompany’s first fiscal year beginning after November 15, 2007. Earlyadoption is permitted as of the beginning of the previous fiscal year providedthe company makes that choice in the first 120 days of that fiscal year andalso elects to apply the provisions of SFAS No. 157. Management hasdetermined that SFAS No. 159 does not have a material impact on ourfinancial position.

 

In December 2007, the FASB issuedSFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”),which requires an acquirer to recognize in its financial statements as ofthe acquisition date (i) the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree, measured at theirfair values on the acquisition date, and (ii) goodwill as the excess ofthe consideration transferred plus the fair value of any noncontrollinginterest in the acquiree at the acquisition date over the fair values of theidentifiable net assets acquired. Acquisition-related costs, which are the costs an acquirer incurs toeffect a business combination, will be accounted for as expenses in the periodsin which the costs are incurred and the services are received, except thatcosts to issue debt or equity securities will be recognized in accordance withother applicable GAAP.  SFASNo. 141(R) makes significant amendments to other Statements and otherauthoritative guidance to provide additional guidance or to conform theguidance in that literature to that provided in SFAS No. 141(R).  SFAS No. 141(R) also providesguidance as to what information is to be disclosed to enable users of financialstatements to evaluate the nature and financial effects of a businesscombination. SFAS No. 141(R) is effective for financial statementsissued for fiscal years beginning on or after December 15, 2008. Earlyadoption is prohibited. The Company has not yet determined the effect on itsconsolidated financial statements, if any, upon adoption of SFASNo. 141(R).

 

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In December 2007, the FASB issued SFASNo. 160, “Noncontrolling Interests in Consolidated Financial Statements —an amendment of ARB No. 51” (“SFAS No. 160”), which revises therelevance, comparability, and transparency of the financial information that areporting entity provides in its consolidated financial statements byestablishing accounting and reporting standards that require (i) theownership interests in subsidiaries held by parties other than the parent beclearly identified, labeled, and presented in the consolidated statement offinancial position within equity, but separate from the parent’s equity,(ii) the amount of consolidated net income attributable to the parent andto the noncontrolling interest be clearly identified and presented on the faceof the consolidated statement of income, (iii) changes in a parent’sownership interest while the parent retains its controlling financial interestin its subsidiary be accounted for consistently as equity transactions,(iv) when a subsidiary is deconsolidated, any retained noncontrollingequity investment in the former subsidiary be initially measured at fair value,with the gain or loss on the deconsolidation of the subsidiary being measuredusing the fair value of any noncontrolling equity investment rather than thecarrying amount of that retained investment, and (v) entities providesufficient disclosures that clearly identify and distinguish between the interestsof the parent and the interests of the noncontrolling owners. SFAS No. 160amends FASB No. 128 to provide that the calculation of earnings per shareamounts in the consolidated financial statements will continue to be based onthe amounts attributable to the parent. SFAS No. 160 is effective forfinancial statements issued for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. Early adoption isprohibited. SFAS No. 160 shall be applied prospectively as of thebeginning of the fiscal year in which it is initially applied, except for thepresentation and disclosure requirements, which shall be appliedretrospectively for all periods presented. The requirements of SFAS No. 160does not apply to the Company as it is currently structured.

 

InMarch 2008—The Financial Accounting Standards Board (FASB) issued FASBStatement No. 161, Disclosures about Derivative Instruments and HedgingActivities. The new standard is intended to improve financial reporting aboutderivative instruments and hedging activities by requiring enhanced disclosuresto enable investors to better understand their effects on an entity’s financialposition, financial performance, and cash flows. It is effective for financialstatements issued for fiscal years and interim periods beginning afterNovember 15, 2008, with early application encouraged.

 

InJune 2008, the FASB issued Staff Position No. EITF 03-6-1, Determining WhetherInstruments Granted in Share-Based Payment Transactions Are ParticipatingSecurities (“FSP EITF 03-6-1”).  FSP EITF03-6-1 provides that unvested share –based payment awards that containnonforfeitable rights to dividends are participating securities and should beincluded in the computation of earnings per share pursuant to the two-classmethod.  FSP EITF 03-6-1 is effective forfiscal years beginning after December 15, 2008. The Company is currently assessing the potential effect of FSP EITF03-6-1 on its financial statements.

 

In June 2008, the FASB ratifiedEmerging Issues Task Force (“EITF”) Issue No. 07-05, “Determining Whether anInstrument (or Embedded Feature) is Indexed to an Entity's Own Stock” (“EITF07-05”). EITF 07-05 mandates a two-step process for evaluating whether anequity-linked financial instrument or embedded feature is indexed to theentity's own stock. Warrants that a company issues that contain a strike priceadjustment feature, upon the adoption of EITF 07-05, results in the instrumentsno longer being considered indexed to the company's own stock. Accordingly,adoption of EITF 07-05 will change the current classification (from equity toliability) and the related accounting for such warrants outstanding at thatdate. EITF 07-05 is effective for fiscal years beginning after December 15,2008, and interim periods within those fiscal years. The Company does notcurrently anticipate that the adoption of EITF 07-05 on January 1, 2009 willhave any impact on its consolidated financial statement presentation ordisclosures.

 

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Results ofOperations - Years Ended December 31, 2008 and 2007:

 

The tableshown below presents information with respect to the Company’s consolidatedstatements of operations as to actual amounts and as a percentage of total netrevenue, for the years ended December 31, 2008 and 2007.

 
| ** **                                                                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                                                                                 | ** ** | **$**                                       | ** ** | **$** | ** ** | **%** | ** ** | **%** | ** ** |
| Net revenue                                                                                                                                |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                 |       | $                                           | 336        |   | 2.8 | % | $ | 1,497 |   | 6.2 | % |
| Media                                                                                                                                      |       | 3,995                                       |       | 32.9 | % | 7,500 |   | 31.0 | % |
| Anti-piracy and file-sharing marketing  services                                                                                           |       | 7,810                                       |       | 64.3 | % | 15,174 |   | 62.8 | % |
| Total net revenue                                                                                                                          |       | 12,141                                      |       | 100.0 | % | 24,171 |   | 100.0 | % |
| Cost of revenue:                                                                                                                           |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                 |       | 320                                         |       | 2.6 | % | 1,531 |   | 6.3 | % |
| Media                                                                                                                                      |       | 2,606                                       |       | 21.5 | % | 3,688 |   | 15.3 | % |
| Anti-piracy and file-sharing marketing  services                                                                                           |       | 7,429                                       |       | 61.2 | % | 9,414 |   | 38.9 | % |
| Total cost of revenue                                                                                                                      |       | 10,355                                      |       | 85.3 | % | 14,633 |   | 60.5 | % |
| Gross profit                                                                                                                               |       | 1,786                                       |       | 14.7 | % | 9,538 |   | 39.5 | % |
| Operating expenses:                                                                                                                        |       |                                        |       |   |   |   |   |   |   |
| Sales and marketing                                                                                                                        |       | 1,535                                       |       | 12.6 | % | 1,993 |   | 8.2 | % |
| General and administrative (including  stock-based compensation)                                                                           |       | 7,022                                       |       | 57.9 | % | 10,867 |   | 45.0 | % |
| Development and engineering                                                                                                                |       | 437                                         |       | 3.6 | % | 525 |   | 2.2 | % |
| Goodwill impairment                                                                                                                        |       | 31,085                                      |       | 256.0 | % |   |   |   |   |
| Write-off of fixed assets                                                                                                                  |       | —                                      |       | — | % | 97 |   | 0.4 | % |
| Total operating costs                                                                                                                      |       | 40,079                                      |       | 330.1 | % | 13,482 |   | 55.8 | % |
| Loss from operations                                                                                                                       |       | (38,293                                     | )          | (315.4 | )% | (3,944 | ) | (16.3 | )% |
| Interest income                                                                                                                            |       | 51                                          |       | 0.4 | % | 211 |   | 0.9 | % |
| Interest expense                                                                                                                           |       | (8,740                                      | )          | (72.0 | )% | (7,923 | ) | (32.8 | )% |
| Loss on foreign currency                                                                                                                   |       | (65                                         | )          | (0.5 | )% | (14 | ) | (0.1 | )% |
| Other income                                                                                                                               |       | 340                                         |       | 2.8 | % | — |   | — | % |
| Liquidated damages under registration  rights agreements                                                                                   |       | —                                      |       | — | % | 395 |   | 1.6 | % |
| Change in fair value of warrant liability                                                                                                  |       | 130                                         |       | 1.0 | % | 4,551 |   | 18.8 | % |
| Change in fair value of derivative  liability                                                                                              |       | 302                                         |       | 2.5 | % | 18,043 |   | 74.7 | % |
| Amortization of deferred financing costs                                                                                                   |       | (842                                        | )          | (6.9 | )% | (841 | ) | (3.4 | )% |
| Write-off of unamortized discount on debt  and deferred financing costs resulting from principal payments on senior  secured notes payable |       | (25                                         | )     | (0.2 | )% | — |   | — | % |
| Income (loss) before income taxes                                                                                                          |       | (47,142                                     | )     | (388.3 | )% | 10,478 |   | 43.4 | % |
| Provision (benefit) for income tax                                                                                                         |       | 814                                         |       | 6.7 | % | (1,039 | ) | (4.3 | )% |
| Net income (loss)                                                                                                                          |       | $                                           | (47,956    | )  | (395.0 | )% | $ | 11,517 |   | 47.7 | % |

 

The Companyevaluates performance based on, among other factors, earnings or loss beforeinterest, taxes, depreciation and amortization (“Adjusted EBITDA”), which is anon-GAAP financial measure.  AdjustedEBITDA also excludes stock-based compensation, changes in the fair value ofwarrant liability and derivative liability, and other non-cash write-offs andcharges.  Management excludes these itemsin assessing financial performance, primarily due to their non-operationalnature or because they are outside of the Company’s normal operations.  The Company has provided this informationbecause management believes that it is useful to investors in understanding theCompany’s financial condition and results of operations.

 

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Managementbelieves that Adjusted EBITDA enhances an overall understanding of theCompany’s financial performance by investors because it is frequently used bysecurities analysts and other interested parties in evaluating companies in itsindustry segment.  In addition,management believes that Adjusted EBITDA is useful in evaluating the Company’soperating performance compared to that of other companies in its industrysegment because the calculation of Adjusted EBITDA eliminates the accountingeffects of financing costs, income taxes and capital spending, which items mayvary for different companies for reasons unrelated to overall operatingperformance.

 

However,Adjusted EBITDA has certain limitations. Adjusted EBITDA is not a recognized measurement under GAAP, and whenanalyzing the Company’s operating performance, investors should use AdjustedEBITDA in addition to, and not as an alternative for, standard GAAP financialmeasures such as net income (loss) or cash flow from operations, or any othermeasure utilized in determining the Company’s operating performance that iscalculated in accordance with GAAP. Because Adjusted EBITDA is not calculated in accordance with GAAP, itmay not be comparable to similarly-titled measures utilized by othercompanies.  Adjusted EBITDA eliminatescertain substantial recurring items from net income (loss), such asdepreciation, amortization, interest expense and income taxes, amongothers.  Each of these items has beenincurred in the past, will continue to be incurred in the future, and should beconsidered in the overall evaluation of the Company’s operating performance.  The Company compensates for these limitationsby providing the relevant disclosure of the items excluded in the calculationof Adjusted EBITDA, both in the reconciliation to the GAAP financial measure ofnet income (loss) and in the consolidated financial statements and footnotes,all of which should be considered when evaluating the Company’s operatingperformance.  Furthermore, AdjustedEBITDA is not intended to be a measure of the Company’s free cash flow orliquidity in general, as it does not consider certain ongoing cashrequirements, such as a required debt service payments and income taxes.

 

Included inAdjusted EBITDA are direct operating expenses for each segment.  Corporate expenses consist of generaloperating expenses that are not directly related to the operations of thesegments

 

The tableshown below summarizes net revenue and Adjusted EBITDA by operating segment forthe years ended December 31, 2008 and 2007, respectively.  A reconciliation of Net Income (Loss) toAdjusted EBITDA is also provided.

 
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                               | ** ** | **(in thousands)**                     | ** ** |
| Net Revenue:                                             |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | 336        |   | $ | 1,497 |   |
| Media                                                    |       | 3,995                                       |       | 7,500 |   |
| Anti-piracy and file-sharing marketing  services         |       | 7,810                                       |       | 15,174 |   |
|                                                     |       | $                                           | 12,141     |   | $ | 24,171 |   |
|                                                     |       |                                        |       |   |   |
| Adjusted EBITDA:                                         |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | (88        | ) | $ | (218 | ) |
| Media                                                    |       | 264                                         |       | 2,604 |   |
| Anti-piracy and file-sharing marketing  services         |       | 264                                         |       | 5,304 |   |
|                                                     |       | 440                                         |       | 7,690 |   |
| Corporate:                                               |       |                                        |       |   |   |
| General and administrative expenses                      |       | (3,635                                      | )          | (4,824 | ) |
| Liquidated damages under registration  rights agreements |       | —                                      |       | 395 |   |
|                                                     |       | $                                           | (3,195     | ) | $ | 3,261 |   |

 

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| ** **                                                                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                                                                                 | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Reconciliation of Adjusted EBITDA to Net  Income (Loss):                                                                                   |       |                                        |       |   |   |
| Adjusted EBITDA per segments                                                                                                               |       | $                                           | (3,195     | )  | $ | 3,261 |   |
| Stock-based compensation                                                                                                                   |       | (991                                        | )          | (2,110 | ) |
| Depreciation and amortization                                                                                                              |       | (906                                        | )          | (1,015 | ) |
| Amortization of intangible assets                                                                                                          |       | (2,181                                      | )          | (3,602 | ) |
| Amortization of deferred financing costs                                                                                                   |       | (842                                        | )          | (841 | ) |
| Goodwill impairment                                                                                                                        |       | (31,085                                     | )     | — |   |
| Write-off of unamortized discount on debt  and deferred financing costs resulting from principal payments on senior  secured notes payable |       | (25                                         | )     | — |   |
| Interest income                                                                                                                            |       | 51                                          |       | 211 |   |
| Other income                                                                                                                               |       | 340                                         |       | — |   |
| Write-off of fixed assets                                                                                                                  |       | —                                      |       | (97 | ) |
| Interest expense, including amortization of  discount on debt of $3,088 and $3,081 in 2008 and 2007, respectively                          |       | (8,740                                      | )          | (7,923 | ) |
| Change in fair value of warrant liability                                                                                                  |       | 130                                         |       | 4,551 |   |
| Change in fair value of derivative  liability                                                                                              |       | 302                                         |       | 18,043 |   |
| Provision (benefit) for income taxes                                                                                                       |       | (814                                        | )     | 1,039 |   |
| Net income (loss)                                                                                                                          |       | $                                           | (47,956    | ) | $ | 11,517 |   |

 

NetRevenue.  The Company’s net revenue decreasedby $12,030,000 or 50%, to 12,141,000 for the year ended December 31, 2008,as compared to $24,171,000 for the year ended December 31, 2007.

 

MediaDefender provided $7,810,000 of revenue for the year ended December 31,2008, as compared to $15,174,000 for the year ended December 31, 2007.  MediaDefender’s anti-piracy revenues in 2008 were negatively impactedby the loss of one customer in November 2007 that accounted for 4% ofMediaDefender’s 2007 annual revenue, which cited cost pressures subsequent to achange in ownership, and the loss of a second customer in January 2008 thataccounted for 12% of MediaDefender’s 2007 annual revenues, which noted thatthey were evaluating the use of alternative methods to deal with piracy.  In June 2008, the Company was advisedthat a third customer that accounted for 18% of MediaDefender’s 2007 annualrevenues was substantially curtailing its use of MediaDefender’s anti-piracyservices subsequent to the expiration of its current contract withMediaDefender on June 30, 2008, citing uncertainty with respect to theeffectiveness and cost/benefit of anti-piracy services.

 

Theloss of revenues from these for customers represented the bulk in the decreasein MediaDefender’s television and catalogue library anti-piracy revenues during2008, as major entertainment conglomerates discontinued or reducedtechnological based anti-piracy measures for libraries and television networkprogramming.  These major entertainmentcompanies have indicated that they are exploring alternative means to combatInternet piracy by distributing television programs via websites utilizing anadvertising supported model.  However,major media companies continue to utilize a variety of anti-piracy countermeasures to protect major theatrical movies and new music album releases inorder to protect traditional marketing revenue channels as well as retail salestransactions.

 

During 2008 MediaDefender continued to offer advertising opportunitiesfor brand specific programs over the peer-to-peer network.  These programs generated $410,000 during 2008as compared to $560,000 for similar advertising programs in 2007.  Due to the evolving nature of thepeer-to-peer Internet network, limited development resources and a significantreduction in Internet advertising campaigns in the fourth quarter of 2008, MediaDefenderwas unable to reach anticipated revenue levels from peer-to-peer advertisinginitiatives.  However, the Companyanticipates that peer-to-peer advertising will continue to provide accretiverevenues with negligible costs.

 

MediaDefender’s revenue accounted for 64.3% of the Company’s total netrevenue for the year ended December 31, 2008, as compared to 62.8% of theCompany’s total net revenue for the year ended December 31, 2007.  The Company expects that revenues fromMediaDefender will continue to represent a significant proportion of its totalrevenues for the foreseeable future.

 

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Media revenue decreased by $3,505,000or 46.7%, to $3,995,000 for the year ended December 31, 2008, as compared to $7,500,000for the year ended December 31, 2007. Media revenue decreased in 2008 as compared to 2007 as a result of asignificant slow-down in online advertising, in particular banner and displayadvertising, and increased competition from new music-related websites.  In addition, in April 2007, the Companyentered into a strategic partnership with T-Mobile with the launch of aspecially designed United Kingdom counterpart to the Company’s UnitedStates-based online music destination website. The United Kingdom version of ARTISTdirect.com (www.ARTISTdirect.com/uk)included numerous T-Mobile enhancements, including exclusive branded contentprovided by T-Mobile.  This contractconcluded during June 2008.  Duringthe year ended December 31, 2008 and 2007, approximately $204,000 and $1,270,000,respectively, of media revenues were generated by T-Mobile.

 

The Company markets and sells advertising on a CPM basis to advertisingagencies and directly to various companies seeking to reach one or more of thedistinct demographic audiences viewing content in the ARTISTdirectNetwork.  The Company also markets andsells sponsorships for various portions of the ARTISTdirect Network.  Customers may purchase advertising space onthe entire ARTISTdirect Network, or they may tailor advertising to specificareas or sections of the Company’s websites.

 

During the years ended December31, 2008 and 2007, the Company’s media revenues were generated by two outsidesales organizations that represented the Company with respect to advertisingand sponsorship on the Company’s website and through affiliated websites, aswell as by in-house sales personnel. During the year ended December 31, 2008, one customer accounted for accountedfor $589,000 or 14.7% of media revenues. During the year ended December 31, 2007, one customer accounted forapproximately $1,270,000 or 16.9% of media revenues.

 

E-commercerevenue decreased by $1,161,000, or 77.6%, to $336,000 for the year ended December 31,2008, as compared to $1,497,000 for the year ended December 31, 2007.  Due to limited opportunities for revenuegrowth and acceptable gross margins, the Company has been de-emphasizinge-commerce activities over the past few years. During the years ended December 31, 2008 and 2007, approximately 0%and 59% of e-commerce revenues were generated from the products related to asingle music merchandising entity. Effective August 31, 2007, the Company restructured its relationship with this merchandisingentity to eliminate such merchandise sales and focus on music sales, which hada negative impact on e-commerce sales for the remainder of 2007, and will havea significant negative impact on future e-commerce revenues, although suchrestructuring is expected to have limited impact on operating margins.

 

Cost of Revenue.  The Company’s total cost of revenue decreasedby $4,280,000 or 36.0%, to $10,355,000 for the year ended December 31, 2008, ascompared to $14,633,000 for the year ended December 31, 2007, primarily as aresult of a decrease in MediaDefender cost of revenues of $1,985,000, mediacost of revenues of $1,082,000, and e-commerce cost of revenues of $1,211,000.  The decline in costs of revenue is the resultof significantly lower amortization and depreciation costs related to fullydepreciated capitalized assets, property and equipment acquired in theMediaDefender acquisition, the absence of e-commerce inventory costs and anoverall decrease in business activity for all business segments.

 

MediaDefender’scost of revenuedecreased by $1,985,000 or 21.1%, to $7,429,000 for the year ended December 31,2008, as compared to $9,414,000 for the year ended December 31, 2007.  The reduction in costs of revenuereflects costs savings in bandwidth of $675,000 and lower amortization anddepreciation costs of $1,216,000 and the balance of the reduced costs were inlower personnel costs.  Included inMediaDefender’s cost of revenue for the years ended December 31, was theamortization of proprietary technology acquired in the MediaDefendertransaction of $1,478,000 and $2,534,000, respectively.  Approximately $1,056,000 of the decrease inMediaDefender cost of revenues reflectsthe completion of amortization in July 2008 of the proprietary technologyand $160,000 of reduced depreciation expense from the expiration of costsassociated with assets with a three-year life which were acquired in the July 2005MediaDefender transaction.

 

Cost ofrevenue relating to media decreased by $1,082,000 or 29.3% to $2,606,000 forthe year ended December 31, 2008, as compared to $3,688,000 for the yearended December 31, 2007.  Themajority of the decrease in costs is the result of the absence of $350,000 ofcontent costs in 2008 for a unique advertising campaign which occurred in 2007and a reduction in outside commissions and affiliate website costs of $386,000and 325,000, respectively.  The balanceof reduced costs was associated with ad serving and other costs reflecting adecrease in advertising activity during 2008.

 

E-commercecosts of revenue decreased by $1,161,000, or 77.60%, to $336,000 for the yearended December 31, 2008, as compared to $1,497,000 for the year ended December 31,2007, primarily as a result of decreased inventory and related costs from thediscontinuation of selling teen apparel and merchandise on the www.Artistdirect.comwebsite as of August 2007.

 

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As a result ofthe foregoing, gross profit was $1,786,000 for the year ended December 31,2008, as compared to $9,538,000 for the year ended December 31, 2007,reflecting a combined gross margin of 14.7% and 39.5%, respectively.  A summary of gross profit and gross margin bysegment is as follows ($000):

 
| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| **Segment:**                                     | ** ** | **Gross  Profit**                           | ** ** | **Gross  Margin** | ** ** | **Gross  Profit** | ** ** | **Gross  Margin** | ** ** |
| E-commerce                                       |       | $                                           | 16         |   | 4.8 | % | $ | (34 | ) | (2.3 | )% |
| Media                                            |       | 1,389                                       |       | 34.8 | % | 3,812 |   | 50.8 | % |
| Anti-piracy and file-sharing marketing  services |       | 381                                         |       | 4.9 | % | 5,760 |   | 38.0 | % |
| Totals                                           |       | $                                           | 1,786      |   | 14.7 | % | $ | 9,538 |   | 39.5 | % |

 

Salesand Marketing.  The Company’s sales andmarketing expense decreased by $458,000 or 23.0%, to $1,535,000 for the yearended December 31, 2008, as compared to $1,993,000 for the year ended December 31,2007.  Also included in sales andmarketing expense for the years ended December 31, 2008 and 2007 is theamortization of customer relationships acquired in the MediaDefendertransaction of $440,000 and $755,000, respectively.  Approximately $315,000 of the decrease insales and marketing expense reflects the completion of amortization in July 2008of the customer relationships with a three-year life that were acquired in the July 2005MediaDefender transaction.  The balanceof the reduced costs is due to reduced wages, commissions and bonus costsassociated with the departure of the Vice President of Sales in November 2008.

 

General andAdministrative.  The Company’s general and administrativeexpense decreased by $3,845,000 or 35.4%, to $7,022,000 for the year ended December 31,2008, as compared to $10,867,000 for the year ended December 31,2007.  General and administrative expensedecreased significantly in 2008 as compared to 2007 as a result of variousfactors, including a reduction in bonus accruals, and reduced legal andaccounting fees, travel expenses, and equity-based compensation.

 

Significantcomponents of general and administrative expense consists of managementcompensation (and bonuses, when applicable), personnel and personnel-relatedcosts, insurance, legal and accounting fees, board compensation, consultingfees, occupancy costs and the provision for doubtful accounts.  Also included in general and administrative expensefor the years ended December 31, 2008 and 2007 are stock-basedcompensation costs of $991,000 and $2,110,000, board fees of $76,000 and$250,000, and the amortization of non-competition agreements of $263,000 and $313,000,respectively, resulting from the MediaDefender transaction.

 

During the yearsended December 31, 2008 and 2007, the Company incurred legal, accounting,consulting and printing fees and costs of approximately $2,274,000 and $1,880,000,respectively, relating to the preparation and filing of various documents withthe SEC, negotiations with senior and subordinated note holders, review andanalysis of various restructuring alternatives, amendments to financingagreements, and other ordinary course legal and accounting matters.  As a result of the event of defaults relatedto the Company’s senior and subordinated debt agreements (see “Going Concern”above), the Company has continued to incur significant costs in this regard in2008.

 

During the yearended December 31, 2008, the Company was not required to accrue anyperformance bonuses for the senior management of MediaDefender.  During the years ended December 31, 2008and 2007, the Company incurred bonus expense of $20,000 and $793,000 respectively.  In 2007, the Company incurred $700,000 withrespect to the accrual of annual performance bonuses payable to MediaDefender’ssenior management pursuant to their respective employment agreements.

 

During the year ended December 31, 2008, the Company recorded acharge to operations of $350,000 for the severance payment with respect to theAmended and Restated Services Agreement dated as of March 6, 2008 betweenthe Company and the Company’s former Chief Executive Officer.  The Company also recorded stock-basedcompensation costs of $571,000 during the year ended December 31, 2008with respect to this settlement, which is included in the $991,000 above.

 

Developmentand Engineering.  Development and engineering costs were $437,000for the year ended December 31, 2008, as compared to $525,000 for the yearended December 31, 2007.  Developmentand engineering costs consist primarily of third-party development costs andpayroll and related expenses for in-house development costs incurred in thedesign and production of the Company’s content and services, includingrevisions to the Company’s website, and are charged to operations as incurred.

 

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GoodwillImpairment. During the year ended December 31, 2008, the Company recorded anon-cash charge to operations aggregating $31,085,000 with respect to theimpairment of the goodwill recognized in conjunction with the acquisition ofMediaDefender in July 2005.  This chargeto operations was based on various factors and developments occurring in 2008,including continuing erosion in the demand for MediaDefender’s core Internetanti-piracy services within the entertainment industry, the unexpectednon-renewal by MediaDefender’s largest customer in mid-2008, continuingdeterioration of operating margins and valuation metrics, and the inability toimplement new advertising initiatives on a large-scale basis.

 

Write-Off of Fixed Assets. During the year ended December 31,2007, the Company recorded a charge to operations of $97,000 to write-off thenet book value of obsolete computer equipment that it did not expect to utilizein future periods.  The Company did notwrite-off any fixed assets during the year ended December 31, 2008.

 

Loss from Operations. As a result of the aforementioned factors, the loss from operations was$38,293,000 for the year ended December 31, 2008, as compared to a lossfrom operations of $3,944,000 for the year ended December 31, 2007.

 

InterestIncome.  Interest income was $51,000 forthe year ended December 31, 2008, as compared to $211,000 for the yearended December 31, 2007.

 

InterestExpense.  Interest expense of $8,740,000and $7,923,000 for the years ended December 31, 2008 and 2007,respectively, relates to the $15,000,000 of 11.25% secured notes payable issuedin the Senior Financing and the $30,000,000 of 4.0% subordinated convertiblenotes payable issued in the Sub-Debt Financing, both of which were issued tofinance the acquisition of MediaDefender in July 2005.  Effective January 1, 2007, the interestrate on the Sub-Debt Financing increased from 4.0% to 12.0% due to the defaulton the Company’s senior and subordinated debt agreements in January 2007(see “Going Concern” above).  On March 17,2008, the Company entered into a Forbearance and Consent Agreement with theinvestors in the Senior Financing, which was effective as of February 20,2008, whereby the investors agreed to forbear from exercising any of theirrights and remedies under the Senior Financing transaction documents through December 31,2008 in exchange for an adjustment in the interest rate associated with the11.25% secured notes payable from 11.25% to 16.0% per annum.

 

Additionalconsideration in the form of warrants issued to the lenders was accounted forat fair value and recorded as a reduction to the carrying amount of the debt,and is being amortized to interest expense over the term of the debt.  Accordingly, the amortization of thisdiscount on debt included in interest expense for the years ended December 31,2008 and 2007 was $716,000 and $717,000, respectively.

 

The Sub-DebtNotes contain several embedded derivative features that have been accounted forat fair value.  The various embeddedderivative features of the Sub-Debt Notes have been valued at the date ofinception of the Sub-Debt Financing and at the end of each reporting periodthereafter.  The value of the embeddedderivatives was bifurcated from the Sub-Debt Notes and recorded as derivative liability,with the initial amount recorded as discount on the related Sub-DebtNotes.  This discount was amortized tointerest expense over the life of the Sub-Debt Notes.  Accordingly, the amortization of thisdiscount on debt included in interest expense for the years ended December 31,2008 and 2007 was $2,372,000 and $2,365,000, respectively.

 

Loss on Foreign Currency Transactions. The loss on foreign currencytransactions was $65,000 and $14,000 for the years ended December 31, 2008and 2007, respectively.

 

OtherIncome.  Other income was $340,000 forthe year ended December 31, 2008, reflecting primarily a reduction incertain old accrued liabilities.  TheCompany did not have any other income for the year ended December 31,2007.

 

Liquidated Damages Under Registration Rights Agreements. The Companydid not have any additional liquidated damages during the year ended December 31,2008.  In accordance with EITF 00-19-2,which the Company adopted as of December 31, 2006, and SFAS No. 5,the Company accrued seven months liquidated damages (throughmid-August 2007) under the registration rights agreements aggregatingapproximately $3,777,000 as a charge to operations at December 31, 2006.As a result of the Company’s registration statement being declared effective onJuly 6, 2007, which was earlier than originally estimated, the Companyrecorded a net reduction to the original accrual of $395,000 in other incomeduring the year ended December 31, 2007.

 

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Change in Fair Value ofWarrant Liability. In accordance with EITF 00-19, the fair value of thewarrants issued in connection with the financing of the MediaDefenderacquisition in July 2005 was recorded as a warrant liability. The carryingvalue of the warrants is adjusted quarterly to reflect any changes in the fairvalue such liability and is included in the statement of operations as otherincome (expense). For the years ended December 31, 2008 and 2007, theCompany recorded income of $130,000 and $4,551,000, respectively, to reflectthe change in warrant liability during such periods.

 

Change in Fair Value ofDerivative Liability. In accordance with EITF 00-19, the fair value of theembedded derivatives was bifurcated from the subordinated convertible notespayable issued in connection with the financing of the MediaDefenderacquisition in July 2005 and recorded as a derivative liability. Thecarrying value of the derivative liability is adjusted quarterly to reflect anychanges in the fair value of such liability and is included in the statement ofoperations as other income (expense). For the years ended December 31, 2008and 2007, the Company recorded income of $302,000 and $18,043,000,respectively, to reflect the change in derivative liability during suchperiods.

 

Amortization of DeferredFinancing Costs. Amortization of deferred financing costs was $842,000 and $841,000for the years ended December 31, 2008 and 2007, respectively. Deferredfinancing costs consist of consideration paid to third parties with respect tothe acquisition and financing of the MediaDefender transaction, including cashpayments, subordinated convertible notes payable and the fair value of warrantsissued for placement agent fees, which were deferred and are being amortizedover the term of the related debt.

 

Write-Off of UnamortizedDiscount on Debt and Deferred Financing Costs Resulting from Principal Paymentson Senior Secured Notes Payable and Conversion of Subordinated ConvertibleNotes Payable. Deferred financing costs and debt discount costs aggregating $17,000were charged to operations as a result of the principal payments on seniorsecured notes payable during the year ended December 31, 2008.

 

Income (Loss) Before IncomeTaxes. As a result of the aforementioned factors, loss before income taxes was$(47,142,000) for the year ended December 31, 2008, as compared to incomebefore income taxes of $10,478,000 for the year ended December 31, 2007.

 

Provision (benefit) for IncomeTaxes. The Company recorded $814,000 during the year ended December 31, 2008 toaccrue for potential additional taxes and interest as a result of a pendingaudit of the Companys 2005 and 2006 tax returns. The Company received a taxrefund and a benefit for income taxes of $1,039,000 for the year ended December 31,2007, as a result of the carryback of 2007 tax losses to 2005 and 2006.

 

Net Income (Loss).As a result of the foregoing factors, the net loss was $(47,956,000) for theyear ended December 31, 2008, as compared to a net income of $11,517,000for the year ended December 31, 2007.

 

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Liquidity andCapital Resources:

 

As of December 31, 2008, approximately $12,994,000 principalamount was outstanding with respect to the Senior Financing, and approximately$27,658,000 principal amount was outstanding with respect to the Sub-DebtFinancing.  In addition, at December 31, 2008, approximately $0 and$2,415,000 were outstanding with respect to accrued registration delayliability to the holders of the Senior Financing and the Sub-Debt Financing,respectively, and approximately $113,000 and $6,362,000 was outstanding withrespect to accrued interest payable to the holders of the Senior Financing andthe Sub-Debt Financing, respectively.  The Senior Notes and the Subordinated Noteswould have been due in June and July 2009, respectively.

 

Effective January 30, 2009, the Company enteredinto a First Amendment to Note and Warrant Purchase Agreement dated as ofDecember 31, 2008 (the “Senior Amendment”) with the holders of theCompany’s senior secured debt (the “Senior Note Holders”).  Pursuant tothe Senior Amendment, the Senior Note Holders agreed to extinguish allobligations by the Company under the Note and Warrant Purchase Agreement, datedJuly 28, 2005, and other documents entered into in connection with thesenior secured debt transaction (the “Senior Debt Restructuring”), uponcompletion of the following: (1) $3,500,000 cash payment to the SeniorNote Holders; (2) issuance of new subordinated notes, in the aggregateprincipal amount of $1,000,000, to the Senior Note Holders (the “New Notes”);(3) issuance of 9,000,000 restricted shares of the Company’s common stockto the Senior Note Holders, which are subject to a lock-up period of 12 months;and (4) the conversion of all of the previously issued Subordinated Notes.The restructuring of the senior debt was consummated on January 30, 2009.

 

The New Notes are unsecured and bear interest at 6.0%per annum, beginning January 30, 2009. The principal and the interestaccrued thereon are payable on the maturity date, January 30, 2014, andare subordinated to the senior indebtedness of the Company.

 

In connection with the Senior Debt Restructuring,effective January 30, 2009, the Company entered into a Second Amendment to theConvertible Subordinated Note with holders of the Subordinated Notesrepresenting no less than the majority of the current outstanding aggregateprincipal amount to provide for the immediate conversion of the SubordinatedNotes (the “Subordinated Amendment”). The Subordinated Amendment also providesfor the extinguishment of all obligations of the Company under the SubordinatedNotes and related documents, including the Registration Rights Agreement amongthe Company and the holders.  Suchobligations included the outstanding principal amount and accrued and unpaidinterest on the Subordinated Notes, accrued and unpaid late charges and amountsowed under the Registration Rights Agreement with the holders of theSubordinated Notes.  Consummation of thetransactions under the Subordinated Amendment occurred as of January 30, 2009.

 

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In order to obtain the additional funds of$1,250,000 to close the restructure and recapitalization plan onJanuary 30, 2009, the Company’s two wholly-owned subsidiaries,ARTISTdirect Internet Group, Inc. (“ADIG”) and MediaDefender eachentered into an Accounts Receivable Purchase & Security Agreement (the“A/R Agreement”) with Pacific Business Capital Corporation (“PBCC”),pursuant to which ADIG and Mediadefender agreed to sell and PBCC agreed topurchase qualified accounts receivable on a recourse basis. On January 30,2009, PBCC purchased an aggregate of approximately $1,600,000 of unpaidreceivables to be acquired by PBCC pursuant to the A/R Agreement, subject to amaximum aggregate amount of $3,000,000. The A/R Agreement is effective fortwelve-months and automatically renews for successive 12-month periods unlessterminated by written notice by either party 30 days prior to such successiveperiod.

 

As collateral for the financing, PBCCreceived a first priority interest in all existing and future assets of theCompany, ADIG and Mediadefender, tangible and intangible, including but notlimited to, cash and cash equivalents, accounts receivable, inventories, othercurrent assets, furniture, fixtures and equipment and intellectual property. Inaddition to the foregoing, the Company, ADIG and Mediadefender entered intocross guarantees of their respective obligations under the A/R Agreement.

 

The Company anticipates thatthere will be sufficient access to working capital from the A/R Agreement andthe consolidated operations of Artist Direct Internet Group and MediaDefenderto pay the interest under the A/R Agreement and fund the ongoing costs ofoperations.  Although there can be noassurance of continued profitability, the Company anticipates that it will beable to raise additional capital as needed or obtain additional financing tooperate the Company.

 

The Companys’ consolidatedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America, whichcontemplate continuation of the Company as a going concern.  Because of the Companys’ declining revenues,negative working capital, net loss, and uncertainties related to improving ouroperating results under current economic conditions, our independent auditors,in their report on the Companys’ financial statements for the year endedDecember 31, 2008 expressed substantial doubt about the Companys’ ability tocontinue as a going concern.  Theconsolidated financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

 

Overview:

 

As of December 31, 2008and 2007, the Company had $1,994,000 and $4,268,000 of unrestricted cash andcash equivalents, respectively.

 

At December 31, 2008, theCompany had a working capital deficiency of $44,512,000, primarily because ofthe classification of senior secured notes payable and subordinated convertiblenotes payable as current liabilities, the accrual of default interest on thesubordinated convertible notes payable of $6,362,000, liquidated damagespayable under registration rights agreements of $1,972,000, warrant liabilityof $35,000, and derivative liability of $11,000 at such date.

 

At December 31, 2007, theCompany had a working capital deficiency of $32,273,000, primarily because ofthe classification of senior secured notes payable and subordinated convertiblenotes payable as current liabilities, the accrual of default interest on thesubordinated convertible notes payable of $3,034,000, liquidated damagespayable under registration rights agreements of $2,382,000, warrant liabilityof $164,000, and derivative liability of $313,000 at such date.

 

The increase in the workingcapital deficiency at December 31, 2008 as compared to December 31,2007 of $12,239,000 was primarily attributable to an increase in the interestowed to the senior and subordinated note holders of $5,947,000 and a reductionin accounts receivable and cash of $5,626,000 and $2,286,000 respectively,offset by a $2,503,000 reduction in accounts payable and accrued expenses.

 

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Operating. Net cash used inoperating activities was $1,704,000 for the year ended December 31, 2008,as compared to net cash used by operating activities for the year ended December 31,2007 of $1,038,000. Operating cash flow decreased in 2008 as compared to 2007primarily as a result of the decrease in operating profitability atMediaDefender.

 

Investing. Net cash used ininvesting activities for the year ended December 31, 2008 was $269,000,which consisted of additions to property and equipment. Net cash used ininvesting activities for the year ended December 31, 2007 was $481,000,which consisted of additions to property and equipment.

 

Financing. Net cash used byfinancing activities for the year ended December 31, 2008 was $301,000,which consisted of principal payments on senior secured notes.  Net cash provided by financing for the yearended December 31, 2007 was $185,000, which was comprised of $101,000 from theexercise of stock options and a net decrease of $84,000 in restricted cash thatsecures certain letters of credit.

 

ContractualObligations:

 

The Company’sprincipal commitments for the next five fiscal years consisted of contractualcommitments as summarized below. The summary shown below reflects the debtrestructuring consummated on January 30, 2009 and the purchase of MediaSentryassets on March 30, 2009.

 
| ** **                                                       | ** ** | ** ** | ** ** | **Payments Due by Year (in thousands)** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------|------------|
| **Contractual cash obligations**                       | ** ** | **Total**  | ** ** | **2009**                                                         | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** |
| Employment contracts (1)                                         |       | $          | 900        |                                                             | $          | 275 |   | $ | 300 |   | $ | 300 |   | $ | 25 |   |
| Lease obligations (2)                                            |       | 2,796      |       | 1,604                                                            |       | 722 |   | 470 |   | — |   |
| MediaSentry asset purchase and Safenet promissory note  (5) |       | 936        |       | 136                                                              |       | 800 |   | — |   | — |   |
| Interest on SafeNet note                                         |       | 99         |       | 48                                                               |       | 51 |   | — |   | — |   |
| Senior secured notes payable debt restructuring  (3)             |       | 3,500      |       | 3,500                                                            |       | — |   | — |   | — |   |
| Accounts receivable credit facilities (4)(7)                     |       | 1,250      |       | —                                                           |       | 1,250 |   | — |   | — |   |
| Convertible short-term note                                      |       | 200        |       | 200                                                              |       | — |   | — |   | — |   |
| Total contractual cash obligations                               |       | $          | 9,681      |                                                             | $          | 5,763 |   | $ | 3,123 |   | $ | 770 |   | $ | 25 |   |

 

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

 

(2)          Leaseobligations include property leases and co-location bandwidth contracts.

 

(3)          Inconnection with the debt restructuring the Company paid $3,500,000 on January30, 2009 to the senior note holders.

 

(4)          Thecredit facilities obtained from Pacific Business Capital Corporation in connectionwith the debt restructing are due in February 2010 and bear interest at 2% permonth of the outstanding balance funded against pledged receivables.

 

(5)          Inconnection with the MediaSentry asset purchase completed on March 30, 2009, theCompany paid SafeNet Inc. $136,000 and issued a $800,000 note at 6% interestdue in March 2010.

 

(6)          Theabove table does not reflect the new five year subordinated 6% notes issued tothe senior note holders in connection with the debt restructuring as theprinciple and interest are due in January 2014.

 

(7)          Short Term automaticallyconvertible note dated March 3, 2009 to Fredrick Field, a director, for$200,000, which is due July 31, 2009 with interest at 5% per year.

 

CapitalExpenditures. The Company estimates that it will have capital expendituresaggregating approximately $250,000 for the year ending December 31, 2009,primarily related to the expansion of MediaDefender’s operations.

 

Off-BalanceSheet Arrangements. At December 31, 2008, the Company did not have anytransactions, obligations or relationships that could be considered off-balancesheet arrangements.

 

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**ITEM 7A.              ****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Notapplicable.

 

**SPECIAL NOTE REGARDING FORWARD-LOOKINGSTATEMENTS**

 

In addition tohistorical information, this Annual Report contains statements relating to ourfuture business and/or results, including, without limitation, the statementsunder the captions “Risk Factors,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and “Description ofBusiness.”  These statements includecertain projections and business trends that are “forward-looking” within themeaning of the United States Private Securities Litigation Reform Act of1995.  You can identify these statementsby the use of words like “may,” “will,” “could,” “should,” “project,”“believe,” “anticipate,” “expect,” “plan,” “estimate,” “forecast,” “potential,”“intend,” “continue” and variations of these words or comparable words.

 

Forward-lookingstatements do not guarantee future performance and involve risks anduncertainties.  Actual results willdiffer, and may differ materially, from projected results as a result ofcertain risks and uncertainties.  Theserisks and uncertainties include, without limitation, those described under“Risk Factors” and those detailed from time to time in our filings with theSEC, and include, among others, the following:

 

·                  Ourlimited operating history;

 

·                  Ourability to protect our intellectual property rights;

 

·                  Ourability to successfully develop and commercialize our proposed products;

 

·                  Thedegree and nature of our competition;

 

·                  Ourability to employ and retain qualified employees;

 

·                  Thelimited trading market for our common stock; and

 

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

 

These risksare not exhaustive.  Other sections ofthis Annual Report may include additional factors which could adversely impactour business and financial performance. Moreover, we operate in a very competitive and rapidly changingenvironment.  New risk factors emergefrom time to time and it is not possible for our management to predict all riskfactors, nor can we assess the impact of all factors on our business or to theextent to which any factor, or combination of factors, may cause actual resultsto differ materially from those contained in any forward-lookingstatements.  Given these risks anduncertainties, investors should not place undue reliance on forward-lookingstatements as a prediction of actual results. These forward-looking statements are made only as of the date of thisAnnual Report.  Except for our ongoingobligation to disclose material information as required by federal securitieslaws, we do not intend to update you concerning any future revisions to anyforward-looking statements to reflect events or circumstances occurring afterthe date of this Annual Report.

 

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**ITEM 8.****                        ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

Ourconsolidated financial statements appear in a separate section of this AnnualReport, see “Index to Consolidated Financial Statements.”  Such information is incorporated herein byreference.

 

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

 

NotApplicable.

 

**ITEM 9A(T)- MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

** **

Our managementis responsible for establishing and maintaining adequate internal control overfinancial reporting as defined in Rules 13a-15(f) under the Exchange Act.  Our internal control over financial reportingis designed to ensure that material information regarding our operations ismade available to management and the board of directors to provide themreasonable assurance that the published financial statements are fairlypresented.  There are limitationsinherent in any internal control, such as the possibility of human error andthe circumvention or overriding of controls. As a result, even effective internal controls can provide onlyreasonable assurance with respect to financial statement preparation.  As conditions change over time so too may theeffectiveness of internal controls.

 

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed in our reports filed or submitted underthe Exchange Act is recorded, processed, summarized and reported, within thetime periods specified in the Securities and Exchange Commission’s rules andforms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed inour reports filed under the Exchange Act is accumulated and communicated tomanagement, including the chief executive officerand chief financial officer as appropriate, to allow timelydecisions regarding required disclosure. Management recognizes that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving their objectives, and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.

 

Our chiefexecutive officer and principal financial officer, have evaluated ourdisclosure controls and procedures and determined that they were effective asof December 31, 2008.

 

Our management,with the participation of our chief executive officer and chief accountingofficer evaluated our internal controls over financial reporting as of December 31,2008 based on the framework in Internal Control - Integrated Framework issuedby the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.Based on this assessment, management concluded that our internal control overfinancial reporting was effective as of December 31, 2008.

 

This annualreport does not include an attestation report of the Company’s registeredpublic accounting firm regarding internal control over financialreporting.  Management’s report was notsubject to attestation by the Company’s registered public accounting firmpursuant to temporary rules of the Securities and Exchange Commission thatpermit the Company to provide only management’s report in this Annual Report.

 

***Changes in Internal Control Over FinancialReporting***

 

There were nochanges to our internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during our most recently completedfiscal quarter that materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**ITEM 9B.****             ****OTHER INFORMATION**

 

Not Applicable.

 

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**PART III**

 

**ITEM10.****                  DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

** **

**Directors**

 

The followingtable sets forth, as of March 24, 2009, the names of, and certaininformation concerning, our directors:

 
| Name               | ** ** | **Age** | ** ** | **Position**                                       | ** ** | **Director Since** | ** ** | **End of Term** |
|--------------------|------------|---------|------------|----------------------------------------------------|------------|-------------------------|------------|---------------------------|
| Dimitri Villard    |       | 66      |       | Chief Executive Officer  and Chairman of the Board |       | 2005                    |       | 2009                      |
| Frederick W. Field |       | 56      |       | Director                                           |       | 2001                    |       | 2009                      |
| Fred Davis         |       | 49      |       | Director                                           |       | 2005                    |       | 2009                      |

 

*DimitriVillard.*   Mr. Villard served as Interim ChiefExecutive officer since March 6, 2008 and as a director since January 2005.Effective February 1, 2009, Mr. Villard was appointed Chief Executive Officerof the Company and its two wholly owned subsidiaries.  Mr. Villard has also served as Presidentand a director of Pivotal BioSciences, Inc., a biotechnology company,since September 1998. In addition, since January 1982 to present, hehas served as President and director of Byzantine Productions, Inc.Previously, Mr. Villard was a director at the investment banking firm ofSG Cowen and affiliated entities, a position he held from January 1997 to July 1999.From 2004 to 2008 Mr. Villard served as Chairman of the Board of DaxSolutions, Inc. (“*Dax*”), anentertainment industry digital asset management venture. He is also a member ofthe Executive Committee of the Los Angeles chapter of the Tech Coast Angels, aprivate venture capital group. Mr. Villard received a B.A. from HarvardUniversity and a Master of Science degree from China International MedicalUniversity.

 

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

 

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

 

**ExecutiveOfficers**

 

The following table setsforth, as of March 24, 2009, the name of, and certain informationconcerning, our executive officer who does not also serve as a director:

 
| **Name**       | ** ** | **Age** | ** ** | **Position**                                           |
|----------------|------------|---------|------------|--------------------------------------------------------|
| Rene Rousselet |       | 53      |       | Corporate Controller and  Principal Accounting Officer |

 

*RenéRousselet*. Mr. Rousselet has served as CorporateController since September 2006 and as Principal Accounting Officer since February 2007.From May 2006 to September 2006, Mr. Rousselet worked as aconsultant for Tag-It Pacific, Inc. (TAG), a publicly-traded apparelcompany. From November 2004 to May 2006, he served as the ChiefFinancial Officer of Asbestos Control Testing, Inc., a privately heldinterior demolition company, and from 1999 to 2004 he was the President andChief Financial Officer of ProService Inc., a privately held professionalemployment organization.  Prior to 1999, Mr. Rousseletserved as either the Chief Financial Officer or Corporate Controller for avariety of entertainment companies in Los Angeles including two publiccompanies Hemdale Communications Inc. (no longer in existence) and TheKushner-Locke Company (KLOC.PK), a television programming company. Mr. Rousseletreceived a Degree in Accounting from California State University Northridge in1977 and became a Certified Public Accountant in 1979 while working as a SeniorAuditor at Arthur Andersen & Co.

 

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**FamilyRelationships**

 

There are no familyrelationships among the directors and executive officers.

 

**Term ofOffice**

 

Our directors and officers hold office until the earlier of theirdeath, resignation, or removal or until their successors have been qualified.

 

**Procedurefor Consideration of Director-Nominees**

 

*StockholderNominees.*

 

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

 

**Section 16(a) BeneficialOwnership Compliance**

 

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

 

To our knowledge, basedsolely on our review of the copies of such forms received by us, or writtenrepresentations from the Reporting Persons, all Section 16(a) formswere timely filed during fiscal 2008.

 

**Code ofEthics**

 

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

 

**TheBoard of Directors and Committees**

 

The Board is responsiblefor the supervision of the overall affairs of the Company. The Board met multipletimes during the year ended December 31, 2008.  During 2008, each director attended eitherin-person or by telephone, at least 90% percent of all Board meetings.

 

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***Audit Committee***

 

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

 

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

 

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

 

·                  discussingour systems of internal control over financial reporting, and

 

·                  meetingindependently with the independent registered public accounting firm andmanagement.

 

The Audit Committee consisted of James N. Lane andDimitri Villard, both of whom were considered “independent” for the year ended December 31,2007.  On March 24, 2008, Mr. JamesLane advised the Company that he would no longer serve as a Director and memberof the Audit Committee.  As Mr. Lanewas, at that time, the only independent member of the Audit Committee, theCompany has suspended the activities of the Audit Committee until a newindependent Director is appointed. In the interim, the functions of the AuditCommittee have been assumed by the Board of Directors.

 

***Compensation Committee***

 

The Board established aCompensation Committee in November 2005. The Compensation Committeeadministers the Company’s compensation and benefit plans, in particular, theincentive compensation and equity-based plans, and approves salaries, bonuses,and other compensation arrangements and policies for the Company’s officers,including the Chief Executive Officer. The Board has adopted a written charterfor the Compensation Committee, a copy of which was filed as an exhibit to theCompany’s Proxy Statement filed on May 8, 2006 with the Securities andExchange Commission. The Compensation Committee currently consists of FredDavis and Frederick Field, both of whom were considered “independent” for theyear ended December 31, 2008.

 

***Nominating Committee***

 

The Board established aNominating Committee in June 2006. The Nominating Committee during 2007 consisted of Frederick Field andFred Davis, both of whom were considered “independent”.  The Nominating Committee was established toensure that the Company is able to attract and retain qualified individuals toserve on the Board of Directors and to establish a fair process for thehandling of stockholder nominations to the Board of Directors.  There were no meetings of the NominatingCommittee during 2008.

 

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**ITEM11.****                                              EXECUTIVECOMPENSATION**

** **

**Overview ofExecutive Compensation Program**

** **

TheCompensation Committee of our board of directors has responsibility forestablishing, implementing and monitoring our executive compensation programphilosophy and practices. The Compensation Committee seeks to ensure that thetotal compensation paid to our named executive officers is fair, reasonable andcompetitive. Generally, the types of compensation and benefits provided to thenamed executive officers are similar to those provided to our other officers.

 

Throughoutthis Annual Report, the individuals included in the Summary Compensation Tableare referred to as the “named executive officers.”

 

**CompensationPhilosophy and Objectives**

** **

Thecomponents of our executive compensation consist of salary, annual cash bonusesawarded based on the Compensation Committee’s subjective assessment of eachindividual executive’s job performance during the past year, stock optiongrants to provide executives with longer-term incentives, and occasionalspecial compensation awards (either cash or stock options) to rewardextraordinary efforts or results.

 

TheCompensation Committee believes that an effective executive compensationprogram should provide base annual compensation that is reasonable in relationto individual executive’s job responsibilities and reward the achievement ofboth annual and long-term strategic goals of our Company. The CompensationCommittee uses annual and other periodic cash bonuses to reward an officer’sachievement of specific goals and employee stock options as a retention tooland as a means to align the executive’s long-term interests with those of ourstockholders, with the ultimate objective of improving stockholder value. TheCompensation Committee evaluates both performance and compensation to maintainour company’s ability to attract and retain excellent employees in keypositions and to assure that compensation provided to key employees remainscompetitive relative to the compensation paid to similarly situated executivesof comparable companies. To that end, the Compensation Committee believesexecutive compensation packages provided by us to our named executive officersshould include both cash compensation and stock options.

 

Becauseof the size of our Company, the small number of executive officers in ourCompany, and our company’s financial priorities, the Compensation Committee hasdecided not to implement or offer any pension benefits, deferred compensationplans, or other similar plans for our named executive officers.

 

**Role ofExecutive Officers in Compensation Decisions**

** **

TheCompensation Committee makes all compensation decisions for the named executiveofficers and approves recommendations regarding equity awards to all of ourofficers. Decisions regarding the non-equity compensation of our other officersare made by our Chief Executive Officer.

 

TheCompensation Committee and the Chief Executive Officer annually review theperformance of each named executive officer (other than the Chief ExecutiveOfficer, whose performance is reviewed only by the Compensation Committee). Theconclusions reached and recommendations based on these reviews, including withrespect to salary adjustments and annual award amounts, are presented to theCompensation Committee. The Compensation Committee can exercise its discretionin modifying any recommended adjustments or awards to executives.

 

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**Setting Executive Compensation**

 

Based on the foregoing objectives, the CompensationCommittee has structured the Company’s annual cash and incentive-based cash andnon-cash executive compensation to seek to motivate our named executives toachieve the business goals set by the Company, to reward the executives forachieving such goals, and to retain the executives. In doing so, theCompensation Committee historically has not employed outside compensationconsultants. The Compensation Committee utilizes data to set compensation forour executive officers at levels targeted at or around a range of compensationamounts provided to executives at comparable companies considering, for eachindividual, their individual experience level related to their position withus. There is no pre-established policy or target for the allocation betweeneither cash and non-cash incentive compensation.

 

**2008 ExecutiveCompensation Components**

** **

For2008, the principal components of compensation for the named executive officerswere:

 

·                  base salary;

 

·                  annual bonuses; and

 

·                  equity incentive compensation.

 

**Base Salary**

** **

TheCompany provides named executive officers and other employees with base salaryto compensate them for services rendered during the year. Base salary rangesfor the named executive officers are determined for each named executiveofficer based on his position and responsibility.

 

Duringits review of base salaries for executives, the Compensation Committeeprimarily considers:

 

·                  the negotiated terms of eachexecutive employment agreement;

 

·                  internal review of the executive’scompensation, both individually and relative to other named executive officers;and

 

·                  individual performance of theexecutive.

 

Salarylevels are typically considered annually as part of the company’s performancereview process, as well as upon a change in job responsibility. Merit-basedincreases to salaries are based on the Compensation Committee’s assessment ofthe individual’s performance.

 

**Annual and Special Bonuses**

 

TheCompensation Committee has not established an incentive compensation programwith fixed performance targets. Because we do not generate significant profits,the Compensation Committee bases its discretionary compensation awards on theachievement of milestones, and effective fund-raising efforts, and effectivemanagement of personnel and capital resources, among other criteria.

 

**EquityIncentive Compensation**

** **

Asindicated above, the Compensation Committee also aims to encourage thecompany’s executive officers to focus on long-term company performance byallocating to them stock options that vest over a period of several years.There were no equity grants during 2008. All stock options had an exercise price equal to the closing market priceon the date of grant, and also vest monthly over three years, provided thatsuch executives remain in our employ through such monthly vesting periods

 

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**Retirement Plans, Perquisites and Other PersonalBenefits**

** **

Wehave adopted a tax-qualified employee savings and retirement plan, the 401(k)Plan, for eligible United States employees, including our named executiveofficers. Eligible employees may elect to defer a percentage of their eligiblecompensation in the 401(k) Plan, subject to the statutorily prescribed annuallimit. We may make matching contributions on behalf of all participants in the401(k) Plan in an amount determined by our board of directors. Matching andprofit sharing contributions, if any, are subject to a vesting schedule; allother contributions are at all times fully vested. We intend the 401(k) Plan,and the accompanying trust, to qualify under Sections 401(k) and 501 of theInternal Revenue Code so that contributions by employees to the 401(k) Plan,and income earned (if any) on plan contributions, are not taxable to employeesuntil withdrawn from the 401(k) Plan, and so that we will be able to deduct ourcontributions, if any, when made. The trustee under the 401(k) Plan, at thedirection of each participant, may invest the assets of the 401(k) Plan in anyof a number of investment options.

 

**OwnershipGuidelines**

** **

TheCompensation Committee has no requirement that each named executive officermaintain a minimum ownership interest in our company.

 

Ourlong-term incentive compensation consists solely of periodic grants of stockoptions to our named executive officers. The stock option program:

 

·                  links the creation of stockholdervalue with executive compensation;

 

·                  provides increased equity ownershipby executives;

 

·                  functions as a retention tool,because of the vesting features included in all options granted by theCompensation Committee; and

 

·                  maintains competitive levels of totalcompensation.

 

Wenormally grant stock options to new executive officers when they join ourcompany based upon their position with us and their relevant prior experience.The options granted by the Compensation Committee generally vest monthly overthe first three years of the option term. Vesting and exercise rights ceaseupon termination of employment (or, in the case of exercise rights, 90 daysthereafter), except in the case of death (subject to a one-year limitation),disability or retirement. Prior to the exercise of an option, the holder has norights as a stockholder with respect to the shares subject to such option,including voting rights and the right to receive dividends or dividendequivalents. In addition to the initial option grants, our CompensationCommittee may grant additional options to retain our executives and reward, orprovide incentive for, the achievement of corporate goals and strong individualperformance. Options are granted based on a combination of individualcontributions to our company and on general corporate achievements, which mayinclude the attainment of product development milestones and attaining otherannual corporate goals and objectives.

 

Onan annual basis, the Compensation Committee assesses the appropriate individualand corporate goals for our new executives and provides additional optiongrants based upon the achievement by the new executives of both individual andcorporate goals. We expect that we will continue to provide new employees withinitial option grants in the future to provide long-term compensationincentives and will continue to rely on performance-based and retention grantsto provide additional incentives for current employees. Additionally, in thefuture, the Compensation Committee may consider awarding additional oralternative forms of equity incentives, such as grants of restricted stock,restricted stock units and other performance-based awards.

 

Wehave no program, practice or plan to grant stock options to our executiveofficers, including new executive officers, in coordination with the release ofmaterial nonpublic information. We also have not timed the release of materialnonpublic information for the purpose of affecting the value of stock optionsor other compensation to our executive officers, and we have no plan to do so.We have no policy regarding the adjustment or recovery of stock option awardsin connection with the restatement of our financial statements, as our stockoption awards have not been tied to the achievement of specific financialgoals.

 

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**Tax and Accounting Implications**

** **

**Deductibilityof Executive Compensation**

** **

Aspart of its role, the Compensation Committee reviews and considers thedeductibility of executive compensation under Section 162(m) of the InternalRevenue Code, which provides that corporations may not deduct compensation ofmore than $1,000,000 that is paid to certain individuals. We believe thatcompensation paid to our executive officers generally is fully deductible forfederal income tax purposes.

 

**Accounting forShare-Based Compensation**

** **

Beginningon January 1, 2006, we began accounting for share-based compensation inaccordance with the requirements of FASB Statement 123(R), Share-Based Payment.This accounting treatment has not significantly affected our compensationdecisions. The Compensation Committee takes into consideration the taxconsequences of compensation to the named executive officers, but taxconsiderations are not a significant part of the company’s compensation policy.

 

**CompensationCommittee Interlocks and Insider Participation in Compensation Decisions**

** **

Thereare no “interlocks,” as defined by the SEC, with respect to any member of theCompensation Committee.

 

**CompensationCommittee Report**

** **

TheCompensation Committee has reviewed and discussed with management the“Compensation Discussion and Analysis” required by Item 402(b) of RegulationS-K and, based on such review and discussions, has recommended to our board ofdirectors that the foregoing “Compensation Discussion and Analysis” be includedin this Annual Report.

 

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**Executive Compensation**

 

The following table setsforth information concerning the compensation earned by our Chief ExecutiveOfficer, our other most highly compensated executive officers (who servedduring fiscal years ended December 31, 2008 and 2007, and whose totalcompensation during fiscal years ended December 31, 2008 and 2007 exceeded$100,000) (collectively, the “*NamedExecutive Officers*”).  We havealso included two additional individuals who serve as executive officers ofMediaDefender, our wholly-owned subsidiary.

 

**Summary Compensation Table**

** **
| ** **                                 | ** ** | ** ** | ** ** | ** **      | ** ** | ** **     | ** ** | ** **             | ** ** | ** **              | ** ** | **Compensation**                     | ** ** | ** **                      | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------|------------|----------------|------------|------------------------|------------|-------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| **Name and  Principal Position** | ** ** | **Year**   | ** ** | **Salary  ($)** | ** ** | **Bonus  ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive  Plan  ($)** | ** ** | **Nonqualified  Deferred  ($)** | ** ** | **All Other  ($)** | ** ** | **Total  ($)** | ** ** |
| Dimitri Villard                            |       | 2008       |       | 281,080         |       |           |       |                   |       |                    |       |                                 |       |                            |       |   |   | 281,090 |   |
| Interim Chief Executive  Officer           |       |       |       |            |       |           |       |                   |       |                    |       |                                 |       |                            |       |   |   |   |   |
| Jonathan V. Diamond              |       | 2008       |       | 58,333          |       |           |       |                   |       |                    |       |                                 |       |                            |       | 405,446 | (3) | 463,779 |   |
| Former Chief Executive  Officer            |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| Rene Rousselet                             |       | 2008       |       | 150,000         |       | 20,000         | (2)        |                   |       |                    |       |                                 |       |                            |       |   |   | 170,000 |   |
| Senior Accounting  Officer                 |       | 2007       |       | 136,667         |       | 19,000         | (2)        |                   |       | 59,500                  | (4)        |                                 |       |                            |       |   |   | 215,167 |   |
| Randy Saaf -  MediaDefender                |       | 2008       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| Chief Executive  Officer              |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| Octavio Herrera                            |       | 2008       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |
| President,  MediaDefender                  |       | 2007       |       | 350,000         |       |           |       |                   |       |                    |       |                                 |       |                            |       | 9,600 | (1) | 359,600 |   |

 

----

(1)             Auto allowance.

(2)             Discretionary bonus.

(3)             Severance of $350,000, vacation pay-out of$53,846 and $1,600 auto allowance.

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

 

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**OUTSTANDINGEQUITY AWARDS AT FISCAL YEAR-END**

 

The following table setsforth certain information relating to unexercised and outstanding options foreach named executive officer as of December 31, 2008. No other equityawards otherwise reportable in this table have been granted to any of our namedexecutive officers.

 
| ** **                                      | ** ** | **Option Awards**                                                                 | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| **Name**                                        | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)  Exercisable** | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)  Unexercisable** | ** ** | **Option  Exercise  Price  ($)** | ** ** | **Option  Expiration  Date** | ** ** |
| Jonathan V. Diamond                   |       | 1,304,659                                                                              |       | — |   | $ | 1.62 |   | 02/05/11 |   |
| Chief Executive Officer                         |       |                                                                                   |       |   |   |   |   |   |   |
| Rene Rousselet                                  |       | 50,000                                                                                 |       | — |   | 1.50 |   | 02/02/12 |   |
| Senior Finance Officer                          |       |                                                                                   |       |   |   |   |   |   |   |
| Randy Saaf                                      |       | 195,238                                                                                |       | 4,762 |   | 3.00 |   | 07/28/12 |   |
| Chief Executive Officer,  MediaDefender(1) |       |                                                                                   |       |   |   |   |   |   |   |
| Octavio Herrera                                 |       | 195,238                                                                                |       | 4,762 |   | 3.00 |   | 07/28/12 |   |
| President, MediaDefender(1)                     |       |                                                                                   |       |   |   |   |   |   |   |
|                                                 |            |                                                                                        |            |  |  |  |  |  |  |  |

 

----

(1) The Options vest over a three and one-half (3.5) year period ona quarterly basis for each named executive officer.

 

**DirectorCompensation**

 

*Board of Directors Compensation:*

 

For the year ended December 31,2008, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000.  In addition, each director that serves on aCommittee of the Board of Directors received, for each committee served, anadditional cash retainer of $10,000 annually, which is paid quarterly.  No stock option grants were made during theyear ended December 31, 2008 under the 2006 Equity Plan.

 

**Tabular Format**

 

Thefollowing table sets forth the compensation paid to all persons who served asmembers of our board of directors (other than our named executive officers)during the 2008 fiscal year. No director who is also a named executive officerreceived any compensation for services as a director in 2008.

 

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

 
| ** **               | ** ** | ** **                                                | ** ** | ** **             | ** ** | ** **              | ** ** | **Compensation**                         | ** ** | ** **                      | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| **Name**                 | ** ** | **Fees Earned  or Paid in  Cash ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive  Plan ($)** | ** ** | **Nonqualified  Deferred  ($)** | ** ** | **All Other  ($)** | ** ** | **Total ($)** | ** ** |
|                     |       |                                                      |       |                   |       |                    | ** ** |                                     | ** ** |                            |       |   |   |   | ** ** |
| Jim Lane (5)             |       | 5,770                                                     |       | 0                      |       | 0                       | ** ** | 0                                        | ** ** | 0                               |       | 0 |   | 5,770 | ** ** |
| Frederick W. Field       |       | 15,000                                                    |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 15,000 |   |
| Fred Davis (4)           |       | 22,500                                                    |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 22,500 |   |
| Teymour BoutrosGhali (1) |       | 9,252                                                     |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 9,252 |   |
| Eric Pulier (1)          |       | 9,252                                                     |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 9,252 |   |
| Jon Diamond (2)          |       | 7,305                                                     |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 7,305 |   |
| Dimitri Villard (3)      |       | 6,923                                                     |       | 0                      |       | 0                       |       | 0                                        |       | 0                               |       | 0 |   | 6,923 |   |

 

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(1)          On August 12, 2008 EricPulier and Teymour Boutros-Ghali resigned as directors of the Company.

(2)          On March 12, 2008 JonDiamond became Chairman of the Board and he resigned on September 5, 2008.

(3)          On March 12, 2008Dimitri Villard became the interim CEO and his Board fees were discontinued.

(4)          There were no committeemeetings in the fourth quarter of 2008.

(5)          On March 24, 2008 JimLane resigned as a director of the Company.

 

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**ITEM 12.****    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

Thefollowing table sets forth, as of March 24, 2009, the number andpercentage of shares of Common Stock beneficially owned, directly orindirectly, by each of our directors, director-nominees, the Named ExecutiveOfficers (as defined below), beneficial owners known by the Company of morethan five percent of the outstanding shares of our Common Stock and by ourdirectors and executive officers as a group. Beneficial ownership is determinedin accordance with the Rule 13d-3(a) of the Securities Exchange Actof 1934, as amended, and do not necessarily indicate ownership for any otherpurpose, and generally includes voting or investment power with respect to theshares and shares which such person has the right to acquire within 60 days of March 24,2009.

 
| ** **                                                                                                               | ** ** | ** **                   | ** ** | **Amount and Nature** | ** ** | ** **          | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                                                                                                               | ** ** | **Title of Class** | ** ** | **of Beneficial**          | ** ** | **Percent**         | ** ** |
| **Beneficial Owner(1)**                                                                                             | ** ** | **of Stock**            | ** ** | **Ownership(2)**                | ** ** | **of Class**** | ** ** |
| *5% Stockholders:*                                                                                                       |       |                         |       |                            |       |                |       |
|                                                                                                                     |       |                         |       |                            |       |                |       |
| DKR Capital Partners, L.P. 1281 East Main  Street  Stamford, CT 06902                                                    |       | Common                       |       | 8,845,803                       | (3)        | 15.8                |       |
| Trilogy Capital Partners, Inc. c/o Robert  Rein, Esq.   10866 Wilshire Boulevard, Suite 400   Los Angeles, CA 90024 |       | Common                       |       | 8,376,627                       | (4)        | 14.9                |       |
| JMB Capital Partners, L.P. 1999 Avenue of  the Stars,  Suite 2040 Los Angeles, California 90067                     |       | Common                       |       | 7,826,304                       | (3)        | 14.0                |       |
| Longview Fund LP. 60 Montgomery Street, 44th Floor  San Francisco, CA  94111                                   |       | Common                       |       | 3,687,651                       | (5)        | 6.6                 |       |
| Octavio Herrera   2461 Santa Monica Blvd., Suite d-520   Santa Monica, CA  90404                                    |       | Common                       |       | 3,164,205                       | (6)        | 5.6                 |       |
| Randy Saaf   2461 Santa Monica Blvd., Suite d-520   Santa Monica, CA  90404                                         |       | Common                       |       | 3,164,205                       | (6)        | 5.6                 |       |
| *Current Executive Officers and Directors:*                                                                              |       |                         |       |                            |       |                |       |
| Dimitri Villard                                                                                                          |       | Common                       |       | 8,504,515                       | (7)        | 15.0                |       |
| Frederick W. Field                                                                                                       |       | Common                       |       | 6,991,360                       | (8)        | *                   |       |
| Fred Davis                                                                                                               |       | Common                       |       | 41,409                          | (9)        | *                   |       |
| Rene Rousselet                                                                                                           |       | Common                       |       | 112,222                         | (9)        | *                   |       |
| All current directors and executive  officers as a group (4 Persons)                                                |       | Common                       |       | 8,533,248                       |       | 15.2                |       |

 

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| *   |   | Indicates less than  1.0%                                                                                                                                                                                                          |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **  |   | Based on 56,087,216  shares of Common Stock outstanding as of March 24, 2009.                                                                                                                                                 |
| (1) |   | Unless otherwise  indicated, the address for each of the individuals listed in the table is  c/o ARTISTdirect, Inc., 1601 Cloverfield Boulevard, Suite 400  South, Santa Monica, California, 90404-4082.            |
| (2) |   | Unless otherwise  indicated, the persons named in the table have sole voting and investment  power with respect to all shares of common stock shown as beneficially owned  by them, subject to applicable community property laws. |
| (3) |   | Based on Schedule 13G/A  filed on February 12, 2009.                                                                                                                                                                               |
| (4) |   | Based on Schedule 13D/A  filed on February 17, 2009.                                                                                                                                                                               |
| (5) |   | Based on Schedule 13G  filed on February 17, 2009.                                                                                                                                                                                 |
| (6) |   | Based on Schedule 13D/A  filed on February 17, 2009.                                                                                                                                                                               |
| (7) |   | Includes options to  purchase 345,662 shares that have fully vested as of March 15, 2009.                                                                                                                                          |
| (8) |   | Consist of options that  have fully vested as of March 15, 2009 and 6,666,666 shares issuable upon  conversion of a promissory note.                                                                                               |
| (9) |   | Consists of options  that have fully vested as of March 15, 2009.                                                                                                                                                                  |

 

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**EmploymentAgreements**

 

As of March 6, 2008, the Company entered into an Amended andRestated Services Agreement (the “Services Agreement”) with Jon Diamond underwhich his employment as Chief Executive Officer was ended and he was elected asthe Company’s Chairman of the Board of Directors.  Under the Services Agreement, the Companyagreed to (a) pay a severance payment of $350,000 payable in semi-monthlyinstallments over a period of six months, (b) accelerate the vestingof  the Time Vesting Options under hisprevious employment agreement, (c) accelerate the vesting of optionsgranted in 2004 to purchase 259,659 shares, (d) extend to February 5,2011 the period for exercising the Time Vesting Options and to March 29,2011 for the 2004 Options, and (e) pay 40 days of accrued vacation time.

 

EffectiveFebruary 1, 2009, Dimitri Villard, pursuant to a three year employmentagreement, the Chairman of the Board of Directors, was appointed to serve asthe Company’s Chief Executive Officer. Prior to that date, Mr. Villard was theCompany’s interim Chief Executive Officer. Mr. Villard will receive base compensation equal to $25,000 per monthsubject to increases as determined by the Board of Directors, in its solediscretion.  Mr. Villard was grantedoptions to purchase 3,920,000 shares of the Company’s stock at $0.03 per sharevesting monthly over 36 months and will receive a bonus equal to 33% of theamount by which the Company’s EBITDA exceeds a certain threshold amount asdetermined by the Company’s Compensation Committee for such fiscal year.

 

EffectiveFebruary 1, 2009, the Company and Rene Rousselet (“Executive”) entered into anEmployment Agreement pursuant to which Mr. Rousselet was employed to continueas the Company’s Corporate Controller and Principal Accounting Officer.  The employment is on an “at will basis.”  Mr. Rousselet will receive a salary of$14,583 per month subject to increases and a bonus as determined by the Boardof Directors, in its sole discretion. Mr. Rousselet was granted options to purchase 560,000 shares of theCommon Stock of the Company at $0.03 per share vesting monthly over 36 monthscommencing February 1, 2009.  If Mr.Rousselet’s employment is terminated without cause, Mr. Rousselet will receivehis salary and vesting of options for an additional period of three months fromthe date of termination.

 

In accordance with theMediaDefender transaction, the Company acknowledged the terms of EmploymentAgreements entered into on July 28, 2005 by MediaDefender with each ofRandy Saaf, who serves as Chief Executive Officer of MediaDefender, and OctavioHerrera, who serves as President of MediaDefender.  Mr. Saaf and Mr. Herrera will eachearn a base salary of no less than $350,000 per annum during the initial termof the agreements, which shall continue until December 31, 2008.  In addition, the Company granted stockoptions to purchase 200,000 shares of common stock to each of Mr. Saaf andMr. Herrera, exercisable for a period of five years at $3.00 pershare.  On January 13, 2009, the Companyentered into agreements with Mr. Saaf and Mr. Herrera to amend theiremployment agreement such that commencing January 1, 2009, eitherExecutive or the Company may terminate this Agreement upon five days writtennotice.  Upon the effective date of termination, with respect to theperiod commencing January 1, 2009 through such effective date, Eachexecutive is entitled to receive his base compensation, vacation pay andreimbursement of expenses related to his employment with the Company.  Each executive was granted the right to havea period of sixty days from the effective date of termination to exercise allvested stock options issued to him.  EffectiveFebruary 15, 2009, MediaDefender terminated the employment of Messrs, Saafand Herrera.

 

Future payments under employment agreements are as follows:

 
| **Years Ending December 31,** | ** ** | **(in thousands)** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
|                                         |       |                    |       |
| 2009                                         |       | $                       | 275        |   |
| 2010                                         |       | 300                     |       |
| 2011                                         |       | 300                     |       |
| 2012                                         |       | 25                      |       |
|                                         |       | $                       | 900        |   |

 

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*Consulting Agreements*

 

Effective August 31, 2007, Robert N.Weingarten, the Chief Financial Officer and Secretary of the Company resignedfrom all positions he held with the Company.  As a result of thisresignation, the Company and Mr. Weingarten entered into a twelve monthconsulting agreement under which he is paid $16,250 per month.

 

In addition, the Company and Mr. Weingartenentered into an Omnibus Stock Option Amendment Agreement which extended theexercise date for 120,000 stock options granted to him in 2004 until March 29,2011; altered the terms of his time vesting options to acquire 275,000 sharesto accelerate their vesting to August 31, 2007 and extend their exercisedate to August 5, 2010.   Inaddition, Mr. Weingarten will be able to exercise the time vesting optionsand the performance vesting options, if vested, until August 5, 2010,provided he does not breach his Consulting Agreement.

 

**Option Plans**

 

Wecurrently maintain our 2006 Equity Incentive Plan, our 1999 Employee StockOption Plan, our 1999 Artist Plan, our 1999 Artist and Artist Advisor Plan andour 2004 Consultant Plan (collectively, the “*Current**Option Plans*”). At March 24,2008, an aggregate of 1,223,941 stock options were outstanding under theCurrent Option Plans. There are an additional 1,709,659 stock optionsoutstanding at March 24, 2008 that were issued by us outside of theCurrent Option Plans.

 

**EQUITY COMPENSATION PLAN INFORMATION**

 

Thefollowing table provides information as of March 24, 2009 regardingcompensation plans (including individual compensation arrangements) under whichour securities are authorized for issuance. Information is included for bothequity compensation plans approved by our stockholders and equity compensationplans not approved by our stockholders.

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

 

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*1999Employee Stock Option Plan*

 

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

 

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

 

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

 

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

 

*1999Artist Plan*

 

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

 

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

 

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

 

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*1999Artist and Artist Advisor Plan*

 

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

 

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

 

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

 

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

 

*2004Consultant Stock Plan*

 

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

 

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*2006Equity Incentive Plan*

 

The ARTISTdirect, Inc. 2006 Equity Incentive Plan, referred to asthe 2006 Equity Plan, became effective on June 19, 2006, the effectivedate of stockholder approval of such plan. The Board of Directors ofARTISTdirect, Inc., a Delaware corporation (the “*Registrant*”), had approved the 2006 EquityPlan in April 2006. The Registrant’s stockholders approved the 2006 EquityPlan at the Annual Meeting of Stockholders held June 19, 2006 (the “*Annual Meeting*”).

 

A total of 1,500,000 new shares of the Registrant’s common stock haveinitially been reserved for issuance under the 2006 Equity Plan.

 

Awards under the 2006 Equity Plan may be granted to any of theRegistrant’s employees, directors, officers, consultants or those of theRegistrant’s affiliates. Awards may consist of stock options (both incentivestock options and non-statutory stock options), stock awards, stockappreciation rights and cash awards. An incentive stock option may be grantedunder the 2006 Equity Plan only to a person who, at the time of the grant, isan employee of the Registrant or a parent or subsidiary of the Registrant.

 

The 2006 Equity Plan will be administered by the Registrant’sCompensation Committee, which the Board of Directors appointed to be the“Administrator” of the plan, with full power to authorize the issuance ofshares of the Registrant’s common stock and to grant options or rights topurchase shares of the Registrant’s common stock. The Administrator has thepower to determine the terms of the awards, including the exercise price, thenumber of shares subject to each award, the exercisability of the awards andthe form of consideration payable upon exercise. The Compensation Committee maydelegate the day-to-day administration of the 2006 Equity Plan to one or moreindividuals.

 

The 2006 Equity Plan provides that in the event of a merger of theRegistrant with or into another corporation or of a “change in control” of theRegistrant, including the sale of all or substantially all of the Registrant’sassets, and certain other events, the Board of Directors or the CompensationCommittee may, in its discretion, provide for the assumption or substitutionof, or adjustment to, each outstanding award, accelerate the vesting of optionsand stock appreciation rights, and terminate any restrictions on stock awardsor cash awards or provide for the cancellation of awards in exchange for a cashpayment to the participant.

 

The 2006 Equity Plan will terminate on June 19, 2016, unless terminatedearlier by the Board of Directors or the Compensation Committee. No awards maybe made after the termination date; however, unless otherwise expresslyprovided in an applicable award agreement, any award granted under the planprior to the expiration may extend beyond the end of such period through theaward’s normal expiration date.

 

The Board of Directors or the Compensation Committee may generallyamend or terminate the 2006 Equity Plan as determined to be advisable. TheInternal Revenue Code or the rules of the Securities and ExchangeCommission may also require the Registrant’s stockholders to approve certainamendments. The Board of Directors or the Compensation Committee may amend the2006 Equity Plan without stockholder approval to comply with legal, regulatoryand listing requirements and to avoid unanticipated consequences determined tobe inconsistent with the purpose of the plan or any award agreement.

 

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

 

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

 

Effective May 31, 2001, we issued to Frederick W. (Ted)Field, our then Chairman and former Chief Executive Officer, a non-qualifiedstock option to purchase 302,370 shares of common stock exercisable at $7.50per share through May 30, 2008.  Theoption vested over a period of five years from June 29, 2001, and wasfully vested in 2006.  The fair value ofthe stock option, determined pursuant to the Black-Scholes option-pricingmodel, was $2,006,000.  The five yearvesting period ended in 2006 and no amounts have been charged since 2006.

 

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EffectiveSeptember 29, 2003, we issued to Jonathan V. Diamond, our Chief ExecutiveOfficer, a non-plan, non-qualified stock option to purchase 259,659 shares ofcommon stock exercisable through August 15, 2010 at $0.85 per share, whichwas the approximate fair market value of the common stock on the date ofgrant.  The option vested over a periodof three years from the date of grant, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $221, 000,as the three year vesting period ended in 2006, no amount was charged off since2006.

 

EffectiveMarch 29, 2004, we issued to Robert N. Weingarten, our Chief FinancialOfficer, a non-plan, non-qualified stock option to purchase 120,000 shares at$0.50 per share, which was not less than the fair market value on the date ofgrant, exercisable through March 29, 2011. The option vests and becomes exercisable in a series of thirty-sixsuccessive equal monthly installments from March 29, 2004 through March 29,2007.  The fair value of the stockoption, determined pursuant to the Black-Scholes option-pricing model, was$42,000, of which $4,000 was charged to operations in 2007 and no amounts werecharged off in 2008.

 

OnJuly 28, 2005, we issued Jonathan Diamond, our President and ChiefExecutive Officer, a non-plan, non-qualified stock option to purchase 2,753,098shares of Common Stock exercisable at $1.55 per share, which was theapproximate fair market value of the Common Stock on the date of grant, throughAugust 25, 2010. Approximately 38 percent of such stock options vests atthe rate of 1/3rd per year over a three-year period and the remainingapproximately 62 percent vests upon the achievement of certain financialmilestones by ARTISTdirect. The fair value of the time-vested options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $2,936,450, of which $570,976 was recorded as stock-based compensation in2008 and $979,000 was recorded as stock-based compensation cost in 2007.

 

On July 28, 2005, we issued RobertWeingarten, our Chief Financial Officer, a non-plan, non-qualified stock optionto purchase 550,000 shares of Common Stock exercisable at $1.55 per share,which was not less than the fair market value on the date of grant, through August 25,2010. One half of such stock option vests at the rate of 1/3 per year over athree year period and one half will vest upon the achievement of certainfinancial milestones by ARTISTdirect.  Thefair value of the time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $772,750, of which $386,000 (due toacceleration) was recorded as stock-based compensation cost in 2007.

 

Theabove-referenced stock option grants were issued without registration inreliance upon the exemption afforded by Section 4(2) of theSecurities Act of 1933, as amended, based on certain representations made to usby the recipients.

 

**ITEM13.****                      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

 

**CertainRelationships and Related Transactions**

 

*Transactions Relatedto MediaDefender Acquisition*

 

In conjunction with theacquisition of MediaDefender, the Company issued 1,109,032 shares of commonstock and a seven-year warrant to purchase 114,985 shares of common stock withan exercise price of $1.55 per share to WNT07 Holdings, LLC.  The managers of WNT07 Holdings, LLC are EricPulier and Teymour Boutros-Ghali, both of whom were members of the Company’sBoard of Directors.  The shares andwarrants were issued as consideration for services provided by Mr. Pulierand Mr. Boutros-Ghali as consultants to the Company in connection with theacquisition of MediaDefender.  OnAugust 12, 2008, Eric Pulier and Teymour Boutros-Ghali resigned asdirectors of the Company.

 

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

 

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Randy Saaf and Octavio Herrera, formerlyprincipals and stockholders of MediaDefender and both executive officers of theCompany’s wholly-owned subsidiary, MediaDefender until February 15,2009, eachinvested $2,250,000 in the Sub-Debt Financing on the same terms and conditionsas the other Sub-Debt Financing investors.

 

*Eric Pulier*

 

Effective as of January 1, 2006, theCompany entered into a one-year consulting agreement with Eric Pulier, adirector of the Company, through WNT Consulting Group, a California limitedliability company wholly-owned by Mr. Pulier (“WNT”).  The consulting agreement was approved by thedisinterested members of the Company’s Board of Directors.  Effective January 12, 2007, the partiesmutually agreed to terminate this consulting agreement, which had automaticallyrenewed for a second one-year term through December 31, 2007.  Underthe terms of the original consulting agreement, Mr. Pulier received a basefee of $10,000 per month, certain other mandatory payments, and was alsoeligible to receive cash bonuses on the achievement of certain specifiedmilestones.  The termination agreement provided for a one-time cash paymentto Mr. Pulier (through WNT) in the amount of $100,000, in considerationfor the termination of the consulting agreement and an acknowledgement andcomplete release of any and all claims related to unpaid compensation, bonusamounts or other out-of-pocket expenses that may have been owed by the Companyas of January 12, 2007.  Mr. Pulier continued to serve as amember of the Company’s Board of Directors until his resignation on August 12,2008.  The termination agreement was approved by the CompensationCommittee of the Company’s Board of Directors.

 

*FredDavis*

 

During the yearsended December 31, 2008 and 2007, the Company incurred legal fees ofapproximately $22,000 and $16,000, respectively, to Davis ShapiroLewit & Hayes, LLP, a law firm in which Fred Davis, a director of theCompany, is a partner.

 

**Director Independence**

 

Our board of directors is comprised of a majority of independentdirectors as defined by NASDAQ Rules.

 

*Independent Directors*. As of December 31, 2008 theindependent directors of the Board were Frederick W. Field and Fred Davis(members of Compensation and Nominating Committees).  Each of these directors qualifies as anindependent director in accordance with the published listing requirements ofthe Nasdaq Stock Market. In addition, our board of directors has made asubjective determination as to each independent director that no relationshipsexist which, in the opinion of our board of directors, would interfere with theexercise of independent judgment in carrying out the responsibilities of adirector. In making these determinations, our directors reviewed and discussedinformation provided by the directors and us with regard to each director’sbusiness and personal activities as they may relate to us and our management.

 

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

 

Aggregatefees billed by our current independent registered public accounting firms, forthe years ended December 31, 2008 and 2007, respectively, are as follows:

 
| ** **                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Audit fees                                 |       | $        | 309,500    |     | $          | 185,460 |   |
| Audit-related and restatement related fees |       | $        |       |     | $          | 298,575 |   |
| Tax Fees                                   |       | $        | 103,850    |     | $          | 103,970 |   |

 

**AuditFees; Audit-Related Fees**

 

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

 

**Tax Fees**

 

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

 

**During2007 and 2008 Polices on Accounting Matters; Pre-Approval of Audit andNon-Audit Services of Independent Registered Public Accounting Firm**

 

Theprimary purpose of the Audit Committee during 2007 and 2008 was to assist theBoard in monitoring (i) the integrity of our financial statements anddisclosures, including oversight of the accounting and financial reportingprocesses and the audits of our financial statements (ii) the complianceby us with our legal, ethical and regulatory requirements and (iii) theindependence and performance of our independent registered public accountingfirm.

 

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

 

## **ITEM 15.****                                             ****EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

##  

Theinformation required by this Item is set forth in the section of this AnnualReport on Form 10-K entitled “EXHIBIT INDEX” and is incorporated herein byreference.

 

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TheAudit Committee has considered the provision of non-audit services provided byour independent registered public accounting firm to be compatible withmaintaining their independence.  As aresult of Mr. James Lane’s resignation from the Audit Committee on March 24,2008, the Company has suspended the activities of the Audit Committee and thefull board has assumed the Audit Committee’s responsibilities.

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|            | ** **     |       | **ARTISTdirect, Inc.** |
|------------|----------------|------------|-----------------------------|
| ** ** | ** **     | ** ** | ** **                  | ** ** |
| Date:      | April 14, 2009 |       | By:                         | /s/ Dimitri Villard |
|       |           |       |                        | Dimitri Villard |
|       |           |       |                        | Chief Executive Officer (Principal Executive  Officer) |
|       |           |       |                        |   |
| Date:      | April 14, 2009 |       | By:                         | /s/ Rene’ Rousselet |
|       |           |       |                        | Rene’ Rousselet |
|       |           |       |                        | Corporate Controller (Principal Accounting Officer) |

 

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In accordance with theSecurities Exchange Act of 1934, this Report has been signed below by thefollowing persons on behalf of the Registrant in the capacity and on the datesindicated.

 
| Signature              | ** ** | **Title**                                           | ** ** | **Date**       |
|------------------------|------------|-----------------------------------------------------|------------|----------------|
|                   |       |                                                |       |           |
|                   |       |                                                |       |           |
| /s/ Dimitri Villard    |       |                                                |       | April 15, 2009 |
| Dimitri Villard        |       | Chairman of the Board and Chief Executive Officer   |       |           |
|                   |       | (Principal Executive Officer)                       |       |           |
|                   |       |                                                |       |           |
| /s/ Rene Rousselet     |       |                                                |       |           |
| Rene Rousselet         |       | Corporate Controller (Principal Accounting Officer) |       | April 15, 2009 |
|                   |       |                                                |       |           |
|                   |       |                                                |       |           |
| /s/ Fred Davis         |       |                                                |       |           |
| Fred Davis             |       | Director                                            |       | April 15, 2009 |
|                   |       |                                                |       |           |
|                   |       |                                                |       |           |
| /s/ Frederick W. Field |       |                                                |       |           |
| Frederick W. Field     |       | Director                                            |       | April 15, 2009 |
|                   |       |                                                |       |           |

 

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ARTISTDIRECT, INC. AND SUBSIDIARIES

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

YEARS ENDED DECEMBER 31, 2008 AND 2007

 
| **Table of Contents**                                                                            | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                 |       |       |
| Report of Independent  Registered Public Accounting Firm:.                                                 |       | 64         |
|                                                                                                       |       |       |
| Consolidated Financial  Statements:                                                                        |       |       |
| Balance Sheets — December 31,  2008 and 2007                                                     |       | 65         |
| Statements of Operations —  Years Ended December 31, 2008 and 2007                               |       | 67         |
| Statements of Changes in  Stockholders’ Deficiency — Years Ended December 31, 2008 and 2007 |       | 68         |
| Statements of Cash Flows —  Years Ended December 31, 2008 and 2007                               |       | 69         |
| Notes to Consolidated  Financial Statements — Years Ended December 31, 2008 and 2007             |       | 70         |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

** **

To the Board of Directors and Stockholders

ARTISTdirect, Inc.

 

We have audited the accompanying consolidated balance sheets ofARTISTdirect, Inc. and subsidiaries (the “Company”) as of December 31, 2008 and2007, and the related consolidated statements of operations, stockholders’equity (deficiency) and cash flows for each of the years then ended.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our audits in accordance with standards of the PublicCompany Accounting****Oversight Board(United States).  Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the consolidated financial statements are free of materialmisstatement.  The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting.  Ouraudits included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the consolidated financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall consolidated financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position ofARTISTdirect, Inc. and subsidiaries as of December 31, 2008 and 2007, and theresults of their operations and their cash flows for each of the years thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

 

The accompanying consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern.  As more fully describedin Note 1, the Company has experienced declining revenues, negative workingcapital, a net loss, and uncertainty relating to its ability to improve itsoperating results under current economic conditions.  These conditions raise substantial doubtregarding the Company's ability to continue as a going concern.  The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

 
| /s/ Gumbiner Savett Inc. |   |
|--------------------------|--------|
|                     |   |
|                     |   |
| GUMBINER SAVETT INC.     |   |
|                     |   |
| April 14, 2009           |   |
| Santa Monica, California |   |

 

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ARTISTdirect, Inc. and Subsidiaries

ConsolidatedBalance Sheets

(amounts in thousands, except for share data)

 
| ** **                                                                                                                      | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                                                                                                            |       |                  |       |   |   |
| Assets                                                                                                                          |       |                  |       |   |   |
| Current assets:                                                                                                                 |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                       |       | $                     | 1,994      |   | $ | 4,268 |   |
| Restricted cash                                                                                                                 |       | 268                   |       | 280 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $229 and $418 at December 31, 2008 and 2007,  respectively |       | 2,542                 |       | 8,168 |   |
| Income taxes refundable                                                                                                         |       | 622                   |       | 1,147 |   |
| Prepaid expenses and other current assets                                                                                       |       | 315                   |       | 351 |   |
| Total current assets                                                                                                            |       | 5,741                 |       | 14,214 |   |
|                                                                                                                            |       |                  |       |   |   |
| Property and equipment                                                                                                          |       | 4,721                 |       | 4,452 |   |
| Less accumulated depreciation and  amortization                                                                                 |       | (3,519                | )          | (2,614 | ) |
| Property and equipment, net                                                                                                     |       | 1,202                 |       | 1,838 |   |
|                                                                                                                            |       |                  |       |   |   |
| Other assets:                                                                                                                   |       |                  |       |   |   |
| Intangible assets:                                                                                                              |       |                  |       |   |   |
| Customer relationships, net                                                                                                     |       | —                |       | 440 |   |
| Proprietary technology, net                                                                                                     |       | —                |       | 1,478 |   |
| Non-competition agreements, net                                                                                                 |       | 153                   |       | 416 |   |
| Goodwill                                                                                                                        |       | —                |       | 31,085 |   |
| Total intangible assets, net                                                                                                    |       | 153                   |       | 33,419 |   |
| Deferred financing costs, net                                                                                                   |       | 393                   |       | 1,243 |   |
| Deposits                                                                                                                        |       | —                |       | 20 |   |
| Total other assets                                                                                                              |       | 546                   |       | 34,682 |   |
|                                                                                                                            |       | $                     | 7,489      |   | $ | 50,734 |   |

 

(continued)

 

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ARTISTdirect, Inc. and Subsidiaries

ConsolidatedBalance Sheets (continued)

(amounts in thousands, except for share data)

 
| ** **                                                                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                   | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Liabilities and stockholders’ equity (deficiency)                                                                                       |       |                  |       |   |   |
| Current liabilities:                                                                                                                         |       |                  |       |   |   |
| Accounts payable                                                                                                                             |       | $                     | 487        |   | $ | 1,539 |   |
| Accrued expenses                                                                                                                             |       | 434                   |       | 1,885 |   |
| Accrued interest payable                                                                                                                     |       | 6,918                 |       | 3,352 |   |
| Deferred revenue                                                                                                                             |       | 379                   |       | 230 |   |
| Income taxes payable                                                                                                                         |       | 803                   |       | 200 |   |
| Liquidated damages payable under  registration rights agreements, net of payments                                                            |       | 1,972                 |       | 2,382 |   |
| Warrant liability                                                                                                                            |       | 35                    |       | 164 |   |
| Derivative liability                                                                                                                         |       | 11                    |       | 313 |   |
| Senior secured notes payable, net of  discount of $177 and $651 at December 31, 2008 and 2007, respectively  (in default)               |       | 12,817                |       | 12,656 |   |
| Subordinated convertible notes payable, net  of discount of $1,261 and $3,892 at December 31, 2008 and 2007,  respectively (in default) |       | 26,397                |       | 23,766 |   |
| Total current liabilities                                                                                                                    |       | 50,253                |       | 46,487 |   |
|                                                                                                                                         |       |                  |       |   |   |
| Long-term liabilities:                                                                                                                       |       |                  |       |   |   |
| Deferred rent                                                                                                                                |       | 159                   |       | 186 |   |
| Financing agreements                                                                                                                         |       | —                |       | 19 |   |
| Total long-term liabilities                                                                                                                  |       | 159                   |       | 205 |   |
|                                                                                                                                         |       |                  |       |   |   |
| Commitments and contingencies                                                                                                                |       |                  |       |   |   |
|                                                                                                                                         |       |                  |       |   |   |
| Stockholders’ equity (deficiency):                                                                                                      |       |                  |       |   |   |
| Common stock, $0.01 par value - Authorized  - 60,000,000 shares                                                                              |       |                  |       |   |   |
| Issued and outstanding - 10,344,666 shares  and 10,338,896 shares at December 31, 2008 and 2007, respectively                           |       | 103                   |       | 103 |   |
| Additional paid-in-capital                                                                                                                   |       | 236,398               |       | 235,407 |   |
| Accumulated deficit                                                                                                                          |       | (279,424              | )          | (231,468 | ) |
| Total stockholders’ equity (deficiency)                                                                                                 |       | (42,923               | )     | 4,042 |   |
|                                                                                                                                         |       | $                     | 7,489      |   | $ | 50,734 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Operations

(amounts in thousands, except for share data)

 
| ** **                                                                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| Net revenue:                                                                                                                               |       |                                        |       |   |   |
| E-commerce                                                                                                                                 |       | $                                           | 336        |   | $ | 1,497 |   |
| Media                                                                                                                                      |       | 3,995                                       |       | 7,500 |   |
| Anti-piracy and file-sharing marketing  services                                                                                           |       | 7,810                                       |       | 15,174 |   |
| Total net revenue                                                                                                                          |       | 12,141                                      |       | 24,171 |   |
|                                                                                                                                       |       |                                        |       |   |   |
| Cost of revenue:                                                                                                                           |       |                                        |       |   |   |
| E-commerce                                                                                                                                 |       | 320                                         |       | 1,531 |   |
| Media                                                                                                                                      |       | 2,606                                       |       | 3,688 |   |
| Anti-piracy and file-sharing marketing  services                                                                                           |       | 7,429                                       |       | 9,414 |   |
| Total cost of revenue                                                                                                                      |       | 10,355                                      |       | 14,633 |   |
| Gross profit                                                                                                                               |       | 1,786                                       |       | 9,538 |   |
|                                                                                                                                       |       |                                        |       |   |   |
| Operating expenses:                                                                                                                        |       |                                        |       |   |   |
| Sales and marketing                                                                                                                        |       | 1,535                                       |       | 1,993 |   |
| General and administrative, including  stock-based compensation costs of $991 and $2,110 in 2008 and 2007,  respectively                   |       | 7,022                                       |       | 10,867 |   |
| Development and engineering                                                                                                                |       | 437                                         |       | 525 |   |
| Goodwill impairment                                                                                                                        |       | 31,085                                      |       |   |   |
| Write-off of fixed assets                                                                                                                  |       | —                                      |       | 97 |   |
| Total operating costs                                                                                                                      |       | 40,079                                      |       | 13,482 |   |
| Loss from operations                                                                                                                       |       | (38,293                                     | )          | (3,944 | ) |
|                                                                                                                                       |       |                                        |       |   |   |
| Other income (expense):                                                                                                                    |       |                                        |       |   |   |
| Interest income                                                                                                                            |       | 51                                          |       | 211 |   |
| Interest expense                                                                                                                           |       | (8,740                                      | )          | (7,923 | ) |
| Loss on foreign currency transactions                                                                                                      |       | (65                                         | )          | (14 | ) |
| Other income                                                                                                                               |       | 340                                         |       | — |   |
| Liquidated damages under registration  rights agreements                                                                                   |       | —                                      |       | 395 |   |
| Change in fair value of warrant liability                                                                                                  |       | 130                                         |       | 4,551 |   |
| Change in fair value of derivative  liability                                                                                              |       | 302                                         |       | 18,043 |   |
| Amortization of deferred financing costs                                                                                                   |       | (842                                        | )          | (841 | ) |
| Write-off of unamortized discount on debt  and deferred financing costs resulting from principal payments on senior  secured notes payable |       | (25                                         | )     | — |   |
| Income (loss) before income taxes                                                                                                          |       | (47,142                                     | )          | 10,478 |   |
| Provision (benefit) for income tax                                                                                                         |       | 814                                         |       | (1,039 | ) |
| Net income (loss)                                                                                                                          |       | $                                           | (47,956    | ) | $ | 11,517 |   |
|                                                                                                                                       |       |                                        |       |   |   |
| Net income (loss) per common share:                                                                                                        |       |                                        |       |   |   |
| Basic                                                                                                                                      |       | $                                           | (4.64      | )  | $ | 0.41 |   |
| Diluted                                                                                                                                    |       | $                                           | (4.64      | ) | $ | (0.23 | ) |
|                                                                                                                                       |       |                                        |       |   |   |
| Weighted average common shares outstanding:                                                                                                |       |                                        |       |   |   |
| Basic                                                                                                                                      |       | 10,344,666                                  |       | 28,100,179 |   |
| Diluted                                                                                                                                    |       | 10,344,666                                  |       | 29,669,682 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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ARTISTdirect, Inc. andSubsidiaries

Consolidated Statement ofStockholders’ Equity (Deficiency)

(amounts in thousands, except for share data)

 
| ** **                                          | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                          | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit**                   | ** ** | **Equity (Deficiency)** | ** ** |
|                                                |       |                  |       |                    |       |            |       |                          |       |   |   |
| Balance at January 1, 2007                          |       | 10,188,445            |       | $                       | 102        |            | $          | 233,197                       |       | $ | (242,985 | ) | $ | (9,686 | ) |
| Fair value of stock options                         |       | —                |       | —                  |       | 2,035           |       | —                        |       | 2,035 |   |
| Common stock issued for consulting services         |       | 23,076                |       | —                  |       | 75              |       | —                        |       | 75 |   |
| Common stock issued upon exercise of stock  options |       | 127,375               |       | 1                       |       | 100             |       | —                        |       | 101 |   |
| Net income                                          |       | —                |       | —                  |       | —          |       | 11,517                        |       | 11,517 |   |
| Balance at December 31, 2007                        |       | 10,338,896            |       |                    | 103        |            |       | 235,407                       |       |   | (231,468 | ) |   | 4,042 |   |
| Fair value of stock options                         |       | —                |       | —                  |       | 972             |       | —                        |       | 972 |   |
| Common stock issued for consulting services         |       | 5,770                 |       | —                  |       | 19              |       | —                        |       | 19 |   |
| Net loss                                            |       | —                |       | —                  |       | —          |       | (47,956                       | )          | (47,956 | ) |
| Balance at December 31, 2008                   |       | 10,344,666            |       | $                       | 103        |            | $          | 236,398                       |       | $ | (279,424 | ) | $ | (42,923 | ) |

 

Seeaccompanying notes to consolidated financial statements.

 

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(amounts in thousands)

 
| ** **                                                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                                                                               |       | **2008**                                    |       | **2007** |   |
| Cash flows from operating activities:                                                                                              |       |                                        |       |   |   |
| Net income (loss)                                                                                                                  |       | $                                           | (47,956    | )  | $ | 11,517 |   |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities:                                              |       |                                        |       |   |   |
| Depreciation and amortization                                                                                                      |       | 7,016                                       |       | 8,539 |   |
| Other Income                                                                                                                       |       |                                        |       |   |   |
| Write-off of accruals                                                                                                              |       | (340                                        | )          | — |   |
| Write-off of unamortized discount on debt  and deferred financing costs resulting from principal payments on senior  secured notes |       | 25                                          |       | — |   |
| Provision for doubtful accounts                                                                                                    |       | (153                                        | )     | 203 |   |
| Stock-based compensation                                                                                                           |       | 991                                         |       | 2,110 |   |
| Goodwill impairment                                                                                                                |       | 31,085                                      |       | — |   |
| Deferred income taxes                                                                                                              |       | —                                      |       | (264 | ) |
| Change in fair value of warrant liability                                                                                          |       | (130                                        | )          | (4,551 | ) |
| Change in fair value of derivative  liability                                                                                      |       | (302                                        | )          | (18,043 | ) |
| Changes in liquidated damages payable under  registration rights agreements                                                        |       | —                                      |       | (395 | ) |
| Write-off of fixed assets                                                                                                          |       | —                                      |       | 97 |   |
| Sub-total                                                                                                                          |       | (9,764                                      | )          | (787 | ) |
| Changes in operating assets and  liabilities:                                                                                      |       |                                        |       |   |   |
| (Increase) decrease in -                                                                                                           |       |                                        |       |   |   |
| Accounts receivable                                                                                                                |       | 5,779                                       |       | (1,443 | ) |
| Finished goods inventory                                                                                                           |       | —                                      |       | 281 |   |
| Prepaid expenses and other current assets                                                                                          |       | 35                                          |       | (1,147 | ) |
| Income taxes refundable                                                                                                            |       | 525                                         |       | (147 | ) |
| Deposits and other assets                                                                                                          |       | 20                                          |       | 1 |   |
| Increase (decrease) in -                                                                                                           |       |                                        |       |   |   |
| Accounts payable                                                                                                                   |       | (1,052                                      | )          | (293 | ) |
| Accrued expenses                                                                                                                   |       | (1,110                                      | )     | 363 |   |
| Accrued interest payable                                                                                                           |       | 3,566                                       |       | 3,285 |   |
| Deferred revenue                                                                                                                   |       | 149                                         |       | 191 |   |
| Deferred rent                                                                                                                      |       | (27                                         | )          | (13 | ) |
| Financing agreements                                                                                                               |       | (19                                         | )          | (34 | ) |
| Income taxes payable                                                                                                               |       | 604                                         |       | (295 | ) |
| Liquidated damages payable under  registration rights agreements                                                                   |       | (410                                        | )          | (1,000 | ) |
| Net cash used in operating activities                                                                                              |       | (1,704                                      | )          | (1,038 | ) |
|                                                                                                                               |       |                                        |       |   |   |
| Cash flows from investing activities:                                                                                              |       |                                        |       |   |   |
| Purchases of property and equipment                                                                                                |       | (269                                        | )          | (481 | ) |
| Net cash used in investing activities                                                                                              |       | (269                                        | )          | (481 | ) |
|                                                                                                                               |       |                                        |       |   |   |
| Cash flows from financing activities:                                                                                              |       |                                        |       |   |   |
| Proceeds from exercise of stock options                                                                                            |       | —                                      |       | 101 |   |
| Principal payments on senior secured notes  payable                                                                                |       | (313                                        | )     | — |   |
| Decrease in restricted cash                                                                                                        |       | 12                                          |       | 84 |   |
| Net cash provided by used in financing  activities                                                                                 |       | (301                                        | )     | 185 |   |
|                                                                                                                               |       |                                        |       |   |   |
| Cash and cash equivalents:                                                                                                         |       |                                        |       |   |   |
| Net decrease                                                                                                                       |       | (2,274                                      | )          | (1,334 | ) |
| Balance at beginning of year                                                                                                       |       | 4,268                                       |       | 5,602 |   |
| Balance at end of year                                                                                                             |       | $                                           | 1,994      |   | $ | 4,268 |   |
|                                                                                                                               |       |                                        |       |   |   |
| Supplemental  disclosure of cash flow information:                                                                                 |       |                                        |       |   |   |
| Cash paid for -                                                                                                                    |       |                                        |       |   |   |
| Interest                                                                                                                           |       | $                                           | 1,995      |   | $ | 1,527 |   |
| Income taxes                                                                                                                       |       | $                                           | 5          |   | $ | 678 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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ARTISTDIRECT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2008 AND 2007

 

1.  BASIS OF PRESENTATION

 

Organizationand Business Activities

 

ARTISTdirect, Inc.,a Delaware corporation, is a digital media entertainment company that is hometo an online music network and, through its MediaDefender subsidiary, is aleading provider of anti-piracy solutions in the Internet-piracy-protection(“IPP”) industry.  The ARTISTdirectNetwork (www.artistdirect.com) is a network of websites appealing to musicfans, artists and marketing partners that offers multi-media content, musicnews and information, communities organized around shared music interests,music-related specialty commerce and digital music services.  The Company is headquartered in Santa Monica,California.  Unless the context indicatesotherwise, ARTISTdirect, Inc. and its subsidiaries are referred to hereinas the “Company”.

 

Principles ofConsolidation

 

Theaccompanying financial statements include the consolidated accounts of theCompany and its subsidiaries in which it has controlling financialinterests.  All intercompany accounts andtransactions have been eliminated for all periods presented.

 

Going Concern (See“Note 18 Subsequent Events”)

 

As a result of communications with the Staff of the Securities andExchange Commission in 2006, in particular regarding the application ofaccounting rules and interpretations related to embedded derivativesassociated with the Company’s subordinated convertible notes payable issued in July 2005,the Company determined that it was necessary to restate previously issuedfinancial statements. As a result, in December 2006, the Company wasrequired to suspend the use of its then effective registration statement forthe holders of its senior and subordinated indebtedness.  In addition to this initial default, theCompany has since experienced other events of default which continued to be ineffect as of December 31, 2008.

 

As a result of the registration failure, the failure to pay theregistration delay penalties and the various financial covenants and otherbreaches of the terms of the Senior Financing and the Sub-Debt Financing, multipleevents of default exist under the Senior Financing and the Sub-DebtFinancing.  The terms of theSubordination Agreement among the Company and the creditor parties thereto (the“Subordination Agreement”) prevent the Company from making any cash payments tothe Sub-Debt Note holders until the events of default under the SeniorFinancing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of atleast 25% of the outstanding senior indebtedness may declare the outstandingprincipal and accrued interest on all senior notes immediately due and payableupon written notice to the Company, and each holder of outstanding subordinatedindebtedness may only demand redemption of all or any portion of theirrespective notes under certain circumstances as described in the SubordinationAgreement. The Company did not have the capital resources necessary to cure theexisting events of default, or to repay any accelerated indebtedness orredemption or penalty amounts.

 

As of December 31, 2008, approximately $12,994,000 principalamount was outstanding with respect to the Senior Financing, and approximately$27,658,000 principal amount was outstanding with respect to the Sub-DebtFinancing.  In addition, at December 31, 2008, approximately$2,415,000 was outstanding with respect to accrued registration delay liabilityto the holders of the Sub-Debt Financing and approximately $6,475,000 wasoutstanding with respect to accrued interest payable to the holders of theSenior Financing and the Sub-Debt Financing.  The Senior Notes and the Subordinated Notes wouldhave been due in June and July 2009, respectively.

 

As more fully described in Note 18, the SeniorFinancing and Sub-Debt Financing have been restructured.  In accordance with the restructuring, theCompany paid $3,500,000 to the Senior Note Holders, issued new subordinatednotes in the aggregate principal amount of $1,000,000 to the Senior NoteHolders, issued 9,000,000 restricted shares of the Company's common stock tothe Senior Note Holders, which are subject to a lock-up period of 12 months,and converted the Sub-Debt to common stock. In order to obtain the necessary funds to accomplish the restructuring,and to fund future operations, the Company obtained financing by factoring itsaccounts receivable.

 

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As a result of the successful debtrestructuring, the Company anticipates that it will have sufficient access toworking capital from operations and the factoring of accounts receivable.  However, because of the Companys’ decliningrevenues, negative working capital, net loss, and uncertainties related toimproving its operating results under current economic conditions, ourindependent auditors, in their report on the Companys’ financial statements forthe year ended December 31, 2008 expressed substantial doubt about theCompanys’ ability to continue as a going concern.  The accompanying consolidated financialstatements have been prepared in conformity with accounting principlesgenerally accepted in the United States of America, which contemplatecontinuation of the Company as a going concern. The consolidated financial statements do not include any adjustmentsthat might result from the outcome of this uncertainty.

 

2.  SIGNIFICANT ACCOUNTINGPOLICIES

 

CashEquivalents

 

Cashequivalents consist of investments, which are readily convertible into cash andhave maturities of three months or less at the time of purchase.

 

RestrictedCash

 

As of December 31,2008 and 2007, restricted cash consisted of a bank certificate of deposit withbalances of $178,000 and $190,000, respectively, securing a bank letter ofcredit provided as security for charge-backs to the Company’s e-commerce creditcard processor.  In addition, at December 31,2008 and 2007, the Company had classified $90,000 as restricted cash as suchcash was pledged to secure an irrevocable bank stand-by letter of credit for thesame amount issued in conjunction with the Company’s office lease whichcommenced in February 2006 (see Note 16).

 

AccountsReceivable

 

The Companygrants credit to its customers generally in the form of short-term tradeaccounts receivable.  Accounts receivableare stated at the amount that management expects to collect from outstandingbalances.  When appropriate, managementprovides for probable uncollectible amounts through a provision for doubtfulaccounts and an adjustment to a valuation allowance.  Management primarily determines the allowancebased on the aging of accounts receivable balances, historical write-offexperience, customer concentrations, customer creditworthiness and currentindustry and economic trends.  Balancesthat are still outstanding after management has used reasonable collectionefforts are written off through a charge to the valuation allowance and acredit to accounts receivable. (See Note 18)

 

Property andEquipment

 

Expenditures for major renewal and betterments that extend the usefullives of property and equipment are capitalized.  Expenditures for maintenance and repairs arecharged to expense as incurred.  Whenproperty and equipment is sold or otherwise disposed of, the assets and relatedaccumulated depreciation accounts are relieved, and any gain or loss isincluded in operations.

 

Depreciation is computed on the straight-line method based on theestimated useful lives of the assets, which is generally three years forcomputer equipment and software and seven years for furniture andfixtures.  Leasehold improvements areamortized over the remaining life of the related lease, which has beendetermined to be shorter than the life of the asset.

 

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Goodwill, IntangibleAssets and Long-Lived Assets

 

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

 

SFAS No. 142 also requires goodwillto be tested for impairment at least on an annual basis and more often undercertain circumstances, and written down when impaired.  An interim impairment test is required if anevent occurs or conditions change that would more likely than not reduce thefair value of the reporting unit below the carrying value.  The Company accounts for the impairment oflong-lived assets, such as property and equipment and intangible assets, underthe provisions of Statement of Financial Accounting Standards No. 144,“Accounting for the Impairment of Long-Lived Assets” (“SFAS No. 144”).  SFAS No. 144 establishes the accountingfor impairment of long-lived tangible and intangible assets other than goodwilland for the disposal of a business. Pursuant to SFAS No. 144, the Company periodically evaluates, atleast annually, whether facts or circumstances indicate that the carrying valueof its depreciable assets to be held and used may not be recoverable.  If such circumstances are determined toexist, an estimate of undiscounted future cash flows produced by the long-livedasset, or the appropriate grouping of assets, is compared to the carrying valueto determine whether impairment exists. In the event that the carrying amount of long-lived assets exceeds theundiscounted future cash flows, then the carrying amount of such assets isadjusted to their fair value.  TheCompany reports an impairment cost as a charge to operations at the time it isrecognized.

 

Goodwill at December 31, 2008 was $0 as compared to $31,085,000 atDecember 31, 2007, which was recorded in conjunction with the acquisition ofMediaDefender in July 2005 (see Note 3).  In accordance with SFAS No. 142,“Goodwill and Other Intangible Assets”, an intangible asset that is not subjectto amortization such as goodwill shall be tested for impairment at least on anannual basis, and more often under certain circumstances, and written down whenimpaired.  An interim impairment test is required if an event occurs orconditions change that would more likely than not reduce the fair value of thereporting unit below its carrying value. The first step of the impairment test consists of a comparison of thetotal fair value of each reporting unit to the reporting unit’s net assets onthe date of the test.  If the fair value is in excess of the net assets,there is no indication of impairment and thus no need to perform thesecond step of the impairment test.

 

During the year ended December 31, 2008, the Company recorded anon-cash charge to operations aggregating $31,085,000 with respect to theimpairment of the goodwill recognized in conjunction with the acquisition ofMediaDefender in July 2005.  This chargeto operations was based on various factors and developments occurring in 2008,including continuing erosion in the demand for MediaDefender’s core Internetanti-piracy services within the entertainment industry, the unexpectednon-renewal by MediaDefender’s largest customer in mid-2008, continuingdeterioration of operating margins and valuation metrics, and the inability toimplement new advertising initiatives on a large-scale basis.

 

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DerivativeFinancial Instruments

 

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

 

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

 

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

 

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

 

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

 

Deferred Financing Costs

 

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

 

Discount on Debt

 

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

 

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RevenueRecognition

 

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

 

E-commercerevenue consists primarily of the gross amount of sales revenue paid by thecustomer for recorded music and merchandise sold via the Internet, includingshipping fees, and is recognized when the products are shipped. The Company hasa contract with a fulfillment house to service its music-related e-commerceactivity. The Company records e-commerce revenue on a gross basis as theCompany enters into the sale transactions with customers, establishes theprices of the products, chooses the suppliers of the products, assumes the riskof inventory loss and collects all amounts from the customers and assumes thecredit risk.  In certain circumstances,e-commerce revenue is subject to royalties, and such expense is recorded aspart of cost of e-commerce revenue.

 

The Companyrecords amounts charged to customers for shipping and handling in accordancewith EITF 00-10, “Accounting for Shipping and Handling Fees and Costs”(“EITF 00-10”).  Pursuant toEITF 00-10, the Company records amounts charged to customers for shippingand handling as revenue, and records the related costs incurred for shippingand handling to direct cost of product sales in the statement ofoperations.  For the years endedDecember 31, 2008 and 2007, the Company recorded $63,000 and $236,000,respectively, as revenue for shipping and handling fees charged to customers.For the years ended December 31, 2007 and 2006, the Company recorded$48,000 and $253,000, respectively, of shipping and handling costs as directcost of product sales in the statements of operations.

 

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

 

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

 

Anti-piracy and file sharing marketing services revenue is recognizedon a monthly basis as services are provided to customers.  Deferred revenue is recorded for customerswho prepay the full, or any portion, of their respective contracts.

 

Cost of Revenue

 

Cost ofproduct sales consists of amounts payable related to e-commerce sales, whichincludes the cost of merchandise sold and royalties, and online commercetransaction costs, including credit card fees, fulfillment charges and shippingcosts.  Distribution expenses consist ofvarious distribution costs, including the cost of processing returns and warehousinginventory.  The Company has a contractwith a fulfillment house to service its music-related e-commerce activity.

 

Media cost ofrevenue consists primarily of web-site hosting and maintenance costs, onlinecontent programming costs, online advertising serving costs, sales commissions,payments to affiliated websites, and payroll and related expenses for staffinvolved with the web-site.  Costsrelated to the web-site are charged to operations as incurred.  Anti-piracy and file sharing marketing servicescost of revenue consists primarily of bandwidth, labor and occupancycosts.  Amortization of proprietarytechnology is included in anti-piracy and file sharing marketing services costof revenue.

 

Depreciationexpense is included in the related cost of revenue category.

 

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Inventories

 

As a result ofthe Companyrestructuring its relationship with a merchandising entity effective August 31,2007 to eliminate merchandise sales (and the related inventory) and focus onmusic sales, the Company does not currently carry any inventory.

 

Income Taxes

 

The Companyaccounts for income taxes under Statement of Financial Accounting Standards No. 109,“Accounting for Income Taxes” (“SFAS No. 109”).  SFAS No. 109 requires recognition ofdeferred tax assets and liabilities for the expected future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled.  The effect on deferred taxassets and liabilities of a change in tax rates is recognized in the statementof operations in the period that includes the enactment date.  A valuation allowance is established, whennecessary, to reduce deferred tax assets to the amount expected to be realized.

 

Developmentand Engineering Costs

 

Developmentand engineering costs consist primarily of third-party development costs andpayroll and related expenses for in-house development costs incurred in thedesign and production of the Company’s content and services, includingrevisions to the Company’s web-site. These costs are charged to operations as incurred.

 

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Concentrationof Risk

 

Financialinstruments that potentially subject the Company to significant concentrationsof credit risk consist principally of cash, short-term investments and tradeaccounts receivable.  The Company placesits cash and short-term investments in high credit quality instruments.  Cash balances at certain financialinstitutions may exceed the FDIC insurance limits.  The Company performs ongoing creditevaluations of its customers but does not require collateral.  Exposure to losses on receivables isprincipally dependent on each customer’s financial condition.  The Company monitors its exposure to credit lossesand maintains appropriate allowances for anticipated losses.

 

Concentrationsof credit risk with respect to trade receivables generated by the Company’soperations are generally limited. However, MediaDefender’s customers consist primarily of large reputablecompanies in the music and entertainment industries.

 

During the year endedDecember 31, 2008, one customer accounted for accounted for $589,000 or 14.7%of media revenues.  During theyear ended December 31, 2007, one customer accounted for $1,270,000 or 16%of total media revenue, of which $423,000 was due from this customer at December 31,2007.

 

The Company’smedia revenues were generated primarily by two outside sales organizations thatrepresented the Company with respect to advertising and sponsorship sales onthe Company’s web-site and through affiliated websites, as well as by in-housesales personnel.

 

During the year ended December 31, 2008, approximately 65% ofMediaDefender’s revenues were from three customers, with one customeraccounting for 32%, another customer accounting for 21% and a third customeraccounting for 12%.  At December 31,2008, the amounts due from such customers were $395,774, $214,275 and $162,737,respectively, which were included in accounts receivable.  In January 2008, MediaDefender wasnotified by a customer accounting for 12% of 2007 revenue, that they werediscontinuing service and were evaluating the use of other methods to offsetthe negative impact of piracy.  In June2008, the Company was advised by one of MediaDefender’s larger customers, whichrepresented approximately 18% of MediaDefender’s revenues for the year endedDecember 31, 2007, that it intended to substantially curtail its use ofMediaDefender’s anti-piracy services subsequent to the expiration of itscurrent contract with MediaDefender on June 30, 2008.

 

During the year ended December 31, 2007, approximately 38% ofMediaDefender’s revenues were from two customers, with one customer accountingfor 21% and another customer accounting for 17%.  At December 31, 2007, the amounts duefrom such customers were $1,872,000 and $677,000, respectively, which were includedin accounts receivable.  In November 2007,a record label customer, which accounted for 4% of MediaDefenders’ 2007revenue, also discontinued service citing costs pressures subsequent to achange in ownership.

 

During the year ended December 31, 2008, MediaDefender purchasedapproximately 94% of its bandwidth from four suppliers.  At December 31, 2008, amounts payable toof these suppliers aggregated $161,000. During the year ended December 31, 2007, MediaDefender purchasedapproximately 55% of its bandwidth from three suppliers.  At December 31, 2007, amounts payable totwo of these suppliers aggregated $124,000. Although there are other suppliers of bandwidth, a change in supplierscould cause delays, which could adversely affect operations in the short-term

 

Foreign CurrencyTransactions

 

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

 

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Fair Value of FinancialInstruments

 

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

 

Earnings Per Share

 

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

 

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

 

Under the two-classmethod, basic income (loss) per common share is computed by dividing net income(loss) applicable to common stockholders by the weighted-average number ofcommon shares outstanding for the reporting period.  Diluted income (loss) per common share iscomputed using the more dilutive of the “two-class” method or the“if-converted” method.  Net losses arenot allocable to the holders of the subordinated convertible notespayable.  Diluted income (loss) per sharegives effect to all potentially dilutive securities, including stock options,senior and sub-debt warrants, and convertible subordinated notes payable,unless they are anti-dilutive.

 

The calculation ofdiluted weighted average common shares outstanding for the years ended December 31,2008 and 2007 is based on the average of the closing price of the Company’scommon stock during each respective period.

 

The calculation ofdiluted loss per share for the year ended December 31, 2008 excluded theeffect from the conversion of subordinated convertible notes payable and theexercise of stock options and senior and sub-debt warrants aggregatingapproximately 25,785,830 shares of common stock, respectively, since theireffect would have been anti-dilutive.

 

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

 

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

 

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The calculation of earnings per share is summarized as follows:

 
| ** **                                                                                                             | ** ** | **Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                                                                                             | ** ** | **2008**                                    | ** **  | **2007** | ** ** |
| Numerator:                                                                                                             |       |                                        |        |   |   |
| Net income (loss), as reported                                                                                         |       | $                                           | (47,956,000 | )  | $ | 11,517,000 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Allocation of net (loss) income:                                                                                       |       |                                        |        |   |   |
| Basic:                                                                                                                 | ** ** | ** **                                  | ** **  | ** ** | ** ** |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) applicable to common  stockholders                                                                   |       | $                                           | (47,956,000 | )  | $ | 4,204,000 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) applicable to convertible  subordinated notes                                                        |       | —                                      |        | 7,313,000 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss)                                                                                                      |       | $                                           | (47,956,000 | )  | $ | 11,517,000 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Diluted:                                                                                                               | ** ** | ** **                                  | ** **  | ** ** | ** ** |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) applicable to common  stockholders                                                                   |       | $                                           | (47,956,000 | )  | $ | (2,710,000 | ) |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) applicable to convertible  subordinated notes                                                        |       | —                                      |        | (4,090,000 | ) |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss)                                                                                                      |       | $                                           | (47,956,000 | )  | $ | (6,800,000 | ) |
|                                                                                                                   | ** ** | ** **                                  | ** **  | ** ** | ** ** |
| Denominator:                                                                                                           | ** ** | ** **                                  | ** **  | ** ** | ** ** |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares outstanding                                                                             |       | 10,344,666                                  |        | 10,256,127 |   |
| Weighted average common shares attributable  to subordinated notes                                                     |       | —                                      |        | 17,844,052 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares used in  calculating basic net income (loss) per common share                           |       | 10,344,666                                  |        | 28,100,179 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares issuable  upon exercise of outstanding stock options based on the treasury stock method |       | —                                      |        | 964,767 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares issuable  upon exercise of sub- debt warrants, based on the treasury stock method       |       | —                                      |        | 604,735 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares used in  computing diluted net income (loss) per common share                           |       | 10,344,666                                  |        | 29,669,682 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Calculation of net income (loss) per common  share:                                                                    |       |                                        |        |   |   |
|                                                                                                                   |       |                                        |        |   |   |
| Basic:                                                                                                                 |       |                                        |        |   |   |
| Net income (loss) applicable to common  stockholders                                                                   |       | $                                           | (47,956,000 | )  | $ | 11,517,000 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares used in  calculating basic net income (loss) per common share                           |       | 10,344,666                                  |        | 28,100,179 |   |
| Net income (loss) per share applicable to  common stockholders                                                         |       | $                                           | (4.64       | )  | $ | 0.41 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Diluted:                                                                                                               |       |                                        |        |   |   |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) applicable to common  stockholders                                                                   |       | $                                           | (47,956,000 | )  | $ | (6,800,000 | ) |
|                                                                                                                   |       |                                        |        |   |   |
| Weighted average common shares used in  calculating diluted net income (loss) per common share                         |       | 10,344,666                                  |        | 29,669,682 |   |
|                                                                                                                   |       |                                        |        |   |   |
| Net income (loss) per common share applicable  to common stockholders                                                  |       | $                                           | (4.64       | ) | $ | (0.23 | ) |

 

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Stock-BasedCompensation

 

EffectiveJanuary 1, 2006, the Company adopted Statement of Financial AccountingStandards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”),a revision to SFAS No. 123, “Accounting for Stock-BasedCompensation”.  SFAS No. 123Rrequires that the Company measure the cost of employee services received inexchange for equity awards based on the grant date fair value of the awards,with the cost to be recognized as compensation expense in the Company’sfinancial statements over the vesting period of the awards.  Accordingly, the Company recognizescompensation cost for equity-based compensation for all new or modified grantsissued after December 31, 2005.  Inaddition, commencing January 1, 2006, the Company recognized the unvestedportion of the grant date fair value of awards issued prior to adoption of SFASNo. 123R based on the fair values previously calculated for disclosurepurposes over the remaining vesting period of the outstanding stock options andwarrants.

 

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

 

Duringthe years ended December 31, 2008 and 2007, the Company recorded $883,000and $1,677,000, respectively, as a charge to operations to recognize theunvested portion of the grant date fair value of awards issued prior to theadoption of SFAS No. 123R.

 

AtDecember 31, 2008, the unvested portion of the grant date fair value ofawards issued prior to adoption of SFAS No. 123R on January 1, 2006,based on the fair values previously calculated, the amount which will be chargedto operations in 2009 is $26,000.

 

For the past several years and in accordance with established publiccompany accounting practice, the Company has consistently utilized theBlack-Scholes option-pricing model to calculate the fair value of stock optionsand warrants issued as compensation, primarily to management, employees anddirectors.  The Black-Scholesoption-pricing model is a widely-accepted method of valuation that publiccompanies typically utilize to calculate the fair value of options and warrantsthat they issue in such circumstances.

 

In calculatingthe Black-Scholes value of stock options and warrants issued, the Company usesthe full term of the option, an appropriate risk-free interest rate (generallyfrom 4% to 5%), and a 0% dividend yield.

 

The Companyutilizes the daily closing stock prices of its common stock as quoted on theOTC Bulletin Board to calculate the expected volatility used in theBlack-Scholes option-pricing model.  Byutilizing daily trading data related to the period of time that reflects theCompany’s current business operations, the Company believes that thismethodology generates volatility factors that more accurately reflect, as wellas adjust for, normal market fluctuations in the Company’s common stock over anextended period of time.  Thismethodology has generated volatility factors ranging from approximately 156% to269% during 2007 and 2008.  Thesevolatility factors reflected sporadic trading, relative uncertainty as itrelated to the Company’s ability to restructure its debt and a general economicdeterioration in the stock market during the latter half of 2008.  These volatility factors have generallytrended upward during 2007 and 2008.  Asthere were no stock-based compensation issued during 2008, a Black-Scholescalculation was not necessary during 2008.

 

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Estimates

 

In preparingfinancial statements in conformity with generally accepted accountingprinciples, management is required to make estimates and assumptions thataffect the reported amounts of assets and liabilities and the disclosure ofcontingent assets and liabilities at the date of the financial statements andrevenues and expenses during the reporting period.  Some of the more significant estimates includeallowances for bad debts and sales returns, impairment of long-lived assets,impairment of fixed assets, stock-based compensation, the valuation allowanceon deferred tax assets, and the change in fair value of the warrant liabilityand derivative liability.  Actual resultscould differ from those estimates.

 

Adoption of New Accounting Policies

 

Effective January 1,2007, the Company adopted FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes” (“FIN 48”). FIN 48 addresses the determination of whether tax benefits claimed orexpected to be claimed on a tax return should be recorded in the financialstatements.  Under FIN 48, the Companymay recognize the tax benefit from an uncertain tax position only if it is morelikely than not that the tax position will be sustained on examination by thetaxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financialstatements from such a position should be measured based on the largest benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement.  FIN 48 alsoprovides guidance on de-recognition, classification, interest and penalties onincome taxes, accounting in interim periods and requires increaseddisclosures.  The adoption of theprovisions of FIN 48 did not have a material effect on the Company’s financialstatements.  As of December 31, 2008,no liability for unrecognized tax benefits was required to be recorded.

 

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

 

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Recent Accounting Pronouncements

 

In February 2007, the FASB issued Statement of FinancialAccounting Standards No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities” (“SFAS No. 159”), which provides companies withan option to report selected financial assets and liabilities at fair value.SFAS No. 159’s objective is to reduce both complexity in accounting forfinancial instruments and the volatility in earnings caused by measuringrelated assets and liabilities differently. Generally accepted accountprinciples have required different measurement attributes for different assetsand liabilities that can create artificial volatility in earnings. SFAS No. 159helps to mitigate this type of accounting-induced volatility by enablingcompanies to report related assets and liabilities at fair value, which wouldlikely reduce the need for companies to comply with detailed rules forhedge accounting. SFAS No. 159 also establishes presentation anddisclosure requirements designed to facilitate comparisons between companiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 requires companies to provide additionalinformation that will help investors and other users of financial statements tomore easily understand the effect of the company’s choice to use fair value onits earnings. SFAS No. 159 also requires companies to display the fair valueof those assets and liabilities for which the company has chosen to use fairvalue on the face of the balance sheet. SFAS No. 159 does not eliminatedisclosure requirements included in other accounting standards, includingrequirements for disclosures about fair value measurements included in SFAS No. 157and SFAS No. 107. SFAS No. 159 is effective as of the beginningof a company’s first fiscal year beginning after November 15, 2007.

 

In December 2007, the FASB issuedSFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”),which requires an acquirer to recognize in its financial statements as ofthe acquisition date (i) the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree, measured at their fairvalues on the acquisition date, and (ii) goodwill as the excess of theconsideration transferred plus the fair value of any noncontrolling interest inthe acquiree at the acquisition date over the fair values of the identifiablenet assets acquired.  Acquisition-relatedcosts, which are the costs an acquirer incurs to effect a business combination,will be accounted for as expenses in the periods in which the costs areincurred and the services are received, except that costs to issue debt orequity securities will be recognized in accordance with other applicable GAAP.SFAS No. 141(R) makes significant amendments to other Statements andother authoritative guidance to provide additional guidance or to conform theguidance in that literature to that provided in SFAS No. 141(R).  SFAS No. 141(R) also providesguidance as to what information is to be disclosed to enable users of financialstatements to evaluate the nature and financial effects of a businesscombination.  SFAS No. 141(R) iseffective for financial statements issued for fiscal years beginning on orafter December 15, 2008, and early adoption is prohibited.

 

In December 2007, the FASBissued SFAS No. 160, “Noncontrolling Interests in Consolidated FinancialStatements – an amendment of ARB No. 51” (“SFAS No. 160”), whichrevises the relevance, comparability, and transparency of the financialinformation that a reporting entity provides in its consolidated financialstatements by establishing accounting and reporting standards that require (i) theownership interests in subsidiaries held by parties other than the parent beclearly identified, labeled, and presented in the consolidated statement offinancial position within equity, but separate from the parent’s equity, (ii) theamount of consolidated net income attributable to the parent and to thenoncontrolling interest be clearly identified and presented on the face of theconsolidated statement of income, (iii) changes in a parent’s ownershipinterest while the parent retains its controlling financial interest in itssubsidiary be accounted for consistently as equity transactions, (iv) whena subsidiary is deconsolidated, any retained noncontrolling equity investmentin the former subsidiary be initially measured at fair value, with the gain orloss on the deconsolidation of the subsidiary being measured using the fairvalue of any noncontrolling equity investment rather than the carrying amountof that retained investment, and (v) entities provide sufficientdisclosures that clearly identify and distinguish between the interests of theparent and the interests of the noncontrolling owners. SFAS No. 160 amendsFASB No. 128 to provide that the calculation of earnings per share amountsin the consolidated financial statements will continue to be based on theamounts attributable to the parent. SFAS No. 160 is effective forfinancial statements issued for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. Early adoption isprohibited. SFAS No. 160 shall be applied prospectively as of thebeginning of the fiscal year in which it is initially applied, except for thepresentation and disclosure requirements, which shall be appliedretrospectively for all periods presented. The requirements of SFAS No. 160does not apply to the Company as it is currently structured.

 

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On March 19, 2008—The Financial Accounting Standards Board (FASB)issued FASB Statement No. 161, Disclosures about Derivative Instrumentsand Hedging Activities. The new standard is intended to improve financialreporting about derivative instruments and hedging activities by requiringenhanced disclosures to enable investors to better understand their effects onan entity’s financial position, financial performance, and cash flows. It iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008, with early application encouraged.  The requirements of SFAS No. 160 do not apply to the Company as itis currently structured.

 

InJune 2008, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 07-05,“Determining Whether an Instrument (or Embedded Feature) is Indexed to anEntity’s Own Stock” (“EITF 07-05”). EITF 07-05 mandates a two-step process forevaluating whether an equity-linked financial instrument or embedded feature isindexed to the entity’s own stock. Warrants that a company issues that containa strike price adjustment feature, upon the adoption of EITF 07-05, results inthe instruments no longer being considered indexed to the company’s own stock.Accordingly, adoption of EITF 07-05 will change the current classification(from equity to liability) and the related accounting for such warrantsoutstanding at that date. EITF 07-05 is effective for fiscal years beginningafter December 15, 2008, and interim periods within those fiscal years.The Company does not currently anticipate that the adoption of EITF 07-05 on January 1,2009 will have any impact on its consolidated financial statement presentationor disclosures.

 

3.  ACQUISITION OFMEDIADEFENDER, INC.

 

On July 28,2005, the Company consummated the acquisition of MediaDefender, Inc., aprivately-held Delaware corporation (“MediaDefender”), which is a leadingprovider of anti-piracy solutions in the Internet-piracy-protection (“IPP”)industry.  The stockholders ofMediaDefender received aggregate consideration of $42,500,000 in cash, subjectto certain holdbacks and adjustments described in the Merger Agreement.  In order to fund the acquisition ofMediaDefender, the Company completed a $15,000,000 senior secured debttransaction and a $30,000,000 convertible subordinated debt transaction, asdescribed at Note 4.

 

In accordancewith the Merger Agreement, the Company acknowledged the terms of EmploymentAgreements entered into on July 28, 2005 by MediaDefender with each ofRandy Saaf and Octavio Herrera, confirming the terms of their employment.  Mr. Saaf and Mr. Herrera each earna base salary of no less than $350,000 per annum during the initial term of theagreements, which continue until December 31, 2008, and are also eachentitled to receive performance bonuses of up to $350,000 if MediaDefenderachieves operating earnings before interest, taxes, depreciation andamortization (calculated using the same accounting methods and policies asMediaDefender has historically used) exceeding $7,000,000 and $7,500,000 infiscal 2007 and 2008, respectively.   Nobonuses were earned during fiscal 2007 or 2008.

 

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to each of Mr. Saaf and Mr. Herrera topurchase 200,000 shares of common stock, exercisable for a period of five yearsat $3.00 per share, which was in excess of the fair value of the common stockissued in the MediaDefender transaction. These options vest quarterly over three and one-half years.  The fair value of each of these options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $546,000, which is being recognized as stock-based compensation over thevesting period.

 

The Companyalso acknowledged the terms of Non-Competition Agreements entered into on July 28,2005 by MediaDefender and Mr. Saaf and Mr. Herrera.  The Non-Competition Agreements prohibit Mr. Saafand Mr. Herrera from (i) engaging in certain competitive businessactivities, (ii) soliciting customers of MediaDefender or the Company, (iii) solicitingexisting employees of MediaDefender or the Company and (iv) disclosing anyconfidential information regarding MediaDefender or the Company.  Each agreement has a term of four yearsand shall continue to remain in force and effect in the event theabove-referenced Employment Agreements are terminated prior to the end of thefour-year term of the Non-Competition Agreements.

 

Mr. Saafand Mr. Herrera each invested $2,250,000 in the convertible subordinateddebt transaction entered into to fund the acquisition of MediaDefender on thesame terms and conditions as the other investors in such financing (see Note4).

 

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to Jonathan Diamond, its Chief Executive Officer,to purchase 1,708,098 shares of common stock, exercisable for a period of fiveyears at $1.55 per share, which was in excess of the fair value of the commonstock issued in the MediaDefender transaction. The fair value of the time-vested options, calculated pursuant to theBlack-Scholes option-pricing model, was determined to be $2,936,450, which wasbeing recognized as stock-based compensation over the vesting period.   The terms of the time-vesting options weremodified effective March 6, 2008 and the unrecognized balance was chargedto expense during 2008 (see Note 16).

 

In conjunctionwith the acquisition of MediaDefender, effective July 28, 2005, theCompany granted stock options to Robert Weingarten, its Chief FinancialOfficer, to purchase 275,000 shares of common stock, exercisable for a periodof five years at $1.55 per share, which was in excess of the fair value of thecommon stock issued in the MediaDefender transaction.    The fair value of the time-vested options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $772,750, which was being recognized as stock-based compensation over thevesting period.  The terms of thetime-vesting options were modified effective August 31, 2007 with all thetime based options becoming fully vested as of August 31, 2008 (see Note 16).

 

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Upon the closing ofthe transaction, the Company issued 1,109,032 shares of common stock and aseven-year warrant to purchase 114,985 shares of common stock with an exerciseprice of $1.55 per share to WNT07 Holdings, LLC (“WNT07”).  The managers of WNT07 are Eric Pulier andTeymour Boutros-Ghali, both of whom were at the time of the issuance of theconsideration and were members of the Company’s Board of Directors.  The shares and warrants were issued asconsideration for services provided by Mr. Pulier and Mr. Boutros-Ghalias consultants to the Company with respect to the MediaDefenderacquisition.  The consideration issued toWNT07 was approved by the disinterested members of the Company’s Board ofDirectors.  The shares and warrants wereissued in reliance upon exemptions from registration pursuant to Section 4(2) underthe Securities Act and Rule 506 promulgated thereunder.  The shares of common stock were valued at$1,585,916 ($1.43 per share) and the warrants were valued at $83,939, based ona valuation report prepared by an independent valuation firm.  The aggregate value of $1,669,855 wasallocated $333,971 (20%) to a covenant not to compete (as described below) and$1,335,884 (80%) to the costs that the Company incurred to acquireMediaDefender, based on management’s estimate of the relative values, asconfirmed by the independent valuation firm.

 

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

 

4.  FINANCING TRANSACTIONS WITH RESPECT TOMEDIADEFENDER, INC. ACQUISITION

 

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

 

The Senior Financing wascompleted in accordance with the terms set forth in the Note and WarrantPurchase Agreement entered into on July 28, 2005 by the Company, each ofthe investors indicated on the schedule of buyers attached thereto andU.S. Bank National Association as Collateral Agent (the “Note PurchaseAgreement”).  Pursuant to the terms ofthe Note Purchase Agreement, each investor received a note with a term of threeyears and eleven months that bears interest at the rate of 11.25% perannum (each a “Senior Note”), payable quarterly, with any unpaid principal andaccrued interest due and payable at maturity. Termination and payment of the Senior Notes by the Company prior tomaturity does not result in a prepayment fee. As collateral for the $15,000,000 Senior Financing, the investorsreceived a first priority security interest in all existing and future assetsof the Company and its subsidiaries, tangible and intangible, including, butnot limited to, cash and cash equivalents, accounts receivable, inventories,other current assets, furniture, fixtures and equipment and intellectualproperty.

 

In addition, not later than ninety days after the close of each fiscalyear, the Company is obligated to apply 60% of its excess cash flow, as definedin the Note Purchase Agreement (the “Annual Cash Sweep”), to prepay theprincipal amount of the Senior Notes.  AtDecember 31, 2007, there was $313,000 payable for the 2007 Annual CashSweep, which is included in senior secured notes payable in the balance sheet atDecember 31, 2007 and was paid on March 28, 2008.

 

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

 

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

 

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The Sub-Debt Financing was completed in accordancewith the terms set forth in the Securities Purchase Agreement entered into on July 28,2005 by the Company and each of the investors indicated on the schedule ofbuyers attached thereto (the “Securities Purchase Agreement”).  Pursuant to the terms of the SecuritiesPurchase Agreement, each investor received a convertible subordinated note witha term of four years that bears interest at the rate of 4.0% per annum(each a “Sub-Debt Note”), with any unpaid principal and accrued interest dueand payable at maturity.  The interestrate increases to 12.0% per annum during any period in which the Company is indefault of its obligations under the Sub-Debt Note.  Commencing September 30, 2006, interestis payable quarterly in cash or shares of common stock, at the option of theCompany.  Each Sub-Debt Note had aninitial conversion price of $1.55 per share, was subject to certainanti-dilution, reset and change-of-control provisions and the Sub-Debt Notescontain specific provisions that expressly prohibit the Company from issuingshares to a Sub-Debt Note holder if, after the conversion, such Sub-Debt Noteholder would exceed the respective limit called for in their Sub-Debt Note,either 4.99% or 9.99%, of the Company’s outstanding common shares.  In addition, each Sub-Debt Note is subject tomandatory conversion by the Company in the event certain trading price targetsfor the Company’s common stock are met.

 

On December 16, 2008, ARTISTdirect, Inc. entered intoan amendment to the Sub-Debt Notes with Trilogy Capital Partners, Inc., RandySaaf and Octavio Herrera, the holders of a majority of the aggregate principalamount outstanding of the subordinated convertible notes.  Pursuant toSection 17 of the Subordinated Notes the Majority Holders have the right toapprove modifications to the Subordinated Notes.  The amendment decreases the conversion priceof the Subordinated Notes from $1.55 to $1.00 per share and waives therequirement of certain holders to give 61 day written notice to increase ordecrease the maximum limitation on such holders’ ability to convert theSubordinated Notes held by them.

 

The holders of the Sub-Debt Notes are entitled to receive any dividendspaid or distributions made to the holders of common stock to the same extent asif such holders had converted their Sub-Debt Notes into common stock (withoutregard to any limitations on conversion) and had held such shares of commonstock on the record date for such dividend or distribution, with such paymentto be made concurrently with the payment of the dividend or distribution to theholders of common stock.

 

The Sub-Debt Financing investors also received five-year warrants topurchase an aggregate of 1,596,774 shares of common stock at an exercise priceof $1.55 per share, subject to certain anti-dilution and price reset provisions(collectively, the “Sub-Debt Warrants”). The Sub-Debt Warrants were valued at $1,133,710 based on a valuationreport prepared by an independent valuation firm utilizing the Black-Scholesoption-pricing model, and were recorded as a discount to the $30,000,000 of convertiblesubordinated debt, and are being amortized to interest expense over the term ofthe debt.

 

In conjunction with the aforementioned financing transactions, aSubordination Agreement dated July 28, 2005 was entered into between theCompany, the Senior Financing investors, and the Sub-Debt Financing investorspursuant to which the Sub-Debt Financing investors agreed to subordinate theirrights to the investors in the Senior Financing in the event of a default underthe Senior Financing transaction documents and on certain other terms andconditions described therein.

 

If all of the securities issued in the Senior Financing and theSub-Debt Financing are converted or exercised into shares of the Company’scommon stock in accordance with their respective terms, it will result insignificant dilution to the Company’s existing stockholders and a possiblechange in control of the Company.  If allof the Company’s outstanding equity-based instruments are converted orexercised into shares of the Company’s common stock in accordance with theirrespective terms, including those issued in conjunction with the acquisition ofMediaDefender, there would be a total of approximately 38,000,000 shares of theCompany’s common stock issued and outstanding.

 

The securities issued by the Company in the Senior Financing and theSub-Debt Financing were offered and sold in reliance upon exemptions fromregistration pursuant to Section 4(2) under the Securities Act of1933, as amended (the “Securities Act”), and Rule 506 promulgatedthereunder.  Each of the investorsqualified as an “accredited investor,” as specified in Rule 501 under theSecurities Act.

 

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

 

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

 

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

 

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

 

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

 

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The financing documentsspecify that an event of default of the senior and subordinated indebtedness istriggered if a resale registration statement is unavailable for use by the holdersfor a period of more than ten consecutive trading days after the expiration ofan allowable ten-day grace period.  The Company invoked its use of theten-day allowable grace period on December 21, 2006, which expired on December 31,2006.  The Company delivered notice to holders of its outstanding seniorand subordinated indebtedness that, as of December 20, 2006, an event ofdefault had been triggered under their respective senior and subordinatedfinancing documents.

 

As of December 20, 2006, the Form SB-2 remained unavailablefor use by the holders, and it continued to be unavailable for use until July 6,2007, when Amendment No. 2 to the registration statement on Form SB-2was declared effective by the SEC.  Accordingly, at December 30,2006, the registration statement covering the resale of shares of common stockunderlying the various securities issued by the Company to each holder of thesenior and subordinated indebtedness was not effective.  As a result, an event of default, amongothers, with respect to the senior and subordinated indebtedness was triggeredby the unavailability of the Form SB-2 to the holders between December 20,2006 and July 6, 2007.  Thefinancing documents provide that while the Form SB-2 remains unavailablefor use, holders of senior indebtedness are entitled to a cash penalty equal to1.5% of the original Senior Financing, on a pro rata basis, and the holders ofsubordinated indebtedness are entitled to a cash penalty equal to 1.0% of theoriginal Sub-Debt Financing, on a pro rata basis.  These cash penaltiesare due and payable by the Company at the end of each thirty-day period whilethe Form SB-2 remains unavailable.  The first cash penalty paymentwas due on January 31, 2007 and monthly thereafter.

 

In accordance with EITF 00-19-2, which the Company adopted as of December 31,2006, and SFAS No. 5, the Company accrued seven months liquidated damages(through mid-August 2007) under the registration rights agreementsaggregating approximately $3,777,000 as a charge to operations at December 31,2006, which was reduced by $395,000 as a result of the Company’s registrationstatement being declared effective on July 6, 2007, which was earlier thanoriginally estimated, and by an aggregate of $1,000,000 of advance paymentsmade to the holders of the Senior Financing during the year ended December 31,2007 for liquidated damages under the registration rights agreement.  Accordingly, liquidated damages payable underregistration rights agreements were $1,972,000 at December 31, 2008 and$2,382,000 at December 31, 2007, and were reflected as a current liabilityat such dates.  The Company believes thatthe amount of the liquidated damages accrued reflects the undiscounted maximumpotential amount of liquidated damages payable to the holders of the SeniorFinancing and the Sub-Debt Financing since the underlying shares becomegenerally available for resale under an effective registration statement on July 6,2007.

 

A summary of theregistration penalty accrual at December 31, 2008 and 2007 is presentedbelow.

 
| ** **                             | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Senior secured notes payable           |       | $                           | —     |                        | $          | 410,000 |   |
| Subordinated convertible notes payable |       | 1,972 ,000                  |       | 1,972,000                   |       |
| Total registration penalty accrual     |       | $                           | 1,972,000  |                        | $          | 2,382,000 |   |

 

As of December 31, 2008 and 2007, approximately $12,494,000 and$13,307,000 principal amount respectively was outstanding with respect to theSenior Financing, and approximately $27,658,000 principal amount wasoutstanding with respect to the Sub-Debt Financing.  In addition, at December 31,2008, approximately $0 and $1,972,000 was outstanding with respect to accruedregistration delay penalties to the holders of the Senior Financing and theSub-Debt Financing, respectively, and approximately $113,000 and $6,805,000 wasoutstanding with respect to accrued interest payable to the holders of theSenior Financing and the Sub-Debt Financing, respectively.  Through December 31, 2008, the Companyhad not paid the registration delay penalties to the Sub-Debt Notes, althoughit had made payments to the holders of the Senior Notes aggregating $1,410,000.  As a result of the registration failure, thefailure to pay the registration delay penalties and the various financialcovenant and other breaches of the terms of the Senior Financing and theSub-Debt Financing, multiple events of default exist under the Senior Financingand the Sub-Debt Financing.  The terms ofthe Subordination Agreement among the Company and the creditor parties thereto(the “Subordination Agreement”) prevent the Company from making any cashpayments to the Sub-Debt Note holders until the events of default under theSenior Financing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of atleast 25% of the outstanding senior indebtedness may declare the outstandingprincipal and accrued interest on all senior notes immediately due and payableupon written notice to the Company, and each holder of outstanding subordinatedindebtedness may only demand redemption of all or any portion of theirrespective notes under certain circumstances as described in the SubordinationAgreement. See “Subsequent Events” Footnote.

 

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All quarterly interest payments due on the outstanding senior andsubordinated indebtedness were timely paid by the Company through December 2006.  In addition, the quarterly interest paymentsdue on the outstanding senior indebtedness in 2008 were timely paid.  Pursuant to the terms of the SubordinationAgreement, interest on the outstanding subordinated convertible notes payablecannot be paid as a result of the existence of the events of default describedherein.

 

A summary of accrued interest payable at December 31, 2008 and2007 is presented below.

 
| ** **                                  | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** |                        | ** ** | ** **                  | ** ** |
| Senior secured notes payable                |       | $                           | 113,000    |                        | $          | 67,000 |   |
| Subordinated convertible notes payable      |       | 6,362,000                   |       | 3,034,000                   |       |
| Liquidated damages payable with respect to: |       |                        |       |                        |       |
| Senior secured notes payable                |       | —                      |       | 79,000                      |       |
| Subordinated convertible notes payable      |       | 443,000                     |       | 172,000                     |       |
| Total accrued interest payable              |       | $                           | 6,918,000  |                        | $          | 3,352,000 |   |

 

Pursuant to aseries of Forbearance and Consent Agreements with the investors in the SeniorFinancing, such investors agreed to forbear from the exercise of their rightsand remedies under the Senior Financing documents as a result of the events ofdefault with respect to the unavailability of the Company’s registrationstatement, as well as certain other events of default that existed or thatcould come into existence during the forbearance period, from April 17,2007 through February 20, 2008, in exchange for aggregate cash payments of$1,000,000 in 2007 and $494,446 in February 2008.  The payments made by the Company under theForbearance and Consent Agreements were credited against the registration delaycash penalties and interest on the penalties resulting from the Company’sdefault under the various agreements between the Company and the SeniorFinancing investors.  On March 17,2008, the Company entered into a Forbearance and Consent Agreement with theinvestors in the Company’s Senior Debt Financing, which was effective as of February 20,2008, whereby the investors  agreed toforbear from exercising any of their rights and remedies under the SeniorFinancing transaction documents through December 31, 2008 in exchange foran adjustment in the interest rate associated with the Senior Notes from 11.25%to 16%.

 

On August 3, 2007, the Company entered into a Waiver andForbearance Agreement with the holders of the Sub-Debt Financing pursuant towhich the holders agreed to waive their right to charge the 12.0% defaultinterest rate triggered by the Company’s defaults under the SubordinatedFinancing transaction documents and instead charge the 4.0% standard interestrate on the Sub-Debt Notes for the period from July 16, 2007 through August 31,2007 (the “Forbearance Period”).  Theholders of the Sub-Debt Financing also agreed to forbear from exercising any oftheir other rights and remedies under the Sub-Debt Financing transactiondocuments during the Forbearance Period, upon the terms and conditions in theWaiver and Forbearance Agreement. Effective September 1, 2007, the interest rate returned to the12.0% default interest rate.

 

As a result of the requirement to restate previously issued financialstatements, which resulted in the recording of an embedded derivativeliability, the reclassification of the senior and subordinated indebtedness tocurrent liabilities, and the recording of liquidated damages payable underregistration rights agreements, the Company was not in compliance with certainof its financial covenants under both the Senior Financing and the Sub-DebtFinancing at December 31, 2006. Notwithstanding such developments, the Company would have been out ofcompliance with certain of its financial covenants at December 31, 2008and 2007.

 

The registration delay penalties and ongoing default interest chargescontinued to have a significant and material negative impact on the Company’soperations and cash flows during fiscal years 2008 and 2007.

 

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5.  DERIVATIVE FINANCIAL INSTRUMENTS

 

In conjunctionwith the financing for the acquisition of MediaDefender on July 28, 2005(see Notes 3 and 4), the Company completed a $15,000,000 senior secured debttransaction (the “Senior Financing”) and a $30,000,000 convertible subordinateddebt transaction (the “Sub-Debt Financing”). The Company also issued various warrants in conjunction with suchfinancings.

 

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

 

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

 

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

 
| ** **                                                          | ** ** | **2005**   | ** ** | **2006**   | ** ** | **2007**   | ** ** | **2008**   |       |
|---------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Embedded derivatives**                                       | ** ** | **28-Jul** | ** ** | **31-Dec** | ** ** | **31-Dec** | ** ** | **31-Mar** | ** ** | **30-Jun** | ** ** | **30-Sep** | ** ** | **31-Dec** | ** ** | **31-Mar** | ** ** | **30-Jun** | ** ** | **30-Sep** | ** ** | **31-Dec** |   |
| Initial fair  value of common stock ($)                             |       | 1.43       |       | —     |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value of  common stock at each reporting period end            |       | —     |       | 3.3        |       | 2.35       |       | 1.9        |       | 2 |   | 1.8 |   | 0.38 |   | 0.38 |   | 0.27 |   | 0.03 |   | 0.01 |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Conversion price  ($)                                               |       | 1.55       |       | 1.55       |       | 1.55       |       | 1.55       |       | 1.55 |   | 1.55 |   | 1.55 |   | 1.55 |   | 1.55 |   | 1.55 |   | 1.00 |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Terminal time  period in months                                     |       | 48         |       | 43         |       | 31         |       | 28         |       | 25 |   | 22 |   | 19 |   | 16 |   | 13 |   | 10 |   | 7 |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected return                                                     |       | 4.04       | %          | 4.35       | %          | 4.69       | %          | 4.58       | %          | 4.87 | % | 3.97 | % | 3.05 | % | 1.62 | % | 2.35 | % | 1.78 | % | 0.37 | % |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Initial  volatility factor                                          |       | 55         | %          | —     |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Volatility factor  for each subsequent reporting period             |       | —     |       | 59         | %          | 53         | %          | 60         | %          | 56 | % | 63 | % | 73 | % | 67 | % | 74 | % | 208.3 | % | 269.5 | % |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Triggering events  to forced conversion:                            |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Event 1 - stock  price equal or above ($)                           |       | 2.32       |       | 2.32       |       | 2.32       |       | 2.32       |       | 2.32 |   | 2.32 |   | 2.32 |   | 2.32 |   | 2.32 |   | 2.32 |   | 2.32 |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Event 2 - daily  share trading volume equal or above (in thousands) |       | 200        |       | 200        |       | 200        |       | 200        |       | 200 |   | 200 |   | 200 |   | 200 |   | 200 |   | 200 |   | 200 |   |
|                                                                |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lack of liquidity  discount for the limitation on conversion        |       | 20         | %          | 20         | %          | 20         | %          | 20         | %          | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % | 20 | % |

 

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

 

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

 
| ** **                                                              | ** ** | **2005**   | ** ** | **2006**   | ** ** | **2007**   | ** ** | **2008**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Warrant liability**                                              | ** ** | **28-Jul** | ** ** | **31-Dec** | ** ** | **31-Dec** | ** ** | **31-Mar** | ** ** | **30-Jun** | ** ** | **30-Sep** | ** ** | **31-Dec** | ** ** | **31-Mar** | ** ** | **30-Jun** | ** ** | **30-Sep** | ** ** | **31-Dec** | ** ** |
| Initial fair  value of common stock ($)                                 |       | 1.43       |       | —     |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   |   |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value of  common stock at each subsequent reporting period end ($) |       | —     |       | 3.3        |       | 2.35       |       | 1.9        |       | 2.00 |   | 1.8 |   | 0.38 |   | 0.38 |   | 0.27 |   | 0.03 |   | 0.01 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise price:                                                         |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior warrants  ($)                                                    |       | 2.00       |       | 2.00       |       | 2.00       |       | 2.00       |       | 2.00 |   | 2.00 |   | 2.00 |   | 2.00 |   | 2.00 |   | 2.00 |   | 2.00 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sub-debt warrants  ($)                                                  |       | 1.55       |       | 1.55       |       | 1.43       |       | 1.43       |       | 1.43 |   | 1.43 |   | 1.43 |   | 1.43 |   | 1.43 |   | 1.43 |   | 1.43 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Libra warrant ($)                                                       |       | 2.00       |       | 2.00       |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Time period in  months:                                                 |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior warrants                                                         |       | 60         |       | 55         |       | 43         |       | 40         |       | 37 |   | 34 |   | 31 |   | 28 |   | 25 |   | 22 |   | 19 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sub-debt warrants                                                       |       | 60         |       | 55         |       | 43         |       | 40         |       | 37 |   | 34 |   | 31 |   | 28 |   | 25 |   | 22 |   | 19 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Libra warrant                                                           |       | 84         |       | 79         |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Expected return %                                                       |       | 4.04       |       | 4.35       |       | 4.69       |       | 4.58       |       | 4.89 |   | 4.03 |   | 3.45 |   | 1.62 |   | 2.35 |   | 2.28 |   | 0.76 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Initial  volatility factor                                              |       | 55         | %          | —     |       | —     |       | —     |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                    |       |       |       |       |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Volatility factor  for each subsequent reporting period                 |       | —     |       | 59         | %          | 53         | %          | 60         | %          | 56 | % | 63 | % | 73 | % | 67 | % | 74 | % | 208.3 | % | 269.5 | % |

 

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

 

The independent valuation firm concluded that the Company’s historicalpattern of stock prices as of July 28, 2005, and for some time thereafter,would not provide a sufficient indication of the long-term expected volatilityof the Company’s stock going forward for purposes of the calculation of thefair value of the compound embedded derivatives, due to the significant changesin the business operations and capital structure of the Company on July 28,2005 as a result of the acquisition of MediaDefender and the related financingtransactions.  The resulting volatilitieswere then used to calculate the fair value, and the changes in fair value, ofthe Company’s compound embedded derivative liabilities at each period end.  The Company also utilized these volatilitiesto calculate the fair value, and the changes in fair value, of the Company’swarrant derivative liabilities at each period end.

 

Paragraph A32 of SFAS No. 123R lists factors to consider inestimating expected volatility.  Theindependent valuation firm retained by the Company to value the compoundembedded derivatives contained in the Sub-Debt Notes determined that theappropriate methodology to calculate volatility with respect to the Company’scompound embedded derivatives was to consider the Company as similar to a newlypublic company without a trading history because of the significanttransformative changes resulting from the acquisition and financing of theMediaDefender transaction on July 28, 2005.  With reference to newly public companies,section (c) of paragraph A32 of SFAS No. 123R suggests that theexpected volatility of similar entities be considered.  The independent valuation firm arrived atthis determination due to the Company’s acquisition of MediaDefender on July 28,2005 and the related equity-based financing transactions that provided thecapital to fund the acquisition.

 

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6.  PROPERTY AND EQUIPMENT

 
| ** **                                                                                                                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **Property and equipment are recorded at cost and consist of the following:** | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                                                                                                                           | ** ** | **(in thousands)** | ** ** |
| Computer equipment and software                                                                                                      |       | $                       | 4,237      |   | $ | 3,973 |   |
| Furniture and fixtures                                                                                                               |       | 194                     |       | 194 |   |
| Leasehold improvements                                                                                                               |       | 290                     |       | 285 |   |
|                                                                                                                                 |       | 4,721                   |       | 4,452 |   |
| Less accumulated depreciation and  amortization                                                                                      |       | (3,519                  | )          | (2,614 | ) |
| Property and equipment, net                                                                                                          |       | $                       | 1,202      |   | $ | 1,838 |   |

 

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

 

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

 

7.  GOODWILL AND OTHER INTANGIBLEASSETS

 

IdentifiableIntangible Assets

 

Componentsof the Company’s identifiable intangible assets at December 31, 2008 and2007, all of which were recorded in conjunction with the acquisition ofMediaDefender in July 2005 (see Note 3), are as follows:

 
| ** **                 | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **(in thousands)**                      | ** ** |
| December 31, 2008     |       |                                         |       |                      |       |                                       |       |
| Customer relationships     |       | $                                            | 440        |                      | $          | 440                                        |       | $ | — |   |
| Proprietary technology     |       | 1,478                                        |       | 1,478                     |       | —                                     |       |
| Non-competition agreements |       | 416                                          |       | 263                       |       | 153                                        |       |
| Total                      |       | $                                            | 2,334      |                      | $          | 2,181                                      |       | $ | 153 |   |
|                       |       |                                         |       |                      |       |                                       |       |
| December 31, 2007     |       |                                         |       |                      |       |                                       |       |
| Customer relationships     |       | $                                            | 1,195      |                      | $          | 755                                        |       | $ | 440 |   |
| Proprietary technology     |       | 4,012                                        |       | 2,534                     |       | 1,478                                      |       |
| Non-competition agreements |       | 728                                          |       | 312                       |       | 416                                        |       |
| Total                      |       | $                                            | 5,935      |                      | $          | 3,601                                      |       | $ | 2,334 |   |

 

Amortizationexpense with respect to intangible assets for the years ended December 31,2008 and 2007 was $2,181,000 and $3,601,000, respectively.  The $153,000 balance of scheduledamortization expense with respect to intangible assets will be charged tooperations in the year ended December 31, 2009.

 

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Goodwill

 

Goodwill at December 31, 2008 and 2007 was $0 and $31,085,000respectively, which was recorded in conjunction with the acquisition ofMediaDefender in July 2005 (see Note 3).  In accordance with SFAS No. 142,“Goodwill and Other Intangible Assets”, an intangible asset that is not subjectto amortization such as goodwill shall be tested for impairment at least on anannual basis, and more often under certain circumstances, and written down whenimpaired.  An interim impairment test is required if an event occurs orconditions change that would more likely than not reduce the fair value of thereporting unit below its carrying value. The first step of the impairment test consists of a comparison of thetotal fair value of each reporting unit to the reporting unit’s net assets onthe date of the test.  If the fair value is in excess of the net assets,there is no indication of impairment and thus no need to perform thesecond step of the impairment test.

 

During the year ended December 31, 2008, theCompany recorded a non-cash charge to operations aggregating $31,085,000 withrespect to the impairment of the goodwill recognized in conjunction with theacquisition of MediaDefender in July 2005.  This charge to operationswas based on various factors and developments occurring in 2008,including continuing erosion in the demand for MediaDefender's core Internetanti-piracy services within the entertainment industry, the unexpected non-renewalby MediaDefender’s largest customer in mid-2008, continuing deterioration ofoperating margins and valuation metrics, and the inability to implement newadvertising initiatives on a large-scale basis.

 

8.   DEFERRED FINANCING COSTS

 

Components ofthe Company’s deferred financing costs at December 31, 2008 and 2007 areas follows:

 
| ** **                             | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Write-offs  Resulting from  Conversions  and  Repayments  of Debt** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **(in thousands)**                      | ** ** |
| Year Ended December 31, 2008      |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred financing costs related to:   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated convertible notes payable |       | $                                            | 912        |                      | $          | 608                                                                             |       | $                                          | —     |   | $ | 304 |   |
| Senior secured notes payable           |       | 331                                          |       |  234                 |       | 8                                                                               |       | 89                                         |       |
| Total                                  |       | $                                            | 1,243      |                      | $          | 842                                                                             |       | $                                          | 8          |   | $ | 393 |   |
|                                   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Year Ended December 31, 2007      |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred financing costs related to:   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated convertible notes payable |       | $                                            | 1,519      |                      | $          | 607                                                                             |       | $                                          | —     |   | $ | 912 |   |
| Senior secured notes payable           |       | 565                                          |       | 234                       |       | —                                                                          |       | 331                                        |       |
| Total                                  |       | $                                            | 2,084      |                      | $          | 841                                                                             |       | $                                          | —     |   | $ | 1,243 |   |

 

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Amortizationexpense with respect to deferred financing costs for the years ended December 31,2008 and 2007 was $842,000 and $841,000, respectively.  The $393,000 balance of deferred financing costs will be charged tooperations in the year ended December 31, 2009.

 

9.  ALLOWANCE FOR DOUBTFULACCOUNTS

 

A summary ofthe activity with respect to the allowance for doubtful accounts is as follows:

 
| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **(in thousands)**                     | ** ** |
| Balance, beginning of year      |       | $                                           | 418        |   | $ | 421 |   |
| Provision for doubtful accounts |       | (36                                         | )     | 203 |   |
| Amounts charged off             |       | (153                                        | )          | (206 | ) |
| Balance, end of year            |       | $                                           | 229        |   | $ | 418 |   |

 

The provision for doubtful accounts for the years ended December 31,2008 and 2007 by segment was as follows:

 
| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| E-commerce                                       |       | $                                           | 8          |   | $ | 10 |   |
| Media                                            |       | (10                                         | )     | 23 |   |
| Anti-piracy and file-sharing marketing  services |       | (34                                         | )     | 170 |   |
| Total                                            |       | $                                           | (36        | )  | $ | 203 |   |

 

10.  ACCRUED EXPENSES

 

Accrued expenses are comprised of the following:

 
| ** **                             | ** ** | **December 31,**   | ** ** |
|----------------------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                             | ** ** | **(in thousands)** | ** ** |
| Accrued cost of sales                  |       | $                       | 104        |   | $ | 221 |   |
| Accrued compensation and related costs |       | 248                     |       | 1,096 |   |
| Accrued professional fees              |       | 2                       |       | 133 |   |
| Accrued business and property taxes    |       | (2                      | )          | 51 |   |
| Other accrued expenses                 |       | 82                      |       | 384 |   |
| Total accrued expenses                 |       | $                       | 434        |   | $ | 1,885 |   |

 

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11.  INCOME TAXES

 

The componentsof the provision for income taxes are as follows:

 
| ** **                                                               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                               | ** ** | **(in thousands)**                     | ** ** |
| Current:                                                                 |       |                                        |       |   |   |
| Federal                                                                  |       | $                                           | 78         |   | $ | — |   |
| Federal – FIN 48                                                    |       | 492                                         |       | — |   |
| State                                                                    |       | 94                                          |       | 5 |   |
| State – FIN 48                                                      |       | 150                                         |       | — |   |
|                                                                     |       |                                        | 814        |   |   | 5 |   |
| Tax benefit of a net operating loss  carry-back – federal (current) |       | —                                      |       | (828 | ) |
| Deferred:                                                                |       |                                        |       |   |   |
| Federal                                                                  |       |                                        | —     |   |   | (170 | ) |
| State                                                                    |       | —                                      |       | (46 | ) |
|                                                                     |       | —                                      |       | (216 | ) |
| Total                                                                    |       | $                                           | 814        |   | $ | (1,039 | ) |

 

Income taxesdiffer from the amount computed using a tax rate of 34% as a result of thefollowing:

 
| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                             | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**                     | ** ** |
| Computed expected tax (tax benefit)                                    |       | $                                           | (16,032    | )  | $ | 3,563 |   |
| Additional Federal Assessments                                         |       | 78                                          |       | — |   |
| State and local income taxes, net of  federal income tax benefit       |       | 63                                          |       | 3 |   |
| Permanent adjustment at state rate, net of  federal income tax benefit |       | 2,391                                       |       | — |   |
| Amortization of non-cash financing costs                               |       | 460                                         |       | 470 |   |
| Adjustments to deferred tax assets                                     |       | (2,329                                      | )          | 8 |   |
| Stock-based compensation                                               |       | 10,880                                      |       | 630 |   |
| Permanent adjustments caused by warrant and  derivative liabilities    |       | 1,792                                       |       | (6,878 | ) |
| Amortization of proprietary technology and  customer list              |       | 652                                         |       | — |   |
| Fin 48 tax reserves and related interest                               |       | 592                                         |       | — |   |
| Other                                                                  |       | 9                                           |       | 18 |   |
|                                                                   |       | (1,444                                      | )          | (2,186 | ) |
| Valuation allowance                                                    |       | 2,258                                       |       | 1,147 |   |
| Total income tax (benefit) expense                                     |       | $                                           | 814        |   | $ | (1,039 | ) |

 

The taxeffects of temporary differences that give rise to significant portions of thedeferred tax assets and liabilities at December 31, 2008 and 2007 are asfollows:

 
| ** **                       | ** ** | **December 31,**   | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Deferred tax liabilities:        |       |                    |       |   |   |
| State income taxes               |       | $                       | 3,843      |   | $ | 3,644 |   |
| Depreciation                     |       | (144                    | )     | 45 |   |
| Total deferred tax liabilities   |       | 3,699                   |       | 3,689 |   |
|                             |       |                    |       |   |   |
| Deferred tax assets:             |       |                    |       |   |   |
| Net operating loss carryforwards |       | 50,876                  |       | 48,660 |   |
| Non-deductible accrued expenses  |       | 1,400                   |       | 1,282 |   |
| Other                            |       | 113                     |       | 179 |   |
| Total deferred tax assets        |       | 52,389                  |       | 50,121 |   |
| Valuation allowance              |       | (48,690                 | )          | (46,432 | ) |
| Net deferred assets              |       | 3,699                   |       | 3,689 |   |
| Net deferred tax liabilities     |       | $                       | —     |   | $ | — |   |
|                                  |            |                         |            |  |  |  |  |  |

 

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AtDecember 31, 2008, the Company had net operating loss carryforwards ofapproximately $111,000,000 for Federal income tax purposes expiring beginningin 2019 and California state net operating loss carryforwards of approximately$114,000,000 expiring beginning in 2009.

 

In assessingthe potential realization of deferred tax assets, management considers whetherit is more likely than not that some portion or all of the deferred tax assetswill be realized.  The ultimaterealization of deferred tax assets (primarily net operating loss carryforwards)is dependent upon the Company attaining future taxable income during theperiods in which those temporary differences become deductible.  As of December 31, 2008 and 2007,management was unable to determine if it is more likely than not that theCompany’s deferred tax assets will be realized, and has therefore recorded anappropriate valuation allowance against deferred tax assets at such dates.

 

Due to the restrictions imposed by Internal Revenue Code Section 382regarding substantial changes in the stock ownership of companies with losscarryforwards, the utilization of the Company’s federal net operating losscarryforward was severely limited as a result of the change in the effectivestock ownership of the Company resulting from the debt financings arranged inconjunction with the acquisition of MediaDefender.

 

As of December 31, 2008, the Company’s 2005 and 2006 U.S. federalincome tax return was undergoing examination by the Internal RevenueService.  The Internal Revenue Servicehas proposed various adjustments to the Company’s 2005 and 2006 taxableincome.  Estimated taxes and interestrelating to such adjustments have been accrued as income taxes payable in theaccompanying financial statements at December 31, 2008.  The Internal Revenue Service has completedits field examination and has taken various positions as to the deductibilityof interest accrued and paid relating to the subordinate notes.  The Company does not agree with the agentsinterpretations of the various treasury regulations in question and the companyhas responded to the agents’ initial findings. In as much as the Company has a substantial NOL for federal purposes theCompany does not expect that any of the IRS positions would have a materialeffect on the federal taxes which ultimately would be due to the Treasury.   However, the disallowance of thedeductibility of interest accrued and paid to the subordinated note holderswould result in an additional tax obligation to the state of California.  Although the final outcome of the federalincome tax examination is uncertain, the company has accrued $814,000 for anyadditional tax expense which may become due in accordance with FIN 48. TheCompany recorded a benefit for income taxes of $1,039,000 for the year endedDecember 31, 2007, as a result of the carryback of 2007 tax losses to 2005and 2006.

 

The Company adopted the provisions of FIN48 on January 1, 2007, and hasidentified unrecognized tax benefits related to the deductibility of certaininterest expense on subordinated debt. However, there would be no additional accrual required due to availablenet operating losses.  The followingtable provides a reconciliation of the Company’s unrecognized tax benefits atDecember 31, 2008:

 
| Unrecognized tax benefits at January 1,  2007                         |   | $          | 0       |   |
|-----------------------------------------------------------------------|--------|------------|---------|--------|
| Increase based upon tax positions taken  prior to 2007                |   | 713,000    |    |
| Increase based upon tax positions taken in  2007                      |   | 1,209,000  |    |
| Increase based upon tax positions taken in  2008                      |   | 1,326,000  |    |
| Decrease based upon net operating loss  arising in 2007               |   | (1,209,000 | )       |
| Decrease based upon 2007 net operating loss  carryback to prior years |   | (69,000    | )       |
| Decrease based upon net operating loss  arising in 2008               |   | (1,326,000 | )       |
| Decrease based upon 2008 net operating loss  carryback to prior years |   | (77,000    | )       |
| Unrecognized tax benefits at December 31,  2008                       |   | $          | 567,000 |   |

 

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12.  RELATED PARTY TRANSACTIONS

 

Transactions Involving Officers and Directors

 

Effective as of January 1, 2006, the Company entered into aone-year consulting agreement with Eric Pulier, a director of the Company,through WNT Consulting Group, a California limited liability company wholly-ownedby Mr. Pulier (“WNT”).  Theconsulting agreement was approved by the disinterested members of the Company’sBoard of Directors.  Effective January 12,2007, the parties mutually agreed to terminate this consulting agreement, whichhad automatically renewed for a second one-year term through December 31,2007.  Under the terms of the original consulting agreement, Mr. Pulierreceived a base fee of $10,000 per month, certain other mandatory payments, andwas also eligible to receive cash bonuses on the achievement of certainspecified milestones.  Mr. Pulier had also agreed to waive all stockoptions and other stock-based compensation granted to outside members of theCompany’s Board of Directors during the term of his original consultingagreement.  The termination agreementprovided for a one-time cash payment to Mr. Pulier (through WNT) in theamount of $100,000, in consideration for the termination of the consultingagreement and an acknowledgement and complete release.  The termination agreement was approved by theCompensation Committee of the Company’s Board of Directors.  On January 12, 2007, the Company enteredinto a new consulting agreement with Mr. Pulier (through WNT).  Thenew consulting agreement which was at the Company’s discretion, provide thatMr. Pulier (through WNT) receive compensation at the rate of $500 perhour.  No consulting services were provided by Mr. Pulier under the newconsulting agreement in either 2007 or 2008. Mr. Pulier resigned as a member of the Company’s Board of Directorsin August 12, 2008.

 

For the year ended December 31,2008, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000.  In addition,each director that serves on a Committee of the Board of Directors received, foreach committee served, an additional cash retainer of $10,000 annually, paidquarterly.  The Company did not grant anystock options during 2008.

 

For the year ended December 31,2007, each non-employee member of the Company’s Board of Directors received acash retainer of $15,000, and a grant of 10,000 stock options having a value(based upon the appropriate Black-Scholes option valuation methodology) equalto $16,200.  In addition, each directorthat serves on a Committee of the Board of Directors received, for eachcommittee served, an additional cash retainer of $10,000, and a grant of 5,000stock options having a value equal to $8,100, having the same terms andconditions as options granted to all non-employee members of the Board ofDirectors generally.  The effective dateof the above stock options was June 29, 2007, a total of 80,000 shareswere granted under the 2006 Equity plan, having an aggregate Black-Scholesvalue of $129,600.  The options areexercisable through June 29, 2012 at $2.00 per share, the fair marketvalue on the date of grant.  The optionsvested 50% on June 30, 2007 and 25% each on September 30, 2007 and December 31,2007.  In addition, to their normal boardfees, two directors also served on the Special Committee related to restructuringmatters and received additional cash compensation of $60,000 each during 2007.

 

During the years endedDecember 31, 2008 and 2007, the Company incurred legal fees ofapproximately $22,000 and $16,000, respectively, to Davis ShapiroLewit & Hayes, LLP, a law firm in which Fred Davis, a director of theCompany, is a partner.

 

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

 

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13.  STOCKHOLDERS’ EQUITY (DEFICIENCY)

 

Stock-Based Transactions- Year Ended December 31, 2008

 

During the year ended December 31,2008, the Company did not issue any common stock options or warrants todirectors, employees or consultants.

 

Stock-Based Transactions- Year Ended December 31, 2007

 

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

 

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

 

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

 

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

 

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

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

 

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

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

 

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Sufficiency of Authorized but Unissued Shares

 

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

 

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

 

Most of the Company’s outstanding options and warrantswere issued to employees, officers and directors in compensatory transactionsaccounted for under SFAS No. 123R. Of the 3,068,585 options and warrants outstanding at December 31,2008, 2,886,085 were issued to employees, officers and directors.  The Company believes that potential impactpursuant to EITF 00-19-2 of the remaining 182,500 options and warrants issuedto consultants, advisors and others is not material to the consolidated financialstatements.  With respect to the 182,500options and warrants, 20,000 are exercisable at $0.50 per share, 82,500 areexercisable at $1.00 per share and the remaining 80,000 are exercisable atprices ranging from $1.80 per share to $2.90 per share; all such exerciseprices are in excess of the current market value of the Company’s common stock.

 

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The Company currently has 60,000,000 shares of commonstock authorized, of which 10,344,666 shares of common stock were issued at December 31,2008, resulting in 49,655,334 unissued shares at such date.  If all of the Company’s equity-basedinstruments were converted or exercised into shares of common stock inaccordance with the second amendment dated December 30, 2008, without regard towhether such instruments have vested or are in-the-money, approximately28,000,000 additional shares would be issued, resulting in a total ofapproximately 38,000,000 shares of common stock issued and outstanding.  Accordingly, this calculation results inapproximately 22,000,000 shares of common stock available for issuance, inexcess of all equity commitments that the Company currently has outstanding asof December 31, 2008.  See Subsequentevent.

 

On December 16, 2008, the Company entered into an amendmentto the Sub-Debt Notes with Trilogy Capital Partners, Inc., Randy Saaf andOctavio Herrera, the holders of a majority of the aggregate principal amountoutstanding of the subordinated convertible notes.  Pursuant to Section 17of the Subordinated Notes the Majority Holders have the right to approvemodifications to the Subordinated Notes. The amendment decreases the conversion price of the Subordinated Notesfrom $1.55 to $1.00 per share and waives the requirement of certain holders togive 61 day written notice to increase or decrease the maximum limitation onsuch holders’ ability to convert the Subordinated Notes held by them.

 

The Company has approximately $27,658,000 of Sub-DebtNotes outstanding at December 31, 2008, which are convertible into commonstock at $1.00 per share and which represent the single largest component ofsuch potential dilution (approximately 27,658,000 shares).

 

Accordingly,based on the foregoing analysis and the Company’s current capital structure,the Company has concluded that it is highly probable that the Company will have sufficient shares availableto satisfy its existing option and warrant obligations for the foreseeablefuture.  The Company will continue toevaluate this issue and if it becomes probable that there are insufficientauthorized shares, the Company will consider alternative accounting treatmentat that time.

 

14.  STOCK-BASED PLANS

 

2004Consultant Stock Plan

 

Effective September 29,2004, the Company’s Board of Directors adopted the ARTISTdirect, Inc. 2004Consultant Stock Plan (the “Consultant Plan”) in order for the Company to beable to compensate consultants, at the option of the Company, who provide bonafide services to the Company not in connection with capital raising orpromotion of the Company’s securities. The Consultant Plan will expire on September 29, 2014, and providesfor the issuance of up to 500,000 shares of common stock to consultants at fairmarket value.  On January 13, 2005,the Company filed a Registration Statement on Form S-8 with the Securitiesand Exchange Commission to register the 500,000 shares of common stock forfuture issuance under the Consultant Plan. As of December 31, 2007, no shares had been issued under theConsultant Plan.

 

2006 EquityIncentive Plan

 

The Company’sstockholders approved the ARTISTdirect, Inc. 2006 Equity Incentive Plan(the “2006 Equity Plan”) at the Company’s Annual Meeting of Stockholders heldon June 19, 2006 (the “Annual Meeting”).  The Board of Directors ofthe Company had previously approved the 2006 Equity Plan in April 2006. A total of 1,500,000 new shares of the Company’s common stock have initiallybeen reserved for issuance under the 2006 Equity Plan.  Awards under the2006 Equity Plan may be granted to any of the Company’s employees, directors,officers, consultants or those of the Company’s affiliates.  Awards mayconsist of stock options (both incentive stock options and non-statutory stockoptions), stock awards, stock appreciation rights and cash awards.  Anincentive stock option may be granted under the 2006 Equity Plan only to aperson who, at the time of the grant, is an employee of the Company or a parentor subsidiary of the Company.  During theyear ended December 31, 2006, the Company issued 34,615 shares of commonstock pursuant to a consulting agreement (see Notes 13 and 16) and options topurchase 126,551 shares of common stock. During the year ended December 31, 2007, the Company issued optionsto purchase 480,000 shares of common stock of which 5,000 were cancelled in2007 and 150,000 were cancelled in 2008. No shares of common stock were issued during 2008.  As of December 31, 2008, 1,013,834shares remained available for future option grant.

 

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A summary of stock optionactivity under the 2006 Equity Plan during the years ended December 31, 2007and 2008 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options outstanding at December 31,  2006 |       | 126,551                      |       | $ | 3.20 |   |
| Granted                                        |       | 480,000                      |       | 1.63 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (5,000                       | )          | 1.50 |   |
| Options outstanding at December 31,  2007 |       | 601,551                      |       | 1.96 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (150,000                     | )          | 1.50 |   |
| Options outstanding at December 31,  2008 |       | 451.551                      |       | $ | 2.12 |   |
| Options exercisable at December 31,  2008 |       | 451,551                      |       | $ | 2.12 |   |

 

The followingtable summarizes information regarding options outstanding and optionsexercisable at December 31, 2008 under the 2006 Equity Plan:

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|                     |       |                         |       |                         |       |   |   |   |   |   |   |   |   |
|                     | $          | 1.50                         |       |                         | 200,000    |   | 3.09 |   | $ | 1.50 |   | 200,000 |   | $ | 1.50 |   |
|                     | $          | 1.55                         |       |                         | 5,000      |   | 2.91 |   | $ | 1.55 |   | 5,000 |   | $ | 1.55 |   |
|                     | $          | 1.80                         |       |                         | 5,000      |   | 2.91 |   | $ | 1.80 |   | 5,000 |   | $ | 1.80 |   |
|                     | $          | 1.90                         |       |                         | 5,000      |   | 2.91 |   | $ | 1.90 |   | 5,000 |   | $ | 1.90 |   |
|                     | $          | 2.00                         |       |                         | 10,000     |   | 2.91 |   | $ | 2.00 |   | 10,000 |   | $ | 2.00 |   |
|                     | $          | 2.00                         |       |                         | 80,000     |   | 3.49 |   | $ | 2.00 |   | 80,000 |   | $ | 2.00 |   |
|                     | $          | 2.15                         |       |                         | 5,000      |   | 2.91 |   | $ | 2.15 |   | 5,000 |   | $ | 2.15 |   |
|                     | $          | 2.20                         |       |                         | 5,000      |   | 2.91 |   | $ | 2.20 |   | 5,000 |   | $ | 2.20 |   |
|                     | $          | 2.25                         |       |                         | 5,000      |   | 2.91 |   | $ | 2.25 |   | 5,000 |   | $ | 2.25 |   |
|                     | $          | 2.30                         |       |                         | 5,000      |   | 2.91 |   | $ | 2.30 |   | 5,000 |   | $ | 2.30 |   |
|                     | $          | 2.35                         |       |                         | 5,000      |   | 2.91 |   | $ | 2.35 |   | 5,000 |   | $ | 2.35 |   |
|                     | $          | 2.90                         |       |                         | 30,000     |   | 2.91 |   | $ | 2.90 |   | 30,000 |   | $ | 2.90 |   |
|                     | $          | 3.35                         |       |                         | 91,551     |   | 2.91 |   | $ | 3.35 |   | 91.551 |   | $ | 3.35 |   |
|                     | $          | 1.50-$3.35                   |       |                         | 451,551    |   | 3.01 |   | $ | 2.12 |   | 451,551 |   | $ | 2.12 |   |

 

The weighted average grant date fair value of stock options issuedduring the year ended December 31, 2007 was $1.63 per share and no optionswere issued the year ended December 31, 2008.

 

The intrinsic value of exercisable but unexercised in-the-money optionsat December 31, 2008 was $0.

 

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The following table summarizes information regarding the Company’snon-vested options under the 2006 Equity Plan as of December 31, 2007 and2008, and the changes during such years:

 
| ** **                                                  | ** ** | **Number   of Shares** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| Options outstanding but unvested at  December 31, 2006 |       | —                           |       |
| Granted                                                     |       | 480,000                          |       |
| Vested                                                      |       | (250,000                         | )          |
| Forfeited                                                   |       | (5,000                           | )          |
| Expired                                                     |       | —                           |       |
| Options outstanding but unvested at  December 31, 2007 |       | 225,000                          |       |
| Granted                                                     |       | —                           |       |
| Vested                                                      |       | (75,000                          | )          |
| Forfeited                                                   |       | (150,000                         | )          |
| Expired                                                     |       | —                           |       |
| Options outstanding but unvested at  December 31, 2008 |       | —                           |       |

 

As of December 31, 2008, unrecognized compensation cost related tounvested stock options under the 2006 Equity Plan will be 0.

 

1999 EmployeeStock Option Plan

 

In October 1999,the Company implemented the 1999 Employee Stock Option Plan (the “EmployeePlan”).  The Employee Plan was notapproved by the public stockholders of the Company.  The Employee Plan has currently reserved 1,273,004shares of the Company’s common stock for issuance to employees, non-employeemembers of the board of directors and consultants.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to2% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 87,500 shares.  No option may have a term in excess often years.  The options generally vest withinthree years.  As of December 31,2008, 500,614 shares remained available for future option grant.

 

A summary ofstock option activity under the Employee Plan during the years ended December 31,2007 and 2008 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options outstanding at December 31,  2006 |       | 864,762                      |       | $ | 3.88 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | (35,375                      | )          | 0.79 |   |
| Cancelled/expired                              |       | (11,310                      | )          | 91.41 |   |
| Options outstanding at December 31,  2007 |       | 818,077                      |       | 2.81 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (45,687                      | )          | 7.5 |   |
| Options outstanding at December 31,  2008 |       | 772,390                      |       | $ | 2.53 |   |
| Options exercisable at December 31,  2008 |       | 762,866                      |       | $ | 2.52 |   |

 

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The followingtable summarizes information regarding options outstanding and optionsexercisable at December 31, 2008 under the Employee Plan:

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|                     |       |                         |       |                         |       |   |   |   |   |   |   |   |   |
|                     | $          | 0.79                         |       |                         | 66,558     |   | 3.24 |   | $ | 0.79 |   | 66,558 |   | $ | 0.79 |   |
|                     | $          | 1.00                         |       |                         | 82,500     |   | 1.35 |   | $ | 1.00 |   | 82,500 |   | $ | 1.00 |   |
|                     | $          | 1.95                         |       |                         | 170,000    |   | 3.69 |   | $ | 1.95 |   | 170,000 |   | $ | 1.95 |   |
|                     | $          | 3.00                         |       |                         | 400,000    |   | 1.57 |   | $ | 3.00 |   | 390,476 |   | $ | 3.00 |   |
|                     | $          | 4.80                         |       |                         | 33,332     |   | 0.77 |   | $ | 4.80 |   | 33,332 |   | $ | 4.80 |   |
|                     | $          | 5.10                         |       |                         | 10,000     |   | 0.77 |   | $ | 5.10 |   | 10,000 |   | $ | 5.10 |   |
|                     | $          | 7.50                         |       |                         | 10,000     |   | 0.88 |   | $ | 7.50 |   | 10,000 |   | $ | 7.50 |   |
|                     | $          | 0.79-$7.50                   |       |                         | 772,390    |   | 2.09 |   | $ | 2.53 |   | 762,866 |   | $ | 2.52 |   |

 

The intrinsic value of exercisable but unexercised in-the-money optionsat December 31, 2008 was $0. The intrinsic value of options exercisedduring the years ended December 31, 2008 and 2007 was $0 and $75,000,respectively.

 

The following table summarizes information regarding the Company’snon-vested options under the Employee Plan as of December 31, 2007 and2008, and the changes during such years:

 
| ** **                                                  | ** ** | **Number  of Shares** | ** ** |
|-------------------------------------------------------------|------------|----------------------------|------------|
| Options outstanding but unvested at  December 31, 2006 |       | 238,095                    |       |
| Vested                                                      |       | (114,285                   | )          |
| Forfeited                                                   |       | —                     |       |
| Expired                                                     |       | —                     |       |
| Options outstanding but unvested at  December 31, 2007 |       | 123,810                    |       |
| Vested                                                      |       | (114,286                   | )          |
| Forfeited                                                   |       | —                     |       |
| Expired                                                     |       | —                     |       |
| Options outstanding but unvested at  December 31, 2008 |       | 9,524                      |       |

 

As of December 31, 2008, unrecognized compensation costs of$26,000 related to unvested stock options under the Employee Plan will becharged to operations in the year ending December 31, 2009.

 

1999 Artistand Artist Advisor Option Plan

 

In June 1999,and as amended in October 1999 and March 2000, the Company adoptedthe 1999 Artist and Artist Advisor Stock Option Plan (the “Advisor Plan”).  The Advisor Plan was not approved by thepublic stockholders of the Company.  TheAdvisor Plan has currently reserved 477,159 shares of common stock for issuanceto artists for whom the Company entered into agreements related to online ande-commerce activities and their agents, business managers, attorneys and otheradvisors.  This share reserveautomatically increases on the first trading day in January each calendaryear by an amount equal to 1% of the total number of shares of the Company’scommon stock outstanding on the last trading day of December in the priorcalendar year, but in no event will this annual increase exceed 37,500shares.  As of December 31, 2008,477,159 shares remained available for future option grants.  The options expire seven years from the dateof grant and vesting generally varies between one to three years.  No new option grants under this plan weremade during 2007 or 2008.

 

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A summary ofstock option activity under the Advisor Plan during the years ended December 31,2007 and 2008 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options outstanding at December 31,  2006 |       | 29,864                       |       | $ | 139.28 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (29,864                      | )          | 139.28 |   |
| Options outstanding at December 31,  2007 |       | —                       |       | — |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | —                       |       | — |   |
| Options outstanding at December 31,  2008 |       | —                       |       | $ | — |   |

 

1999 ArtistStock Plan

 

In June 1999,and as amended in October 1999, the Company adopted the 1999 Artist StockPlan (the “Artist Plan”).  The ArtistPlan was not approved by the public stockholders of the Company.  The Artist Plan currently has reserved 1,023,004shares of common stock for issuance to artists for whom the Company enteredinto agreements related to their online and e-commerce activities.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to2% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 87,500 shares.  As of December 31, 2008, 1,023,004shares remained available for future option grants.  The options expire seven years from the dateof grant and vesting generally varies between one to three years.  No new option grants under this plan weremade during 2007 or 2008.

 

A summary ofstock option activity under the Artist Plan during the years ended December 31,2007 and 2008 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options outstanding at December 31, 2006  |       | 10,375                       |       | $ | 139.28 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | (10,375                      | )          | 139.28 |   |
| Options outstanding at December 31,  2007 |       | —                       |       | — |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled/expired                              |       | —                       |       | — |   |
| Options outstanding at December 31, 2008  |       | —                       |       | $ | — |   |

 

As of December 31, 2008, unrecognized compensation cost related toall unvested stock options (plan and non-plan) of $26,000 will be charged tooperations in the year ending December 31, 2009.

 

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1999 EmployeeStock Purchase Plan

 

In October 1999,the Company adopted the 1999 Employee Stock Purchase Plan that initiallyreserved 50,000 shares of common stock for issuance under this plan.  As of December 31, 2008, this plan had 250,000shares reserved for issuance, of which 237,831 shares remained available forfuture issuances.  This share reserveautomatically increases on the first trading day in January each calendaryear, by an amount equal to 1% of the total number of shares of the Company’scommon stock outstanding on the last trading day of December in the priorcalendar year, but in no event will this annual increase exceed 25,000 shares.  Terms of the plan permit eligible employeesto purchase common stock through payroll deduction of up to 15% of eachemployee’s compensation.  The accumulateddeductions are applied to the purchase of shares on each semi-annual purchasedate at a purchase price per share equal to 85% of the fair market value pershare on the participant’s entry date into the offering period or thesemi-annual purchase date, whichever is lower. During the years ended December 31, 2007 and 2008, no shares wereissued under this plan.

 

Non-Plan Options Outstanding

 

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

 

Effective March 29,2004, the Company issued to Robert N. Weingarten, the Company’s Chief FinancialOfficer, a non-plan, non-qualified stock option to purchase 120,000 shares at$0.50 per share, which was not less than the fair market value on the date ofgrant, exercisable through March 29, 2011. The option vested and became exercisable in a series of thirty-sixsuccessive equal monthly installments from March 29, 2004 throughMarch 29, 2007.  The fair value ofthe stock option, determined pursuant to the Black-Scholes option-pricingmodel, was $42,000, of which $0 and $3,500 was charged to operations in 2008and 2007, respectively.

 

Effective May 31,2001, the Company issued to Frederick W. (Ted) Field, the Company’sChairman and former Chief Executive Officer, a non-qualified stock option topurchase 302,370 shares of common stock exercisable at $7.50 per share through May 30,2008.  The option vested over a period offive years from June 29, 2001, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $2,006,000,of which $201,000 was charged to operations in 2006.

 

15. 401(K) PLAN

 

The Companyhas adopted the Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) ofthe Internal Revenue Code (the “401(k) Plan”).  Under the 401(k) Plan, participatingemployees may defer a percentage (not to exceed 15%) of their eligiblepretax earnings up to the Internal Revenue Service’s annual contributionlimit.  All employees of the Company whoare 21 years or older and who complete three months of service are eligible toparticipate in the 401(k) Plan.  TheCompany does not match contributions by participants to the 401(k) Plan.  Accordingly, there is no related expense forthe years ended December 31, 2008 and 2007.

 

16.  COMMITMENTS AND CONTINGENCIES

 

LeaseCommitments

 

On January 30,2006, the Company entered into a sub-lease agreement for office facilities inSanta Monica, California, effective February 2, 2006 through November 30,2011, to house the operations of ADI and MediaDefender.  In connection with the sub-lease agreement,the Company provided an irrevocable standby bank letter of credit for $180,000as security for the Company’s obligations under the sub-lease agreement, whichwas secured by cash of $180,000, which was classified as restricted cash in theCompany’s balance sheet.  Pursuant to theterms of the sub-lease agreement, the letter of credit was reduced to $90,000during February 2007.

 

This lease contains predetermined fixed increases in the minimum rentalrate during the initial lease term.  TheCompany began to recognize the related rent expense on a straight-line basis onthe effective date of the lease.  TheCompany records the difference between the amount charged to expense and therent paid as deferred rent on the Company’s balance sheet.

 

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Future cashpayments under such operating lease are as follows (amounts are in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
|                                         |       |       |       |
| 2009                                         |       | 485        |       |
| 2010                                         |       | 499        |       |
| 2011                                         |       | 471        |       |
|                                         |       | $          | 1,455      |   |
|                                              |            |            |            |  |

 

Rent expenseunder operating leases for the years ended December 31, 2008 and 2007 was$470,000 and $441,000.

 

EmploymentAgreements

 

On July 28, 2005, the Company entered into an Employment Agreementwith Jonathan Diamond to serve as the Company’s Chief Executive Officer. Duringthe term of the Employment Agreement through December 31, 2008, Mr. Diamond’sbase salary would be no less than $350,000 per annum, plus certain specifiedperquisites that include a monthly car allowance. Mr. Diamond was alsoeligible to receive an annual discretionary bonus of up to 100% of base salary,as determined by the Compensation Committee of the Board of Directors or, ifnone, the Board of Directors, and an annual performance bonus of up to 100% ofbase salary if the Company achieved defined earnings before interest, taxes,depreciation and amortization in fiscal 2007 ($12,000,000 - $14,400,000) andfiscal 2008 ($15,000,000 - $18,000,000). Mr. Diamond was also entitled toreceive stock options at the discretion of the Company’s Board of Directors. Inthe event Mr. Diamond was terminated “without cause,” he would be entitledto receive 12 months of severance pay at the rate of 100% of his monthlysalary, any performance bonus due for the year in which termination occurs andall stock options subject to time vesting shall be deemed fully vested andexercisable.  On October 14, 2005, February 3,2006, June 19, 2006 and July 31, 2006, the Company entered intoagreements with Mr. Diamond to incorporate non-material modifications intothe Employment Agreement.

 

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

 

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

 

Effective August 31, 2007, Mr. Weingarten resigned from allpositions he held with the Company.  The Company and Mr. Weingartenentered into a Separation Agreement and Release dated August 31, 2007,whereas the Company and Mr. Weingarten mutually agreed to terminate theiremployment relationship as of August 31, 2007 and the parties releasedeach other from any and all claims.  As aresult of this resignation, the Company and Mr. Weingarten entered into anAgreement for Consulting Services (the “Consulting Agreement”) dated August 31,2007 whereas Mr. Weingarten would be retained as a consultant for atwelve-month period, unless sooner terminated pursuant to the terms of theConsulting Agreement, and shall be paid a base consulting fee of $16,250 permonth.  Upon the expiration of theConsulting agreement the Company entered into an open consulting agreementwithin Mr. Weingarten would be paid and hourly fee for services rendered andwould be reimbursed for expenses incurred on a monthly invoice.

 

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In addition, the Company and Mr. Weingarten entered into anOmnibus Stock Option Amendment Agreement (the “Option Agreement”) dated August 31,2007 whereas the Company agreed to amend certain provisions of stock optionspreviously granted to Mr. Weingarten (see Note 13).  Mr. Weingarten would be allowed toexercise the 120,000 stock options granted to him in 2004 until the originalexpiration date of March 29, 2011 without regard to his resignation fromthe Company.  Pursuant to the OptionAgreement, the vesting of time-vesting options to acquire 275,000 shares willbe accelerated provided he does not breach the Consulting Agreement such thatthe remaining unvested time-vesting options became fully vested and exercisableas of August 31, 2007.  The vesting of the performance-vestingoptions to acquire 275,000 shares will occur only upon the closing of a sale,merger or other “change of control” transaction at a price above $3.10 pershare occurring prior to August 31, 2008 provided he does not breach theConsulting Agreement.  In addition, Mr. Weingarten will be able toexercise the time-vesting options and the performance-vesting options, ifvested, until August 5, 2010, without regard to his resignation providedhe does not breach the Consulting Agreement.

 

In accordance with the MediaDefender transaction, the Companyacknowledged the terms of Employment Agreements entered into on July 28,2005 by MediaDefender with each of Randy Saaf, who serves as Chief ExecutiveOfficer of MediaDefender, and Octavio Herrera, who serves as President ofMediaDefender. Mr. Saaf and Mr. Herrera will each earn a base salaryof no less than $350,000 per annum during the initial term of the agreements,which shall continue until December 31, 2008, and are also each entitledto receive performance bonuses of up to $350,000 if MediaDefender achievesdefined operating earnings before interest, taxes, depreciation andamortization (calculated using the same accounting methods and policies asMediaDefender has historically used) exceeding $7,000,000 and $7,500,000 infiscal 2007 and fiscal 2008, respectively.  The Company determined to pay the performancebonuses to Mr. Saaf and Mr. Herrera for 2007, however there were nobonuses due for the year ended December 31, 2008.

 

In addition, the Company granted stock options to purchase 200,000shares of common stock to each of Mr. Saaf and Mr. Herrera,exercisable for a period of five years at $3.00 per share and vesting quarterlyover a period of three and one-half years. On July 28, 2006, the Company entered into agreements with Mr. Saafand Mr. Herrera to incorporate non-material modifications into theEmployment Agreements.

 

ConsultingAgreements

 

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

 

On October 1,2006, the Company entered into a one-year non-exclusive consulting agreementwith an entity for business development consulting services.  The consulting agreement provides for anaggregate cash fee of $108,000, consisting of an initial payment of $18,000 anda base fee payable monthly in twelve installments of $7,500, and stock options,consisting of an initial award of options to acquire 25,000 shares of commonstock, and subsequent awards of options to acquire 5,000 shares of common stockon the last day of each month of the term of the consulting agreement through September 30,2007.

 

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The stockoptions are fully vested when issued. Accordingly, during the years ended December 31, 2008 and 2007, theCompany issued options to acquire 0 shares and 45,000 shares of common stockunder this consulting agreement pursuant to the Company’s 2006 Equity IncentivePlan, exercisable through November 30, 2011, at prices ranging from $1.55to $2.30 per share, the market price on the date of grant.  The aggregate fair value of the options,calculated pursuant to the Black-Scholes option-pricing model was $0 and$71,000, respectively, which was charged to operations (see Note 13).

 

Legal Matters

 

The Company isperiodically subject to various pending and threatened legal actions that arisein the normal course of business.  TheCompany’s management believes that the impact of any such litigation will nothave a material adverse impact on the Company’s financial position or resultsof operations.

 

As a result ofthe restatement of our financial statements and the other events describedelsewhere in this Annual Report on Form 10-K, the Company has triggeredvarious events of default under our senior debt and subordinated debt financingdocuments.  We could be subject to futureclaims under our financing documents (see Note 18).

 

17.  REPORTABLE SEGMENTS

 

Informationwith respect to the Company’s operating segments for the years ended December 31,2008 and 2007 is presented below.  Duringthe years ended December 31, 2008 and 2007, the Company’s operationsconsisted of three reportable segments: e-commerce, media and anti-piracy and file-sharing marketing services.

 

The factorsfor determining reportable segments were based on services and products.  Each segment is responsible for executing aunique marketing and business strategy. The accounting policies of the segments are as described in the summaryof significant accounting policies.  TheCompany evaluates performance based on, among other factors, earnings or lossbefore interest, taxes, depreciation and amortization (“Adjusted EBITDA”).  Adjusted EBITDA also excludes stock-basedcompensation, changes in the fair value of warrant liability and derivativeliability, and other non-cash write-offs and charges.  Included in Adjusted EBITDA are directoperating expenses for each segment.

 

The tableshown below summarizes net revenue and Adjusted EBITDA by operating segment forthe years ended December 31, 2008 and 2007.  Corporate expenses consist of generaloperating expenses that are not directly related to the operations of thesegments.  A reconciliation of Net Income(Loss) to Adjusted EBITDA is also provided.

 
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                               | ** ** | **(in thousands)**                     | ** ** |
| Net Revenue:                                             |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | 336        |   | $ | 1,497 |   |
| Media                                                    |       | 3,995                                       |       | 7,500 |   |
| Anti-piracy and file-sharing marketing  services         |       | 7,810                                       |       | 15,174 |   |
|                                                     |       | $                                           | 12,141     |   | $ | 24,171 |   |
|                                                     |       |                                        |       |   |   |
| Adjusted EBITDA:                                         |       |                                        |       |   |   |
| E-commerce                                               |       | $                                           | (88        | ) | $ | (218 | ) |
| Media                                                    |       | 264                                         |       | 2,604 |   |
| Anti-piracy and file-sharing marketing  services         |       | 264                                         |       | 5,304 |   |
|                                                     |       | 440                                         |       | 7,690 |   |
| Corporate:                                               |       |                                        |       |   |   |
| General and administrative expenses                      |       | (3,635                                      | )          | (4,824 | ) |
| Liquidated damages under registration rights  agreements |       | —                                      |       | 395 |   |
|                                                     |       | $                                           | (3,195     | ) | $ | 3,261 |   |

 

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| ** **                                                                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                                                                                 | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                                                                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Reconciliation of Adjusted EBITDA to Net  Income (Loss):                                                                                   |       |                                        |       |   |   |
| Adjusted EBITDA per segments                                                                                                               |       | $                                           | (3,195     | )  | $ | 3,261 |   |
| Stock-based compensation                                                                                                                   |       | (991                                        | )          | (2,110 | ) |
| Depreciation and amortization                                                                                                              |       | (906                                        | )          | (1,015 | ) |
| Amortization of intangible assets                                                                                                          |       | (2,181                                      | )          | (3,602 | ) |
| Amortization of deferred financing costs                                                                                                   |       | (842                                        | )          | (841 | ) |
| Goodwill Impairment                                                                                                                        |       | (31,085                                     | )     | — |   |
| Write-off of unamortized discount on debt  and deferred financing costs resulting from principal payments on senior  secured notes payable |       | (25                                         | )     | — |   |
| Interest income                                                                                                                            |       | 51                                          |       | 211 |   |
| Other income                                                                                                                               |       | 340                                         |       | — |   |
| Write-off of fixed assets                                                                                                                  |       | —                                      |       | (97 | ) |
| Interest expense, including amortization of  discount on debt of $3,088 and $3,081 in 2008 and 2007, respectively                          |       | (8,740                                      | )          | (7,923 | ) |
| Change in fair value of warrant liability                                                                                                  |       | 130                                         |       | 4,551 |   |
| Change in fair value of derivative  liability                                                                                              |       | 302                                         |       | 18,043 |   |
| Provision (benefit) for income tax                                                                                                         |       | (814                                        | )          | 1,039 |   |
| Net income (loss)                                                                                                                          |       | $                                           | (47,956    | ) | $ | 11,517 |   |

 

The followingtable summarizes assets as of December 31, 2008 and 2007.  Assets by segment are those assets used in oremployed by the operations of each segment. Corporate assets are principally made up of cash and cash equivalents,prepaid expenses, computer equipment, leasehold improvements and other assets.

 
| ** **                                       | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **2008**                | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| ** **                                       | ** ** | ** **              | ** ** | ** ** | ** ** |
| Assets:                                          |       |                    |       |   |   |
| Corporate                                        |       | $                       | 1,437      |   | $ | 3,144 |   |
| E-commerce                                       |       | 241                     |       | 248 |   |
| Media                                            |       | 1,441                   |       | 2,149 |   |
| Anti-piracy and file-sharing marketing  services |       | 4,370                   |       | 44,923 |   |
|                                             |       | $                       | 7,489      |   | $ | 50,734 |   |

 

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18.  SUBSEQUENT EVENTS (UNAUDITED)

 

Debt Restructuring

 

*SeniorDebt Restructuring*

* *

Effective January 30,2009, ARTISTdirect, Inc. (the “Company”) entered into a First Amendment toNote and Warrant Purchase Agreement dated as of December 31, 2008 (the “SeniorAmendment”) with the holders of the Company’s senior secured debt (the “SeniorNote Holders”).  Pursuant to the Senior Amendment, the Senior Note Holdersagreed to extinguish all obligations by the Company under the Note and WarrantPurchase Agreement, dated July 28, 2005, and other documents entered intoin connection with the senior secured debt transaction (the “Senior DebtRestructuring”), upon completion of the following: (1) $3,500,000 cashpayment to the Senior Note Holders; (2) issuance of new subordinatednotes, in the aggregate principal amount of $1,000,000, to the Senior NoteHolders (the “New Notes”); (3) issuance of 9,000,000 restricted shares ofthe Company’s common stock to the Senior Note Holders, which are subject to alock-up period of 12 months; and (4) the conversion of all of thepreviously issued Subordinated Notes.

 

The New Notes are unsecuredand bear interest at 6.0% per annum, beginning January 30, 2009. Theprincipal and the interest accrued thereon are payable on the maturity date,January 30, 2014, and are subordinated to the senior indebtedness of theCompany.

 

Additionally, in connectionwith the Senior Debt Restructuring, Trilogy Capital Partners, Inc. agreedto deliver to the Company for cancellation a warrant to purchase up to 433,333shares of the Company’s capital stock at an exercise price of $2.00 pershare.  Fifty percent of such warrant was beneficially owned by DimitriVillard, the Company’s Chief Executive Officer, who had acquired such warrantsas part of the acquisition of 6,190,000 shares from Trilogy CapitalPartners, Inc., which occurred on January 15, 2009.

 

*Conversionof Subordinated Notes*

* *

In connection with theSenior Debt Restructuring, effective January 30, 2009, the Company enteredinto a Second Amendment to the Convertible Subordinated Note with holders ofthe Subordinated Notes representing no less than the majority of the currentoutstanding aggregate principal amount to provide for the immediate conversionof the Subordinated Notes (the “SubordinatedAmendment”). TheSubordinated Amendment also provides for the extinguishment of all obligationsof the Company under the Subordinated Notes and related documents, includingthe Registration Rights Agreement among the Company and the holders.  Suchobligations included the outstanding principal amount and accrued and unpaidinterest on the Subordinated Notes, accrued and unpaid late charges and amountsowed under the Registration Rights Agreement.

 

*Financingby Factoring Accounts Receivables*

* *

On January 30, 2009,the Company’s two wholly-owned subsidiaries, ARTISTdirect InternetGroup, Inc. (“ADIG”) and MediaDefender, Inc. each entered into anAccounts Receivable Purchase & Security Agreement (the “A/R Agreement”)with Pacific Business Capital Corporation (“PBCC”), pursuant to which ADIG and Mediadefenderagreed to sell and PBCC agreed to purchase qualified accounts receivable on a recoursebasis. On January 30, 2009, PBCC purchased an aggregate of approximately$1,600,000 of unpaid receivables to be acquired by PBCC pursuant to the A/RAgreement, subject to a maximum aggregate amount of $3,000,000. The A/RAgreement is effective for twelve-months and automatically renews forsuccessive 12-month periods unless terminated by written notice by either party30 days prior to such successive period.

 

As collateral for thefinancing, PBCC received a first priority interest in all existing and futureassets of the Company, ADIG and Mediadefender, tangible and intangible,including but not limited to, cash and cash equivalents, accounts receivable,inventories, other current assets, furniture, fixtures and equipment andintellectual property. In addition to the foregoing, the Company, ADIG and Mediadefenderentered into cross guarantees of their respective obligations under the A/RAgreement.

 

The following table is aproforma presentation of the Consolidated Balance Sheet reflecting the above describedDebt Restructuring as if it had occurred as of December 31, 2008.

 
| ** **                                              | ** ** | **December 31, 2008** | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **Audited**                     | ** ** | **Proforma** | ** ** |
| Assets:                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash                                                    |       | $                               | 2,262,000  |   | $ | 12,000 |   |
| Other current assets, net                               |       | 3,480,000                       |       | 3,480,000 |   |
| Property and equipment, net                             |       | 1,201,000                       |       | 1,201,000 |   |
| Other non-current assets, net                           |       | 546,000                         |       | 153,000 |   |
|                                                    |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |
|                                                    |       |                            |       |   |   |
| Liabilities and Stockholders’ Equity  (Deficiency) |       |                            |       |   |   |
| Accounts payable and accrued expenses                   |       | $                               | 921,000    |   | $ | 971,000 |   |
| Accrued interest and liquidated damages                 |       | 8,890,000                       |       | — |   |
| New credit facility                                     |       | —                          |       | 1,250,000 |   |
| Senior secured notes, net                               |       | 12,817,000                      |       | — |   |
| Subordinated convertible notes, net                     |       | 26,397,000                      |       | — |   |
| Other current liabilities                               |       | 1,228,000                       |       | 1,183,000 |   |
|                                                    |       | 50,253,000                      |       | 3,404,000 |   |
|                                                    |       |                            |       |   |   |
| New subordinated notes, net of discount                 |       | —                          |       | 270,000 |   |
| Other long-term liabilities                             |       | 159,000                         |       | 159,000 |   |
|                                                    |       | 159,000                         |       | 429,000 |   |
|                                                    |       |                            |       |   |   |
| Net  Stockholders’ Equity (Deficiency), net        |       | (42,923,000                     | )          | 1,013,000 |   |
|                                                    |       |                            |       |   |   |
|                                                    |       | $                               | 7,489,000  |   | $ | 4,846,000 |   |

 

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* *

*Convertible short-term note to Director*

 

On March 3, 2009, theCompany issued a convertible note (the “Note”) to Frederick W. Field, adirector of the Company.  The Note is in the principal amount of $200,000with the principal amount and accrued interest at the rate of 5% per annum dueon July 31, 2009.  The Note isautomatically convertible into shares of the Company’s Common Stock at a priceof $0.03 per share at such time as the Company has sufficient authorizedshares.

* *

*Managementand Director Changes*

* *

Effective January 13,2009, each of Randy Saaf and Octavio Herrera (each, an “Executive”) enteredinto separate amendments (collectively, the “Amendments”) to their respectiveEmployment, Confidentiality and Noncompetition Agreements (collectively,the “Employment Agreements”) dated as of July 28, 2005 withMediaDefender, Inc., the Company’s wholly owned subsidiary (the“Subsidiary”).  Under each of the Amendments, commencing January 1,2009 the term of employment between each Executive and the Subsidiary wereat-will, and either the Subsidiary or the Executive may terminate theapplicable Employment Agreement upon five days’ written notice, in which casesuch Executive shall have a period of 60 days from the effective date oftermination to exercise all vested stock options. Effective February 15,2009, MediaDefender, Inc., a wholly-owned subsidiary ofARTISTdirect, Inc., terminated the employment of Randy Saaf, ChiefExecutive Officer of MediaDefender, and Octavio Herrera, President of MediaDefender.

 

Effective February 1,2009, Dimitri Villard, the Chairman of the Board of Directors, was appointed toserve as the Company’s Chief Executive Officer. Prior to that date,Mr. Villard was the Company’s interim Chief Executive Officer.

 

Pursuant to a 3-yearemployment agreement, effective February 1, 2009, Mr. Villard willreceive base compensation equal to $25,000 per month.  Mr. Villardwill also be entitled to participate in the Company’s stock compensation planthat may exist from time to time and will receive a bonus based on theCompany’s EBITDA if the Company’s EBITDA exceeds a certain threshold amount asdetermined by the Company’s Compensation Committee for such fiscal year.

 

EffectiveFebruary 1, 2009, the Company and Rene Rousselet (“Executive”) entered into anEmployment Agreement pursuant to which Mr. Rousselet was employed to continueas the Company’s Corporate Controller and Principal Accounting Officer.  The employment is on an “at will basis.”  Mr. Rousselet will receive a salary of$14,583 per month subject to increases and a bonus as determined by the Boardof Directors, in its sole discretion. Mr. Rousselet was granted options to purchase 560,000 shares of theCommon Stock of the Company at $0.03 per share vesting monthly over 36 monthscommencing February 1, 2009.  If Mr.Rousselet’s employment is terminated without cause, Mr. Rousselet will receivehis salary and vesting of options for an additional period of three months fromthe date of termination.

 

*Acquisitionof MediaSentry*

* *

The Company and its whollyowned subsidiary, MediaDefender entered into an Asset Purchase Agreement datedas of March 30, 2009 (the “Purchase Agreement”) pursuant to which the Companythrough MediaDefender agreed to purchase from SafeNet, Inc. andMediaSentry, Inc. (collectively the “Sellers”), substantially all theassets of the MediaSentry operating unit (the “Acquired Assets”).  Inconnection with the acquisition, MediaDefender acquired the receivables,equipment and intellectual property of MediaSentry as well as assumedsubstantially all the employees, offices and client contracts relating toMediaSentry.  The purchase price of the Acquired Assets was $936,000consisting of $136,000 in cash and a $800,000 one-year promissory note of theCompany.  The acquisition was consummatedon March 30, 2009.  The MediaSentry operatingunit provides (a) comprehensive business and marketing intelligenceservices for digital media measurement and (b) services to globallydetect, track and deter the unauthorized distribution of digital content.

 

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INDEX TO EXHIBITS

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                   |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                              |
| 2.1                 |       | Agreement and Plan of Merger, dated July 28, 2005, by and among  ARTISTdirect, Inc., ARTISTdirect Merger Sub, Inc. and  MediaDefender, Inc. (incorporated by reference to current report on  Form 8-K filed on August 5, 2005).                                     |
|                |       |                                                                                                                                                                                                                                                                                              |
| 3.1                 |       | Fourth Amended and Restated Certificate of Incorporation of  ARTISTdirect, Inc. (incorporated by reference to Exhibit 3.1 to  current report on Form 8-K filed on June 22, 2006).                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                              |
| 3.2                 |       | Amended and Restated Bylaws of ARTISTdirect, Inc. (incorporated  by reference to current report on Form 8-K filed on April 18,  2006).                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.1                 |       | Form of 11.25% Senior Note Due July 28, 2009 issued to each  of the Senior Financing investors dated July 28, 2005 (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                   |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.2                 |       | Form of Warrant to Purchase Common Stock issued to each of the  Senior Financing investors dated July 28, 2005 (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                            |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.3                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and each of the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                          |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.4                 |       | Form of Convertible Subordinated Note issued to each of the  Sub-debt investors dated July 28, 2005 (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.5                 |       | Form of Sub-Debt Financing Warrant issued July 28, 2005  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.6                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and each of the Sub-Debt Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                        |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.7                 |       | Warrant issued to Libra FE, LP on July 28, 2005 (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.8                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and Libra FE, LP. (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.9                 |       | Warrant issued to WNT07, LLC on July 28, 2005 (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.10                |       | Waiver of Registration Rights Agreement, dated November 25,  2005, by and among ARTISTdirect, Inc. and certain of the Senior  Financing investors (incorporated by reference to current report on  Form 8-K filed on November 30, 2005).                                      |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.11                |       | Waiver of Registration Rights Agreement, dated November 25,  2005, by and among ARTISTdirect, Inc. and certain of the Sub-Debt  Financing investors (incorporated by reference to current report on  Form 8-K filed on November 30, 2005).                                    |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.12                |       | Omnibus Amendment to Note and Warrant Purchase Agreement and Warrants  to Purchase Common Stock by and between ARTISTdirect, Inc. and the  Senior Financing investors dated April 7, 2006 (incorporated by  reference to current report on Form 8-K filed on April 10, 2006). |
|                |       |                                                                                                                                                                                                                                                                                              |
| 4.13                |       | Amendment No.1 to Registration Rights Agreement by and between  ARTISTdirect, Inc. and the Senior Financing investors dated  April 7, 2006 (incorporated by reference to current report on  Form 8-K filed on April 10, 2006).                                                |

 

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| 4.14   |   | Omnibus Amendment and Waiver to Notes and Warrants Issued Pursuant to  Securities Purchase Agreement by and between ARTISTdirect, Inc. and the  Senior Financing investors dated April 7, 2006 (incorporated by  reference to current report on Form 8-K filed on April 10, 2006).                                                                                                                                           |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.15   |   | Amendment No.1 to Registration Rights Agreement executed by  ARTISTdirect, Inc. and CCM Master Qualified Fund dated April 7,  2006 (incorporated by reference to current report on Form 8-K filed on  April 10, 2006).                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.16   |   | Amendment No.1 to Registration Rights Agreement executed by  ARTISTdirect, Inc. and DKR SoundShore Oasis Holding Funding, Ltd. dated  April 7, 2006 (incorporated by reference to current report on  Form 8-K filed on April 10, 2006).                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.17   |   | First Amendment to Convertible Subordinated Note, dated December 16,  2008, by and among ARTISTdirect, Inc., Trilogy Capital Partners, Inc., Randy  Saaf and Octavio Herrera (incorporated by reference to Exhibit 4.1 to  current report on Form 8-K filed on December 19, 2008).                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.18   |   | Second Amendment to Subordinated Convertible Subordinated Note, dated  as of December 31, 2008, by and among ARTISTdirect, Inc., DKR Soundshore  Oasis Holding Fund Ltd., Trilogy Capital Partners, Inc., Michael Rapp,  Broadband Capital Management, LLC, Philip Wagenheim, Karl Brenza, Jeffrey  Meshel and Cliff Chapman (incorporated by reference to Exhibit 4.1 to  current report on Form 8-K filed on February 4, 2009). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.19   |   | Form of Subordinated Note, dated as of January 30, 2009, issued to  each of the Senior Lenders (incorporated by reference to Exhibit 4.2 to  current report on Form 8-K filed on February 4, 2009).                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.1   |   | Notice of Grant of Stock Option dated as of September 29, 2003  by and between ARTISTdirect, Inc. and Jon Diamond (incorporated by  reference to quarterly report on Form 10-Q filed on November 14,  2003).                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.2   |   | Settlement, Release and Termination of Lease Agreement dated as of  September 8, 2003, by and between 5670 Wilshire L.P. and  ARTISTdirect, Inc. (incorporated by reference to quarterly report on  Form 10-Q filed on November 14, 2003).                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.3   |   | Form of Director Indemnification Agreement (incorporated by  reference to registration statement on Form S-1/A filed on  January 27, 2000).                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.4   |   | Form of Officer Indemnification Agreement (incorporated by  reference to registration statement on Form S-1/A filed on  January 27, 2000).                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.5   |   | ARTISTdirect, Inc. 1999 Employee Stock Option Plan (incorporated  by reference to registration statement on Form S-1/A filed on  January 27, 2000).                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.6   |   | ARTISTdirect, Inc. Artist Plan (incorporated by reference to  registration statement on Form S-1/A filed on January 27, 2000).                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.7   |   | ARTISTdirect, Inc. Artist and Artist Advisor Plan (incorporated  by reference to registration statement on Form S-1/A filed on  January 27, 2000).                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.8   |   | ARTISTdirect, Inc. 2004 Consultant Stock Plan (incorporated by  reference to registration statement on Form S-8 filed on  January 13, 2005).                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.9   |   | Notice of Grant of Stock Option dated as of March 29, 2004 by  and between ARTISTdirect, Inc. and Robert N. Weingarten  (incorporated by reference to quarterly report on Form 10-Q filed on  August 20, 2004).                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.10  |   | ARTISTdirect, Inc. 2006 Equity Incentive Plan (incorporated by  reference to definitive proxy statement on Schedule 14A filed on May 8,  2006).                                                                                                                                                                                                                                                                                        |

 

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| 10.11  |   | Employment, Confidentiality and Noncompetition Agreement, dated  July 28, 2005, by and between MediaDefender, Inc. and Randy Saaf  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                                                                                 |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.12  |   | Employment, Confidentiality and Noncompetition Agreement, dated  July 28, 2005, by and between MediaDefender, Inc. and Octavio  Herrera (incorporated by reference to current report on Form 8-K filed  on August 3, 2005).                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.13  |   | Non-Competition Agreement, dated July 28, 2005, entered into  between MediaDefender, Inc. and Randy Saaf (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.14  |   | Non-Competition Agreement, dated July 28, 2005, entered into  between MediaDefender, Inc. and Octavio Herrera (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.15  |   | Note and Warrant Purchase Agreement, dated July 28, 2005, by and  among ARTISTdirect, Inc., the investors indicated on the schedule of  buyers thereto and U.S. Bank National Association, as Collateral Agent for  the Senior Financing investors (incorporated by reference to current report  on Form 8-K filed on August 3, 2005). |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.16  |   | Security Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and its subsidiaries and U.S. Bank National  Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005)                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.17  |   | Pledge Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and U.S. Bank National Association, as Collateral  Agent for the Senior Financing investors (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.18  |   | Form of Copyright Security Agreement (incorporated by reference  to current report on Form 8-K filed on August 3, 2005).                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.19  |   | Patent Security Agreement, dated July 28, 2005, by and among  MediaDefender, Inc. and U.S. Bank National Association, as Collateral  Agent for the Senior Financing investors (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.20  |   | Trademark Security Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and U.S. Bank National Association, as Collateral  Agent for the benefit of the Senior Financing investors (incorporated by  reference to current report on Form 8-K filed on August 3, 2005).                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.21  |   | Subsidiary Guaranty, dated July 28, 2005, made by  ARTISTdirect, Inc. and its subsidiaries in favor of U.S. Bank National  Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.22  |   | Securities Purchase Agreement, dated July 28, 2005, entered into  by and among ARTISTdirect, Inc. and the Sub-debt Financing investors  (incorporated by reference to current report on Form 8-K filed on  August 3, 2005).                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.23  |   | Subordination Agreement, dated July 28, 2005, among  ARTISTdirect, Inc., and certain of its subsidiaries, the Sub-debt  Financing investors and U.S. Bank National Association, as Collateral Agent  for the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).            |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.24  |   | Non-Competition Agreement, dated July 28, 2005, entered into  between ARTISTdirect, Inc. and WNT07, LLC (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                       |
| 10.25  |   | Employment Agreement, dated July 28, 2005, entered into between  ARTISTdirect, Inc. and Jon Diamond (incorporated by reference to current  report on Form 8-K filed on August 3, 2005).                                                                                                                                                |

 

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| 10.26  |   | Employment Agreement, dated July 28, 2005, entered into between  ARTISTdirect, Inc. and Robert Weingarten (incorporated by reference to  current report on Form 8-K filed on August 3, 2005).                                                                                                                                                                                                                                                                            |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.27  |   | Amendment No. 1 to Employment Agreement, dated October 11,  2005), entered into between ARTISTdirect, Inc. and Jon Diamond  (incorporated by reference to current report on Form 8-K filed on  October 14, 2005).                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.28  |   | Acknowledgement and Amendment regarding Employment Agreement by and  between ARTISTdirect, Inc. and Jon Diamond dated February 3, 2006  (incorporated by reference to current report on Form 8-K filed on  February 3, 2006).                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.29  |   | Acknowledgement and Amendment regarding Employment Agreement by and  between ARTISTdirect, Inc. and Robert Weingarten dated February 3,  2006 (incorporated by reference to current report on Form 8-K filed on  February 3, 2006).                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.30  |   | Sublease by and between Sapient Corporation and  ARTISTdirect, Inc. dated January 26, 2006 (incorporated by  reference to current report on Form 8-K filed on February 3, 2006).                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.31  |   | Amendment, dated July 28, 2006, to Employment, Confidentiality  and Non-Competition Agreement by and between ARTISTdirect, Inc. and  Randy Saaf (incorporated by reference to Exhibit 10.1 to current report  on Form 8-K filed on August 1, 2006).                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.32  |   | Amendment, dated July 28, 2006, to Employment, Confidentiality  and Non-Competition Agreement by and between ARTISTdirect, Inc. and  Randy Saaf (incorporated by reference to Exhibit 10.1 to current report  on Form 8-K filed on August 1, 2006).                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.33  |   | Offer of Employment between ARTISTdirect, Inc. and Rene  Rousselet approved as of February 2, 2007 (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on  February 6, 2007).                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.34  |   | Omnibus Stock Option Amendment Agreement dated August 31, 2007,  between the Registrant and Robert N. Weingarten (incorporated by reference to  Exhibit 10.69 to quarterly report on Form 10-QSB filed on  November 14, 2007).                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.35  |   | Separation Agreement and Release dated August 31, 2007, between  the Registrant and Robert N. Weingarten (incorporated by reference to  Exhibit 10.70 to quarterly report on Form 10-QSB filed  November 14, 2007).                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.36  |   | Engagement Letter, dated as of February 7, 2008, by and between  the Registrant and Salem Partners LLC (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on  February 14, 2008).                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.37  |   | Amended and Restated Services Agreement dated as of March 6,  2008 between the Company and Jon Diamond (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed March 12,  2008).                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.38  |   | Amendment No. 1 to Employment, Confidentiality and Noncompetition  Agreement dated as of December 23, 2008 between the Company and Randy Saaf  (incorporated by reference to Exhibit 10.1 to current report on  Form 8-K filed on January 13, 2009).                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.39  |   | Amendment No. 1 to Employment, Confidentiality and Noncompetition  Agreement dated as of December 23, 2008 between the Company and Octavio  Herrera (incorporated by reference to Exhibit 10.2 to current report on  Form 8-K filed on January 13, 2009).                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.40  |   | First Amendment to Note and Warrant Purchase Agreement, dated as of  December 31, 2008, by and among ARTISTdirect, Inc., U.S. Bank National  Association, JMB Capital Partners, L.P., JMG Capital Partners, L.P., CCM  Master Qualified Fund, Ltd., JMG Triton Offshore Fund, Ltd., and with respect  to Section 3 only, Trilogy Capital Partners, Inc.  (incorporated by reference to Exhibit 10.1  to current report on Form 8-K filed on February 4, 2009). |

 

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| 10.41  |   | Form of Accounts Receivable Purchase & Security Agreement with  Pacific Business Capital Corporation, dated as of January 27, 2009  (incorporated by reference to  Exhibit 10.2 to current report on Form 8-K filed on  February 4, 2009). |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                               |
| 10.42  |   | Employment Agreement dated as of February 1, 2009 between Rene  Rousselet and the Company (incorporated by reference to Exhibit 10.1 to  current report on Form 8-K filed on March 11, 2009).                                                  |
|   |   |                                                                                                                                                                                                                                                               |
| 10.43  |   | Employment Agreement dated as of February 1, 2009 between  Dimitri Villard and the Company (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on March 23,  2009).                                                |

 
| 10.44  |   | Asset Purchase Agreement dated as of March 30, 2009 among the  Company, MediaDefender, SafeNet, Inc. and MediaSentry, Inc. (incorporated by  reference to Exhibit 10.1 to current report on Form 8-K filed on April 2,  2009). |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                          |
| 10.45  |   | Promissory Note dated March 30, 2009 of the Company (incorporated by  reference to Exhibit 10.2 to current report on Form 8-K filed on  April 2, 2009).                                                                        |
|   |   |                                                                                                                                                                                                                                          |
| 14.1   |   | Code of Business Conduct and Ethics (incorporated by reference to current  report on Form 8-K filed on June 22, 2006).                                                                                                              |
|   |   |                                                                                                                                                                                                                                          |
| 14.2   |   | ARTISTdirect, Inc. Audit Committee Charter (incorporated by  reference to definitive proxy statement on Schedule 14A filed on May 8,  2006).                                                                                        |
|   |   |                                                                                                                                                                                                                                          |
| 21.1   |   | Subsidiaries of ARTISTdirect, Inc. (incorporated by reference to  registration statement on Form SB-2 filed on November 10, 2005).                                                                                             |
|   |   |                                                                                                                                                                                                                                          |
| 23.1   |   | Consent of Gumbiner Savett Inc., independent registered public  accounting firm, with respect to ARTISTdirect, Inc. and subsidiaries.                                                                                                    |
|   |   |                                                                                                                                                                                                                                          |
| 31.1   |   | Certifications of the Chief Executive Officer under Section 302  of the Sarbanes-Oxley Act.                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                          |
| 31.2   |   | Certifications of the Principal Accounting Officer under  Section 302 of the Sarbanes-Oxley Act.                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                          |
| 32.1   |   | Certifications of the Chief Executive Officer under Section 906  of the Sarbanes-Oxley Act.                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                          |
| 32.2   |   | Certifications of the Principal Accounting Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                                                         |

 

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