** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

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** **

**FORM 10-KSB/A**

** **

**Amendment No. 1**

** **

**(Mark One)**

| **ý** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**     |
|------------|------------|-------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                      |
| ** ** | ** ** | **For the  fiscal year ended December 31, 2005**                                                |
| ** ** | ** ** | ** **                                                                                      |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**Commission File Number:  000-30063**

 

**ARTISTdirect, Inc.**

(Name of Small Business Issuerin 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 Principal ExecutiveOffices, including Zip Code)

 

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

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**Securities registered pursuant to Section 12(b) of theAct:  NoneSecurities registered pursuant to Section 12(g) of the Act:  common stock, $0.01 par value**

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** **

Checkwhether the issuer is not required to file reports pursuant to Section 13or 15(d) of the Exchange Act. o

 

Checkwhether 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 shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý No o

 

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B contained in this form, and no disclosure will be contained, tothe best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB o

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).

Yes o No ý

 

Stateissuer’s revenues for its most recent fiscal year. $13,971,000.

 

Asof March 29, 2006, the aggregate market value of the voting common stock heldby non-affiliates of the registrant was approximately $25,981,540, based on theclosing price per share of $4.47 for the registrant’s common stock as reportedon the Over-the-Counter Bulletin Board on such date.

 

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

 

**Documents incorporated by reference**:  Theregistrant has incorporated by reference into Part III of this Form 10-KSBportions of its definitive proxy statement to be filed with the Securities andExchange Commission within 120 days after the fiscal year end to which thisReport relates.

 

 

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**Explanatory Note**

 

This Amendment No. 1 to theAnnual Report on Form 10-KSB/A of ARTISTdirect, Inc. for the fiscal year endedDecember 31, 2005 (“Amendment No. 1”) is being filed primarily to correctcertain pro forma financial disclosures contained in “ITEM 6. MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION” and in Note 9 to the ConsolidatedFinancial Statements.  This Amendment No.1 does not revise or update or in any way effect any other information ordisclosures contained in the previously filed document, except for Signatures,the Exhibit 31.1 and 31.2 Certifications, the Exhibit 32.1 and 32.2Certifications and to update the incorporation by reference information for ExhibitNumber 3.2.

 

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

** **

**TABLE OF CONTENTS**

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

 

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**NOTE CONCERNING FORWARD-LOOKING STATEMENTS**

** **

*In addition to historical information, this Annual Report onForm 10-KSB/A (“Annual Report”) for ARTISTdirect, Inc. (“ARTISTdirect,” the “Company,”“we,” “our”  or “us”) contains “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended(the “Exchange Act”), including statements that include the words “may,” “will,”“believes,” “expects,” “anticipates,” or similar expressions. These forwardlooking statements may include, among others, statements concerning ourexpectations regarding our business, growth prospects, revenue trends,operating costs, working capital requirements, competition, results ofoperations and other statements of expectations, beliefs, future plans andstrategies, anticipated events or trends, and similar expressions concerningmatters that are not historical facts. The forward-looking statements in thisAnnual Report involve known and unknown risks, uncertainties and other factorsthat could cause our actual results, performance or achievements to differmaterially from those expressed or implied by the forward-looking statementscontained herein.*

 

*Each forward-looking statement should be read in contextwith, and with an understanding of, the various disclosures concerning ourbusiness made elsewhere in this Annual Report, as well as other public reportsfiled by us with the United States Securities and Exchange Commission.Investors should not place undue reliance on any forward-looking statement as aprediction of actual results of developments. Except as required by applicablelaw or regulation, we undertake no obligation to update or revise anyforward-looking statement contained in this Annual Report.*

 

**PART I**

** **

**ITEM 1.****                            ****DESCRIPTION OF BUSINESS**

** **

**General**

** **

Incorporatedunder the laws of the****State ofDelaware in July 1999, we are a digital media entertainment company that ishome to an on-line music network. Through our acquisition of MediaDefender,Inc., a Delaware corporation (“MediaDefender”), in July 2005, we are also aprovider of anti-piracy solutions in the Internet piracy protection industry.Below is an overview of our three business segments:

** **

•                  *Media.*Our media operations include ourcontent-oriented web-sites, a network of third party music sites and ourentertainment marketing initiatives. Revenue from media operations is generatedfrom the sale of online advertising and integrated marketing solutions. Wemarket and sell advertising on a cost-per-impression basis to advertisingagencies and directly to various companies as part of their marketing programs.Customers may purchase advertising space for the entire ARTISTdirect network,or they may tailor advertising based on music genre (e.g., jazz, country orrock music) or based on functionality (e.g., directing advertising to customersusing music download features or broadband-only features of the ARTISTdirectnetwork). Since we are increasingly aware of web-sites outside the ARTISTdirectnetwork that are frequently visited by artists and music fans, we have alsooffered our customers advertising space on behalf of third party music-related web-sites.Our media segment accounted for 42% and 38% of our revenue during the fiscalyears ended December 31, 2004 and 2005, respectively. Refer to “ARTISTdirectOverview-Media and E-Commerce Segments” below for additional information.

 

•                  *E-Commerce.*E-commerce operations consist of the sale ofrecorded music and artist-related merchandise on our web-sites. Most of oursales come from our ARTISTdirect shopping area, which offers a comprehensiveselection of music CDs and broad range of artist and lifestyle merchandise. Oure-commerce segment accounted for 58% and 19% of our revenue during the fiscalyears ended December 31, 2004 and 2005, respectively. Refer to “ARTISTdirectOverview-Media and E-Commerce Segments” below for additional information.

 

•                  *Internet Piracy Prevention.*Our Internet piracyprevention (“IPP”) segment is currently operated by MediaDefender, as awholly-owned subsidiary of ARTISTdirect. MediaDefender’s proprietary suite of IPPsolutions offers significant levels of protection on the 15 major peer-to-peer(“P2P”) file-sharing networks, as well as on Internet Relay Chat (“IRC”) andUsenet. MediaDefender’s uber-level solutions are capable of providing up to 95%effectiveness in preventing unauthorized downloads of customer-specifiedcontent. Although MediaDefender was acquired by us in the third quarter offiscal 2005, our IPP segment accounted for 43% of our revenue during the fiscalyear ended December 31, 2005. Refer to “MediaDefender Overview-InternetAnti-Piracy Segment” and “Media Defender Acquisition” below for additionalinformation.

 

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AtDecember 31, 2005, we employed 57 full-time employees and eight part-timeconsultants, none of whom are covered by a collective bargaining agreement. Webelieve that our relationship with our employees is good.

 

**MediaDefenderAcquisition**

 

Weconsummated the acquisition of MediaDefender in July 2005. The aggregateconsideration for the acquisition was $42.5 million in cash, subject to aholdback of $4.25 million which was placed into an escrow account to covercertain indemnification claims for a limited period of time ($2.0 million ofwhich has been released to former MediaDefender stockholders since the closingof the acquisition). Concurrent with the consummation of the acquisition, wecompleted a $15.0 million senior secured debt transaction and a $30.0 millionconvertible subordinated debt transaction. Refer to “Management’s Discussionand Analysis or Plan of Operation” for additional information related to thefinancing transactions.

 

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

 

TheARTISTdirect network (www.artistdirect.com) is a network of web-sites offeringmulti-media content, music news and information, community around shared musicinterests, advertising sponsorships, music-related specialty commerce anddigital music services.

 

Ournetwork consists of our music search engine and database containing informationon more than 100,000 artists, retail goods, e-commerce offering a wideselection of artist merchandise and music, our proprietary music guide thatenables users to browse music by artist, genre or time period, a music-orientedonline community and the ability for users to download and listen to music andview music videos.

 

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

 

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

 

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

 

•                  We have a month-to-month agreement withAlliance Entertainment Corp. (“Alliance”) to be the primary supplier of ourmusic and music-related information. Alliance fulfills compact discs ordered byour customers and we pay Alliance the wholesale cost plus a fulfillment fee. Inaddition, Alliance provides warehouse space and fulfillment services pursuantto an oral agreement that Alliance may terminate at any time for a majority ofthe music-related merchandise that we offer which allows the consolidatedshipping of customer orders for both music and merchandise.

 

•                  We have a month-to-month agreement with BennCo., LLC (“Benn Co.”) for it to be a wholesale supplier of music-relatedmerchandise and provide fulfillment services for the products for which itsells to us.

 

Ifwe are unable to continue our agreements with these suppliers our businesscould be adversely affected.

 

*Customer Service.*We have a month-to-month agreement with Alliance to provide customersupport services for our web-sites’ consumers and respond to customerinquiries, orders and other requests made by phone, fax, e-mail and regularmail.

 

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

 

Weuse a number of methods to create awareness of the ARTISTdirect networkdesigned to drive traffic to our web-sites. We have focused much of ourmarketing activity on e-mail direct marketing to communicate with registeredusers about specific artists and the ARTISTdirect network. Campaigns haveincluded direct notification of special merchandise offers, contests,promotions and available music downloads. To the extent our registeredusers in the future opt out of e-mails or use technology to block marketinge-mails, our operating results could be adversely affected. Ad-blockingtechnologies may be used to limit the effectiveness of web advertising.

 

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

 

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

 

•                  for music consumers and advertisers withproviders of music information, community and content such as MTV, AmericaOnline, MSN, Yahoo!, Listen.com and various other companies;

 

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

 

•                  for music consumers and artist relationshipswith traditional music industry companies, including Sony BMG MusicEntertainment, EMI Music, a unit of EMI Group, Warner Music Group, andUniversal Music Group, a unit of Vivendi. Some of these companies have recentlyestablished online presences to promote and distribute the music and tours oftheir respective artists;

 

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

 

•                  with traditional retailers targeting musicconsumers, including Tower Records and Virgin Megastore and their Internetaffiliates, in selling music and merchandise.

 

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

 

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

 

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

 

•                  the ease of use and consumer acceptance ofthe ARTISTdirect network.

 

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

 

•                  longer operating histories;

 

•                  significantly greater financial, technicaland marketing resources;

 

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•                  greater brand name recognition;

 

•                  larger existing customer bases; and

 

•                  more popular 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. Web-sites 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-sitetraffic levels, 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 and regulations that govern ourbusiness change rapidly. Although our operations are currently based inCalifornia, the United States government and the governments of other statesand foreign jurisdictions have attempted to regulate activities on theInternet. The following are some of the evolving areas of law that are relevantto our business:

 

*Content Regulation.*Federal, state and foreign governments haveadopted and proposed laws governing the content of material transmitted overthe Internet. These include laws relating to obscenity, indecency, libel anddefamation. For example, the Child Online Protection Act, or “COPA,” prohibitsand imposes criminal penalties and civil liability on anyone communicating materialharmful to minors through the Internet for commercial purposes, unless accessto such material is blocked to minors under age 17. The Third U.S. CircuitCourt of Appeals has upheld a preliminary injunction precluding enforcement ofCOPA. In June 2004, the U.S. Supreme Court upheld the injunction and remandedthe case to the District Court. We could be liable if the injunction againstCOPA is lifted and if content delivered by us or placed on our web-sitesviolates COPA.

 

*Privacy Law.*The state of privacy law is unsettled, and rapidly changing. Currentand proposed federal, state and foreign privacy regulations and other lawsrestricting the collection, use and disclosure of personal information couldlimit our ability to use the information in our databases to generate revenues.In late 1998, the Children’s Online Privacy Protection Act, or “COPPA,” wasenacted, mandating that measures be taken to safeguard minors under the age of13. The Federal Trade Commission (“FTC”) promulgated regulations implementingCOPPA on October 21, 1999, which became effective on April 21, 2000.

 

Theprincipal COPPA requirement is that individually identifiable information aboutminors under the age of 13 not be collected, used, displayed or otherwisecollected without first obtaining informed parental consent that is verifiablein light of present technology. The FTC final regulations create a “slidingscale” of permissible methods for obtaining such consent based on how theinformation will be used. Consent for internal use of the individuallyidentifiable information of children under the age of 13 can be obtainedthrough e-mail plus an additional safeguard, such as confirming consent with adelayed e-mail, telephone call, or letter.

 

Wecomply with the COPPA requirements by not collecting or displaying theindividually identifying information of users who, when attempting to registeron the web-sites, enter their birth date indicating they are under the age of13. Complying with the COPPA requirements is costly and may dissuade some ofour potential customers.

 

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

 

*Laws Governing Sending of Unsolicited Commercial E-mail.*We typically provide our customers and othervisitors to our web-sites with an opportunity to “opt-in,” or agree to receivee-mail from us. The federal government signed the Controlling the Assault ofNon-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM) designed tolimit unsolicited commercial e-mail commonly referred to as “spam.” Inaddition, California and a number of other states regulate the sending ofe-mails for commercial

 

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purposes to third parties wherethere is no preexisting business relationship. Further, several states giveInternet service providers (“ISPs”) a private right of action against those whosend large e-mailings across their servers in contravention of the ISP’s postedpolicy. There is no guarantee that we will always be fully compliant in all ofour communications at all times. Our failure to comply with applicable lawsregarding these types of e-mails could result in significant fines, actual orstatutory damages, and injunctive actions.

 

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

 

*Sales Tax.*The tax treatment of goods sold over the Internet is currentlyunsettled. We collect sales taxes for goods shipped to California and Florida,where we have a physical presence (i.e., a “nexus”). A number of proposals havebeen made at the state and local level that would impose additional taxes onthe sale of goods through the Internet. Such proposals, if adopted, couldsubstantially impair the growth of electronic commerce and could adverselyaffect our opportunity to derive financial benefit from electronic commerce.The Internet Tax Freedom Act (ITFA), which placed a moratorium on new state andlocal taxes on Internet commerce, expired on November 1, 2003, but hassince been reinstated through November 2007 as part of the Internet TaxNondiscrimination Act.

 

*OnlineContests and Sweepstakes.*We conduct online promotional contests and sweepstakes. No purchase isnecessary 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 web-sites.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 ourpromotions in a way that attempts to comply with applicable statutes ascurrently interpreted and enforced in all fifty states, many of those statuteswere drafted long before the advent of promotions over the Internet, anddifferent states have interpreted substantially similar statutes differently.Thus, our ability to conduct online promotions is subject to the broaddiscretionary enforcement powers vested in various authorities. Further, ourability to conduct online promotions may be affected in whole or in part byvarious business method patents that may have been issued. In addition, foreignjurisdictions may attempt to regulate or ban our promotional contests. Underany of those three scenarios, we could face fines or possible exposure toliability or lose an effective tool for increasing traffic to and keepingvisitors at our web-sites, and our business could be adversely affected.

 

*Intellectual Property.*Software,**contentand other material that we develop, as well as our service marks and domainnames relating to the ARTISTdirect or UBL brands, and other proprietary rightsare important to our business prospects. Significant impairment of ourintellectual property rights could harm our business. We seek to protectcertain of our common-law trademarks through Federal registration in the UnitedStates of America and State registrations in Puerto Rico. We also havetrademark registrations in Argentina, Australia, Brazil, Canada, Chile, CostaRica, the European Union, France, Germany, Japan, Mexico, Panama, Peru, theUnited Kingdom and Venezuela. Given the cost of filing, maintaining andprotecting federal registrations, we may choose not to register or enforce ourcopyrights or other innovations or certain of our trademarks that later turnout to be important. Despite our efforts, it is possible that the scope ofprotection gained from seeking trademark registration will be insufficient orthat the registration may be deemed invalid or unenforceable.

 

Weseek to protect many of our innovations as trade secrets and principally relyupon trade secret and contract law in the Unites States to protect ourproprietary rights. We generally enter into confidentiality agreements, “work-made-for-hire”contracts and intellectual property licenses with our employees, consultantsand corporate partners, respectively, as part of our efforts to control accessto and distribution of our technologies, content and other proprietaryinformation. For example, where consultants develop copyrighted content for us,our general policy is to use written agreements prior to content creation toobtain ownership of that content.

 

The following sets forth aschedule of our active trademarks:

 

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Federal Trademark Filings

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

 

State Trademark Filings

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

 

International Filings

 
| **MARK**        | ** ** | **COUNTRY**     | ** ** | **APPL. NO.** | ** ** | **REG. NO.** | ** ** | **REG. DATE** |
|-----------------|------------|-----------------|------------|---------------|------------|--------------|------------|---------------|
| A &  Design |       | Argentina       |       | 2,320,737     |       | 1911466      |       | 1/27/2003     |
| A &  Design |       | Argentina       |       | 2,320,739     |       | 1911467      |       | 1/27/2003     |
| A &  Design |       | Argentina       |       | 2,374,722     |       | *            |       |          |
| A &  Design |       | Australia       |       | 908102        |       | 908102       |       | 3/28/2002     |
| A &  Design |       | Brazil          |       | 824492609     |       | *            |       |          |
| A &  Design |       | Brazil          |       | 822892340     |       | *            |       |          |
| A &  Design |       | Brazil          |       | 822892359     |       | *            |       |          |
| A &  Design |       | Brazil          |       | 822892332     |       | *            |       |          |
| A &  Design |       | Costa Rica      |       | 2002-0003186  |       | 136855       |       | 1/21/2003     |
| A &  Design |       | European  Union |       | 2006336       |       | 2006336      |       | 6/20/2002     |
| A &  Design |       | France          |       | 23158012      |       | 23158012     |       | 4/8/2002      |
| A &  Design |       | Germany         |       | 30217397.8/09 |       | 30217397     |       | 4/5/2002      |
| A &  Design |       | Japan           |       | 2002-24589    |       | 4648627      |       | 2/28/2003     |
| A &  Design |       | Mexico          |       | 464672        |       | 708608       |       | 7/30/2001     |
| A &  Design |       | Mexico          |       | 464671        |       | 699283       |       | 5/24/2001     |
| A &  Design |       | Mexico          |       | 464670        |       | 703484       |       | 6/21/2001     |
| A &  Design |       | Mexico          |       | 541631        |       | 785949       |       | 3/31/2003     |
| A &  Design |       | Panama          |       | 112008        |       | *            |       |          |
| A &  Design |       | Panama          |       | 112010        |       | *            |       |          |
| A &  Design |       | Panama          |       | 112009        |       | *            |       |          |
| A &  Design |       | Peru            |       | 120227        |       | *            |       |          |
| A &  Design |       | Peru            |       | 120228        |       | *            |       |          |
| A &  Design |       | Peru            |       | 120229        |       | *            |       |          |
| A &  Design |       | Peru            |       | 151886-2002   |       | 82635        |       | 8/22/2002     |
| A &  Design |       | United  Kingdom |       | 2296994       |       | 2296994      |       | 8/30/2002     |
| ARTISTDIRECT    |       | Argentina       |       | 2,264,378     |       | 1886206      |       | 9/20/2002     |
| ARTISTDIRECT    |       | Argentina       |       | 2,264,379     |       | 1886207      |       | 9/20/2002     |
| ARTISTDIRECT    |       | Argentina       |       | 2,264,380     |       | 1886208      |       | 9/20/2002     |
| ARTISTDIRECT    |       | Argentina       |       | 2,264,381     |       | 1886209      |       | 9/20/2002     |
| ARTISTDIRECT    |       | Argentina       |       | 2,374,721     |       | 1920978      |       | 4/3/2003      |
| ARTISTDIRECT    |       | Australia       |       | 818867        |       | 818867       |       | 12/30/1999    |
| ARTISTDIRECT    |       | Australia       |       | 908101        |       | 908101       |       | 3/28/2002     |
| ARTISTDIRECT    |       | Brazil          |       | 821955756     |       | *            |       |          |
| ARTISTDIRECT    |       | Brazil          |       | 821955764     |       | *            |       |          |
| ARTISTDIRECT    |       | Brazil          |       | 821955730     |       | *            |       |          |
| ARTISTDIRECT    |       | Brazil          |       | 821955748     |       | *            |       |          |
| ARTISTDIRECT    |       | Brazil          |       | 824492625     |       | *            |       |          |
| ARTISTDIRECT    |       | Canada          |       | 864116        |       | 512153       |       | 5/25/1999     |
| ARTISTDIRECT    |       | Chile           |       | 471162        |       | 574481       |       | 8/18/2000     |
| ARTISTDIRECT    |       | Chile           |       | 471163        |       | 574480       |       | 8/18/2000     |
| ARTISTDIRECT    |       | Chile           |       | 471161        |       | 574482       |       | 8/18/2000     |
| ARTISTDIRECT    |       | Chile           |       | 471160        |       | 574469       |       | 8/18/2000     |
| ARTISTDIRECT    |       | Costa Rica      |       | 1999-0010547  |       | 121896       |       | 8/24/2000     |
| ARTISTDIRECT    |       | Costa Rica      |       | 1999-0010548  |       | 121134       |       | 7/27/2000     |
| ARTISTDIRECT    |       | Costa Rica      |       | 1999-0010549  |       | 121133       |       | 7/27/2000     |
| ARTISTDIRECT    |       | Costa Rica      |       | 1999-0010550  |       | 121132       |       | 7/27/2000     |
| ARTISTDIRECT    |       | Costa Rica      |       | 2002-0003185  |       | 136854       |       | 1/21/2003     |

 

6

----

 
| ARTISTDIRECT            |   | European  Union |   | 699538        |   | 699538   |   | 6/5/2000   |
|-------------------------|--------|-----------------|--------|---------------|--------|----------|--------|------------|
| ARTISTDIRECT            |   | France          |   | 23158011      |   | 23158011 |   | 4/8/2002   |
| ARTISTDIRECT            |   | Germany         |   | 30217395.1/09 |   | 30217395 |   | 4/5/2002   |
| ARTISTDIRECT            |   | Japan           |   | 183723/1997   |   | 4359836  |   | 2/10/2000  |
| ARTISTDIRECT            |   | Japan           |   | 2002-24588    |   | 4648626  |   | 2/28/2003  |
| ARTISTDIRECT            |   | Mexico          |   | 409261        |   | 645860   |   | 3/22/2000  |
| ARTISTDIRECT            |   | Mexico          |   | 409262        |   | 645861   |   | 3/22/2000  |
| ARTISTDIRECT            |   | Mexico          |   | 409263        |   | 649514   |   | 3/31/2000  |
| ARTISTDIRECT            |   | Mexico          |   | 409264        |   | 645862   |   | 3/22/2000  |
| ARTISTDIRECT            |   | Mexico          |   | 541632        |   | 743912   |   | 4/29/2002  |
| ARTISTDIRECT            |   | Panama          |   | 105638        |   | 105638   |   | 2/15/2001  |
| ARTISTDIRECT            |   | Panama          |   | 105641        |   | 105641   |   | 2/15/2001  |
| ARTISTDIRECT            |   | Panama          |   | 105640        |   | 105640   |   | 2/15/2001  |
| ARTISTDIRECT            |   | Panama          |   | 105642        |   | 105642   |   | 2/15/2001  |
| ARTISTDIRECT            |   | Peru            |   | 99622         |   | 22837    |   | 9/12/2000  |
| ARTISTDIRECT            |   | Peru            |   | 99623         |   | 22761    |   | 9/8/2000   |
| ARTISTDIRECT            |   | Peru            |   | 99624         |   | 22762    |   | 9/8/2000   |
| ARTISTDIRECT            |   | Peru            |   | 099625-2000   |   | 25765    |   | 5/24/2001  |
| ARTISTDIRECT            |   | Peru            |   | 151884-2002   |   | 82854    |   | 9/4/2002   |
| ARTISTDIRECT            |   | United  Kingdom |   | 2296996       |   | 2296996  |   | 10/4/2002  |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003045   |   | S-015483 |   | 11/22/2000 |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003043   |   | S-015481 |   | 11/22/2000 |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003044   |   | S-015482 |   | 11/22/2000 |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003042   |   | S-015480 |   | 11/22/2000 |
| ARTISTDIRECT  DIGITAL   |   | Japan           |   | 2002-095128   |   | 4688729  |   | 7/4/2003   |
| THE ULTIMATE  BAND LIST |   | Argentina       |   | 2.119.984     |   | 1720730  |   | 2/10/1999  |
| THE ULTIMATE  BAND LIST |   | Argentina       |   | 2.119.985     |   | 1720731  |   | 2/10/1999  |
| THE ULTIMATE  BAND LIST |   | Australia       |   | 750646        |   | 750646   |   | 12/9/1997  |
| THE ULTIMATE  BAND LIST |   | Brazil          |   | 820399078     |   | *        |   |       |
| THE ULTIMATE  BAND LIST |   | Brazil          |   | 820399086     |   | *        |   |       |
| THE ULTIMATE  BAND LIST |   | Canada          |   | 863917        |   | 511964   |   | 5/18/1999  |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471173        |   | 574472   |   | 8/18/2000  |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471172        |   | 574473   |   | 8/18/2000  |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471171        |   | 574474   |   | 8/18/2000  |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471170        |   | 574475   |   | 8/18/2000  |
| 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  |

 

7

----

 
| THE ULTIMATE  BAND LIST |   | Costa Rica      |   | 1999-0010558 |   | 121895  |   | 8/24/2000  |
|-------------------------|--------|-----------------|--------|--------------|--------|---------|--------|------------|
| THE ULTIMATE  BAND LIST |   | European  Union |   | 699355       |   | 699355  |   | 2/25/2000  |
| THE ULTIMATE  BAND LIST |   | Japan           |   | 183722/1997  |   | 4359835 |   | 2/10/2000  |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409269       |   | 647112  |   | 3/27/2000  |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409270       |   | 647113  |   | 3/27/2000  |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409271       |   | 645866  |   | 3/22/2000  |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409272       |   | 645867  |   | 3/22/2000  |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105628       |   | 105628  |   | 2/15/2001  |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105627       |   | 105627  |   | 4/6/2001   |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105626       |   | 105626  |   | 2/13/2001  |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105629       |   | 105629  |   | 2/13/2001  |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99630        |   | 23005   |   | 9/28/2000  |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99631        |   | 22959   |   | 9/20/2000  |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99632        |   | 26107   |   | 6/18/2001  |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99633        |   | 23034   |   | 9/29/2000  |
| UBL                     |   | Argentina       |   | 2,119,987    |   | 1846303 |   | 10/2/2001  |
| UBL                     |   | Argentina       |   | 2,119,986    |   | 1870610 |   | 5/10/2002  |
| UBL                     |   | Australia       |   | 750647       |   | 750647  |   | 12/9/1997  |
| UBL                     |   | Brazil          |   | 820399060    |   | *       |   |       |
| UBL                     |   | Brazil          |   | 820399051    |   | *       |   |       |
| UBL                     |   | Canada          |   | 863917       |   | 503204  |   | 10/28/1998 |
| UBL                     |   | Chile           |   | 471167       |   | 574476  |   | 8/18/2000  |
| UBL                     |   | Chile           |   | 471166       |   | 574477  |   | 8/18/2000  |
| UBL                     |   | Chile           |   | 471165       |   | 574478  |   | 8/18/2000  |
| UBL                     |   | Chile           |   | 471164       |   | 574479  |   | 8/18/2000  |
| UBL                     |   | Costa Rica      |   | 1999-0010551 |   | 121890  |   | 8/24/2000  |
| UBL                     |   | Costa Rica      |   | 1999-0010552 |   | 121888  |   | 8/24/2000  |
| UBL                     |   | Costa Rica      |   | 1999-0010553 |   | 121131  |   | 7/27/2000  |
| UBL                     |   | Costa Rica      |   | 1999-0010554 |   | 121889  |   | 8/24/2000  |
| UBL                     |   | European  Union |   | 698951       |   | 698951  |   | 3/3/2000   |
| UBL                     |   | Japan           |   | 183721/1997  |   | 4359834 |   | 2/10/2000  |
| UBL                     |   | Mexico          |   | 409265       |   | 645863  |   | 3/22/2000  |
| UBL                     |   | Mexico          |   | 409266       |   | 645864  |   | 3/22/2000  |
| UBL                     |   | Mexico          |   | 409267       |   | 684935  |   | 1/31/2001  |
| UBL                     |   | Mexico          |   | 409268       |   | 645865  |   | 3/22/2000  |
| UBL                     |   | Panama          |   | 105636       |   | 105636  |   | 2/15/2001  |
| UBL                     |   | Panama          |   | 105635       |   | *       |   |       |
| UBL                     |   | Panama          |   | 105634       |   | 105634  |   | 2/13/2001  |

 

8

----

 
| UBL |   | Panama    |   | 105637      |   | 105637   |   | 2/13/2001  |
|-----|--------|-----------|--------|-------------|--------|----------|--------|------------|
| UBL |   | Peru      |   | 99626       |   | 23004    |   | 9/28/2000  |
| UBL |   | Peru      |   | 99627       |   | 22958    |   | 9/20/2000  |
| UBL |   | Peru      |   | 99628       |   | 25918    |   | 5/31/2001  |
| UBL |   | Peru      |   | 99629       |   | 23033    |   | 9/29/2000  |
| UBL |   | Venezuela |   | 2000-003035 |   | S-015477 |   | 11/22/2000 |
| UBL |   | Venezuela |   | 2000-003036 |   | S-015478 |   | 11/22/2000 |
| UBL |   | Venezuela |   | 2000-003034 |   | S-015476 |   | 11/22/2000 |
| UBL |   | Venezuela |   | 2000-003037 |   | S-015479 |   | 11/22/2000 |

 

----

* Indicates thatregistration is pending.

 

Despiteour efforts to protect our proprietary rights from unauthorized use or disclosure,our efforts may not be sufficient or successful. It may be possible that someof our innovations may not be protectable. The steps that we have taken may notprevent misappropriation of our proprietary rights, particularly in foreigncountries where laws or law enforcement practices may not protect ourproprietary rights at all, or as fully as in the United States**.**Confidentiality may be compromisedintentionally or accidentally by contractors, customers, other third parties orour employees. If third parties were to use or otherwise misappropriate our web-sitecontent, source code, other copyright materials, trademarks, service marks orother proprietary rights without our consent or approval, our competitiveposition could be harmed, or we could become involved in costly and distractinglitigation to enforce our rights.

 

Acopyright gives the owner divisible rights, including those of performance,reproduction and distribution. The music featured by us is typically comprisedof copyrighted works owned, controlled or administered by multiple thirdparties, including record labels, artists, songwriters, music publishers andperformance rights and licensing organizations such as (but not limited to) TheHarry Fox Agency, Broadcast Music Inc. (“BMI”) and the American Society ofComposers, Authors and Publishers (“ASCAP”). Each song often has multiplecopyright 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.

 

9

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Ourweb-sites, depending upon the specific musical work, may offer audio streamingof part or all of an entire song or “Web casting,” or the downloading of anentire song in MP3 or other compressed audio formats. Full-length streamingonly occurs in special instances after obtaining a license from the recordlabel or band manager for the “sound recording.” In that case, an ASCAP or BMIblanket music license is also obtained by us or by our artists for rights toperform the associated underlying “musical composition.” Where we offerfull-length downloads of songs in MP3 or other compressed audio formats, weseek 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 license agreement with the publisher,writer or other owner of such copyright in the “musical composition”;

 

•                  a waiver of any fees or royalties that wouldotherwise be required for such use; and/or

 

•                  a representation and warranty from the ownerof the copyrights in the “sound recording” that no mechanical royalties areowed to any third parties.

 

Inthe event that the foregoing steps are insufficient to clear rights, or weotherwise fail to obtain rights, we could be exposed to claims of copyrightinfringement, with attendant disruption to our operations and liabilityincluding 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.

 

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

 

Forexample, the Copyright Office recently opined that additional royalties,besides those collected for musical compositions by ASCAP or BMI, are due forwebcasted music that is selected by or on behalf of the recipient pursuant to17 U.S.C. Section 2114(j)(7). If upheld, that ruling would prevent us fromexpanding our service to permit users to play a requested song via our web-sitewithout paying additional royalties.

 

*Linking and Framing of Third-Party web-sites.*We link to and “frame” third-party web-sitesof our artists without express written permission to do so. In addition, in thepast we have provided a search feature to allow users to find music residingelsewhere on the Internet. Those practices are controversial, and have, ininstances not involving us, resulted in litigation. Various claims, includingtrademark and copyright infringement, unfair competition, and commercialmisappropriation, as well as infringement of the right of publicity may beasserted against us as a result of these practices. The law regarding linkingand framing remains unsettled; it is uncertain as to how existing laws,especially trademark and copyright law, will be applied by the judiciary to theInternet. Also, Congress is increasingly active in passing new laws related tothe Internet, and there is uncertainty as to the impact of future potentiallaws, especially those involving domain names, databases and privacy.

 

*Defamation or Contributory Infringement.*Our web-site features a community area wherevisitors can post comments. We do not censor such comments and it is possiblethat a customer could use our web-sites as a forum to make false, misleading ordisparaging remarks about others. Such on-line comments could lead to claimsfor defamation or infringement. As to libel claims brought in the UnitedStates, we believe that we qualify for safe harbor protection for third-partypostings under 47 U.S.C. Section 230(c)(1). However, other countries, notablythe United Kingdom, may impose such liability, and it is possible we could besued there for third-party postings. Separately, our web-sites allow consumersto use our personal web publishing tools to post samples of their works. Suchpostings could be misused to post unlicensed copyrighted content of others. Wehave obtained limited safe-harbor protection under the Digital MillenniumCopyright Act against liability for infringing material of which we do not havecontrol and knowledge.

 

10

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*Seasonality.*The seasonality of our e-commerce segment affects our revenue. Our CDsand other online goods are most often purchased during the holiday season andalso during the summer months, traditionally when artists go on tour.

 

**MediaDefenderOverview- Internet Anti-Piracy Segment**

** **

MediaDefenderwas incorporated under the laws of the State of Delaware in July 2000 and is aprovider of anti-piracy solutions in the high-growth IPP industry. We completedthe acquisition of MediaDefender in the third quarter of fiscal 2005.MediaDefender’s solutions have been adopted by major entertainment companies asa practical means to thwart Internet piracy and drive consumers to pay fordigitized content distributed through authorized Internet sites.

 

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

 

Dueto the relatively small size of MP3 files, music was the first industry to beimpacted by Internet piracy. From 1999 to 2003, total music sales in the U.S.declined by approximately 25%, or $3.7 billion. The 2.3% increase in 2004 albumsales may be partially attributed to the increased use of anti-piracy solutionsby music companies. The growth of broadband Internet access is now makinglarger-sized files, such as movies, software and video games, similarlyvulnerable to Internet-based piracy. Already, the majority of motion picturesare available in some form on the Internet before theatrical release.

 

Todate, attempts to limit Internet-piracy have been largely unsuccessful.Litigation, legislation, education, commercial innovation, packaged media anddigital rights management (“DRM”) anti-piracy technologies have been employedwith limited impact. For example, despite the litigation that forced theclosure of Napster, then the most widely used P2P forum for illegal downloads,in July 2001, P2P file-sharing networks continue to evolve and thrive.

 

*IPP Solutions.*MediaDefender employs a wide array of technical countermeasures on P2Pnetworks to frustrate users’ attempts to find, copy and share unauthorizedcopyrighted materials. MediaDefender’s customers specify the timing, duration,scope and level of effectiveness of desired protection on a track-by-track,album-by-album or movie-by-movie basis. Users of P2P networks attempting  to download a file 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 they weresearching, or download a file to find that it works for the first few secondsand then reverts to white noise or static. By making it more difficult for P2Pusers to access unauthorized content on the Internet, MediaDefender inducesconsumers to pay for content distributed through legitimate means, such asApple Corporation’s iTunes.

 

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

 

*Suite of Solutions.*MediaDefender’s solutions are a practical andproven means of thwarting Internet piracy and driving consumers to pay foronline content. MediaDefender’s piracy-detection techniques can pinpoint theinitial leak of content onto the Internet and allow MediaDefender to direct itsefforts to limit replication at the point of origin. Customers also receiveaccess to MediaDefender’s secure on-line reporting system, which providescritical information regarding the number of attempted and blocked illegaldownloads per specified title. The primary means by which MediaDefender’ssolutions hinder illegal Internet file-sharing and downloading include:

 

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

 

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

 

•                  *Decoying*. Decoys are false files that are named andtitled so as to appear to be legitimate content.

 

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

 

11

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•                  *Counter-posting*. Counter-posting is a method of protectionthat operates on UseNet.

 

•                  *Queuing*. Queuing is used on IRC to prevent P2P usersfrom accessing protected content by taking up space in the line to downloadthat content.

 

*Monitoring.*In addition to providing IPP solutions, MediaDefender also tracksattempts by P2P users to access files illegally and provides such informationto its customers in the form of weekly monitoring reports. By continuouslymonitoring the Internet to detect leaks of copyrighted material, MediaDefenderis able to advise its customers concerning the origination of such leaks andhelp determine when MediaDefender’s IPP solutions are needed. Customers oftenemploy MediaDefender’s monitoring capabilities in anticipation of executing afull-scale IPP solutions contract. This early monitoring allows its customersto observe the level of piracy affecting their copyrighted materials and hasproven to be an effective marketing tool for MediaDefender’s IPP solutions.

 

MediaDefendercontinuously monitors Internet activity for leaks of any new customer-ownedcontent. In addition to an automated web crawler device that monitors leaks 24hours per day, MediaDefender also employs several individuals who detectcustomer content leaks by monitoring activity on the various networks web-sitesand chat rooms. MediaDefender is able to make customers aware of any leaksimmediately 24 hours per day seven days per week. This awareness enablescustomers to better manage their relationships with creative talent bydemonstrating control and knowledge of the situation. Monitoring reportscontain information that allows customers to determine:

 

•                  The piracy problem’s size and nature for eachindividual release;

 

•                  When particular copyrighted materials shouldbe protected;

 

•                  The IP addresses of individuals who aredownloading copyrighted content;

 

•                  How often a specific title is requested;

 

•                  How often a title is illegally shared; and

 

•                  Demographics of illegal sharers.

 

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

 

*Next-Generation Solutions.*Due to the rapidly evolving nature of the P2Penvironment, MediaDefender must continually adapt its technologies in order tooffer customers increasing levels of effectiveness against the latestInternet-piracy threats. In the third quarter of 2003, MediaDefendercommercially released its next-generation solution, called “uber.”  Uber-level solutions allow MediaDefender toprovide an approximate 95 percent effectiveness in preventing unauthorizeddownloads of customer-specified content. MediaDefender’s development team isconstantly monitoring advances in peer-to-peer networking and developingsolutions to target new networks.

 

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

 

*Intellectual Property.*In December 2002, MediaDefender filed anumbrella patent that covers a variety of its concept and back-end technologies,which is still pending. Due to the evolving nature of P2P networks, thesetechnologies are not based on any one service, but rather have the fluidity tobe transferred to any P2P network. The claims in the patent filing arepredominantly methods for managing a large array of computers for the purposeof preventing piracy on P2P networks.

 

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

 

12

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

 

*Market Share and Competition.*Management believes that MediaDefender has amajority of the growing IPP solution market. Its two major competitors,MediaSentry, Inc. and Macrovision, have been in the IPP market for two and fiveyears, respectfully, without gaining significant market share.

 

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

** **

Thefollowing table provides a schedule of corporate offices and facilities leasedby us:

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

 

----

*Torelocate to Santa Monica, California location in April 2006.

 

Webelieve that all real property and facilities leased by us are in good repairand adequate for our purposes for the next 12 months.

 

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

** **

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

 

**ITEM 4.****                            ****SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

** **

Therewere no matters submitted to a vote of our stockholders during the fourthquarter of the fiscal year ended December 31, 2005.

 

13

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**PART II**

** **

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

** **

*MarketInformation*

* *

Ourcommon stock has been listed for quotation on the Over-the-Counter BulletinBoard under the symbol “ARTD.OB” since May 9, 2003. Prior to that, our commonstock was listed on The Nasdaq National Market. The following table sets forththe high and low sales prices for our common stock, as reported by theOver-the-Counter Bulletin Board for fiscal 2004 and 2005, respectively:

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2004**       |       |     |       |    |       |
| First Quarter  |       | $        | 0.35       |    | $          | 0.25 |   |
| Second Quarter |       | $        | 0.62       |    | $          | 0.32 |   |
| Third Quarter  |       | $        | 0.45       |    | $          | 0.40 |   |
| Fourth Quarter |       | $        | 0.40       |    | $          | 0.26 |   |
|           |       |     |       |    |       |   |   |
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 1.25       |    | $          | 0.22 |   |
| Second Quarter |       | $        | 1.85       |    | $          | 0.94 |   |
| Third Quarter  |       | $        | 4.00       |    | $          | 1.47 |   |
| Fourth Quarter |       | $        | 3.30       |    | $          | 1.65 |   |

 

Theclosing price of our common stock on March 29, 2006 was $4.47 per share,as reported on the Over-The-Counter Bulletin Board.

 

*Holders ofRecord*

* *

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

 

*Dividends*

* *

Wehave not declared or paid any cash dividends on our common stock, and wecurrently intend to retain future earnings, if any, to finance the expansion ofour business, and we do not expect to pay any cash dividends in the foreseeablefuture. The decision whether to pay cash dividends on our common stock will bemade by our Board of Directors, in their discretion, and will depend on ourfinancial position, operating results, capital requirements and other factorsthat the Board of Directors considers significant.

 

*Equity CompensationPlan Information*

* *

Referto Item 11 below for information with respect to our equity compensationplans.

 

*AdditionalInformation*

* *

Copiesof our Annual Reports on Form 10-KSB, Quarterly Reports onForm 10-QSB, Current Reports on Form 8-K, and any amendments to thosereports, are available free of charge on the Internet at www.sec.gov. Allstatements made in any of our filings, including all forward-lookingstatements, are made as of the date of the document in which the statement isincluded, and we do not assume or undertake any obligation to update any ofthose statements unless we are required to do so by law.

 

**ITEM 6.****                            ****MANAGEMENT’S DISCUSSION ANDANALYSIS OR PLAN OF OPERATION**

** **

**Overview**

** **

Weconduct our media and e-commerce business operations through an online musicnetwork appealing to music fans, artists and marketing partners. TheARTISTdirect Network (www.artistdirect.com) is a network of web-sites offeringmulti-media content, music news and information, communities organized aroundshared music interests, music-related specialty commerce and digital musicservices.

 

14

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**Acquisitionof MediaDefender and Related Transactions**

** **

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

 

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

 

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

 

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

 

Inaddition, the investors received five year warrants to purchase up to anaggregate of 3,250,000 shares of our common stock at an exercise price of $2.00per share, subject to certain anti-dilution adjustments (collectively, the “SeniorWarrant Shares”). The warrants were valued at $1,397,500 based on a valuationreport prepared by an independent valuation firm and were recorded as adiscount to the $15.0 million Senior Financing debt, and are being amortizedover the term of the debt.

 

TheSenior Warrant Shares are subject to certain registration rights requiring usto file and maintain effective a registration statement with the Securities andExchange Commission (the “SEC”) covering the shares of common stock underlyingthe warrants. In accordance with EITF No. 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock” (“EITF No. 00-19”), the fair value of the warrants has been recorded aswarrant liability. The carrying value of the warrants will be adjusted toreflect any changes in the fair value of the warrants from the date of issuanceto the end of each reporting period, and any such changes will be included inthe statement of operations as other income (expense). Due to the classificationof the Senior Warrant Shares, the Sub-Debt Warrant Shares (as defined below)and the Libra Warrant Shares (as defined below) as a current liability on ourfinancial statements, we were not in compliance with certain financial covenantscontained in the Note Purchase Agreement at December 31, 2005.  The investors have provided waivers withrespect to any past technical default of the financial covenants related to theaccounting treatment of the above-referenced warrant shares.

 

TheSub-Debt Financing was completed in accordance with the terms set forth in asecurities purchase agreement entered into by us on July 28, 2005 (the “SecuritiesPurchase Agreement”). Pursuant to the Securities Purchase Agreement, eachinvestor received a convertible subordinated note with a term of four yearsthat bears interest at the rate of 4.00% per annum (each a “Sub-Debt Note”), withany unpaid principal and accrued interest due and payable at maturity. Interestis payable quarterly in cash or shares of our common stock, at our option, withpayments beginning September 30, 2006. Each Sub-Debt Note has an initialconversion price of $1.55 per share, subject to certain anti-dilution andchange-of-control adjustments. In addition, each Sub-Debt Note is subject tomandatory conversion by us in the event certain trading price targets for ourcommon stock are met following effectiveness of a registration statement filedby us for the resale of the securities issued in the Sub-Debt Financing. We arerequired to comply with certain financial covenants, including minimum workingcapital, maximum capital expenditures, minimum leverage ratio, minimum EBITDAand minimum fixed charge coverage ratio.

 

15

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Inaddition, the Sub-Debt Financing investors received five year warrants topurchase up to 1,596,774 shares of our common stock at an exercise price of$1.55 per share, subject to certain anti-dilution adjustments (collectively,the “Sub-Debt Warrant Shares”). The warrants were valued at $878,026 based on avaluation report prepared by an independent valuation firm and were recorded asa discount to the $30.0 million Sub-Debt Financing debt, and are beingamortized over the term of the debt.

 

TheSub-Debt Notes and the Sub-Debt Warrant Shares are subject to certainregistration rights requiring us to file and maintain effective a registrationstatement with the SEC covering the resale of shares of common stock underlyingsuch warrants and notes. In accordance with EITF No. 00-19, the fair value ofthe warrants has been recorded as warrant liability. The carrying value of thewarrants will be adjusted to reflect any changes in the fair value of thewarrants from the date of issuance to the end of each reporting period, and anysuch changes will be included in the statement of operations as other income(expense). Due to the classification of the Senior Warrant Shares, the Sub-DebtWarrant Shares and the Libra Warrant Shares (as defined below) as a currentliability on our financial statements, we were not in compliance with certain financialcovenants contained in the Sub-Debt Notes at December 31, 2005.  The investors have provided waiver withrespect to any past technical default of the financial covenants related to theaccounting treatment of the above-referenced warrant shares.

 

Inconnection with our obligations under the Note Purchase Agreement and theSecurities Purchase Agreement, we filed a resale registration statement on FormSB-2 with the SEC that was declared effective on December 9, 2005.

 

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

 

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

 

Achange in control could occur as a result of the Senior Financing and theSub-Debt Financing. Assuming maximum conversion of the securities issued in theSenior Financing and Sub-Debt Financing occurs, the Senior Financing investorswould own approximately 9% of our voting stock, on a fully diluted basis, andthe Sub-Debt investors would own approximately 55% of our voting stock, on afully diluted basis.

 

Thesecurities issued by us in the Senior Financing and the Sub-Debt Financing wereoffered and sold in reliance upon exemptions from registration pursuant toSection 4(2) under the Securities Act of 1933, as amended (the “Securities Act”),and Rule 506 promulgated thereunder. Each of the investors qualified as an “accreditedinvestor,” as specified in Rule 501 under the Securities Act.

 

Pursuantto the terms of the Note Purchase Agreement and the Securities PurchaseAgreement, we were required to amend our Certificate of Incorporation toincrease the number of authorized shares of our common stock from 15,000,000shares to 60,000,000 shares. We obtained the requisite Board and stockholderapproval and filed a Certificate of Amendment to our Certificate ofIncorporation with the Delaware Secretary of State on November 7, 2005 toeffect the increase.

 

Pursuantto the terms of a letter agreement, dated July 15, 2005, between us andBroadband Capital Management LLC (“Broadband”), we issued to Broadband aSub-Debt Note in the amount of $1,460,500 (in addition to the $30.0 millionreferred to above) and warrants to purchase up to 1,516,935 shares of ourcommon stock with an exercise price of $1.55 per share. The notes and warrantsissued to Broadband or its affiliates were issued on the same terms andconditions granted to the other Sub-Debt Financing investors. The securitieswere issued as partial consideration for Broadband’s services as our placementagent in the Sub-Debt Financing and the Senior Financing. The securities wereissued in reliance upon exemptions from registration pursuant to Section 4(2)under the Securities Act and Rule 506 promulgated thereunder. The warrants werevalued at $834,314, based on a valuation report prepared by an independentvaluation firm. The aggregate value of the Sub-Debt Note, the warrants andadditional cash payments to Broadband aggregating $299,500 were charged todeferred financing costs and are being amortized over the term of the debt.

 

TheSub-Debt Notes and the Sub-Debt Warrant Shares issued to Broadband are subjectto certain registration rights requiring us to file and maintain effective aregistration statement with the SEC covering the shares of common stockunderlying such warrants and notes. In accordance with EITF No. 00-19, the fairvalue of the warrants has been recorded as warrant liability. The carryingvalue of the warrants will be adjusted to reflect any changes in the fair valueof the warrants from the date of issuance to the end of each reporting period,and any such changes will be included in the statement of operations as otherincome (expense).

 

Pursuantto the terms of a letter agreement, dated June 21, 2005, between us and LibraFE, LP (“Libra”), we issued Libra warrants to purchase up to 237,500 shares ofour common stock with an exercise price of $2.00 per share upon the closing ofthe

 

16

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Senior Financing (the “LibraWarrant Shares”). The warrants were issued as partial consideration for Libra’sservices as our placement agent in the Senior Financing described above. Weentered into a Registration Rights Agreement with Libra on July 28, 2005 (the “LibraRegistration Rights Agreement”), pursuant to which we included the LibraWarrant Shares in the registration statement covering the securities issued inthe Senior Financing and the Sub-Debt Financing described above. The warrantswere issued in reliance upon exemptions from registration pursuant to Section4(2) under the Securities Act and Rule 506 promulgated thereunder. The warrantswere valued at $149,625, based on a valuation report prepared by an independentvaluation firm. The aggregate value of the warrants and additional payments toLibra of $450,997 were charged to deferred financing costs and are beingamortized over the term of the debt.

 

TheLibra Warrant Shares are subject to certain registration rights requiring us tofile and maintain effective a registration statement with the SEC covering theshares of common stock underlying such warrants and notes. In accordance withEITF No. 00-19, the fair value of the warrants has been recorded as warrantliability. The carrying value of the warrants will be adjusted to reflect anychanges in the fair value of the warrants from the date of issuance to the endof each reporting period, and any such changes will be included in thestatement of operations as other income (expense).

 

Pursuantto a report prepared by an independent valuation firm, as of and throughDecember 31, 2005, there was no change in the fair value of the warrants thatwere recorded as warrant liability at July 28, 2005.

 

Uponthe closing of the acquisition, we issued 1,109,032 shares of our common stockand a warrant to purchase up to 114,985 shares of our common stock with anexercise price of $1.55 per share to WNT07 Holdings, LLC. The managers of WNT07Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both members of ourBoard of Directors. The shares and warrants were issued as consideration forservices provided by Messrs. Pulier and Boutros-Ghali as consultants to us inconnection with the acquisition. The issuance of the shares and warrants toWNTO7 Holdings, LLC were approved by the independent members of our Board of Directors.The shares and warrants were issued in reliance upon exemptions fromregistration pursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder.

 

Theshares of common stock were valued at $1,585,916 ($1.43 per share) and the warrantswere valued at $83,939, based on a valuation report prepared by an independentvaluation firm, for an aggregate value of $1,669,855, of which $333,971 wasallocated to the covenant not to compete and the remaining $1,335,884 wasincluded in total costs that we incurred to acquire MediaDefender.

 

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

 

Dueto the restrictions imposed by Internal Revenue Code Section 382 regardingsubstantial changes in the stock ownership of companies with losscarry-forwards, the utilization of our federal net operating loss carry-forwardwas severely limited as a result of the change in our effective stock ownershipresulting from the financings arranged in conjunction with the acquisition ofMediaDefender.

 

Thisacquisition of MediaDefender was accounted for as a purchase in accordance withSFAS No. 141, “Business Combinations,” and the operations of the two companieshave been consolidated commencing August 1, 2005. The following tablesummarizes the assets acquired and liabilities assumed of MediaDefender at July28, 2005. The fair value of the intangible assets acquired and their respectiveamortization periods was determined by an independent valuation firm. 

 
| ** **                                | ** ** | **(in thousands)** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
|                                      |       |                    |       |
| Assets Acquired:                          |       |                    |       |
| Cash                                      |       | $                       | 1,365      |   |
| Accounts receivable                       |       | 2,499                   |       |
| Deferred income tax                       |       | 116                     |       |
| Prepaid expenses and other current assets |       | 91                      |       |
| Property and equipment                    |       | 1,749                   |       |
| Deposits                                  |       | 3                       |       |
|                                      |       |                    |       |
| Total assets acquired                     |       | 5,823                   |       |
|                                      |       |                    |       |
| Liabilities Assumed:                      |       |                    |       |
| Accounts payable                          |       | 41                      |       |
| Accrued expenses                          |       | 87                      |       |
| Income taxes payable                      |       | 230                     |       |
| Due to ARTISTdirect, Inc.                 |       | 930                     |       |
| Deferred revenue                          |       | 38                      |       |
|                                           |            |                         |            |  |

 

17

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| Deferred income tax                            |   | 338    |   |
|------------------------------------------------|--------|--------|--------|
|                                           |   |   |   |
| Total liabilities assumed                      |   | 1,664  |   |
|                                           |   |   |   |
| Net assets acquired                            |   | 4,159  |   |
|                                           |   |   |   |
| Intangible assets acquired:                    |   |   |   |
| Customer relationships                         |   | 2,264  |   |
| Proprietary technology                         |   | 7,602  |   |
| Goodwill                                       |   | 31,085 |   |
|                                           |   |   |   |
| Total assets acquired                          |   | $      | 45,110 |   |
|                                           |   |   |   |
| Total purchase consideration paid as  follows: |   |   |   |
| Cash paid to MediaDefender stockholders        |   | $      | 42,500 |   |
| Transaction costs incurred                     |   | 2,610  |   |
|                                           |   |   |   |
| Total purchase consideration                   |   | $      | 45,110 |   |

 

**Pro FormaInformation**

 

Thefollowing pro forma operating data presents the results of operations for theyears ended December 31, 2004 and 2005, respectively, as if the acquisition hadoccurred on the first day of each such period. Discontinued operations, impairmentlosses and non-recurring items for the years ended December 31, 2004 and 2005are not included. The pro forma results are not necessarily indicative of thefinancial results that might have occurred had the acquisition actually takenplace on the respective dates, or of future results of operations. 

 
| ** **                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| **Pro Forma**                                  | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                     | ** ** |
|                                                |       |                                        |       |   |   |
| Net revenue                                         |       | $                                           | 15,665     |   | $ | 20,637 |   |
|                                                |       |                                        |       |   |   |
| Net loss                                            |       | $                                           | (4,911     | ) | $ | (3,054 | ) |
|                                                |       |                                        |       |   |   |
| Adjusted EBITDA                                     |       | $                                           | 4,033      |   | $ | 7,095 |   |
|                                                |       |                                        |       |   |   |
| Net loss per common share – basic and  diluted |       | $                                           | (1.07      | ) | $ | (0.66 | ) |
|                                                |       |                                        |       |   |   |
| Weighted average common shares outstanding          |       | 4,611,149                                   |       | 4,611,149 |   |
|                                                     |            |                                             |            |  |  |  |  |  |  |

 

Ourpresentation of financial results includes “Adjusted EBITDA” as a financialmeasure, which is not a measure of performance calculated in accordance withaccounting principles generally accepted in the United States (“GAAP”).Adjusted EBITDA is a non-GAAP financial measure that represents income or loss fromcontinuing operations before net interest expense, provision for income taxes,depreciation and amortization, as well as certain other items, including stock-basedcompensation, impairment losses, and non-recurring gains. Management excludesthese items in assessing financial performance, primarily due to theirnon-operational nature or because they are outside of our normal operations. Wehave provided this information because management believes that it is useful toinvestors in understanding our financial condition and results of operations.

 

Areconciliation of Net Loss to Adjusted EBITDA is shown below.

 

18

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| ** **                                                                                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **Pro Forma**                                                                                                                                     | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**                     | ** ** |
|                                                                                                                                                   |       |                                        |       |   |   |
| Net loss                                                                                                                                               |       | $                                           | (4,911     | ) | $ | (3,054 | ) |
|                                                                                                                                                   |       |                                        |       |   |   |
| Add (deduct):                                                                                                                                          |       |                                        |       |   |   |
| Interest income                                                                                                                                        |       | (32                                         | )          | (47 | ) |
| Interest expense                                                                                                                                       |       | 2,971                                       |       | 2,973 |   |
| Amortization of discount on debt                                                                                                                       |       | 599                                         |       | 599 |   |
| Amortization of deferred financing costs                                                                                                               |       | 871                                         |       | 871 |   |
| Write-off of unamortized discount on debt  and deferred financing costs due to conversion of subordinated convertible  notes payable into common stock |       | —                                      |       | 39 |   |
| Amortization of intangible assets                                                                                                                      |       | 3,749                                       |       | 3,749 |   |
| Depreciation                                                                                                                                           |       | 569                                         |       | 397 |   |
| Income taxes                                                                                                                                           |       | 210                                         |       | 1,495 |   |
| Stock-based compensation                                                                                                                               |       | 7                                           |       | 73 |   |
|                                                                                                                                                   |       |                                        |       |   |   |
| Adjusted EBITDA                                                                                                                                        |       | $                                           | 4,033      |   | $ | 7,095 |   |

** **

**CriticalAccounting Policies**

** **

Thediscussion and analysis of our financial condition and results of operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an ongoing basis, we evaluate our estimates, includingthose related to accounts receivable, tangible and intangible assets, incometaxes, and contingencies and litigation, among others. We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions. We believe that thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of its consolidated financialstatements:   accounts receivable,revenue recognition, stock-based compensation, impairment of long-lived assetsand goodwill, and income taxes.

 

*Revenue Recognition*. We comply 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 an arrangementexists; (ii) delivery of the products and/or services has occurred; (iii) theselling price is both fixed and determinable; and (iv) collectibility isreasonably 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. We recorde-commerce revenue on a gross basis as we enter into sale transactions withcustomers, establish the prices of our products, choose the suppliers of ourproducts, assume the risk of inventory loss and collect all amounts from thecustomers and assumes the credit risk. E-commerce revenue is subject to amountsdue to the respective artists based on their contracts, and such expense isrecorded as part of cost ofe-commerce revenue.

 

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

 

Mediarevenue consists primarily of the sale of advertisements and sponsorships, bothonline and offline, under short-term contracts. To date, the duration of ouradvertising and sponsorship commitments has generally averaged from one tothree months, with certain programs lasting up to six months. Our onlineobligations typically include the guarantee of a minimum number of times

 

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(“impressions”) that anadvertisement appears in pages viewed by the users of our online properties.Online advertising revenue is generally recognized as the impressions areserved during the period in which the advertisement is displayed, provided thatno significant obligations remain and collection of the resulting receivable isreasonably assured. To the extent that minimum guaranteed page deliveries arenot met, recognition of the corresponding revenue is deferred until theguaranteed impressions are delivered.

 

Werecognize revenue for sponsorship arrangements, both online and offline, overthe period during which the advertising is provided, generally on astraight-line basis. If the sponsorship arrangement is for the sponsorship of aspecific event, we recognize revenue when the event occurs. We recognizerevenue separately for each element of integrated entertainment marketingpackages that offer advertisers a combination of offline concert and toursponsorships that are supported by online banner advertising, web-pagesponsorships, e-mails to our customers and custom content. We determine thefair value of each deliverable based on the relative fair value of thedifferent deliverables when sold on a stand-alone basis. We recognize revenue foreach deliverable as the services are provided. We recognize revenue for thebanner impression deliverable as the banner impressions are delivered. Werecognize revenue for the customer e-mails when the e-mails are sent. Werecognize revenue for web-page sponsorships on a straight-line basis over theterm of the sponsorship. We recognize revenue for custom content when thecontent is provided to the customer.

 

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

 

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

 

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

 

Publiccompanies are permitted to adopt the requirements of SFAS No. 123R using one oftwo methods:

 

(1)A “modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of SFAS No.123R for all share-based payments granted after the effective date and (b)based on the requirements of SFAS No. 123R for all awards granted to employeesprior to the effective date of SFAS No. 123R that remain unvested on theeffective date.

 

(2)A “modified retrospective” method which includes the requirements of themodified prospective method described above, but also permits entities torestate based on the amounts previously recognized under SFAS No. 123 forpurposes of pro forma disclosures for either (a) all prior periods presented or(b) prior interim periods of the year of adoption.

 

Weadopted SFAS No. 123R effective January 1, 2006 and will use the modifiedprospective method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of SFAS No. 123R for allshare-based payments granted after the effective date and (b) based on therequirements of SFAS No. 123R for all awards granted to employees prior to theeffective date of SFAS No. 123R that remain unvested on the effective date.Although the expense for stock options that may be vested or granted in futureperiods cannot be determined at this time due to the uncertainty of the vestingor timing of future grants, our future stock price, and the related fair valuecalculation, the adoption of SFAS No. 123R will have a material effect on ourfuture financial statements.

 

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

 

Assetallocations and amortization periods with respect to the MediaDefendertransaction were determined by an independent valuation firm.

 

SFASNo. 142 requires goodwill to be tested for impairment on an annual basis andunder certain circumstances, and written down when impaired. An interimimpairment test is required if an event occurs or conditions change that wouldmore likely than not reduce the fair value of the reporting unit below thecarrying value.

 

Weevaluate the recoverability of goodwill by estimating the future discountedcash flows of the businesses to which the goodwill relates. We use a ratecorresponding to our cost of capital, risk adjusted where appropriate, indetermining discounted cash flows. Estimated cash flows will be determined bydisaggregating the business segments to a reporting level for which meaningfulidentifiable cash flows can be determined. When estimated future discountedcash flows are less than the carrying value of the net assets (tangible andidentifiable intangibles) and related goodwill, we will perform an impairmenttest to measure the amount of the impairment loss, if any. Impairment losses,limited to the carrying value of goodwill, represent the excess of the carryingamount of a reporting unit’s goodwill over the implied fair value of thatgoodwill. In determining the estimated future cash flows, we will considercurrent and projected future levels of income based on management’s plans forthat business, as well as business trends, prospects and market and economicconditions.

 

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

 

*Income Taxes*. We account for income taxes under Statement of Financial AccountingStandards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). SFAS No. 109requires recognition of deferred tax assets and liabilities for the expectedfuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin the statement of operations in the period that includes the enactment date.A valuation allowance is established, when necessary, to reduce deferred taxassets to the amount expected to be realized.

 

*Accounts Receivable*. We grant credit to our customers generally in the form of short-termtrade accounts receivable. Accounts receivable are stated at the amountmanagement expects to collect from outstanding balances. When appropriate,management provides for probable uncollectible amounts through a provision fordoubtful accounts and an adjustment to a valuation allowance. Managementprimarily determines the allowance based on the aging of accounts receivablebalances, historical write-off experience, customer concentrations, customercreditworthiness and current industry and economic trends. Balances that arestill outstanding after management has used reasonable collection efforts arewritten off through a charge to the valuation allowance and a credit toaccounts receivable.

 

Concentrationsof credit risk with respect to trade receivables generated by our operationsare generally limited. However, MediaDefender’s customers consist primarily oflarge reputable companies in the music and entertainment industries.

 

**RecentlyIssued Accounting Pronouncements and Developments**

** **

InMay 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections” (“SFAS No. 154”). SFAS No. 154 is a replacement of APB Opinion No.20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes inInterim Financial Statements – (an Amendment of APB Opinion No. 28)” andprovides guidance on the accounting for and reporting of accounting changes anderror corrections. SFAS No. 154 establishes retrospective application as therequired method for reporting a change in accounting principle, and providesguidance for determining whether retrospective application of a change inaccounting principle is impracticable and for reporting a change whenretrospective application is impracticable. Retrospective application is the

 

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application of a differentaccounting principle to a prior accounting period as if that principle hadalways been used or as the adjustment of previously issued financial statementsto reflect a change in the reporting entity. SFAS No. 154 also addresses thereporting of the correction of an error by restating previously issuedfinancial statements. We will adopt the provisions of SFAS No. 154 effectiveJanuary 1, 2006.

 

OnSeptember 22, 2005, the SEC issued rules to delay by one-year the requiredreporting by management on internal controls over financial reporting fornon-accelerated filers. The new SEC rule extends the compliance date for suchregistrants to fiscal years ending on or after July 15, 2007. Accordingly, wequalify for the deferral until its year ending December 31, 2007 to comply withthe internal control reporting requirements.

 

**Results ofOperations - Years Ended December 31, 2004 and 2005**

** **

Thefollowing table presents information with respect to our consolidatedstatements of operations, excluding income (loss) from discontinued operations,and as a percentage of total net revenue, for the years ended December 31, 2004and 2005. As a result of our acquisition of MediaDefender effective July 28,2005, we have consolidated the operations of MediaDefender for the five monthsended December 31, 2005. Accordingly, our result of operations for the yearended December 31, 2005 are not directly comparable to our results ofoperations for the year ended December 31, 2004.

 

Consolidated Statements of Operations ($000)

 
| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | **$**                                       | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| Net revenue:                                                                                                                         |       |                                        |       |   |   |   |   |   |   |
| E-Commerce                                                                                                                           |       | $                                           | 2,994      |   | 58.2 | % | $ | 2,665 |   | 19.1 | % |
| Media                                                                                                                                |       | 2,149                                       |       | 41.8 | % | 5,297 |   | 37.9 | % |
| Anti-piracy services                                                                                                                 |       | —                                      |       | — | % | 6,009 |   | 43.0 | % |
| Total net revenue                                                                                                                    |       | 5,143                                       |       | 100.0 | % | 13,971 |   | 100.0 | % |
| Cost of revenue:                                                                                                                     |       |                                        |       |   |   |   |   |   |   |
| E-Commerce                                                                                                                           |       | 2,631                                       |       | 51.2 | % | 2,400 |   | 17.2 | % |
| Media                                                                                                                                |       | 1,144                                       |       | 22.2 | % | 2,745 |   | 19.7 | % |
| Anti-piracy services                                                                                                                 |       | —                                      |       | — | % | 2,659 |   | 19.0 | % |
| Total cost of revenue                                                                                                                |       | 3,775                                       |       | 73.4 | % | 7,804 |   | 55.9 | % |
| Gross profit                                                                                                                         |       | 1,368                                       |       | 26.6 | % | 6,167 |   | 44.1 | % |
| Operating expenses:                                                                                                                  |       |                                        |       |   |   |   |   |   |   |
| Sales and marketing                                                                                                                  |       | 167                                         |       | 3.3 | % | 527 |   | 3.8 | % |
| General and administrative                                                                                                           |       | 2,676                                       |       | 52.0 | % | 4,065 |   | 29.1 | % |
| Provision for doubtful accounts                                                                                                      |       | 110                                         |       | 2.2 | % | 105 |   | 0.7 | % |
| Stock-based compensation                                                                                                             |       | 7                                           |       | 0.1 | % | 73 |   | 0.5 | % |
| Total operating costs                                                                                                                |       | 2,960                                       |       | 57.6 | % | 4,770 |   | 34.1 | % |
| Income (loss) from operations                                                                                                        |       | (1,592                                      | )          | (31.0 | )% | 1,397 |   | 10.0 | % |
| Interest income                                                                                                                      |       | 29                                          |       | 0.6 | % | 29 |   | 0.2 | % |
| Interest expense                                                                                                                     |       | —                                      |       | — | % | (1,517 | ) | (10.8 | )% |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable |       | —                                      |       | — | % | (39 | ) | (0.3 | )% |
| Amortization of deferred financing costs                                                                                             |       | —                                      |       | — | % | (373 | ) | (2.7 | )% |
| Gain from sale of tradename                                                                                                          |       | 500                                         |       | 9.7 | % | — |   | — | % |
| Loss from continuing operations before  taxes                                                                                        |       | (1,063                                      | )          | (20.7 | )% | (503 | ) | (3.6 | )% |
|                                                                                                                                      |            |                                             |            |  |  |  |  |  |  |  |  |

 

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| ** **                 | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **2004**                     | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **$**                        | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                 | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Provision for income taxes |       | —                       |       | — | % | 241 |   | 1.7 | % |
| Net loss                   |       | $                            | (1,063     | ) | (20.7 | )% | $ | (744 | ) | (5.3 | )% |
|                            |            |                              |            |  |  |  |  |  |  |  |  |

 

We evaluate performance based on, among otherfactors, Adjusted EBITDA. Included in Adjusted EBITDA are direct operatingexpenses for each segment. The following table summarized net revenue andAdjusted EBITDA by operating segment for the years ended December 31, 2004 and2005, respectively. Corporate expenses consist of general operating expensesthat are not directly related to the operations of the segments. Areconciliation of Net Income (Loss) to Adjusted EBITDA is also provided.

 
| ** **            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2004**                     | ** ** | **2005** | ** ** |
| ** **            | ** ** | **(in thousands)**           | ** ** |
|                  |       |                         |       |   |   |
| Net Revenue:          |       |                         |       |   |   |
| E-commerce            |       | $                            | 2,994      |   | $ | 2,665 |   |
| Media                 |       | 2,149                        |       | 5,297 |   |
| Anti-piracy  services |       | —                       |       | 6,009 |   |
|                  |       | $                            | 5,143      |   | $ | 13,971 |   |
| Adjusted EBITDA:      |       |                         |       |   |   |
| E-commerce            |       | $                            | 293        |   | $ | 157 |   |
| Media                 |       | 789                          |       | 2,198 |   |
| Anti-piracy  services |       | —                       |       | 3,851 |   |
|                  |       | 1,082                        |       | 6,206 |   |
| Corporate             |       | (1,944                       | )          | (2,969 | ) |
|                  |       | $                            | (862       | ) | $ | 3,237 |   |

 

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| ** **                                                                                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2004**                     | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**           | ** ** |
|                                                                                                                                                   |       |                         |       |   |   |
| Reconciliation of Adjusted EBITDA to Net Income (Loss):                                                                                                |       |                         |       |   |   |
| Adjusted  EBITDA per segments                                                                                                                          |       | $                            | (862       | ) | $ | 3,237 |   |
| Stock-based  compensation                                                                                                                              |       | (7                           | )          | (73 | ) |
| Depreciation                                                                                                                                           |       | (223                         | )          | (205 | ) |
| Amortization  of intangible assets                                                                                                                     |       | —                       |       | (1,562 | ) |
| Amortization  of deferred financing costs                                                                                                              |       | —                       |       | (373 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable into common stock |       | —                       |       | (39 | ) |
| Interest  income                                                                                                                                       |       | 29                           |       | 29 |   |
| Interest  expense, including amortization of discount on debt of $246                                                                                  |       | —                       |       | (1,517 | ) |
| Provision  for income taxes                                                                                                                            |       | —                       |       | (241 | ) |
| Loss from  discontinued operations -                                                                                                                   |       |                         |       |   |   |
| –  ARTISTdirect Records, LLC                                                                                                                      |       | (2,111                       | )          | (271 | ) |
| – iMusic  record label                                                                                                                            |       | (137                         | )          | — |   |
| Gain from  sale of ARTISTdirect Records, LLC                                                                                                           |       | —                       |       | 21,079 |   |
| Net income  (loss)                                                                                                                                     |       | $                            | (3,311     | ) | $ | 20,064 |   |

 

Adjusted EBITDA is a non-GAAP financial measure thatrepresents earnings before net interest expense, provision for income taxes,depreciation and amortization, as well as certain other charges, includingstock-based compensation and impairment losses. Management excludes these itemsin assessing financial performance, primarily due to their non-operationalnature or because they are outside of our normal operations. We have providedthis information because management believes that it is useful to investors inunderstanding our financial condition and results of operation.

 

Management believes that Adjusted EBITDA enhances anoverall understanding of our financial performance by investors because it isfrequently used by securities analysts and other interested parties inevaluating companies in our industry segment. In addition, management believesthat Adjusted EBITDA is useful in evaluating our operating performance compared to that of other companies in  our industry segment because the calculationof Adjusted EBITDA eliminates the accounting effects of financing costs, incometaxes and capital spending, which items may vary for different companies forreasons unrelated to overall operating performance.

 

However, Adjusted EBITDA is not a recognizedmeasurement under GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to,and not as an alternative for, income (loss) from operations, income (loss)before income taxes, and net income (loss), or any other measure utilized indetermining the Company’s operating performance that is calculated inaccordance with GAAP. Because Adjusted EBITDA is not calculated in accordancewith GAAP, it may not be comparable to similarly-titled measures utilized byother companies. Furthermore, Adjusted EBITDA is not intended to be a measureof  our free cash flow, as it does notconsider certain ongoing cash requirements, such as a required debt servicepayments and income taxes.

 

*Net Revenue*. Our net revenue increased by $8,828,000 or171.7%, to $13,971,000 for the year ended December 31, 2005, as compared to$5,143,000 for the year ended December 31, 2004, primarily as a result of anincrease in media revenue of $3,148,000 and the acquisition of MediaDefender,which provided revenue of $6,009,000 from its anti-piracy services since itsacquisition on July 28, 2005. MediaDefender’s revenue accounted for 43.0% ofour total net revenue for the year ended December 31, 2005. We expect thatrevenues from MediaDefender will represent a significant proportion of ourtotal revenues in the foreseeable future.

 

E-commerce revenue decreased by $329,000, or 11.0%,to $2,665,000 for the year ended December 31, 2005, as compared to $2,994,000for the year ended December 31, 2004, primarily due to a decrease in sales ofproducts related to a single music merchandising entity.

 

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

 

Media revenue increased by $3,148,000, or 146.5%, to$5,297,000 for the year ended December 31, 2005, as compared to $2,149,000 forthe year ended December 31, 2004, as a result of an increase in the number ofonline advertisers, an increase in the cost per thousand (“CPM”) amounts earnedfrom the sales of impression and non-impression based advertising and theexpansion of our affiliations with other web-sites for which we both marketadvertising and participate in advertising revenues. A short-term program witha major advertiser/sponsor during the three months ended June 30, 2005contributed approximately $1,786,000 of the increase in media revenue duringthe year ended December 31, 2005. The program ended June 30, 2005 and, asdesigned, did not continue.

 

We market and sell advertising on a CPM basis toadvertising agencies and directly to various companies as part of our marketingprogram. We also market and sell sponsorships for various portions of theARTISTdirect Network. Customers may purchase advertising space on the entireARTISTdirect Network, or they may tailor advertising based on music genre orfunctionality. We intend to continue to focus on increasing revenue from ourmedia operations business segment, which generates revenues from the sale ofonline advertising and sponsorships to companies seeking to reach one or moreof the distinct demographic audiences viewing content in the ARTISTdirectNetwork.

 

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

 

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MediaDefender’s cost ofrevenue for the year ended December 31, 2005 was the amortization of proprietarytechnology acquired in the MediaDefender transaction of $1,056,000.

 

E-commerce cost of revenue decreased by $231,000, or8.8%, to $2,400,000 for the year ended December 31, 2005, as compared to$2,631,000 for the year ended December 31, 2004, primarily as a result of thedecrease in e-commerce revenues.

 

Media cost of revenue increased by $1,601,000 or139.9% to $2,745,000 for the year ended December 31, 2005, as compared to$1,144,000 for the year ended December 31, 2004, as a result of an increase inimpressions being delivered by affiliate web-sites with which we haverevenue-sharing arrangements, advertising serving costs, and sales commissionspaid to a third party in conjunction with increased media revenues.

 

As a result of the foregoing, gross profit was$6,167,000 for the year ended December 31, 2005, as compared to $1,368,000 forthe year ended December 31, 2004, reflecting gross margins of 44.1% and 26.6%,respectively. The significant improvement in gross margin for the year endedDecember 31, 2005, as compared to the year ended December 31, 2004, was due toa change in the business mix, reflecting an increase in revenues from highermargin segments. A summary of gross profit and gross margin by segment is asfollows ($000):

 

| ** **            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2004**                     | ** ** | **2005** | ** ** |
| **Segment:**          | ** ** | **Gross  Profit**            | ** ** | **Gross  Margin** | ** ** | **Gross  Profit** | ** ** | **Gross  Margin** | ** ** |
| E-commerce            |       | $                            | 363        |   | 12.1 | % | $ | 265 |   | 9.9 | % |
| Media                 |       | 1,005                        |       | 46.8 | % | 2,552 |   | 48.2 | % |
| Anti-piracy  services |       | —                       |       | — |   | 3,350 |   | 55.7 | % |
| Totals                |       | $                            | 1,368      |   | 26.6 | % | $ | 6,167 |   | 44.1 | % |

 

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

 

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

 

The increase in general and administrative expensein 2005, as compared to 2004, was in part attributable to the awarding ofdiscretionary cash bonuses to certain of our senior executives, as describedbelow.

 

In March 2005, we awarded discretionary cash bonusesto our Chief Executive Officer and Chief Financial Officer aggregating$125,000, which were paid during 2005. We awarded such bonuses as considerationfor management successfully completing our corporate restructuring during thethree months ended March 31, 2005. In particular, management restructured ourinternet operations, which had sustained losses since inception, into agrowing, profitable business segment; negotiated the extinguishment of our$12.0 million funding obligation to ARTISTdirect Records; and disposed of ourinvestment in ARTISTdirect Records effective February 28, 2005, which resultedin the elimination of $19.137 million of liabilities from our consolidatedbalance sheet at that date. Such bonuses were reviewed and approved by ourBoard of Directors. We also awarded a discretionary cash bonus to our VicePresident – Business Development of $40,000, which was reviewed and approved bythe Compensation Committee of our Board of Directors, and was accrued at December31, 2005 and we accrued $100,000 in board fees to two independent directors atDecember 31, 2005.

 

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

 

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

 

*Interest Income*. Our interest income was $29,000 for theyears ended December 31, 2005 and 2004, respectively.

 

*Interest Expense*. Our interest expense for the year endedDecember 31, 2005 of $1,517,000 relates to $15.0 million of secured notespayable issued in the Senior Financing, which bear interest at 11.25% perannum, and $30.0 million of convertible notes payable issued in the Sub-DebtFinancing, which bears interest at 4.0% per annum, both issued to finance theacquisition of MediaDefender in July 2005.

 

Additional consideration in the form of warrantsissued to the lenders was accounted for at fair value and recorded as areduction to the carrying amount of the debt, and is being amortized to interestexpense over the term of the debt. Accordingly, the amortization of discount ondebt included in interest expense for the year ended December 31, 2005 was$246,000. We did not have any interest expense for the year ended December 31,2004.

 

*Write-Off of Unamortized Discounton Debt and Deferred Financing Costs Due to Conversion of SubordinatedConvertible Notes Payable*. Our deferred financing costs and debt discount costs aggregating$39,000 were charged to operations as a result of the conversion ofsubordinated convertible notes payable aggregating $387,500 into 250,000 sharesof our common stock in December 2005.

 

*Amortization of Deferred FinancingCosts*. Amortizationof deferred financing costs was $373,000 for the year ended December 31, 2005. Deferredfinancing costs consist of consideration paid to third parties with respect tothe acquisition and financing of the MediaDefender transaction, including cashpayments, subordinated notes payable and the fair value of warrants issued forlegal fees and placement agent fees, which were deferred and are beingamortized over the term of the related debt. We did not have any amortizationof deferred financing costs for the year ended December 31, 2004.

 

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

 

*Loss from Continuing OperationsBefore Income Taxes*.As a result of the aforementioned factors, the loss from continuing operationswas $503,000 for the year ended December 31, 2005, as compared to a loss fromcontinuing operations of $1,063,000 for the year ended December 31, 2004.

 

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

 

*Discontinued Operations*. On February 28, 2005, we completed the saleof 100% of the common stock of ARTISTdirect Recordings to Radar Recordspursuant to a transfer agreement for a cash payment of $115,000, as a result ofwhich we no longer had any equity or other economic interest in ARTISTdirectRecords, and Radar Records became the owner of a majority of the membershipinterests in ARTISTdirect Records and also acquired the receivable reflectingthe $33.0 million of loan advances previously provided to ARTISTdirect Recordsby us. In conjunction with this transaction, at February 28, 2005, we wrote-offthe inter-company balance due from ARTISTdirect Records of $80,000, which waseliminated in consolidation. Radar Records acquired the common stock ofARTISTdirect Recordings subject to the rights of BMG. Radar Records also agreedto offer to investors who had provided bridge funding to ARTISTdirect Records,excluding Frederick W. Field and entities related or controlled by him, theright to acquire proportional shares (based on the amount of bridge fundingmade by each bridge investor in ARTISTdirect Records) of the common stock ofARTISTdirect Recordings on the same terms and conditions as set forth in thetransfer agreement.

 

The amount of consideration received by us wasdetermined with reference to various factors, including, but not limited to,our future business plans and intention to focus on our Internet and web-siteoperations, ARTISTdirect Records’ current limited

 

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capital resources andsubstantially reduced level of operations, ARTISTdirect Records’ futurebusiness plans and capital requirements and the likelihood of obtaining suchcapital on a timely basis and under reasonable terms and conditions, the unpaidcosts that we had advanced ARTISTdirect Records to date and would be requiredto continue to advance ARTISTdirect Records in the future, and the probabilityof us obtaining a return on our investment to date of $33.0 million inARTISTdirect Records.

 

As a result of the existence of various conflicts ofinterest with respect to this transaction, full disclosure of these conflictsof interest was made to our Board of Directors and the required approval by thedisinterested members of our Board of Directors was obtained prior to theclosing of the transaction.

 

As a result of the sale of all of our interest inARTISTdirect Recordings to Radar Records effective February 28, 2005, weaccounted for our interest in ARTISTdirect Records as a discontinued operationfor all periods presented in accordance with SFAS No. 144, and the assetsand liabilities of ARTISTdirect Records were classified as “held for sale”through February 28, 2005.

 

As a result of the disposition of our interest inARTISTdirect Records effective February 28, 2005, we recognized a net gain(primarily non-cash) in its consolidated statement of operations for the yearended December 31, 2005 of $21.079 million, primarily as a result of theelimination of the liabilities of ARTISTdirect Records.

 

A summary of the loss from discontinued operationsfor the years ended December 31, 2005 and 2004, respectively, is presentedbelow. No information with respect to our discontinued operations of the iMusicrecord label for the year ended December 31, 2005 is included, as ouriMusic record label was discontinued during December 2004 and did not have anybusiness operations during 2005.

 

Loss from Discontinued Operations ($000)

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

 

*Net Income (Loss)*. As a result of the foregoing factors, netincome was $20,064,000 for the year ended December 31, 2005, as compared to anet loss of $3,311,000 for the year ended December 31, 2004.

 

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**Liquidity and Capital Resources**

 

*Overview*. Until the acquisition of MediaDefendereffective July 28, 2005, we primarily financed our continuing operations fromthe sale of our equity securities.

 

As of December 31, 2005 and 2004, we had $3,102,000and $1,156,000 of unrestricted cash and cash equivalents, respectively. AtDecember 31, 2005, we had working capital of $60,000 (including $3,260,000 ofwarrant liability at December 31, 2005), as compared to a working capitaldeficiency of $18,438,000 at December 31, 2004. Excluding the warrant liability,our working capital would have been $3,320,000 at December 31, 2005. Theimprovement in our cash and working capital positions at December 31, 2005 wasattributable primarily to the acquisition of MediaDefender and the dispositionof ARTISTdirect Records.

 

Concurrent with the acquisition of MediaDefender inJuly 2005, we completed the $15.0 million Senior Financing and the $30.0million Sub-Debt Financing, which generated approximately $1.0 million forgeneral working capital purposes. In addition, MediaDefender had workingcapital of $2,745,000 at the acquisition date. We anticipate positive resultsof operations and cash flows from this business.

 

We sold our interest in ARTISTdirect Records in fiscal 2005. We had consolidatedARTISTdirect Records at December 31, 2004, which had current liabilities of$18,770,000 at such date. Effective February 28, 2005, we sold 100% of ourinterest in ARTISTdirect Records for a cash payment of $115,000, as a result ofwhich we no longer have any equity or other economic interest in ARTISTdirectRecords. As a result of the sale of our interest in ARTISTdirect Recordseffective February 28, 2005, the liabilities of ARTISTdirect Records wereeliminated from our balance sheet at that date.

 

As a result of the general improvement in our mediaoperations and the expected positive impact from the acquisition ofMediaDefender, we believe that available cash resources are likely to besufficient to meet anticipated working capital requirements for at least thenext 12 months. However, we may seek additional funding for possibleacquisitions, expansion of existing operations or other purposes, or to theextent that our operations do not generate sufficient levels of profitabilityand cash flow. Should we seek to raise additional capital, there can be noassurances that such capital can be raised on terms satisfactory, on a timelybasis, or at all.

 

If all of our outstanding equity-based instrumentsare converted or exercised into shares of 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 ourcommon stock issued and outstanding.

 

*Operating*. Net cash provided by operating activitieswas $1,486,000 for the year ended December 31, 2005, as compared to net cashused in operating activities of $3,473,000 for the year ended December 31,2004. Net cash provided by continuing operations was $1,524,000 for the yearended December 31, 2005, as compared to net cash used in continuing operationsof $625,000 for the year ended December 31, 2004. The improvement in net cashprovided by continuing operations in 2005, as compared to 2004, was primarily aresult of the decrease in net loss and an increase in accrued liabilities. Netcash used in discontinued operations was $38,000 and $2,848,000 for the yearsended December 31, 2005 and 2004, respectively.

 

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

 

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

 

**Contractual Obligations**

 

As of December 31, 2005, our principalcommitments for the next five fiscal year periods consisted of contractualcommitments as summarized below. The summary shown below assumes that thesenior secured notes payable and the subordinated

 

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convertible notes payableare outstanding for their full terms, without any early reduction of theprincipal balances based on cash flows, except for a 2006 scheduled principalpayment on the senior secured notes payable of $390,000.

 
| ** **                                               | ** ** | **Payments Due by Year** | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|
| ** **                                               | ** ** | **(in thousands)**       | ** ** |
| **Contractual  cash obligations**                        | ** ** | **Total**                | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
| Employment  contracts                                    |       | $                        | 3,942      |   | $ | 1,414 |   | $ | 1,264 |   | $ | 1,264 |   | $ | — |   | $ | — |   |
| Guaranteed  payments to MediaDefender management         |       | 1,050                    |       | 1,050 |   | — |   | — |   | — |   | — |   |
| Lease  obligations                                       |       | 2,261                    |       | 343 |   | 464 |   | 470 |   | 485 |   | 499 |   |
| Senior  secured notes payable                            |       | 15,000                   |       | 390 |   | — |   | — |   | 14,610 |   | — |   |
| Interest on  senior secured notes payable                |       | 5,826                    |       | 1,604 |   | 1,666 |   | 1,666 |   | 890 |   | — |   |
| Subordinated  convertible notes payable (1)              |       | 27,954                   |       | — |   | — |   | — |   | 27,954 |   | — |   |
| Interest on  subordinated convertible notes  payable (2) |       | 4,537                    |       | 1,661 |   | 1,118 |   | 1,118 |   | 640 |   | — |   |
| Total  contractual cash obligations                      |       | $                        | 60,570     |   | $ | 6,462 |   | $ | 4,512 |   | $ | 4,518 |   | $ | 44,579 |   | $ | 499 |   |

 

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(1) Subordinated convertible notes payable reflects $3,506,000 ofsubordinated debt principal converted into shares of our common stock as ofMarch 31, 2006.

 

(2)  In 2006,$68,000 has been paid in cash as of March 31, 2006 due to conversion ofsubordinated debt principal into shares of our common stock. The remaininginterest payments are calculated in the ordinary course.

 

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

 

**Off-Balance Sheet Arrangements**

 

At December 31, 2005, we did not have anytransactions, obligations or relationships that could be considered off-balancesheet arrangements.

 

**RISK FACTORS**

 

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

 

**RISKS RELATED TO OUR BUSINESS**

 

***It is difficult to evaluate ourbusiness and prospects because we have a limited operating history and arapidly evolving business.***

 

We were incorporated under the laws of the state ofDelaware in July 1999. Our limited operating history and rapidly evolvingbusiness make it difficult to evaluate our prospects or to accurately predictour future revenue or results of operations. Our

 

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revenue and income potentialare unproven, and our business model is constantly and rapidly evolving. Inparticular, the Internet is constantly changing and we may need to modify ourbusiness model to adapt to these changes.

 

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

 

Our future success depends to a significant extenton the continued services of our senior management, including Jonathan V.Diamond, Randy Saaf and Octavio Herrera. The loss of any of these individualswould likely have an adverse effect on our business. Competition for personnelthroughout our industry is intense and we may be unable to retain these keyemployees or attract, integrate or retain other highly qualified employees inthe future. We have in the past experienced, and we expect to continue toexperience, difficulty in hiring and retaining highly skilled employees withappropriate qualifications. If we do not succeed in attracting new personnel orretaining and motivating our current personnel, our business could be adverselyaffected. Recent changes in corporate governance and securities laws andregulations, such as the Sarbanes-Oxley Act of 2002, could make it moredifficult for us to attract and retain qualified executive officers orqualified members of our Board of Directors, particularly individuals to serveon our audit committee.

 

***We have substantial debtobligations, which could materially and adversely affect our business.***

 

To obtain sufficient cash resources to fund theacquisition of MediaDefender, we incurred approximately $45.0 million worth ofindebtedness. We will require substantial amounts of cash to fund scheduledpayments of interest on the notes issued in the debt transactions, payment ofthe principal amount of the notes, future capital expenditures, payments on ourleases and any increased working capital requirements due to the acquisition.If we are unable to meet our cash requirements out of cash flow fromoperations, there can be no assurance that we will be able to obtainalternative financing. The degree to which we are financially leveraged couldmaterially and adversely affect our ability to obtain financing for workingcapital, acquisitions or other purposes and could make us more vulnerable toindustry downturns and competitive pressures. In the absence of such financing,our ability to respond to changing business and economic conditions, to make futureacquisitions, to absorb adverse operating results or to fund capitalexpenditures or increased working capital requirements would be significantlyreduced. Our ability to meet our debt service obligations will be dependentupon our future performance, which will be subject to financial, business andother factors affecting our operations, some of which are beyond our control.

 

***The success of our newly-acquiredInternet piracy prevention segment depends in part on the continued success ofMediaDefender’s content protection technology.***

*** ***

If current MediaDefender customers, which includemajor movie studios and record labels, determine that the benefits ofMediaDefender’s technology do not justify the expense, or other competitivetechnologies are superior than those provided by MediaDefender, demand for itsIPP technology would decline and our operating results would be harmed.

 

***Our relationships with entertainmentindustry participants are particularly important to our newly-acquired Internetpiracy prevention segment, and if we fail to maintain such relationshipsfostered by MediaDefender our business prospects could be materially harmed.***

*** ***

If we fail to maintain and expand MediaDefender’srelationships with a broad range of participants throughout the entertainmentindustry, including movie studios and record labels, our business prospectscould be materially harmed. Relationships have historically played an importantrole in the entertainment industries that MediaDefender serves. If we fail tomaintain and strengthen these relationships, these entertainment industryparticipants may not purchase or use our technologies, which could materiallyharm our business and business prospects. In addition, if major entertainmentindustry participants form strategic relationships that exclude us, ourbusiness and business prospects could be materially adversely affected.

 

***Global sales of recorded music haverecently declined and this trend may continue in the future.***

*** ***

Based on data compiled by The Recording Industry Associationof America, or RIAA, the number of CDs shipped from record companies to retaildistribution channels fell approximately 8% in 2005, as compared to theprevious year. Dollar value also fell substantially from 11.4 billion to 10.5billion in 2005 from 2004. This decline represents the greatest drop since2002, when shipped units and dollar value fell by 8.9% and 6.7%, respectively.According to the RIAA, the decline, in sales had been due in part, towidespread copying and illegal Internet downloading of music. If the overalltrend continues, it may affect our e-commerce business and have a materialaffect on our revenues.

 

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***If we are unable to grow our onlineadvertising significantly in the near future, our business may be adverselyaffected.***

 

If we do not increase advertising revenue in ourmedia and e-commerce segments, our business will be adversely affected.Increasing our advertising revenue depends upon many factors, including ourability to:

 

•                  respondto and anticipate fluctuations in the demand for, and pricing of, onlineadvertising;

 

•                  developand maintain key advertising relationships and compete for advertisers withInternet and traditional media companies;

 

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

 

•                  successfullydevelop, sell and execute entertainment marketing solutions;

 

•                  increasethe size of our audience and the amount of time that our audience spends on ourweb-sites;

 

•                  accuratelymeasure the size and demographic characteristics of our audience;

 

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

 

•                  increasethe amount of revenue per advertisement.

 

Our failure to achieve one or more of theseobjectives could impair our ability to increase advertising revenue, whichcould adversely affect our business. In addition to the above factors, generaleconomic conditions, as well as economic conditions specific to online advertising,electronic commerce and the music industry, could affect our ability toincrease our advertising revenue.

 

***We may not be able to develop orobtain sufficiently compelling content to attract and retain our targetaudience.***

 

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

 

•                  reducedaccess to content controlled by record labels, music publishers and artists;

 

•                  diminishedtechnical expertise and creativity of our production staff; and

 

•                  inabilityto anticipate and capitalize on trends in music.

 

***If we do not build and maintainstrong brands, we may not be able to attract a significant number of users toour web-sites.***

 

To attract users we must develop a brand identityfor ARTISTdirect and increase public awareness of the ARTISTdirect network;however, to conserve cash we have significantly decreased the amounts we havespent and plan to spend on our offline and online advertising and promotionalefforts to increase brand awareness, traffic and revenue. Accordingly, ourmarketing activities may not result in increased revenue and, even if they do,any increased revenue may not offset the expenses we incur in building ourbrands. Moreover, despite these efforts we may be unable to increase publicawareness of our brands, which would have an adverse effect on our results ofoperations.

 

***The market for online promotion anddistribution of music and related merchandise is highly competitive and we maynot be able to compete successfully against our current and future competitors.***

*** ***

The market for the online promotion and distributionof music and related merchandise is highly competitive and rapidly changing.There are a significant number of web-sites promoting and distributing musicand related merchandise that compete for the attention and spending ofconsumers, advertisers and users. We face competitive pressures from numerousactual and potential

 

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competitors. Our competitorsinclude America Online, MSN, Yahoo!, Amazon.com, MTV, myspace.com, mp3.com,billboard.com and other web-sites and traditional music companies.

 

Competition is likely to increase significantly asnew companies enter the market and current competitors expand their services.Some of our competitors have entered into agreements to work together to offermusic over the Internet, and we may face increased competitive pressures as aresult. Many of our current and potential competitors in the Internet and musicentertainment businesses may have substantial competitive advantages relativeto us, including:

 

•                  longeroperating histories;

 

•                  significantlygreater financial, technical and marketing resources;

 

•                  greaterbrand name recognition;

 

•                  largerexisting customer bases; and

 

•                  morepopular content or artists.

 

These competitors may be able to respond morequickly to new or emerging technologies and changes in customer requirementsand devote greater resources to develop, promote and sell their products orservices than we can. Consumers, artists, talent management companies and othermusic-related vendors or advertisers may perceive web-sites maintained by ourexisting and potential competitors as being superior to ours. In addition,increased competition could result in reduced advertising rates and margins andloss of market share, any of which could harm our business.

 

***We depend on a limited number ofsuppliers for music merchandise, fulfillment and distribution and if we cannotsecure alternate suppliers, our business may be harmed.***

*** ***

We rely to a large extent on timely distribution bythird parties. During 2005, we relied on two vendors, Alliance Entertainment,and Benn Co. to fulfill and distribute our orders for music and relatedmerchandise. During the year ended December 31, 2005, approximately 94%and 6%, respectively, of our total customer orders were fulfilled by Allianceand Benn Co., respectively. We purchase a significant portion of ourartist-licensed merchandise from Benn Co. and most all of our compact discsfrom Alliance. Our contracts with Alliance and Benn Co. are both on amonth-to-month basis. Our business could be significantly disrupted if Allianceor Benn Co. were to terminate or breach their agreements or suffer adversedevelopments that affect their ability to supply products to us. If, for anyreason, Alliance, Benn Co. or other vendors are unable or unwilling to supplyproducts to us in sufficient quantities and in a timely manner, we may not beable to secure alternative suppliers, on acceptable terms, in a timely manneror at all.

 

***We depend on third party inventoryand financial systems and carrier services.***

*** ***

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

 

***Our media and e-commerce segmentsare subject to seasonality, which could adversely affect our operating results.***

*** ***

We have experienced and expect to continue toexperience seasonal fluctuations in our online sales. These seasonal patternswill cause quarterly fluctuations in our operating results. In particular, adisproportionate amount of our online sales have been realized during thefourth calendar quarter and during the summer months, traditionally whenartists go on tour. Due to our limited operating history, it is difficult topredict the seasonal pattern of our online sales and the impact of suchseasonality on our business and operating results. Our seasonal online salespatterns may become more pronounced, strain our personnel, warehousing, andorder

 

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shipment activities andcause our operating results to be significantly less than expected for anygiven period. This would likely cause our stock price to fall.

 

***We may be subject to systemdisruptions, which could reduce our revenue.***

*** ***

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

 

***If we are unable to protect ourintellectual property rights, our competitive position could be harmed or wecould be required to incur expenses to enforce our rights.***

*** ***

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

 

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

 

***Our access to copyrighted contentdepends upon the willingness of content owners to make their content available.***

*** ***

The music content available on the ARTISTdirectnetwork is typically comprised of copyrighted works owned or controlled bymultiple third parties. Most of the content on our artist-specific web-sites iseither owned or licensed by the artist. On other parts of the ARTISTdirectnetwork, depending on the nature of the content and how we use the musiccontent, we typically license such rights from publishers, record labels,performing rights societies or artists. We frequently either do not havewritten contracts or have short-term contracts with copyright owners, and, accordingly,our access to copyrighted content depends upon the willingness of such partiesto continue to make their content available. If the fees for music contentincrease substantially or if significant music content becomes unavailable, ourability to offer music content could be materially limited. We have notobtained a license for some of the content offered on the ARTISTdirect network,including links to other music-related sites and thirty-second streamed songsamples, because we believe that a license is not required under existing law.However, this area of law remains uncertain and may not be resolved for anumber of years. When this area of law is resolved, we may be required toobtain licenses for such content, alter or remove the content from our web-sitesand be forced to pay potentially significant financial damages for pastconduct.

 

***Intellectual property claims againstus could be costly and could result in the loss of significant rights.***

*** ***

Third parties may assert and have asserted trademark,copyright, patent and other types of infringement or unfair competition claimsagainst us. If we are forced to defend against any such claims, whether theyare with or without merit or are determined in our favor, we may face costlylitigation, loss of access to, and use of, content, diversion of technical andmanagement personnel, or product shipment delays. As a result of such adispute, we may have to develop non-infringing technology, enter into royaltyor licensing agreements, cease using certain technology or content or paydamages, any of which may increase our operating expenses

 

33

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and harm our business. Suchroyalty or licensing agreements, if required, may be unavailable on termsacceptable to us, or at all. While we have resolved all such disputes in thepast, we may not be able to do so in the future.

 

***If our online security measuresfail, we could lose visitors to our sites and could be subject to claims fordamage from our users, content providers, advertisers and merchants.***

*** ***

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

 

***We may be subject to liability ifprivate information provided by our users were misused.***

*** ***

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

 

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

 

***We may be sued for content availableor posted on our web-sites or products through our web-sites or for linking andframing of third-party web-sites.***

 

We may be liable to third parties for contentpublished on our web-sites and other web-sites where our syndicated contentappears if the music, artwork, text or other content available violates theircopyright, trademark or other intellectual property rights or if the availablecontent is defamatory, obscene or pornographic. Similar claims have beenbrought, sometimes successfully, against web-site operators in the past. Wealso may be liable for content uploaded or posted by our users on our web-sites,such as digitally distributed music files, postings on our message boards, chatroom discussions and copyrightable works. In addition, we could have liabilityto some of our content licensors for claims made against them for contentavailable on our web-sites. We also could be exposed to these types of claimsfor content that may be accessed from our web-sites or via links to other web-sitesor for products sold through our web-site. While we have resolved all of thesetypes of claims made against us in the past, we may not be able to do so in thefuture. We intend to implement measures to reduce exposure to these types ofclaims, but such measures may not be successful and may require us to expendsignificant resources. Any litigation as a result of defending these types ofclaims could result in substantial costs and damages. Our insurance may notadequately protect us against these types of claims or the costs of theirdefense or payment of damages. We link to and “frame” third-party web-sites ofour artists without express written permission to do so. In addition, in thepast we have provided a search feature to allow users to find music residingelsewhere on the Internet. Those practices are controversial, and have, ininstances not involving us, resulted in litigation. Various claims, includingtrademark and copyright infringement, unfair competition, and commercialmisappropriation, as well as infringement of the right of publicity may beasserted against us as a result. The law regarding linking and framing remainsunsettled; it is uncertain as to how existing laws, especially trademark andcopyright law, will be applied by the judiciary to the Internet. Also, Congressis increasingly active in passing new laws

 

34

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related to the Internet, andthere is uncertainty as to the impact of future potential laws, especiallythose involving domain names, databases and privacy.

 

**RISKS RELATED TO OUR CAPITAL STRUCTURE**

** **

***Our stock price is volatile andcould decline in the future.***

*** ***

The price of our common stock may fluctuate in thefuture. The stock market, in general, and the market price for shares oftechnology companies in particular, have experienced extreme stock pricefluctuations. In some cases, these fluctuations have been unrelated to theoperating performance of the affected companies. Many companies in thetechnology and related industries have experienced dramatic volatility in themarket prices of their common stock. We believe that a number of factors, bothwithin and outside of our control, could cause the price of our common stock tofluctuate, perhaps substantially. Factors such as the following could have asignificant adverse impact on the market price of our common stock:

 

•                  announcementsof technological innovations or new products by us or our competitors;

 

•                  U.S.and foreign governmental actions;

 

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

 

•                  ourability to obtain additional financing and, if available, the terms andconditions of the financing;

 

•                  ourfinancial position and results of operations;

 

•                  period-to-periodfluctuations in our operating results;

 

•                  changesin estimates of our performance by any securities analysts;

 

•                  marketconditions for technology stocks in general; and

 

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

 

***The limited trading market may causevolatility in the market price of our common stock.***

*** ***

Our common stock is currently traded on a limitedbasis on the Over-the-Counter Bulletin Board under the symbol “ARTD.OB.” Thequotation of our common stock on the Over-the-Counter Bulletin Board does notassure that a meaningful, consistent and liquid trading market currentlyexists, and in recent years such market has experienced extreme price andvolume fluctuations that have particularly affected the market prices of manysmaller companies like us. Our common stock is thus subject to volatility. Inthe absence of an active trading market:

 

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

 

•                  marketvisibility for our common stock may be limited; and

 

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

 

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***Our common stock is considered a “pennystock” and may be difficult to sell.***

*** ***

Our common stock is considered to be a “penny stock”since it meets one or more of the definitions in Rules 15g-2 through 15g-6promulgated under Section 15(g) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”). These include but are not limited to the following:(i) the stock trades at a price less than $5.00 per share; (ii) it isNOT traded on a “recognized” national exchange; (iii) it is NOT quoted onthe NASDAQ Stock Market, or even if so, has a price less than $5.00 per share;or (iv) is issued by a company with net tangible assets less than$2.0 million, if in business more than a continuous three years, or withaverage revenues of less than $6.0 million for the past three years. Theprincipal result or effect of being designated a “penny stock” is that securitiesbroker-dealers cannot recommend the stock but must trade in it on anunsolicited basis. Section 15(g) of the Exchange Act and Rule 15g-2promulgated thereunder by the SEC require broker-dealers dealing in pennystocks to provide potential investors with a document disclosing the risks ofpenny stocks and to obtain a manually signed and dated written receipt of thedocument before effecting any transaction in a penny stock for the investor’saccount.

 

Potential investors in our common stock are urged toobtain and read such disclosure carefully before purchasing any shares that aredeemed to be “penny stock.” Moreover, Rule 15g-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 requiresthe broker-dealer to (i) obtain from the investor information concerninghis or her financial situation, investment experience and investmentobjectives; (ii) reasonably determine, based on that information, thattransactions in penny stocks are suitable for the investor and that theinvestor has sufficient knowledge and experience as to be reasonably capable ofevaluating the risks of penny stock transactions; (iii) provide theinvestor with a written statement setting forth the basis on which thebroker-dealer made the determination in (ii) above; and (iv) receivea signed and dated copy of such statement from the investor, confirming that itaccurately reflects the investor’s financial situation, investment experienceand investment objectives. Compliance with these requirements may make it moredifficult for holders of our common stock to resell their shares to thirdparties or to otherwise dispose of them in the market or otherwise.

 

***Standards for compliance withSection 404 of the Sarbanes-Oxley Act of 2002 are uncertain, and if wefail to comply in a timely manner, our business could be harmed and our stockprice could decline.***

*** ***

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

 

**SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS**

** **

In addition to historical information, this AnnualReport contains statements relating to our future business and/or results,including, without limitation, the statements under the captions “Risk Factors,”“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and “Description of Business.” These statements include certainprojections and business trends that are “forward-looking” within the meaningof the United States Private Securities Litigation Reform Act of 1995. You canidentify these statements by the use of words like “may,” “will,” “could,” “should,”“project,” “believe,” “anticipate,” “expect,” “plan,” “estimate,” “forecast,” “potential,”“intend,” “continue” and variations of these words or comparable words.Forward-looking statements do not guarantee future performance and involverisks and uncertainties. Actual results will differ, and may differ materially,from projected results as a result of certain risks and uncertainties. Theserisks and uncertainties include, without limitation, those described under “RiskFactors” and those detailed from time to time in our filings with the SEC, andinclude, among others, the following:

 

•                  Ourlimited operating history;

 

•                  Ourability to protect our intellectual property rights;

 

36

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•                  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 risks are not exhaustive. Other sections ofthis Annual Report may include additional factors which could adversely impactour business and financial performance. Moreover, we operate in a verycompetitive and rapidly changing environment. New risk factors emerge from timeto time and it is not possible for our management to predict all risk factors,nor can we assess the impact of all factors on our business or to the extent towhich any factor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements. Given theserisks and uncertainties, investors should not place undue reliance onforward-looking statements as a prediction of actual results. Theseforward-looking statements are made only as of the date of this Annual Report.Except for our ongoing obligation to disclose material information as requiredby federal securities laws, we do not intend to update you concerning anyfuture revisions to any forward-looking statements to reflect events orcircumstances occurring after the date of this Annual Report.

 

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

** **

Our consolidated financial statements appear in aseparate section of this Annual Report. Such information is incorporated hereinby reference.

 

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

** **

Effective February 6, 2004, we dismissed KPMG LLP (“KPMG”)as our independent accountant. The dismissal was recommended by our AuditCommittee and approved by our Board of Directors.

 

KPMG’s reports on our financial statements for theyears ended December 31, 2001 and 2002 did not contain an adverse opinion or adisclaimer of opinion, nor were they qualified or modified as to uncertainty,audit scope, or accounting principles, except that KPMG’s report, datedFebruary 14, 2003, for the years ended December 31, 2002 and 2001 contained anexplanatory paragraph stating that “the Company has incurred substantialoperating losses and negative cash flows from operations to date and hasfunding commitments related to its record label joint venture. The Companyneeds additional capital to fund its operations and the operations of therecord label joint venture. These conditions raise substantial doubt about theCompany’s ability to continue as a going concern. Management’s plans in regardto these matters are also described in note 1. The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.”

 

During the years ended December 31, 2001 and 2002,and the period from January 1, 2003 through February 6, 2004, there were nodisagreements with KPMG on any matter of accounting principles or practices,financial statement disclosure, or auditing scope or procedure, whichdisagreements, if not resolved to the satisfaction of KPMG, would have caused KPMGto make reference to the subject matter of the disagreements in connection withits reports on the our financial statements. In addition, none of the eventsdescribed in Item 304(a)(1)(iv) of Regulation S-K occurred during such periods.

 

Effective February 17, 2004, we retained GumbinerSavett Inc. (“GS”) as our independent accountant. The retention of GS wasrecommended by our Audit Committee and approved by our Board of Directors.

 

During the years ended December 31, 2002 and 2003,and the subsequent interim period from January 1, 2004 through February 16,2004, we did not, nor did anyone on our behalf, consult with GS regardingeither: (i) the application of accounting principles to a specifiedtransaction, either completed or proposed; or the type of audit opinion thatmight be rendered on our financial statements, and no written report or oraladvice was provided that GS concluded was an important factor considered by usin reaching a decision as to the accounting, auditing or financial reporting issue;or (ii) any matter that was either the subject of a disagreement as defined atItem 304(a)(1)(iv) or a reportable event as defined at Item 304(a)(1)(v) ofRegulation S-K.

 

**ITEM 8A.****                   ****INTERNAL CONTROLS OVERFINANCIAL REPORTING**

** **

**Evaluation of Disclosure Controlsand Procedures.**Underthe supervision and with the participation of management, our Chief ExecutiveOfficer and our Chief Financial Officer, have carried out an evaluation of theeffectiveness of our disclosure controls and procedures, as such term isdefined under Rule 13a-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended.  Based upon that evaluation, our ChiefExecutive Officer and our Chief Financial Officer concluded that there werematerial weaknesses in our internal controls over financial reporting as of theend of the period covered by this report. Our Chief Executive Officerand Chief Financial Officer identified weaknesses related to the segregation ofduties and the review, approval and reconciliation of accounting data and entries.We are addressing these issues by reviewing and revising our internalaccounting policies and procedures, expanding the resources allocated to ouraccounting department and reviewing and revising our accounting and managementinformation systems software. We expect resolution of these issues to takeseveral months.

37

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**Changes in Internal Controls Over Financial Reporting.**Under the supervisionand with the participation of management, our Chief Executive Officer and ChiefFinancial Officer also conducted an evaluation of our internal controls overfinancial reporting to determine whether any changes occurred during the fourthquarter of 2005 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting. Based on thatevaluation, there has been no such change during the fourth quarter of 2005.

 

**ITEM 8B.****                   ****OTHER INFORMATION**

** **

None.

 

**PART III**

 

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

** **

The information required by this Item is to be setforth in our definitive proxy statement to be filed with the Securities andExchange Commission within 120 days of our 2005 fiscal year end and isincorporated herein by reference.

 

**ITEM 10.****                     ****EXECUTIVE COMPENSATION**

** **

The information required by this Item is to be setforth in our definitive proxy statement to be filed with the Securities andExchange Commission within 120 days of our 2005 fiscal year end and isincorporated herein by reference.

 

**ITEM 11.****                     ****SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

** **

The information required by this Item is to be setforth in our definitive proxy statement to be filed with the Securities andExchange Commission within 120 days of our 2005 fiscal year end and isincorporated herein by reference.

 

**ITEM 12.****                     ****CERTAIN RELATIONSHIPS ANDRELATED PARTY TRANSACTIONS**

** **

The information required by this Item is to be set forthin our definitive proxy statement to be filed with the Securities and ExchangeCommission within 120 days of our 2005 fiscal year end and is incorporatedherein by reference.

 

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

** **

The information required by this Item is set forthin the section of this Annual Report entitled “EXHIBIT INDEX” and isincorporated herein by reference.

 

**ITEM 14.****                     ****PRINCIPAL ACCOUNTANT FEESAND SERVICES**

** **

The information required by this Item is to be setforth in our definitive proxy statement to be filed with the Securities andExchange Commission within 120 days of our 2005 fiscal year end and isincorporated herein by reference.

 

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**SIGNATURES**

 

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

 
|   |           | **ARTISTdirect, Inc.** |
|--------|----------------|------------------------|
|   |           | ** **             |
| Date:  | April 20, 2006 | By:                    | /s/ JONATHAN V. DIAMOND |   |
|   |           |                   | Jonathan V. Diamond |   |
|   |           |                   | Chief Executive Officer (Principal Executive Officer) |
|   |           |                   |   |   |
| Date:  | April 20, 2006 | By:                    | /s/ ROBERT N. WEINGARTEN | ** ** |
|   |           |                   | Robert N. Weingarten | ** ** |
|   |           |                   | Chief Financial Officer (Principal Financial Officer) |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the Registrant and in the capacities and onthe dates indicated.

 
| **Signature**            | ** ** | **Title**                                                            | ** ** | **Date**       | ** ** |
|--------------------------|------------|----------------------------------------------------------------------|------------|----------------|------------|
|                     |       |                                                                 |       |           |       |
| *                        |       | Chairman of the Board of Directors                                   |       | April 20, 2006 |       |
| Frederick W. Field       |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       | President, Chief Executive Officer and Director                      |       |           |       |
| /s/ Jonathan V. Diamond  |       | (Principal Executive Officer)                                        |       | April 20, 2006 |       |
| Jonathan V. Diamond      |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
| /s/ Robert N. Weingarten |       | Chief Financial Officer and Secretary (Principal Accounting Officer) |       | April 20, 2006 |       |
| Robert N. Weingarten     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
| *                        |       | Director                                                             |       | April 20, 2006 |       |
| Teymour Boutros-Ghali    |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
| *                        |       | Director                                                             |       | April 20, 2006 |       |
| Fred Davis               |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
|                     |       |                                                                 |       |           |       |
| *                        |       | Director                                                             |       | April 20, 2006 |       |
| James Lane               |       |                                                                 |       |           |       |

 

39

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| **Signature**   | ** ** | **Title** | ** ** | **Date**       | ** ** |
|-----------------|------------|-----------|------------|----------------|------------|
|            |       |      |       |           |       |
|            |       |      |       |           |       |
| *               |       | Director  |       | April 20, 2006 |       |
| Eric Pulier     |       |      |       |           |       |
|            |       |      |       |           |       |
|            |       |      |       |           |       |
| *               |       | Director  |       | April 20, 2006 |       |
| Dimitri Villard |       |      |       |           |       |
|            |       |      |       |           |       |
|            |       |      |       |           |       |

----

| *By:   | /s/  Jonathan V. Diamond  |   |   |   |   |   |
|--------|--------------------------------|--------|--------|--------|--------|--------|
|   | Jonathan V. Diamond            |   |   |   |   |   |
|   | (Attorney-in-Fact)             |   |   |   |   |   |
|   |                           |   |   |   |   |   |
|   |                           |   |   |   |   |   |
| *By:   | /s/  Robert N. Weingarten |   |   |   |   |   |
|   | Robert N. Weingarten           |   |   |   |   |   |
|   | (Attorney-in-Fact)             |   |   |   |   |   |

 

40

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ARTISTDIRECT, INC. AND SUBSIDIARIES

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

YEARS ENDED DECEMBER 31, 2004 AND 2005

 

 

**Table ofContents**

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

 

41

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REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM

 

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 31,2004 and 2005 and the related consolidated statements of operations,comprehensive loss, stockholders’ equity (deficiency) and cash flows for theyears then ended. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

We conducted our audits in accordance withstandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financialstatements, an audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallconsolidated financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of ARTISTdirect, Inc. and subsidiaries as of December 31,2004 and 2005, and the consolidated results of their operations and their cashflows for the years then ended, in conformity with accounting principlesgenerally accepted in the United States of America.

 

 
| /s/ GUMBINER SAVETT INC.                                                               |   |
|----------------------------------------------------------------------------------------|--------|
|                                                                                   |
| Santa Monica, California                                                               |
| March 30, 2006, except for Notes 9 and 23,  as to which the date is April 7, 2006 |

 

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Balance Sheets

(amounts in thousands, except for share data)

 
| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2004**              | ** ** | **2005** | ** ** |
|                                      |       |                  |       |   |   |
| Assets                                    |       |                  |       |   |   |
| Current assets:                           |       |                  |       |   |   |
| Cash and cash equivalents                 |       | $                     | 1,156      |   | $ | 3,102 |   |
| Restricted cash                           |       | 175                   |       | 359 |   |
| Accounts receivable, net                  |       | 751                   |       | 3,667 |   |
| Income taxes refundable                   |       | —                |       | 1,211 |   |
| Finished goods inventory, net             |       | 138                   |       | 303 |   |
| Prepaid expenses and other current assets |       | 58                    |       | 85 |   |
| Assets of discontinued operations         |       | 16                    |       | — |   |
| Total current assets                      |       | 2,294                 |       | 8,727 |   |
|                                      |       |                  |       |   |   |
| Property and equipment                    |       | 9,441                 |       | 3,120 |   |
| Less accumulated depreciation             |       | (9,342                | )          | (1,175 | ) |
| Property and equipment, net               |       | 99                    |       | 1,945 |   |
|                                      |       |                  |       |   |   |
| Other assets:                             |       |                  |       |   |   |
| Intangible assets:                        |       |                  |       |   |   |
| Customer relationships, net               |       | —                |       | 1,950 |   |
| Proprietary technology, net               |       | —                |       | 6,546 |   |
| Non-compete agreements, net               |       | —                |       | 1,191 |   |
| Goodwill                                  |       | —                |       | 31,085 |   |
| Total intangible assets, net              |       | —                |       | 40,772 |   |
| Deferred financing costs, net             |       | —                |       | 3,063 |   |
| Deposits                                  |       | 20                    |       | 25 |   |
| Total other assets                        |       | 20                    |       | 43,860 |   |
|                                      |       | $                     | 2,413      |   | $ | 54,532 |   |

 

(continued)

 

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Balance Sheets (continued)

(amounts inthousands, except for share data)

 
| ** **                                                                                                                                                                                     | ** ** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | ** ** | **2004**              | ** ** | **2005** | ** ** |
|                                                                                                                                                                                           |       |       |                  |       |   |   |
| Liabilities and Stockholders’ Equity  (Deficiency)                                                                                                                                        |       |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                           |       |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                               |       |       | $                     | 538        |   | $ | 911 |   |
| Accrued expenses                                                                                                                                                                               |       |       | 1,274                 |       | 1,923 |   |
| Accrued interest payable                                                                                                                                                                       |       |       | —                |       | 607 |   |
| Current portion of senior secured notes  payable                                                                                                                                               |       |       | —                |       | 390 |   |
| Deferred revenue                                                                                                                                                                               |       |       | —                |       | 377 |   |
| Warrant liability                                                                                                                                                                              |       |       | —                |       | 3,260 |   |
| Guaranteed payments to MediaDefender  management                                                                                                                                               |       |       | —                |       | 1,050 |   |
| Liabilities of discontinued operations                                                                                                                                                         |       |       | 18,920                |       | 149 |   |
| Total current liabilities                                                                                                                                                                      |       |       | 20,732                |       | 8,667 |   |
|                                                                                                                                                                                           |       |       |                  |       |   |   |
| Long-term liabilities:                                                                                                                                                                         |       |       |                  |       |   |   |
| Senior secured notes payable, net of  discount of $1,245, less current portion                                                                                                                 |       |       | —                |       | 13,365 |   |
| Subordinated convertible notes payable, net  of discount of $774                                                                                                                               |       |       | —                |       | 30,300 |   |
| Deferred income taxes                                                                                                                                                                          |       |       | —                |       | 264 |   |
| Total long-term liabilities                                                                                                                                                                    |       |       | —                |       | 43,929 |   |
|                                                                                                                                                                                           |       |       |                  |       |   |   |
| Minority interest – discontinued operations                                                                                                                                               |       |       | 1,940                 |       | — |   |
|                                                                                                                                                                                           |       |       |                  |       |   |   |
| Commitments and contingencies                                                                                                                                                                  |       |       |                  |       |   |   |
|                                                                                                                                                                                           |       |       |                  |       |   |   |
| Stockholders’ equity (deficiency):                                                                                                                                                        |       |       |                  |       |   |   |
| Preferred stock, $0.01 par value -  Authorized - 5,000,000 shares  Issued and outstanding – none                                                                                          |       |       | —                |       | — |   |
| Common stock, $0.01 par value -  Authorized – 60,000,000 shares  Issued and Outstanding – 4,861,149 shares at December 31, 2005 and  3,502,117 shares at December 31, 2004 |       |       | 38                    |       | 49 |   |
| Treasury stock, 0 shares at  December 31, 2005 and 322,902 shares at December 31, 2004, at cost                                                                                      |       |       | (3,442                | )          | — |   |
| Additional paid-in-capital                                                                                                                                                                     |       |       | 209,135               |       | 207,832 |   |
| Deferred compensation                                                                                                                                                                          |       |       | —                |       | (19 | ) |
| Accumulated deficit                                                                                                                                                                            |       |       | (225,990              | )          | (205,926 | ) |
| Total stockholders’ equity (deficiency)                                                                                                                                                   |       |       | (20,259               | )          | 1,936 |   |
|                                                                                                                                                                                           |       |       | $                     | 2,413      |   | $ | 54,532 |   |

 

See accompanying notes to consolidated financial statements.

 

44

----

 

ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Operations

(amounts in thousands, except for share data)

 
| ** **                                                                                                                           | ** ** | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------------------------|------------|
| ** **                                                                                                                           | ** ** | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Net revenue:                                                                                                                         |       |       |                              |       |   |   |
| E-commerce                                                                                                                           |       |       | $                                 | 2,994      |   | $ | 2,665 |   |
| Media                                                                                                                                |       |       | 2,149                             |       | 5,297 |   |
| Anti-piracy services                                                                                                                 |       |       | —                            |       | 6,009 |   |
| Total net revenue                                                                                                                    |       |       | 5,143                             |       | 13,971 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Cost of revenue:                                                                                                                     |       |       |                              |       |   |   |
| E-Commerce                                                                                                                           |       |       | 2,631                             |       | 2,400 |   |
| Media                                                                                                                                |       |       | 1,144                             |       | 2,745 |   |
| Anti-piracy services                                                                                                                 |       |       | —                            |       | 2,659 |   |
| Total cost of revenue                                                                                                                |       |       | 3,775                             |       | 7,804 |   |
| Gross profit                                                                                                                         |       |       | 1,368                             |       | 6,167 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Operating expenses:                                                                                                                  |       |       |                              |       |   |   |
| Sales and marketing                                                                                                                  |       |       | 167                               |       | 527 |   |
| General and administrative                                                                                                           |       |       | 2,676                             |       | 4,065 |   |
| Provision for doubtful accounts                                                                                                      |       |       | 110                               |       | 105 |   |
| Stock-based compensation                                                                                                             |       |       | 7                                 |       | 73 |   |
| Total operating costs                                                                                                                |       |       | 2,960                             |       | 4,770 |   |
| Income (loss) from operations                                                                                                        |       |       | (1,592                            | )          | 1,397 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Other income (expense):                                                                                                              |       |       |                              |       |   |   |
| Interest income                                                                                                                      |       |       | 29                                |       | 29 |   |
| Interest expense                                                                                                                     |       |       | —                            |       | (1,517 | ) |
| Amortization of deferred financing costs                                                                                             |       |       | —                            |       | (373 | ) |
| Write-off of unamortized discount on debt  and deferred financing costs due to conversion of subordinated convertible  notes payable |       |       | —                            |       | (39 | ) |
| Gain from sale of tradename                                                                                                          |       |       | 500                               |       | — |   |
| Loss from continuing operations before  income taxes                                                                                 |       |       | (1,063                            | )          | (503 | ) |
| Provision for income taxes                                                                                                           |       |       | —                            |       | 241 |   |
| Loss from continuing operations                                                                                                      |       |       | (1,063                            | )          | (744 | ) |
|                                                                                                                                 |       |       |                              |       |   |   |
| Income (loss) from discontinued operations:                                                                                          |       |       |                              |       |   |   |
| Income (loss) from operations:                                                                                                       |       |       |                              |       |   |   |
| ARTISTdirect Records, LLC                                                                                                            |       |       | (2,111                            | )          | (271 | ) |
| iMusic record label                                                                                                                  |       |       | (137                              | )          | — |   |
| Gain from sale of interest in ARTISTdirect  Records, LLC  (substantially all non-cash)                                               |       |       | —                            |       | 21,079 |   |
| Income (loss) from discontinued operations                                                                                           |       |       | (2,248                            | )          | 20,808 |   |
| Net income (loss)                                                                                                                    |       |       | $                                 | (3,311     | ) | $ | 20,064 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Net income (loss) per common share - basic:                                                                                          |       |       |                              |       |   |   |
| From continuing operations                                                                                                           |       |       | $                                 | (0.30      | ) | $ | (0.19 | ) |
| From discontinued operations                                                                                                         |       |       | (0.64                             | )          | 5.25 |   |
| Net income (loss)                                                                                                                    |       |       | $                                 | (0.94      | ) | $ | 5.06 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Net income (loss) per common share -  diluted:                                                                                       |       |       |                              |       |   |   |
| From continuing operations                                                                                                           |       |       | $                                 | (0.30      | ) | $ | (0.01 | ) |
| From discontinued operations                                                                                                         |       |       | (0.64                             | )          | 1.46 |   |
| Net income (loss)                                                                                                                    |       |       | $                                 | (0.94      | ) | $ | 1.45 |   |
|                                                                                                                                 |       |       |                              |       |   |   |
| Weighted average common shares outstanding:                                                                                          |       |       |                              |       |   |   |
| Basic                                                                                                                                |       |       | 3,502,117                         |       | 3,969,145 |   |
| Diluted                                                                                                                              |       |       | 3,502,117                         |       | 14,264,852 |   |

 

See accompanying notes to consolidated financial statements.

 

45

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of ComprehensiveIncome (Loss)

(amounts in thousands)

 
| ** **                                        | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                        | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Net income (loss)                                 |       | $                                 | (3,311     | ) | $ | 20,064 |   |
| Other comprehensive loss:                         |       |                              |       |   |   |
| Unrealized loss on available for sale  securities |       | (10                               | )          | — |   |
| Comprehensive income (loss)                       |       | $                                 | (3,321     | ) | $ | 20,064 |   |

 

See accompanying notes to consolidated financial statements.

 

46

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statement of Stockholders’Equity (Deficiency)

(amounts in thousands, except for share data)

 
| ** **                                                                                     | ** ** | **Common Stock** | ** ** | **Treasury  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|----------------------------------|------------|
| **Shares**                                                                                     | ** ** | **Amount**       |
| Balance at December 31, 2003                                                              |       | 3,502,117        |       | $                   | 38         |                             | $          | (3,442 | ) | $ | 209,128 |   |
| Unrealized loss on available for sale securities                                               |       | —           |       | —              |       | —                           |       | — |   |
| Issuance of warrants as settlement and for  services rendered                                  |       | —           |       | —              |       | —                           |       | 7 |   |
| Net loss                                                                                       |       | —           |       | —              |       | —                           |       | — |   |
| Balance at December 31, 2004                                                              |       | 3,502,117        |       | 38                  |       | (3,442                           | )          | 209,135 |   |
| Stock options issued for consulting  services                                                  |       | —           |       | —              |       | —                           |       | 92 |   |
| Amortization of deferred compensation                                                          |       | —           |       | —              |       | —                           |       | — |   |
| Issuance of shares upon conversion of  subordinated convertible notes payable                  |       | 250,000          |       | 3                   |       | —                           |       | 385 |   |
| Warrants issued to consultants in  conjunction with financing of MediaDefender acquisition     |       | —           |       | —              |       | —                           |       | 84 |   |
| Common stock issued to consultants in  conjunction with financing of MediaDefender acquisition |       | 1,109,032        |       | 11                  |       | —                           |       | 1,575 |   |
| Cancellation of outstanding shares of  treasury stock                                          |       | —           |       | (3                  | )          | 3,442                            |       | (3,439 | ) |
| Net income                                                                                     |       | —           |       | —              |       | —                           |       | — |   |
| Balance at December 31, 2005                                                              |       | 4,861,149        |       | $                   | 49         |                             | $          | — |   | $ | 207,832 |   |

 
| ** **                                                                                     | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Unrealized  Gain (Loss)  on Available  for Sale  Securities** | ** ** | **Total  Stockholders’  Equity  (Deficiency)** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Balance at December 31, 2003                                                              |       | $                          | —     |                     | $          | (222,679                                                        | )          | $                                                   | 10         |   | $ | (16,945 | ) |
| Unrealized loss on available for sale  securities                                              |       | —                     |       | —                   |       | (10                                                             | )          | (10                                                 | )          |
| Issuance of warrants as settlement and for  services rendered                                  |       | —                     |       | —                   |       | —                                                          |       | 7                                                   |       |
| Net loss                                                                                       |       | —                     |       | (3,311                   | )          | —                                                          |       | (3,311                                              | )          |
| Balance at December 31, 2004                                                              |       | —                     |       | (225,990                 | )          | —                                                          |       | (20,259                                             | )          |
| Stock options issued for consulting  services                                                  |       | (92                        | )          | —                   |       | —                                                          |       | —                                              |       |
| Amortization of deferred compensation                                                          |       | 73                         |       | —                   |       | —                                                          |       | 73                                                  |       |
| Issuance of shares upon conversion of  subordinated convertible notes payable                  |       | —                     |       | —                   |       | —                                                          |       | 388                                                 |       |
| Warrants issued to consultants in  conjunction with financing of MediaDefender acquisition     |       | —                     |       | —                   |       | —                                                          |       | 84                                                  |       |
| Common stock issued to consultants in  conjunction with financing of MediaDefender acquisition |       | —                     |       | —                   |       | —                                                          |       | 1,586                                               |       |
| Cancellation of outstanding shares of  treasury stock                                          |       | —                     |       | —                   |       | —                                                          |       | —                                              |       |
| Net income                                                                                     |       | —                     |       | 20,064                   |       | —                                                          |       | 20,064                                              |       |
| Balance at December 31, 2005                                                              |       | $                          | (19        | )                        | $          | (205,926                                                        | )          | $                                                   | —     |   | $ | 1,936 |   |

 

See accompanying notes to consolidated financial statements.

 

47

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(amounts in thousands)

 
| ** **                                                                                                                                                     | ** ** | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                     | ** ** | ** ** | **2004**                          | ** ** | **2005** | ** ** |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Cash flows from operating activities:                                                                                                                          |       |       |                              |       |   |   |
| Net income (loss)                                                                                                                                              |       |       | $                                 | (3,311     | ) | $ | 20,064 |   |
| Income (loss) from discontinued operations                                                                                                                     |       |       | 2,248                             |       | (20,808 | ) |
| Loss from continuing operations                                                                                                                                |       |       | (1,063                            | )          | (744 | ) |
| Adjustments to reconcile net loss from continuing  operations to net cash provided by (used in) continuing operating activities:                               |       |       |                              |       |   |   |
| Depreciation and amortization                                                                                                                                  |       |       | 223                               |       | 2,179 |   |
| Provision for doubtful accounts                                                                                                                                |       |       | 110                               |       | 105 |   |
| Stock-based compensation                                                                                                                                       |       |       | 7                                 |       | 73 |   |
| Deferred income taxes                                                                                                                                          |       |       |                              |       | 42 |   |
| Change in assets and liabilities, net of  effect from acquisition of  MediaDefender:                                                                           |       |       | 9                                 |       | — |   |
| (Increase) decrease in -                                                                                                                                       |       |       |                              |       |   |   |
| Accounts receivable                                                                                                                                            |       |       | (574                              | )          | (510 | ) |
| Finished goods inventory                                                                                                                                       |       |       | 34                                |       | (165 | ) |
| Prepaid expenses and other current assets                                                                                                                      |       |       | 59                                |       | 64 |   |
| Income taxes refundable                                                                                                                                        |       |       |                              |       | (1,211 | ) |
| Deposits                                                                                                                                                       |       |       | —                            |       | (1 | ) |
| Increase (decrease) in -                                                                                                                                       |       |       |                              |       |   |   |
| Accounts payable                                                                                                                                               |       |       | 323                               |       | 333 |   |
| Accrued expenses                                                                                                                                               |       |       | 261                               |       | 410 |   |
| Accrued interest payable                                                                                                                                       |       |       | —                            |       | 607 |   |
| Other assets                                                                                                                                                   |       |       | (5                                | )          | — |   |
| Deferred revenue                                                                                                                                               |       |       | (9                                | )          | 320 |   |
| Other                                                                                                                                                          |       |       | —                            |       | 22 |   |
| Net cash provided by (used in) continuing  operations                                                                                                          |       |       | (625                              | )          | 1,524 |   |
| Net cash used in discontinued operations                                                                                                                       |       |       | (2,848                            | )          | (38 | ) |
| Net cash provided by (used in) operating  activities                                                                                                           |       |       | (3,473                            | )          | 1,486 |   |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Cash flows from investing activities:                                                                                                                          |       |       |                              |       |   |   |
| Purchases of property and equipment                                                                                                                            |       |       | (55                               | )          | (303 | ) |
| Proceeds from sale of interest in  ARTISTdirect Records, LLC                                                                                                   |       |       | —                            |       | 115 |   |
| Acquisition of MediaDefender                                                                                                                                   |       |       | —                            |       | (42,500 | ) |
| Costs incurred in MediaDefender acquisition                                                                                                                    |       |       | —                            |       | (1,115 | ) |
| Cash acquired in connection with  MediaDefender acquisition, net of adjustments and amount due to ADI                                                          |       |       | —                            |       | 435 |   |
| Sale/maturity of short-term investments,  net                                                                                                                  |       |       | 1,012                             |       | — |   |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Net cash provided by (used in) investing  activities                                                                                                           |       |       | 957                               |       | (43,368 | ) |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Cash flows from financing activities:                                                                                                                          |       |       |                              |       |   |   |
| Proceeds from senior and subordinated debt  financings                                                                                                         |       |       | —                            |       | 45,000 |   |
| Payments for deferred financing costs                                                                                                                          |       |       | —                            |       | (1,025 | ) |
| Increase (decrease) in restricted cash                                                                                                                         |       |       | 175                               |       | (184 | ) |
| Net cash provided by discontinued  operations –                                                                                                           |       |       |                              |       |   |   |
| Proceeds from issuance of bridge notes by  ARTISTdirect Records,  LLC during the year ended December 31, 2004 and the two months ended  February 28, 2005 |       |       | 2,778                             |       | 37 |   |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Net cash provided by financing activities                                                                                                                      |       |       | 2,953                             |       | 43,828 |   |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Cash and cash equivalents:                                                                                                                                     |       |       |                              |       |   |   |
| Net increase                                                                                                                                                   |       |       | 437                               |       | 1,946 |   |
| Balance at beginning of year                                                                                                                                   |       |       | 719                               |       | 1,156 |   |
| Balance at end of year                                                                                                                                         |       |       | $                                 | 1,156      |   | $ | 3,102 |   |
|                                                                                                                                                           |       |       |                              |       |   |   |
| Supplemental disclosure of cash flow  information:                                                                                                             |       |       |                              |       |   |   |
| Cash paid for -                                                                                                                                                |       |       |                              |       |   |   |
| Interest                                                                                                                                                       |       |       | $                                 | —     |   | $ | 657 |   |
| Income taxes                                                                                                                                                   |       |       | $                                 | —     |   | $ | 1,637 |   |

 

(continued)

 

48

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows(continued)

(amounts in thousands)

 
| ** **                                                                                                           | ** ** | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------------------------|------------|
| ** **                                                                                                           | ** ** | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Non-cash investing and financing  activities:                                                                        |       |       |                              |       |   |   |
| Issuance of subordinated convertible note  payable to placement agent                                                |       |       | $                                 | —     |   | $ | 1,460 |   |
| Issuance of warrants to holders of senior  secured notes payable                                                     |       |       | $                                 | —     |   | $ | 1,398 |   |
| Issuance of warrants to holders of  subordinated convertible notes payable                                           |       |       | $                                 | —     |   | $ | 878 |   |
| Issuance of common stock to directors as  consulting fee in conjunction with MediaDefender acquisition               |       |       | $                                 | —     |   | $ | 1,586 |   |
| Issuance of warrants to directors as  consulting fee in conjunction with MediaDefender acquisition                   |       |       | $                                 | —     |   | $ | 84 |   |
| Issuance of shares upon conversion by  subordinated convertible note payable                                         |       |       | $                                 | —     |   | $ | 388 |   |
| Issuance of warrants to placement agent for  senior secured notes payable                                            |       |       | $                                 | —     |   | $ | 150 |   |
| Issuance of warrants to placement agent for  senior secured notes payable and subordinated convertible notes payable |       |       | $                                 | —     |   | $ | 834 |   |
| Guaranteed payments to MediaDefender  management accounted for as non-compete agreements                             |       |       | $                                 | —     |   | $ | 1,050 |   |
| Accrued expenses related to MediaDefender  acquisition                                                               |       |       | $                                 | —     |   | $ | 160 |   |
| Assets acquired in MediaDefender  transaction, excluding cash and intercompany payable:                              |       |       |                              |       |   |   |
| Assets acquired                                                                                                      |       |       | $                                 | —     |   | $ | 4,458 |   |
| Liabilities assumed                                                                                                  |       |       | $                                 | —     |   | $ | 734 |   |
| Customer relationships                                                                                               |       |       | $                                 | —     |   | $ | 2,264 |   |
| Proprietary technology                                                                                               |       |       | $                                 | —     |   | $ | 7,602 |   |
| Goodwill                                                                                                             |       |       | $                                 | —     |   | $ | 31,085 |   |
|                                                                                                                      |            |            |                                   |            |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

 

49

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ARTISTDIRECT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2004 AND 2005

 

1.   BASIS OF PRESENTATION

 

ORGANIZATIONAND BUSINESS ACTIVITIES

 

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

 

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

 

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

 

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

 

On February 28,2005, the Company completed the sale of all of its interest in ARTISTdirectRecordings to Radar Records (see Note 11). In accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”, the Companyhas determined that it complied with the provisions of SFAS No. 144 at December 31,2004 with respect to the classification of the operations of ARTISTdirectRecords as a discontinued operation. Accordingly, the Company has accounted forits interest in ARTISTdirect Records as a discontinued operation for allperiods presented, and the assets and liabilities of ARTISTdirect Records wereclassified as “held for sale” through February 28, 2005.

 

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

 

On November 7,2005, the Company filed with the Secretary of State of the State of Delaware aCertificate of Amendment of its Certificate of Incorporation to increase theauthorized number of shares of its common stock from 15,000,000 shares to60,000,000 shares.

 

Unlessthe context indicates otherwise, ARTISTdirect, Inc. and its subsidiariesare referred to herein as the “Company”.

 

50

----

 

PRINCIPLESOF CONSOLIDATION

 

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

 

In February 2003,the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidationof Variable Interest Entities” (“FIN 46”), which addresses the consolidation bybusiness enterprises of variable interest entities. FIN 46 defines when acompany should evaluate “controlling financial interest”, and thusconsolidation, based on factors other than voting rights, and requires that anew “risks and rewards” model be applied in these situations. ADI adopted FIN46 as of December 31, 2003. As a result of the adoption of FIN 46, thebalance sheet of ARTISTdirect Records was consolidated beginning as of December 31,2003, and the operations of ARTISTdirect Records were consolidated beginningwith the year ended December 31, 2004 (see Note 10). There was no changein the operating or business relationship between ADI and ARTISTdirect Recordsas a result of the adoption of FIN 46.

 

As aresult of the sale of all of the Company’s interest in ARTISTdirect Recordseffective February 28, 2005 (see Note 11), ARTISTdirect Records wasaccounted for as a discontinued operation for all periods presented, and theassets and liabilities of ARTISTdirect Records were classified as “held forsale” through February 28, 2005.

 

Forthe year ended December 31, 2004, ADI recorded 70% of the losses (afterintercompany eliminations) of ARTISTdirect Records. Since Ted Field owned 30%of ARTISTdirect Records, 30% of the losses (after intercompany eliminations)were offset against the minority interest of Ted Field. This minority interestresulted from the beneficial conversion feature related to the Bridge Notes(see Note 12).

 

2.   SIGNIFICANTACCOUNTING POLICIES

 

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 31,2004 and 2005, restricted cash consisted of a bank certificate of deposit withbalances of $175,000 and $179,000, 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, 2005, the Company hadclassified $180,000 of cash as restricted cash as such cash was pledged tosecure an irrevocable bank stand-by letter of credit issued in conjunction withthe Company’s new office lease which commences in February 2006.

 

ACCOUNTSRECEIVABLE

 

TheCompany grants credit to is customers generally in the form of short-termtrade accounts receivable. Accounts receivable are stated at the amountmanagement expects to collect from outstanding balances. When appropriate,management provides for probable uncollectible amounts through a provision fordoubtful accounts and an adjustment to a valuation allowance. Managementprimarily determines the allowance based on the aging of accounts receivablebalances, historical write-off experience, customer concentrations, customercreditworthiness and current industry and economic trends. Balances that arestill outstanding after management has used reasonable

 

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collection effortsare written off through a charge to the valuation allowance and a credit toaccounts receivable.

 

PROPERTYAND EQUIPMENT

 

Expendituresfor major renewal and betterments that extend the useful lives of property andequipment are capitalized. Expenditures for maintenance and repairs are chargedto expense as incurred. When property and equipment is sold or otherwisedisposed of, the assets and related accumulated depreciation accounts arerelieved, and any gain or loss is included in operations.

 

Depreciationis computed on the straight-line method based on the estimated useful lives ofthe assets, which is generally three years for computer equipment and softwareand seven years for furniture and fixtures.

 

GOODWILL,INTANGIBLE ASSETS AND LONG LIVED ASSETS

 

Statementof Financial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), requires purchased intangible assets other thangoodwill to be amortized over their useful lives unless these lives aredetermined to be indefinite.

 

Accordingly,with respect to the MediaDefender transaction, non-compete agreements are beingamortized over the life of the respective non-compete agreements, ranging from20 months to 4 years, and customer relationships and proprietary technology arebeing amortized over 3 years.

 

Assetallocations and amortization periods with respect to the MediaDefendertransaction were determined by an independent valuation firm.

 

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

 

TheCompany evaluates the recoverability of goodwill by estimating the futurediscounted cash flows of the businesses to which the goodwill relates. TheCompany uses a rate corresponding to its cost of capital, risk adjusted whereappropriate, in determining discounted cash flows. Estimated cash flows will bedetermined by disaggregating the business segments to a reporting level forwhich meaningful identifiable cash flows can be determined. When estimatedfuture discounted cash flows are less than the carrying value of the net assets(tangible and identifiable intangibles) and related goodwill, the Company willperform an impairment test to measure the amount of the impairment loss,if any. Impairment losses, limited to the carrying value of goodwill, representthe excess of the carrying amount of a reporting unit’s goodwill over theimplied fair value of that goodwill. In determining the estimated future cashflows, the Company will consider current and projected future levels of incomebased on management’s plans for that business, as well as business trends,prospects and market and economic conditions.

 

TheCompany accounts for the impairment of long-lived assets, such as property andequipment and intangible assets, under the provisions of Statement of FinancialAccounting Standards No. 144, “Accounting for the Impairment of Long-LivedAssets” (“SFAS No. 144”). SFAS No. 144 establishes the accounting forimpairment of long-lived tangible and intangible assets other than goodwill andfor the disposal of a business. Pursuant to SFAS No. 144, the Companyperiodically evaluates, at least annually, whether facts or circumstancesindicate that the carrying value of its depreciable assets to be held and used may notbe recoverable. If such circumstances are determined to exist, an estimate ofundiscounted future cash flows produced by the long-lived asset, or theappropriate grouping of assets, is compared to the carrying value to determinewhether impairment exists. In the event that the carrying amount of long-livedassets exceeds the undiscounted future cash flows, then the carrying amount ofsuch assets is adjusted to their fair value. The Company reports an impairmentcost as a charge to operations at the time it is recognized.

 

DEFERREDFINANCING COSTS

 

Deferredfinancing costs consist of consideration paid to third parties with respect tothe acquisition and

 

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financing of theMediaDefender transaction, including cash payments, subordinated notes payableand the fair value of warrants issued for legal fees and placement agent fees. Suchcosts are being deferred and amortized over the term of the related debt. Uponconversion of subordinated convertible notes payable into common stock, anyrelated unamortized deferred financing costs are charged to operations.

 

DISCOUNTON DEBT

 

Additionalconsideration in the form of warrants issued to lenders and placementagents was accounted for at fair value based on a report prepared by anindependent valuation firm. The fair value of such warrants was recorded as areduction to the carrying amount of the debt, and is being amortized tointerest expense over the term of the debt, with the offsetting entry being recordedas warrant liability on the balance sheet pursuant to EITF No. 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” (“EITF No. 00-19”). The carrying value of thewarrants will be adjusted to reflect any material changes in the fair value ofthe warrants from the date of issuance to the end of each reporting period, andany such changes will be included in the statement of operations as otherincome (expense). Upon conversion of subordinated convertible notes payableinto common stock, any related unamortized discount on debt is charged tooperations.

 

REVENUERECOGNITION

 

TheCompany complies 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) collectibilityis 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 Companyrecords e-commerce revenue on a gross basis as the Company enters into the saletransactions with customers, establishes the prices of the products, choosesthe suppliers of the products, assumes the risk of inventory loss and collectsall amounts from the customers and assumes the credit risk. E-commerce revenueis subject to amounts due to the respective artists based on their contracts,and such expense is recorded as part of cost of e-commerce revenue.

 

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

 

Mediarevenue consists primarily of the sale of advertisements and sponsorships, bothonline and offline, under short-term contracts. To date, the duration of theCompany’s advertising and sponsorship commitments has generally averaged fromone to three months, with certain programs lasting up to six months. TheCompany’s online obligations typically include the guarantee of a minimumnumber of times (“impressions”) that an advertisement appears in pages viewedby the users of the Company’s online properties. Online advertising revenue isgenerally recognized as the impressions are served during the period in whichthe advertisement is displayed, provided that no significant obligations of theCompany remain and collection of the resulting receivable is reasonablyassured. To the extent that minimum guaranteed page deliveries are notmet, recognition of the corresponding revenue is deferred until the guaranteedimpressions are delivered.

 

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

 

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TheCompany recognizes revenue for sponsorship arrangements, both online andoffline, over the period during which the advertising is provided, generally ona straight-line basis. If the sponsorship arrangement is for the sponsorship ofa specific event, the Company recognizes revenue when the event occurs. TheCompany recognizes revenue separately for each element of integratedentertainment marketing packages that offer advertisers a combination ofoffline concert and tour sponsorships that are supported by online banneradvertising, web-page sponsorships, e-mails to the Company’s customers andcustom content. The Company determines the fair value of each deliverable basedon the relative fair value of the different deliverables when sold on astand-alone basis. The Company recognizes revenue for each deliverable as theservices are provided. The Company recognizes revenue for the banner impressiondeliverable as the banner impressions are delivered. The Company recognizesrevenue for the customer e-mails when the e-mails are sent. The Companyrecognizes revenue for web-page sponsorships on a straight-line basis overthe term of the sponsorship. The Company recognizes revenue for custom contentwhen the content is provided to the customer.

 

Recordlabel revenue consisted of the sale of compact discs by artists under contractto the iMusic record label and to ARTISTdirect Records in 2004. The Companyrecognized revenues upon the shipment of compact discs from its distributor toretailers and independent wholesalers and records estimated reserves forproduct returns. At the time of the shipment of the product, the followingcriterion under Statement of Financial Accounting Standards No. 48, “RevenueRecognition When Right of Return Exists”, had been met: the seller’s price tothe buyer was substantially fixed or determinable at the date of sale; thebuyer had paid the seller, or the buyer was obligated to pay the seller, andthe obligation was not contingent on resale of the product; the buyer’sobligation to the seller would not have been changed in the event of theft orphysical destruction or damage of the product; the buyer acquiring the productfor resale had economic substance apart from that provided by the seller;the seller did not have significant obligations for future performance todirectly bring about resale of the product by the buyer; and the amount offuture returns could be reasonably estimated.

 

TheCompany estimated the provision for returns on a quarterly basis by album basedon the amount of time since the initial album release, the actual returns todate, the trend of sales activity (sales by the retailers and wholesalers) andthe number of unsold units at retailers and wholesalers. Returns to the Company’sdistributor are deemed to be returns to the Company. Returns in excess of theestimated current provision were charged to revenue.

 

COSTOF REVENUE

 

Costof product sales consists of amounts payable to artists related to e-commercesales, which includes the cost of merchandise sold and the share of net proceedsdue to artists, and online commerce transaction costs, including credit cardfees, fulfillment charges and shipping costs. Manufacturing costs consist ofthe cost of pressing compact discs, manufacturing printed booklets andpackaging materials and a provision for the obsolescence of finished goods andcomponents. Distribution expenses consist of various distribution costs,including the cost of processing returns and warehousing inventory.

 

Mediacost of revenue consists primarily of web-site hosting and maintenance costs,online content programming costs, online advertising serving costs, salescommissions, payments to affiliated web-sites, and payroll and related expensesfor staff involved with the web-site. Costs related to the web-site are recognizedimmediately when incurred.

 

Anti-piracyservices cost of revenue consists primarily of bandwidth and labor costs.Amortization of proprietary technology is included in anti-piracy services costof revenue.

 

Depreciationexpense is included in the related cost of revenue category.

 

DISCONTINUEDOPERATIONS

 

TheCompany has accounted for its iMusic record label and its interest inARTISTdirect Records, LLC as discontinued operations for all periods presentedin accordance with SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets” (see Notes 11 and 13).

 

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INVENTORIES

 

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

 

INCOMETAXES

 

TheCompany accounts for income taxes under Statement of Financial AccountingStandards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). SFASNo. 109 requires recognition of deferred tax assets and liabilities forthe expected future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in the statement of operations in the period that includes theenactment date. A valuation allowance is established, when necessary, to reducedeferred tax assets to the amount expected to be realized.

 

WEB-SITEDEVELOPMENT COSTS

 

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

 

ADVERTISINGCOSTS

 

Advertisingcosts are included in selling and marketing expense and charged to expense asincurred, and totaled $0 and $22,000 during the years ended December 31,2004 and 2005, respectively.

 

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 places its cash and short-term investments inhigh credit quality instruments. Cash balances at certain financialinstitutions may exceed the FDIC insurance limits. The Company performsongoing credit evaluations of its customers but does not require collateral. Exposureto losses on receivables is principally dependent on each customer’s financialcondition. The Company monitors its exposure to credit losses and maintainsallowances for anticipated losses.

 

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

 

TheCompany purchases 94% of its music-related merchandise inventory from onesupplier. The Company is subject to risk in the event that any of the suppliersis unable to fulfill its orders. However, there are a number of differentsuppliers who can provide such products to the Company.

 

Duringthe years ended December 31, 2004 and 2005, approximately 70% and 67%,respectively, of e-commerce revenues were generated from the products relatedto a single music merchandising entity.

 

Duringthe year ended December 31, 2004, one customer accounted for $245,000 or12% of total media revenue, of which $34,000 was due from this customer at December 31,2004. During the year ended December 31, 2005, one majoradvertiser/sponsor accounted for $1,786,000 or 34% of total media revenue, allof which was paid during 2005.

 

Duringthe year ended December 31, 2004 and 2005, the Company’s media revenueswere generated primarily by a single outside sales organization whichrepresented the Company with respect to advertising and sponsorship sales onthe Company’s web-site.

 

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

 

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

 

Information with respect to the year ended December 31,2005 relating to MediaDefender reflects only the five-month period in whichMediaDefender has been included in the Company’s consolidated results ofoperations.

 

FAIRVALUE OF FINANCIAL INSTRUMENTS

 

Thecarrying amounts of financial instruments, which includes cash and cashequivalents, short-term investments, accounts receivable, accounts payable,accrued expenses and warrant liability approximate fair value because of theshort maturity of these instruments.

 

NET INCOME(LOSS) PER COMMON SHARE

 

TheCompany computes net income (loss) per common share in accordance with SFAS No. 128,“Earnings per Share” and Securities and Exchange Commission Staff AccountingBulletin No. 98 (“SAB 98”). SFAS No. 128 requires companies withcomplex capital structures to present basic and diluted EPS. Basic EPS ismeasured as the income or loss available to common shareholders divided by theweighted average common shares outstanding for the period. Diluted EPS issimilar to basic EPS but presents the dilutive effect on a per share basis ofpotential common shares (e.g., convertible securities, options and warrants) asif they had been converted at the beginning of the periods presented, orissuance date, if later. Potential common shares that have an anti-dilutiveeffect (i.e., those that increase income per share or decrease loss per share)are excluded from the calculation of diluted EPS.

 

Thecalculation of diluted weighted average common shares outstanding for the yearended December 31, 2005 is based on the average of the closing price ofthe Company’s common stock during such period. The calculation of dilutedincome (loss) per share excluded approximately 908,115 shares and 1,159,000shares of common stock for the years ended December 31, 2005 and 2004,since their effect would have been anti-dilutive.

 

STOCK-BASEDCOMPENSATION

 

TheCompany accounts for stock-based employee compensation in accordance with theprovisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASBInterpretation No. 44 (“FIN 44”), “Accounting for Certain TransactionsInvolving Stock Compensation”, and complies with the disclosure requirements ofSFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB No. 25,compensation expense is recorded based on the difference, if any, between thefair value of the Company’s stock and the exercise price on the measurementdate. The Company accounts for stock issued to non-employees in accordance withSFAS No. 123, which requires entities to recognize as expense over theservice period the fair value of all stock-based awards on the date of grantand EITF No. 96-18, “Accounting for Equity Investments that are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices”, which addresses the measurement date and recognition approach forsuch transactions.

 

TheCompany recognizes compensation expense related to variable awards inaccordance with FASB Interpretation No. 28, “Accounting for StockAppreciation Rights and Other Variable Stock Option or Award Plans” (“FIN 28”).For fixed awards, the Company recognizes expense over the vesting period or theperiod of service.

 

 In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(revised 2004), “Share Based Payment” (“SFAS No. 123R”), a revision toSFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123Rsupercedes Accounting Principles Board Opinion No. 25, “Accounting forStock

 

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

 

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

 

(1) A “modified prospective” method in which compensation cost isrecognized beginning with the effective date (a) based on the requirementsof SFAS No. 123R for all share-based payments granted after the effectivedate and (b) based on the requirements of SFAS No. 123R for allawards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date.

 

(2) A “modified retrospective” method which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS No. 123 for purposes of pro forma disclosures for either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

 

The Company adopted SFAS No. 123R effective January 1,2006 and will use the modified prospective method in which compensation cost isrecognized beginning with the effective date (a) based on the requirementsof SFAS No. 123R for all share-based payments granted after the effectivedate and (b) based on the requirements of SFAS No. 123R for allawards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date. Although the expense for stockoptions that may be vested or granted in future periods cannot bedetermined at this time due to the uncertainty of the vesting or timing offuture grants, the Company’s future stock price, and the related fair valuecalculation, the adoption of SFAS No. 123R will have a material effect onthe Company’s future financial statements.

 

Pro forma information regarding net loss per share isrequired by SFAS No. 123, and has been determined as if the Company hadaccounted for its employee stock options under the fair value method of suchstatement. The fair value for these options was estimated at the date of grantusing either the Black-Scholes option-pricing model or the report of anindependent valuation firm. The assumptions used in the model and the weightedaverage fair value of each option granted for 2004 and 2005 are as follows:

 
| ** **                             | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|
| ** **                             | ** ** | **2004**                          | ** ** | **2005** | ** ** |
|                                   |       |                              |       |   |   |
| Risk-free interest rate                |       | 4.00                              | %          | 5.00 | % |
| Volatility                             |       | 388                               | %          | 170 | % |
| Dividend yield                         |       | 0                                 | %          | 0 | % |
| Weighted average expected life (years) |       | 7                                 |       | 5 |   |
| Weighted average fair value of option  |       | $                                 | 0.35       |   | $ | 3.21 |   |
|                                        |            |                                   |            |  |  |  |  |

 

For the purpose of pro forma disclosures, theestimated fair value of the options is amortized to operations over the vestingperiod of the options or the expected period of benefit. The Company’s proforma information is as follows:

 

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| ** **                                                                                                            | ** ** | **Years Ended December 31,**                              | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2004**                                                       | ** ** | **2005** | ** ** |
| ** **                                                                                                            | ** ** | **(in thousands,  except for share data)** | ** ** |
|                                                                                                                  |       |                                                           |       |   |   |
| Net income (loss) — as reported                                                                                  |       | $                                                              | (3,311     | ) | $ | 20,064 |   |
| Less:  Stock-based  employee compensation expense determined under fair value methods not charged  to operations |       | (473                                                           | )          | (859 | ) |
| Net income (loss) — pro forma                                                                                    |       | $                                                              | (3,784     | ) | $ | 19,205 |   |
|                                                                                                                  |       |                                                           |       |   |   |
| Net income (loss) per share - basic:                                                                                  |       |                                                           |       |   |   |
| As reported                                                                                                           |       | $                                                              | (0.94      | ) | $ | 5.06 |   |
| Pro forma                                                                                                             |       | $                                                              | (1.08      | ) | $ | 4.84 |   |
|                                                                                                                  |       |                                                           |       |   |   |
| Net income (loss) per share — diluted:                                                                           |       |                                                           |       |   |   |
| As reported                                                                                                           |       | $                                                              | (0.94      | ) | $ | 1.45 |   |
| Pro forma                                                                                                             |       | $                                                              | (1.08      | ) | $ | 1.35 |   |

 

COMPREHENSIVEINCOME (LOSS)

 

TheCompany has adopted the provisions of Statement of Financial AccountingStandards No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”).SFAS No. 130 establishes standards for the reporting and display ofcomprehensive income, its components and accumulated balances in a full set ofgeneral purpose financial statements. SFAS No. 130 defines comprehensiveincome (loss) to include all changes in equity except those resulting frominvestments by owners and distributions to owners, including adjustments to minimumpension liabilities, accumulated foreign currency translation, and unrealizedgains or losses on marketable securities.

 

TheCompany’s only component of other comprehensive loss is the unrealized loss onavailable for sale securities, consisting of a loss of $10,000 for the yearended December 31, 2004. This amount has been recorded as a separatecomponent of stockholders’ equity (deficiency).

 

ESTIMATES

 

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

 

RECLASSIFICATION

 

Certainamounts have been reclassified in 2004 to conform to the presentation in2005. Such reclassifications did not have any effect on income (loss) fromoperations or net income (loss).

 

3.   RECENTACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS

 

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

 

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On September 22, 2005, the Securities andExchange Commission (“SEC”) issued rules to delay by one-year the requiredreporting by management on internal controls over financial reporting fornon-accelerated filers. The new SEC rule extends the compliance date forsuch registrants to fiscal years ending on or after July 15, 2007. Accordingly,the Company qualifies for the deferral until its year ending December 31,2007 to comply with the internal control reporting requirements.

 

4.   PROPERTYAND EQUIPMENT

 

Propertyand equipment are recorded at cost and consist of the following:

 
| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **(in thousands)**    | ** ** |
| Computer equipment and software |       | $                     | 8,735      |   | $ | 2,977 |   |
| Furniture and fixtures          |       | 706                   |       | 143 |   |
|                            |       | 9,441                 |       | 3,120 |   |
| Less accumulated depreciation   |       | (9,342                | )          | (1,175 | ) |
| Property and equipment, net     |       | $                     | 99         |   | $ | 1,945 |   |

 

At December 31,2005, the Company reclassified $8.372 million of property and equipment againstthe related accumulated deprecation accounts to reflect the retirement of suchproperty and equipment.

 

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

 

5.   GOODWILLAND OTHER INTANGIBLE ASSETS

 

Components of the Company’s identifiable amortizableintangible assets at December 31, 2005 are as follows:

 
| ** **             | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|------------------------|------------|----------------------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **             | ** ** | **(in thousands)**         | ** ** |
|                   |       |                       |       |                          |       |                     |       |
| Customer relationships |       | $                          | 2,264      |                          | $          | 314                      |       | $ | 1,950 |   |
| Proprietary technology |       | 7,602                      |       | 1,056                         |       | 6,546                    |       |
| Non-compete agreement  |       | 1,384                      |       | 193                           |       | 1,191                    |       |
| Total                  |       | $                          | 11,250     |                          | $          | 1,563                    |       | $ | 9,687 |   |

 

Amortization expense of intangible assets for the yearended December 31, 2005 was $1.563 million. There was no amortization ofintangible assets for the year ended December 31, 2004. Amortizationexpense of intangible assets for the next four succeeding years is as follows:

 

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| **Years  Ending December 31,** | ** ** | **Amortization  Expense** | ** ** |
|-------------------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **(in thousands)**        | ** ** |
|                                |       |                      |       |
| 2006                                |       | $                         | 3,752      |   |
| 2007                                |       | 3,601                     |       |
| 2008                                |       | 2,182                     |       |
| 2009                                |       | 152                       |       |
| Total                               |       | $                         | 9,687      |   |

 

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

 

6.   DEFERREDFINANCING COSTS

 

Components of the Company’s deferred financing costs atDecember 31, 2005 are as follows:

 

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| ** **                                                                  | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Write-off  Related to  Conversion of  Subordinated  Convertible  Notes Payable  into Shares of  Common  Stock** | ** ** | **Net  Carrying  Amount** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                  | ** ** | **(in thousands)**          | ** ** |
|                                                                        |       |                        |       |                          |       |                                                                                                              |       |                      |       |
| Deferred financing costs related to subordinated  convertible notes payable |       | $                           | 2,479      |                          | $          | 265                                                                                                               |       | $                         | 29         |   | $ | 2,185 |   |
| Deferred financing costs related to senior secured  notes payable           |       | 985                         |       | 107                           |       | —                                                                                                            |       | 878                       |       |
| Total                                                                       |       | $                           | 3,464      |                          | $          | 372                                                                                                               |       | $                         | 29         |   | $ | 3,063 |   |

 

Amortization expense of deferred financing costs forthe next four succeeding years is as follows:

 
| **Years  Ending December 31,** | ** ** | **Amortization  Expense** | ** ** |
|-------------------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **(in thousands)**        | ** ** |
|                                |       |                      |       |
| 2006                                |       | $                         | 871        |   |
| 2007                                |       | 871                       |       |
| 2008                                |       | 871                       |       |
| 2009                                |       | 450                       |       |
| Total                               |       | $                         | 3,063      |   |

 

7.   ALLOWANCEFOR DOUBTFUL ACCOUNTS AND RESERVE FOR SALES RETURNS

 

Asummary of the activity with respect to the allowance for doubtful accounts isas follows:

 
| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| **Continuing  Operations**      | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **(in thousands)**                | ** ** |
|                            |       |                              |       |   |   |
| Balance, beginning of year      |       | $                                 | 88         |   | $ | 171 |   |
| Provision for doubtful accounts |       | 110                               |       | 105 |   |
| Amounts charged off             |       | (27                               | )          | (99 | ) |
| Balance, end of year            |       | $                                 | 171        |   | $ | 177 |   |

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

 

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Asummary of the activity with respect to the reserve for sales returns is asfollows:

 
| ** **                 | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------|------------|-----------------------------------|------------|
| **Continuing  Operations** | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **(in thousands)**                | ** ** |
|                       |       |                              |       |   |   |
| Balance, beginning of year |       | $                                 | 12         |   | $ | — |   |
| Amounts charged off        |       | (12                               | )          | — |   |
| Balance, end of year       |       | $                                 | —     |   | $ | — |   |

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

 

8.   ACCRUEDEXPENSES

 

Accruedexpenses are comprised of the following:

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

 

9.   ACQUISITIONOF MEDIADEFENDER, INC.

 

On July 28, 2005, the Company consummated theacquisition (the “Acquisition”) of MediaDefender, Inc., a privately-heldDelaware corporation (“MediaDefender”), pursuant to the terms of an Agreementand Plan of Merger (the “Merger Agreement”) entered into by and among theCompany, ARTISTdirect Merger Sub, Inc., a Delaware corporation andwholly-owned subsidiary of the Company (“Merger Sub”), and MediaDefender. Underthe terms of the Merger Agreement, Merger Sub merged with and intoMediaDefender, the separate corporate existence of Merger Sub ceased andMediaDefender survived as a wholly-owned subsidiary of the Company. Thestockholders of MediaDefender received aggregate consideration of $42.5 millionin cash, subject to a holdback of $4.25 million which has been placed intoan escrow account through June 30, 2006 to cover any indemnificationclaims under the Merger Agreement by the parties. The amount of considerationpaid by the Company upon the closing of the Acquisition was determined in arm’s-lengthnegotiations among the parties thereto. Prior to entering into the agreementdiscussed above, there were no material relationships between or among theCompany or any of its affiliates, officers or directors, or associates of anysuch officers or directors, on the one hand, and MediaDefender or any of itsaffiliates, officers or directors, or associates of any such officers ordirectors, on the other.

 

MediaDefenderis a provider of anti-piracy solutions in the high-growthInternet-piracy-protection

 

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(“IPP”) industryand offers services designed to thwart Internet piracy and encourage consumersto pay for online content. 

 

In accordance with the Merger Agreement, the Companyacknowledged the terms of Employment Agreements entered into on July 28,2005 by MediaDefender with each of Randy Saaf, 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 entitled toreceive performance bonuses of up to $350,000 if MediaDefender achievesspecified earnings targets in fiscal 2007 and 2008. Mr. Saaf and Mr. Herreraare each entitled to receive 12 months of severance pay at the rate of 100% oftheir monthly salary and the pro-rata portion of the performance bonusreferenced above if they are terminated “without cause”. In addition, theCompany granted stock options to purchase up to 200,000 shares of common stockto each of Mr. Saaf and Mr. Herrera, exercisable for a period of 5years at $3.00 per share.

 

The Company also acknowledged the terms ofNon-Competition Agreements entered into on July 28, 2005 by MediaDefenderand Mr. Saaf and Mr. Herrera. The Non-Competition Agreements prohibitMr. Saaf and Mr. Herrera from (i) engaging in certaincompetitive business activities, (ii) soliciting customers ofMediaDefender or the Company, (iii) soliciting existing employees ofMediaDefender or the Company and (iv) disclosing any confidentialinformation regarding MediaDefender or the Company. Each agreement has a termof 4 years and shall continue to remain in force and effect in the eventthe above-referenced Employment Agreements are terminated prior to the end ofthe 4 year term of the Non-Competition Agreements. In consideration, Mr. Saafand Mr. Herrera are each entitled to a cash payment of $525,000 fromMediaDefender to be paid on December 31, 2006.

 

As a result of these agreements, effective July 28,2005, the Company recorded an asset of $1,050,000 for the non-competeagreements and a related liability of $1,050,000 for the guaranteed payments toMediaDefender management. The $1,050,000 allocated to non-compete agreements isbeing amortized over the life of the employment agreements.

 

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

 

Concurrent with the consummation of the Acquisitiondescribed above, the Company completed a $15 million senior secured debttransaction (the “Senior Financing”) and a $30 million convertiblesubordinated debt transaction (the “Sub-Debt Financing”). Legal fees paid orreimbursed by the Company for services provided by the respective legalcounsels for the lenders were recorded as a charge to deferred financing costsand are being amortized over the terms of the related debt.

 

The Senior Financing was completed in accordance withthe terms set forth in the Note and Warrant Purchase Agreement entered into on July 28,2005 by the Company, each of the investors indicated on the schedule ofbuyers attached thereto and U.S. Bank National Association as Collateral Agent(the “Note Purchase Agreement”). Pursuant to the terms of the Note Purchase Agreement,each investor received a note with a term of three years and eleven monthsthat bears interest at the rate of 11.25% per annum (each a “Senior Note”),payable quarterly, with any unpaid principal and accrued interest due andpayable at maturity. Termination and payment of the Senior Notes by the Companyprior to maturity will not result in a prepayment fee. As collateral for the$15 million Senior Financing, the investors received a first prioritysecurity interest in all existing and future assets of the Company and itssubsidiaries, tangible and intangible, including but not limited to, cash andcash equivalents, accounts receivable, inventories, other current assets,furniture, fixtures and equipment and intellectual property.

 

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The Company is required to comply with certainfinancial covenants, including minimum working capital, maximum capitalexpenditures, minimum leverage ratio, minimum EBITDA and minimum fixed chargecoverage ratio. In addition, not later than ninety days after the close of eachfiscal year, the Company is obligated to apply 60% of its excess cash flow, asdefined, to prepay the principal amount of the Notes, which the Company hasdetermined to be $390,000 and has been shown as a current liability at December 31,2005. The Company was not in compliance with certain of these financialcovenants at December 31, 2005. On April 7, 2006, the lendersprovided waivers with respect to such events of default under the Notes andamended their loan documents such that the warrant liability and any changethereto in future periods (as described below) will not affect future covenant andexcess cash flow calculations.

 

In addition, the investors received five year warrantsto purchase up to an aggregate of 3,250,000 shares of the Company’s commonstock at an exercise price of $2.00 per share, subject to certain anti-dilutionadjustments (collectively, the “Senior Warrant Shares”). The warrants werevalued at $1,397,500 based on a valuation report prepared by an independentvaluation firm and were recorded as a discount to the $15 million seniorsecured debt, and are being amortized over the term of the debt.

 

The Senior Warrant Shares are subject to certain registrationrights requiring the Company to file and maintain effective a registrationstatement with the SEC covering the shares of common stock underlying suchwarrants. In accordance with EITF No. 00-19, the fair value of thewarrants has been recorded as warrant liability. The carrying value of thewarrants will be adjusted to reflect any material changes in the fair value ofthe warrants from the date of issuance to the end of each reporting period, andany such changes will be included in the statement of operations as otherincome (expense).

 

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 theterms of the Securities Purchase Agreement, each investor received aconvertible subordinated note with a term of four years that bearsinterest at the rate of 4.00% per annum (each a “Sub-Debt Note”), with anyunpaid principal and accrued interest due and payable at maturity. Interest ispayable quarterly in cash or shares of common stock, at the option of theCompany, with payments commencing September 30, 2006. Each Sub-Debt Notehas an initial conversion price of $1.55 per share, subject to certainanti-dilution and change-of-control adjustments. In addition, each Sub-DebtNote is subject to mandatory conversion by the Company in the event certaintrading price targets for the Company’s common stock are met followingeffectiveness of a registration statement filed by the Company for thesecurities issued in the Sub-Debt Financing.

 

The Company is required to comply with certainfinancial covenants, including minimum working capital, maximum capitalexpenditures, minimum leverage ratio, minimum EBITDA and minimum fixed chargecoverage ratio. The Company was not in compliance with certain of these financialcovenants at December 31, 2005. On April 7, 2006, the lenders providedwaivers with respect to such events of default under the Notes and amendedtheir loan documents such that the warrant liability and any change thereto infuture periods (as described below) will not affect future covenantcalculations.

 

In addition, the Sub-Debt Financing investors receivedfive year warrants to purchase up to 1,596,774 shares of common stock atan exercise price of $1.55 per share, subject to certain anti-dilutionadjustments (collectively, the “Sub-Debt Warrant Shares”). The warrants werevalued at $878,026 based on a valuation report prepared by an independentvaluation firm and were recorded as a discount to the $30 million ofconvertible subordinated debt, and are being amortized over the term of thedebt.

 

The Sub-Debt Notes and the Sub-Debt Warrant Shares aresubject to certain registration rights requiring the Company to file andmaintain effective a registration statement with the SEC covering the shares ofcommon stock underlying such notes and warrants. In accordance with EITF No. 00-19,the fair value of the warrants has been recorded as warrant liability. Thecarrying value of the warrants will be adjusted to reflect any material changesin the

 

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fair value of the warrants from the date of issuance to the end of eachreporting period, and any such changes will be included in the statement ofoperations as other income (expense).

 

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

 

To induce the Senior Financing investors toparticipate in the above referenced transaction, the Sub-Debt Financinginvestors entered into a Subordination Agreement for the benefit of the SeniorFinancing investors pursuant to which the Sub-Debt Financing investors agreedto subordinate their rights to the holders of the senior debt.

 

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

 

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

 

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

 

Pursuant to the terms of a letter agreement, dated July 15,2005, by and between the Company and Broadband Capital Management LLC (“Broadband”),the Company issued to Broadband a Sub-Debt Note in the amount of $1,460,500 (inaddition to the $30 million referred to above) and warrants to purchase upto 1,516,935 shares of common stock with an exercise price of $1.55 per share. Thenotes and warrants issued to Broadband or its affiliates were issued on thesame terms and conditions granted to the other Sub-Debt Financing investors.The securities were issued as partial consideration for Broadband’s services asthe Company’s placement agent in the Sub-Debt Financing and the SeniorFinancing. The securities were issued in reliance upon exemptions fromregistration pursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder. The warrants were valued at $834,314, based on avaluation report prepared by an independent valuation firm. The aggregate valueof the Sub-Debt Note, the warrants and additional cash payments to Broadbandaggregating $299,500 were charged to deferred financing costs and are beingamortized over the term of the debt.

 

The Sub-Debt Notes and the Sub-Debt Warrant Shares issuedto Broadband are subject to certain registration rights requiring the Companyto file and maintain effective a registration statement with the SEC coveringthe shares of common stock underlying such warrants and notes. In accordancewith EITF No. 00-19, the fair value of the warrants has been recorded as warrantliability. The carrying value of the warrants will be adjusted to reflect anymaterial changes in the fair value of the warrants from the date of issuance tothe end of each reporting period, and any such changes will be included in thestatement of operations as other income (expense).

 

Pursuant to the terms of a letter agreement, dated June 21,2005, by and between the Company and Libra FE, LP (“Libra”), the Company issuedLibra warrants to purchase up to 237,500 shares of its common stock with anexercise price of $2.00 per share upon the closing of the Senior Financing (the“Libra Warrant Shares”). The warrants were issued as partial consideration forLibra’s services as the Company’s placement agent in the Senior

 

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Financing described above. The Company entered into a RegistrationRights Agreement with Libra on July 28, 2005 (the “Libra RegistrationRights Agreement”), pursuant to which the Company will include the LibraWarrant Shares in the registration statement covering the securities issued inthe Senior Financing and the Sub-Debt Financing described above. The warrants wereissued in reliance upon exemptions from registration pursuant to Section 4(2) underthe Securities Act and Rule 506 promulgated thereunder. The warrants werevalued at $149,625, based on a valuation report prepared by an independentvaluation firm. The aggregate value of the warrants and additional payments toLibra of $450,997 were charged to deferred financing costs and are beingamortized over the term of the debt.

 

The Libra Warrant Shares are subject to certainregistration rights requiring the Company to file and maintain effective aregistration statement with the SEC covering the shares of common stockunderlying such warrants and notes. In accordance with EITF No. 00-19, thefair value of the warrants has been recorded as warrant liability. The carryingvalue of the warrants will be adjusted to reflect any material changes in thefair value of the warrants from the date of issuance to the end of eachreporting period, and any such changes will be included in the statement ofoperations as other income (expense).

 

Pursuant to a report prepared by an independentvaluation firm, as of and through December 31, 2005, there was no changein the fair value of the warrants that were recorded as warrant liability at July 28,2005.

 

Upon the closing of the Acquisition, the Companyissued 1,109,032 shares of common stock and a warrant to purchase up to 114,985shares of common stock with an exercise price of $1.55 per share to WNT07Holdings, LLC, which was approved by the disinterested members of the Company’sBoard of Directors. The managers of WNT07 Holdings, LLC are Eric Pulier andTeymour Boutros-Ghali, both members of the Company’s Board of Directors. Theshares and warrants were issued as consideration for services provided by Mr. Pulierand Mr. Boutros-Ghali as consultants to the Company in connection with theAcquisition. The shares and warrants were issued in reliance upon exemptionsfrom registration pursuant to Section 4(2) under the Securities Actand Rule 506 promulgated thereunder.

 

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

 

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

 

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

 

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

 

The following pro forma operating datapresents the results of operations for the years ended December 31, 2004and 2005, as if the acquisition had occurred on the first day of each suchperiod. Discontinued operations, impairment losses and non-recurring items forthe years ended December 31, 2004 and 2005 are not included. The pro formaresults are not necessarily indicative of the financial results that might haveoccurred had the acquisition actually taken place on the respective dates, orof future results of operations.

 
| ** **                                          | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **2004**                           | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                 | ** ** |
|                                                |       |                               |       |   |   |
| Net revenue                                         |       | $                                  | 15,665     |   | $ | 20,637 |   |
|                                                |       |                               |       |   |   |
| Net loss                                            |       | $                                  | (4,911     | ) | $ | (3,054 | ) |
|                                                |       |                               |       |   |   |
| Net loss per common share – basic and  diluted |       | $                                  | (1.07      | ) | $ | (0.66 | ) |
|                                                |       |                               |       |   |   |
| Weighted average common shares outstanding          |       | 4,611,149                          |       | 4,611,149 |   |

 

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10. INVESTMENT IN AND ADVANCES TOARTISTDIRECT RECORDS, LLC

 

In May 2001, ADI, through its wholly-owned subsidiary,ARTISTdirect Recordings, Inc., a Delaware corporation (“ARTISTdirectRecordings”), entered into an agreement with Radar Records Holdings, LLC (“RadarRecords”), a company owned by Frederick W. (Ted) Field, to form a newrecord label, ARTISTdirect Records, LLC (“ARTISTdirect Records”), as a 50/50co-venture between ADI and Radar Records. On June 29, 2001, ADI’sstockholders approved the employment of Mr. Field as Chairman and ChiefExecutive Officer of ADI and the formation of the ARTISTdirect Records recordlabel. Mr. Field is the Chief Executive Officer of ARTISTdirect Records.

 

ARTISTdirect Records, headquartered in Los Angeles, California, was inthe business of developing new musical artists and producing and distributingtheir recordings as an independent label utilizing both traditional channelsand emerging Internet distribution channels.

 

ADI initially committed to fund a total of $50.0 million toARTISTdirect Records over five years at the rate of $15.0 million per year,subject to a limit of $33.0 million in any three year period. Any funding inexcess of these amounts required the approval of ADI’s Board of Directors. ADIfunded $33.0 million through December 31, 2003.

 

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

 

In December 2002, BMG exercised its option to extend the term ofthe distribution and license agreement until September 2004. BMG did notrenew its distribution agreement and license agreement upon its expiration in September 2004.

 

Under the distribution and license agreements, BMG made non-refundableadvances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002and $5.0 million in 2003 that were recoupable from net sales proceeds fromARTISTdirect Records’ artist repertoire pursuant to a defined calculation on amonthly basis. As of December 31, 2003 and 2004, the unrecouped balancesrelated to distribution advances from BMG were $8.7 million and $8.9 million,respectively.

 

In August 2002, ADI’s Board of Directors approved an agreement(the “Accelerated Funding Agreement”) to accelerate up to $10.0 million of itsfunding commitment to ARTISTdirect Records. This funding was in addition to the$15.0 million that ADI was obligated to advance to ARTISTdirect Records in 2002as part of the initial $50.0 million funding commitment. During 2002, ADIfunded its $15.0 million commitment plus the additional $10.0 million bridgeloan for total advances to the record label of $25.0 million in 2002 and $30.25million from the inception of the record label through December 31, 2002. The$10.0 million of accelerated funding was credited toward the satisfaction ofADI’s overall funding commitment and funding obligation for 2003, resulting ina remaining funding commitment of $2.75 million for 2003 and $12.0 million for2004. ADI advanced the $2.75 million during 2003.

 

As consideration for entering into the Accelerated Funding Agreement,ADI received an additional 20% interest in ARTISTdirect Records from RadarRecords, the entity through which Mr. Field owned his interest inARTISTdirect Records, which resulted in an increase in ADI’s ownership share ofARTISTdirect Records from 45% to 65% and a decrease in Mr. Field’sownership share from 50% to 30%. The Accelerated Funding Agreement alsoprovided that any dilution from the issuance of equity interests in ARTISTdirectRecords that would have been borne solely by ADI would be borne both by RadarRecords and ADI pro rata with their then respective ownership interests. Furthermore,the Accelerated Funding Agreement provided for Radar Records to guarantee a 25%

 

68

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minimum annualcompounded return to be realized from ADI’s advances and equity interests inARTISTdirect Records. Due to the uncertainty with respect to the realization ofsuch rate of return, ADI did not record any amounts related to the 25% minimumannual compounded return in its consolidated financial statements.

 

Because ADI did not have voting or operating control of ARTISTdirectRecords, even with its majority ownership position, through December 31,2003 it did not consolidate the results of ARTISTdirect Records; ADI recordedits share of losses based on the equity method of accounting as loss fromequity investments in its consolidated statements of operations. Prior to thecompletion of BMG’s purchase of a 5% interest in ARTISTdirect Records in April 2002and BMG’s assumption of 10% of ADI’s total funding commitment, ADI hadcommitted to fund 100% of the operations of ARTISTdirect Records and hadrecorded 100% of the losses attributable to that venture from the inception ofARTISTdirect Records to April 30, 2002. From May 1, 2002 through December 31,2003, ADI has recorded only its proportionate share, on the basis of remainingrelative funding commitments, of any losses of ARTISTdirect Records. ADI fundeda total of $33.0 million of its funding commitment. ADI recognized $8.6million, $29.2 million and $9.3 million of equity loss from ARTISTdirectRecords for the years ended December 31, 2001, 2002 and 2003, respectively.The loss for ARTISTdirect Records for the year ended December 31, 2004 was$4.881 million before intercompany interest elimination of $2.011 million. Theloss for ARTISTdirect Records for the two months ended February 28, 2005was $802,000 before intercompany interest elimination of $416,000. The lossesof ARTISTdirect Records for 2004 and 2005 were included in ADI’s results ofoperations for the respective periods.

 

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

 

Through December 31, 2003, ADI continued to record the losses ofARTISTdirect Records. ADI recorded its loan advances to ARTISTdirect Records asadditional equity investments. As of December 31, 2003 and 2004, theCompany consolidated the balance sheets of ARTISTdirect Records.

 

ADI has no recorded investment in its loans to ARTISTdirect Records, asthe carrying amount of the loans had been reduced to zero as a result of ADIrecording its share of losses of ARTISTdirect Records during the year ended December 31,2003. ADI did not record interest income on the loans to ARTISTdirect Records. Theinterest expense of ARTISTdirect Records is eliminated in consolidation. Assuch, interest expense related to ADI was not included in allocating losses tothe minority interest in ARTISTdirect Records.

 

The loan advances provided to ARTISTdirect Records by ADI and BMG boreinterest at a rate of LIBOR plus 4% and the principal and interest were notrepayable until December 31, 2015 or upon such time as ARTISTdirect Recordsachieved certain defined levels of excess cash flow and available cash. As of December 31,2003 and 2004, ARTISTdirect Records had loans payable to ADI of $33.0 million,which were eliminated in consolidation, and to BMG of $4.75 million. In addition,as of December 31, 2003 and 2004, ARTISTdirect Records had accruedinterest payable to ADI of $3.0 million and $5.0 million, respectively, whichwere eliminated in consolidation, and to BMG of $447,000 and $747,000,respectively.

 

During the three months ended September 30, 2003, ARTISTdirectRecords significantly reduced its overhead costs and operating activities andlaid off the majority of its staff while it continued to restructure itsoperations and seek additional capital. During 2003, ARTISTdirect Recordsrelied on a loan advance from ADI of $2.75 million and bridge loans from Mr. Fieldand outside investors aggregating $2.048 million to fund its operations. As of December 31,2003, ARTISTdirect Records did not have sufficient working capital resources toconduct operations. During 2004 and the two months ended February 28, 2005,ARTISTdirect Records relied on bridge loans from Mr. Field of $2.778million and $36,500, respectively, to fund its reduced level of operations. ThroughFebruary 28,

 

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2005, Mr. Fieldhad provided bridge funding to ARTISTdirect Records aggregating $3.713 million,including $898,000 in 2003, $2.778 million in 2004 and $36,500 in 2005 (seeNote 12).

 

Effective July 30, 2004, ADI entered into a Termination Agreementwith BMG and ARTISTdirect Records which extinguished all of ADI’s obligationsunder its funding guaranty, including the remaining $12.0 million fundingobligation to ARTISTdirect Records.

 

11. DISCONTINUED OPERATIONS — ARTISTDIRECTRECORDS, LLC

 

On February 28, 2005, ADI completed the sale of 100% of the commonstock of ARTISTdirect Recordings to Radar Records pursuant to a TransferAgreement for a cash payment of $115,000, as a result of which ADI no longerhad any equity or other economic interest in ARTISTdirect Records, and RadarRecords became the owner of a majority of the membership interests inARTISTdirect Records and also acquired the receivable reflecting the $33.0million of loan advances previously provided to ARTISTdirect Records by ADI. Inconjunction with this transaction, at February 28, 2005, ADI wrote-off theintercompany balance due from ARTISTdirect Records of $80,000, which waseliminated in consolidation. Radar Records acquired the common stock ofARTISTdirect Recordings subject to the rights of BMG. Radar Records also agreedto offer to investors who had provided bridge funding to ARTISTdirect Records(see Note 12), excluding Frederick W. Field and entities related or controlledby him, the right to acquire proportional shares (based on the amount of bridgefunding made by each bridge investor in ARTISTdirect Records) of the commonstock of ARTISTdirect Recordings on the same terms and conditions as set forthin the Transfer Agreement.

 

The amount of consideration received by ADI was determined withreference to various factors, including, but not limited to, ADI’s futurebusiness plans and intention to focus on its internet and web-site operations,ARTISTdirect Records’ current limited capital resources and substantiallyreduced level of operations, ARTISTdirect Records’ future business plans andcapital requirements and the likelihood of obtaining such capital on a timelybasis and under reasonable terms and conditions, the unpaid costs that ADI hasadvanced ARTISTdirect Records to date and would be required to continue toadvance ARTISTdirect Records in the future, and the probability of ADIobtaining a return on its investment to date of $33.0 million in ARTISTdirectRecords.

 

As a result of the existence of various conflicts of interest withrespect to this transaction, full disclosure of these conflicts of interest wasmade to ADI’s Board of Directors and the required approval by the disinterestedmembers of ADI’s Board of Directors was obtained prior to the closing of thetransaction.

 

As a result of the sale of all of ADI’s interest in ARTISTdirectRecordings to Radar Records effective February 28, 2005, ADI accounted forits interest in ARTISTdirect Records as a discontinued operation for allperiods presented in accordance with SFAS No. 144, and the assets andliabilities of ARTISTdirect Records were classified as “held for sale” through February 28,2005.

 

A summary of the assets and liabilities of ARTISTdirect Records, whichwere classified as discontinued operations on ADI’s balance sheets at December 31,2004 and February 28, 2005, is as follows:

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

 

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A summary of the results of operations of ARTISTdirect Records for theyear ended December 31, 2004 and the two months ended February 28,2005 is as follows:

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

 

As a result of the disposition of ADI’s interest in ARTISTdirectRecords effective February 28, 2005, ADI recognized a gain (primarilynon-cash) in its consolidated statement of operations for the year ended December 31,2005 of $21.079 million, primarily as a result of the elimination of theliabilities of ARTISTdirect Records.

 

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

 

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12. BRIDGENOTES PAYABLE

 

As of December 31, 2003 and 2004, and February 28, 2005,ARTISTdirect Records had outstanding loans of $898,000, $3.676 million and$3.713 million, respectively, due to Ted Field and $1.150 million of loans dueto outside investors (including $100,000 from Jonathan V. Diamond, the Company’sPresident and Chief Executive Officer). These loans were obtained through theissuance of convertible promissory notes (the “Bridge Notes”). The Bridge Notesaccrued interest at 8% per annum, were due two years from the date of issuance,and were convertible into new preferred equity of ARTISTdirect Records as part ofits next equity financing. The Bridge Notes payable to Mr. Field and tooutside investors were included in liabilities of discontinued operations heldfor disposal in the consolidated balance sheets at December 31, 2003 and2004.

 

The holders of the Bridge Notes also received warrants with a term offive years to purchase additional equity of ARTISTdirect Records at $0.01 perunit equivalent to the number of units of new equity into which their BridgeNotes were ultimately converted. The aggregate relative fair value of thewarrants issued was $2.431 million as of February 28, 2005 (one-half of theamount funded by the investors in the Bridge Notes), which was recorded as areduction to the carrying amount of the Bridge Notes and a credit to capital,and was being charged to operations as interest expense over the specified termof the Bridge Notes.

 

The Bridge Notes were convertible into equity based on their faceamount, which resulted in a beneficial conversion feature with a relative fairvalue of $2.431 million. Since the commitment date for the beneficialconversion feature was contingent upon the completion of ARTISTdirect Record’snext equity financing, the fair value of the beneficial conversion feature wasto be charged to operations over the remaining life of the Bridge Notes at thattime.

 

During the years ended December 31, 2003 and 2004 and the twomonths ended February 28, 2005, ARTISTdirect Records recognized $203,000,$998,000 and $183,000, respectively, as interest expense with respect to theamortization of the fair value of the warrants. Additional interest expense ofapproximately $1.2 million was scheduled to be recognized ratably over theremainder of 2005 and 2006 over the remaining term of the Bridge Notes. As of December 31,2004 and February 28, 2005, the carrying amount of the Bridge Notes,including accrued interest of $396,000 and $459,000, respectively, was $4.009million and $4.292 million, respectively.

 

A reconciliation of Bridge Notes payable issued by ARTISTdirect Recordsduring 2003 and 2004 to amounts included in liabilities of discontinued operationsin the consolidated balance sheets at December 31, 2003 and 2004 ispresented below. During the years ended December 31, 2003 and 2004 and thetwo months ended February 28, 2005, ARTISTdirect Records recorded costswith respect to such bridge notes as summarized below.

 

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| ** **                                                   | ** ** | **Outside  Investors** | ** ** | **Ted Field** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|---------------|------------|
| ** **                                                   | ** ** | **(in thousands)**     | ** ** |
|                                                         |       |                   |       |          |       |
| Gross amount  funded during 2003                             |       | $                      | 1,150      |          | $          | 898 |   |
| Deduct:                                                      |       |                   |       |          |       |
| Fair value  of warrants                                      |       | (575                   | )          | (449          | )          |
| Add:                                                         |       |                   |       |          |       |
| Accrued  interest                                            |       | 44                     |       | 23            |       |
| Amortization  of fair value of warrants in 2003              |       | 136                    |       | 67            |       |
| Net  liability at December 31, 2003                     |       | 755                    |       | 539           |       |
| Gross amount  funded during 2004                             |       | —                 |       | 2,778         |       |
| Deduct:                                                      |       |                   |       |          |       |
| Fair value  of warrants                                      |       | —                 |       | (1,389        | )          |
| Add:                                                         |       |                   |       |          |       |
| Accrued  interest                                            |       | 94                     |       | 235           |       |
| Amortization  of fair value of warrants in 2004              |       | 287                    |       | 710           |       |
| Net  liability at December 31, 2004                     |       | 1,136                  |       | 2,873         |       |
| Gross amount  funded during 2005 (two months)                |       | —                 |       | 37            |       |
| Add:                                                         |       |                   |       |          |       |
| Accrued  interest (two months)                               |       | 15                     |       | 48            |       |
| Amortization  of fair value of warrants in 2005 (two months) |       | 47                     |       | 136           |       |
| Net  liability at February 28, 2005                     |       | 1,198                  |       | 3,094         |       |
| Less:                                                        |       |                   |       |          |       |
| Amounts due  within one year                                 |       | (1,198                 | )          | (1,821        | )          |
| Amounts due  after one year                                  |       | $                      | —     |          | $          | 1,273 |   |

 

13. DISCONTINUED OPERATIONS — iMUSIC

 

During 2002, the Company began operating a record label under the brandname iMusic through its wholly-owned subsidiary, ARTISTdirect Digital, Inc.Operations consisted primarily of the sale of compact discs by artists signedto the iMusic record label. During the three months ended June 30, 2003,management of the Company decided to scale back the activity of its iMusiclabel in order to conserve capital. During the three months ended September 30,2003, the Company executed an agreement with GC Music, pursuant to which theCompany assigned its rights and obligations to six unreleased artists inexchange for a cash payment of $100,000 as a reduction to prior advancesrelated to the six artists and a profit interest in the projects. GC Music waspartially owned by a former officer and director of the Company. The Companyretained the distribution rights to the albums previously released under theoriginal terms of its distribution agreements with its other signed artists,but did not intend to sign any additional artists or release any additionalalbums domestically or internationally under the iMusic label and thereforeexpected very minimal sales activity subsequent to the transaction. At December 31,2004 and 2005, the Company has provided a sufficient reserve for remainingcontract obligations and estimated product returns.

 

Effective November 23, 2004, pursuant to a Trademark Assignmentand Purchase Agreement dated as of November 12, 2004, the Company sold allof its rights, title and interest in and to certain trademarks, service marketsand trade names, in certain countries of the world, that consist of orincorporate the term “iMusic” (the “Marks”), including domain names thatconsist of or incorporate the term iMUSIC (the “Domain Names”) and goodwillrelated to such marks or trade names, to Apple Computer, Inc. for a cashpayment of $500,000. The Marks and Domain Names that the Company sold did nothave any carrying value on the Company’s books.

 

As a result of the foregoing, during December 2004, the Companyceased the sale of products under the iMusic label and discontinued theoperations of the iMusic record label. Accordingly, the Company has accountedfor the operations of iMusic as a discontinued operation for all periodspresented to reflect the termination of the business operations of iMusic.

 

A summary of the liabilities of iMusic, which were classified asdiscontinued operations on the Company’s balance sheets at December 31,2004 and 2005, is shown below. iMusic did not have any assets at December 31,2004 or 2005.

 

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

 

A summary of the operations of the iMusic record label for the yearsended December 31, 2004 and 2005 is as follows:

 
| ** **                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------|------------|-----------------------------------|------------|
| ** **                | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                | ** ** | **(in thousands)**                | ** ** |
|                      |       |                              |       |   |   |
| Net revenue               |       | $                                 | (136       | ) | $ | — |   |
| Cost of  revenue          |       | (1                                | )          | — |   |
| Gross profit  (loss)      |       | (135                              | )          | — |   |
| Operating  expenses:      |       |                              |       |   |   |
| Sales and  marketing      |       | 2                                 |       | — |   |
| Total  operating expenses |       | 2                                 |       | — |   |
| Net loss                  |       | $                                 | (137       | ) | $ | — |   |

 

14. INCOMETAXES

 

The components of the provision for income taxes are as follows:

 
| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|-----------------------------------|------------|
| ** ** | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** ** | ** ** | **(in thousands)**                | ** ** |
| Current:   |       |                              |       |   |   |
| Federal    |       | $                                 | —     |   | $ | 158 |   |
| State      |       | —                            |       | 40 |   |
|       |       | $                                 | —     |   | $ | 198 |   |
|       |       |                              |       |   |   |
| Deferred:  |       |                              |       |   |   |
| Federal    |       | $                                 | —     |   | $ | 12 |   |
| State      |       | —                            |       | 31 |   |
|       |       | —                            |       | 43 |   |
| Total      |       | $                                 | —     |   | $ | 241 |   |
|            |            |                                   |            |  |  |  |  |  |

 

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Income taxes differ from the amount computed using a tax rate of 35% asa result of the following:

 
| ** **                                                       | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                       | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**                | ** ** |
|                                                             |       |                              |       |   |   |
| Computed  expected tax expense (benefit)                         |       | $                                 | (1,145     | ) | $ | 7,107 |   |
| State and  local income taxes, net of federal income tax benefit |       | 19                                |       | 25 |   |
| Amortization  of non-cash financing costs                        |       | 648                               |       | 537 |   |
| Adjustments  to deferred tax assets                              |       | 2,058                             |       | 6,688 |   |
| Other                                                            |       | 20                                |       | 25 |   |
|                                                             |       | 1,600                             |       | 14,382 |   |
| Decrease in  valuation allowance                                 |       | (1,600                            | )          | (14,141 | ) |
| Total income  tax expense                                        |       | $                                 | —     |   | $ | 241 |   |

 

The tax effects of temporary differences that give rise to significantportions of the deferred tax assets and liabilities at December 31, 2004and 2005 are as follows:

 
| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(in thousands)**    | ** ** |
| Deferred tax  liabilities:         |       |                  |       |   |   |
| State income  taxes                |       | $                     | 4,056      |   | $ | 3,237 |   |
| Depreciation                       |       | —                |       | 63 |   |
| Total  deferred tax liabilities    |       | 4,056                 |       | 3,300 |   |
|                               |       |                  |       |   |   |
| Deferred tax  assets:              |       |                  |       |   |   |
| Net  operating loss carryforwards  |       | 58,152                |       | 48,022 |   |
| Amortization  of intangible assets |       | —                |       | 640 |   |
| Depreciation                       |       | 615                   |       | — |   |
| Other                              |       | 5,376                 |       | 320 |   |
| Total  deferred tax assets         |       | 64,143                |       | 48,982 |   |
| Less:  valuation allowance         |       | (60,087               | )          | (45,946 | ) |
| Net deferred  assets               |       | 4,056                 |       | 3,036 |   |
| Net deferred  tax liabilities      |       | $                     | —     |   | $ | 264 |   |

 

At December 31, 2005, the Company had net operating losscarryforwards totaling approximately $111 million for Federal income taxpurposes expiring beginning in 2020 and California state net operating losscarryforwards of approximately $102 million expiring beginning in 2008. Due tothe uncertainty surrounding the realization of the benefits of the Company’stax attributes, primarily net operating loss carryforwards as of December 31,2004 and 2005, the Company recorded a 100% valuation allowance against its netdeferred tax assets as of December 31, 2004 and 2005.

 

In assessing the potential realization of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will be realized. The ultimate realization ofdeferred tax assets is dependent upon the Company attaining future taxableincome during the periods in which those temporary differences becomedeductible. As of December 31, 2005, management is unable to determine if it ismore likely than not that the deferred tax assets will be realized.

 

Due to the restrictions imposed by InternalRevenue Code Section 382 regarding substantial changes in the stockownership of companies with loss carryforwards, the utilization of the Company’sfederal net operating loss carryforward was severely limited as a result of thechange in the effective stock ownership of the Company resulting from the debtfinancings arranged in conjunction with the acquisition of MediaDefender.

 

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

 

15. RELATEDPARTY TRANSACTIONS

 

Since 2003 the Company’s administrative offices have been located in anoffice leased by Radar Pictures, Inc., a company owned by Ted Field, theChairman of the Company, pursuant to a month-to-month arrangement. For the

 

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years ended December 31,2004 and 2005, the Company paid $168,000 and $90,000, respectively, to RadarPictures, Inc. as rent and facilities usage expense. On February 28,2005, the Company paid Radar Pictures, Inc. accrued rent through December 31,2004. The Company relocated to new office facilities in March 2006.

 

During 2005, the Company completed theimplementation of a new business initiative to create global awareness of theARTISTdirect brand and increase traffic to the Company’s web-site. Throughrelationships previously developed by the Company’s senior management in themusic and entertainment industry, the Company has begun to developopportunities for major corporations to sponsor cause-based programs in variousparts of the world in conjunction with music and entertainment celebrities. TheCompany believes that this effort would enhance the global reputation of theCompany through associations with leading performers and entertainers, whichcould then be expected to drive brand awareness and traffic to the Company’sdigital media properties. During the year ended December 31, 2005, theCompany received a fee advance of $35,000 from an international non-profitorganization with respect to the first such project. This fee advance wasbudgeted to fund initial planning and oversight and accordingly, one-half waspaid to the Company’s Chief Executive Officer and one-half was paid to theCompany’s Executive Vice President as a co-producer’s fee. During the yearsended December 31, 2004 and 2005, total costs incurred with respect to thisproject were $204,000 and $46,000, respectively.

 

In conjunction with the acquisition ofMediaDefender, the Company issued 1,109,032 shares of common stock and awarrant to purchase up to 114,985 shares of common stock with an exercise priceof $1.55 per share to WNT07 Holdings, LLC. The managers of WNT07 Holdings, LLCare Eric Pulier and Teymour Boutros-Ghali, both of whom are members of theCompany’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 acquisition of MediaDefender(see Note 9).

 

On July 28, 2005, the Company enteredinto a Non-Competition Agreement with WNT07 Holdings, LLC, Eric Pulier andTeymour Boutros-Ghali (collectively, the “Advisors”). The Non-CompetitionAgreement prohibits any of the Advisors (i) from engaging in certaincompetitive business activities and (ii) from soliciting existingemployees of the Company or its subsidiaries. The covenants not to complete orsolicit expire on the earlier of April 1, 2007 or the date of terminationof Advisor’s services with the Company.

 

The Company also acknowledged the terms ofNon-Competition Agreements entered into on July 28, 2005 by MediaDefenderand Mr. Saaf and Mr. Herrera. The Non-Competition Agreements prohibitMr. Saaf and Mr. Herrera from (i) engaging in certaincompetitive business activities, (ii) soliciting customers of MediaDefenderor the Company, (iii) soliciting existing employees of MediaDefender orthe Company and (iv) disclosing any confidential information regardingMediaDefender or the Company. Each agreement has a term of 4 years andshall continue to remain in force and effect in the event the above-referencedEmployment Agreements are terminated prior to the end of the 4 year termof the Non-Competition Agreements. In consideration, Mr. Saaf and Mr. Herreraare each entitled to a cash payment of $525,000 from MediaDefender to be paidon December 31, 2006.

 

Randy Saaf and Octavio Herrera, formerlyprincipals and stockholders of MediaDefender and currently both executiveofficers of the Company’s wholly-owned subsidiary, MediaDefender, each electedto invest $2,250,000 in the Sub-Debt Financing on the same terms and conditionsas the other Sub-Debt Financing investors (see Note 9).

 

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

 

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

 

See Notes 10, 11, 12, 13, 16 and 19 foradditional related party transactions.

 

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16.STOCKHOLDERS’ EQUITY (DEFICIENCY)

 

Equity-Based Transactions During the Year Ended December 31, 2004:

 

Effective January 1, 2004, the Company entered into a one-yearconsulting agreement with Keith Yokomoto, the Company’s then director andformer President and Chief Operating Officer (see Note 19). Effective January 9,2004, the Company also issued to Mr. Yokomoto two non-qualified stockoptions to purchase 10,000 shares and 50,000 shares exercisable at $0.50 pershare, which was not less than the fair market value on the date of grant,through January 9, 2011. The option for 10,000 shares was immediatelyvested upon issuance. The option for 50,000 shares was scheduled to vest inincrements of 10,000 shares on February 1, 2004, March 31, 2004, June 30,2004, September 30, 2004 and December 31, 2004, based on theaccomplishment of certain milestones by each respective date, which were notattained. Accordingly, the option for 50,000 shares did not vest and thusexpired. The fair value of the stock option for 10,000 shares, determinedpursuant to the Black-Scholes option pricing model, was $3,500.

 

Effective March 29, 2004, the Company issued to Robert N.Weingarten, the Company’s Chief Financial Officer, a non-plan, non-qualifiedstock option to purchase 120,000 shares at $0.50 per share, which was not lessthan the fair market value on the date of grant, exercisable through March 29,2011. The option vests and becomes exercisable in a series of 36successive equal monthly installments from March 29, 2004. The fair valueof the stock option, determined pursuant to the Black-Scholes option pricingmodel, was $42,000.

 

 Effective June 30, 2004,the Company settled a claim by a real estate broker related to the terminationof the Company’s former office lease by issuing a warrant to purchase 10,000shares of common stock exercisable for a period of five years at $0.50 per share.The fair value of the warrant was determined to be $4,000, calculated pursuantto the Black-Scholes option-pricing model, and was charged to operations during2004.

 

Effective August 31, 2004, the Company issued a warrant to aconsultant for services rendered to purchase 10,000 shares of common stockexercisable for a period of five years at $0.50 per share. The fair value ofthe warrant was determined to be $3,000, calculated pursuant to theBlack-Scholes option-pricing model, and was charged to operations during theyear ended December 31, 2004.

 

Equity-BasedTransactions During the Year Ended December 31, 2005:

 

On March 29, 2005, the Company issued to its Vice President –Business Development a non-plan, non-qualified stock option to purchase 92,000shares of the Company’s common stock exercisable for a period of seven years at$0.79 per share, the market price on the date of grant. The stock option vestedmonthly over a period of one year commencing January 1, 2005. The fairvalue of this option, calculated pursuant to the Black-Scholes option-pricingmodel, was determined to be $63,000.

 

On March 29, 2005, the Company issued to its employees stockoptions to purchase an aggregate of 205,150 shares of the Company’s commonstock pursuant to the Company’s 1999 Employee Stock Option Plan exercisable fora period of seven years at $0.79 per share, the market price on the date ofgrant. The stock options are scheduled to vest quarterly through September 30,2006. The fair value of these options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $140,000.

 

On May 6, 2005, the Company issued to three consultants stockoptions to purchase an aggregate of 78,000 shares of the Company’s common stockpursuant to the Company’s 1999 Employee Stock Option Plan exercisable for aperiod of five years at $1.00 per share, the market price on the date of thegrant, pursuant to short-term consulting agreements with a durationapproximating one year. The fair value of these options, calculated pursuant tothe Black-Scholes option-pricing model, was determined to be $79,000, of which$60,000 was charged to operations during the year ended December 31, 2005and $19,000 was recorded as deferred compensation at December 31, 2005,which is being amortized to operations through March 31, 2006.

 

On May 6, 2005, the Company issued to a consultant a stock optionto purchase an aggregate of 22,000 shares of the Company’s common stockpursuant to the Company’s 1999 Employee Stock Option Plan exercisable for aperiod of five years at $1.00 per share, the market price on the date of thegrant, pursuant to short-term consulting agreements. The option was subject tomilestones, one of which was partially attained during the year ended December 31,2005. The fair value of the vested portion of these options, calculatedpursuant to the Black-Scholes

 

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option-pricingmodel, was determined to be $40,000, of which $13,000 was charged to operationsduring the year ended December 31, 2005.

 

Effective as of July 28, 2005, the Company agreed to issue to eachof its two independent directors at that time a stock option to purchase up to85,000 shares of the Company’s common stock exercisable for a period of sevenyears at 85% of the average closing price of the Company’s common stock for the30 trading day period prior to July 28, 2005 and the 30 trading day periodsubsequent to July 28, 2005. The stock options were issued at an exerciseprice of $1.95 per share on September 9, 2005, which was in excess of thefair value of the common stock issued in the MediaDefender transaction, andwere fully vested at issuance. The fair value of each of these options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $245,650.

 

In conjunction with the acquisition of MediaDefender, effective July 28,2005, the Company granted stock options to each of Randy Saaf, MediaDefender’sChief Executive Officer, and Octavio Herrera, Media Defender’s President, topurchase up to 200,000 shares of common stock to each of Mr. Saaf and Mr. Herrera,exercisable for a period of five years at $3.00 per share, which was in excessof the fair value of the common stock issued in the MediaDefender transaction. Theseoptions are scheduled to vest quarterly over three and one-half years. The fairvalue of each of these options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $546,000.

 

In conjunction with the acquisition ofMediaDefender, effective July 28, 2005, the Company granted stock optionsto Jonathan Diamond, its Chief Executive Officer, to purchase up to 2,753,098shares of common stock, exercisable for a period of five years at $1.55 pershare, which was in excess of the fair value of the common stock issued in theMediaDefender transaction. Options with respect to 1,045,000 shares arescheduled to vest over three years and options with respect to 1,708,098 sharesare scheduled to vest based on specified performance milestones. The fair valueof the time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $2,936,450.

 

In conjunction with the acquisition ofMediaDefender, effective July 28, 2005, the Company granted stock optionsto Robert Weingarten, its Chief Financial Officer, to purchase up to 550,000shares of common stock, exercisable for a period of five years at $1.55 pershare, which was in excess of the fair value of the common stock issued in theMediaDefender transaction. Options with respect to 275,000 shares are scheduledto vest over three years and options with respect to 275,000 shares arescheduled to vest based on specified performance milestones. The fair value ofthe time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $772,750.

 

In conjunction with the acquisition of MediaDefender, the Companyissued 1,109,032 shares of common stock and a warrant to purchase up to 114,985shares of common stock with an exercise price of $1.55 per share to WNT07Holdings, LLC. The managers of WNT07 Holdings, LLC are Eric Pulier and TeymourBoutros-Ghali, both of whom are members of the Company’s Board of Directors. Theshares and warrants were issued as consideration for services provided by Mr. Pulierand Mr. Boutros-Ghali as consultants to the Company with respect to theMediaDefender acquisition. WNT07 Holdings, LLC, Mr. Pulier and Mr. Boutros-Ghalientered into a Non-Competition Agreement with the Company effective July 28,2005, which prohibits them (i) from engaging in certain competitivebusiness activities and (ii) from soliciting existing employees of theCompany or its subsidiaries. The covenants not to complete or solicit expire onthe earlier of April 1, 2007 or the date of termination of Advisor’sservices with the Company. The shares of common stock were valued at $1,585,916($1.43 per share) and the warrants were valued at $83,939, based on a valuationreport prepared by an independent valuation firm, for an aggregate value of$1,669,855, of which $333,971 was allocated to covenant not to compete and theremaining $1,335,884 was included in total costs that the Company incurred toacquire MediaDefender.

 

The warrants and convertible securities were issued in conjunction withthe acquisition and financing of the MediaDefender transaction, and aredescribed at Note 9.

 

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In December 2005, subordinated convertible notes payableaggregating $387,500 were converted into 250,000 shares of common stock. As aresult, related deferred financing costs and debt discount costs aggregating$39,000 were charged to operations.

 

Effective July 29, 2005, the Company cancelled 322,902 shares ofcommon stock held in treasury with a carrying cost of $3.442 million.

 

17. STOCKOPTION AND STOCK PURCHASE PLANS

 

CONSULTANT STOCK PLAN

 

Effective September 29, 2004, the Company’s Board of Directorsadopted the ARTISTdirect, Inc. 2004 Consultant Stock Plan (the “ConsultantPlan”) in order for the Company to be able to compensate consultants, at theoption of the Company, who provide bona fide services to the Company not inconnection with capital raising or promotion of the Company’s securities. TheConsultant Plan will expire on September 29, 2014, and provides for theissuance of up to 500,000 shares of common stock to consultants at fair marketvalue. On January 13, 2005, the Company filed a Registration Statement on Form S-8with the Securities and Exchange Commission to register the 500,000 shares ofcommon stock for future issuance under the Consultant Plan. As of December 31,2005, no shares had been issued under the Consultant Plan.

 

EMPLOYEE OPTION PLAN

 

In October 1999, the Company implemented the 1999 Employee StockOption Plan (the “Employee Plan”) that replaced the 1998 Unit Option Plan. TheEmployee Plan was not approved by the public stockholders of the Company. TheEmployee Plan has currently reserved 1,010,504 shares of the Company’s commonstock for issuance to employees, non-employee members of the board of directorsand consultants. This share reserve automatically increases on the firsttrading day in January each calendar year by an amount equal to 2% of thetotal number of shares of the Company’s common stock outstanding on the lasttrading day of December in the prior calendar year, but in no event willthis annual increase exceed 87,500 shares. No option may have a term inexcess of ten years. The options generally vest within three years. As of December 31,2005, 41,886 shares remained available for future option grant.

 

Through December 31, 2005, the Company has accounted for itsEmployee Plan in accordance with the provisions of Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees”,Interpretation No. 44, and other related interpretations. As such,compensation expense has been recorded on the date of grant only if the currentmarket price of the underlying stock exceeded the exercise price.

 

A summary of stock option activity under Employee Plan during the yearsended December 31, 2004 and 2005 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 118,897                 |       | $ | 14.79 |   |
| Granted                                        |       | —                  |       | — |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | (7,743                  | )          | 9.11 |   |
| Options  outstanding at December 31, 2004 |       | 111,154                 |       | 15.18 |   |
| Granted                                        |       | 875,150                 |       | 1.74 |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | (17,686                 | )          | 1.31 |   |
| Options  outstanding at December 31, 2005 |       | 968,618                 |       | $ | 3.57 |   |
|                                                |            |                         |            |  |  |  |  |

 

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The following table summarizes information regarding optionsoutstanding and options exercisable at December 31, 2005 under theEmployee Plan:

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

 

ADVISOR OPTIONPLAN

 

In June 1999, and as amended in October 1999 and March 2000,the Company adopted the 1999 Artist and Artist Advisor Stock Option Plan (the “AdvisorPlan”). The Advisor Plan was not approved by the public stockholders of theCompany. The Advisor Plan has currently reserved 364,659 shares of common stockfor issuance to artists for whom the Company entered into agreements related toonline and e-commerce activities and their agents, business managers, attorneysand other advisors. This share reserve automatically increases on the firsttrading day in January each calendar year by an amount equal to 1% of thetotal number of shares of the Company’s common stock outstanding on the lasttrading day of December in the prior calendar year, but in no event willthis annual increase exceed 37,500 shares. As of December 31, 2005,329,123 shares remained available for future option grants. The options expireseven years from the date of grant and vesting generally varies between one tothree years. No new option grants under this plan were made during 2004 or2005.

 

A summary of stock option activity under the Advisor Plan during theyears ended December 31, 2004 and 2005 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 35,536                  |       | $ | 123.29 |   |
| Granted                                        |       | —                  |       | — |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | —                  |       | — |   |
| Options  outstanding at December 31, 2004 |       | 35,536                  |       | 123.29 |   |
| Granted                                        |       | —                  |       | — |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | —                  |       | — |   |
| Options  outstanding at December 31, 2005 |       | 35,536                  |       | $ | 123.29 |   |

 

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The following table summarizes information regarding optionsoutstanding and options exercisable under the Advisor Plan at December 31,2005:

 
| ** **          | ** **    | **Options Outstanding and  Exercisable** | ** ** |
|---------------------|---------------|------------------------------------------|------------|
| **Exercise Prices** | ** **    | **Number  of Shares**                    | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| ** **          | ** **    | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                   | 36.00         |                                     |       | 1,250 |   | 0.78 |   | $ | 36.00 |   |
| 40.00               |          |                                     | 4,422      |   | 0.60 |   | 40.00 |   |
| 139.28              |          |                                     | 29,864     |   | 1.24 |   | 139.28 |   |
| $                   | 36.00-$139.28 |                                     |       | 35,536 |   | 1.15 |   | $ | 123.29 |   |

 

ARTIST OPTIONPLAN

 

In June 1999, and as amended in October 1999, the Companyadopted the 1999 Artist Stock Plan (the “Artist Plan”). The Artist Plan was notapproved by the public stockholders of the Company. The Artist Plan currentlyhas reserved 760,504 shares of common stock for issuance to artists for whomthe Company entered into agreements related to their online and e-commerceactivities. This share reserve automatically increases on the first trading dayin January each calendar year by an amount equal to 2% of the total numberof shares of the Company’s common stock outstanding on the last trading day of December inthe prior calendar year, but in no event will this annual increase exceed87,500 shares. As of December 31, 2005, 736,630 shares remained availablefor future option grants. The options expire seven years from the date of grantand vesting generally varies between one to three years. In December 2001,a majority of the outstanding options under the Advisor plan were rescinded andcancelled. No new option grants under this plan were made during 2004 or 2005.

 

A summary of stock option activity under the Artist Plan during theyears ended December 31, 2004 and 2005 is as follows:

 
| ** **                                     | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Options  outstanding at December 31, 2003 |       | 23,874                  |       | $ | 83.15 |   |
| Granted                                        |       | —                  |       | — |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | —                  |       | — |   |
| Options  outstanding at December 31, 2004 |       | 23,874                  |       | 83.15 |   |
| Granted                                        |       | —                  |       | — |   |
| Exercised                                      |       | —                  |       | — |   |
| Cancelled                                      |       | —                  |       | — |   |
| Options  outstanding at December 31, 2005 |       | 23,874                  |       | $ | 83.15 |   |

 

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The following table summarizes information regarding optionsoutstanding and options exercisable under the Artist Plan at December 31,2005:

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

 

EMPLOYEE STOCKPURCHASE PLAN

 

In October 1999, the Company adopted the 1999 Employee StockPurchase Plan that initially reserved 50,000 shares of common stock forissuance under this plan. As of December 31, 2005, this plan had 175,000shares reserved for issuance, of which 162,831 shares remained available forfuture issuances. This share reserve automatically increases on the firsttrading day in January each calendar year, by an amount equal to 1% of thetotal number of shares of the Company’s common stock outstanding on the lasttrading day of December in the prior calendar year, but in no event willthis annual increase exceed 25,000 shares. Terms of the plan permit eligibleemployees to purchase common stock through payroll deduction of up to 15% ofeach employee’s compensation. The accumulated deductions are applied to thepurchase of shares on each semi-annual purchase date at a purchase price pershare equal to 85% of the fair market value per share on the participant’sentry date into the offering period or the semi-annual purchase date, whicheveris lower. Pursuant to the provisions of APB No. 25, shares issued toemployees under this plan are considered non-compensatory. During the yearsended December 31, 2004 and 2005, no shares were issued under this plan.

 

18. 401(K) PLAN

 

The Company has adopted the Cash or Deferred Profit Sharing Plan andTrust under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”).Under the 401(k) Plan, participating employees may defer a percentage (notto exceed 15%) of their eligible pretax earnings up to the Internal RevenueService’s annual contribution limit. All employees of the Company who are 21years or older and who complete three months of service are eligible toparticipate in the 401(k) Plan. The Company does not match contributions byparticipants to the 401(k) Plan. Accordingly, there is no related expense forthe years ended December 31, 2004 and 2005.

 

19.COMMITMENTS AND CONTINGENCIES

 

LEASECOMMITMENTS

 

On January 30, 2006, the Company entered into a sub-leaseagreement for new office facilities in Santa Monica, California through November 30,2011. The effective date of the sub-lease agreement was February 2, 2006. Thenew office facilities will house both ADI and MediaDefender. In connection withthe sub-lease agreement, the Company provided an irrevocable standby bankletter of credit for $180,000 as security for the Company’s obligations underthe sub-lease. The letter of credit will be reduced to $90,000 on the 13thmonth of the sub-lease, provided the Company is in compliance with all termsunder the sub-lease.

 

This lease contains predetermined fixedincreases in the minimum rental rate during the initial lease term. The Companywill recognize the related rent expense on a straight-line basis beginning onthe effective date of the lease. The Company will record the difference betweenthe amount charged to expense and the rent paid as deferred rent on the Company’sbalance sheet.

 

Future cash payments under operating leases are as follows:

 
| **Years Ending December 31,** | ** ** | **(in thousands)** | ** ** |
|------------------------------------|------------|--------------------|------------|
|                               |       |               |       |
| 2006                               |       | $                  | 343        |   |
| 2007                               |       | 464                |       |
| 2008                               |       | 470                |       |
| 2009                               |       | 485                |       |
| 2010                               |       | 499                |       |
| 2011                               |       | 471                |       |
|                               |       | $                  | 2,732      |   |

 

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

 

EMPLOYMENTAGREEMENTS

 

On July 28, 2005, the Company enteredinto an Employment Agreement with Jonathan Diamond, the Company’s ChiefExecutive Officer. During the term of the Employment Agreement, which shallcontinue through December 31, 2008, Mr. Diamond will earn a base salaryof no less than $350,000 per annum, plus certain specified perquisites thatinclude a monthly car allowance. Mr. Diamond is also eligible to receivean annual discretionary bonus of up to 100% of base salary, as determined bythe Compensation Committee of the Board of Directors or, if none, the Board ofDirectors, and an annual performance bonus of up to 100% of base salary if theCompany achieves specified earnings targets in fiscal 2007 and 2008. Mr. Diamondshall also be entitled to receive stock options at the discretion of theCompany’s Board of Directors. In the event Mr. Diamond is terminated “withoutcause,” he shall be entitled to receive 12 months of severance pay at therate of 100% of his monthly salary, any performance bonus due for the year inwhich termination occurs and all stock options subject to time vesting shall bedeemed fully vested and exercisable.

 

On July 28, 2005, the Company enteredinto an Employment Agreement with Robert Weingarten, the Company’s ChiefFinancial Officer. During the term of the Employment Agreement, which shallcontinue through December 31, 2008, Mr. Weingarten will earn a basesalary of no less than $195,000 per annum, plus certain specified perquisitesthat include a monthly car allowance. Mr. Weingarten is also eligible toreceive an annual discretionary bonus of up to 100% of base salary, asdetermined by the Compensation Committee of the Board of Directors or, if none,the Board of Directors, and an annual performance bonus of up to 100% of basesalary if the Company achieves specified earnings targets in fiscal 2007 and2008. Mr. Weingarten shall also be entitled to receive stock options atthe discretion of the Company’s Board of Directors. In the event Mr. Weingartenis terminated “without cause,” he shall be entitled to receive 12 monthsof severance pay at the rate of 100% of his monthly salary, any performancebonus due for the year in which termination occurs and all stock optionssubject to time vesting shall be deemed fully vested and exercisable.

 

In accordance with the MediaDefendertransaction, the Company acknowledged the terms of Employment Agreementsentered into on July 28, 2005 by MediaDefender with each of Randy Saaf,who serves as Chief Executive Officer of MediaDefender, and Octavio Herrera,who serves as President of MediaDefender. Mr. Saaf and Mr. Herrerawill each earn a base salary of no less than $350,000 per annum during theinitial term of the agreements, which shall continue until December 31,2008, and are also entitled to receive performance bonuses of up to $350,000 ifMediaDefender achieves specified earnings targets in fiscal 2007 and 2008. Mr. Saafand Mr. Herrera are each entitled to receive twelve months of severancepay at the rate of 100% of their monthly salary and the pro-rata portion of theperformance bonus referenced above if they are terminated “without cause.”  In addition, the Company granted stockoptions to purchase up to 200,000 shares of common stock to each of Mr. Saafand Mr. Herrera, exercisable for a period of 5 years at $3.00 per share.

 

Effective December 31, 2003, Keith Yokomoto, the Company’s formerPresident and Chief Operating Officer, entered into a Termination Agreement andMutual General Release. Mr. Yokomoto subsequently resigned as a directorof the Company on October 22, 2004. Effective January 1, 2004, theCompany entered into a one-year consulting agreement with Mr.Yokomoto thatprovided for total compensation of $120,000.

 

83

----

 

Future payments under employment agreements are as follows:

 
| **Years Ending December 31,** | ** ** | ** **         | ** ** |
|------------------------------------|------------|--------------------|------------|
| ** **                         | ** ** | **(in thousands)** | ** ** |
|                               |       |               |       |
| 2006                               |       | $                  | 1,414      |   |
| 2007                               |       | 1,264              |       |
| 2008                               |       | 1,264              |       |
|                               |       | $                  | 3,942      |   |

 

LITIGATION

 

The Company is periodically subject to various pending and threatenedlegal actions which arise in the normal course of business. The Company’smanagement believes that the impact of any such litigation will not have amaterial adverse impact on the Company’s financial position or results ofoperations.

 

20. FOURTH QUARTERRECLASSIFICATION

 

Effective July 28, 2005, the Company issued warrants to lenders andplacement agents in conjunction with the financing of the MediaDefender transaction(see Note 9), which were accounted for at fair value based on a report preparedby an independent valuation firm.  Theaggregate fair value of such warrants of $3,260,000 was originally recorded asa credit to additional paid-in capital.

 

Effective December 31, 2005, pursuant to EITF No. 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the Company has reclassified the aggregate fair value ofsuch warrants from additional paid-in capital to warrant liability, which isincluded in current liabilities on the balance sheet at such date.

 

This reclassification had no effect on the Company’s statement ofoperations for the year ended December 31, 2005.

 

21. REPORTABLESEGMENTS

 

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

 

The segment data presented below has been restated for all periods toreflect operations discontinued at December 31, 2004. In December 2004,the Company discontinued the operations of its iMusic record label and as aresult it has been presented as a discontinued operation for all periodspresented. The Company consolidated the operations of ARTISTdirect Records forthe year ended December 31, 2004. As a result of the sale of the Company’sinterest in ARTISTdirect Records effective February 28, 2005, theoperations of ARTISTdirect Records have been presented as a discontinuedoperation for all periods presented.

 

Information with respect to the year ended December 31, 2005relating to MediaDefender reflects only the five-month period in whichMediaDefender has been included in the Company’s consolidated results ofoperations.

 

The factors for determining reportable segments were based on servicesand products. Each segment is responsible for executing a unique marketing andbusiness strategy. The accounting policies of the segments are as described inthe summary of significant accounting policies. The Company evaluatesperformance based on, among other factors, earnings or loss before interest,taxes, depreciation and amortization (“Adjusted EBITDA”). Adjusted EBITDA alsoexcludes stock-based compensation and impairment losses. Included in AdjustedEBITDA are direct operating expenses for each segment.

 

The following table summarizes net revenue and Adjusted EBITDA byoperating segment for the years ended December 31, 2004 and 2005. Corporateexpenses consist of general operating expenses that are not directly related tothe operations of the segments. A reconciliation of Net Income (Loss) toAdjusted EBITDA is also provided.

 
| ** **            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------|------------|-----------------------------------|------------|
| ** **            | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **            | ** ** | **(in thousands)**                | ** ** |
|                  |       |                              |       |   |   |
| Net Revenue:          |       |                              |       |   |   |
| E-commerce            |       | $                                 | 2,994      |   | $ | 2,665 |   |
| Media                 |       | 2,149                             |       | 5,297 |   |
| Anti-piracy  services |       | —                            |       | 6,009 |   |
|                  |       | $                                 | 5,143      |   | $ | 13,971 |   |
| Adjusted  EBITDA:     |       |                              |       |   |   |
| E-commerce            |       | $                                 | 293        |   | $ | 157 |   |
| Media                 |       | 789                               |       | 2,198 |   |
| Anti-piracy  services |       | —                            |       | 3,851 |   |
|                  |       | 1,082                             |       | 6,206 |   |
| Corporate             |       | (1,944                            | )          | (2,969 | ) |
|                  |       | $                                 | (862       | ) | $ | 3,237 |   |

 

84

----

 
| ** **                                                                                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| ** **                                                                                                                                             | ** ** | **(in thousands)**                | ** ** |
|                                                                                                                                                   |       |                              |       |   |   |
| Reconciliation  of Adjusted EBITDA to Net Income (Loss):                                                                                               |       |                              |       |   |   |
| Adjusted  EBITDA per segments                                                                                                                          |       | $                                 | (862       | ) | $ | 3,237 |   |
| Stock-based  compensation                                                                                                                              |       | (7                                | )          | (73 | ) |
| Depreciation                                                                                                                                           |       | (223                              | )          | (205 | ) |
| Amortization  of intangible assets                                                                                                                     |       | —                            |       | (1,562 | ) |
| Amortization  of deferred financing costs                                                                                                              |       | —                            |       | (373 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable into common stock |       | —                            |       | (39 | ) |
| Interest  income                                                                                                                                       |       | 29                                |       | 29 |   |
| Interest  expense, including amortization of discount on debt of $246                                                                                  |       | —                            |       | (1,517 | ) |
| Provision  for income taxes                                                                                                                            |       | —                            |       | (241 | ) |
| Loss from  discontinued operations -                                                                                                                   |       |                              |       |   |   |
| –  ARTISTdirect Records, LLC                                                                                                                      |       | (2,111                            | )          | (271 | ) |
| – iMusic  record label                                                                                                                            |       | (137                              | )          | — |   |
| Gain from  sale of ARTISTdirect Records, LLC                                                                                                           |       | —                            |       | 21,079 |   |
| Net income  (loss)                                                                                                                                     |       | $                                 | (3,311     | ) | $ | 20,064 |   |

 

Assets as of December 31, 2004 and 2005 are summarized as follows:

 
| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2004**              | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(in thousands)**    | ** ** |
|                     |       |                  |       |   |   |
| Assets:                  |       |                  |       |   |   |
| Corporate                |       | $                     | 1,313      |   | $ | 4,726 |   |
| E-commerce               |       | 314                   |       | 941 |   |
| Media                    |       | 772                   |       | 1,931 |   |
| Anti-piracy  services    |       | —                |       | 46,934 |   |
| Discontinued  operations |       | 14                    |       | — |   |
|                     |       | $                     | 2,413      |   | $ | 54,532 |   |

 

Assets by segment are those assets used in or employed by theoperations of each segment. Corporate assets are principally made up of cashand cash equivalents, short-term investments, prepaid expenses, computerequipment, leasehold improvements and other assets.

 

22. QUARTERLYRESULTS OF OPERATIONS (UNAUDITED)

 

The following table sets forth unaudited quarterly results ofoperations for the years ended December 31, 2004 and 2005. This unauditedquarterly information has been derived from the Company’s unaudited financialstatements and, in the Company’s opinion, includes all adjustments, includingnormal recurring adjustments, necessary for a fair presentation of theinformation for the periods covered. The operating results for any quarter arenot necessarily indicative of the operating results for any future period.

 

85

----

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

 
| ** **                                         | ** ** | **Three Months Ended**                     | ** ** | ** **              | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | **March 31,  2005**                   | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **Year Ended  December 31, 2005** | ** ** |
| ** **                                         | ** ** | **(in thousands, except for share  data)** | ** ** |
|                                               |       |                                       |       |                    |       |   |   |   |   |   |   |
| Net revenue                                        |       | $                                          | 1,290      |                    | $          | 3,169 |   | $ | 3,852 |   | $ | 5,660 |   | $ | 13,971 |   |
| Gross profit                                       |       | 367                                        |       | 1,394                   |       | 1,680 |   | 2,726 |   | 6,167 |   |
| Income  (loss) from continuing operations          |       | (375                                       | )          | 604                     |       | (671 | ) | (302 | ) | (744 | ) |
| Income from  discontinued operations               |       | 20,808                                     |       | —                  |       | — |   | — |   | 20,808 |   |
| Net income  (loss)                                 |       | $                                          | 20,433     |                    | $          | 604 |   | $ | (671 | ) | $ | (302 | ) | $ | 20,064 |   |
|                                               |       |                                       |       |                    |       |   |   |   |   |   |   |
| Net income  (loss) per common share – basic:  |       |                                       |       |                    |       |   |   |   |   |   |   |
| From  continuing operations                        |       | $                                          | (0.11      | )                       | $          | 0.17 |   | $ | (0.16 | ) | $ | (0.07 | ) | $ | (0.19 | ) |
| From  discontinued operations                      |       | 5.94                                       |       | 0.00                    |       | (0.00 | ) | 0.00 |   | 5.25 |   |
| Total                                              |       | $                                          | 5.83       |                    | $          | 0.17 |   | $ | (0.16 | ) | $ | (0.07 | ) | $ | 5.06 |   |
|                                               |       |                                       |       |                    |       |   |   |   |   |   |   |
| Net income  (loss per common share – diluted: |       |                                       |       |                    |       |   |   |   |   |   |   |
| From  continuing operations                        |       | $                                          | (0.11      | )                       | $          | 0.15 |   | $ | (0.16 | ) | $ | (0.07 | ) | $ | (0.01 | ) |
| From  discontinued operations                      |       | 5.94                                       |       | 0.00                    |       | (0.00 | ) | 0.00 |   | 1.46 |   |
| Total                                              |       | $                                          | 5.83       |                    | $          | 0.15 |   | $ | (0.16 | ) | $ | (0.07 | ) | $ | 1.45 |   |
|                                               |       |                                       |       |                    |       |   |   |   |   |   |   |
| Weighted  average common shares outstanding:       |       |                                       |       |                    |       |   |   |   |   |   |   |
| Basic                                              |       | 3,502,117                                  |       | 3,502,117               |       | 4,241,472 |   | 4,611,149 |   | 3,969,145 |   |
| Diluted                                            |       | 3,502,117                                  |       | 3,927,844               |       | 4,241,472 |   | 4,611,149 |   | 14,264,852 |   |

 

23. SUBSEQUENT EVENTS (UNAUDITED)

 

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

 

During theperiod from January 1, 2006 through March 31, 2006, the Company hasissued 2,013,000 shares of common stock upon the conversion of $3.120 millionof subordinated convertible notes payable.

 

Effective April 7, 2006, the Company entered intovarious agreements with the investors in its Senior Financing and Sub-DebtFinancing (see Note 9) to amend their respective registration rights agreementsand to amend and waive certain financial covenants. In consideration thereof,the Company offered to temporarily reduce the exercise price of the 3,250,000warrants held by the investors in the Senior Financing from $2.00 to $1.85 pershare through April 30, 2006, and agreed to permanently reduce the exerciseprice of the 1,596,744 warrants held by the investors in the Sub-Debt Financingfrom $1.55 to $1.43 per share. Any exercise of the aforementioned warrants atthe reduced exercise price shall be for cash only. The conversion price of theSub-Debt Notes of $1.55 per share was not affected. The Company also enteredinto similar agreements, as applicable, and provided identical temporary andpermanent reductions to warrant exercise prices, with Broadband CapitalManagement LLC (1,516,935 warrants originally exercisable at $1.55 per share)and Libra FE, LP (237,500 warrants originally exercisable at $2.00 per share).

 

The Company also agreed to utilize 25% of the proceeds from theexercise of the warrants held by the investors in the Senior Financing toreduce the respective principal balance on the notes payable held by suchexercising investors, and to pay any related unpaid accrued interest on suchprincipal payments.

 

86

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**INDEX TO EXHIBITS**

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                        |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                             |
| 2.1                 |       | Agreement and Plan of Merger, dated July 28, 2005, by and among  ARTISTdirect, Inc., ARTISTdirect Merger Sub, Inc. and MediaDefender, Inc.  (incorporated by reference to current report on Form 8-K filed August 5,  2005). |
|                |       |                                                                                                                                                                                                                                   |
| 3.1                 |       | Amended and Restated Certificate of Incorporation of ARTISTdirect,  Inc. (incorporated by reference to registration statement on Form S-1/A  filed on January 27, 2000).                                                          |
|                |       |                                                                                                                                                                                                                                   |
| 3.2                 |       | Amended and Restated Bylaws of ARTISTdirect, Inc. (incorporated by  reference to current report on Form 8-K filed on April 18, 2006).                                                                                             |
|                |       |                                                                                                                                                                                                                                   |
| 3.3                 |       | Certificate of Amendment of the Amended and Restated Certificate of  Incorporation (incorporated by reference to quarterly report on Form 10-Q  filed August 14, 2001).                                                           |
|                |       |                                                                                                                                                                                                                                   |
| 3.4                 |       | Certificate of Amendment of the Amended and Restated Certificate of  Incorporation (incorporated by reference to quarterly report on  Form 10-Q filed August 14, 2002).                                                      |
|                |       |                                                                                                                                                                                                                                   |
| 3.5                 |       | Certificate of Amendment of the Amended and Restated Certificate of  Incorporation (incorporated by reference to current report on Form 8-K filed  November 9, 2005).                                                                  |
|                |       |                                                                                                                                                                                                                                   |
| 4.1                 |       | Registration Rights Letter Agreement dated May 31, 2001 between  ARTISTdirect, Inc. and Frederick W. Field (incorporated by reference to  definitive proxy statement filed June 11, 2001).                              |
|                |       |                                                                                                                                                                                                                                   |
| 4.2                 |       | Form of 11.25% Senior Note Due July 28, 2009 issued to each of  the Senior Financing investors dated July 28, 2005 (incorporated by  reference to current report on Form 8-K filed August 3, 2005).                     |
|                |       |                                                                                                                                                                                                                                   |
| 4.3                 |       | Form of Warrant to Purchase Common Stock issued to each of the Senior  Financing investors dated July 28, 2005 (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                              |
|                |       |                                                                                                                                                                                                                                   |
| 4.4                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and each of the Senior Financing investors (incorporated  by reference to current report on Form 8-K filed August 3, 2005).             |
|                |       |                                                                                                                                                                                                                                   |
| 4.5                 |       | Form of Convertible Subordinated Note issued to each of the Sub-debt  investors dated July 28, 2005 (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                         |
|                |       |                                                                                                                                                                                                                                   |
| 4.6                 |       | Form of Sub-Debt Financing Warrant issued July 28, 2005  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                                                    |
|                |       |                                                                                                                                                                                                                                   |
| 4.7                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and each of the Sub-Debt Financing investors (incorporated  by reference to current report on Form 8-K filed August 3, 2005).           |
|                |       |                                                                                                                                                                                                                                   |
| 4.8                 |       | Warrant issued to Libra FE, LP on July 28, 2005 (incorporated by  reference to current report on Form 8-K filed August 3, 2005).                                                                                             |
|                |       |                                                                                                                                                                                                                                   |
| 4.9                 |       | Registration Rights Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and Libra FE, LP. (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                      |
|                |       |                                                                                                                                                                                                                                   |
| 4.10                |       | Warrant issued to WNT07, LLC on July 28, 2005 (incorporated by  reference to current report on Form 8-K filed August 3, 2005).                                                                                               |
|                |       |                                                                                                                                                                                                                                   |
| 4.11                |       | Waiver of Registration Rights Agreement, dated November 25, 2005, by  and among ARTISTdirect, Inc. and certain of the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed November 30,  2005).  |
|                |       |                                                                                                                                                                                                                                   |
| 4.12                |       | Waiver of Registration Rights Agreement, dated November 25, 2005, by  and among ARTISTdirect, Inc. and                                                                                                                                 |

 

E-1

----

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                         |
|                |       | certain of the Sub-Debt Financing investors (incorporated by  reference to current report on Form 8-K filed November 30, 2005).                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.13                |       | Omnibus Amendment to Note and Warrant Purchase Agreement and Warrants  to Purchase Common Stock by and between ARTISTdirect, Inc. and the Senior  Financing investors dated April 7, 2006 (incorporated by reference to current  report on Form 8-K filed April 10, 2006).                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.14                |       | Amendment No.1 to Registration Rights Agreement by and between  ARTISTdirect, Inc. and the Senior Financing investors dated April 7, 2006  (incorporated by reference to current report on Form 8-K filed April 10,  2006).                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.15                |       | Omnibus Amendment and Waiver to Notes and Warrants Issued Pursuant to  Securities Purchase Agreement by and between ARTISTdirect, Inc. and the  Senior Financing investors dated April 7, 2006 (incorporated by reference to  current report on Form 8-K filed April 10, 2006).                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.16                |       | Amendment No.1 to Registration Rights Agreement executed by ARTISTdirect,  Inc. and CCM Master Qualified Fund dated April 7, 2006 (incorporated by  reference to current report on Form 8-K filed April 10, 2006).                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.17                |       | Amendment No.1 to Registration Rights Agreement executed by ARTISTdirect,  Inc. and DKR SoundShore Oasis Holding Funding, Ltd. dated April 7, 2006  (incorporated by reference to current report on Form 8-K filed April 10,  2006).                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.18                |       | Amendment and Waiver to Convertible Subordinated Note executed by ARTISTdirect,  Inc. and CCM Master Qualified Fund dated April 7, 2006 (incorporated by  reference to current report on Form 8-K April 10, 2006).                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.19                |       | Amendment and Waiver to Convertible Subordinated Note executed by  ARTISTdirect, Inc. and DKR SoundShore Oasis Holding Fund, Ltd. dated April 7,  2006 (incorporated by reference to current report on Form 8-K April 10,  2006).                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.20                |       | Amendment and Waiver entered into by and between ARTISTdirect, Inc.  and Libra FE, LP dated April 7, 2006 (incorporated by reference to current  report on Form 8-K April 10, 2006).                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.21                |       | Amendment No.1 to Registration Rights Agreement entered into by and  between ARTISTdirect, Inc. and Libra FE, LP April 7, 2006 (incorporated by  reference to current report on Form 8-K filed April 10, 2006).                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.1                |       | Amendment No. 1 dated February 27, 2002 to the Agreement  dated July 19, 2000 between ARTISTdirect, Inc. and Ticketmaster  (incorporated by reference to quarterly report on Form 10-Q filed  May 15, 2002).                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.2                |       | Escrow Agreement dated March 13, 2002 among ARTISTdirect, Inc.,  Ticketmaster and JPMorgan Chase Bank (incorporated by reference to quarterly  report on Form 10-Q filed May 15, 2002).                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.3                |       | Agreement dated October 22, 2001 between ARTISTdirect, Inc. and  Old Glory Boutique Distributing, Inc. (incorporated by reference to quarterly  report on Form 10-Q filed August 14, 2002).                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.4                |       | Letter Agreement, dated as of December 9, 2002, by and between  ARTISTdirect, Inc. and Frederick W. Field to amend the Employment  Agreement dated May 31, 2001 between ARTISTdirect, Inc. and  Mr. Field (incorporated by reference to current report on Form 8-K  filed December 13, 2002).                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.5                |       | Letter Agreement, dated as of December 9, 2002, by and between  ARTISTdirect Records, L.L.C. and Frederick W. Field to amend the  Employment Agreement dated May 31, 2001 between ARTISTdirect Records,  L.L.C. and Mr. Field (incorporated by reference to current report on  Form 8-K filed December 13, 2002).                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.6                |       | Letter Agreement, dated as of December 23, 2002, by and between  ARTISTdirect, Inc. and Keith Yokomoto to amend the Employment Agreement dated  July 1, 2001 between ARTISTdirect, Inc. and Mr. Yokomoto  (incorporated by reference to quarterly report on Form 10-Q/A filed  December 23, 2002).                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.7                |       | Letter Agreement, dated as of December 23, 2002, by and between  ARTISTdirect, Inc. and Marc Geiger to amend the Employment Agreement dated  July 28, 1998, as amended on July 1, 2001, between ARTISTdirect,  Inc. and Mr. Geiger (incorporated by reference to current report on Form 8-K  filed December 23, 2002).                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.8                |       | Letter Agreement dated December 11, 2002 between ARTISTdirect,  Inc. and Benn Co., LLC consenting to the assignment by Old Glory Boutique  Distributing, Inc. to Benn Co., LLC of the Agreement dated October 22,  2001 between ARTISTdirect, Inc. and Old Glory Boutique Distributing, Inc.  (incorporated by reference to annual report on Form 10-K filed  March 31, 2003). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.9                |       | Agreement for Services dated as of June 13, 2002 between  ARTISTdirect, Inc. and Frankel & Company (incorporated by reference  to annual report on Form 10-K filed March 31, 2003).                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.10               |       | Letter Agreement, dated as of May 1, 2003, by and between  ARTISTdirect, Inc. and Frederick W. Field to amend the Employment  Agreement dated May 31, 2001 between ARTISTdirect, Inc. and  Mr. Field (incorporated by reference to quarterly report on  Form 10-Q filed August 14, 2003).                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.11               |       | Letter Agreement, dated as of May 1, 2003, by and between  ARTISTdirect Records, L.L.C. and Frederick W. Field to amend the Employment  Agreement dated May 31, 2001 between ARTISTdirect Records, L.L.C. and  Mr. Field (incorporated by reference to quarterly report on  Form 10-Q filed August 14, 2003).                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.13               |       | Notice of Grant of Stock Option dated as of September 29, 2003  by and between ARTISTdirect, Inc. and Jon Diamond (incorporated by reference  to quarterly report on Form 10-Q filed November 14, 2003).                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.14               |       | Settlement, Release and Termination of Lease Agreement dated as of  September 8, 2003, by and between 5670 Wilshire L.P. and  ARTISTdirect, Inc. (incorporated by reference to quarterly report on  Form 10-Q filed on November 14, 2003).                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.15               |       | Termination Agreement and Mutual Release by Keith Yokomoto and  ARTISTdirect, Inc. dated as of December 31, 2003 (incorporated by reference  to annual report on Form 10-K filed on May 17, 2004).                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.16               |       | Form of Director Indemnification Agreement (incorporated by reference  to registration statement on Form S-1/A                                                                                                                                                                                                                                                                                |

 

E-2

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| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                    |
|                |       | filed January 27, 2000).                                                                                                                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.17               |       | Form of Officer Indemnification Agreement (incorporated by reference  to registration statement on Form S-1/A filed January 27, 2000).                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.18               |       | ARTISTdirect, Inc. 1999  Employee Stock Option Plan (incorporated by reference to registration  statement on Form S-1/A filed January 27, 2000).                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.19               |       | ARTISTdirect, Inc. Artist  Plan (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.20               |       | ARTISTdirect, Inc. Artist  and Artist Advisor Plan (incorporated by reference to registration statement  on Form S-1/A filed January 27, 2000).                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.21               |       | ARTISTdirect, Inc. 2004  Consultant Stock Plan (incorporated by reference to registration statement on  Form S-8 filed January 13, 2005).                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.22               |       | Notice of Grant of Stock Option dated as of March 29, 2004 by  and between ARTISTdirect, Inc. and Robert N. Weingarten (incorporated by  reference to quarterly report on Form 10-Q filed August 20, 2004).                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.23               |       | Termination Agreement made as of July 30, 2004 among  ARTISTdirect, Inc., ARTISTdirect Records, LLC and BMG Music (incorporated by  reference to quarterly report on Form 10-Q filed August 20, 2004).                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.24               |       | Trademark Assignment and Purchase Agreement between ARTISTdirect,  Inc. and Apple Computer, Inc. dated November 12, 2004 (incorporated by  reference to current report on Form 8-K filed November 29, 2004).                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.25               |       | Transfer Agreement between ARTISTdirect Recordings, Inc.,  ARTISTdirect, Inc. and Radar Records Holdings, Inc. dated as of  December 31, 2004 (incorporated by reference to current report on  Form 8-K filed March 4, 2005).                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.26               |       | Employment, Confidentiality and Noncompetition Agreement, dated  July 28, 2005, by and between MediaDefender, Inc. and Randy Saaf (incorporated  by reference to current report on Form 8-K filed August 3, 2005).                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.27               |       | Employment, Confidentiality and Noncompetition Agreement, dated  July 28, 2005, by and between MediaDefender, Inc. and Octavio Herrera  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.28               |       | Non-Competition Agreement, dated July 28, 2005, entered into  between MediaDefender, Inc. and Randy Saaf (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.29               |       | Non-Competition Agreement, dated July 28, 2005, entered into  between MediaDefender, Inc. and Octavio Herrera (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.30               |       | Note and Warrant Purchase Agreement, dated July 28, 2005, by and  among ARTISTdirect, Inc., the investors indicated on the schedule of buyers  thereto and U.S. Bank National Association, as Collateral Agent for the  Senior Financing investors (incorporated by reference to current report on  Form 8-K filed August 3, 2005). |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.31               |       | Security Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and its subsidiaries and U.S. Bank National Association,  as Collateral Agent for the Senior Financing investors (incorporated by  reference to current report on Form 8-K filed August 3, 2005)                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.32               |       | Pledge Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and U.S. Bank National Association, as Collateral Agent  for the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.33               |       | Form of Copyright Security Agreement (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.34               |       | Patent Security Agreement, dated July 28, 2005, by and among  MediaDefender, Inc. and U.S. Bank National Association, as Collateral Agent  for the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.35               |       | Trademark Security Agreement, dated July 28, 2005, by and among  ARTISTdirect, Inc. and U.S. Bank National Association, as Collateral Agent  for the benefit of the Senior Financing investors (incorporated by reference  to current report on Form 8-K filed August 3, 2005).                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.36               |       | Subsidiary Guaranty, dated July 28, 2005, made by ARTISTdirect,  Inc. and its subsidiaries in favor of U.S. Bank                                                                                                                                                                                                                         |

 

E-3

----

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                         |
|                |       | National Association, as Collateral Agent for the Senior Financing  investors (incorporated by reference to current report on Form 8-K filed  August 3, 2005).                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.37               |       | Securities Purchase Agreement, dated July 28, 2005, entered into  by and among ARTISTdirect, Inc. and the Sub-debt Financing investors  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.38               |       | Subordination Agreement, dated July 28, 2005, among  ARTISTdirect, Inc., and certain of its subsidiaries, the Sub-debt Financing  investors and U.S. Bank National Association, as Collateral Agent for the  Senior Financing investors (incorporated by reference to current report on  Form 8-K filed August 3, 2005). |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.39               |       | Non-Competition Agreement, dated July 28, 2005, entered into  between ARTISTdirect, Inc. and WNT07, LLC (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.40               |       | Employment Agreement, dated July 28, 2005, entered into between  ARTISTdirect, Inc. and Jon Diamond (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.41               |       | Employment Agreement, dated July 28, 2005, entered into between  ARTISTdirect, Inc. and Robert Weingarten (incorporated by reference to  current report on Form 8-K filed August 3, 2005).                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.42               |       | Amendment No. 1 to Employment Agreement, dated October 11, 2005),  entered into between ARTISTdirect, Inc. and Jon Diamond (incorporated by  reference to current report on Form 8-K filed October 14, 2005).                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.43               |       | Acknowledgement and Amendment regarding Employment Agreement by and  between ARTISTdirect, Inc. and Jon Diamond dated February 3, 2006  (incorporated by reference to current report on Form 8-K filed February 3,  2006).                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.44               |       | Acknowledgement and Amendment regarding Employment Agreement by and  between ARTISTdirect, Inc. and Robert Weingarten dated February 3, 2006  (incorporated by reference to current report on Form 8-K filed February 3,  2006).                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.45               |       | Sublease by and between Sapient Corporation and ARTISTdirect, Inc.  dated January 26, 2006 (incorporated by reference to current report on Form  8-K filed February 3, 2006).                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.46               |       | Fiscal 2006 Board of Directors Compensation (incorporated by reference  to current report on Form 8-K filed April 4, 2006.)                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 10.47               |       | Amendment No.1 and Waiver to Note and Warrant Purchase Agreement  entered into by and between ARTISTdirect, Inc. and the Senior Financing  investors dated April 7, 2006 (incorporated by reference to current report on  Form 8-K filed April 10, 2006).                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 14.1                |       | Code of Business Conduct and Ethics (incorporated by reference to  annual report on Form 10-K filed May 17, 2004).                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 16.1                |       | Letter from KPMG LLP regarding change in certifying accountants  (incorporated by reference to current report on Form 8-K filed February 12,  2004).                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 21.1                |       | Subsidiaries of ARTISTdirect, Inc. (incorporated by reference to  registration statement on form SB-2 filed November 10, 2005).                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 23.1                |       | Consent of Gumbiner Savett Inc., independent registered public  accounting firm, with respect to ARTISTdirect, Inc. and subsidiaries.                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 24.1                |       | Power of Attorney (incorporated by reference to annual report on Form  10-KSB filed April 13, 2006).                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 31.1                |       | Certifications of the Chief Executive Officer under Section 302 of  the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 31.2                |       | Certifications of the Chief Financial Officer under Section 302 of  the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 32.1                |       | Certifications of the Chief Executive Officer under Section 906 of  the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                               |
| 32.2                |       | Certifications of the Chief Financial Officer under Section 906 of  the Sarbanes-Oxley Act.                                                                                                                                                                                                                                        |

 

E-4

----